Accounting is one of the most important parts of a business. Accounting information help investors predict the cash flows of the company and help them estimate their risk in investing in them. Shareholders of a company have a right to demand information about the financial stability of the company and managers satisfy this requirement with accounting information and reports (Ronen and Yaari 7). Earnings management has been a very controversial topic among business enterprises. In the accounting world, earnings management is increasing becoming an area of interest to many people including government regulators, SEC and stakeholders. Earnings management is defined as the use of accounting techniques to produce financial reports that may paint an overly positive picture of a company’s financial position (“Earnings Management” 1). Ethics and integrity are key aspects of earnings management and people believe that professionals that use earnings management to manipulate their company’s financial standings are not being ethical nor do they have integrity. Much research has been done to understand what drives companies to use earnings management and the methods that are used. Even though companies believe that using earning management will help them shine in the eyes of their stockholders, using it may bring many negative consequences. Training our future accountants and teaching them how to make ethical decisions regarding earnings management is key and should be integrated into their education. This is very important because at the end, using earnings management affects the quality of earnings being reported and manipulates many groups of people.
As defined before, 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 numbers (Healy and Wahlen 6). Key to this definition is the judgment part because managers must make several crucial decisions using good judgment. Many times, though, managers become blindsided and do not use good judgment when creating their financial reports. First and foremost it is important to research and understand the reasons and incentives of why companies use earnings management. This is not a very easy task for researchers because to find whether companies are inappropriately using earnings management, they must first try to estimate the earnings before earnings management was used. One reason why managers use earnings management is because of investors and financial analysts (Healy and Wahlen 10). Researchers have found that companies usually overstate their earnings before equity offers, initial public offers, and stock-financed acquisitions (Healy and Wahlen 11). This is not surprising since companies want to portray to the public that they are in good financial standings so that they will invest in them. Companies also want to meet analysts’ forecasts so they manage their earnings to do so. Managers also have a strong stock market incentive to use earnings management.
Another reason why managers use earnings management is because of contracting motivations. To make a qualified and adequate contract, earnings of a company are key to designing these contracts. Companies have many contracts both with external agents and also internally within the company with employees. Lending contracts are made to make sure that managers do not take actions or make decisions that benefit the company’s stockholders at the expense of its creditors. Lenders favor that companies pay them the principal first before they pay out dividends to shareholders (Ronen and Yaari 11). The use of earning management causes misleading financial reporting which are then shown to debt investors and to investors’ representatives on the board of directors. Using earnings management...
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