Earnings Management: When Does Juggling the Numbers Become Fraud?

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.

GAAP Choices 

In an ideal world, performing (conducting the company’s business as effectively and efficiently as possible) would be the focus of a management team, and performance reporting would flow without much thought or effort by simply following GAAP that ensured reporting of economic reality. But, in the real world, GAAP allows considerable discretion and, as a result, managers and accountants often devote substantial energy to reporting concerns.

Various inventory methods and approaches to depreciation calculation, for example, are acceptable alternative accounting treatments that allow companies to adapt their reporting methods to reflect economic reality. However, two companies experiencing the exact same economic events may choose different inventory methods and depreciation calculations and thus report different quarterly and annual earnings figures. In fact, GAAP contains numerous instances in which managers and accountants can choose alternative methods to account for company performance. And, while such choices may allow for a truer measure of earnings, too often the selection of a particular GAAP method is made to distort performance measurements.

Conversely, GAAP sometimes shuts the door on accounting methods that may provide a truer measure of earnings. For example, if a company increases research and development (R&D) spending by $10 million in a given year, a case could be made for treating that amount as an asset, spreading the cost over more than one year. However, with few exceptions, GAAP calls for R&D costs to be expensed as incurred. The costs are matched against revenues of the current period and not against the future year revenues they may generate. The result is understated reported earnings initially and then overstated reported earnings in future years.

Moving Earnings Around and the Analyst’s Quick Fix 

It’s indisputable that some companies manage their earnings. Analysts recognize this and, in fact, can predict reported earnings more easily for companies that use earnings management to show smooth, consistent earnings growth. Some company officials even prompt analysts occasionally, assuring them of no impending surprises, which guarantees most analysts’ estimates will fall into a small, tight range.

Many analysts mistakenly equate the “quality” of reported earnings (again, the similarity of the numbers to economic reality) with the direction of the earnings management. If the analysts can detect managing, they “fix” reported earnings by labeling them as “high quality” if they have been managed downward and “low quality” if managed upward. Even though understating, or managing earnings downward, may appear to be a conservative action, resulting in “safer” reporting, it’s not accurate; it often leads to overstated earnings – not a conservative action – in later periods. Therefore, the analyst’s quick fix doesn’t work because the quality of financial information is eroded by manipulations, regardless of the direction of the earnings management.

The Game of Nods and Winks 

SEC chairman Arthur Levitt noted in a recent speech, “too many corporate managers, auditors, and analysts are participants in a game of nods and winks … in the zeal to satisfy consensus earnings estimates and project a smooth earnings path.”3 If a company shows steady growth (and analysts are patted on the back for predicting it), everyone’s apparently happy. But should everyone be happy? Are investors and others getting a true picture of performance when a management team smoothes out earnings fluctuations by recording sales early or booking expenses late? Are company managers acting responsibly and with integrity when they time the performance of an event (such as maintenance) with no sound business purpose in mind, or when they time performance reporting (such as recording inventory obsolescence) to show desired rather than actual results?

When an economic event or transaction occurs, the question addressed should be, “How should this be recorded to best reflect economic reality?” not “How should this be recorded to best show the stream of earnings we want to show?” Economic reality – that which should be reported to financial statement readers – is a function of performance, not a function of earnings management. To the extent reported earnings are managed, their quality is lessened. Furthermore, generating low quality earnings information is simply not good business. Rather, as Peter Lewis, CEO of Progressive (a fast-growing Cleveland, Ohio, automobile insurer), recently warned, “the accounting stuff that’s required to smooth things out causes management to mislead itself.”4

Suggestions for Improving Performance Reporting 

William Bruns and Kenneth Merchant, two well-known accounting academics, have said that “anyone who uses information on short-term earnings (for example, reported quarterly and annual net earnings figures) is vulnerable to misinterpretation, manipulation, or deliberate deception.”5 That’s a sad commentary on the state of performance reporting – but all too true. And, because the analyst’s quick fix (that is, labeling earnings as high quality or low quality) is misleading, financial statement readers lose out on all fronts.

All financial statement users need to be aware of earnings management practices. Such practices seriously erode the quality of earnings information and thus are “far from an arcane accounting debate,” as noted recently in Business Week.6 Today’s users of financial statements include a broad cross-section of the American public – from young couples saving for their first homes to workers investing their retirement funds with the hopes of doing some traveling in their “golden years.” They put their faith in earnings information as a measure of economic reality.

Building awareness of earnings management practices isn’t, however, the long-run solution to the problem. As SEC chairman Levitt sees it, earnings management is “a game that, if not addressed soon, will have adverse consequences for America’s financial reporting system.”7

Levitt has challenged corporate management to improve oversight of performance reporting via the audit committee – members of a company’s board of directors who “represent the most reliable guardians of the public interest.”8 Research shows that audit committees can curtail earnings management practices and ensure more reliable performance reporting. For example, John Wild, a professor of accounting, provides empirical evidence to support the claim that reported earnings of companies with audit committees are of better quality than those without.9 And, looking at the reverse, university professors Patricia Dechow, Richard Sloan, and Amy Sweeney offer empirical evidence that “poor oversight of management through weak governance structures is an important catalyst for earnings manipulation.”10

SEC chairman Levitt also has called for the private-sector, rule-making body in accounting – the Financial Accounting Standards Board (FASB) – to improve current reporting standards.11 In 1978 and then in 1980, FASB issued “concepts” statements that describe the objectives of financial reporting and enumerate the characteristics of useful accounting information. In particular, Statement of Financial Accounting Concepts No. 2 calls “relevance and reliability … the two primary qualities that make accounting information useful for decision making.”12

FASB’s concepts statements were devised to guide improvements in reporting standards. The key solution for the earnings management problem isn’t to improve these concepts statements but to rededicate ourselves to quality performance reporting based upon these statements. GAAP will evolve satisfactorily only if standard-setters don’t lose sight of these concepts statements as they tackle reporting issues caused by an increasing array of economic events and transactions. More importantly, managers, accountants, and boards of directors – through their audit committees – must fully accept and fulfill their reporting responsibilities, balancing their self-interests with the interests of the public. They need to focus on making good decisions and reporting the outcomes of those decisions in the manner that best portrays economic reality.

Of course, not everyone will rededicate themselves to improving the performance reporting systems within their companies. That’s why fraud examiners and auditors will continue to play a critical role in helping assure the verity of reported financial information. And in this process, they must guard against unknowingly collaborating in the “game of nods and winks.” Recognizing earnings management abuses and understanding why they occur is an important first step.

Stephen D. Makar, Ph.D., CPA, is assistant professor of accounting in the College of Business Administration at the University of Wisconsin in Oshkosh, Wisc. Pervaiz Alam, Ph.D., CPA, is associate professor of accounting in the College of Business Administration at Kent State University in Kent, Ohio. Michael A. Pearson, D.B.A., CFE, CPA, CMA, is professor of accounting in the College of Business Administration at Kent State University in Kent, Ohio. He is a member of the Editorial Review Board of The White Paper.  

1 Davis, Ann, “SEC, Grace Near Accord in Fraud Case,” The Wall Street Journal, June 25, 1999, A3.
2 King, Ralph T. Jr., “McKesson Restates Income Again as Probe of Accounting Widens,” The Wall Street Journal, July 15, 1999, A1.
3 Levitt, Arthur, “The Numbers Game,” speech delivered at New York University, New York, NY, Sept. 28, 1998.
4 McGough, Robert, “Executive Critical of ‘Managed’ Earnings Doesn’t Mind if the Street Criticizes Him,” The Wall Street Journal, April 16, 1999, C1.
5 Bruns, William J. Jr., and Merchant, Kenneth A., “The Dangerous Morality of Managing Earnings,” Management Accounting, August 1990, p. 22.
6 Byrnes, Nanette; Melcher, Richard A.; and Sparks, Debra, “Earnings Hocus-Pocus,” Business Week, Oct. 5, 1998, p. 136.
7 Levitt, “The Numbers Game.”
8 Ibid.
9 Wild, John J., “The Audit Committee and Earnings Quality,” Journal of Accounting, Auditing & Finance, Spring 1996, pp. 247-276.
10 Dechow, Patricia M.; Sloan, Richard G.; and Sweeney, Amy P., “Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC,” Contemporary Accounting Research, Spring 1996, pp. 1-36.
11 Levitt, “The Numbers Game.”
12 Financial Accounting Standards Board, “Qualitative Characteristics of Accounting Information,” Norwalk, CT: FASB, 1980.