Earnings management (“EM”) is the practice of earnings smoothing. Research shows there are three reasons why managers engage in EM. They include: optimal contract design, signaling and rational expectations. One example of an optimal contract design is when management’s compensation is tied to the earnings of the firm. Risk-averse managers will engage in EM to smooth their own compensation. Next, a signaling approach is when smooth earnings signal a desirable characteristic to third-parties, like effective management skills. Lastly, EM is adopted to set a rational expectation. For example, management might be attempting to present higher quality earnings to influence the firm’s stock price.
The top five red flags of EM are:
- Earnings are just above an important benchmark: Studies have demonstrated that if earnings are just above an important benchmark, say last year’s financial results or management’s forecast, chances are EM has occurred.
- Issuance of capital: Companies are more likely to overstate earnings when they raise capital or engage in an M&A transaction.
- High accruals: Revenue is equal to total cash received plus accruals. It is more difficult to manipulate cash receipts than accrual accounts. Thus, if accruals are relatively large, earnings are more likely to have been overstated.
- Low taxable income related to book income: Since the tax code allows for less discretion in the application of the tax code than GAAP accounting, it is likely that earnings management has occurred if taxable income is far less than book income.
- A change in accounting policy: Firms that increase reported income by changing accounting policies could be engaging in earnings management.
For investors in the private equity markets, it is important to understand and identify EM before the transaction is completed, rather than after the purchase agreement is signed.
Mike Metzler, CPA, ABV, CMA, CGMA, ASA