Question

In: Accounting

a. Define Earnings Management and how it relates to earnings quality. (5 marks) b. Discuss the...

a. Define Earnings Management and how it relates to earnings quality.

b. Discuss the three (3) types of incentives for earnings management.

c. By use of examples, describe how earnings management can be perpetrated.

Solutions

Expert Solution

(A)

Company is incorporated to earn money. Company wants to earn money at the end the year to show their financial statement look good. Finanial statement is the only thing based on which creditors & investors make their decisions. And at that time concept of Earning Management comes into play.

Earning management is the creative use of accounting techniques to make financial statements look better. Earning management related to quality earning. Quality earning means dismissing any anomalies tricks or one time events that may skew the real bottom line numbers on performance. once these are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.

Earning management relates to Quality earning by way that company should adopt the accounting treatment that shows the coorect treatment & do not adopt any mal-practice or window dressing. If company follows the earning mangement ethically then automatically concept of Quality earning will be acheived.

(B)

(i) Cookie Jar-reserve - It means aggressive accounting because this will result into big reserve in the profit year & let them down when the company faces a loss in any year or bad debts.

(ii) the Big Bath - During a loss years of the company due to external fctors, profit will be affected. Company will show the position worse then actual by writing off bad debts, overvaluation of assets etc to evade tax.

(iii) Expense & revenue Recognition - It is also known as "Income Smoothing". It is a fraudlent accounting. in this method company recognizes expenses before it has incurred. Another trick is to infated the sales as compared to actual figures or they don’t recognize a bad debt in the current year and shifts it to next year as it reduces this year’s profit.

(C) Example

Let’s consider if a company is having $20,000 as bad debts and it is not recoverable, so it has to be written off during this financial year but the financial manager says to show $10,000 as debtors and write off the balance in next financial year as this year profit is low. This comes under the type of expense and revenue recognition as expense in not recognized correctly to inflate profit.


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