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Earnings Management

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Definition of Earnings Management

Earnings Management Image 1

Earnings Management

The active manipulation of earnings toward a predetermined target.
That target may be one set by management, a forecast made by analysts, or an amount that is consistent
with a smoother, more sustainable earnings stream. Often, although not always, earnings
management entails taking steps to reduce and “store” profits during good years for use during
slower years. This more limited form of earnings management is known as income smoothing.



Related Terms:

Abusive Earnings Management

The use of various forms of gimmickry to distort a company's true financial performance in order to achieve a desired result.


Abusive Earnings Management

A characterization used by the Securities and Exchange
Commission to designate earnings management that results in an intentional and material misrepresentation
of results.


Operational Earnings Management

management actions taken in the effort to create stable
financial performance by acceptable, voluntary business decisions. An example: a special discount
promotion to increase flagging sales near the end of a quarter when targets are not being met.


Real Actions (Earnings) Management

Involves operational steps and not simply acceleration
or delay in the recognition of revenue or expenses. The delay or acceleration of shipment would
be an example.


income statement

Financial statement that summarizes sales revenue
and expenses for a period and reports one or more profit lines for the
period. It’s one of the three primary financial statements of a business.
The bottom-line profit figure is labeled net income or net earnings by
most businesses. Externally reported income statements disclose less
information than do internal management profit reports—but both are
based on the same profit accounting principles and methods. Keep in
mind that profit is not known until accountants complete the recording
of sales revenue and expenses for the period (as well as determining any
extraordinary gains and losses that should be recorded in the period).
Profit measurement depends on the reliability of a business’s accounting
system and the choices of accounting methods by the business. Caution:
A business may engage in certain manipulations of its accounting methods,
and managers may intervene in the normal course of operations for
the purpose of improving the amount of profit recorded in the period,
which is called earnings management, income smoothing, cooking the
books, and other pejorative terms.



Creative Accounting Practices

Any and all steps used to play the financial numbers game, including
the aggressive choice and application of accounting principles, both within and beyond
the boundaries of generally accepted accounting principles, and fraudulent financial reporting.
Also included are steps taken toward earnings management and income smoothing. See Financial
Numbers Game.


Earning Power

A company's ability to generate a sustainable, and likely growing, stream of
earnings that provide cash flow.
earnings management The active manipulation of earnings toward a predetermined target.
That target may be one set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream. Often, although not always, earnings management entails taking steps to reduce and “store” profits during good years for use during slower years. This more limited form of earnings management is known as income smoothing.


Earnings Management Image 2

Income Smoothing

A form of earnings management designed to remove peaks and valleys
from a normal earnings series. The practice includes taking steps to reduce and “store” profits
during good years for use during slower years.


Accounting earnings

earnings of a firm as reported on its income statement.


Asset/liability management

Also called surplus management, the task of managing funds of a financial
institution to accomplish the two goals of a financial institution:
1) to earn an adequate return on funds invested, and
2) to maintain a comfortable surplus of assets beyond liabilities.


Bottom-up equity management style

A management style that de-emphasizes the significance of economic
and market cycles, focusing instead on the analysis of individual stocks.


Cash management bill

Very short maturity bills that the Treasury occasionally sells because its cash
balances are down and it needs money for a few days.


Corporate financial management

The application of financial principals within a corporation to create and
maintain value through decision making and proper resource management.


Earnings

Net income for the company during the period.


Earnings before interest and taxes (EBIT)

A financial measure defined as revenues less cost of goods sold
and selling, general, and administrative expenses. In other words, operating and non-operating profit before
the deduction of interest and income taxes.


Earnings per share (EPS)

EPS, as it is called, is a company's profit divided by its number of outstanding
shares. If a company earned $2 million in one year had 2 million shares of stock outstanding, its EPS would
be $1 per share. The company often uses a weighted average of shares outstanding over the reporting term.


Earnings Management Image 3

Earnings retention ratio

Plowback rate.


Earnings surprises

Positive or negative differences from the consensus forecast of earnings by institutions
such as First Call or IBES. Negative earnings surprises generally have a greater adverse affect on stock prices
than the reciprocal positive earnings surprise on stock prices.



Earnings yield

The ratio of earnings per share after allowing for tax and interest payments on fixed interest
debt, to the current share price. The inverse of the price/earnings ratio. It's the Total Twelve Months earnings
divided by number of outstanding shares, divided by the recent price, multiplied by 100. The end result is
shown in percentage.


Economic earnings

The real flow of cash that a firm could pay out forever in the absence of any change in
the firm's productive capacity.


Fully diluted earnings per shares

earnings per share expressed as if all outstanding convertible securities
and warrants have been exercised.


Low price-earnings ratio effect

The tendency of portfolios of stocks with a low price-earnings ratio to
outperform portfolios consisting of stocks with a high price-earnings ratio.


Management/closely held shares

Percentage of shares held by persons closely related to a company, as
defined by the Securities and exchange commission. Part of these percentages often is included in
Institutional Holdings -- making the combined total of these percentages over 100. There is overlap as
institutions sometimes acquire enough stock to be considered by the SEC to be closely allied to the company.


Management buyout (MBO)

Leveraged buyout whereby the acquiring group is led by the firm's management.


Management fee

An investment advisory fee charged by the financial advisor to a fund based on the fund's
average assets, but sometimes determined on a sliding scale that declines as the dollar amount of the fund increases.


Money management

Related: Investment management.


Passive investment management

Buying a well-diversified portfolio to represent a broad-based market
index without attempting to search out mispriced securities.


Portfolio management

Related: Investment management



Price/earnings ratio (PE ratio)

Shows the "multiple" of earnings at which a stock sells. Determined by dividing current
stock price by current earnings per share (adjusted for stock splits). earnings per share for the P/E ratio is
determined by dividing earnings for past 12 months by the number of common shares outstanding. Higher
"multiple" means investors have higher expectations for future growth, and have bid up the stock's price.


Retained earnings

Accounting earnings that are retained by the firm for reinvestment in its operations;
earnings that are not paid out as dividends.


Risk management

The process of identifying and evaluating risks and selecting and managing techniques to
adapt to risk exposures.


Surplus management

Related: asset management


Top-down equity management style

A management style that begins with an assessment of the overall
economic environment and makes a general asset allocation decision regarding various sectors of the financial
markets and various industries. The bottom-up manager, in contrast, selects the specific securities within the
favored sectors.


Working capital management

The management of current assets and current liabilities to maximize shortterm liquidity.


Earnings per share of common stock

How much profit a company made on each share of common stock this year.


RETAINED EARNINGS

Profits a company plowed back into the business over the years. Last January’s retained earnings, plus the net income or profit that a company made this year (which is calculated on the income statement), minus dividends paid out, equals the retained earnings balance on the balance sheet date.


Earnings before interest and taxes (EBIT)

The operating profit before deducting interest and tax.


Earnings before interest, taxes, depreciation and amortization (EBITDA)

The operating profit before deducting interest, tax, depreciation and amortization.


Management accounting

The production of financial and non-financial information used in planning for the future; making decisions about products, services, prices and what costs to incur; and ensuring that plans are implemented and achieved.


Strategic management accounting

The provision and analysis of management accounting data about a business and its competitors, which is of use in the development and monitoring of strategy (Simmonds).


Value-based management

A variety of approaches that emphasize increasing shareholder value as the primary goal of every business.


Retained earnings

The residual earnings of the company.


Statement Retained Earnings

One of the basic financial statements; it takes the beginning balance of retained earnings and adds net income, then subtracts dividends. The Statement of Retained earnings is prepared for a specified period of time.


basic earnings per share (EPS)

This important ratio equals the net
income for a period (usually one year) divided by the number capital
stock shares issued by a business corporation. This ratio is so important
for publicly owned business corporations that it is included in the daily
stock trading tables published by the Wall Street Journal, the New York
Times, and other major newspapers. Despite being a rather straightforward
concept, there are several technical problems in calculating
earnings per share. Actually, two EPS ratios are needed for many businesses—
basic EPS, which uses the actual number of capital shares outstanding,
and diluted EPS, which takes into account additional shares of
stock that may be issued for stock options granted by a business and
other stock shares that a business is obligated to issue in the future.
Also, many businesses report not one but two net income figures—one
before extraordinary gains and losses were recorded in the period and a
second after deducting these nonrecurring gains and losses. Many business
corporations issue more than one class of capital stock, which
makes the calculation of their earnings per share even more complicated.


diluted earnings per share (EPS)

This measure of earnings per share
recognizes additional stock shares that may be issued in the future for
stock options and as may be required by other contracts a business has
entered into, such as convertible features in its debt securities and preferred
stock. Both basic earnings per share and, if applicable, diluted
earnings per share are reported by publicly owned business corporations.
Often the two EPS figures are not far apart, but in some cases the
gap is significant. Privately owned businesses do not have to report earnings
per share. See also basic earnings per share.


earnings before interest and income tax (EBIT)

A measure of profit that
equals sales revenue for the period minus cost-of-goods-sold expense
and all operating expenses—but before deducting interest and income
tax expenses. It is a measure of the operating profit of a business before
considering the cost of its debt capital and income tax.


earnings per share (EPS)

See basic earnings per share and diluted earnings per share.


management control

This is difficult to define in a few words—indeed, an
entire chapter is devoted to the topic (Chapter 17). The essence of management
control is “keeping a close watch on everything.” Anything can
go wrong and get out of control. management control can be thought of
as the follow-through on decisions to ensure that the actual outcomes
happen according to purposes and goals of the management decisions
that set things in motion. Managers depend on feedback control reports
that contain very detailed information. The level of detail and range of
information in these control reports is very different from the summarylevel
information reported in external income statements.


net income (also called the bottom line, earnings, net earnings, and net

operating earnings)
This key figure equals sales revenue for a period
less all expenses for the period; also, any extraordinary gains and losses
for the period are included in this final profit figure. Everything is taken
into account to arrive at net income, which is popularly called the bottom
line. Net income is clearly the single most important number in business
financial reports.


price/earnings ratio (price to earnings ratio, P/E ratio, PE ratio)

This key ratio equals the current market price
of a capital stock share divided by the earnings per share (EPS) for the
stock. The EPS used in this ratio may be the basic EPS for the stock or its
diluted EPS—you have to check to be sure about this. A low P/E may signal
an undervalued stock or may reflect a pessimistic forecast by
investors for the future earnings prospects of the business. A high P/E
may reveal an overvalued stock or reflect an optimistic forecast by
investors. The average P/E ratio for the stock market as a whole varies
considerably over time—from a low of about 8 to a high of about 30.
This is quite a range of variation, to say the least.


Basic Earnings Power Ratio

Percentage of earnings relative to total assets; indication of how
effectively assets are used to generate earnings. It is calculated by
dividing earnings before interest and taxes by the book value of all
assets.


Earnings per Share

A measure of the earnings generated by a company on a per
share basis. It is calculated by dividing income available for
distribution to shareholders by the number of common shares
outstanding.


Price to Earnings Ratio (P/E, PE Ratio)

A measure of how much investors are willing to pay for each dollar
of a company's reported profits. It is calculated by dividing the
market price per share by the earnings per share.


activity-based management (ABM)

a discipline that focuses on the activities incurred during the production/performance process as the way to improve the value received
by a customer and the resulting profit achieved by providing
this value


Certified Management Accountant (CMA)

a professional designation in the area of management accounting that
recognizes the successful completion of an examination,
acceptable work experience, and continuing education requirements


cost management system (CMS)

a set of formal methods
developed for planning and controlling an organization’s
cost-generating activities relative to its goals and objectives
cost object anything to which costs attach or are related


Institute of Management Accountants (IMA)

an organization composed of individuals interested in the field of management accounting; it coordinates the Certified management
Accountant program through its affiliate organization
(the Institute of Certified management Accountants)


management accounting

a discipline that includes almost
all manipulations of financial information for use by managers
in performing their organizational functions and in
assuring the proper use and handling of an entity’s resources;
it includes the discipline of cost accounting


Management Accounting Guidelines (MAGs)

pronouncements of the Society of management Accountants of
Canada that advocate appropriate practices for specific
management accounting situations


management control system (MCS)

an information system that helps managers gather information about actual organizational occurrences, make comparisons against plans,
effect changes when they are necessary, and communicate
among appropriate parties; it should serve to guide organizations
in designing and implementing strategies so that
organizational goals and objectives are achieved


management information system (MIS)

a structure of interrelated elements that collects, organizes, and communicates
data to managers so they may plan, control, evaluate
performance, and make decisions; the emphasis of the
MIS is on internal demands for information rather than external
demands; some or all of the MIS may be computerized
for ease of access to information, reliability of input
and processing, and ability to simulate outcomes of
alternative situations


management style

the preference of a manager in how he/she interacts with other stakeholders in the organization;
it influences the way the firm engages in transactions and
is manifested in managerial decisions, interpersonal and
interorganizational relationships, and resource allocations


open-book management

a philosophy about increasing a firm’s performance by involving all workers and by ensuring
that all workers have access to operational and financial
information necessary to achieve performance improvements


performance management system

a system reflecting the entire package of decisions regarding performance measurement and evaluation


Society of Management Accountants of Canada

the professional body representing an influential and diverse
group of Certified management Accountants; this body produces
numerous publications that address business management issues


Statement on Management Accounting (SMA)

a pronouncement developed and issued by the management
Accounting Practices Committee of the Institute of management
Accountants; application of these statements is
through voluntary, not legal, compliance


strategic resource management

organizational planning for the deployment of resources to create value for customers and shareholders; key varibles in the process include the management of information and the management of change in response to threats and opportunities


supply-chain management

the cooperative strategic planning,
controlling, and problem solving by a company and
its vendors and customers to conduct efficient and effective
transfers of goods and services within the supply chain


synchronous management

the use of all techniques that help an organization achieve its goals


total quality management (TQM)

a structural system for creating organization-wide participation in planning and implementing a continuous improvement process that exceeds
the expectations of the customer/client; the application
of quality principles to all company endeavors; it is also known as total quality control


Retained earnings

A company’s accumulated earnings since its inception, less any distributions to shareholders.


Statement of retained earnings

An adjunct to the balance sheet, providing more detailed information about the beginning balance, changes, and ending balance in
the retained earnings account during the reporting period.


management buyout (MBO)

Acquisition of the firm by its own management in a leveraged buyout.


price-earnings (P/E) multiple (ratio)

Ratio of stock price to earnings per share.


retained earnings

earnings not paid out as dividends.


Demand Management Policy

Fiscal or monetary policy designed to influence aggregate demand for goods and services.


Roth IRA. An IRA account whose earnings are not taxable at all under certain

circumstances.


Adjusted Earnings

Net income adjusted to exclude selected nonrecurring and noncash items of reserve, gain, expense, and loss.


Core Earnings

A measure of earnings that includes only the results of the primary operating
activities of the firm. It is most common to see the measure used by financial firms.


Cost Plus Estimated Earnings in Excess of Billings

Revenue recognized to date under the percentage-of-completion method in excess of amounts billed. Also known as unbilled accounts
receivable.


Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

An earningsbased measure that, for many, serves as a surrogate for cash flow. Actually consists of working
capital provided by operations before interest and taxes.


EBBS - Earnings before the bad stuff

An acronym attributed to a member of the Securities and
Exchange Commission staff. The reference is to earnings that have been heavily adjusted to
remove a wide range of nonrecurring, nonoperating, and noncash items.


EBDDT - Earnings before depreciation and deferred taxes

This measure is used principally by
firms in the real estate industry, with the exception of real estate investment trusts, which typically
do not pay taxes.


Operating Earnings

A term frequently used to describe earnings after the removal of the
effects of nonrecurring or nonoperating items.


Premanaged Earnings

earnings before the effects of any earnings-management activities.


Pro-Forma Earnings

Reported net income with selected nonrecurring items of revenue or gain
and expense or loss deducted from or added back, respectively, to reported net income. Occasionally
selected nonoperating or noncash items are also treated as adjustment items.


Sustainable Earnings

Reported earnings that have had the after-tax effects of all material
items of nonrecurring revenue or gain and expense or loss removed.


Earnings

In general, refers to a company's total sales less cost of sales and operating expenses, including interest and income tax.


Management

management refers to the individuals in an entity that have the authority and the responsibility to manage the entity. The positions of these individuals, and their titles, vary from one entity to another and, to some extent, from one country to another depending on the local laws and customs. Thus, when the context requires it, the term includes the board of directors or committees of the board which are designated to oversee certain matters (e.g., audit committee).


Price / Earnings (P/E) Ratio

The ratio of price to earnings. Faster growing or less-risky firms typically have higher P/E ratios than either slower-growing or more risky firms.


Retained Earnings

Net profits kept to accumulate in a business after dividends are paid.


management expense ratio (MER)

The total expenses expressed as an annualized percentage of daily average net assets. MER does not include brokerage fees and commissions, which are also payable by the Fund.


management fee

The fee paid to the fund’s manager for supervising the administration of the fund.


Performance shares

Shares of stock given to managers on the basis of performance as measured by earnings
per share and similar criteria. A control device used by shareholders to tie management to the self-interest of
shareholders.


Signaling view (on dividend policy)

The argument that dividend changes are important signals to investors
about changes in management's expectation about future earnings.


Tilted portfolio

An indexing strategy that is linked to active management through the emphasis of a
particular industry sector, selected performance factors such as earnings momentum, dividend yield, priceearnings
ratio, or selected economic factors such as interest rates and inflation.


profit

The general term profit is not precisely defined; it may refer to net
gains over a period of time, or cash inflows less cash outflows for an
investment, or earnings before or after certain costs and expenses are
deducted from income or revenue. In the world of business, profit is
measured by the application of generally accepted accounting principles
(GAAP). In the income statement, the final, bottom-line profit is generally
labeled net income and equals revenue (plus any extraordinary gains)
less all expenses (and less any extraordinary losses) for the period. Inter-
nal management profit reports include several profit lines: gross margin,
contribution margin, operating profit (earnings before interest and
income tax), and earnings before income tax. External income statements
report gross margin (also called gross profit) and often report one
or more other profit lines, although practice varies from business to
business in this regard.


profit module

This concept refers to a separate source of revenue and
profit within a business organization, which should be identified for
management analysis and control. A profit module may focus on one
product or a cluster of products. Profit in this context is not the final, bottom-
line net income of the business as a whole. Rather, other measures
of profit are used for management analysis and decision-making purposes—
such as gross margin, contribution margin, or operating profit
(earnings before interest and income tax).


Special Items

Significant credits or charges resulting from transactions or events that, in the
view of management, are not representative of normal business activities of the period and that
affect comparability of earnings. This term is often used interchangeably with nonrecurring
items.



 

 

 

 

 

 

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