Asian Financial Statement Analysis: Detecting Financial Irregularities

CHAPTER 4

DETECTING EARNINGS MANAGEMENT

This chapter extends the material in previous two chapters one step further, addressing 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. This chapter reveals the most common methods companies use to smooth variability and presents analysis techniques and warning signs to detect them.

Management may be incentivized to smooth the volatility or to alter the perceived trajectory of earnings. For example, a smooth earnings stream over time may be valued by creditors and investors, as it makes the company look more stable and less risky. 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 are 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. For example, if management receives a lump-sum bonus only when earnings exceed a certain amount, management may be incentivized to “save” earnings in excess of the required to earn the bonus for a later year when earnings might be lower. Management may also want ...