Management of incomes involves the understanding of the effect of the accounting decisions by the management so as to make a decision that is best for the company. Earnings indicate the extent of a firm’s engagement in value-added activities. Therefore an increased earning represents an increase in the value of the company (Ronen & Yaari, 2008).
Since accounting process deals with matters of judgment and of resolving conflicts between different competing approaches to the presentation of the results of events and transactions in a business, there is room for manipulation. Such practices by the accounting professionals are intended to achieve income smoothing, manipulation of profits forecasts, distract attention from unwelcome news through income boosting accounting policy and maintain or boost share prices (Ronen & Yaari, 2008). Ultimately the effect is on the decision of the investors in the stock market.
Ethical perspective of earnings management
Considering earnings management in relation to both managers and shareholders, it is true that each can draw benefits from the practice. For managers, they can manipulate incomes so as to ensure big bonus entitlements (Ronen & Yaari, 2008). Shareholders on the other hand benefit from the fact that reported earnings manipulation that ensures reduced volatility of earnings as a result ensuring the value of shares. Even though earnings management hides true earnings of the company, it is possible for shareholders to make informed decisions based on the levels and patterns of earnings. The shift from earnings management to earnings manipulation is unethical.
Tactics for earnings management
Managers can exploit the flexibility in accounting choices and or operational choices so as to manage earnings. The practice could involve adopting a depreciable life for a new machine to lower the depreciation expense and, therefore, maximize future reported earnings. The choice of accounting practice is to manage the earnings in the desired direction. Similarly, manipulation of tax reported liabilities, reserve account calculations, and legal cost estimates can be used to achieve similar results (Ronen & Yaari, 2008)
The balance sheet is a representation of investment by shareholders and how the cash investment is allocated among competing resources. This investment should be rewarded through financial gains. An under-investment in assets or a failure to capture costs of operation would lead to overestimation of earnings. An example of such operation costs is depreciation. The company would, therefore, fail to recognize depletion or use extended depletion periods.
Ronen, J., & Yaari, V. (2008). Earnings management. New York: Springer.