Earning Management and Creative Accounting
Earning Management and Creative Accounting
EM can be viewed from:-
A. Financial reporting- manager use EM to meet analysts earnings forecasts, thereby avoiding the strong negative share price reaction that quickly follows a failure to meet investor expectation. Use into create a stream of smooth and growing earnings over time.
B.Contracting perspectives- used as a way to protect the firm from the consequences for unforeseen
Events when contracts are rigid and incomplete.
The choice by a manager of accounting policies so as to achieve some specific objective.
Choose accounting policies that will help to achieve managers objectives.
2 types of accounting policies:-
a. The choice of accounting policies per se such as straight line vs. declining balance amortization or
Policies for revenue recognition.
B.Discretionary accruals such as provision for credit losses, warranty costs, inventory values and
Timing and amounts of non-recurring and extraordinary items- write off and provisions for
Reorganization.
Accruals reverse which relate to iron law surround the EM. Hence, manager manages earnings upwards to an amount more than can be sustained(continuous) will find that the reversal of these accruals in subsequent periods will force future earnings downwards just as surely as current earnings were raised.
The possibility of good EM cannot be used to rationalize misleading or fraudulent reporting.
Can be classified into 3 categories:
a. Fraudulent accounting involves accounting choices that violate GAAP.
b. Accruals management involves within-GAAP choices that try to “obscure” or
“mask” true economic performance.
c. Real earnings management (RM) occurs when managers undertake actions that
deviate from the first best practice to increase reported earnings.
Importance in understanding EM:
A .EM enables an improved understanding of the usefulness of net income, both for reporting to
investors and for contracting.
b. It may assist accountant to avoid serious legal and reputation consequences that arise when firms
become