Question

In 200 words or more, explain what Earnings Management is in Accounting and how it affects a business.

Answer 1

Earnings management is the attempt by corporate officers to influence short-term reported income. It is believed that managers may attempt to manage earnings because they believe investors are influenced by reported earnings. The methods of earnings management include the use of production and investment decisions, and the strategic choice of accounting techniques (including the early adoption of new accounting standards). In most cases, earnings management techniques are designed to improve reported income effects; however, such is not always the case. An alternate explanation is the Big Bath theory which suggests that management may take the opportunity to report more bad news in periods when performance is low to increase future profits. Anargument has also been made that management may choose to take large write-offs inperiods when their performance is otherwise extremely positive.
Some methods that may be used by management to smooth earnings are: postponingend-of-the-year inventory replacement expenditures for merchandising companies,postponing the production of products for manufacturing companies, and the earlyadoption of new FASB accounting standards such as SFAS No. 109 when it has a positiveeffect on reported net income due to the recording of deferred tax benefits
Accounting for businesses requires judgment and estimates. Often managers estimate revenues and uncollectible accounts, which can sway the net income to be much higher than it should. The wider the range of reasonable estimates, the more management’s choice will influence bottom-line net income and comprehensive income. When management’s number-choice is made with an eye to its effect on net or comprehensive income, it is engaging in earnings management. Management can choose when to buy and, thereby, manage earnings, which involves the timeliness of the transactions.