Forensic Accounting
Earnings management: good,
bad or downright ugly?
By Paul Dunmore
Paul Dunmore is research professor of accounting at Massey University,
Wellington.
E
arnings management – arranging
matters to achieve a predetermined
result – is usually regarded as a bad
thing, to be stamped out if possible. I
argue that not only is stamping it out impossible,
but that there are good reasons for accepting that
it will always occur.
Earnings management (EM) occurs for two
reasons. First, managers and directors have
strong incentives to report particular results.
Second, there is no true figure against which
reported results can be tested.
For example, some years ago a NZ university
changed the depreciation life estimate for its
major buildings from 60 years to 100 years,
bringing it in line with the other universities. There
was one data point: the original building had been
closed as an earthquake hazard after 70 years,
and newer buildings were presumably better
engineered. So the change was easily justified
as giving a fairer presentation of the university’s
performance.
This reduced depreciation expense by some
$900,000. Universities budget for a small surplus.
So if the new estimate was better, students had
previously been overcharged by $900,000 a year.
The estimate matters to management as well as to
students: it is easier and more pleasant to achieve
a target surplus by improving an accounting
estimate than by fighting with Deans about their
budgets. Changing the estimate, then, was partly
a convenient way of achieving a desired surplus
figure.
32 Chartered Accountants Journal April 2008
But why 100 years? Several NZ universities
use buildings older than that; New College,
Oxford, still uses 600-year-old buildings. There
is no correct depreciation expense. Even if we
could travel far into the future and discover that a
particular building will last 143 years, there would
still be no way of knowing the true depreciation of
that building in 2008 because there is no way to
measure how much really belongs to that year. All
we can do is to assume a reasonable value.
Incentives to report a particular result
This example shows that EM is not confined
to business. It may occur whenever managers
control the accounting system and have
incentives to report particular results. Research
has found a number of self-interest incentives:
managers whose pay is related to earnings or
to the share price have incentives to increase
earnings, to meet earnings expectations to raise
the share price, and to smoothe earnings to
understate the volatility of the business. EM, some
of it quite subtle, has been found in each of these
situations.
Managers also have an obligation to protect
the firm’s interests. In particular, they must
manage the risk that arises from reporting a
particular profit. There are risks of driving down
the share price to the detriment of current
shareholders; triggering technical default under
debt covenants; drawing unwelcome attention
from competition and tax authorities; giving
ammunition to unions, suppliers and customers in
negotiations; losing donations and sponsorships;
and more. Researchers have looked at several of
these risks and found that they do in fact increase
the incidence of EM. Fraudulent reporting of
results is unacceptable; but when several different
fair reports are possible, managers would be
derelict in their duty if they did not consider the
consequences of the alternatives.
 Forensic Accounting

Finally, managers have private information
about the firm and its prospects. By modifying
the reported earnings, managers may
share information about their medium-term
expectations. They do this by altering earnings
because, despite the enormous and increasing
detail of disclosure in the financial statements, the
bottom-line profit is still the figure that attracts
most attention.
There is no “real” earnings figure
The distance between Auckland and Wellington
is a real figure, which can be measured fairly
accurately. But there is no real figure against
which reported earnings can be tested. It is
not possible to demonstrate that one allowed
accounting method (e g historical cost or
revaluation of fixed assets) gives the “true” profit
and the other a “false” profit, nor which is the
correct estimate of depreciation, collectability of
debts and so on. If we could measure the true
earnings figure, we could simply report it, and
there would be no need for accounting standards
at all.
To summarise: the absence of a “real”
earnings figure creates the opportunity for EM,
and the incentives to report a particular result
create the motivation.
So how common is EM,
and how effective are
current arrangements
The distance between Auckland and
for preventing it?
Wellington is a real figure . . . But
EM in practice there is no real figure against which
Figure 1 shows earnings reported earnings can be tested
before interest and tax
(EBIT) divided by total
assets for over 16,500
global companies from 2006 and 2007. The
division by assets is purely for scaling; the year-
end figure is used for convenience. The number
of firms is shown for each 1%-wide group (e g
one column is the number of firms with EBIT of at
least zero but less than 1% of ending assets). The

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 Forensic Accounting
distribution of firms by EBIT is a bit skewed and
rather long-tailed, but unremarkable.
Figure 2 presents a histogram of net income
for the same firms, again scaled by ending total
assets. This distribution shows a remarkable
jump at zero profit. The number of firms making
profits of 0-1% of assets is over 3.5 times the
number making losses of the same size. (Only
five firms reported a profit of exactly zero; they
were included in the positive-profit group, but it
Figure 1. Histogram of EBIT divided by total assets for 16,514 firms. Each bar is
1% wide. Data sourced from Compustat Global Vantage.
Figure 2. Histogram of net income divided by total assets for the same firms as in
Figure 1.
would make no material difference how they were
treated.)
Figure 2 implies either that many firms have
tuned their accounting to turn small actual losses
into small reported profits, or that firms coming
to the end of the year and expecting small losses
have taken real actions before the year end to
ensure that the outcome will be a profit. There is
no evidence in Figure 1 that firms took any such
action to prevent their EBIT being negative.
Much research has found similar patterns
around important thresholds: not reporting
a loss, not reporting a smaller profit than the
previous year, and not reporting a worse result
34 Chartered Accountants Journal April 2008
than what analysts have been forecasting, etc.
The equivalent chart to Figure 2 for over 7,200
US-listed firms shows an even greater jump
between the number of firms reporting small
losses and small profits, suggesting that not
even the vigorous oversight of the SEC and the
requirements of the Sarbanes-Oxley Act have had
much effect on EM.
Accounting adjustments for EM involve
making suitable estimates of necessary accruals,
particularly inventory valuation, receivables
valuation, depreciation and amortisation,
impairments, and provisions. If there is nothing to
accrue, this form of EM is impossible. When the
meat company Fortex failed in 1994, its inventory
and, therefore, its past earnings turned out to be
grossly overstated. Had the amount of inventory
been negligible, as Fortex’s just-in-time business
strategy called for, material overstatement would
have been impossible. But I am not suggesting
that such EM typically constitutes fraud. It is
the use of various estimates, judgements, and
accounting policies, all of which must be made
by management and all of which are individually
reasonable, in such a way that their combined
effect is to report a preferred outcome.
The avoidance of expected losses requires
action before the end of the period when the
outcome is still somewhat uncertain. It involves
reduction or deferral of expenses such as
advertising, training and maintenance, and actions
such as year-end sales to boost revenues. By
simply advancing or delaying the planning for an
expected restructuring, management can ensure
that the critical moment at which the provision
and expense must be recognised will occur late in
one financial year or early in the next.
Public sector bodies also engage in EM, using
the same techniques. Swedish municipalities
accrue more depreciation and impairment
write-offs in years when their surpluses are
high (thus smoothing surpluses and creating
hidden reserves which can be drawn down in
future years), and also in “big bath” situations
(Stalebrink, 2007). In 1996, the New Zealand
Symphony Orchestra (NZSO) adopted a
revaluation policy for the building whose value
had declined since it was purchased, and
changed the timing of recognition of sponsorship
revenue. These changes reduced its surplus from
$645,000 to a reported amount of $79,000. In
 Forensic Accounting

1998, the building value had increased again and Considering ethics as right behaviour, rather
the NZSO brought into income some previously than compliance with a code, the ethics of EM
deferred income which it decided no longer met depends on both the management’s intention and
the definition of a liability. These items turned a on the way in which it is carried out. EM that is
deficit of $753,000 into a surplus of $3,000. The intended to benefit managers personally is clearly
effect of the adjustments was to smooth reported unethical, a breach
surpluses to within a medium-term range of about of the duty owed
$150,000 surplus or deficit (Gaa and Dunmore, to an employer. EM
2007). intended to protect the Running a sale just before year-
company’s interests or
end . . . may permanently lower
Is EM ethical? to give readers a better
Accounting codes of ethics have little to say understanding of the
customers’ expectations of what
about EM, although they are properly very hostile company’s performance they should pay
to fraudulent reporting. It seems unlikely that can be defended,
ethical rules could be drafted that would offer provided it is carried
much help in deciding which reasonable estimate out in an ethical way.
to choose, which acceptable accounting policy Much EM is carried out secretly, without
to adopt or how quickly to advance plans for disclosure of the fact of the management, the
a possible restructuring. And an ethical code methods used, or the amount. The secrecy
should certainly not tell managers to ignore their seems to be driven by the social attitude that
responsibility to manage accounting risks facing EM is a bad thing. If a US-listed company were
their firm. to say “we estimated this year’s provision for

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 Forensic Accounting

doubtful debts at the low end of the
range of reasonable estimates and
thereby changed our result from a loss
of $1 million to a profit of $2.5 million”,
it seems clear that the SEC would
immediately force them to restate their
accounts, even if everyone agreed that
$2.5 million was a fair estimate of the
profit. In such an environment, EM can
only occur in secret.
But in fact some of it appears to
be quite open. Changes in judgements
and policies, such as those adopted by
the NZSO, are disclosed, and readers
need not be deceived about what
has happened. All that is missing is
an acknowledgement that managers
considered the effect on earnings as
a factor in deciding to change. When
deception can be avoided in pursuit
of a legitimate end, as here, then it is
more ethical to avoid the deception.
But in a situation where disclosure of
the EM would lead it to being reversed
by regulators, deception of the readers
by failing to mention EM may be
unavoidable and therefore ethical,
provided the intention is itself ethical.
The greatest question may arise
over “real” EM, if actions taken to
improve reported profit may cause
permanent harm to the company.
Running a sale just before year-end
not only sells goods cheaply which
might otherwise have been sold for a
better price early in the next financial
year, but it may also permanently lower
customers’ expectations of what they
should pay. These outcomes, which
have actually afflicted several computer
manufacturers, lower the firm’s lifetime
revenue in order to report a higher profit
in the current year. Likewise, producing
goods for stock towards the end of a
year boosts earnings under full-cost
accounting, but the unsold goods may
be in excess of requirements (and extra
cash is consumed to make them).
Such “real” EM may be genuinely
harmful to the company and therefore,
ethically unjustifiable by management
whose obligation is to protect the
interests of the company. Yet this form
of EM is not only regarded as acceptable
by accountants, it is often admired.
Can EM be prevented/detected?
It is not realistic to expect that EM can
be effectively prevented:
• while firms control their own
activities and accounting systems
• while firms must make accrual
judgements and estimates
• when reported earnings cannot be
anchored to any real reference point
• when managers have both good and

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bad incentives to report particular
results.
If even the draconian US attitude to
regulation cannot control EM, we should
not expect that regulation and standard-
setting are ever going to stamp it out.
The personal attitudes of managers
matter. An interesting study (Krishnan
and Parsons 2008) finds that EM is
less likely in firms with more women
in senior positions. Incentives for EM
could be reduced – if all managers were
paid straight salaries, covenants were
not based on earnings and investors
and other outsiders decided to ignore
earnings. The idea is fanciful: we could
reduce EM by making accounting itself
irrelevant.
There is clear evidence of EM from
large samples, but the existence of EM
is hard to show in any particular case.
The issue is management’s intention,
not that a particular result has occurred.
As the NZSO example illustrates, even
conservative earnings may have been
managed.
For an auditor or forensic accountant
to detect EM, the first question must be
what management wishes to achieve:
• a high profit?
• a near-zero surplus (usual in the
public sector)?
• a big bath?
• avoiding a loss?
Changes in accounting policies or
estimates, even if the new one is better,
may suggest EM. Monthly or weekly
data may suggest unusual activity,
which could be confirmed by talking to
maintenance, sales and shipping staff.
There is, of course, no requirement for
the auditor to report on EM, whether
produced by real actions or by shading
real estimates; but strong suspicion
Chartered Accountants Journal April 2008 37
Forensic Accounting
of EM should be a red flag, raising the
risk that management has somewhere
crossed the line from presenting a view
that is a little fairer to presenting one
that is no longer true. J
References
1. Gaa, J C and Dunmore, P V, The
ethics of earnings management.
Chartered Accountants Journal
86(8):60-62 (Sept 2007).
2. Krishnan, G V & Parsons, L M,
Getting to the Bottom Line: An
Exploration of Gender and Earnings
Quality. Journal of Business Ethics
78: 65-76 (March 2008)
3. Stalebrink, O J, An Investigation of
Discretionary Accruals and Surplus-
Deficit Management: Evidence from
Swedish Municipalities. Financial
Accountability & Management 23(4):
441-458. (Nov 2007)