Question

Explain why a company's reported earnings may not necessarily be an objective measure of economic reality. Give examples of when this might occur.

Answer 1

"Generally accepted accounting principles” (GAAP) allow an accountant to select from various methods when computing earnings and other financial measures, which could lead to lower quality financial information depending on the accounting methods used. (The “quality” of financial information is measured by how well the numbers reflect economic reality.) Furthermore, company managers can “manage earnings” subjectively by timing business activities or the reporting of those activities.

Earnings management becomes fraud when companies intentionally provide materially misstated information. W.R. Grace and Co. officials, for example, learned this the hard way. The company was charged with stashing earnings in reserve accounts in good years and then tapping them in later years to mask actual slowing earnings.1 (Without admitting to or denying the charges, Grace later signed a cease-and-desist order and promised $1 million to support educational programs that enhance public awareness of financial reporting and GAAP.)