Question

Describe what is meant by the phrase “earnings management” and briefly describe how it is measured.

Is the tendency to engage in earnings management affected by corporate governance? If so, how?

Answer 1

Earnings management
Earnings management is a concept wherein we use various accounting techniques to produce financial reports that make the financial statements of the company look better. While preparing the accounts of the company, many accounting rules and principles are used. Some of these requires the management to make various judgments to follow these accounting rules and principles. Earnings management takes advantage of how these accounting rules and principles are applied and creates financial statements that inflate earnings, revenue, or total assets.
Some examples of such accounting rules and principles are
1) Recoginzing the inventory - FIFO Method or LIFO Method
2) Method of charging depreciation on the asset.

The financial statements represents the financial position of the company and it is used by the outsiders to know about the company. So, potential investors and creditors look at them to make the decisions such as whether or not to lend the company money or to become an investor, when to sell or purchase the shares. Thus the management of the company may be aligned to show the financial statements of the company as lucrative as possible.
Also, in various companies there may be policies for the management employees wherein they receive bonuses on the basis of earnings performance. Some employees may get bonuses or commissions when the stock pries of the company rises. So the management of the company can be inclined towards the earnings management.