Contrary to popular belief, earnings management is not the same as managing the hidden business segments of a company. Instead, earnings management refers to practices the companies follow to influence their earnings reported in financial statements. In simple terms, companies use earnings management to better portray a company’s financials, payments, and positions. Also, note that earnings management is part of the accounting process, not financial management.
Why Do Companies Use Earnings Management?
Again, earnings management is a broad term for various strategies used by companies to reduce inconsistencies in their financial statements. In most cases, earnings discrepancies and inconsistencies are common in businesses. However, these factors may influence future investments and a company’s growth, which is where earnings management comes into the picture. Investors are usually on the lookout for stable options for their investments. Companies try to show seamless business operations and financials to gain the trust of their investors. Hence, the need for earnings management occurs.
What are the Different Perspectives on Earnings Management?
There are different approaches used by companies globally for earnings management. Here are some of the commonly followed practices:
Earnings Management Through Accrual Accounting
Accrual accounting records business transactions when profit or loss occurs, unlike traditional accounting, where you record transactions when cash is received or paid. With accrual accounting, a clearer picture of a company’s financial standing is visible, allowing management to decide how to mold it. While most prominent organizations worldwide have practices to ensure their financial data is not corrupted by bias, the administration can still quickly develop the data as per their liking. Since transactions are not recorded as sales and purchases but rather as profit and loss, there is always a gap between distorting information.
Expense Management
Another strategy organizations use to manage their profits is limiting their expenses. By its sound, expense management, in contrast to the revenues, is easy, but it can create long-term problems for an organization. Since such companies are usually focused on reducing their expenses to boost their earnings, the company’s growth is affected. The management is focused purely on cutting costs instead of growing profit, impeding a company’s growth. For example, limiting a company’s growth to its employees might lose loyalty. Since the growth prospect was limited, it will invest in human resources that will move to competitors’ organizations.
Moderating Accounting Principles
In most countries worldwide, there are different accounting rules for similar transactions.
For instance, you can record land acquisition as a fixed asset or an expense. This flexibility allows management to adjust accounting principles as per their liking to reduce their costs on paper and show an inflated profit. In most large-scale organizations, these principles are pre-decided, and internal and external audit teams ensure no such alteration occurs. However, it is up to the management of a company to record certain transactions, giving them complete freedom over their choices.
Is Earnings Management Legal?
Generally, there is nothing illegal with earnings management. A company has the right to decide how to portray its earnings. Whether it is a small business or a large one, they can use different accounting methods and strategies to highlight the positive side of their company’s earnings. That is perfectly legal and ethical if they are not omitting information but just rephrasing it. However, with large-scale organizations that are obliged to third-party auditing, earnings management becomes a problem. Since a third-party audit might raise eyebrows on how a company boosts its profit, it tends to get the businesses in trouble. As long as the management uses earnings management within the legal parameters, there shouldn’t be a problem.
About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.
