Before really understanding what earnings management is, it is vital to have a solid understanding of the term earnings. Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. A company's ability to generate profit in the future plays a very important role in determining a stock's price. (Anderson, 2009, pp.205)
Definition of Earning Management
Earning management is a strategy used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target. This practice is carried out for the purpose of income smoothing. Thus, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts. (Cascino, 2010, pp.246)
Differences between Real Earnings and Accrual Management
There are two terms which are real earning management and accrual management. Real earning management is deemed by the Securities & Exchange Commission to be a material and intentional misrepresentation of results. When income smoothing becomes excessive, the SEC may issue fines. Unfortunately, there's not much individual investors can do. Accounting laws for large corporations are extremely complex, which makes it very difficult for regular investors to pick up on accounting scandals before they happen. Accrual management basically refers to the different methods used by managers to smooth earnings which can be very complex and confusing however the important thing is the driving force which is behind managing earnings is to meet a pre-specified target. (Ahrens, 2006, pp.819)
There are various methods used by the accounting researchers to detect definitions of earnings management but our focus will be on three methods. Although earnings management is a major research topic in the financial accounting field, this stream of research has directed only limited attention to the antecedents of financial reporting quality in private firms. The question of why private firms would engage in earnings management is an important but still unresolved one. Therefore we need to go beyond traditional examples of accounting methods. Nevertheless, because private firms represent the majority of firms worldwide, it has been suggested by various countries that earnings management is more prominent in private firms than in public firms. (Jarvis, 2002, pp.100)
Three main methods used by Accounting Researchers
The accounting researchers typically use three different accounting methods for the proper determination of Earnings Management. The first method is when firm performance is poor, private firms having an incentive to influence firm performance through upward earnings management to avoid a decline in their overall wealth. The second method is that private firms are usually characterized by informational data, that is, financial statements which is the only source of public information. Several important firm stakeholders such as bankers, suppliers, or external investors use this information source to make a credit or investment decision. The third method is the better understanding about the quality of this information ...