Definition Of Earnings Management Accounting Essay

For legion old ages, net incomes direction has been of grave concern for regulators and practicians, and has received significant attending in the accounting literature. Healy and Wahlen ( 1999: p.380 ) in their survey “ A Review of the Earnings Management Literature and its Deductions for Standard Setting ” , pinpoint that “ anterior research has focused about entirely on understanding whether net incomes direction exists and why. ” They halt that net incomes direction remains a fruitful country for academic research and suggest that future research parts is important for the finding of the possible factors that restrict net incomes direction.

Definition of Earnings Management

Cardinal to this survey is the definition of net incomes direction. Beneish ( 2001 ) and Healy & A ; Wahlen ( 1999 ) argue that, there is a broad organic structure of literature with respect to net incomes direction but no consensus on the definition of net incomes direction and there are several different definitions. For case, Davidson et Al. in 1987 express that, “ net incomes direction is the procedure of taking calculated stairss within the restraints of by and large accepted accounting rules to convey approximately coveted degree of reported net incomes. ” In the same venas, Dye ( 1988 ) and Scott ( 1997 ) averred that, “ net incomes direction is the pick by house of accounting policies so as to accomplish some specific managerial aim. ” Scott ( 2011 ) further provinces that, “ net incomes direction as the pick by a director of accounting policies, or existent actions that affect net incomes so as to accomplish a particular reported net incomes aim. ”

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Healy and Wahlen ( 1999 ) express that, “ net incomes direction refers to the judgement used by directors to change fiscal studies to either misdirect some stakeholders about the economic public presentation of the house or to act upon contractual results that are contingent on accounting Numberss. “ [[ 1 ]] Further, in the same twelvemonth, Degeorge, Patel, & A ; Zeckhauser in there survey find that, “ net incomes direction as unreal net incomes use by directors to make the expected degree of net income for some particular determinations like effects on analysts ‘ prognosiss or appraisal of old gaining tendencies. ” Therefore, they believed that the chief end of net incomes direction is investors ‘ imaginativeness direction.

Back in 1989, Schipper states that pull offing net incomes is a “ purposeful intercession in the external fiscal coverage procedure with the purpose of obtaining some private addition. ” In the same visible radiation, Dechow et Al. ( 1995 ) ; Burgsthaler and Dichev ( 1997 ) ; Dechow and Dichev ( 2002 ) averred that, “ the term net incomes direction is by and large used to bespeak the usage of discretion by those fixing the histories in prosecuting aims of a personal or peculiar nature in order to obtain an advantage or mislead certain stakeholders in footings of cognition of operations and corporate consequences. ” They continue to construct upon this definition by saying, “ net incomes direction qualifies those accounting policies that outside the range of the quantitative finding of histories are aimed at the methodical change of periodic corporate coverage. ”

On a contrary item, Fischer and Rosensweig ( 1995 ) defined net incomes direction as, “ actions by division directors which serve to increase ( lessening ) current reported net incomes of a division without a corresponding addition ( lessening ) of the long-run economic profitableness of the division. ” As such, this definition identifies two of import constituents of net incomes direction: effects and purpose. Further in 2008, Ronen and Yaari province that, “ net incomes direction can be slackly defined as a scheme of bring forthing accounting net incomes and go on by reasoning that net incomes direction is an umbrella impression for Acts of the Apostless that affect the reported accounting net incomes or their reading. ” However, other research workers have tried to give an in-depth penetration of net incomes direction from assorted positions as discuss below:

Agency Problem

Net incomes direction may emerge as an consequence of bureau job. The term bureau job besides known as principal-agent job is defined as, “ an bureau cost where the misalignment of involvements between the agent ( e.g. , director ) and chief ( e.g. , house, superior, stockholders ) leads the agent to maximise his/her ain economic involvements at the disbursal of the principal. “ [[ 2 ]] Jensen and Meckling ( 1976 ) I? Watts and Zimmerman ( 1986 ) , farther argue that, “ an of import facet of pull offing these differing involvements is the demand to command the directors ‘ behaviors through monitoring mechanisms. ” In the same venas, back in 1932, Berle and Means branded that, “ the rights of stockholders have long been considered an of import external administration mechanism to aline the actions of directors with the involvements of proprietors. ”

Net incomes direction is by and large perceived as being unwanted from the point of position of investor ‘s and stakeholders ‘ . The underlying construct as gaining control of this ‘undesirable ‘ is that, “ it may queer their attempts to do a right appraisal of the house ‘s basicss and find the stock ‘s just value. “ [[ 3 ]] Besides, Levitt in 1998 notes that, “ the overall effect of net incomes direction is the eroding of trust between stockholders and companies and that such hocus-pocus is employed to befog existent fiscal volatility, thereby dissembling the true effects of direction ‘s determinations. ” Loomis ( 1999 ) farther echoes this point of view by saying that, “ directors may befog facts that stakeholders ought to cognize, go forthing them in the dark about the true value of a concern. ” [[ 4 ]]

McNichols and Stubben ( 2008 ) note that, “ net incomes direction complicates equity rating as it conceals the company existent public presentation and masks underlying tendencies in gross and net incomes growing that aid to construct outlooks of future growing and merchandise demand. ” Cheng high spots in 2005 that, “ net incomes are utile because they can capture true information relevant in measuring and foretelling steadfast public presentation. ” However, Bernard ( 1995 ) averred that, “ houses ‘ calculated net incomes direction activities may present mistakes into net incomes and thereby cut down their ability to convey true information. ”

Notwithstanding, it is intrinsic to emphasize that the aim of fiscal study is “ to supply fiscal information about the coverage entity that is utile to bing and possible investors and creditors in doing determinations about supplying resources to the entity. “ [[ 5 ]] However, Healy & A ; Wahlen ( 1999 ) argue that, “ directors use their cognition about the concern and its chances to choose describing methods, estimations, and revelations that might non accurately reflect their houses ‘ underlying economic sciences. ”

Prior research in this field reveals that, principals ‘ usage reported accounting net incomes for measuring the house ‘s public presentation which consists of two constituents ; a hard currency constituent and an accrual constituent. Furthermore, it is critical to indicate out that a major part of these accumulations could be capable to direction ‘s discretional power, and this brings to light direction ‘s ability to switch net incomes between accounting periods to act upon users ‘ perceptual experiences. [[ 6 ]] Thus, pull offing net incomes may impede the quality of the net incomes information, which thenceforth diminishes the quality of the fiscal analyses based on net incomes figures. Yet, in 2003, Leuz et Al. emphasis that, “ directors can sometimes utilize discretional accumulations to increase the informativeness of fiscal studies. ”

Information Asymmetry

Anterior literature besides reveals that, net incomes direction is closely related to dissymmetry of information between the agents ( e.g. , directors ) and house ‘s other involvement groups. In other words, as research workers have argued that, “ direction discretion in fiscal net incomes may take to information dissymmetry about hard currency flows between inside directors and outside bing and/or possible investors. ” Besides, Dye ( 1998 ) and Trueman & A ; Titman ( 1988 ) show analytically that, “ the being of information dissymmetry between direction and stockholders is a necessary status for net incomes direction. ” However, Schipper ( 1989 ) emphasis that, “ there is information dissymmetry between directors and other involvement groups and that dissymmetry can non be wholly eliminated by altering the contractual understanding. ”

Quality of Audit Process

Furthermore, assorted literatures focus on the quality of the scrutinizing procedure as a determiner of net incomes direction. For case, Tie ( 1999 ) ; Chambers ( 1999 ) in there analyze pinpoint “ the concern about the quality of accounting Numberss and its relation with the quality of the auditing procedure which is increasing over clip following the periodical bunchs of concern failures, frauds, and the judicial proceeding. ” The scrutinizing procedure as argue by Wallace in 1980, “ is supposed to function as a monitoring device that will cut down directors ‘ inducements to pull strings reported net incomes. ” In other term, as the writer argues that, “ the audit procedure adds some value to accounting information and is valued as a agency of bettering the quality of the fiscal information. ” Hence, if the auditing is imperfect, directors may utilize elite coverage methods that do non adequately reflect houses ‘ underlying economic sciences ( Healy & A ; Wahlen, 1999 ) .

Degree of freedom of accounting regulations

Another watercourse of research on net incomes direction reveals that, managing of net incomes may by and large depends on the grade of freedom that direction is being granted for accounting estimations by accounting regulations. In a survey by Tiziano Onesti and Mauro Romano ( 2012 ) demonstrate that, “ despite high quality accounting criterions, the impulse to pull strings consequences is still vigorous in the presence of managerial inducements, besides in relation to the accounting criterions execution method. “ [[ 7 ]] Back in 1999, Healy and Wahlen emphasis that, “ accounting criterions must guarantee an equal rapprochement of rigidness and flexibleness demands. ” They continue reasoning that, “ the acceptance of overly stiff accounting regulations, whilst cut downing direction discretion, could take to applications that are non peculiarly flexible and ill adaptable to the assortment of possible instances and besides indicate out that, inordinate flexibleness, ‘loosening the mesh ‘ of accounting options and possible interventions, involves greater subjectiveness in accounting estimations. ”

Ethical issue

Furthermore, few researches posit that pull offing of net incomes is an unethical pattern which has negative effects on the house ‘s image in the long tally. Back in 1994, Merchant and Rockness contend that net incomes direction is “ likely the most of import ethical issue confronting the accounting profession. ” However, this point of view was contested in 2000 by Parfet who suggests that “ net incomes direction is non needfully a negative phenomenon, but a necessary and logical consequence of the flexibleness in fiscal coverage options. That is, if directors have a duty to maximise stockholders ‘ value, so directors must take among all legal options that will assist accomplish this end. ”

Anterior literature has provided an tremendous penetration on the assorted definitions of net incomes direction. These definitions can be condense in these few lines as argue by Ronen & A ; Yaari in 2008, “ net incomes direction is a tool used for flexibleness of accounting information which directors apply as signals of their ain sole information from their several administration to stockholders and besides to pull strings accounting informations in order to diminish transparence of fiscal studies and cause to misdirect stockholders and other stakeholders in their determination devising procedure that lead to heighten directions ‘ personal net income. ”

Drivers of Net incomes Management

In recent old ages, legion accounting researches try to scrutiny the drivers of net incomes direction and the factors that induce directors ‘ inducements to pull off reported net incomes, following the immense corporate prostrations in the US ( e.g. Enron and WorldCom ) . The concern environment in itself provides assorted obliging inducements for agents ( e.g. directors ) to prosecute in net incomes use. To farther repeat this point of view, the motivation for net incomes direction is driven in portion from direction ‘s responsibility to direct concern activities in a manner that achieves targeted results. Intrinsically, another component that forms portion of the grounds for net incomes use is that the value of the house and the wealth of directors and stockholders are inextricably linked to reported net incomes. [[ 8 ]]

By and large, a director ‘s inducement to pull strings net incomes is closely related to ways in used information is used. For case, direction might increase the utility of fiscal statements in purpose to pull new investors, as the latter will account for current net incomes information when measuring the house ‘s future chances. Besides, net incomes and hard currency flow information are of extreme importance to loaners in measuring the recognition worthiness of the house ‘s. Furthermore, researches besides conclude that net incomes can be manipulated by strategically clocking and structuring minutess. For illustration, Bushee in 1998 progresss that, “ direction may opportunistically increase net incomes by cut downing research and development and other discretional disbursals. ”

Anterior literatures demonstrate the being of legion inducements for directions ‘ to prosecute in net incomes use, which can so be categorised under these three chief headers:

Market Incentives

Contractual Incentives

Regulatory Incentives

Market Incentives

Scott B. , Jackson and Marshall K. Pitman ( 2001 ) posit that, “ market inducements to pull off net incomes originate when house directors perceive a connexion between reported net incomes and the company ‘s market value. ” Friedlan ( 1994 ) further stresses that, “ direction might seek to pull strings net incomes in the hope of having a higher monetary value for their portions as describing net incomes and house ‘s value are closely linked. ” Other surveies to nail that director may pull strings net incomes in an attempt to describe positive net incomes and net incomes growing. For illustrations, directors can utilize their accounting discretion to bolster net incomes if the companies are in danger of falling below their net incomes mark or in periods environing Initial Public Offerings ( IPOs ) in an evident effort to change investors ‘ perceptual experiences. Therefore, IPOs is a nucleus constituent for market inducements as discuss below:

Initial Public Offerings ( IPOs )

Initial Public Offerings ( IPOs ) as outlined in accounting literature, occurs when steadfast security is traded to the general populace for the first clip, with the anticipation that a liquid market will develop. Notwithstanding, houses doing these IPOs do non hold an established market monetary values for these security, and one manner for measuring them is to see the promotion prospectus of the concern. Hence, net incomes direction during IPOs consists of window dressing or heightening fiscal studies pull better rating. However, this raises the inquiry of whether the monetary values quoted in regard of those portions of the IPO houses are impersonal.

Contractual Incentives

In “ Hearers and Net incomes Management ” , Scott B. Jackson and Marshall K. Pitman ( 2001 ) further postulates that “ contractual inducements to pull off net incomes originate when contracts between a company and other parties rely upon accounting Numberss to find exchanges between them. ” In this point of view, directors can change the sum and timing of those exchanges by pull stringsing the consequences of operations. These techniques chiefly include debt compacts and compensation contracts which are discuss below:

Debt compacts

Debt compacts have long been at the Centre of many arguments during the last decennaries. Accounting researches have try to size up the ground for debt compacts hypothesis that houses opt for their accounting pick or manage accumulations to avoid go againsting compacts in debt contracts. Studies further uncover that houses close to go againsting or have violated those compacts are campaigners for pull offing net incomes as it involves immense cost to direction or the house as a whole. Therefore, directors try to exert their discretion by doing income-increasing accounting picks that would loosen up the house ‘s liability. Hence, as argue by Duke & A ; Hunt ( 1990 ) ; Holthausen ( 1981 ) ; Jelinek ( 2007 ) , house ‘s liability is positively associated with net incomes direction. By the same item, if a company needs to borrow, directions have an inducement to heighten the liquidness reflected in the company ‘s fiscal studies.

Directors try to convey a more favorable image of the fiscal place of the house by shriveling the debt-equity ratio and boosting income through net incomes direction in purpose to do involvement coverage ratios look better that would ease entree to loan allowing. Accounting surveies further reveal that, “ to better entree to capital, executive tend to pull off net incomes in a mode that leads creditors to believe that a house has strong potency to bring forth future net hard currency influx. ” [[ 9 ]] Nevertheless, literatures besides pinpoint that ; the recent economic downswing is well respecting the use of hard currency flow coevals with the purpose of relieving the fiscal emphasis of houses. As a consequence, directors may prosecute in net incomes direction through debt contracts to pull strings the accounting figures to heighten the fidelity of the fiscal studies to misdirect the loaners.

Compensation Contracts ( Bonus strategy )

In today ‘s corporation, stockholders put in topographic point mechanisms that align the involvements of the directors of the house with the involvements of the proprietors of the houses in purpose to cut down bureau costs and prevent directors from moving in their ain involvements. In other words, in line to maximize stockholders wealth and to understate struggles of involvements between troughs and stockholders ; corporation create compensation contract by associating managerial wage to the betterment of house value. Studies further demonstrate that the fillips for direction compensation are determined, in portion, by steadfast net incomes. Hence by pull stringsing these accounting Numberss, for case in a scenario where directors are have a fillip based on accomplishing certain net incomes marks ( i.e. rewarded on the public presentation of the house ) , directors may unsuitably switching gross or disbursal figures to current or future periods which can act upon their current and future compensation.

Anterior research workers have provided groundss on the influence of compensation contracts on net incomes direction behavior. The best-known empirical probe is possibly ; “ The consequence of Bonus strategies on Accounting Decision ” by Healy in 1985. He put frontward that directors tend to maximize their fillip through timeserving net incomes direction since they have insider information on the house ‘s net income. He farther echoes this point of view by saying that if net incomes autumn within expected scope, direction will take appropriate accounting policy to further net incomes. However, when net incomes autumn outside the expected scope, directors tend to postpone net incomes to hereafters to maximize their fillip in the long tally.

Holthausen, Larcker, and Sloan ( 1995 ) and Gaver, Gaver, and Austin ( 1995 ) in their surveies confirm the hypothesis put frontward by Healy ( 1985 ) . They clarify that upwards and downwards net incomes direction around the upper edge do be and farther suggest that directors have inducements to pull off net incomes around a mark to maximise fillip payments. In a recent survey in 2008, Daniel, Denis, and Naveen echo that directions manipulate net incomes upward when pre-managed net incomes are expected to fall short of dividend payments. However, Goel & A ; Thakor ( 2003 ) emphasis an opposite position in their survey by saying that “ directors choose describing schemes that maximize their ain expected compensation, taking into history the consequence of net incomes studies on investors ‘ perceptual experiences and later direction ‘s compensation ”

Regulatory Incentives

Scott B. Jackson and Marshall K. Pitman farther assert in their article “ Hearers and Net incomes Management ” that “ regulative inducements to pull off net incomes originate when reported net incomes are thought to act upon the actions of regulators or authorities functionaries. ” As such, by pull stringsing the results of operations, directions may bring on the actions of regulators or authorities functionaries, thereby decreasing political examination and the effects of ordinance. Notwithstanding, some researches echo in the opposite way by foregrounding that small room for manoeuvre exist for houses to understate corporate revenue enhancement. Back in 1997, Scott stresses that “ revenue enhancement governments apply different accounting methods to cipher the indictable net income of a concern thereby cut downing houses ‘ room for use. ” For case, non all disbursals incurred by a concern are allowed to be deducted against net incomes and besides for revenue enhancement intents, tax write-off like depreciation on touchable non-current assets is non allowed.


Since use Numberss is likely to go on under the market inducements, contractual inducements and regulative inducements, it is cardinal for stockholders to hold their fiscal statements audited and monitored by independent hearers. As a affair of fact, the latter will show opinion on the rationality of the accounting policies used by directions. Nevertheless, following the immense corporate prostrations in the US ( i.e. Enron and WorldCom ) in recent old ages, investor ‘s trust has fade to the truth of fiscal information published by houses as answering confidently on the hearer ‘s work is going excessively questionable.

Pattern of net incomes direction

From the above treatment, it can be encapsulate that for the assorted inducements for net incomes direction, troughs may prosecute in different form for pull stringsing net incomes in income statement. In the same line, prior survey have documented that each type of use has its associated benefits and costs. Hence, directors will pull strings net incomes to run into or crush net incomes benchmarks at the lowest cost to accomplish the extreme benefits by prosecuting in the undermentioned form: –

Large Bath

Numerous empirical surveies have documented that directors do used ‘big bath ‘ to pull strings net incomes. [[ 10 ]] The term ‘big bath ‘ in accounting, is an net incomes direction scheme that manipulates a house ‘s income statement to do hapless consequences look even worse. Accounting literatures consistent with the findings of DeAngelo et Al. ( 1994 ) demonstrate that, “ a new Chief Executive Officer ( CEO ) may take a ‘big bath ‘ in the twelvemonth of alteration to increase the chance of higher future net incomes when his/her public presentation will be measured, particularly when low net incomes in the alteration twelvemonth can be blamed on the old CEO. ” [[ 11 ]] However, another watercourse of idea, Kirschenheiter and Melumad ( 2002 ) show that “ if true net incomes are bad, the director will take a large bath to present extra noise into his study and cut down the sensed preciseness of net incomes study. ”

Income minimization

Prior research works postulate that income minimization is similar to taking a bath to some extent but is less utmost. Such a form may be chosen by directions in clip of high profitableness to write-downs of capital and intangibles assets, write offing of advertisement and research and development ( R & A ; D ) expenditures. Surveies in this field farther revealed that, “ net incomes decreasing, instrumental losingss, particularly in state of affairss where in the presence of strong corporate restructuring and direction alterations, it is desirable to switch duty of negative consequences to the old direction and highlight the greater abilities of the new direction or the good effects of economic and fiscal restructuring or reorganization. “ [[ 12 ]]

Income maximization

Looking at the other terminal of the spectrum, directors may besides pull strings net incomes upwards. Income maximization as coined by Tiziano Onesti and Mauro Romano in 2012 “ is to unnaturally increase net incomes, typically originating from the direction ‘s desire to show better consequences than existent in order to obtain private benefits ( respect, reconfirmation, extra wage ) or to forestall unsustainable environmental force per unit areas, particularly from external loaners. ” Years back, Healy ‘s survey was a cardinal component in this form of net incomes direction. The writer put frontward that troughs may prosecute in a form of maximization of reported net income for fillip intents and besides houses near to debt compact misdemeanors, may maximize income.

Income smoothing

Income smoothing is a signifier to pull strings net incomes and is by and large defined as “ the moistening of fluctuations in reported net incomes over clip. “ [[ 13 ]] In other footings, net incomes smoothing is the procedure of seting reported net incomes to be greater or lower than expected, ( Beidleman, 1973 ) . As such, directors may tend to take actions to hike net incomes when they are comparatively low and to diminish net incomes when comparatively high. Hence, by smoothing net incomes over clip, directors convey information to stakeholders that is biased, which does non dependably stand for implicit in economic public presentation of the company. As a consequence, the utility of the information to house foreigners is condensed, therefore it is argued that net incomes smoothing diminishes accounting quality ( Lang et al. , 2003 ; Barth et al. , 2008 ) .

Drawbacks of Net incomes Management

Anterior literatures postulate that there are peculiar drawbacks when companies apply this technique, net incomes directions, as it creates a major information spread between Sellerss ( for e.g. houses ) and purchasers ( for e.g. investors ) at the stock market. By prosecuting in net incomes use, directions are likely to show fiscal study that will miss just value, as it does non reflect the company ‘s existent activities ( Dechow & A ; Skinner, 2000 ) . An undeniable fact put frontward by Nobes back in 1998 is that “ stockholders or new investors do non hold the same entree to information as members in the board, therefore this puts investors in a quandary because they merely have the fiscal study as the beginning for determination ” . Hence, when directors manipulate accounting figures in fiscal studies, the accounting information ‘s credibleness psychiatrist.

Further surveies stress that net incomes direction non merely harm investors but the society every bit good, as the efficient resource allotment are distorts. As such, public assistance will decrease if houses allocate resources to undertakings that are looking to look good but which are in world bad. Likewise, another watercourse of research reveals that when a house seeks to pull strings net incomes to increase current twelvemonth public presentation, this needfully done at the hurt of future old ages. In order word as stated by Barton and Simko in 2002, “ the unreal addition in current twelvemonth ‘s net incomes will ensue in a coverage flexibleness, where net incomes direction in old accounting period constraint the house ‘s ability to pull off net incomes in current period. ” Hence, by seeking to hike current twelvemonth public presentation by pull stringsing accounting figures, the house may stop up paying more corporate revenue enhancements.

Summary of Empirical Studies on Net incomes Management

Different surveies found empirical grounds that net incomes direction exists and directors have assorted inducements to pull strings net incomes to hike the steadfast public presentation. [[ 14 ]] For case, back in 1997, Burilovich looked at peculiar inducements to pull strings reported net incomes in the instance of alternate minimal revenue enhancement. Using a sample of 72 regulated life insurance houses during the period 1984 to 1989, she found that income diminishing discretional accumulations ( DA ) differ significantly across the companies audited by large auditing houses. She farther added that “ auditing houses with the greatest market portion appear to let greater discretion to the client in finding accumulations. ” Hence, directors will be tempted to pull strings net incomes as the auditing houses are leting such discretion.

Further, in a survey of Korean industrial houses in 2002, Yoon and Miller provide important grounds that net incomes direction is affect by the degree of operating public presentation. As such, they found grounds back uping the large bath theory in that, when runing public presentation is highly hapless, houses took income decrease schemes instead than income increasing 1s ( .i.e. houses tend to take a large bath ) . This point of view was farther reverberations by Rosner ( 2003 ) who endorsed this hypothesis by foregrounding that house in fiscal hurt were more likely to misstate their fiscal studies compared to less-distressed houses.


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