According to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or to influence contractual outcomes that depend on reported accounting numbers.
Earnings management usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics. Aggressive earnings management is a form of fraud and differs from reporting error.
Management wishing to show earnings at a certain level or following a certain pattern seek loopholes in financial reporting standards that allow them to adjust the numbers as far as is practicable to achieve their desired aim or to satisfy projections by financial analysts. These adjustments amount to fraudulent financial reporting when they fall 'outside the bounds of acceptable accounting practice'. Drivers for such behaviour include market expectations, personal realisation of a bonus, and maintenance of position within a market sector. In most cases conformance to acceptable accounting practices is a matter of personal integrity. Aggressive earnings management becomes more probable when a company is affected by a downturn in business.
Earnings management is seen as a pressing issue in current accounting practice. Part of the difficulty lies in the accepted recognition that there is no such thing as a single 'right' earnings figure and that it is possible for legitimate business practices to develop into unacceptable financial reporting.
It is relatively easy for an auditor to detect error but earnings management can involve sophisticated fraud that is covert. The requirement for management to assert that the accounts have been prepared properly offers no protection where those managers have already entered into conscious deceit and fraud. Auditors need to distinguish fraud from error by identifying the presence of intention.
The main forms of earnings management are as follows:
- unsuitable revenue recognition
- inappropriate accruals and estimates of liabilities
- excessive provisions and generous reserve accounting
- intentional minor breaches of financial reporting requirements that aggregate to a material breach