Detecting Earnings Management

Abstract

Management may be incentivized to smooth the volatility or to alter the perceived trajectory of earnings. However, creditors and investors would like to see smooth earnings only when it is real — when the underlying economics of the business are stable. If earnings is actually volatile but management engages in artificial means to make it appear smooth, then the true financial state of the company is not known to creditors and investors. Management may also have incentives to smooth out fluctuations if their compensation depends on it. Management may also want to alter the pattern of earnings to show a steady growth rate or other desired trajectory of earnings. This chapter addresses the multiyear manipulation. In a bid to smooth the volatility of earnings or manage the perceived trajectory of earnings, a company may purposefully understate earnings in the current year with the expectation of using this “cookie jar” reserve to boost earnings in later years. It reveals the most common methods companies use to smooth variability and presents analysis techniques and warning signs to detect them.