Earning Management

&
Accounting Quality

Earnings management is defined as the way of making

accounting decision by the management for the purpose of
achieving stable & predictable earnings. It helps them make
their book of accounts look attractive. Eg: A company may
overstate revenue which it has actually not received or it may
understate its expenses. Also the vice-versa is done for the
purpose of not showing exceptionally great performance. The
market prefers a stable earning company and thus thats
what even the management try for by manipulating the
accounts by finding loopholes which helps them maintain it
within the legal frameworks as well. The accounting quality of

such a company is under suspicion always. They are also

highlighted in public and sometimes lead to even the death
of the company. Eg: Enron & Sathyam. Thus this means that
companies should not over exploit such a loop hole and at
some point it might back fire them and suffer the faith like
that of the above companies.
An analyst needs to be concerned about the accounting
quality because the analyst may miscalculate the actual net
worthiness of the company. If the accounting quality is not
good in a company there remains a risk of even bankruptcy in
some cases and with that keeping in mind, an analyst needs
to show that in his report and access the actual risk to return
ratio. An analyst needs to use various methods & techniques
along with his own complete understanding of financial
statement to evaluate any earnings management cases in
the company and reflect the same in its report. Thus a
prudent analyst is one who not only questions the accounting
quality but also is smart enough to detect any misdoing or
earnings management done by the company.
There are various techniques to carry out earnings
management such as the big bath, cookie jar reserves,
operating activities, materiality, big bet on the future,
flushing the investment portfolio, throw out a problem child,
amortization, depreciation, depletion, sales/leaseback and
asset exchange techniques, shrink the ship, etc. Management
use such techniques commonly and these techniques make
the accounting of firms questionable but not illegal. There are
various other techniques as well which management keeps
on finding so that they can make earnings management as
much untraceable as possible.

Earnings Management can be detected using methods such

as the cross-sectional abnormal accurals model or large
accruals and weak governance structure, using discontinuity
evidence, using real activities manipulation model, through
ANN model (Artificial Neural Networks). Apart from this a
complete indepth analysis and knowledge is also required to
detect earnings management. Without complete knowledge
about the accounting methods, we cannot detect earnings
management. All these methods are derived from accounting
analysis.
One of the examples from Myers is that of depreciation.
Myers had used the technique as stated above, Amortization,
depreciation & depletion technique. Here depreciation was
the main thing. Myers had manipulated its depreciation so
that in can show a stable earnings over the period and not a
very high volatility.
In the Costco case study, Sams club had also done earnings
management but they used a different technique. What they
did was show better earnings by lowering their labour cost,
whereas that was not the actual case. Such methods are used
quiet often.
Thus earnings management has become a huge part of even
big companies, infact mainly big companies. Huge amount of
expenses or revenue are either understated or overstated
just to bring about a stable income statement as investors &
market love non-volatile income statement of companies.