Understanding the Basic Concepts of Earnings Management

Examples of earnings management in everyday life such as reducing expenses from invoices that should be, increasing income from what they should be, and so on.   Profit management patterns  that can be carried out in profit management practices according to Scott (2009) in Wahyono et al.  (2013), there are basically four archetypes in profit management, including:

  • Pattern Taking a Bath. Occurs at the time of reorganization, such as the appointment of a new CEO. This technique recognizes the costs of future periods and losses of the current period, thus requiring management to charge estimates of future costs so that the profit of the next period will be higher.  In this pattern, management should remove some assets and charge an estimate of future costs on the current report. In addition, he must also “clear the desk” or hide the existing evidence so that the profit reported in the coming period increases.
  • Income Minimization Pattern. Done if the company experiences an increase in profit,  so that if it is estimated that the profit for the next period will decrease, it can be overcome by taking profit in the previous period.  This pattern is carried out at a time when the profitability of the enterprise is very high. The point is not to get attention politically. The actions carried out include write-offs on capital goods and intangible assets, advertising costs, and expenses for research and development.
  • Income Maximization Pattern. Contrary to the income minimization pattern, the income maximization pattern is carried out when profits decrease. Generally, the purpose of using this pattern is to report high net income in order to get a greater bonus and to protect the company  in the event of inappropriate things related to the debt agreement (this is done by the company to avoid violations of long-term debt contracts).  The action that management performs is to manipulate accounting data in reports.
  • Income Smoothing Patterns. This pattern is carried out by leveling the reported profit for external reporting purposes (to reduce too large profit fluctuations), especially for investors because investors generally prefer relatively stable profits.

Profit Management techniques/strategies as follows :

  • Changes in accounting methods. Different accounting methods can produce different calculation figures.  Management changes the accounting method differently from the previous method so that it can increase or decrease the profit rate. The accounting method provides an opportunity for management to record a certain fact in a different way, for example,  changing the method of depreciation or depreciation of fixed assets from the method of sum of the year to the straight line depreciation method and changing the depreciation period.
  • Plays accounting forecasting policy. Management influences financial statements by playing accounting forecasting policies.  This provides an opportunity for management to involve subjectivity in compiling estimates, for example: (1) policyon the estimated amount of uncollectible receivables; (2) Policy regarding estimated warranty costs; (3) Policy on estimates of uninterrupted litigation.
  • Shifting the Period of Costs or Revenues. The value of the company’s profit and performance will also look different if the cost or revenue periods are different. That’s why management shifts periods of costs or revenues that are often called manipulation of operational decisions, for example: (1) Accelerate or delay spending on research and development (R&D) until the next accounting period; (2) Accelerate or postpone promotional expenses until the next period; (3) Cooperation with vendors to speed up or delay the delivery of bills until the next accounting period; (3) Selling securities investments to manipulate profit rates; (5) Regulate the time for the sale of unused fixed assets.
  • Offsetting Extraordinary/Unusual Gains. It is carried out by moving unusual or temporal profit effects that are opposite to the profit trend.
  • Aggressive Accounting Applications. A technique that is interpreted as misstatement and is used to divide profits between periods.
  • Timing Revenue and Expense Recognition. This technique is carried out by creating certain policies related to the timing of a transaction. Take for example premature recognition of income.

According to Setiawati and Na’im (2000) in Wahyono et al.  (2013), there are three techniques that can be used in profit management practice, namely:

  • Take Advantage of Opportunities or Policies to Make Accounting Estimates.
    Management affects profits by using accounting estimates, such as estimated levels of uncollectible receivables, estimated periods of depreciation of fixed assets or amortization of intangible assets, and so on to influence financial statements.
  • Changing accounting methods.
    To increase or decrease profits, it can be done by using accounting methods that are different from the previous period. For example, changing the method of depreciation of fixed assets from the method of depreciation of year numbers to the method of straight-line depreciation, or changing the method of calculating inventory from the LIFO method to FIFO, or vice versa.
  • Shifting Periods of Costs and Revenues.
    There are many ways to shift the period of costs and revenues. For example, accelerating or delaying expenses for research and development to a subsequent accounting period, accelerating or delaying promotional expenses until the next period, accelerating or delaying product delivery to customers, timing the sale of unused fixed assets, and so on.

According to Subramanyam and Wild (2010:133-134), several main methods in profit management are:

  1. Profit Transfer.
    Profit transfer is profit management by moving profits from one period to another. The transfer of profits can be carried out by accelerating or delaying the recognition of income or expenses. This form of profit management usually causes a reversing impact on one or several future periods , often the next one period. For this reason, the transfer of profits is very useful for the leveling of profits.
  2. Profit Management through Classification
    Profit can also be determined by specifically classifying expenses and income on a certain part of the income statement. The general form of profit management through classification is to move the load below the line, or report the load on the outpost is extraordinary and non-repetitive, so it is not considered important by the analysis.
  3. Discretionary Accrual
    Discretionary accrual has often been used as an opportunistic profit management proxy in some previous studies, according to their respective contexts. Managers may have another motivation to record discretionary accruals,  namely to give signals about current and future management performance (Widodo, 2005).

References:

  • Ahmad K, Subekti I, and Wijayanti A.(2010).  The real and accruals earnings management: one perspective of prospect theory.  Collection of papers of the XIII National Symposium on Accounting (SNA), Purrwokerto.
  • Ahmad Z, Subekti I, and Kee PL,. (2010). The effect of integrated earnings management on the value Relevance of earnings and book value of equity. Algifri, Khaled.  2007. Measurement an Motivations of Earning Management: A Critical Perspective. Journal of Accountin, Bussines and Economics 14 975-95).
  • Ali, Ashidiq and Krisna R Kumar, 1994. The Magnitude of financial Statement Effect and Acounting Choice. The case of the adoption of SFAS no 87, Journal of Accounting and Economic. P. 89-114.
  • Alijoyo, F. Antonius. 2002. Effective Audit Committee: Learning from the Enron Case.   http:/www.fcgi.or.id . Astuti, Goddess Saptantinah Praise. (2005). Analysis of Factors Influencing Profit Management Motivations Around Right Issues.
  • Avianti, Ilya. 2006. Uncovering Earning management practices in companies. Journal of Business, management and economics, Volume 7.No.3, February 3, 2006 Baharuddin I, Satyanugraha H. 2008. Earning management practice of Indonesian Public companies.  Journal of Management and Accounting ,Volume 10 No.2. August 2008, pp 69-80.

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Dr. Meiryani, S.E., Ak., M.M., M.Ak., CA.