Summary by Michael Becker
Master of Accountancy Program
University of South Florida, Summer 2003
Dechow and Skinner began their analysis into the disparity between the Academic view of earnings management (or, what could be termed the conceptual view) and the Practitioner/Regulator view of earnings management (which could be termed the operational view) with the following sentence:
"Despite significant attention on earnings management from regulators and the financial press, academic research has shown limited evidence of earnings management."
As is implicit in the title, the authors’ objective in this article is to bridge the schism between the two different views. The authors do this by first attempting to construct a framework within which earnings management can be defined and measured. They note that a potentially more effective way to observe earnings management is by focusing on managerial incentives. This leads to the second focus of the article, which is that the academics’ research should be directed at the various “capital market incentives” which have recently become more prevalent (e.g., stock-based compensation).
While attempting to define earnings management, they note that the line of demarcation between earnings management and accrual accounting (which has its basis in such concepts as revenue recognition and the matching principle) has, unfortunately, become blurred. As such, a specific managerial practice, for example, income smoothing, is difficult, if not impossible, to adequately and accurately diagnose as earnings management. Through accrual accounting’s key concepts, income and earnings tend to be smoother than the related cash flows. Therefore, accrual accounting and earnings management are congenially related in that earnings management occurs when a firm goes “too far” with its revenue recognition and matching implementation; however, the proper classification of a specific action requires a more utilitarian definition of earnings management.
With this in mind, Dechow and Skinner note that an actual workable explanation for earnings management does not exist. All of the literature and references to such practice are simply determined based on management’s intent (an obviously un-measurable indicator). As the aforementioned point regarding the relationship between earnings management and accrual accounting is again brought to light, it is explained that certain systematic decisions made within the framework of GAAP can be construed as earnings management. This serves to further complicate the issue at hand.
As indicated by the words of Chairman Levitt (of the SEC), a managerial decision, made within the boundaries of GAAP, can be considered earnings management if the intention of the decision was to obscure or mask the true economic reality of the event.
This leads the authors to make several rhetorical questions based on an example which presents a software company’s managerial decisions. This hypothetical company records unearned revenue when their software is sold due to their future obligation to provide customer support. As such, when sales are high, unearned revenue is high (which unearned revenue will be proportionally recognized in the following periods as the customer support obligation expires) and when sales are low, unearned revenue is low. This illustrates the fact that by simple accrual accounting concepts, income and earnings have been smoothed when compared to the entity’s cash flows. This leads to several interesting questions, namely:
Does this constitute earnings management or just a legitimate accounting process?
If the intent to meet pre-specified earnings projects were present, would this then become earnings management?
If this is the case, then could another presumably identical company with the same accounting practices be determined not to be guilty of earnings management simply because they did not meet their analysts’ expectations?
Finally, if this deferral practice were made explicit to outside investors, would the problem still exist?
This final question then begs the more far-reaching concept of: should earnings management even be considered an issue if its practice and effects are made clear to investors. Academics are likely to determine that no issue would arise if the managerial practices were made transparent - easily recognizable - at a non-prohibitive cost. However, the authors suspect that the SEC would continue to have concerns regarding the questionable tactics, regardless of their conspicuousness.
Although the article has been based primarily on conceptual definitions and rhetorical questions, the authors shift their emphasis from debating issues to examining real-world practices. To summarize their findings, it is essential for managers to meet simple benchmarks - i.e., earnings forecasts. As this is an essential agenda for managers, they dabble in earnings management to ensure their goals are reached. However, if and when the investors of a particular stock are made aware of earnings management practices, the repercussions (a drop in stock price) are harsh. As “capital market incentives” have increased over the years, and as most managers are now rewarded by stock options/ownership plans, they are inadvertently enticed to not reveal their potentially fraudulent accounting practices.
On a final note, the authors summarize their findings by expounding upon the following:
Managers have intense inducement to meet or beat analysts expectations, which, ipso facto, leads one to believe that the firms which just meet the
expectations have engaged in some form of earnings management, and
Those firms which are contemplating additional (or initial) equity offerings are enticed by high stock prices and, as such, are enticed by questionable, if not completely illicit, earnings management.
Collingwood, H. 2001. The earnings game: Everyone plays, nobody wins. Harvard Business Review (June): 65-74. (Summary).
Healy, P. M. and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons (December): 365-383. (Summary).
Healy, P. M. and K. G. Palepu. 2003. How the quest for efficiency corroded the market. Harvard Business Review (July): 76-85. (Summary).
Romney, M. B., W. S. Albrecht and D. J. Cherrington. 1980. Red-flagging the white collar criminal. Management Accounting (March): 51-54, 57. (Note and list of Red Flags).
Schilit, H. 2002. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. 2nd edition. McGraw Hill. (Summary).
Waddock, S. 2005. Hollow men and women at the helm ... Hollow accounting ethics? Issues in Accounting Education (May): 145-150. (Summary).