Explain why a company's reported earnings may not necessarily be an objective measure of economic reality. Give examples of when this might occur.

Question

What will be an ideal response?

Answer 1

For one thing, "generally accepted accounting principles" (GAAP) allow an accountant to select from various methods when computing earnings and other financial measures, which could lead to lower quality financial information depending on the accounting methods used. The "quality" of financial information is measured by how well the numbers reflect economic reality. Furthermore, company managers can "manage earnings" subjectively by timing business activities or the reporting of those activities.

Earnings management becomes fraud when companies intentionally provide materially misstated information. W.R. Grace and Co. officials, for example, learned this the hard way. The company was charged with stashing earnings in reserve accounts in good years and then tapping them in later years to mask actual slowing earnings. Without admitting to or denying the charges, Grace later signed a cease-and-desist order and promised $1 million to support educational programs that enhance public awareness of financial reporting and GAAP.

Companies manage earnings when they ask, "How can we best report desired results?" rather than "How can we best report economic reality (the actual results)?" Earnings management includes selecting GAAP methods with concern for appearance rather than reality. It also includes subtle techniques such as changing reported earnings through "performance timing." For example, a manager seeking to reduce expenses in the current period might defer scheduled routine equipment maintenance until the next accounting period. The result is higher reported earnings in the current period, but the maintenance delay may be detrimental to the company's future operations. Also, a company may vary the timing of performance reporting. Recording inventory obsolescence is required under GAAP, for example, but choosing when to record obsolescence is fairly subjective. A manager may know some part of the company's inventory has become obsolete, but if earnings in the current period are lower than desired, he might defer recording the loss, or "write-down," until a future period.

When firms inflate reported financial information by managing earnings, they generate income-increasing accruals that reverse over time. Firms with income-increasing accruals in prior years must, therefore, either deal with the consequences of the accrual reversals or commit fraud to offset the reversals. Prior year income-increasing discretionary accruals might also cause firms to run out of ways to manage earnings. When confronted with earnings reversals and decreased earnings management flexibility, managers might resort to fraudulent activities to achieve objectives that were previously accomplished by managing earnings thereby further impeding the representational faithfulness of recorded amounts and obscuring economic realty.