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. When is earnings season?

    Earnings season is the period of time during which a large number of publicly traded companies release their quarterly earning ... Read Answer >>
  2. What is the difference between earnings and income?

    See how earnings and income are different and when they are used in relation to personal finance versus a business' financial ... Read Answer >>
  3. Can pro forma financial statements be more helpful to analysts and investors than ...

    Examine the controversy over GAAP reporting standards as compared to pro forma statements, and learn which are considered ... Read Answer >>
  4. How is revenue related to retained earnings?

    Learn what business revenue is and how it relates to retained earnings. See how accountants calculate these key figures and ... Read Answer >>
Related Articles
  1. Investing

    Everything Investors Need To Know About Earnings

    We go over the concepts behind the excitement over the most important figure in the stock market.
  2. Insights

    Earnings Forecasts: A Primer

    Learn how this key metric is calculated and how it is used to judge market performance.
  3. Investing

    Strategies For Quarterly Earnings Season

    Breeze through consensus estimates like the biggest Wall Street forecasters.
  4. Investing

    Surprising Earnings Results

    Consensus estimates can send stocks spiraling - but are they representing reality?
  5. Managing Wealth

    How to Use Earnings Season to Make Better Decisions

    Earnings season reflects the state of the stock market, but also demonstrates how the overall economy is performing.
  6. Small Business

    The Financial Characteristics Of A Successful Company

    There are many factors that contribute to a profitable business. Find out what they are here.
  7. Investing

    The Most Important Metrics For Earnings Season

    Knowing how to read an earnings report can help investors decide which stocks to buy.
  8. Investing

    Become Your Own Stock Analyst

    Learn how to do your own stock analysis and become a wiser investor.
RELATED TERMS
  1. Accounting Earnings

    The amount of money a company has earned during a given period, ...
  2. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. ...
  3. Forward Earnings

    A company's forecasted, or estimated, earnings made by analysts ...
  4. Cookie Jar Accounting

    A disingenuous accounting practice in which periods of good financial ...
  5. Earning Potential

    The possible upside of the earnings that could be generated for ...
  6. Managed Futures Account

    An account that is like a mutual fund, except that positions ...
Hot Definitions
  1. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  2. Whole Life Insurance Policy

    A life insurance contract with level premiums that has both an insurance and an investment component. The insurance component ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  4. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. ...
  5. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability of potential investments.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center