EarningsManagement

WhendoesJugglingtheNumbersBecomeFraud?January/February2000
ByByStephenD.Makar,Ph.D.,CPAPervaizAlam,Ph.D.,CPAandMichaelA.Pearson,D.B.A.,CFE,CPA,CMA

Haveyouheardtheoneaboutthecompanythatneededtohireachiefcorporateaccountant?Inthelast
interviewsessioneachfinalistwasgivenfinancialinformationandasked,Whatarethenetearnings?All
applicantsbutonedutifullycomputedthenetearningsbutnoneofthemgotthejob.Thecandidatewholanded
thepositionansweredthequestionbyreplying,Whatdoyouwantyournetearningstobe?
Thestory,whetherfactualorfictitious,doesdemonstratehowacompanysreportedearningsmaynot
necessarilybeanobjectivemeasureofeconomicreality.Foronething,generallyacceptedaccounting
principles(GAAP)allowanaccountanttoselectfromvariousmethodswhencomputingearningsandother
financialmeasures,whichcouldleadtolowerqualityfinancialinformationdependingontheaccounting
methodsused.(Thequalityoffinancialinformationismeasuredbyhowwellthenumbersreflecteconomic
reality.)Furthermore,companymanagerscanmanageearningssubjectivelybytimingbusinessactivitiesor
thereportingofthoseactivities.
Earningsmanagementbecomesfraudwhencompaniesintentionallyprovidemateriallymisstatedinformation.
W.R.GraceandCo.officials,forexample,learnedthisthehardway.Thecompanywaschargedwithstashing
earningsinreserveaccountsingoodyearsandthentappingtheminlateryearstomaskactualslowing
earnings.1(Withoutadmittingtoordenyingthecharges,Gracelatersignedaceaseanddesistorderand
promised$1milliontosupporteducationalprogramsthatenhancepublicawarenessoffinancialreportingand
GAAP.)
McKessonHBOCInc.waschargedwiththeoppositeofGrace.Thecompanyallegedlybookedpremature
revenuesbyincludinginsalesfiguresasubstantiallistofcontractsthathadnotbeenfinalized.2TheSecurities
andExchangeCommission(SEC)andotheragenciesareinvestigatingmanymorecaseslikethesetwofor
earningsmanipulation.(McKessonHBOClaterfiredoracceptedtheresignationsofitschairmanandsixother
topexecutives,restatedpreviouslyreportedearnings,andinstitutednewinternalaccountingprocedures.)
ADefinitionofEarningsManagement
Companiesmanageearningswhentheyask,Howcanwebestreportdesiredresults?ratherthanHowcan
webestreporteconomicreality(theactualresults)?EarningsmanagementincludesselectingGAAPmethods
withconcernforappearanceratherthanreality.Italsoincludessubtletechniquessuchaschangingreported
earningsthroughperformancetiming.Forexample,amanagerseekingtoreduceexpensesinthecurrent
periodmightdeferscheduledroutineequipmentmaintenanceuntilthenextaccountingperiod.Theresultis
higherreportedearningsinthecurrentperiod,butthemaintenancedelay,ofcourse,maybedetrimentaltothe
companysfutureoperations.Also,acompanymayvarythetimingofperformancereporting.Recording
inventoryobsolescenceisrequiredunderGAAP,forexample,butchoosingwhentorecordobsolescenceis
fairlysubjective.Amanagermayknowsomepartofthecompanysinventoryhasbecomeobsolete,butif

earningsinthecurrentperiodarelowerthandesired,hemightdeferrecordingtheloss,orwritedown,untila
futureperiod.