“Managed earnings” refers to the practice where management deliberately manipulates a company’s financial results to make its financial performance appear better than it actually is. This can be done within the bounds of generally accepted accounting principles (GAAP), though it sometimes veers into unethical or even illegal territory.
Earnings management techniques might include:
- Revenue Recognition: Revenue could be recognized prematurely, such as booking sales before the product is delivered, or deferred to a later period.
- Cookie Jar Reserves: Creating large reserves in good years (overstating expenses) that can be used to boost earnings in leaner years.
- Big Bath Accounting: Taking all possible write-offs and charges in one period (usually a bad year) to make future earnings look better.
- Changing Depreciation Methods: Switching from an accelerated to a straight-line depreciation method to reduce depreciation expense and increase net income.
It’s important to note that while some forms of earnings management might be legal, they can distort the true financial picture of the company, mislead investors, and potentially lead to financial scandals. Therefore, they are generally seen as a breach of management’s fiduciary duty to provide clear, fair, and complete information to shareholders and other stakeholders. Auditors, regulators, and financial analysts are always on the lookout for signs of earnings management.
Example of Managed Earnings
Let’s consider an example where a company uses “revenue recognition” to manage earnings.
Company XYZ sells software subscriptions and has had a poor quarter. To meet investor expectations, the company decides to recognize revenue prematurely from software subscriptions that have been sold but not yet delivered.
So, let’s say a customer signs a contract to purchase a two-year software subscription in the final week of December, but the software will not be delivered and activated until January. Despite this, Company XYZ decides to recognize the full two years’ worth of subscription revenue in December’s financials, instead of recognizing the revenue gradually over the life of the subscription, as per the generally accepted accounting principle of revenue recognition.
This inflates Company XYZ’s revenue for December and the fourth quarter, making the company’s financial performance appear better than it actually is. However, it’s important to note that this is not a sustainable strategy and could potentially lead to legal and reputational consequences if discovered.
This is just one example. There are numerous ways in which a company might engage in earnings management, and the specifics will vary greatly depending on the company’s situation and the creativity (or audacity) of its management team.