Earning management is good or not?
This essay is to examine whether earning management is it good or bad. Though there is so many debate about whether it should be accepted to be good rather than bad, however, this essay will explain the both side of earnings management.
Earnings management reduces the quality of financial reporting, it can interfere with the resource allocation in the economy and can bring adverse consequences to the financial market. This essay analyses both, causes and motives of earnings management as well as possible remedies. Therefore, it is not surprising that market participants, legislators, regulators, and academics are concerned with the need to ...view middle of the document...
Firstly, lowering contracting costs in the face of rigid and incomplete contracts. Secondly, earnings management can reveal inside information to investors.
1) Incentives given on contracts
a) Bonus is given on net income referring to contract
Volatility of the new accounting standards may lead to lower net income
May adversely affect manager effort
b) Debt covenant contracts
New accounting standards may increase probability of debt covenant violation
Contract violation is costly, earnings management may be low-cost way to work around
2) Investor-based arguments
Credibly communicate inside information to investors
a) Blocked communication may inhibit direct disclosure of earnings expectations
b) Discretionary accrual management as a way to credibly reveal management‘s inside information about earnings expectations, some of examples :-
Manager foolish to report more earnings than can be maintained
Manager reported earnings to an amount management expects will persist
Bad Side of Earning Management
Bad earning management means intervention to hide real operating performance. Some of the techniques used that will influence bad earnings management is as follow below based on my investigation from some of the research done in the past.
From a contracting perspective, we can think that managers manage earnings to opportunistically maximize their utilities. Healy (1985) examines that managers act on their self-interest when their bonus schemes are tied to the reported net incomes. However, managers not only manage earnings for self-interests but also manage earnings for an efficient contracting. Healy (1985) found that managers utilize such information superiority to maximize their wealth on their bonus scheme which suggests that managers might possibly manage earnings to protect their bonuses. This is the contract between the firm and the managers. Research examining SEC enforcement actions has found that accrual information is a key determinant of the earnings manipulation (Dechow, Sloan and Sweeney, 1996). Therefore, it is reasonable to assume that earnings restatement firms can be characterized as firms who knowingly and intentionally engaged in earnings manipulation.
Financial Reporting Perspective
Based on Hanna (1999) article in CA magazine review, important point to get across from this article is that management is tempted to provide excessive unusual, non-recurring and extraordinary charges, to put future earnings in the bank. Furthermore, these future earnings are buried in operations. This makes it difficult for investors to diagnose the reasons for subsequent earnings increases.
Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items Implies manager not penalized for non-core charges, such as write-downs, provisions for restructuring. But current non-core charges...