Accountants' Handbook Volume One: Financial Accounting and General Topics, Eleventh Edition

Chapter 6. EARNINGS MANAGEMENT

Paul Rosenfield, CPA

EARNINGS MANAGEMENT BY DISTORTING THE APPLICATION OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

On September 28, 1998, Chairman Arthur Levitt of the Securities and Exchange Commission (SEC) referred to a "widespread, but too little-challenged custom: earnings management." He referred to the practice as a game of nods and winks, accounting being perverted, cutting corners, and wishful thinking ... winning the day over faithful representation. He stated his fear that "we are witnessing an erosion in the quality of earnings, and therefore the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion.... in the gray area between legitimacy and outright fraud"^[174]

The SEC defines "earnings management" as "distorting the application of generally accepted accounting principles."^[175] Levitt said that "Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy." He said that the practice "reflect[s] the desires of management rather than the underlying financial performance of the company." He said earnings may be managed by "gimmicks."^[176] Those gimmicks distort the application of generally accepted accounting principles (GAAP) to serve the desires of management, for example, by (1) reporting higher overall earnings than the underlying financial performance of the reporting entity justifies, ...