Accrual Base Accounting and cash based accounting are 2 methods employed by managers in financial reporting of the earnings of a company over a period. As per Generally accepted accounting principles (GAAP), a company has a choice in application of accounting methods which is often referred to as earning management.
Accrual based accounting is a form of measuring the income where the effect of transaction is recorded when the transaction occurs rather than being recorded when cash is received or paid, which is the cash based accounting method. This method enables the combining of the current cash inflows and outflows with future expected cash inflow and outflow that could be expected. This way, the company can project a statement that more closely reflects its current financial statement.
In accrual based accounting the revenue and expenses are defined differently than in the cash based system. The transaction in modern day businesses are complex and thus a need for this type of accounting was felt. It arose from the “Buy now Pay later” principle that dominates all payment processes today. The example of use of credit card by a customer is a good example for why accrual based accounting is widely used by firms. When a customer buys something through a credit card, the transaction is made today while the cash might be received by the company a month later. The company is expected to get the cash at a future date and decides to record it in the current month. The revenue is recognized when it is earned, realized or realizable. Earned is referred to when a product is delivered or services are rendered. It is realized when cash is received and realizable when it is reasonable to expect that the cash shall be received in the future.
There can be situations where the managers can start misusing the system to system to project a false picture of success through manipulating earnings that the earning management enables. Through earning management the managers try to reflect the actual picture of growth or the financial standing of the company. Through the discretionary powers that they possess, there can be occasions where grossly incorrect pictures of growth are predicted. The management of earnings can then lead to manipulation and misstatement taking management down the path from questionable ethical practices (McGregor, 2008). The earning can be manipulated upward or downwards in such cases thus concealing the truth that can be considered unethical (Belski & Brazovsky, 2002). The case of Enron and its accounting procedures where they projected abnormal figures as accruals that were expected to be received is perhaps one of the most famous incidents of malpractices in financial reporting.
Three Reasons to manipulate the earnings upwards
The earning management is a common practice in companies. Very often mangers would use judgment in financial reporting and restructure transactions to alter the financial reports of the company. This is done with a view to mislead the stakeholders of a company on the performance of the company or influence contractual outcomes that might be dependent on the reported figures (Healy and Wahlen, 1999).
Missing targets can also cause the stock prices to drop sharply (Graham et al, 2006). It has also been noticed that missing targets can precipitate significant negative price reactions (Skinner & Sloan, 2002; Lopez & Rees, 2002). Thus the missing of targets can be significantly costly to the shareholders. The company might want to manipulate its earnings upwards to keep the stock prices up. Managers also increase earnings to increase the value of employee stock options and option exercises (Jensen et al., 2004). Cheng and Warfield (2005) found that managers manipulate earnings upward to meet or beat earnings targets before stock-option exercises.
Upward manipulation is also carried out through psychological heuristics heaping when there exists uncertainty in future firm performance (Fengyi et al., 2011).
Other reasons for upward manipulation include tax management, job security of the managers, receive bonus related pay and to cover up fraud, as in the case of Enron.
Reason to manipulate the earnings downwards
While majority of manipulations in earnings are projected upwards, there can be situation where it is beneficial to the managers to manipulate it downwards too. In cases where there is a possibility of large stock option grants (i.e. options granted after the earnings are announced), the managers might have an incentive for downward earning management. Balsam et al. (2003) found that the managers decrease earnings to increase the value of stock option grants. McAnally et al. (2008) added that the companies even manipulated earnings to miss their targets to get grants in spite of the psychological and economic importance attached to it. Thus one major reason for the downward manipulation is the possibility of large stock option grants that can be made available to the management in case the financial targets are not met.
Cookie Jar Reserves
The cookie jar reserves refers to an earning management and manipulation technique where the company sets up additional expense accruals during periods of strong earning to draw from later at the times of slow financial performance. It is the creation of excessive accounting reserves in one year to smoothen the earning of a year with lesser earnings. According to McKenna (2011) “A cookie jar is the place manipulative managers build up generous reserves in good quarters so they can use them to offset losses that might be incurred in bad quarters.”
The cookie jar works the following way:
Suppose the company is able to meet the expected earnings for few years at a stretch. This would result in the stock prices of the company to rise. In one of these years the results were very favorable and high growth was recorded. In such a case, if the company foresees that future growth might not be that strong due to various factors like competition and change in technology, the company might consider taking a share of the profits to set up an excessive reserve. This liability or an expense is not directly linked to any particular accounting period. In the following year when the growth is slower than the previous year as expected, the company can cash in on the cookie jar reserve and still post numbers of high profits. The practice of cookie jar accounting is not permissible for public companies by United States Securities and Exchange Commission (SEC) as it can be misleading to the investors.
Earning Smoothing: Ethical/Unethical
The earning smoothing is referred to the accounting practice involving intertemporal smoothing of reported earning relative to economic earning to make the earnings look less variable over time (Goel & Thakor, 2003).
The smoothing of earnings can either be real or artificial. Real smoothing is based on decisions that affect cash flow and the firm value. Some examples are changing the timing of any investment or providing discounts that alter the affect of cash flow and the account statement of the quarter/year.
Artificial smoothing refers to the employment of accounting techniques like cookie jar reserves, capitalization practices or “Big Bath” one time changes to bring about smoothing of the earnings.
The smoothing of earnings is permissible under GAAP and a common earning management practice. It is believed that the firms are less likely to manage earnings for opportunistic reasons when they behave ethically (Barton et al., 2010). It is also found that ethical firms do in fact engage in earnings management, but through “real” activities rather than mere accrual manipulation (Barton et al, 2010).
Incentive related to managerial compensation and equity stakes are seen as opportunistic. There exists a relation between the earning smoothing such managerial incentives of bonus and stock. Thus companies engaging in smoothing operations through accrual manipulation practices should be seen as unethical. Thus to sum it up, every company carries out earning smoothing to some degree. Those practices brought about by real activities are seen as ethical. The artificial smoothing through accrual manipulation and creative accounting techniques, in spite of being within the boundaries of the law, are unethical practices.
Balsam, S., Chen, H. & Sankaraguruswamy, S. (2003). Earnings management prior to stock-option grants. Working paper, Temple University.
Barton, J. et al. (2010). Is It OK to Manage Earnings?, insead.edu.
Belski, W.H. & Brozovsky, J.A. (2002). Ethical judgments in accounting: an examination on the ethics of managed earnings. Critical Perspectives on Accounting Conference.
Cheng, Q., & Warfield, T. (2005). Equity incentives and earnings management. The Accounting Review, 80 (2), p. 441–476.
Fengyi, L., Liming, G., & Wenchang, F. (2011). Heaping in Reported Earnings: Evidence from Monthly Financial Reports of Taiwanese Firms. Emerging Markets Finance & Trade, 47(2), 62-73.
Goel, A.M. & Thakor, A.V. Why Do Firms Smooth Earnings?. Journal of Business, 2003, 76(1), pp. 151-192.
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Healy, P. M. & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, pp. 365–383.
Lopez, T., & Rees. L. (2002). The effect of beating and missing analysts’ forecasts on the information content of unexpected earnings. Journal of Accounting, Auditing, and Finance, 17 (2), p. 155–184.
McAnally, M., Srivastava, A., & Weaver, C. D. (2008). Executive Stock Options, Missed Earnings Targets, and Earnings Management. Accounting Review, 83(1), 185-216.
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Skinner, D., & Sloan, R. (2002). Earnings surprises, growth expectations, and stock returns or don’t let an earnings torpedo sink your portfolio. Review of Accounting Studies, 7, p. 289–312.