Why business monitoring is incomplete without an earnings management radar

Earnings Management is the act of influencing the performance reported by a business. Although numerous academic studies have concluded that earnings management is prevailant, it should be noted that earnings management does not necessarily contravene accounting standards, as the latter might allow a degree of flexibility. Nevertheless, identifying earnings management is of vital importance to professional investors and lenders who wish to understand all the drivers behind the reported financial performance.

Detecting earnings management is reliant on the identification of unusual items within the financial accounts of a business, where there is both an incentive and an opportunity to manage earnings. Incentives can be created from financial targets, a need to satisfy product and labour market restrictions, contractual arrangements and the regulatory environment.

Below we present three simple scenarios faced by a management team that is heavily incentivised to meet EBITDA targets. We assume we are now in October and the business has a December year end.

Scenario 1: The latest management forecast suggests the business will end the year at 95% of its annual EBITDA target

This year’s target is very much within reach so there is a clear incentive to close the 5% earnings' gap. Management can influence a variety of accounting entries to close the gap to target before year end. For example, management could adjust a range of accounting estimates or discretionary expenditures, none of which might be material in their own right but when combined are sufficient for the business to meet its EBITDA target.

Scenario 2: The latest management forecast suggests the business will end the year at 70% of its annual EBITDA target

The achievement of this year’s target may be perceived to be out of reach. There may be an incentive to use the current year as a 'sink hole' for costs that would otherwise burden the next financial period. Management may decide to increase accounting cost provisions (given these are estimates) or discretionary expenditures (e.g. R&D, marketing etc.) thus taking these away from future accounting periods. This would make next year’s target more achievable or could lower the base upon which next year’s targets are set.

Scenario 3: The latest management forecast suggests the business will end the year at 130% of its annual EBITDA target

Clearly this is a favourable position to be in however this may create an incentive to sacrifice some of this year’s earnings in order to bolster next year’s performance, i.e. turning a ‘great’ year into a ‘good’ year. Opportunities exist for management to smooth earnings in this way and it should not be assumed that earnings management does not take place in high performing settings.

For a professional investor or lender, the achievement of an annual EBITDA target is only one example where earnings management might be of interest. Consider the more serious implications where earnings management is used to meet this quarter’s banking covenant or where earnings management smooths earnings prior to the sale of the business, materially influencing the exit valuation.