Question

Q1.)

Recent events have shown that earnings management is a significant problem in the business world. Evidence suggests that many firms tend to manage their earnings to some extent via the accrual process.

Is earnings management always a bad thing or can it really help provide a better view of the company (Using some real-world examples)?

Q2.)

What are some advantages and disadvantages of earnings management? Please provided examples.

Answer 1

Q1)

We need to be clear what is meant by earnings management. In my view, earnings management is the attempt to smooth the path of earnings over time by using various accounting strategies to shift earnings from one quarter to another. This is not to be confused with attempts to inflate earnings by dubious accounting methods (think Enron, for example). The primary reason to engage in earnings management is to make the stream of earnings seem more predictable and less volatile. The belief is that the stock market rewards a steadily growing and predictable earnings stream rather than a volatile one. Whether this belief is true or not may be worthy of investigation but it is taken as gospel. Wall Street equity analysts build models to forecast earnings. Firms guide analysts subject these days to Fair Disclosure rules in the U.S. The market punishes negative earnings surprises, so the key is not to miss on the downside.

One could argue that the stock market engages in excessive short-termism by putting such focus on quarterly results and it is certainly a complaint I heard voiced in policy circles. The feeling is that companies spend too much time and effort on earnings management and not enough on the long-term business plan.

There is one form of earnings management that the regulators should encourage and that is loan loss reserves at banks. It is rational to put aside for a rainy day. Loan loss reserves should be added to when banks make loans that could go bad if the economy turns down in good economic times. Banks should be allowed to release these reserves in downturns. Sun Trust (a Florida Bank) tried this but run afoul of the regulators for earnings management! Instead, without such management, bank capital his highly cyclical with potentially destabilizing consequences.

Q2)

The positive role of earnings management is concerned, is help enterprise through a temporary financial crisis. When the enterprise is in operation difficulty, and needed investment funds, often using profits push measures before. At this time, enterprise in general is in a poor financial situation, net assets yield rate can't achieve match financing conditions; High property debt, potential creditors credit support is not willing to provide. If confirmed later ahead of enterprise profit, be like, the straight-line method with accelerated depreciation, reduce the proportion of the loss of bad, delayed provision for impairment of long-term investment, so, the current profits will be improved, so that the net assets yield to match demand. At the same time, these practices can raise the rate of shareholders' equity, enterprise more easily through the debt way to raise money. Such, can help enterprise have financial difficulties, causes the enterprise to have plenty of money to fund the production and business operation activities.

Two is to help enterprise to reduce the cost of contract. The contract view (EfficientContracting Perspective) scholars pointed out that surplus management can reduce the cost of contract. They think that the choice of accounting method with enterprise organization form and contracts the same form, can reduce enterprise the contract between the parties costs, promote the maximization of enterprise value.

Considering the contract is incomplete, need to give operators certain accounting selection and treatment of flexibility on, in order to cope with the enterprise environment changes and other unforeseen events. Especially in the peripheral environment changes affect the enterprise contract reference index, the enterprise management can through the proper surplus adjustments affect contract index, thus it can effectively avoid the costs or technical negotiation default cost, realize the maximization of enterprise value. Managers have certain of earnings management ability, to maintain effective contract is necessary. But, this kind of earnings management on managers must not excessive opportunism behavior, not sedulous damage related interest group the interests of the premise. That is, by earnings management, is benefit to the enterprise development.

Three is help enterprise long-term development. In production and management for the instability of the enterprise, the implementation of the profit smoothing method, can deliver to the outside a production and business operation stability of information, strengthen the confidence of investors for the enterprise, stable prices, and also help to shareholders to wealth maximization goal. Take profits back measures is increasing year by year, make enterprise performance out of "growth" trend is increasing year by year, to set up the business enterprise operating performance of the steady growth of the good image, in order to attract more investors. Enterprise if can seize the opportune time, adjust the production and business operation management, improve market share, turn "virtual growth" for "real growth", be helpful for setting up the enterprise image, the realization enterprise long-term development goals.

4 it is to achieve the goal of tax planning. Modest earnings management can help enterprise reasonable, tax avoidance and tax planning. It can not violate national tax policy, under the premise of not only reduce the tax burden on the enterprise, and at the same time and in conformity with the tax law contains the policy guidance. For enterprise, for example, it is a good choice.

The negative part of earnings management is concerned, although earnings management in the domestic and foreign enterprises are to be used extensively, but, when earnings management more than a reasonable degree, can make the accounting information lost fair sex, reliability and comparability, thus misleading information user, affect the market resources optimization allocation function, undermine social economic development. Excessive the disadvantages of earnings management mainly displays in the following respects.

1, reducing the financial statements the reliability of the information. When earnings management more than reasonable limit, it is easy to change for profit manipulation, making accounting information lose relevance and reliability. And the correlation and reliability is the two fundamental accounting information quality characteristics. Among them, the reliability is a foundation, left the reliability, accounting and lost vitality. Earnings information is the most important accounting information, it is investors, creditors and external information users to evaluate the character of the enterprise is significant. Excessive surplus management make statements of the earnings of information become Numbers game, seriously will reduce the quality of accounting information, the reliability of the information lost financial statements.

2, to enterprise's development has some of the risk. Earnings management to a certain extent though can maintain the interests of the business operators and even enterprise, but also put in bigger risk. In fact, many enterprise surplus management motivation did not give due consideration to the future development of the enterprise, and just as an expedient sight. The company through the earnings management current profit increase, will make the expected goals profits becomes more and more big. If no improving enterprise production and management activities, the next year if not reach the expected goal, in order to maintain enterprise image and company managers interests, and only more forcefully by earnings management, or even making illegal profits manipulation and accounting fraud, will eventually destroy the confidence of investors for the earnings quality, leading to a fall in the value of the enterprise market. The Shanghai securities news for investors a survey, and profit, earnings management in later turned back to will make investors disappointed. Performance of the company is not beautiful, will lead a stock value negative effects such as the downturn.

Three, the local interest to damage the interests of the whole. Due to the economic interests of the enterprise management and investors, creditors and the national interest in consistency, usually, earnings management to improve the management level of enterprises, but can't ignore management authorities in order to maintain their own economic interests and damage the investors, creditors and the country's economic interests of the facts. Excessive use of earnings management, because the local interest will damage the interests of the whole. At present, the U.S. subprime mortgage crisis, the emergence of China's financial market stability, looked up, and each enterprise by earnings management means too also have particular concern. If because every enterprise in order to its own interests, not controlled on earnings management, then, standing in the whole society's point of view, the consequences is unimaginable.

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