Earnings Management
Candlefocus EditorEarnings management can involve various tactics closer to creative accounting than to outright fraud. It could be an arrangement to overstate or understate profits or to manipulate the timing of such statements to ensure that a company meets Wall Street or analyst expectations. For example, a company could choose to record as current expenses costs that should have been recorded over a period of time.
The most commonly used accounting practices that can lead to earnings management are earnings smoothing, revenue recognition, asset valuation, and more. Earnings smoothing involves using accounting policies to understate or overstate a company's profits in different period of time. This is done to make the company's financial results more predictable.
Revenue recognition is the process of recognizing revenue from the sale of products or services. It involves deciding how to recognize revenue on the income statement, generally at the point of sale or at the point of delivery. Companies can also manipulate their revenue recognition practices by delaying or front-loading revenue to enhance financial performance.
Finally, asset valuation is the process of determining the value of a company's assets, such as buildings and equipment. Companies can manipulate asset values by understating or overstating the value of their assets. For example, a company may make unrealistic assumptions about the future potential of an asset, or ignore the market depreciation rate when calculating its value.
Overall, earnings management can lead to misleading financial statements because it distorts the true financial performance of the company. When financial statements are not accurate, investors and other stakeholders are misled into making decisions that are not in their best interests. Because of this, earnings management is considered unethical and is heavily regulated.