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The theoretical value of a company’s stock is the present value of its future earnings, thus increased earnings represents increased value and decrease in earnings signals a decrease in the company’s value. Given the importance of earnings, it’s no surprise that management of organizations have keen interest in the way they are reported. Every executive therefore needs to understand the effect of their accounting choices so that they can make the best possible choice for the organization. In other words, they must learn to manage earnings.
There are two schools of thought on earnings management, Acceptable Earnings Management and Unacceptable Earnings Management. According to Acceptable Earnings Management view, earnings management concerns reasonable and legally accepted management decisions and financial reporting with the aim of achieving predictable financial results. Earnings management in this view can be in two forms, thus It can either be “artificial” or “real. ” Real earnings management, also known as economic earnings management involves decisions that affect cash flows.
Examples Include leasing certain equipment instead of buying, changing the timing of Investments and providing promotional discounts to Increase sales toward the end of he period where revenue targets are not likely to be met. By contrast, artificial earnings management also known as accounting earnings management does not affect cash flows. This kind of management Is basically achieved by using the reporting flexibility provided by Generally Accepted Accounting Principles (GAP). Examples Include choice of method of asset depreciation and treatment of expenses as capital Items. Unacceptable earnings management however perceive earnings management as not good since it reduces transparency. According to Healy and Whalen (1 999), ‘Earnings management occurs when managers use judgments in uncial reporting and structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance or to numbers. ‘. From this definition we clearly see that the main reason for earnings management is to mislead and therefore it is unacceptable.
It may either be to report an increase earnings for example using financial reporting flexibility to overstate earnings, or to understate earnings for example creating reserves for future periods by understating earnings in years of good performance. In general, earnings management is perceived as adverse things. It is because firm managers can use it to take their private benefit at the cost of firms, such as receiving bonuses for work they have not done especially when bonuses are tied to accounting numbers. This can deteriorate shareholder value.
This expropriation is commonly known as managerial opportunism. Managers face capital market pressures to meet short-term performance benchmarks (Graham et al. 2005), and a long line of research suggests that they are willing to engage in earnings management to do so (Decode et al. 2010). Graham et al. 2005) argues that managers prefer real earnings management because it is safer than accruals-based earnings management because it does not get as much attention from regulatory bodies and external auditors as accruals- based earnings management.
For example, management can influence net income by adjusting maintenance expenses or advertisement expenses. Real earnings management undertaken to increase current accounting numbers, however, results in damaging long-term firm value. However, some researches have argued that earnings management can be used in the beneficial way like to reduce volatility and monomaniac some future earnings forecasting to investors. Data and Giggler (2002) have developed the model in order to Justify the benefit of earnings management.
In the model, they show that the shareholders wealth can be reduced when the potential of earnings management is restricted by accounting standard and auditing process. Therefore, under the restriction, the benefit of earnings management is reduced as it is more costly for the manager to communicate trustful forecasting. McGrath and Weld (2002) discuss the benefit of earnings management to the firm value. Managers can use earning management to reduce the volatility of earning. This can help to reduce the level of firm perceived risks by investors and increase the value of the firm.
Therefore, managers who have involved in earnings management also follow the value minimization principal. Inning (2006) has also argued that earnings management is not fraud because it is done within legitimate constraint. Moreover, the earnings management may create the misrepresentation of earnings reporting but it does not misrepresent the firm economic value in terms of total value of asset, liabilities, and equity. Research also shows that earnings management is beneficial because there is the positive relation between firm value and earnings management.
One of the external factors that motivates managers to engage in earnings management is to meet expectations of analyst as well as increase the share price of the company. Both of these goals are in the best interest of shareholders since it has the potential of increasing their wealth in the form of capital gains on their investments. Active earnings management may also improve the image of the company which leads to the attraction of investors, customers and ay decrease the cost of capital.