Techniques in Earnings Management

To someone unfamiliar with accounting language, "earnings management" might sound like a perfectly innocent activity. In fact, the term is a euphemism that refers to the manipulation of accounting entries to make a particular period's profits look better -- or to make profits appear more consistent from one period to the next. It's usually a questionable practice -- and if it presents a distorted picture of a company's earnings to investors, lenders and others, it's considered unethical. Ethical business owners and managers should be familiar with the techniques of earnings management so they can recognize it when it occurs.

"Earnings" is just another word for profit, and profit is simply revenue minus expenses. So the simplest way for a company to manage earnings is by changing the dates on which it enters certain revenues and expenses in its books. To increase earnings in the current period, the company can recognize future revenue prematurely -- before that revenue has been fully earned -- or delay recognizing expenses. Similarly, if it wants to shift "extra" earnings from the current period to the next, it could delay the recognition of revenue that has been earned, or recognize expenses prematurely, before they're actually incurred.

Accounting rules require companies to recognize future expenses at the time they recognize the revenue associated with those expenses. For example, when a company sells an item with a warranty, it must estimate its future warranty costs and recognize that expense at the time it makes the sale. Similarly, when a company sells items to customers on credit, it must estimate the value of customer bills that will eventually go unpaid and immediately recognize that "bad debt expense." If a company overestimates these kinds of expense in the current period, it won't have to recognize as big an expense in future periods. Therefore, it shifts earnings from the current period to the future. This tactic goes by the name "cookie jar accounting."

In many areas of business bookkeeping, accounting standards allow companies to choose the reporting method that works best for them. Examples include the system the company uses to account for the value of its inventory and the schedule it uses to depreciate its capital assets. Over the long term, different methods for doing the same thing should produce the same end result -- the same total value will go into and out of inventory, for example, or the same amount of value will get depreciated. In the short term, however, a company's choice of methods can significantly affect its earnings from one period to the next. If a company switches from one accounting method to another primarily to affect earnings, it's engaging in earnings management.

From time to time, companies may have to report a particularly large one-time expense -- writing off the cost of a failed project, for example, or significantly reducing the value of an asset on the balance sheet. Companies that practice earnings management may try to "save" these charges for a time when earnings are high enough to absorb the hit -- or take the charges prematurely if current earnings are high. Similarly, a company that must take a big one-time charge in the current period might use the opportunity to accelerate all kinds of other expenses to that period, too. This is called the "big bath," after the idea that if the company is going to "take a bath" -- suffer bad results in a particular period -- it might as well take a big bath and get as many future expenses out of the way as possible.