Firms resort to earnings management to disguise financial soundness

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The earnings reporting period has begun and many companies are publishing their quarterly reports. All the listed companies are expected to meet or surge the analyst and market earnings estimate. To meet the estimated levels, stakeholders and managers of companies indulge in earnings management as their compensation, financial incentives, and promotion prospects are connected with the performance of their firm. 

Earnings management

The deliberate delude of financial values such as the revenues and earnings of a company is known as earnings management. Companies favor manifesting a healthy financial ecosystem through various permissible and legal accounting techniques. However, by providing the before-mentioned information misleads the various stakeholders such as analysts and investors and results in loss of shareholder wealth.

How do earnings management work?

Companies tend to window-dress in multiple ways, for instance, they create reserves during the years of profit and use these reserves in a bad financial position to show the company’s profitability. Some companies also follow an income smoothing approach whereby earnings are administered over a period to show a steady uphill trend.

Seldom, companies recognize estimated expenses resulting out of restructuring or elimination of operations, when revenues are high and lower expenses are recognized when revenues are low. Another popular way to manage earnings is to do more number of transactions with related parties. Primarily companies use their discretionary powers to manage earnings either on accrual or actual basis.

Firms in developing markets manage earnings more than the firms in developed countries. Many firms in developing economies are affiliated with business groups as well. Business group affiliated firms manage earnings more than that of the non-business group or standalone firms. Therefore, they have a higher possibility to inflate profits through related party transactions based earnings management.

Notes for investors

It is very challenging to prevent or detect earnings management because there exist information asymmetries and managerial discretion. However, audit checks, monitoring by regulatory bodies, and analysis by financial analysts could keep earnings management in line. Investors should also focus on non-financial measures to evaluate the company’s performance.

Moreover, to recognize earnings management, investors can also track the changes in accounting strategies of a company in the past years. The company following the same accounting policy over a period, the financial statements of that company are more likely to be steady. Companies with frequent changes in accounting policies are more prone to earnings management. Financially vulnerable firms practice earning management to dodge earnings surprises, losses, to boost their market value. 

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