Earnings Management

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In financials it is seen that managers enjoy a lot of discretion. An accounting judgment can hover between legal and illegal or between ethical and unethical. As we have come across in previous examples where manipulations were done by accountants to enhance their income statement and create an enhanced image of the firm in the eyes of the customers.

A manager makes many judgments in the case of accrual accounting. Certain speculations which managers make, rather optimistically is the estimation of product return from customers or the estimation of the durability of a machine, etc. A manager even makes the decision whether a certain transaction is an investment or an expense. He even gets to decide how much expense will be considered more than necessary. All these little manipulations and judgments are a part of every manager’s role. The manipulation can even extend to cash flow statements although the techniques can be difficult as well as costly.

For example, if a company decides to allocate their short period securities as trading items, then these securities will then be considered as cash. In this way, the finance statement can show more positive cash flow. Another popular technique used by companies to increase immediate cash flow is by reducing their inventory and thereby delaying payment to supplier. It will definitely generate more cash but this method can hurt the business in the long run. Also selling off receivable accounts at a discounted price can generate immediate cash but reduce profit margins. All these are forms of earning management, accelerating income rate. A certain form of earning management that is considered as aggressive technique is when a company aggressively sells off their products on credit and registering it immediately into income section. The loan is accounted in the investment section.

To judge which firms are using aggressive earning management techniques is by comparing similar firms based on the ratio of short term accruals to sales. If any particular firm has a much higher than average ratio, then it might indicate that the firm is using aggressive technique. To make the comparison accurately it is important to ensure that the comparison is made between equally grown companies. This is because an established company will obviously show a higher ratio than a growing one as a growing company consumes more cash in general.

Most managers with tendency to manipulate their earnings to show a more hiked earning tries aggressive management of their accruals. But it always doesn’t mean a bad thing. Some managers might be very confident about the success of the firm and hence can opt for aggressive accrual management. Thus aggressive accrual management might not necessarily always indicate under performance in later years. These management techniques which involve manipulation of financial statements can sometimes slip towards illegal boundaries. Hence careful scrutiny is required. Also an investor must be wary about companies that change their financial year. Investments must be made with careful scrutiny only.

Earnings Management 36


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