Earning Management & Accounting Quality

Earnings management is defined as the way of making accounting decision by the management for the purpose of achieving stable & predictable earnings. It helps them make their book of accounts look attractive. Eg: A company may overstate revenue which it has actually not received or it may understate its expenses. Also the vice-versa is done for the purpose of not showing exceptionally great performance. The market prefers a stable earning company and thus thats what even the management try for by manipulating the accounts by finding loopholes which helps them maintain it within the legal frameworks as well. The accounting quality of such a company is under suspicion always. They are also highlighted in public and sometimes lead to even the death of the company. Eg: Enron & Sathyam. Thus this means that companies should not over exploit such a loop hole and at some point it might back fire them and suffer the faith like that of the above companies.An analyst needs to be concerned about the accounting quality because the analyst may miscalculate the actual net worthiness of the company. If the accounting quality is not good in a company there remains a risk of even bankruptcy in some cases and with that keeping in mind, an analyst needs to show that in his report and access the actual risk to return ratio. An analyst needs to use various methods & techniques along with his own complete understanding of financial statement to evaluate any earnings management cases in the company and reflect the same in its report. Thus a prudent analyst is one who not only questions the accounting quality but also is smart enough to detect any misdoing or earnings management done by the company.There are various techniques to carry out earnings management such as the big bath, cookie jar reserves, operating activities, materiality, big bet on the future, flushing the investment portfolio, throw out a problem child, amortization, depreciation, depletion, sales/leaseback and asset exchange techniques, shrink the ship, etc. Management use such techniques commonly and these techniques make the accounting of firms questionable but not illegal. There are various other techniques as well which management keeps on finding so that they can make earnings management as much untraceable as possible.Earnings Management can be detected using methods such as the cross-sectional abnormal accurals model or large accruals and weak governance structure, using discontinuity evidence, using real activities manipulation model, through ANN model (Artificial Neural Networks). Apart from this a complete indepth analysis and knowledge is also required to detect earnings management. Without complete knowledge about the accounting methods, we cannot detect earnings management. All these methods are derived from accounting analysis.One of the examples from Myers is that of depreciation. Myers had used the technique as stated above, Amortization, depreciation & depletion technique. Here depreciation was the main thing. Myers had manipulated its depreciation so that in can show a stable earnings over the period and not a very high volatility. In the Costco case study, Sams club had also done earnings management but they used a different technique. What they did was show better earnings by lowering their labour cost, whereas that was not the actual case. Such methods are used quiet often.Thus earnings management has become a huge part of even big companies, infact mainly big companies. Huge amount of expenses or revenue are either understated or overstated just to bring about a stable income statement as investors & market love non-volatile income statement of companies.