Oct 14, 2008

Earnings Mangement: Real Versus Accounting

When someone mentions earnings management, I tend to think of accounting adjustments at the end of the quarter. Over-accruing an expense in a good period or recognizing sales earlier in a bad period. To the extent GAAP permits legitimate discretion in these areas, there is substantial evidence that managers take advantage of these items to manage earnings.

However, there is another way to manage earnings that involves real value rather than just accounting optics. A CFO may decide to delay funding a value creating project (positive NPV) if he feels that he is at risk for missing his earnings estimate. While manipulating accounting results does not affect the true economic value of the firm, delaying a good project or investment can have a negative effect on firm value.

Publicly traded firms are not the only ones who are subject to this short-term thinking, as private firms may also prioritize quarterly earnings in order to prepare for an IPO or to secure favorable terms for debt financing.

No comments: