Earnings Management: The Role Of Accounting Professionals

In today’s financial markets there is a great deal of pressure for corporations to meet investors’ earnings expectations. Failure to do so may result in the loss of millions of dollars in stock capitalization. As a result, an increasing number of corporate executives have succumbed to the temptation to “manage” their earnings in order to achieve targeted profits. The number of companies under investigation by the Securities and Exchange Commission (SEC) for possible accounting fraud related to earnings management has increased significantly in recent years. This article identifies and discusses four common areas of potential financial reporting abuse: restructuring costs, miscellaneous reserve accounts, materiality, and manipulation of revenue recognition. In addition, this paper discusses the vital role of accounting professionals as gatekeepers responsible for helping to maintain the viability of our financial markets. Introduction to the Problem et income and earnings per share information reported by companies represents some of the most important data available to investors. This bottom line information is particularly significant to many readers of financial statements because it has a sense of finality and a ring of truth. The importance of this statistical information can be witnessed by the fact that a reported earnings per share figure that is a few pennies below analysts expectations can result in a dramatic decline in the share price of a company’s stock. For start up companies seeking new capitalization or for established mainline companies, the implications of a 5%, 10%, or even larger drop in stock prices are formidable. As the result of this pressure, corporate executives may at times feel inclined to manipulate their company’s earnings. Earnings manipulation has been defined as a situation in which a company’s management violates generally accepted accounting principles (GAAP) in order to favorably represent the company’s financial performance (Beneish, 1999). Because investors tend to prefer companies that demonstrate steady growth, some corporate managers feel compelled to manipulate earnings in order to show steady, continuous, upward growth in their profits. The role of financial reporting is to provide and communicate information that assists in business decisionmaking. Timely, sufficiently detailed, and high quality information is essential for investors to make sound investment decisions. However, according to the Securities and Exchange Commission (SEC), misleading financial reports are being issued at a startling rate (Schroeder, 2001). This is evidenced by the fact that a study by the Financial Executives International group reported that the number of financial restatements issued in the last three years was higher than the previous ten years combined (Weil, 2001). The increased pressure on corporate executives to meet investors’ expectations has driven many of them to not only bend the accounting rules to the breaking point, but also in some cases to deliberately manipulate reported earnings. Under increased scrutiny from the SEC regarding the issue of “managed earnings”, these companies have found it necessary to restate previously misleading financial statements. The purpose of this paper is to identify examples of common abuses associated with the deliberate attempt by corporate management to manipulate their earnings report. In addition, the role that accounting professionals, as well as the Securities and Exchange Commission, play in preserving the integrity and __________ Readers with comments or questions are encouraged to contact the author via e-mail. viability of the capital markets in the United States will be examined. N International Business & Economics Research Journal Volume 1, Number 3 10 Earnings Management In 1998, then Chairman of the SEC Arthur Levitt expressed increasing concern that the desire by corporations to meet investors earnings expectations was resulting in an erosion in the quality of financial reporting (Levitt, 1998). He expressed concern that the motivation to achieve consensus earnings estimates prompted many corporate managers to engage in earnings manipulation in order to project a pattern of smooth corporate earnings. Mr. Levitt expressed frustration on the part of the SEC regarding areas where integrity in financial reporting was losing out to illusion, where gray areas in accounting were being abused for corporate gain, and where corporate earnings reports reflect the hopes of management rather than the underlying performance of the company. There are a number of approaches corporations have engaged in to manipulate their reported earnings. The following discussion focuses on four common areas of abuse: restructuring costs, miscellaneous reserves, materiality, and manipulation of revenue recognition.