Have you heard the one about the company that needed to hire a chief corporate accountant? In the last interview session each finalist was given financial information and asked, “What are the net earnings?” All applicants but one dutifully computed the net earnings but none of them got the job. The candidate who landed the position answered the question by replying, “What do you want your net earnings to be?”
The story, whether factual or fictitious, does demonstrate how a company’s reported earnings may not necessarily be an objective measure of economic reality. For one thing, “generally accepted accounting principles” (GAAP) allow an accountant to select from various methods when computing earnings and other financial measures, which could lead to lower quality financial information depending on the accounting methods used. (The “quality” of financial information is measured by how well the numbers reflect economic reality.) Furthermore, company managers can “manage earnings” subjectively by timing business activities or the reporting of those activities.
Earnings management becomes fraud when companies intentionally provide materially misstated information. W.R. Grace and Co. officials, for example, learned this the hard way. The company was charged with stashing earnings in reserve accounts in good years and then tapping them in later years to mask actual slowing earnings.1 (Without admitting to or denying the charges, Grace later signed a cease-and-desist order and promised $1 million to support educational programs that enhance public awareness of financial reporting and GAAP.)
McKesson HBOC Inc. was charged with the opposite of Grace. The company allegedly booked premature revenues by including in sales figures a substantial list of contracts that had not been finalized.2 The Securities and Exchange Commission (SEC) and other agencies are investigating many more cases like these two for earnings manipulation. (McKesson HBOC later fired or accepted the resignations of its chairman and six other top executives, restated previously reported earnings, and instituted new internal accounting procedures.)
A Definition of Earnings Management
Companies manage earnings when they ask, “How can we best report desired results?” rather than “How can we best report economic reality (the actual results)?” Earnings management includes selecting GAAP methods with concern for appearance rather than reality. It also includes subtle techniques such as changing reported earnings through “performance timing.” For example, a manager seeking to reduce expenses in the current period might defer scheduled routine equipment maintenance until the next accounting period. The result is higher reported earnings in the current period, but the maintenance delay, of course, may be detrimental to the company’s future operations. Also, a company may vary the timing of performance reporting. Recording inventory obsolescence is required under GAAP, for example, but choosing when to record obsolescence is fairly subjective. A manager may know some part of the company’s inventory has become obsolete, but if earnings in the current period are lower than desired, he might defer recording the loss, or “write-down,” until a future period.