In recent decades, more and more fraudulent scandals have come to light of companies deliberately shifting revenues to deceive investors. This is called profit control or earnings management. Nevertheless, the vast majority of companies are involved in earnings management. But is this misleading investors legal? And how exactly does earnings management work?
Earnings management is legal, as long as the technique/method used complies with the rules of IFRS and/or the regional GAAP. As soon as the techniques fall outside these rules, it is referred to as fraud. Determining this is a complex task carried out by accountants and supervisors.
In this article, I’m going to explain what earnings management is and why companies do earnings management. I also give the pros and cons of earnings management and explain why one way of profit control is legal, and the other is not.
What is Earnings Management?
In order to understand when profit control or earnings management is legal or illegal, I first want to explain in a simple way what profit control is exactly.
Profit management is the deliberate intervening with financial reporting in order to mislead stakeholders (investors, regulators, creditors, etc.). Companies increase their profits by curbing costs, or companies allocate portions of the profits made in a given period to different periods. This is also known as ‘income smoothing’. An example of this is the following:
The CEO of a company often receives a bonus if the company achieves a certain profit target. In a well-performing year, the profit target can easily be reached. To ensure that the CEO meets next year’s goal, he can choose to book expected costs from next year in this year. In this way, the profit of the current year will be less. But the chance that the CEO will reach the profit target again the following year is greater.
It is important to mention that profit control, or ‘earnings management’, can be applied in many other ways. Companies continue to come up with handy tricks to look as good as possible to the outside world.
Why Earnings Management?
There are several motives for earnings management. I have just discussed the first one. The CEO of a company can have a lot of influence on the contents of the income statement. A CEO often has a contract that states that he or she must achieve certain goals in order to receive lucrative bonuses. It is therefore not surprising that the CEO makes use of his or her power.
The following reason seems a bit obvious, but it has a controversial outcome. Companies with money problems do more to manage profits than companies without money problems. This sounds logical, companies in harsh times don’t want to show that they have problems. Research only shows that companies that are in financial trouble with earnings management generally do even worse in the future than companies that do not participate in earnings management. So the companies are working themselves into even more trouble.
The last reason is to increase the proceeds of an IPO. On several occasions, it has been found that a company manually increased profits just before the initial public offering (IPO) in order to raise more liquidity. Investors are willing to pay a higher price for a stock when the company appears to be performing better. This form of earnings management has also been investigated and concluded to have a negative effect on the company’s performance in the future.
Disadvantages of Earnings Management
Of course, there are also disadvantages to earnings management. It is not for nothing that profit management has acquired a negative connotation among investors and institutions.
Short-term solution
The benefits of profit control have been discussed above and almost always only have a positive effect in the short term. In the long run, tricks in accounting techniques don’t work to save an underperforming company. This is because, for example, with ‘income smoothing’, the effect always reverses. By deferring costs to the next period, the performance of this period seems better. But in the next period it will be even more difficult to perform better, because the costs of the previous year also have to be taken into account.
Negative charge
Credibility and integrity are also questioned when investors or other stakeholders suspect the company of earnings management. Because profit steering is seen as something negative, investors will want to pull their hands off the company and the price of its shares will fall.
Quickly in violation of regulation
The last disadvantage is the risk of high fines and sometimes even imprisonment. It is possible that auditors and/or supervisors determine that the way in which profit management is applied does not comply with the rules of IFRS (what is IFRS?) and/or the US GAAP. There is talk of fraud, which can have disastrous consequences for the company.
Example Parmalat earnings management fraud
In 2003, Italy’s largest food chain (Parmalat) disappeared from the stock exchange. Years before, Parmalat was struggling to pay the bills and began funneling losses to subsidiaries. The owners of Parmalat had a lot of power, which meant that supervisors and auditors did not dare to indicate that they had doubts about the internal reporting of the income statements. This is due to potential loss of a job/reputation.
In the end, Parmalat had to pay back a €150 million Eurobond that they were unable to do. This while the financial statements showed that Parmalat had about €4 billion in liquid assets. At this point, all fraud came to light and the CEO was sentenced to 2.5 years in prison. So Parmalat has been siphoning off losses for years. They have done this by having a lot of political power and applying smart accounting techniques. As in this example, fraudulent practices (almost) always come to light sooner or later.
Read my article about another very large fraud case (Bernie Madoff) here.
When is Earnings Management illegal?
When is earnings management legal, and when is it not? I’m going to explain this by means of an example where certain methods are allowed, and others are not.
FIFO and LIFO
The IFRS provides various ways to calculate the value of inventory. When the stock is purchased at different times, the cost price can vary. If this price is constantly rising, you can choose not to use the FIFO (First in First out) method but the LIFO (Last in First out) method. Calculating depreciation is also an important aspect to pay attention to.
With the LIFO method, you first sell the product you last bought on paper. This is the product with the highest cost. As a result, the gross profit is lower than when the FIFO method is used. This can be advantageous because you have to pay taxes on your gross profits. The tax payable will be less due to a higher value of the cost price, and therefore the lower value of the gross profit.
The IFRS has determined that the LIFO method does not fairly reflect the actual financial performance of a company and has therefore prohibited it (although it is allowed in the US GAAP). Read here a detailed explanation of why the LIFO method is prohibited under IFRS. This makes this way of shuffling profits illegal. Now, this is a very simple example, and the actual determination of whether earnings management methods are legal or illegal is often seen as complex, with multiple professionals and agencies shedding light on the issue.
Extra information:
Many scientific articles have been published on earnings management, mostly in English and very informative. Dechow et al. (1995) and Baneish (2001), among others, are commonly used scientific articles. These articles are more suitable for when you really want to do research on earnings management.