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.