Earnings Management

Accounting leaves room for judgment: estimates of provisions and asset lives, when to book a sale, when to spend discretionary costs. Using that room to steer profit toward a target is earnings management. Common forms include income smoothing, which trims good years and lifts weak ones so profit looks steady; cookie jar reserves, where extra provisions are built in strong years and released in weak ones; and the big bath, a heavy write-off in a poor year to clear the way for better results. Pushing sales into, or costs out of, the period is another. Creative accounting is the older and looser name, usually implying aggressive readings of the rules. The boundary with financial statement fraud is blurred. Choices made within the standards are not in themselves unlawful, even when they mislead; deliberate misstatement is fraud. Warning signs include results that land just above targets and accruals that drift away from cash flow. Analysts look at it when they ask how much of a profit figure will repeat next year.

A software vendor is close to missing its quarterly profit target. The finance director releases part of a bad-debt provision built up in the previous strong quarter and asks sales to ship two large orders before the quarter ends. Profit lands just above the forecast. Auditors later notice that the provision fell while overdue receivables rose.