Earnings Management Definition
What is Revenue Management?
Earnings management is the use of accounting techniques to produce financial state that present an overly positive view of a company’s business activities and financial condition. Many accounting rules and principles require the management of a business to exercise judgment in following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that bloat or “smooth” earnings.
Key points to remember
- In accounting, earnings management is a method of using accounting techniques to improve the appearance of a company’s financial condition.
- Companies use earnings management to present the appearance of consistent earnings and to smooth fluctuations in earnings.
- One of the most popular ways to manipulate financial records is to use an accounting policy that generates higher short-term profits.
Understanding Revenue Management
Revenue refers to income from a business net revenue Where profit over a certain period of time, such as a quarter or a fiscal year. Companies use earnings management to smooth fluctuations in earnings and present more consistent earnings each month, quarter, or year.
Large fluctuations in income and expenses can be a normal part of a company’s operations, but change can alarm investors who prefer to see stability and growth. A company’s stock price often goes up or down after a announcement of resultswhether earnings are in line with or below analysts’ expectations.
Management may feel pressure to manage earnings by manipulating the company’s accounting practices to meet financial expectations and keep the company’s stock price high. Many executives receive bonuses based on earnings performance, and others may be eligible for stock options when the stock price increases.
Many forms of earnings manipulation end up being discovered either by a accountant (CPA) company performing an audit or through Security and Exchange Commission (DRY).
Important
The Securities and Exchange Commission (SEC) requires financial statements of publicly traded companies to be certified by the chief executive officer (CEO) and chief financial officer (CFO) and has sued executives who engaged in mismanagement benefits.
Revenue Management Examples
One method of manipulation when managing profits is to adopt an accounting policy that generates higher profits in the short term.
For example, suppose a furniture retailer uses the last in, first out (LIFO) to account for the cost of inventory items sold. Under LIFO, the most recent units purchased are considered to be sold first. Since inventory costs generally increase over time, newer units are more expensive, creating a higher cost to sell and lower profit.
If the retailer switches to first in, first out (FIFO) method of accounting for inventory costs, the company considers that the oldest and least expensive units should be sold first. FIFO creates a lower value cost of goods sold expenses and, therefore, higher profit, so the company can show a higher net profit in the current period.
Significant changes in accounting policies must be disclosed in the company’s financial statements.
Another form of profit management is changing company policy to increase costs. In capital letters rather than being spent immediately. Capitalize costs as assets delays expense recognition and increases short-term profits.
Suppose, for example, that company policy states that each item purchased for less than $5,000 is immediately expensed and that costs over $5,000 can be capitalized as an asset. If the company changes policy and begins to capitalize all items over $1,000, expenses decrease in the short term and profits increase.
Special Considerations
A change in accounting policy must be explained to readers of the financial statements, and this information is generally disclosed in a footnote to financial statements. The disclosure is required because of the accounting principle of consistency.
Financial statements are consistent if the company uses the same accounting methods each year. This is important because it allows the user of financial statements to easily identify variations when looking at historical trends in the business.
The fact that a change in policy must be explained and all of a company’s accounts are laid bare in its financial statements means that attentive readers are likely to learn about the earnings management strategy. The problem is that not everyone has the time to go through the reports in their entirety or the knowledge to understand everything that is written.
Is revenue management illegal?
Changing accounting techniques is not illegal in itself. However, if the SEC believes a company is creatively misleading investors and intentionally misrepresenting its results, then it can take action and impose fines.
Why do companies engage in earnings management?
There are many reasons business leaders engage in earnings management. These include higher bonuses, avoiding falling below closely watched analyst forecasts, tax savings, increasing company value and creating sentiment of stability.
What are the types of revenue management?
Several techniques are used to manage winnings. Examples include lowering capitalization limits, moving from the last-in, first-out method of inventory valuation to the first-in, first-out method, reducing non-compulsory expenses for short periods, or attribution of regular business expenses to a one-time, non-recurring event.
The essential
Investors should always do their homework before investing in a stock. This means analyzing the company’s financial report to get a true picture of how it is doing. Don’t just focus on the headlines the company wants you to read or trust analysts or someone else to do the work on your behalf. Go through everything yourself and do it with a skeptical eye.