Earnings refer to the profits that a company makes and is usually presented in the income statement. In accounting, as well as to the stakeholders, it represents the most significant parameter since it is a reflection of the performance of the given organization. In the capital market, earnings signal direct allocation of resources in that the current value of a company’s future earnings is the measure of the company’s stock. Analysts and investors measure the attractiveness of a company’s stock by looking at its earnings. Earnings management refers to reasonable, legal decision-making, management and reporting aimed at achieving predictable and stable financial results. Analysts are the accounting professionals who audit the earnings management process.
The Motivations of Earnings Management
There are two main earnings management methods. The first method is utilizing the flexibility that is generally allowed within accounting principles to manipulate and/or alter reported earnings without interfering with underlying cash flows. This is referred to as accounting earnings management. The second method is whereby a manager may change decisions on operations like maintenance or delivery schedule so as to alter the underlying cash flows which will in turn affect the income report. This is referred to as structuring of transactions or economic earnings management.
Earnings management, which is an act of falsifying monetary earnings, is often aimed at giving an exaggerated outlook about a business’ performance. By doing that, the management gains by winning the confidence of the investors. Other than that, by manipulating its earnings, the management benefits more from monetary incentives such as remunerations. In addition, the shareholders in such businesses also earn more through dividends. The only drawback, in this case, is that falsification gives a false representation of the operating capital of the business. This, in a way, might affect the operations of the affected businesses through lack of liquidity. In addition, earnings pegged on managed earnings might negatively affect the actual profits of a business.
There are several motivations behind earnings management as proposed in several literatures. However, most of these motivations in the numerous reviews are inconsistent and lack empirical support. Several studies report a lack of continuation in the distributions of earnings relative to set benchmarks like zero profit level. The evidence available in regards to ascertaining if these discontinuities are related to the behaviour of earnings management is, however, still very uncertain. Moreover, evidence on the ability of the various management mechanisms to contain earnings management is equally varied. These issues, therefore, necessitate investigations on the behaviour of managers which incentivise or motivate practices of earnings management via a qualitative research approach.
Literature on earnings management show that motivations, as well opportunities for the manipulation of income, vary depending on circumstances such as changes of CEOs. Research shows different managerial motivations behind earnings management. There is a direct link in the job securities of senior managers against their motivations to manipulate earnings (Balsam, 2010). The study focused on the managers who were faced with the likelihood of losing their positions. According to Balsam (2010), in the final years of employment, many CEOs mostly have a tendency of reducing expenditure on research and development. Furthermore, he observed that when the managers’ bonuses are at the maximum, they tend to manipulate the earnings downwards.
Earnings management usually comes into play where managers are required to use their own judgement in making financial reports as well as in restructuring transactions so as to mislead stakeholders on the economic performance of the company. It could also be used to exert external influence on contractual outcomes whose results are dependent on the accounting numbers in a report. Balsam relates components of earning like discretionary accruals to monetary compensation of CEOs. His studies show that executive compensation is significantly and positively associated with discretionary accruals. This suggests that managers increase their compensation using discretionary accruals. However, research also added that some extraordinary losses are not directly related to CEOs’ compensation in that nondiscretionary components of earnings are more relevant in terms of value as compared to discretionary components of earnings. Balsam concludes that accrual accounting, by its nature, gives managers significant discretion, within a given time period, to determine the earnings. In another study, there was evidence that small reported gains or profits are more pronounced than losses of similar magnitude. The study also found that small increments in reported income were common any decline in the amounts reported to have been earned are uncommon. This suggests that the various firms’ managers utilize their accounting discretion to evade reporting declines in earnings and reporting losses. Managers enhance earnings information by exercising discretion over earnings. Any losses incurred should always be reported. However, once profitability has been attained, the gains made have to be reported since it would influence the decisions made within the business (Erickson &Wang, 2012).
Most recent studies have narrowed their research on capital market motivations towards earnings management. The studies focus on discretionary accruals at those times when capital market motivations are believed to be at their peak. Erickson and Wang (2012) investigated the relationship between security offerings and earnings management. They researched on the earnings management practices at seasoned equity offerings and during IPOs (Initial Public Offerings). They observed that during the issue year, on average firms have abnormal accruals and report high positive earnings which are then followed by a spell of negative abnormal accruals and long-run poor earnings (Musfiqur, Mohammad & Jamil, 2013).
Stock-for-stock mergers are another point of focus when it comes to earnings management. It was found that in the quarters prior to the merger, the acquiring companies manage their earnings upwards. This is likely with the aim of increasing their stock prices (Erickson &Wang, 2012). During such times, regulators and the public tend to believe that the reported earnings are manipulated by managers. The research provides evidence of earnings manipulated by managers towards the predicted direction during the year prior to the public announcement of the intention by the management for a buyout. Earnings per share (EPS) have also been thought to influence earnings management. Managers of companies which achieve consecutive positive rise in quarterly earnings per share have stronger motivation as compared to other managers. According to the above literatures, the motives and incentives to manipulate earnings are varied depending on the reasons for earnings management by the managers of the firms.
Role of Analysts in Earnings Management
Analysts influence the use of various earnings management practices by managers. To enhance short-term performance, the managers, in response to analysts’ pressure, utilize real earnings management. These effects are not covered in the focus of accrual-based practices. Securities analysts emphasize on short-term earnings’ benchmarks and recommendations which exert pressure on managers to manipulate their reported earnings. Firms that fail to beat or meet quarterly targets experience a market valuation loss (Grundfest & Malenko, 2012). Furthermore, there is a decrease in the compensation of the managers of these firms and a greater possibility of turnover. There is a lot of literature emphasising on the roles of analysts in exerting pressure on managers, and on the decline of overall transparency given the expected personal costs to the managers.
There is a divisive debate on the impact of analysts on the behaviour of managers and whether or not it has any positive impact on the firm’s value. These relationships have not been clarified in existing literature thus they warrant more research. A recent literature on earnings management proposes “real manipulation of activities”. These include structure and timing of operational activities, advertising, or the changing of investments. The activities are given as an alternative to the methods based on accrual (Grundfest & Malenko, 2012. By solely emphasising on a particular technique of earnings management, it would not be possible to give an exact picture of how analysts affect the reporting of earnings.
Earnings management is strongly influenced by securities analysts. This can be evidenced using both real activities and discretionary accrual-based measures of earnings management. A decline in the analyst coverage pressures managers to employ less manipulation of real activities in their financial report (Jones, 2013). Therefore, the adjustment in manipulation of real activities primarily emanates from a decrease in discretionary expenses. This suggests that managers are pressured by the analysts following to meet external expectations by manipulation of real activities during financial reporting.
Main Points for Motivation
• To improve the job securities of senior managers
• To win the confidence of investors
• To gain monetary benefits from incentives such as remunerations
• To influence public perception during IPOs
• To cover up for losses
• To remain optimistic in tough economic environment
- Balsam, S. 2010. Accounting earnings and executive compensation: The Consequences to Managers for Financial Misrepresentation. Journal of Accounting and Economics.
- Erickson, M., and S. Wang. 2012. Executive compensation and earnings management. Journal of Accounting and Economics.
- Grundfest, J., Malenko, N., 2012. The Economic Implications of Corporate Financial Reporting. Journal of Accounting and Economics
- Jones, J. J., 2013. Monitoring and Corporate Disclosure: Implications for Empirical Research. Journal of Financial Economics
- Musfiqur, R., Mohammad M., & Jamil S., 2013. Techniques, Motives and Controls of Earnings Management. International Journal of Information Technology and Business Management