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Contents:

1. Introduction.2 2. Earnings Management has been described by a number of phrases...3 3. Earnings Management affects the firm investment decisions.5 4. Earnings Management to avoid losses....7 5. Ethics and Earnings Management...9 6. Earnings Management to smooth income.11 7. Earnings Management to meet analyst forecasts..13 8. Conclusion.15 9. Reference...16

Introduction:
Earnings, sometimes also referred as the bottom line or net income, are one of the most important things in financial statements. They show the engagement of the company in value-added activities. This helps the direct resource allocation in capital markets. Also, earnings sometimes show the value of a company, for example, a rise in the earnings of the company will show an increase in the value of the company, while a decrease will indicate a fall in the company value. Through this importance of earnings, there is no surprise of the interest of company management in the way earnings is reported. Hence, each and every executive must understand the implications of their accounting choices so as to make the most suitable decision for the company. In other words, they must learn to manage their earnings. Earnings management can be described as the manipulation of the financial earnings of a company directly or indirectly through accounting methods. It is the use of financial techniques to produce financial reports that may show an overly positive image of the activities of the business and its financial position. Earnings management takes into advantage of how accounting rules can be used in their favors. Earnings management is more likely to take place when a business company consistently is not capable to meet the investor expectations or in periods of volatile earnings. Earnings management is frequently considered as materiality deceptive and thus a deceitful activity. Even though the changes may tag on all of

the accounting standards and laws, they may go against what the standards and laws were initially trying to establish. For instance, a change from LIFO to FIFO in inventory management may aid a companys financial ratios but may not indicate the true value of its inventory. Company use Earnings Management to smooth out variations in earnings and/or to meet stock analysts predictions. Large fluctuations in income and expenses may be a normal part of a companys activities, but the changes may alarm investors who have a preference for stability and growth, alluring managers to take benefit of accounting gimmicks. Also, a companys stock will often increase or fall after an earnings declaration, depending on whether it meets, exceeds or falls short of expectations. Managers can feel the pressure to maneuver the companys accounting practices and therefore its financial reports. Hence, earnings Management takes place when managers use judgements in financial reporting and in structuring dealings to modify financial reports to either deceive some stakeholders about the underlying economic performance of the company, or to manipulate contractual outcomes that depend on reported accounting numbers.

Earnings Management has been described by a number of phrases:


Income smoothing Accounting hocus-pocus Financial Statements management The numbers game Aggressive accounting Reengineering the Income Statement Juggling the books Creative accounting Financial Statement manipulation Accounting magic Borrowing income from future Banking income for future Financial shenanigans Window dressing Accounting alchemy

There is no standard, universally accepted definition for any of these terms. People use them in different degrees of appreciation to cover a wide variety of activities, many perfectly legal. This tends to blurs the distinction between the entirely legal earnings management and illegally cooking the books.1

Earnings

Management

affect

the

firms

investment decisions:
Investment decisions depend on expectations of the profits of the investment, which in turn are based on expectations of upcoming growth and product demand. Expectations of future growth depend on information that consists of revenues and earnings. In addition to merely hiding the true performance during the period, misstated financial numbers can hide underlying trends in revenue and earnings growth. Thus, overstatements of revenues and earnings are probable to disfigure expectations of growth by those unaware of the misstatement.

One might assume that if management decides to paint a better view for investors in the results they report externally, then they would not allow this to have an impact on internal investment decisions. However, it is likely that

investment decision makers in the firm accept as true the misreported growth trend because they are either over-confident or uninformed of the misstatement and invest accordingly. On the other hand, investment decision makers might recognize the actual state of the firm but choose to over-invest in a high-risk way to turn around performance.

In spite of of the motive for the over-investment, truthful reporting might have disallowed it. Several parties are normally implicated in investment decisions, consisting of managers who make the decision to invest, boards who appraise the capital budget, and external suppliers of finds. If financial data are reported

truthfully, then other parties could step in to restrain the investment. As a result, firms spend more than they otherwise would have, and tries to meet capital market expectations or meet bonus objectives, that could for example affect investors, employees, customers, and a large set of related parties.

Earnings Management to avoid losses:


In most cases, firms with negative returns in the period face a higher pressure to apply Earnings Management, and that their final aim is to conceal from credit markets a signal (loss) that could negatively influence their cost of debt.

The transaction costs theory states that the costs of information treatment may direct some stakeholders to find out the terms of the transactions with the firm. A loss (earnings fall) may thus express a hint to outsiders assessing the company, in particular credit raters and stock analysts, affecting the company credit ratings and their cost of debt in a negative way. However, such a sign might be weighed in a different way by outsiders, depending on the firms previous signals.

For example consider a firm with negative returns and pre-managed earnings a little below zero; it is probable that this company had positive earnings in the previous years, so a indication is being sent to credit markets. Managers may evade the cost of a rating change if they manipulate earnings upward. They have a high reason to do so.

Now take into consideration a firm with positive returns and pre-managed earnings a little below zero. Optimistically, this suggests that the firms pasts earnings were also negative. The indication was sent out the pasts year and the cost incurred. As it is improbable that credit markets use zero earnings as a signal on the up side the management is not significant to the cost. Consequently, less Earnings Management will be anticipated for this firm. Hence, companies might

face an asymmetric encouragement to influence, depending on the sign of their market returns and on which they use to take on the earnings target from above or from below , and a larger incentive is expected to be converted into greater Earnings Management. This seems to emphasize on the significance of the cost of debt as firms final incentive to undertake earnings management to keep away from losses. Given that the sensitivity of a company to this cost depends on its contact to credit markets, there is expectation for such an incentive to be more significant for businesses with higher needs of debt.

Ethics and Earnings Management:


The aim of financial statements is to deliver data about the financial position, performance and modifications in financial position of a company that is helpful to numerous users in making economic decisions. There are several users of financial statements. These groups consist of employees, investors, suppliers, lenders, clients, governments and the last but not least the general public. All these users are important, however main concern is usually given to investors and their information needs as they provide risk capital to companies. Hence, it is managements responsibility to present timely and accurate data to all these groups of users about the companys financial standing. Internal management reporting regularly needs the manager to implement judgment. This judgment usually relates to issues involving cut off of either revenue or expenditure. The main motivator for earnings management is greed2 by Bitner. Arnott even emphasizes that if investors cannot trust the numbers, the investment world may well price equities to offer not merely a risk premium but also a credibility premium3. Merchant and Rockness stresses earnings management and manipulation as the greatest threats to ethics in accounting4.

There are 2 types of earnings management: operating earnings management and accounting earnings management. Operating earnings management deals with changing operating decisions to influence cash flows and net income for a period such as facilitating credit terms to raise up sales. Accounting earnings management deals with the use of flexibility in accounting standards to modify earnings numbers.

Earnings Management can be considered as an unethical behavior in contrast with accounting smartness as while modifying accounting numbers, management are also affecting directly or indirectly other users of financial information such as employees, investors, suppliers, lenders, clients, governments as well as the general public.

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Earnings Management to smooth income:


Healy and Wahlen: Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting practices.5

Accounting information have no significance without being compared to some benchmark. Companies thus have incentives to manipulate earnings to overcome such benchmarks as zero earnings, expected variations in earnings between parallel periods, and analysts predictions. Evidence demonstrate that there are high pressure to keep away from reporting losses. There are psychological explanations to this, such as the idea that investors would like to see positive earnings.

An earnings management strategy that has resisted the test of time is smoothing. Income smoothing has been there for decades, and there are in general two thought as to what encourages managers to smooth their earnings. Firstly, smoothing presents an arguably efficient way for managers to disclose private accounting results. Secondly, smoothing is a form of garbling, that is, smoothing is an method used by managers in an effort to fool analysts and others and to enhance managerial compensation. Hence it can be assumed that only firms with good prospects elect to smooth. Basically, the first thought holds that income smoothing may help in the disclosure of private information in much the same way that dividend smoothing can occasion information revelation.

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The second thought is the fact that garbling is considered as a form of smoothing abuse. For example, the Federal Home Loan Mortgage Corporation was found by the government to have illicitly altered the volatility mark on its put swaptions in order to achieve a smoother earnings growth profile6.

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Earnings Management to meet analysts forecasts:


There are many capital markets and managerial incentives for firms to meet or beat earnings expectations. Firstly, there is a market premium to exceed the earnings predictions. Firms that meet or beat earnings forecasts receive a market premium and an additional returns premium for specific earnings surprise, and firms that beat forecasts have an added returns premium over the firms that do not meet forecasts. This shows that the stock market rewards companies that beat earnings expectations, and undoubtedly provides companies with the added motivation to not just meet, but to exceed the expectations.

Secondly, managers would want to overcome earnings predictions to increase the present value of their stock options. When reported income is between the minimum reported and the maximum reported income to receive a specific bonus, managers might want to increase the reported earnings to maximize their compensation. In a similar way, beating earnings expectations will lead to more significant stock prices as compared to just meeting the predictions, and managers bonuses are normally related to stock price. Moreover, given that the executives decision level is shorter than that of companies, this enables risk-averse managers the motivation to exceed earnings expectations to boost stock prices in order to enlarge the present value of their executive bonus.

Thirdly, managers of companies prior to selling stocks on their own accounts have an incentive to direct financial analysts expectations downwards

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before earnings declaration, and later beat these under-valued expectations at earnings announcement in favour to obtain the most significant share price during stock sale on their personal accounts. Adding to that, market rewards firms for the magnitude above which expectations are exceeded, hence managers of companies have the encouragement to overcome the expectations to obtain the most significant share price after earnings publication.

Last but not the least, firms may obtain additional market bonus from having a track record of regularly exceeding earnings expectations. As documented by Kasznik and McNichols, firms that consistently meet market expectations command a higher market premium over and above their market fundamentals7.

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Conclusion:
It can thus be understood that earnings management is a strategy used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target. It has many effects such as implications on firms investment decisions, to avoid losses, and on ethical issues, only to name a few. Although there are many different implications and methods used by managers for earnings management, income smoothing is one of its most important and complex, and it is also the driving force behind managing earnings to meet a pre-specified target. However, Abusive earnings management is considered by the Securities and Exchange Commission (SEC) to be a material and intentional misrepresentation of results and for any excessive use of income smoothing, the SEC may issue fines.

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Reference:
1. There is no standard, universally accepted definition for any of these terms. People use them in different degrees of appreciation to cover a wide variety of activities, many perfectly legal. This tends to blurs the distinction between the entirely legal earnings management and illegally cooking the books Article Name: What is Earnings Management,

http://www.swlearning.com/pdfs/chapter/0324223250_1.PDF 2. The main motivator for earnings management is greed by Bitner http://arno.unimaas.nl/show.cgi?fid=19848, Article Name: Ethics and Management, pg 4 3. if investors cannot trust the numbers, the investment world may well price equities to offer not merely a risk premium but also a credibility premium by Arnott http://arno.unimaas.nl/show.cgi?fid=19848, Article name: Ethics and Management, pg 4 4. earnings management and manipulation as the greatest threats to ethics in accounting by Merchant and Rockness,

http://arno.unimaas.nl/show.cgi?fid=19848, Article Name: Ethics and Management, pg 4 5. Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported

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accounting

practices.

By

Healy

and

Wahlen,

http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol3No1/Article_4. pdf, Article Name: Income Smoothing, real Earnings Management and longrun stock returns. 6. For example, the Federal Home Loan Mortgage Corporation was found by the government to have illicitly altered the volatility mark on its put swaptions in order to achieve a smoother earnings growth profile http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol3No1/Article_4. pdf, Article Name: Income Smoothing, real Earnings Management and long-run stock returns, Page 56. 7. firms that consistently meet market expectations command a higher market premium over and above their market fundamentals by Kasznik and McNichols http://www.kellogg.northwestern.edu/accounting/papers/jimmy%20lee.pdf, Article Name: Earnings Management to just meet analysts forecasts, page 4

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