Earnings management

Question

What do you mean by Earnings management and what are their actions and activities?

Answer 1

Earnings management is a technique used by the management to make the actual earnings of the company match with the previous earnings.

It can be defined as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”.1 (Lev, B. “On the Usefulness of Earnings and Earnings Research: Lessons and Directions From Two Decades of Empirical Research.” Journal of Accounting Research, 27 Supplements (1989):153-201)

People believe that if the company is following GAAP then earnings shall not be misrepresented. However GAAP authorizes many accounting choices and estimations thereby enabling earnings management. Also companies do engage in lot of operating choices, so earnings management by default becomes the choice. Companies are taking advantage of earnings management.

The company we are referring for our analysis is Lian Beng Group Ltd. The two accounts that have been selected are Revenue account and Inventory account. The reason for selecting these two accounts is the huge number of transactions that are made in these accounts to manage earnings. These accounts on the contrary are easy to manipulate.

Earnings management can be achieved by practicing certain management actions like:-

• Adopting accounting choices from GAAP
• Taking some operating decisions (investing in new plant, etc.)

Following are the activities that the management engaged in to practice earnings management:-

A) Bad debts expense is an estimate made by the company to insure itself from customer defaults. If the company wishes to increase its current earnings it will lower the bad debt rate. Lian Beng has reduced its allowance for bad debts from 1006 in 2009 to 792 in 2010. Consequently we can see an increase in the revenues of the company.2 ( statistics annual report for 2010 and 2009)

B) The gross revenue of the company has increased just 12.3% in 2010 when compared with the year 2009. But the rate of revenue increased from 2008 to 2009 is 53% respectively. This shows that there is no significant increase in the gross revenue of the company. The earnings have been increased to create shareholders wealth.3 ( statistics annual report for 2010 and 2009)

C) If we overstate the inventory, cost of goods sold shall be underestimated and earnings will be overstated. The inventory has increased by 137% from 2009 to 2010 but the cost of goods sold has not increased and it shows a downward trend of 10% when compared with previous year. Now since the closing inventory was overstated, naturally the cost of goods sold has been underestimated to show increase in earnings.4 (statistics annual report for 2010 and 2009)

The above citations depict that the revenue of the company had not increased significantly but to keep in line with its revenue pattern it had managed its earnings in 2010.

Earnings management is a widespread phenomenon. Most of the companies are following it to show steady increase in growth of earnings. It should not be confused with the illegal activities carried out to misstate financial statements and reporting of non economic reality.

Because of the crucial nature of the earnings of the company the managers needs to acknowledge the effect of accounting policies that they choose to build best possible decisions for the company. That is the core reason why the managers should learn to manage their earnings i.e. earnings management.