What is earnings management?

By Investopedia Staff AAA
A:

Before diving into what earnings management is, it is important to have a solid understanding of what we mean when we refer to earnings. Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. Remember that a company's ability to generate profit in the future plays a very important role in determining a stock's price. (For more on this concept, check out our Stock Basics tutorial.)

That said, earnings management is a strategy used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target. This practice is carried out for the purpose of income smoothing. Thus, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts (known colloquially as "cookie jar" accounts).

Abusive earnings management is deemed by the Securities & Exchange Commission to be "a material and intentional misrepresentation of results". When income smoothing becomes excessive, the SEC may issue fines. Unfortunately, there's not much individual investors can do. Accounting laws for large corporations are extremely complex, which makes it very difficult for regular investors to pick up on accounting scandals before they happen.

Although the different methods used by managers to smooth earnings can be very complex and confusing, the important thing to remember is that the driving force behind managing earnings is to meet a pre-specified target (often an analyst's consensus on earnings). As the great investor Warren Buffett once said, "Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers".

(For more on earnings management, check out the articles Earnings: Quality Means Everything and The Tricks and Treats of Pro Forma Earnings.)

RELATED FAQS

  1. What are the differences between installment sales and credit sales?

    Determine the differences between credit sales and installment sales, which businesses often offer their customers for deferred ...
  2. When do you use installment sales method vs. the cost recovery method?

    Take a deeper look at the installment sales method and the cost recovery method of recognizing business sales revenue and ...
  3. What are the differences between operating expenses and SG&A?

    Learn what businesses mean when they list operating expenses or SG&A as line items on an income statement; understand how ...
  4. What are the differences between operating expenses and overhead expenses?

    Learn how operating expenses and overhead expenses affect profit margins; businesses are unique and different costs may fall ...
RELATED TERMS
  1. Inherent Risk

    The risk posed by an error or omission in a financial statement ...
  2. Financial Action Task Force (FATF)

    An intergovernmental organization that designs and promotes policies ...
  3. patent attorney

    A lawyer with expertise in intellectual property law as it pertains ...
  4. Patent Pending

    Wording inventors use to let the public know they've filed a ...
  5. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  6. Provisional Patent Application

    A short-term means of protecting an invention that requires less ...
comments powered by Disqus
Related Articles
  1. How To Invest In The Nikkei 225
    Mutual Funds & ETFs

    How To Invest In The Nikkei 225

  2. Pick the Right Brokerage Account for ...
    Options & Futures

    Pick the Right Brokerage Account for ...

  3. Warren Buffett's Probability Analysis ...
    Investing Basics

    Warren Buffett's Probability Analysis ...

  4. The Top Technical Indicators For Options ...
    Options & Futures

    The Top Technical Indicators For Options ...

  5. Understanding The Bond Behemoth That ...
    Mutual Funds & ETFs

    Understanding The Bond Behemoth That ...

Trading Center