Living in a world widely driven by money you should be taking measures to improve your financial security in order to live a better life. People should know what to do with their money, how to invest, where to invest, for how long to invest it, and choose the best option. This is all possible because of the power of information which is essential to each investment. You should be able to read financial statements and draw conclusion behind it, but when it comes to the bottom line the only important thing that draws the attention of everyone is the earnings and how well the company is doing.
Earnings can influence the company's stock value by increasing it or by decreasing it. This is why the whole thing called earnings management is there for. "Earnings management is an attempt to present the financial information in the most positive light, usually by downplaying any negative elements to the point that they are extremely difficult to detect. " Definition by: (what is earnings management, n. d) But earnings management can stretch itself to the point of being fraud which is actually very easy to do which in that case is entirely illegal and not a case of caveat emptor.
According to Ronen and Yaari(2008 p. 25) "the different definitions of earnings management, classifying them as white, gray, or black. Beneficial (white) earnings management enhances the transparency of the reports; the pernicious (black) involves outright misrepresentation and fraud; the gray is manipulation of reports within the boundaries of compliance with bright-line standards, which could be either opportunistic or efficiency enhancing. "
Earnings Management or sometimes referred as creative accounting is most of the times ambiguous and many people tend to confuse it as misusing and manipulating the financial data so that managers can show better figures in the income sheet. And therefore there is a fine line between earnings management and fraud and it is very hard to detect until it is already late, resulting in big loses for both investors and company. Generally Accepted Accounting Principles or GAAP is a term that includes all guidelines for a financial framework or also knows as Accounting Standards.
It includes regulations and rules that people who create financial statements should follow. However GAAP rules and regulations sometimes can be very confusing, arbitrary and hard to interpret because some of the cases there is clearly no limit to what you can do and not know where exactly the crossing line between legal accounting activity and illegal is. ( Financial Accounting Standards Advisory Council (FASAC) n. d) That is why earnings management is so flexible in its reporting and managers and chief accountants have a lot of room to work with.
By fake improving the earnings of the company by managers achieve higher stock price so they keep the shareholders satisfied and also managers get huge bonuses at the end of the year and the view this strategy as a win-win. Also they attract new shareholders so that means fresh capital for the company. This is all due to the reason that managers have the need to meet the expectations of the investors. This is why they calculate their balance sheets all different starting with the expected profit and then adding all the rest such as expenses and costs.
This is basically backwards the original way to calculate a balance sheet. (Earnings Management and the Abuse of Materiality, Grant, T. JR. September 2000. ) In a "Numbers Game" speech in 1998 former SEC chairman Arthur Levitt said that "too many corporate managers, auditors, and analysts let the desire to meet earnings expectations override good business practices. I call for a fundamental cultural change on the part of corporate management and the entire financial community.
(Abusive earnings management and early warning signs, Magrath, Lorraine, Aug 2002,) I do believe that most of the cases which include earnings management and turned out to be bad for investors are cases of caveat emptor because people who put in money in the company failed to realize what was going on. Of course for most of us it is hard to draw a clear conclusion out of the financial statements and that is why if you want to give a big lump of money to someone you should consult with somebody who actually knows his way around.
Nevertheless there are some situations where indeed the firms overstretched themselves by aggressive earnings management which unfortunately ended with big scandals and money being lost for the investors. However managers who practice earnings management do so mainly to satisfy the shareholders otherwise the manager would lose his job. All this comes from absence of mutual understanding between the people who run the companies and the shareholders. ( What is earnings management, n. d)
It is not hard to imagine why managers would like to be engaged with aggressive earnings management. There are many reasons why such fraudulent activity may occur for example for someone the goal could be to boast up price of the shares in order to attract new investor who seek more profit for the current year or for future times. Also firms with high stock price have high valuation and also they are able to reduce their cost of capital, and also managers benefit enormously from a situation like this because it assures high personal gains.
Another reason for a company to use aggressive earnings management is the so called "borrowing cost effect" which is basically by reporting high earnings companies successfully take the image of a firm that has improved the quality of debt meaning that they could pay with ease and also attract some new investors who seek a firm with bright future to take care of their money. On cause for creative accounting is the "bonus plan effect" by which some of the big corporations have an options for some important employees to be given stocks of the firm as a bonus.
Of course employees like the idea of receiving stocks or cash which is connected to the current stock price of the firm so that brings the employees and shareholders to the same interest which mean workers are more prone to commit fraud in order to receive a high amount in the end. Also "political cost effects" can be a great motivator for big firms with high profit. What they do is basically try to report lower incomes in order to avoid suspicions from authorities. (The financial numbers game, Wiley, 2002,) (Earnings management and its implications, Akers, M. , n. d)