earnings management

Examples of earnings management in the following topics:

• Limitations of the Income Statement

  • One example of this is earnings management, which occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports in a way that usually involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures.
  • The goal with earnings management is to influence views about the finances of the firm.
  • Aggressive earnings management is a form of fraud and differs from reporting error.
  • Managers could seek to manage earnings for a number of reasons.
  • For example, if a manager earns his or her bonus based on revenue levels at the end of December, there is an incentive to try to represent more revenues in December so as to increase the size of the bonus.

• Evaluating Financial Statements

  • In this way, earnings could be separated into normal or core earnings and transitory earnings with the idea that normal earnings are more permanent and hence more relevant for prediction and valuation.
  • In terms of adjustment of financial statements, analysts may adjust earnings numbers up or down when they suspect the reported data is inaccurate due to issues like earnings management.

• Benefits of Repurchasing Shares

  • Share repurchases are beneficial when the stock is undervalued, management needs to meet a financial metric, or there is a takeover threat.
  • Repurchasing shares may also be a signal that the manager feels that the company's shares are undervalued.
  • If management needs to boost the EPS of the company to meet the metric, s/he has two choices: raise earnings or reduce the number of shares.
  • If earnings cannot be increased, there are a number of ways to artificially boost earnings (called earnings management), but s/he can also reduce the number of shares by repurchasing shares .
  • Strictly speaking, this is a benefit to the management and executives, not the company or the shareholders.

• Forms of Business Organizations

  • Goal of a business is to earn profits.
  • A partnership is a business owned and managed by two or more people.
  • Unfortunately, corporations can become so complex; the management loses sight on its goal of earning profits.
  • For instance, shareholders represent the owners of the corporation, and they should benefit.Sometimes corporate managers lose sight of earning profits.
  • Unfortunately, the managers do not maximize the shareholders' wealth, maximize share price, or maximize a firm's value.

• Dangers Involved in Inventory Management

  • Excessive inventory means idle funds which earn no profits; inadequate inventory means lost sales.
  • Inventory management is primarily about specifying the size and placement of stocked goods.
  • The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting.
  • Excessive inventory means the firm has idle funds which earn no profits for the firm.
  • Inventory management will be more complicated as moderate inflation and seasonality gets involved.

• Financial Management Before and During Bankruptcy

  • To avoid the negative impacts of bankruptcy, individuals and companies in financial distress can implement certain financial management techniques.
  • Financial Management before and during Bankruptcy is an effective method for companies and individuals to remedy financial distress and insolvency.
  • For the option of financial management during bankruptcy to exist, a form of bankruptcy allowing reorganization, such as chapter 11, must be used.
  • Under this plan, a debtor may be able to acquire financing and loans on favorable terms by giving new lenders first priority on the business' earnings.
  • Devise a management plan when a company is in financial distress

• ROE and Potential Limitations

  • In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth.
  • It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better.
  • Stock prices are most strongly determined by earnings per share (EPS) as opposed to return on equity.
  • Earnings per share is the amount of earnings per each outstanding share of a company's stock.
  • In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.

• Price/Earnings Ratio

  • Price to earnings ratio (market price per share / annual earnings per share) is used as a guide to the relative values of companies.
  • Monthly earnings data for individual companies are not available, and usually fluctuate seasonally, so the previous four quarterly earnings reports are used, and earnings per share are updated quarterly.
  • Longer-term P/E data, such as Shiller's, use net earnings.
  • The P/E ratio of a company is a significant focus for management in many companies and industries.
  • Managers have strong incentives to increase stock prices, firstly as part of their fiduciary responsibilities to their companies and shareholders, but also because their performance based remuneration is usually paid in the form of company stock or options on their company's stock (a form of payment that is supposed to align the interests of management with the interests of other stock holders).

• Setting the Target Payout Ratio

  • The part of the earnings not paid to investors in the form of a dividend is left for investment to provide for future earnings growth.
  • The Target Payout Ratio depends on what investors the management of a company are trying to attract, and what current investors' expectations are.
  • A more established firm with an established market probably does not need to expand its operations, and would prefer to use its earning to compensate its investors.
  • As they mature, they tend to return more of the earnings back to investors.
  • The payout rate has gradually declined from 90% of operating earnings in the 1940s to about 30% in recent years.

• Overview of the Role of Financial Manager

  • The financial manager is responsible for budgeting, projecting cash flows, and determining how to invest and finance projects.
  • The manager is responsible for managing the budget.
  • The manager is responsible for figuring out the financial projections for the business.
  • The finance manager is responsible for knowing how much the product is expected to cost and how much revenue it is expected to earn so that s/he can invest the appropriate amount in the product.
  • The finance manager must collaborate across business functions in order to determine how to best allocate and manage assets.