We need to be clear what is meant by earnings management. In my view, earnings management is the attempt to smooth the path of earnings over time by using various accounting strategies to shift earnings from one quarter to another. This is not to be confused with attempts to inflate earnings by dubious accounting methods (think Enron, for example). The primary reason to engage in earnings management is to make the stream of earnings seem more predictable and less volatile. The belief is that the stock market rewards a steadily growing and predictable earnings stream rather than a volatile one. Whether this belief is true or not may be worthy of investigation but it is taken as gospel. Wall Street equity analysts build models to forecast earnings. Firms guide analysts subject these days to Fair Disclosure rules in the U.S. The market punishes negative earnings surprises, so the key is not to miss on the downside.

One could argue that the stock market engages in excessive short-termism by putting such focus on quarterly results and it is certainly a complaint I heard voiced in policy circles. The feeling is that companies spend too much time and effort on earnings management and not enough on the long-term business plan.

There is one form of earnings management that the regulators should encourage and that is loan loss reserves at banks. It is rational to put aside for a rainy day. Loan loss reserves should be added to when banks make loans that could go bad if the economy turns down in good economic times. Banks should be allowed to release these reserves in downturns. Sun Trust (a Florida Bank) tried this but run afoul of the regulators for earnings management! Instead, without such management, bank capital his highly cyclical with potentially destabilizing consequences.

Firms engaging in "earnings management" to push profits up do so for manipulating market price, credit rating, improving management image close to a shareholders meeting, and the list can continue. The side effects are bankruptcy, prison, lawsuits, fines, management being fired, of course, only if manipulation is detected. Assuming investors are stupid is usually a bad strategy.

Some companies do another type of earning management, towards diminishing profits using provisions and amortization policy to push this year's profits toward covering next year potential loss, that practice diminish risk, it's called prudence, and is generally an accepted practice, unless it goes to far towards tax evasion.

In theory, a company having all corporate governance in place and working decently well should provide a financial statement that is as objective as it can be.

Investment is a matter of trust, if financial statements are faked, or even suspicion is strong enough, trust is broken, and investors avoid such companies.

Even governments faking statistics can suffer consequences (Greece).

Trust is the best asset in this world, it's the hardest to obtain, rare, and very easy to loose.

Thanks John Ryding and Bradut Bolos , your answers are elaborate and have enlightened me.

earnings management is followed by the firms to satisfied the shareholders.this earnings management not consider about the cost of earnings

I found your answers really fruitful. Anyway, have you got any references (papers) on "why" firms engage in earnings management?

basically, you answered to push profits up for credit rating, improving management image, and the list can continue. Well. could you please suggest any references?

Last time i was interested in this topic was around seven years ago. Back then i used to print articles, and photocopy book chapters i liked and archive them in tomes. They are in a basement about 5.000 km away.

However, if you want literature, audit is the place to start with. They may not explain why, but they explain how to detect certain "over-creative" accounting practices.

You can also search creative accounting, and you may find out how to do-it.

Basically all famous defaults and tax-fraud cases include some extreme earning management practices.

This was a very hard concept for me to grasp when I was learning it. How could something that seems so illegal actually be legal? And, why would there be the need to dabble on that fine line between legal and illegal? The best way to answer this question is to use the acronym WISE. WISE stands for: Window dressing, Internal targets, income Smoothing, External Expectations.

Window dressing refers to the company's decision to dress up the financial statements for potential investors and creditors. The goal of this is to attract new supporters by having financial statements that look like the company's doing great. The company needs to appear to have a history of being profitable, even if it means lowering profits in one accounting period to increase profits in another. Even though this seems fraudulent, it isn't. Overall, the company is still reporting the same amount of profits, but is spreading the amount evenly over a specific time period.

Internal targets are another reason that a company may choose to use earnings management techniques. Often times, the company has set its own internal goals, such as departmental budgeting, and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so earnings management techniques are used to balance this out.

Income smoothing comes into play here because of the fact that potential investors generally like to invest in companies that have a continuous growth pattern. Smoothing out income generated, when there may be spikes at certain times and drops at others, allows it to appear like the company has that smooth growth pattern.

External expectations comes into play when the company has already made projections as to what their profits will be and investors now expect that exact amount of profits or more. Management may feel the need to shift revenue from one accounting period to another in order to meet the projected goal. Earnings management, quite simply, takes advantage of the different ways that accounting policies and procedures can be applied to financial reporting.