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Look out for cover-ups in financial reports

Earnings management: Financially weaker firms indulge in managing their earnings to avoid earnings surprises, losses and meet benchmarks to boost their market value

Look out for cover-ups in financial reports
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Earnings reporting season just started and many companies are communicating their quarterly reports. Invariably all the listed companies are expected to meet or beat the analyst and market earnings estimate. In order to meet the expectation, some managers and insiders of companies indulge in earnings management as their compensation, financial incentives and promotion prospects are connected with the performance of their firm. Let us understand what is earning management, how it is operationalised and as investors how one should be careful about the same.

What is earnings management?
The intentional delude of financial figures such as the revenues and earnings of a company is known as earnings management. Companies wish to exhibit a healthy financial position through various permissible and legal accounting techniques. So, as such nothing is done that is against the law of the land. However, providing such information misleads the various stakeholders such as analysts and investors and results in loss of shareholder wealth.

How earnings management is operationalised
Companies draw a better financial picture in multiple ways. For instance, they create reserves during the years of profit and use these reserves in a bad year in order to show the company is profitable. Sometimes managers accelerate losses and get rid of it in the bad year, to show the company is profitable in the later years. Some companies also practice income smoothing approach wherein earnings are managed over a period to show a continual upward trend.

Sometimes, companies recognise estimated expenses arising out of restructuring or elimination of operations, etc., when revenues are high and lower expenses are recognised when revenues are low. Another common way to manage earnings is to do more number of transactions with related parties. Essentially companies use their discretionary powers to manage earnings either on accrual or actual basis.

Empirical evidence
Empirical evidence suggests that firms in emerging markets manipulate earnings more than the firms in developed countries. A large numbers of firms in emerging economies are affiliated with business groups. Business group affiliated firms manage earnings more than that of the non-business group or standalone firms. Therefore, they have higher probability to inflate profits through related party transactions based earnings management.

What investors should look for?
It is very difficult to stop and detect earnings management because there exists information asymmetries and managerial discretion. However, audit checks, monitoring by regulatory bodies, and scrutiny by financial analysts could keep earnings management in check. Investors should focus on non-financial measures to assess the company’s performance.

Further, to identify earnings management, investors should also focus on change in the accounting policies of a company in the past few years. If a company follows the same accounting policy over a period, the financial statements of that company are more likely to be consistent. Companies with frequent changes in accounting policies are more prone to earnings management.

To conclude, financially weaker firms indulge in managing their earnings to avoid earnings surprises, losses, meeting benchmarks, etc., to boost their market value. So, investors should look for the parameters as discussed above and stay away from investing in such companies.

P Saravanan is a professor of finance and accounting at IIM Tiruchirappalli. Narendra Kushwaha and Swechha Chada are the FPM scholars at IIM Tiruchirappalli

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First published on: 17-06-2020 at 01:10:34 am