Question

1. Explain how managers use the accounting standards to manage company's earnings.
2. Explain how carnings management from an informational perspective differs from the true income perspective.
3. Explain when and why the users of financial statements are not able to detect earnings management.
4. According to the Accounting research, managers cannot manipulate all the earnings and Schipper (1989) offered ways to detect any managed earnings. Explain the above statement and give an example from Schipper's commentary paper.

Answer 1

Solution:

1) Management can feel pressure to manage earnings by manipulating the company's accounting practices to meet financial expectations and keep the company's stock price up. Many executives receive bonuses based on earnings performance, and others may be eligible for stock options when the stock price increases.

One method of manipulation when managing earnings is to change an accounting policythat generates higher earnings in the short term. For example , assume a furniture retailer uses the last-in ,first-out (LIFO) method to account for the cost of inventory items sold. Under LIFO , the newest units purchased are considered to be sold first.Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit.If the retailer switches to the first-in,first-out(FIFO) method of recognizing inventory costs, the company considers the older, less expensive units to be sold first. FIFO creats a lower cost of goods soldexpense and, therefore, higher profit so the company can post higher net income in the current period.

Another form of earnings management is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term.