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Encyclopedia > Earnings management

Creative accounting and earnings management are euphemisms referring to accounting practices that deviate from standard accounting practices. They are characterized by excessive complication and the use of novel ways of characterizing income, assets or liabilities. This results in financial reports that are not at all dull, but have all the complication of a novel by James Joyce, hence the appellation "creative." Sometimes the words "innovative" or "aggressive" are used. A euphemism is an expression intended by the speaker to be less offensive, disturbing, or troubling to the listener than the word or phrase it replaces, or in the case of doublespeak to make it less troublesome for the speaker. ... Accountancy (British English) or accounting (American English) is the process of maintaining, auditing, and processing financial information for business purposes. ... Publicly-traded companies are required to follow certain accounting rules to prepare financial statements so that the readers of the statements can easily compare different companies. ... James Augustine Aloysius Joyce (February 2, 1882 – January 13, 1941) was an expatriate Irish writer and poet, widely considered to be one of the most influential writers of the 20th century. ...

In some cases, the term is used in professional humor, as when accountants poke fun at each other's more esoteric accountancy practices. In this usage the use of the term "creative accounting" has quite complex connotations: a good laugh, trying to encourage more honest practices, and sometimes despair at ever cleaning up the mess. Both outside and within a profession such as law there are jokes which serve to poke fun at the peculiarities of the profession. ... Accountancy (profession) or accounting (methodology) is the measurement, disclosure or provision of assurance about information that helps managers and other decision makers make resource allocation decisions. ... Etymology Esoteric is an adjective originating during Hellenic Greece under the domain of the Roman Empire; it comes from the Greek esôterikos, from esôtero, the comparative form of esô: within. It is a word meaning anything that is inner and occult, a latinate word meaning hidden (from which...

The term is used more seriously and disparagingly to refer to systematic misrepresentation of the true income and assets of business organizations. "Creative accounting" on this scale has led to a number of recent accounting scandals, and many proposals for accounting reform - usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added. In the broadest sense, a fraud is a deception made for personal gain, although it has a more specific legal meaning, the exact details varying between jurisdictions. ... Accounting scandals, or corporate accounting scandals are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations. ... Accounting reform is change to accounting rules that goes beyond the enforcement of standard accounting practices and the elimination of creative accounting. It is advocated by those who consider the present standards and practices of the profession wholly inadequate to the task of measuring and reporting the activity, success, and... به خاطر اعمال تخریبی یک کاربر مشخص AOL، ویکی‌پدیا معمولاً proxyهای AOL را می‌بندد. متأسفانه ممکن است تعداد زیادی از کاربران AOL از یک خادم proxy واحد استفاده کنند، و در نتیجه کاربران بی‌تقصیر AOL معمولاً ندانسته بسته می‌شوند. از دردسر ایجاد شده عذر می‌خواهیم. اگر این اتفاق برای شما افتاد، لطفاً به یکی از مدیران از یک نشانی پست الکترونیک AOL پیغام بفرستید. حتماً نشانی IPی را در فوق داده شده ذکر کنید. بازگشت به صفحهٔ اصلی. گرفته شده از «http://fa. ... Factors of production are resources used in the production of goods and services in economics. ...

Newspaper and television journalists have hypothesized that the stock market downturn of 2002 was precipitated by reports of accounting irregularities at the Enron, Worldcom, and other business entities in the United States. Journalism is a discipline of collecting, verifying, analyzing and presenting information gathered regarding current events, including trends, issues and people. ... The stock market downturn of 2002 (some say stock market crash) is the sharp drop in stock prices during 2002 in stock exchanges across the United States and Europe. ... Enron Corporation Enron Corporation is an energy trading and communications company based in Houston, Texas that employed around 21,000 people in mid-2001 (before bankruptcy). ... For a time, WorldCom (WCOM) was the United States second largest long distance phone company (AT&T was the largest). ...

One commonly accepted incentive for the systemic over-reporting of corporate income which came to light in 2002 was the granting of stock options as part of executive compensation packages. Since stock prices reflect earning reports, stock options could be most profitably exercised when income is exaggerated, and the stock can be sold at an inflated profit. 2002 (MMII) was a common year starting on Tuesday of the Gregorian calendar. ... Main article: Option A stock option is a specific type of option with a stock as the underlying (the instrument that determines the pay-off of the option, and therefore its value). ... Executive compensation is how top executives of business corporations are paid. ...

The most notable activist is Abraham Briloff (professor emeritus of CUNY Baruch) who for years wrote a column for Barron's that constantly analyzed breaches of ethics and audit professionalism among CPA firms. His most famous book is called Unaccountable Accounting. A professor is a senior teacher and researcher, usually in a college or university. ... Baruch College is one of the constituent colleges comprising the City University of New York. ... Barrons magazine is an American weekly newspaper covering U.S. financial information, market developments, and relevant statistics. ... For other meanings of CPA see CPA (disambiguation) Certified Public Accountants (CPAs) are accounting professionals of the United States who have passed the Uniform CPA exam, which was developed and is maintained by the American Institute of Certified Public Accountants (AICPA), and have subsequently met additional state requirements for licensure...

The profession, in turn, was not kind to Dr. Briloff [1]. Briloff was trying to save the profession from what it is now going through in the wake of the Enron scandal.


Creative Accounting Tactics

  • Although not technically wrong, many annual and quarterly reports and presentations dive heavily into theoretical scenarios where "one-time charges" to earnings are excluded. What this means is for example, a law suit settlement amount would be taken out of the reported profit in one big chunk, even if its paid out little by little over time (this practice is called reserving). Often, when explaining the quarterly results, a CEO might say "Well if we didn't take this charge for the law suit, we would have made this much money". Very often, the hypothetical situations proposed get even more complicated. The main "creative" aspect to this is when a "one time" "exceptional" charge really is something that is very common to the business.
  • Banks are able to lend out most of the money they receive in deposit (they also can lend money they borrow from other banks). However, to protect against bad loans, banks must keep aside a stash of money called a "reserve". The bank, within general guidelines, gets to set the size of this reserve to what it feels is prudent compared to how risky its outstanding loans are. However, when the bank wants to make it look like it made more money this quarter than last, one way to do that is to take money from the reserve and call it profit with the excuse that the loans are safer now than before and that amount was no longer needed.
  • One of the main genres of "creative accounting" is known as slush fund accounting, whereby some earnings from this quarter are hidden away just in case the profit from next quarter is not enough for the management to make their bonuses. This happened most famously at Freddie Mac. As of 2004 there is a large investigation underway to see if retroactive insurance policies from insurers such as General Re of Berkshire Hathaway were used for slush fund accounting. The question is if these insurance policies truly transferred some risk or were merely a slush fund.
  • Creative accounting is not limited to large firms with banks of accountants. Smaller companies often use creative accounting, but for tax saving purposes rather than meeting bonuses or shareholder expectations. Salaries are sometimes included in profits to benefit from corporation tax rates being lower than personal tax rates and spouses are sometimes put on the books as employees though they may never have worked for the company. As smaller companies are generally subject to less onerous rules - and many of them fall below the limit required for a full annual audit every year - much of the creative accounting in this sector does not get a lot of publicity.

Slush fund was originally a nautical term; the slush referred to the fat or grease that was obtained by boiling meat, the sale of which could then be used to provide the crew with special luxuries. ... The Federal Home Loan Mortgage Corporation (Freddie Mac) (NYSE: FRE) is a stockholder-owned, publicly-traded company chartered by the United States federal government in 1970 to purchase mortgages and related securities, and then issues securities and bonds in financial markets backed by those mortgages in secondary markets. ... General Re is a reinsurance company. ... Berkshire Hathaway (NYSE: BRKa, NYSE: BRKb) is a company headquartered in Omaha, Nebraska, USA, that oversees and manages a number of subsidiary companies. ...

Earnings Management

According to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or to influence contractual outcomes that depend on reported accounting numbers. Management (from Old French ménagement the art of conducting, directing, from Latin manu agere to lead by the hand) characterises the process of leading and directing all or part of an organization, often a business, through the deployment and manipulation of resources (human, financial, material, intellectual or intangible). ... A stakeholder was originally a person who holds money or other property while its owner is being determined. ...

Earnings management usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics. Aggressive earnings management is a form of fraud and differs from reporting error. In business, revenue is the amount of money that a company actually receives from its activities, mostly from sales of products and/or services to customers. ... Profit is a positive return made on an investment by an individual or by business operations. ...

Management wishing to show earnings at a certain level or following a certain pattern seek loopholes in financial reporting standards that allow them to adjust the numbers as far as is practicable to achieve their desired aim or to satisfy projections by financial analysts. These adjustments amount to fraudulent financial reporting when they fall 'outside the bounds of acceptable accounting practice'. Drivers for such behaviour include market expectations, personal realisation of a bonus, and maintenance of position within a market sector. In most cases conformance to acceptable accounting practices is a matter of personal integrity. Aggressive earnings management becomes more probable when a company is affected by a downturn in business.

Earnings management is seen as a pressing issue in current accounting practice. Part of the difficulty lies in the accepted recognition that there is no such thing as a single 'right' earnings figure and that it is possible for legitimate business practices to develop into unacceptable financial reporting.

It is relatively easy for an auditor to detect error but earnings management can involve sophisticated fraud that is covert. The requirement for management to assert that the accounts have been prepared properly offers no protection where those managers have already entered into conscious deceit and fraud. Auditors need to distinguish fraud from error by identifying the presence of intention.

The main forms of earnings management are:

  • unsuitable revenue recognition
  • inappropriate accruals and estimates of liabilities
  • excessive provisions and generous reserve accounting
  • intentional minor breaches of financial reporting requirements that aggregate to a material breach.


Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

Further reading

  • How Companies Lie: Why Enron Is Just the Tip of the Iceberg, A. Larry Elliott, Larry Elliott, Richard Joseph Schroth, Random House, 2002, Hardback, ISBN 0609610813

See also

Corporate abuse refers to incidents that involve unethical behavior on behalf of a corporation; a case of corporate abuse may be a scandal, fraud, or negligence toward the corporations employees and/or the local community. ...

External links

  • A news report on creative accounting in the technological sector
  • Salary non-disclosure - Masking costs to show higher profit

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I believe this to be the best teaching case on either IPOs or earnings management out there.
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