Methods Entities Use to Manage Earnings

1. Accounting Discretion (GAAP Flexibility):

Elaborations:
Firms often take advantage of the flexibility allowed under Generally Accepted Accounting
Principles (GAAP) to make changes that affect reported earnings. These changes may not be
illegal, but they are often used opportunistically to influence financial results. Managers can
justify such changes as being in line with industry standards or business needs, even if the true
motive is to manipulate earnings.

Examples:

 Changing depreciation policies: For instance, Southwest Airlines increased the useful
life of its aircraft from 20 to 25 years. This reduced depreciation expense and helped
maintain a consistent upward earnings trend.
 Capitalizing expenses: Expenses that were previously expensed immediately (like
development costs or certain software costs) may now be capitalized and amortized over
several years to reduce current period expenses.
 Delaying amortization: Slower amortization of capitalized expenses results in lower
current period expenses.
 Reducing provisions: Managers may decrease provisions for doubtful debts or warranty
liabilities to boost current period earnings.

2. One-Time Charges (Big Bath Accounting):

Elaborations:
During periods of poor performance, firms may record large one-time charges to make the
results look worse. The rationale is that investors will ignore one-time losses, but future results
will appear stronger. This method effectively “clears the slate” and sets up a more favorable
comparison for future periods.

Examples:

 Restructuring charges: Firms might record higher-than-necessary costs related to

layoffs, plant closures, or other restructuring.
 Asset write-downs: Large write-offs of impaired assets or obsolete inventory may be
recorded to reduce current earnings.
 These charges create a buffer, allowing for future income to appear stronger due to lower
ongoing expenses.

Illustration from the article:

Arthur Levitt, former SEC Chairman, criticized this practice, highlighting that inflated
restructuring charges can later be reversed as income, making earnings appear to improve even if
the actual business performance doesn’t.
3. Revenue Timing and Channel Stuffing:

Elaborations:
Firms may manipulate the timing of revenue recognition to meet earnings targets. This is often
done by accelerating sales into the current period, even if those sales would naturally occur in the
next period.

Examples:

 Offering deep discounts or extended credit to encourage customers to buy before the
end of the period.
 Channel stuffing: Shipping excessive inventory to distributors or retailers at period-end,
often with lenient return or payment terms, and recognizing revenue even though the sale
may not be final.

Red flags include:

 A sudden spike in receivables compared to revenue growth.

 Sharp fourth-quarter sales increases that do not align with overall trends.

4. Cookie-Jar Reserves:

Elaborations:
In years of strong performance, firms may deliberately understate earnings by creating excessive
reserves or deferring revenue. These “savings” can then be drawn upon during future periods
when earnings need to be boosted. This allows firms to smooth earnings over time.

Examples:

 Deferring revenue recognition: As seen in Microsoft’s case, the company was accused
of slowing down revenue recognition to build up reserves.
 Overestimating expenses or liabilities in good years (e.g., warranty liabilities or loan
loss reserves), which can later be reversed to increase future earnings.

Purpose:

 To prevent earnings from appearing too high and triggering a ratchet effect (higher future
expectations).
 To manage investor expectations and keep earnings growth steady.

5. Use of Accruals (Discretionary Accruals):

Elaborations:
Accruals are adjustments that allow firms to recognize income and expenses when they are
incurred, not when cash is received or paid. Since accruals involve estimates (e.g., expected bad
debts, warranty costs), they provide a key avenue for manipulation.
Examples:

 Overstating revenue by recording sales before they are earned.

 Understating expenses by estimating lower future costs.

Types:

 Non-discretionary accruals: Normal business-related adjustments based on real

transactions.
 Discretionary accruals: Manager-driven, subjective decisions that can be used to
manipulate earnings.

Detection:

 The Jones Model is a popular tool to separate discretionary from non-discretionary

accruals. Analysts use it to estimate expected accruals based on sales and assets, and any
excess is assumed to be manipulation.

6. Strategic Transaction Management:

Elaborations:
Firms may alter real business activities to affect accounting results. These decisions are not
purely financial-reporting-based but have long-term business implications.

Examples:

 Delaying marketing or R&D expenses to avoid reporting high expenses in the current
period.
 Selling long-term assets to record one-time gains that boost earnings.
 Postponing necessary maintenance to reduce current costs.

These actions may provide short-term earnings benefits but can harm the business in the long
run.

Why Entities Engage in Earnings Management

1. To Meet or Beat Earnings Benchmarks

Elaborations:
Companies often face intense pressure to meet specific financial targets. These benchmarks
include:

 Prior year earnings (to show growth),

 Analysts’ forecasts (to maintain market confidence),
 Zero earnings (to avoid reporting a loss), and
 Management’s bonus thresholds (performance-based incentives).
Missing these benchmarks—even by as little as one cent—can have disproportionately
negative consequences, such as:

 A sharp drop in share price,

 Negative analyst reports,
 Loss of credibility with investors,
 Lower employee morale, and
 Reduced access to capital.

Example:
Studies by DeGeorge, Patel & Zeckhauser (1999) and Burgstahler & Dichev (1997) found that
companies are far more likely to just meet or slightly exceed targets than to narrowly miss them.
This statistical anomaly suggests widespread earnings management near benchmarks.

When earnings fall just short of a benchmark, firms will engage in upward earnings
management (e.g., accelerating revenue or deferring expenses) to cross the line, even by a few
cents.

2. To Maximize Executive Compensation

Elaborations:
Executives’ bonuses, stock options, and performance incentives are frequently tied directly to
financial metrics, such as earnings per share (EPS), return on assets (ROA), or net income.

To ensure they reach the required thresholds:

 Managers may artificially inflate earnings using discretionary accounting methods.

 They may postpone bad news to avoid hurting current performance metrics.

Example:
Executives might delay recognizing an expense until the next period, allowing them to meet
bonus targets for the current year. Alternatively, they could bring forward revenue or reduce
reserves to boost reported profits.

Stock options incentive:

Before stock options are granted, executives may manage earnings downward to reduce the
company’s stock price. Since stock options are often priced “at-the-money,” this results in more
valuable options if the stock later rebounds.

Research by Aboody and Kasznick (2000) confirms that managers tend to delay good news and
accelerate bad news before option grants.

3. To Influence the Firm’s Stock Price

Elaborations:
Firms care deeply about how their stock performs in the market, especially if:
  They’re planning a new share issuance (e.g., IPO or secondary offering),
 They want to attract institutional investors, or
 Executives or insiders plan to sell shares.

By managing earnings to meet or exceed expectations, firms may create the illusion of strong
financial health, which:

 Boosts investor confidence,

 Increases the stock price,
 Reduces the cost of capital,
 Enhances the perceived value of the company.

Example:
Just before a public offering, a company may engage in aggressive earnings management to
show exceptional results, attracting a higher valuation.

On the flip side, after the offering or once the insiders have sold their shares, earnings may
return to normal (or decline), revealing the earlier results were unsustainable.

4. To Avoid the “Ratchet Effect” of Overperformance

Elaborations:
Doing too well in a current period can actually backfire in the long run. When companies
significantly exceed expectations, it raises the bar for future performance.

This is known as the ratchet effect: once higher earnings are achieved, investors and analysts
raise their expectations, making it harder for the firm to sustain or exceed them in future
periods.

Strategy: Instead of reporting the full extent of the overperformance, firms may deliberately
understate earnings through:

 Accelerating expenses,
 Deferring revenue, or
 Creating reserves (cookie-jar accounting).

This creates a cushion that can be used to smooth earnings in future periods, making it easier to
meet expectations consistently.

Example:
If a firm’s actual EPS is $2.50 while analyst expectations are $2.00, it might report $2.30 instead
—beating expectations but saving $0.20 for a future period when performance may falter.
5. To Build a Turnaround Narrative (“Big Bath Accounting”)

Elaborations:
In years of particularly poor performance, when it’s clear that earnings will be far below targets,
firms may engage in downward earnings management to make results look even worse.

Why? Because if the firm is going to miss the target anyway:

 The penalty is already priced in by investors.

 Making the loss look bigger (a “big bath”) allows for greater future earnings rebound.
 It gives the appearance that future improvements are more impressive, even if part of
the recovery is just accounting.

Tactics used:

 Write off assets aggressively,

 Increase provisions and reserves,
 Take restructuring charges and impairments.

This strategy effectively “cleans the slate,” and sets the stage for:

 Stronger future earnings due to fewer expenses,

 Improved investor confidence in management’s ability to turn the company around.

Example from the article:

Arthur Levitt, in his famous speech "The Numbers Game", warned that companies often pad
restructuring charges. These overstated losses later "miraculously" reappear as earnings when
estimates change or expenses are reversed.

Classification Shifting as an Earnings Management Tool

1. Definition:

Classification shifting is a form of earnings management where a firm misclassifies items

within the income statement to make core or recurring earnings appear better than they
actually are. Instead of altering total net income, classification shifting relocates expenses or
revenues between different line items, typically between operating and non-operating
categories. Unlike accrual-based earnings management, which affects total earnings through
judgment in recognition and measurement, classification shifting does not change total net
income, but it enhances the perceived quality of earnings by manipulating how components
are presented.

2. How It Works:
Companies use classification shifting to move unfavorable expenses or losses from operating
sections to non-operating sections of the income statement. This inflates pro forma or
operating earnings — the figure often highlighted in earnings announcements, analyst
forecasts, and media reports — without affecting the bottom-line net income.

Common Examples Include:

 Reclassifying core operating expenses (e.g., advertising, R&D, or administrative costs)

as special or non-recurring charges.
 Moving recurring losses from normal business operations into categories such as:
o “Other expenses,”
o “Extraordinary items,” or
o “Discontinued operations.”
 Reclassifying cost of goods sold (COGS) into selling, general, and administrative
(SG&A) expenses to improve gross profit margin.

3. Why It Is Used:

1. To Meet or Beat Pro Forma Earnings Targets:

 Analysts and investors often focus more on core or recurring earnings rather than
GAAP net income. By shifting costs out of the core operating section, companies can
inflate operating income or earnings before interest and taxes (EBIT), even if
bottom-line net income remains unchanged. This can help the company beat earnings
expectations and positively influence stock prices.

2. To Influence Perceptions of Earnings Quality:

 Investors perceive operating earnings as more sustainable and indicative of a firm’s

long-term profitability. Classification shifting can make a firm appear to have stronger
core operations by hiding weaknesses behind one-time or exceptional events.

3. To Enhance Management’s Credibility or Compensation:

 Management bonuses and stock awards are often tied to operating performance
metrics, such as EBIT or EBITDA. By reclassifying expenses, managers can achieve
performance thresholds without actually improving the firm’s operational efficiency.

4. Is Classification Shifting Legal or Ethical?

 Legality: Technically Legal but Context-Dependent

Classification shifting is often legally permissible under both GAAP (Generally Accepted
Accounting Principles) and IFRS (International Financial Reporting Standards) as long as
the categorizations can be justified based on the nature of the transaction or expense.
Why It’s Legal:

Accounting standards offer flexibility in classifying certain items in the income statement. For
example: Revenue and expense classifications are not always rigidly defined, allowing
managerial judgment. This discretion exists to accommodate different business models,
industries, and one-off circumstances.

Examples of Permitted Use: A firm may label an unexpected legal settlement as a non-
recurring expense, even if such events occur occasionally in its line of business.

However: If the true nature of an expense is recurring (e.g., advertising or employee

bonuses), reclassifying it as “non-operating” or “non-recurring” is technically misleading,
even if it's not strictly illegal.

 Ethics: Questionable, Especially When used to Mislead

While classification shifting may comply with the letter of the law, it often violates the spirit of
ethical financial reporting, especially when its main purpose is to manipulate perceptions of
performance rather than reflect economic reality.

Why It’s Ethically Problematic:

 It distorts the true performance of a company’s core operations.

 It misleads investors, analysts, and other stakeholders, who rely on the quality of
earnings to make informed decisions.

Example: A firm repeatedly classifies normal, recurring expenses (like annual litigation costs in
a high-risk industry) as “non-recurring” to artificially inflate operating profits. Even if this is not
illegal, it is ethically misleading, as it implies those expenses are unusual when they are not.

When It Crosses Ethical Lines:

 Lack of disclosure: Failing to transparently explain reclassifications in the financial

statement footnotes or management commentary.
 Timing manipulation: Shifting items to meet earnings forecasts or enhance executive
bonuses.

Short-Term Consequences of Classification Shifting

1. Favorable Market Reactions

By shifting non-operating income to boost operating profits, companies may appear more
efficient and profitable. This can lead to positive investor sentiment, stock price
increases, and improved market value—even if total net income remains unchanged.
2. Increased Executive Compensation
Many executive bonuses and stock options are tied to performance indicators like EPS or
operating income. Classification shifting can help managers meet these targets without
 improving actual performance, offering personal financial gain from temporarily
enhanced results.

Long-Term Consequences

1. Loss of Credibility
If the shifting is later exposed—through analysts, regulators, or media—it can damage
the company’s reputation. Investors may feel misled, leading to long-term distrust,
reduced confidence in future reports, and potential stock price declines.
2. Regulatory Scrutiny
Though it may comply with accounting rules, classification shifting can still be seen as
deceptive. Regulators like the SEC may investigate if the practice misleads investors,
potentially resulting in enforcement actions, revised statements, and stricter controls.
3. Investor Distrust
Even if legal, shifting can create a perception of manipulation. This can reduce investor
confidence, spark sell-offs, and increase skepticism from analysts and institutions, raising
capital costs and depressing share value over time.
4. Restatements and Legal Risks
If the misclassification materially affects investor decisions, the company may be forced
to restate financials. This often triggers lawsuits from shareholders who suffered losses,
bringing financial penalties, legal costs, and long-term reputational harm.

Key Ethical Accounting Principles at Stake

 Faithful Representation

This principle requires that financial statements accurately reflect the economic reality of
transactions—not just their legal form. Classification shifting violates this by misclassifying
recurring expenses as non-recurring, masking the true nature of operations and misleading
users about core profitability.

 Transparency

Transparency ensures that financial information is presented in a clear, honest, and complete
manner. When companies shift classifications without proper disclosure, it obscures important
details, preventing investors from fully understanding the company’s performance.

 Integrity and Fairness

Ethical accounting demands that management acts with honesty and fairness, prioritizing the
interests of all stakeholders. Classification shifting done solely to meet short-term targets or
boost compensation reflects self-interest over stakeholder trust, undermining the ethical
foundation of financial reporting.
3. Discuss whether CEO compensation is related to earnings management.
Refer to Tahir et al (2019)

4. Discuss the role of corporate governance in preventing earnings

management. Refer to Xie et al (2003)

5. Discuss the role of ethics in reducing earnings management. Refer to Chen

et al 2018.
CREATIVE ACCOUNTING

1. Fair Presentation

This involves using the flexibility within accounting rules to give a true and fair picture of the
financial statements. The primary purpose is to serve the interest of users such as investors,
creditors, and regulators. Although some level of judgment is permitted in accounting (like
choosing depreciation methods or estimating provisions), those judgments are applied ethically
and transparently. The aim is to reflect the actual financial position and performance of the
company without manipulation or bias.

2. Creative Accounting

Creative accounting refers to the use of accounting flexibility to manage the measurement and
presentation of financial statements in a way that benefits the preparers, usually the company’s
management. It remains within the limits of the accounting standards but stretches those rules to
portray a more favorable performance. Common techniques include timing the recognition of
revenue or expenses and selectively applying accounting policies. While legal, it can be
misleading and is often used to meet performance benchmarks or influence stakeholder
perception.

3. Impression of Management

This involves manipulating the presentation and language of financial statements—especially

through narratives, graphs, or charts—to create a more positive impression of the company’s
performance. Even when the numerical data is accurate and complies with standards, the way it
is communicated can be biased. For example, management may emphasize growth figures while
avoiding discussion of rising debt or falling profits. This method is subtle but can shape
stakeholders’ perceptions in favor of management’s interests.

4. Fraud

Fraud occurs when a company deliberately steps outside the boundaries of accounting
regulations to create a false picture of its financial health. This includes illegal actions such as
fabricating revenues, concealing liabilities, or falsifying transactions. The intent behind fraud is
to deceive stakeholders for personal or corporate gain, such as increasing share prices, obtaining
loans, or avoiding regulatory penalties. Unlike creative accounting, fraud violates laws and
accounting standards, and it can result in legal consequences, financial penalties, and
reputational damage.
WINDOW DRESSIG

1. Window dressing is the practice of making financial statements look better

than they really are.

This usually happens near reporting dates (like year-end) and includes actions such as delaying
expenses, accelerating revenues, or inflating asset values to create a more favorable impression.

2. It is often used to mislead users, but not necessarily through illegal means.

While the intent is to influence stakeholders like investors or lenders, many window dressing
techniques still fall within the boundaries of accounting standards and legal rules.

3. It is more associated with short-term, cosmetic changes.

Unlike creative accounting, which may involve long-term policy choices or complex estimates,
window dressing focuses on temporary adjustments that improve financial appearance without
changing actual performance.

4. It is perceived as more deceptive and closer to fraud than creative accounting.

Even if it doesn’t break laws, its misleading nature makes it ethically questionable. That’s why
people often associate window dressing more strongly with fraudulent behavior.

5. It does not always involve illegality or regulatory breaches.

Some forms of window dressing may simply be aggressive but legal interpretations of the rules.
It only becomes fraud when the company deliberately violates standards or fabricates data.