What do you get when you mix the public ownership structure of the equity and debt markets, management by representation and divergent self interest?That’s right - earnings management.
Some call it creative accounting. Others call it aggressive accounting. Ultimately they’re just referring to different shades of the same thing.
Loosely defined, earnings management occurs when a company “manipulates” either legally or illegally its’ financial results for one reason or another. Normally, it’d be pretty simple to say that anything that adjusts a reasonable person’s expectations of a company’s performance away from precise, “to the penny” results is wrong and should be illegal. However, the problem runs much deeper than that. Let’s start with the roots of the problem and work our way upward from there.
Our equity and debt markets are fantastic for funding and stimulating business. They allow efficient allocation of capital and give people the opportunity to put their money where they want it to go. This structure creates a problem though. How does a business with thousands of owners decide how the business should be run? In a situation like this, the obvious solution is to elect a small group of representatives (who are presumably also owners) from the larger pool of owners. This small group, otherwise known in the United States as the board of directors, is in charge of representing the owners by making management and other decisions regarding the business. They are charged with maximizing owner profit while complying with appropriate legal and ethical standards. They hire and fire managers, approve strategic decisions, and ensure that the business is running smoothly. The company’s managers, in turn, see to the day to day operations of the business. This is all good and fine if one presumes that all parties are consistently acting in the best interest of the owners. We all know, however, that this is not the case.
Thus we come to the heart of the issue: self-interest.
Given the choice, nearly every individual would choose to act in their own self-interest before acting in the interest of others. Many times, individuals only act in the interest of others because both interests are temporarily aligned and synergistically provide additional benefit to both parties. Fortunately, owners have recognized this, and have gone so far as to utilize it as a tool for company success.
The method most companies employ is the granting of additional compensation, whether through stock options or other perquisites, based upon the company’s financial performance. That is, the manager’s personal income and success is often directly tied to that of the company. When the company does well, the manager does well, and vice versa. The downfall of this capitalistic, “greed is good” strategy is that personal self interest is still king. Individuals place much more weight on their own personal success than that of the company, and are willing to sacrifice and compromise “lesser” things for all of the benefits they derive from such transactions. This direct correlation between company and manager success ultimately leads us back to where we began.
As if all of this weren’t enough, the difference between legal and illegal earnings management is not always clear. Accounting rules exist to provide accurate financial results to current and prospective owners about the state of the business. However, they also necessarily contain inherent flexibility to compensate for the wide diversity and complexity of the nature of different types of businesses. Generally Accepted Accounting Principles (GAAP) generally works on a principles based system that requires specific application to various situations1.
For example, let’s look at revenue recognition. GAAP provides specific rules for when revenue or sales can be recognized by a company. They include components such as an agreed upon price, actual delivery of goods, and arm’s length transactions. While companies have acted outside of these specified guidelines and recognized revenue anyways, there are plenty of examples of working within these guidelines and still managing earnings. A common example is channel stuffing. Channel stuffing involves offering steep discounts in product pricing to customers towards the end of a fiscal period to boost revenue before the end of that period. Is channel stuffing earnings management? Most would agree, that yes, it is. Is it illegal or deceptive? Most certainly not. In fact, it would be fairly easy to draw the conclusion that it is, in fact, a good business practice that maximizes company profitability.
While most would view earnings management in a negative light, it is clearly not always negative, and can even be helpful and useful when applied appropriately. As professionals, it is vital that we are critical and detailed in our assessments of situations, while simultaneously withholding judgment until all the observable facts are in. If we neglect these responsibilities, we risk losing the very thing we sought to achieve in the first place: the maximization of owner profit.
