Net income is a key number for shareholders, creditors, and analysts alike. Indeed, analysts' projections of net income for a company are viewed as a standard a company must achieve for a period of time. Failure to achieve this standard can have

Question

devastating effects on a company's stock price and its management. The importance of net income in the eyes of analysts and others can tempt managers to take steps to ensure that the appropriate level of net income is achieved. The process of manipulated net income to achieve a desired level of earnings is referred to as earnings management. Required: List and explain the economic motivations for earnings management.

Answer 1

There are four economic motivations for earnings management. They are:
1 . Meet internal targets.Internal earnings targets are important tools in motivating managers to increase sales, control costs, and use resources efficiently. Unfortunately, the economic factors underlying a metric may be overshadowed by the desire of managers to achieve the measured number itself.

The pressure to achieve the target level of earnings may cause managers to engage in activities that are fraudulent and unlawful. More than one manager has tried to recognize additional revenue during a period through creating fictitious sales transactions or recording valid sales in the wrong accounting period. Some managers have forced their customers to accept goods that the customers had not ordered and did not want in return for not having to pay the vendor of the goods until the goods ultimately sold. This is referred to as "channel stuffing". All of these activities have occurred as the result of the desire of managers to achieve budgetary and other goals so that they might remain employed.

The existence of a bonus plan in which amounts awarded to management are based on net income has been shown by academic researchers to be a motivation for managers to engage in earnings management. Researchers have found that managers subject to the bonus will manage earnings upward if earnings are near the bonus threshold. Researchers also have demonstrated that managers will manage earnings downward if the reported earnings are substantially greater than the maximum bonus level, thus defer earnings to the next period to compensate for unfavorable earnings results. The existence of earnings-based bonus plans and the accompanying temptations such plans create for managers is major factor in the independent auditor's assessing levels of audit risk and designing of audit plans and programs.

2 . Meet external expectations. A wide variety of stakeholders have an interest in the company's financial performance. Employees and suppliers want to see the entity thrive in order to maintain continued employment and associated benefits and sales, respectively.

Financial analysts make buy and sell recommendations to investors regarding company stocks. Analysts prepare forecasts of the financial performance of companies as part of their buy and sell recommendations. Analyst forecasts must be met in order to avoid a drop in the market price of a company's shares-actual net income must equal or exceed the net income forecasted by the analyst! Managers of companies for which the net income is just slightly below the analysts' forecasts have a strong incentive to use accounting assumptions to manipulate the level of earnings to the forecasted level.

3 . Provide income smoothing. Investors, creditors, and others are interested in companies whose earnings are increasing steadily year after year at a reasonable, sustainable rate. Investors, creditors, and other external stakeholders interested in the enterprise derive a sense of stability, reliability, and reduced risk related to the company if company earnings are rising at a sustainable rate. It is an axiom that managers want no earnings surprises.

The desire to avoid earnings surprises and maintain sustainable growth in earnings encourages managers to consider using aggressive accounting assumptions in order to defer or accelerate the recognition of revenues and expenses and to avoid earnings volatility. Less volatility in earnings through income smoothing is attractive both to investors buying stock and creditors extending loans.

4 . Provide window dressing for an Initial Public Offering (IPO) or a loan. Research has demonstrated that managers will engage in earnings management activities just prior to IPOs and to making a large loan application. An increase in reported earnings can help to ensure a successful IPO or a loan.