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 individuals can do to suss out abuses. Accounting laws for large corporations are extremely complex, which makes it very difficult for retail investors to pick up on accounting scandals before they happen.

Although the different methods used by managers to smooth earnings can be very 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 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 "Earnings: Quality Means Everything" and "The Tricks and Treats of Pro Forma Earnings.")

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