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Financial reporting requires management to make estimates about future benefits and obligations. For example, management is required to estimate the fraction of credit sales for which cash is unlikely to be collected in the future (i.e., provisioning for bad and doubtful debts). Accountants have also developed different methods of accounting for the same activity. For example, a variety of approaches to valuing inventory are available to management including FIFO, weighted average, units of production (and in some jurisdictions LIFO).
The requirement to make estimates and the ability to choose between different accounting procedures provides management with the ability to influence financial reporting outcomes. For example, management may select a particular accounting treatment that leads to higher reported income or they may make estimates that affect the carrying values of assets and liabilities. Earnings management is the generic term given to accounting decisions that influence financial reporting outcomes. The term is something of a misnomer in so far as reported earnings may not be the primary target: in some situations management may be more interested in reducing levels of gearing (leverage) or boosting return on investment metrics.
The term tends to be used pejoratively in the sense that it implies an attempt to mislead or obfuscate. History is littered with instances where management have used their financial reporting discretion to camouflage poor performance (e.g., Maxwell Corporation) or create the illusion of spectacular growth (e.g., Enron). Research reveals that groups manipulate financial reporting outcomes in response to a wide range of factors including capital market pressures for superior growth, the desire to meet or beat analysts’ consensus earnings forecasts, incentives to maximise compensation tied to earnings outcomes, avoiding debt covenant violation, and influencing regulatory outcomes. Note that while shareholders may lose out from earnings management in some of these situations (e.g., when management attempt to hide poor performance) they may gain in other circumstances (e.g., in the case where the firm achieves a favourable regulatory outcome).
Discretion over financial reporting decisions is integral to the accounting process and helps management convey a more accurate picture of performance and financial position. Research demonstrates that on average reported earnings provides more information about value and changes in value than raw cash flow. In spite of all the opportunities to manipulate reported outcomes and mislead users, the accounting process appears to add value. Eradicating all opportunities for earnings management is not an option for regulators therefore because it risks throwing out the baby with the bathwater. Consequently, regulators and users of accounting information have to accept a limited of risk of manipulation in pursuit of more informative financial reporting.