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.

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 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).

Key Takeaways

  • Earnings management refers to a company's deliberate use of accounting techniques to make its financial reports look better.
  • Earnings management can occur when a company feels pressured to manipulate earnings in order to match a pre-determined target.
  • Excessive earnings management can lead a company to misrepresent facts on its financial statements, which can cause the Securities and Exchange Commission (SEC) to impose fines and other punishments.
  • Different types of earnings management include moving earnings from one reporting period to another in order to paint a better picture or manipulating the balance sheet to hide liabilities and inflate earnings.

Earnings Management and the SEC

Abusive earnings management is deemed by the Securities and Exchange Commission (SEC) to be "material and intentional misrepresentation of results." When income smoothing becomes excessive, the SEC may issue fines.

Unfortunately, it can be challenging for the individual investor to discover abuses on their own. 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. However, understanding the different types of earnings management can make it easier for investors to detect when a company is using these techniques to manipulate its results.

Types of Earnings Management

One type of earnings management is when a company adopts an accounting procedure that makes it appear the company is generating higher earnings over a short-term time period. The widely publicized collapse and bankruptcy of energy giant Enron Corporation in Dec. 2001 is an example of this. The company used fake holdings and off-the-books accounting principles to manipulate its balance sheet. The purpose of this was to hide the company's liabilities and inflate earnings.

Another form of earnings management relates to how a company capitalizes its costs. Rather than immediately recognizing costs as expenses on its balance sheet, a company will capitalize costs as assets over a longer period of time. By delaying the recording of expenses, the company can inflate its profits, at least for the short-term.

Detecting Earnings Management

Financial statement manipulation comes in a variety of forms. Investors who know what to look for can sometimes detect earnings management by performing a financial statement analysis of a company's quarterly and annual reports.

Here are some signs a company might be using earnings management techniques to distort its financial statement figures:

  • Claiming revenue growth that doesn't come with a corresponding growth in cash flows.
  • Reporting increased earnings that only occur during the fiscal year's final quarter.
  • Expanding fixed assets beyond what is considered normal for the company and/or industry.
  • Exaggerating an asset's net worth by neglecting to use the correct depreciation schedule.

Investors can sometimes glean important insights into changes in a company's accounting and reporting practices by reviewing the footnotes of the financial statements, which is where a company must disclose such changes.

The Bottom Line

Given that earnings management can skew a company's true financial picture, it's important that investors perform as much due diligence as possible before making an investment decision. 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."