Earnings management refers to practices used by company managers to misrepresent financial performance or alter reported income. There are several motives for and techniques of earnings management, including income smoothing and using discretionary estimates to manipulate reported earnings. Earnings management can be done through accrual manipulation or real activities manipulation like reducing discretionary expenses or timing asset sales. While some studies find earnings management can positively impact short-term measures like stock price, most research shows it adversely affects long-term financial performance indicators like return on assets. Case studies on companies like GE and Samsung provide examples of earnings management techniques.

1. Earnings Management

2. Main Points
• EM Definition and main Concept
• Earnings Management Motives
• Earnings Management Techniques
• Earnings Management Ways
• EM impact on Firms Performance
• Case Studies

3. Earnings Management Concepts
• Earnings are the vital item in financial statement because it represents to
what extent the company engaged in value added activities and also
indicate the signal of direct resource allocation in capital market.
Increased earnings represent a rise in company value, while decreased
earnings indicate a decline in that value
• there is no wonder that the company managers are highly interested in
how earnings are reported. In the companies where managers attempt to
alter and misrepresent the financial performance or the true income and
assets in order to present a more favorable image of the company,
earnings management occurs

4. Earnings Management Concepts
• “Earnings management occurs when managers use judgment in financial
reporting and in structuring transactions to alter financial reports to either
mislead some stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on reported
accounting numbers” (Healy and Wahlen, 1999).
• Fraudulent financial reporting is also known as earnings management fraud
where management intentionally manipulates accounting policies or accounting
estimates to improve financial statements.
• EM is at the legal end of a continuum where it is Legal but Unethical.
Fraud clearly violates GAAP, Financial fraud is at the illegal end and Unethical
• Other Nick Names:

5. Earnings Management Motives

6. Earnings Management Motives
• Income Smoothing
The practice of carefully timing the
recognition of Revenues and
Expenses to even out the reported
earnings form year to year

7. Earnings Management Techniques
Cookie-Jar technique:
• The cookie-jar technique deals with estimations of future events. According to
GAAP, management has to estimate and record obligations that will be paid in the
future as a result of events or transactions in the current fiscal year based on
accrual basis.
• Under the cookie-jar technique, the corporation will try to overestimate expenses
during the current period to manage earnings. If and when actual expenses turn
out lower than estimates, the difference can be put into the "cookie jar" to be
used later when the company needs a boost in earnings to meet predictions.
• Some examples of estimation to manage earnings are: sales returns and
allowances, estimates of bad debt and write-downs; estimating inventory write
downs; estimating warranty costs; estimating pension expense; terminating
pension plans and estimating percentage of completion for long term contracts
etc.

8. Earnings Management Techniques
Cookie-Jar “Dell case”
• The Dell case is about income statement. Prior to 2007, Dell had cooperated with
Intel by exclusivity payments. Intel paid some amounts to Dell to use its chip
exclusively in Dell’s computer. The amounts of payment reached 76% or Dell quarterly
operating income in first quarter 2007.
• In 2007, Dell decided to use AMD’s processors in its product, which is in
competition with Intel’s processors. This made Intel stopped its exclusivity payments.
After Intel cut its payments, Dell again misled investor my not disclosing the true
reason behind company’s decreased profitability. Dell said that the main reason was
too aggressive pricing in the face of slowing demand and component cost declined
less than expected.

9. Earnings Management Techniques
Big bath technique:
• Although a rare occurrence, sometimes corporations may restructure debt,
write-down assets or change and even close down an operating segment.
• In these instances, expenses are generally unavoidable. If the management
record estimated charge(a loss) against earnings for the cost of implementing
the change then it will negatively affect the cost of the share price.
• But the share price may go up rapidly if the charge for restructuring and
related operational changes is viewed as positively.
• According to Big bath technique, if the manager have to report bad news i.e.,
a loss from substantial restructuring , it is better to report it all at once and get
it out of the way

10. Earnings Management Techniques
Big bath technique “Samsung Case”
• Samsung Electronics is accused of having employed this strategy
dubbed big bath accounting over the fourth quarter of 2008
when it posted a record operating loss of 937 billion won. Back
then, the market consensus on the loss was around 400 billion
won.
• It was the first quarterly operating loss of the world's top
memory chipmaker since 2000, and was caused by rising
marketing and management costs of 4.4 trillion won, up 1.15
trillion won from the previous quarter.

11. Earnings Management Ways
• Accrual accounting is the opposite
of cash accounting, which recognizes
transactions only when there is an
exchange of cash. Accrual accounting
is almost always required for
companies that carry inventory or
make sales on credit.

12. 1-Accrual Manipulation
• The general concept of accrual accounting is measuring a
company's performance and position when economic events are
recognized by matching revenues to expenses (the matching
principle) at the time when the transaction occurs rather than when
payment is made or received.
• This method allows the current cash inflows or outflows to be
combined with future expected cash inflows or outflows to give a
more accurate picture of a company's current financial position.
Earnings Management Ways

13. Earnings Management Ways
2-Real Activities Manipulation
• Discretionary Spending Reduction (R&D AND SG&A)
• Timing the sale of fixed assets to report gains
The sale of asset timing is the choice of the managers and given the fact that the
benefits must be included on the financial report at the time of the asset sale, the
sale of asset timing can be used as a way of managing real earnings
• Overproduction (reducing of prices)
Price reduction “towards the end of a financial year to enhance sales from the
next fiscal year into the current year, implies that the company is willing to
sacrifice profits, in the long run, to register additional sales in the current financial
period”

14. Earnings Management Ways
Evidence on real and accrual earnings management
• The correlations between real activities manipulation and accruals-based
actions have many implications. For example, the companies involved in
the real activities manipulation, that after controlling for sales levels, show
either unusually low cash flow or the unexpectedly low discretionary
expenses Furthermore, such measures, as a rule, result in unusually
production costs that are higher than in the previous fiscal periods. For
that reason, companies with higher financial liabilities show higher
production costs.
• However, the managers themselves classify discretion of the earnings in
their financial reports as either garbling or the means of protecting the
sensitive and private information that can only be accessed by the insiders
of the company.

15. EM impact on Firms Performance
• The term "performance" was presented by the ratio of reported annual
earnings as reported by the firms divided by the firms' total assets.
• The more intense the practice of earnings management, the greater
its adverse effect on firms’ rate of return on assets in the following
year.
Performance Indicators:
1. ROA (Return on assets)
2. Tobin’s Q
3. Return on Equity

16. EM impact on Firms Performance
Impact of Real Earnings Management on Performance Indicators
ROA = α + ε + β1MLR.
TQ = α + ε + β2MLR.
ROA = Return on Assets
TQ = Tobin's-Q
MLR = real earnings management through cash
flow operating activities
ε = constant
β1 = regression coefficient MLR
β2 = coefficient of regression MLR
ε = error term
• Conclusion: Affect ROA but doesn’t affect Tobin’s Q and in some other
researches it negatively affects Tobin’s Q.

17. EM impact on Firms Performance
• Several studies assume a positive
impact on corporate value.
• The more intense the practice of earnings
management, the greater its adverse effect on firms’
rate of return on assets in the following year.
Management seems to transfer gains from the future
to the present period in order to gain from reporting
relatively good results in the present period at the
expense of the future.
• When measured against ROE, financial performance is
negatively impacted by EM.

18. EM impact on Firms Performance
Impact Of Accrual Earning Management on Performance Indicators
(1) ROAit = β0 + β1DAit + β2Sizeit +β3 Debtit + β4 Liqit+ ε it
(2) ROE it = β0 + β1DAit + β2Size it +β3Debt it + β4 Liqit+ ε it
(3) QT it = β0 + β1DAit + β2Size it +β3Debt it + β4 Liqit+ ε it
ROA = Return on Assets
ROAit: the return on assets of the firm i for the year t;
- ROEit : the return on equity of the firm i for the year t ;
- QT it: the Tobin Q of the firm i for the year t ;
- DA it: the discretionary accruals of the firm i for the year t
- Size it: the size of the firm i for the year t ;
- Debt it: the debt of the firm i for the year t ;
- Liq it: the liquidity of the firm i for the year t ;
- εit: error.
Conclusion:
• Affect Liquidity has a positive impact on ROA.
• The size of the firm positively correlates with ROA
• There is a negative impact of debt on financial performance.

19. Case Studies
General Electric
• GE was able to meet expectations every year for time is unbelievable
• GE smoothed earnings in different ways, such as the careful timing of capital gains
and the use of restructuring charges and resources
• it achieved $10.7 billion in earnings for fiscal year 2000. It had had a 482 percent
total return over the previous five-year KMPG admitted the error after discovering
• The trick is that financial assets owned by GE Capital are more liquid than tangible
assets owned by the industrial side. As a result, when they need to report
earnings, GE can buy or sell these financial assets in the final days of a quarter to
give a smooth rise to reported earnings

20. Case Studies
Xerox
• The company overstate the revenues in the financial statement by putting all the
future revenues into present period to raise the stock price (Cookie Jar)
• KMPG external auditor failed to rerealise that Xerox were manipulating their
financial statements by closing a “$3 billion gap between actual operating results
and results reported to the shareholders”
• Xerox corporation paid $10 million penalty and restated
its financial results through years 1997-2000
• KMPG admitted the error after discovering

21. Case Studies
Egypt Gas
• It was reported By FRA about Egypt Gas in 2020 in
manipulating the income of the company
• The manipulating effect on the income statement
for the period ending 9/30/2020 is about 403
million pounds and that the share of profits
changes by about 0.38 L.E/share to losses by
about (16.42) L.E/share