Earning Management: Is it Good or Bad?

Abstract

Use of accounting discretion to address financial statements seems to be eroding public confidence in the financial reporting process. Some managers are abusing GAAP’s afforded discretion to manage earnings thus reducing the quality of the financial reporting process and ultimately bring adverse effects on resource allocation in the economy. Market participants, legislators, regulators, and academics are concerned in order for them to have the need to control financial reporting abuses. In this paper, I briefly analyze the recent literature and theories on earnings management and show the techniques used by managers to manipulate earnings. I found strong incentives and reasons for managers to report such smooth and increasing earnings by the: a) increase market capitalization; b) enhance management compensation and job security; and c) reduce the company’s cost of capital. The evidence found suggests that the managers used: a) big bath restructuring charges; b) miscellaneous cookie jar reserves (a hidden reserve that do not show up on the balance sheet (understating values) which can be used to adjust quarterly earnings reports c) premature and aggressive revenue recognition; and d) creative acquisition accounting and purchased R&D to manage earnings.

Keywords: Accounting, Earning Management, GAAP