Earnings management

Earnings management is the controversial practice among publicly held corporations of adjusting the timing of reporting certain revenues and expenses by the company. In recent years, under pressure to meet WALL STREET analysts’ earnings estimates, many U.S. corporations have deferred expense recognition or counted as revenue funds from sales that have not been fully completed. In 2000 the SECURITIES AND EXCHANGE COMMISSION (SEC), sensing an increase in abusive earnings-management practices, proposed new Supplemental Financial Information rules to address these abuses. The SEC recognized such problems were largely caused by a lack of transparency (openness and easily understood) in financial reporting, including problems associated with
• failure to comply with the disclosure requirements for changes in accrued liabilities for certain costs to exit an activity during periods subsequent to the initial charge
• grouping dissimilar items into an aggregated classification
• recurring “nonrecurring” charges
• inadequate disclosure of changes in estimates and in underlying assumptions during the period of change
• inconsistent application of SEC-required disclosures of valuation and loss accruals
• insufficient information about expected useful lives, changes in useful lives, and salvage values of long-lived ASSETs
A company’s failure to comply with disclosure rules for changes in accrued liabilities can increase or decrease reported net INCOME. Information explaining changes provides investors with better estimates of present and future obligations. Grouping dissimilar items into an aggregated category has sometimes been used by companies to conceal something that is unfavorable and potentially a risk for investors. Reporting “recurring” charges as nonrecurring charges can be a misrepresentation of costs. Typical nonrecurring charges include restructured charges, merger expenses, and write-down of impaired assets. Investors assume nonrecurring charges are one-time costs, not costs that will have to be included in the future. Inadequate disclosure of changes in estimates is often associated with bad debt estimates or product returns. Increases in bad debt or product-return allowances reduce corporate income, but without adequate information, investors cannot easily assess the significance of the change being made. Inconsistent application of SEC-required disclosures of valuation and loss accruals is often associated with the value of future income-tax benefits. Lack of consistency in valuation can lead to over- and understatements of net income. During the late 1990s, many of these problems were particularly evident among DOT-COMS attempting reach profitability or minimize losses and operating in markets where rapidly changing technology made standard depreciation allowances subject to considerable variation. A related issue is the use of “pro forma” earnings. Companies issue pro forma (projected) earnings by adjusting net earnings reported using GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP). Pro forma earnings exclude items such as restructuring charges, employee severance expenses, and write-offs of fixed assets that have declined in value (impairment charges). This increases a company’s earnings and makes it look better to investors. The problem is there are no definitions of what pro forma earnings include or exclude. Thus investors looking at companies’ pro forma earnings cannot easily compare them. In December 2001 the SEC warned companies they could face civil- FRAUD lawsuits for issuing misleading earnings numbers, and directed companies to fully explain how their pro forma results are calculated.
See also LEVERAGE; PROFITS.