Question

Please briefly discuss what is “earnings management” and possible ways to manage earnings.

Answer 1

Discussion: This the way of showing inflated incomes, sales, or total assets in a firm’s financial statements. There are so many accounting techniques which make financial reports better but it misleads stakeholders of the firm. Earning management is not illegal but unethical because the interests of stakeholders are involved.

Ways:

(1) Inventory valuation: A firm has policy of maintaining inventory under last-in-first-out (LIFO) method – in this method material receives last is issued first for production. After following this system for so many years, it has suddenly changed the policy to first-in-first-out (FIFO) – material receives first should be issued first for production; in the world of rising price, the firm still able to charge material at lower earlier price; it gives the firm additional amount of profit.

(2) Capitalization cost: If a firm has a policy of charging expenses for very small amount only and the rest of the amount as capital cost, then income statement must have smaller amount of expenses which tends to increase higher net income. Suppose the company may have policy of charging capital cost for anything above $500; therefore, expenses only will be up to $500 (which is very low).