In this video, learn how managers of companies often are motivated to manage reported earnings. The reasons vary, but include meeting internal targets, meeting external expectations, smoothing income across reporting periods, and window dressing for an IPO or a loan.
- Here's an old accounting joke. A business owner is hiring a new manager. She conducts an interview with each candidate by asking just one question. What's two plus two? Most of the candidates reply with the obvious answer, two plus two is four. But the final candidate was an accountant. The business owner asked the same question, what's two plus two? The accountant walked quietly to the door and locked it. Then the accountant tip toed to the windows to make sure they were securely closed. Finally, the accountant leaned in close to the business owner and whispered the following, two plus two what do you need it to be? That's the essence of earning management.
Massaging the numbers, making estimates carefully and strategically timing business events to make the report of net income number come in at some desired level. Managers of companies often are motivated to manage reported earnings. Sources of this motivation include pressure to, meet internal targets. Meet external expectations. Smooth income across reporting periods. And window dress for an IPO or a loan. I will briefly describe each of these four potential motivations for earnings management.
First, meeting internal targets. Anyone who has worked under a system of monthly or annual sales quotas know how important it is to meet internal targets. Company managers will often have internally set profit targets. And those targets will often be linked to compensation bonuses. A company manager is certainly tempted to use whatever legitimate tools are available including finessing the reported accounting numbers to reach those profit targets. Second, meeting external expectations.
If you were paying attention to the business news you will hear this kind of thing all the time. XYZ company announced earnings per share of $1.32 per share short of analysts expectations of $1.40 per share. The companies share price was down 11% in heavy trading, et cetera, et cetera, et cetera. Now Wall Street evaluates a companies quarterly performance based on whether or not reported earning reached the expected level. To avoid a negative stock price reaction managers are certainly going to press the accountants to report a net income number that meets external expectations.
Now the third reason. Income smoothing. What kind of earning series do you want to report to your shareholders, or to your bank? One that is high one year, and low the next? Or one that is safe and steadily rising? Banks and investors get nervous when they see reported earnings fluctuating up and down from year to year. Volatile earnings increase the perception of risk. So to the extent possible managers prefer to strategically make accounting assumptions to smooth out the ups and downs.
And finally, the fourth reason, window dressing. Of course we all want to make ourselves look as good as possible when going to a job interview. Applying for a loan. Visiting the future in-laws for the first time, and so forth. Is this personal window dressing okay? Of course it is. A company is the same when going to a bank for that big loan, or when preparing to sell shares to the public for the first time. An IPO. The owners of a company want reported net income to look as good as possible.
Okay. We see why business owners and company executives would want to manage reported net income. The next question is, how can they manage earnings? Well, that's a question that deserves its own module. Briefly stated, computation of reported net income involves making many many assumptions. For example, in computing depreciation expense to report in the income statement, do we assume that the company computer equipment is going to last for three years? Or for four years? If we assume four years then we are spreading out the cost of the equipment over more years decreasing the depreciation expense this year and increasing reported net income.
Now, techniques to manage reported earnings range across a broad continuum. From the strategic timing of when to close a deal, to out and out lying about sales and customers and expenses. The fact that company owners and business managers have strong economic incentives to manage reported earnings is an important reason for having another set of eyes an independent external auditor to look at the estimates and assumptions made in computing reported net income.
Now, here's the philosophical question. Should business owners and company managers take strategic action to manage reported earnings? Well, the perfect world response is that a company should never manage earnings under any circumstances. However, this simple response is both naive in today's financial reporting environment. And is also not necessarily correct. On the other hand, there can be great risk in starting down the slippery slope of managing reported results.
Deciding whether a company should manage earnings is a difficult question. There are good reasons to protect the public image of a company by reporting within the rules the best earnings possible. But companies should be careful when starting down the path of managing reported results. If management is trying to deceive potential investors, lenders, regulatory authorities, employees, or other company stakeholders, then managing earnings poses a real risk of lost credibility in the future. And there is one final important item to consider.
Most of us believe that intentionally trying to deceive others is wrong no matter what the economic consequences. Now, what does all of this mean to you? The user of reported earnings? You should always remember that the reported numbers have been made to look as good as possible. You should always push back and ask questions about important estimates and assumptions that have been made in computing the reported earnings. And you should be very skeptical about reported earnings numbers that have not been audited by an independent third party.
Skill Level Beginner
Q: Why can't I earn a Certificate of Completion for this course?
A: We publish a new tutorial or tutorials for this course on a regular basis. We are unable to offer a Certificate of Completion because it is an ever-evolving course that is not designed to be completed. Check back often for new movies.