Is earnings management good or bad? Who (or which part of corporate governance mechanisms) is responsible to constrain earnings management? To what extent can the auditor constrain earnings management? Propose some methods for the auditors to detect and constrain earnings management. Does market react to firm's earnings management behavior?
In order to discuss earnings management and what its affects are on business and whether or not it's a good thing, one must first understand what earnings management really is. Earnings management is often referred to as creative accounting or income smoothing. By definition, earnings management is "strategies used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target" (Investopedia.com). One of the main reasons that managers or companies manage their earnings is to meet a pre-specified target, which is often set by an analyst. Companies find it important to make their numbers because their earnings are the companies' profit which analysts use to determine the attractiveness of that specific company's stock. If analysts don't like the earnings produced by the company, they find the stock to be unattractive which will affect the share price and low share price doesn't make the company or management look good.
There is good earnings management and bad earnings management. Earnings management is bad when it becomes abusive, because at that point, it's illegal according to the Securities and Exchange Commission (SEC). According to the SEC, abusive earnings management is "a material and intentional misrepresentation of results" (Investopedia.com). When the SEC sees that a company was involved in abusive earnings management, they usually issue fines but investors have already received the false numbers and made their decisions based on those numbers and there is nothing they can do to recover potential losses. Improper earnings management, or abusive earnings management, just does not happen on its own. Improper earnings management is seen as bad and unproductive. Most improper earnings management can be blamed on corporate management along with analysts and investors who have set high expectations for the company. Bad, or improper, earnings management is when someone actually intervenes with the financial reporting to hide the real operating performance of the company by creating artificial accounting entries or stretching estimates beyond a point of reasonableness. Disguising real operating trends with artificial and undisclosed accounting offsets is what makes up bad earnings management. Companies who participate in bad earnings management can often be found having hidden reserves, improper revenue recognition techniques and their accounting departments probably made either overly aggressive or overly conservative accounting judgments. Actions such as these are often illegal and constitute fraud and, at best, are considered bad business practices and will ruin the reputation of the company. Lastly, actions such as these are unproductive and create no real long-term value for the company, which should be the company's ultimate goal. Earnings management isn't always bad. There is also the other end of the spectrum, where good earnings management practices are found. Good earnings management techniques include "reasonable and proper practices that are part of operating a well-managed business and delivering value to shareholders." Many companies participate in good earnings management, also known as operational earnings management, in their day-to-day activities. Some examples of good earnings management are setting reasonable budget targets, monitoring results and market conditions, reacting to all the unexpected threats and opportunities that arise and reliably delivering on commitments. A company has to participate in some sort of earnings management, and more than likely, it's the good kind. A company...
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