Earnings Management and Earnings Quality1. What is Earnings Management? (Bryan Halls Webpage)Earnings management is defined by accounting literature as “distorting the application of generally accepted accounting principles.” Arthur Levitt, the old SEC Chairman, defined earnings management as “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.”Earnings management is often defined as the planned timing of revenues, expenses, gains and losses to smooth out bumps in earnings. In most cases, earnings management is used to increase income in the current year at the expense of income in future years. For example, companies prematurely recognize sales before they are complete in order to boost earnings. Earnings management can also be used to decrease current earnings in order to increase income in the future. The classic case is the use of cookie jar reserves, which are established, by using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses, and warranty returns.Managers engage in income smoothing activities because they know that volatile earnings streams typically lead to lower market valuations. Many successful management teams believe that the strategic timing of investments, sales, expenditures, and financing decisions is an important and necessary strategy for managers committed to maximizing shareholder value.Investors are dissatisfied with the management of earnings; however, investors become enraged when quarterly or annual earnings forecast are not met by firms. Therefore, investors and the public view minor earnings management as acceptable and an everyday business practice. In response to public complaints and concern for earnings management, the SEC has issued bulletins to help prevent earnings management.2.The Public Perception of Earnings ManagementEarnings management has a negative effect on the quality of earnings if it distorts the information in a way that it less useful for predicting future cash flows. Within the Conceptual Framework, useful information is both relevant and reliable. However, earnings management reduces the reliability of income, because the income measure is biased (up or down) and/or the reported income that is not representationally faithful to that which it is supposed to report (e.g., volatile earnings are made to look more smooth).The term quality of earnings refers to the credibility of the earnings number reported. Companies that use liberal accounting policies report higher income numbers in the short-run. In such cases, we say that the quality of earnings is low. Similarly if a nonrecurring gain increases income, but the gain is obviously not sustainable, then the quality of earnings is considered low.For the markets to work efficiently, it is vital that investors be able to trust the earnings numbers of the companies in which they have chosen to invest their capital. Recent studies have shown that the investing public believes that the occurrence of earnings management is both widespread and pervasive in the financial statements of corporations worldwide. However, it is interesting to note that the investing public does not necessarily view minor earnings management as unethical, but in fact as a common and necessary practice in the everyday business world. It is only when the impact of earnings management is great enough to affect the investors portfolio that they feel fraud has been committed.3.The Impact of Earnings ManagementPublic perception about the widespread occurrence of earnings management is affecting the publics confidence in external financial reporting. The practice ofearnings management damages the perceived quality of reported earnings over the entire market, resulting in the belief that reported earnings do not reflect economic reality. Investors rely on financial information provided by the company to make their investment decisions, and when investors believe they are being given meaningless information they become wary of trusting the companies they have invested in. Investors apprehension will eventually lead to unnecessary stock price fluctuation. As investors lose faith in reported earnings, they are forced into a guessing game concerning the actual financial position of a company. This uncertainty ultimately has the potential to undermine the efficient flow of capital thereby damaging the markets as a whole.4. Incentives to Manage EarningA. EXTERNAL FORCES Analyst Forecasts - Companies are under extreme pressure to meet analysts earnings estimates in order to prevent large drops in their stock price. Debt markets and contractual obligations - Companies depend on achieving certain earnings figures to obtain access to debt markets, or even to meet their current debt covenants and other contractual obligations. Competition - There is pressure in