Question

What is the difference between real earnings management technique and accrual earnings management technique?

Answer 1

Managers may use several EM techniques to manipulate earnings figures to report that the company is performing to the required standard. Real activity manipulation (Real Earnings Management) and accrual-based EM are discussed below.

Real Earnings Management (RM) is used to adjust the reported earnings by determining a different timing or reconstructing an investment or transaction. For example, if a firm’s goods are sold at a reduced price, the sales volume tends to increase in the short-run, resulting in higher revenues. The excess production also leads to a higher value of closing inventory, which means that the cost of sales decreases and the annual profit increases.

RM can also apply to operating expenses. Firms can set up an employee stock option scheme to motivate workers. This involves repurchasing the stock where the funds are taken from the research and development or capital expenditure accounts to reduce operating costs.

Accrual-based EM does not reconstruct the transaction, instead, it can only allocate the incurred cost in the fixed period. For example, the methods of depreciation usually involve the straight-line and reducing balance methods. Accountants may choose different methods to incur depreciation expenses early or postpone them to the future; however, the total amount to be depreciated will not vary during the fixed period. Also, the company may decide to defer taxation and interest payments to increase their profit for the year.

The uncertainty of future profits and cash flows can lead to the use of cookie jar accounting. It is reasonable to have varying estimates of future required provisions. By using the worst estimate, the company will incur the highest possible expenditure in this accounting year. For example, if the company forecasts different values of bad debt, it will provide a provision for the worst estimate. This may generate a reserve of funds, which can be used when earnings are not expected to meet expectations.

Changing operating accruals will have an impact on the earnings figure, the receivables turnover and payables turnover. However, after a certain period, the effect is bound to reverse since the transaction cannot be changed. Managers can use the accruals from non-current assets. For example, in 2014, Tesco overestimated profits by £263 million. They managed this through the accelerated recognition of earnings and the postponing of accrued costs.

Usually, there is a trade-off between RM and accrual-based EM methods. Managers tend to alter the level of accrual-based EM in response to the real activities manipulation realized.