In every organisation, management relies on the plan to guide, assist and advise them on decisions to make throughout the year. These plans, particularly net earnings, become the benchmark against which management measures performance. 

But what happens when they realise that actual results will exceed the plan? Management may not want this excess, raising concerns that they may have to increase future performance to higher levels. 

Similarly, what happens when they expect actual results to miss the plan? A missing plan reflects poorly on performance.

Techniques of Earnings Management

Management, aided by the finance team, may use a technique called ‘earnings management’ to align actual net earnings close to the plan.

The easiest way is to adjust reserves or accruals. For example, management can overestimate reserves, such as those for bad debts or obsolete inventory, thus reducing reported earnings when results are ahead of plan. Another easy way is adjusting reserves for current and future litigation. Management can then release these reserves, often called ‘cushions’, in future years when times turn bad. Conversely, if results fall short, reducing these cushions can help meet the plan.

Let’s consider a hypothetical scenario. A subsidiary of a multinational corporation has its annual plan approved by headquarters. As year-end approaches, management sees that net earnings will exceed the plan, so they search for ways to lower earnings. Inventories have increased from a recently canceled order, and some items exceed their normal levels. Management has no plans to reduce production and believes they can sell the excess inventory to other clients. They do not need to make a provision for these items, but they have decided to pass an additional reserve for obsolete inventory to reduce earnings back to the plan. 

The reserve can be justified to the auditors. Next year, when the items are sold, they can reverse the reserve, making next year’s plan easier to achieve. If results fall short, they can reverse it to increase the results up to the plan. This is earnings management.

The UK Auditing Practices Board (APB 1995) shows how earnings management is possible:

“A degree of imprecision is inevitable in the preparation of all but the simplest of financial statements because of inherent uncertainties and the need to use judgement in making accounting estimates and selecting appropriate accounting policies. Accordingly, financial statements may be prepared in different ways, yet they still present a true and fair view.”

These inherent uncertainties and uses of judgement give accountants the flexibility to alter earnings to bring the actual results close to the plan.

Earnings Management vs. Earnings Manipulation

It is crucial to distinguish earnings management from earnings manipulation. Earnings management stays within the boundaries of Generally Accepted Accounting Principles (GAAP), and the auditors sign off the financial statements as fairly stated (or true and fair in the UK). On the other hand, earnings manipulation crosses ethical and legal boundaries. The financial statements can never be fairly stated and never follow generally accepted accounting principles. 

Types of Earnings Management

Earnings management is well-known to accountants, and accounting academics have released hundreds of research papers. But to write about it, researchers had to invent theories and give names to the different ways accountants change the results.

Earnings management is now part of a theory called Agency Theory, which explains the psychology arising from the potential conflict between shareholders who want to maximise shareholder value and management who pursue their own interests. When management reduces earnings by increasing reserves, they reduce shareholder value and thus work against the shareholders. 

Within agency theory, accountants recognise two types of earnings management:

1. Accrual-based earnings management

2. Real earnings management

In the example above, accountants call the build-up of an unnecessary reserve for excess inventories a ‘cookie jar reserve’ within accrual-based earnings management.

Under real earnings management, organisations resort to creating real transactions by altering the activity of the business. For instance, if management is having difficulty reaching a plan, they often decide to reduce spending. They can stop hiring, abolish travelling and make other operating decisions. Employees recognise this as official, legitimate, and open decision-making when managing the business to make a plan.

However, management should worry about the unofficial, illegitimate, and secret types of real earnings management. They can, for example, inflate sales to meet the plan by using a tactic called ‘channel stuffing’. Here, they invite distributors to increase inventory towards the end of the year to boost sales and income up to the planned level. But they do not tell their hierarchy. It remains a secret, and it puts the results of the next period when distributors buy less at risk because they bought more than they needed in the current period at risk.

When management connects bonuses to achieving the plan, the incentive to modify the results through real or accrual-based earnings management becomes even greater. Here, the incentive to earn the bonus can encourage managers to alter results as closely as possible to earnings manipulation.

Comparing Accrual-Based vs. Real Earnings Management 

Forecasts

In publicly quoted companies, a similar dynamic occurs around published earnings forecasts or targets. Shareholders believe that companies are well managed when they meet earnings targets, and they penalise management that misses them. These beliefs encourage management to adjust accruals and reserves to ensure that reported results align with forecasts, which is called ‘earnings threshold targeting’ by accountants.

Real-life example

I encountered a similar but different behaviour as a CFO of a supplier of a well-known quoted retail company. Halfway through the year, the company sent us an email informing us that they would NOT pay any due invoices for six months. They made special arrangements to pay all overdue invoices on 1st January of the following year. I contacted other suppliers to see whether they had received the same message. They had. 

Their year-end was 31st December, so with the long delay, they massively improved cash flow and reduced short-term borrowing in the balance sheet. While these actions were not earnings management, I consider this similar behaviour to channel stuffing and a legal way of manipulating the presentation of the balance sheet.

Actions for FP&A teams

Forecasts and plans stimulate and encourage earnings management and have become a structural feature of the financial reporting system rather than a behavioural flaw. Accounting researchers and auditors recognise that earnings management exists, but I have never found it recognised or discussed in organisations. Management applies it in secret, deceiving their hierarchy.

Earnings management occurs regularly in all organisations and must be brought out into the open. FP&A teams are in the best position to educate senior leadership and boards of directors on its existence and inevitability. 

FP&A teams should take the following actions: 

1. Discuss earnings management openly with senior leadership – it cannot be eliminated, but it can be controlled.

2. Make earnings management part of the system of internal control:

• Review year-end accruals for unusual swings versus historical patterns.
• Challenge year-end adjustments for unusual entries that increase or decrease earnings.
• Track Q4 forecast variances for a sudden slowdown or acceleration in net earnings.

3. Encourage Internal Audit to look for evidence of earnings management

4. Convince management that bonuses should be designed not to rely only on net earnings.

A Final Thought

FP&A leaders should have a goal to understand, monitor, and contain earnings management, not ignore it.

Source:

1. UK Auditing Practices Board (1995). Statement of Principles: The True and Fair Requirement, Paragraph 4. London: Financial Reporting Council (FRC), United Kingdom.