List of Techniques in Earnings Management
The term earnings management is a well-known term in the world of accounting. In this article, you will learn what it means and what techniques are most popular.
What is Earnings Management?
One of the primary aims of every company is to generate money. Company owners not only look forward to seeing better profit at the end of every accounting period but also to seeing their company’s financial statements as good as they can. This is due to the fact that potential investors and creditors are looking into financial statements when they make the decision whether or not to lend the company money or to become an investor.
This is where the idea of earnings management takes place. Basically, earnings management is the manipulation of accounting entries to make a specific period’s profit look better, or to make profits appear more consistent from one period to the next. It is quite a questionable practice, that is why ethical company owners and managers must know and understand the techniques of this idea in order to acknowledge it when it happens.
• Recognizing revenue and expenses
The word ‘earnings’ also means profit and profit is taken from revenue minus expenses. So the simplest and easiest way for a company to manage earnings is by modifying the dates on which it writes certain revenues and expenses in its books. The company can acknowledge future revenue prematurely, prior that revenue has been fully gained, or delay acknowledging expenses to increase earnings in the current period. Likewise, if the company wants to move extra earnings from the present period to the next, it could suspend the acknowledgment of revenue that has been gained or acknowledge expenses prematurely, prior they are actually incurred.
• Cookie Jar Reserve Technique
Business firms need to recognize future expenses at the moment they recognize the revenue connected with those expenses. For instance, when a business firm markets a product with a warranty, it must approximate its future warranty costs and acknowledge that expense at the moment it conducts the sale. Likewise, when a business firm markets products to customers on credit, it must approximate the value of customer bills that will go unpaid in the long run and quickly acknowledge the bad debt expense. If a firm overestimates these kinds of expense in the present period, it won’t need to acknowledge as large an expense in the future times. Thus, it moves earnings from the present period to the future and this technique is called ‘cookie jar accounting.’
• Changing Accounting Methods
Accounting standards let companies select the method of reporting, which they think works best for them. Examples include the company’s system that it uses to know the value of its inventory and the schedule it follows to run down its capital assets. Over the long course of action, various methods for executing the same thing should produce a similar outcome. Over the short period, on the other hand, the choice of methods of a company can significantly affect its earnings from one period to the next. If a company changes its accounting method mainly to affect earnings, it is involving earnings management.
• Big Bath Technique
Sometimes, companies need to report a particularly big one-time expense on the balance sheet. Those firms that exercise earning management may try to ‘save’ these charges for a period when earnings are high enough to absorb the hit, or take the charges prematurely if the current earnings are high. Likewise, a company that needs to take a large one-time charge in the current period might use the chance to increase all kinds of other expenses to that period also. This is referred as ‘big bath’ after the idea that if the firm will ‘take a bath’, experience bad outcomes in a certain period, it might also take a big bath and get as many future expenses out of the way as possible.
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