earnings management and fraud

what is earnings management?

earnings managements occurred when managers use discretion over financial reporting in business transactions to impact reported earnings (net income) in a way that influences how investors and creditors view company performance

what are incentives to e gage in earnings management?

deliver growth

deliver expected earnings (net income) to the stock market

meet natural milestones of performance

meet the net income goal tied to compensation bonuses

meet the net income goal stated in any debt covenant

when would companies face incentive to look bad?

sometimes managers have incentives to reduce earnings:

first year CEOs so the 2nd year looks like they helped the company improve a lot

government bailout

reduce its tax burden

avoid accusations of being a monopoly

avoid looking unhumanitarian

avoid beating the target by too much

pile all of the bad earnings news into one year (big bath). This way next year looks better.

what is a big bath?

pile all of the bad earnings news into one year. This way next year looks better.

what are the two ways to manage earnings?

1. accounting management: altering accounting judgements and estimates to meet certain financial goals or targets. NO CASH INFLOW IMPACT

2. Real activities managament: deviating from normal business practices to meet certain financial goals or targets. CASH INFLOW IS IMPACTED

what are examples of accounting management

change your assumptions for:

-amount of product returns you expect to receive

-amount of accounts receivable you expect to collect

-useful life or residual value of PPE

Amount of revenue you have earned to date on a customer contract

amount of bonuses you expect to pay out to employees

Value of investments that are not traded on public markets

examples of real activities management:

change the amount of

-employees raises and bonuses

Research and development

Advertising and marketing

Company, perks, and events

Customer incentives

And facilities maintenance

accountant management we ______ something different

real activities management we ___ something different

assume, do