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Earnings management comprises the use of Accounting strategies to generate financial statements representing a positive overview of the business activities and financial status of a company. Several accounting principles and rules need the management of a company to make judgements by adhering these principles.
The concept of earnings management takes the benefits of how rules of accounting get applied, and the financial statement is generated that smoothen the earnings.
From earnings, one can refer to the profit or net Income of a company for a specific period, be it a quarter or a year. Generally, companies and organizations use the method of earnings management to simplify the fluctuations in earnings and provide a constant profit for every month, quarter or a year.
In case there are massive fluctuations in the income and expenditure of a company, it may alarm the investors, despite the situation being completely normal for the operations of the company. And then, most of the times, the stock prices of a company can increase or decrease after the announcement of earnings is made. This is specifically based on whether the company could meet the expectations of analysts or not.
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One of the manipulation methods, while managing the earnings, is to alter the accounting policy that creates higher income in a shorter period of time. For instance, suppose a clothes retailer uses the last-in, first-out (LIFO) method to keep a track on the inventory items that were sold.
Typically, under this method, the new purchases are sold first. Considering that the cost of inventory may increase over the period of time, the new items could be more expensive, which may lead to higher sales cost and lesser profit.
However, if the same retailer switches to first-in, first-out (FIFO) method, the company will be selling the older, inexpensive products first. This method will help create a lower cost of selling products; thus, the company will churn out a higher profit to cover a higher net income in a specific period.
Apart from this, another part of earnings management could be altering the company policy to capitalize on more costs and not the immediate expenses. This primarily helps with delaying the expense recognition and an increase in short-term profits.
Let’s understand this with an example. Suppose that the policy of a company demands that every purchased item that is under Rs. 5,000 should be expensed immediately and the ones that are more than Rs. 5,000 should be capitalized in the form of assets.
In case the company changes this policy and begins capitalizing every item that goes over Rs. 1000, expenditure will decrease, and the profits will increase in the short-term.