Earnings management occurs when companies artificially inflate or
deflate their revenues, profits, or earnings per share figures. Gaa and
Dunmore point out that earnings may be managed in many different
ways, but they all boil down to two basic possibilities. One is to alter
the numbers already in the financial records by using discretionary
accruals and other adjustments, and the other is to create or
structure real transactions for the purpose of altering the reported
numbers (Mintz, 2016). There are five earnings management
techniques, these include the Big Bath, Cookie Jar Reserves,
Operating Activities, Materiality, and Expense and Revenue
Recognition methods.
• A big bath is an accounting term that is defined by a company's
management team knowingly manipulating its income
statement to make poor results look even worse in order to
make future results appear better. It is often implemented in a
relatively bad year so that a company can enhance the next
year's earnings in an artificial manner (Investopedia.com, 2020).
• Cookie jar reserves are savings from previous quarters that a
company records as earnings in subsequent quarters to make it
appear that its earnings were higher than they really were.
When a company fails to meet its earnings target, a company
accountant can dip into the cookie jar to inflate the numbers
(Investopedia.com, 2021).
• The operating activities technique is used when managers plan
specific events within certain periods. It is used to flatten
income, thus eliminating spikes and dramatic declines in
particular accounting periods (study.com, 2022).
• Materiality plays a vital role in the financial reporting process.
Earnings management abuses often stem from misuse or
misunderstanding of the proper application of the materiality
concept (journalofaccountantcy.com, 2000).
• Expense and revenue recognition can also be called “Income
Smoothing” This comes under fraudulent accounting as the
company records its expenses before it incurs or does not show
the profit and sales when earned. They can even accelerate the
sales showing extra revenue, or they don’t recognize a bad debt
in the current year and shifts it to next year as it reduces this
year’s profit (wallstreetmojo.com, YEAR).
In 2019, the SEC charged The Kraft Heinz Company and two of their
former executives for engaging in years-long financial statement
fraud. The company ended up paying $62 million to settle charges
related to inflated cost savings that caused it to restate several years
of financial reporting. b According to the SEC's order, from the last
quarter of 2015 to the end of 2018, Kraft engaged in various types of
accounting misconduct, including recognizing unearned discounts
from suppliers and maintaining false and misleading supplier
contracts, which improperly reduced the company's cost of goods
sold and allegedly achieved "cost savings." Kraft, in turn, touted these
purported savings to the market, which were widely covered by
financial analysts. The accounting improprieties resulted in Kraft
reporting inflated adjusted "EBITDA," a key earnings performance
metric for investors. As alleged in the SEC's order and in its complaint
against Hofmann, Kraft failed to design and maintain effective
internal accounting controls for its procurement division. As a result,
finance and gatekeeping personnel repeatedly overlooked indications
that expenses were being improperly accounted for (SEC.gov, 2019).
In this case, Heinz violated the expense and revenue recognition
techniques, also known as Income Soothing. The fraud resulted in
nearly 300 misleading transactions that, if they had been recorded
properly, would have added $50 million to the company’s cost of
goods sold during that time. After the Kraft Heinz merger,
management promised an aggressive push to reduce expenses. “The
cost-saving strategy, including its impact on costs of goods sold, was
widely covered by analysts at the time,” the SEC noted. But after the
company “encountered significant headwinds in its effort to meet
annual budget and savings targets,” the commission said, Pelleissone
“failed to adjust expense reduction expectations for the procurement
division, creating a high-pressure environment focused on obtaining
same-year cost savings” (cfo.com, 2021).
Resources
C. Terry Grant, J. C. M. D. A. G. H. G. (2000, September 1). Earnings
management and the abuse of materiality. Journal of Accountancy.
Retrieved October 13, 2022, from
https://www.journalofaccountancy.com/issues/2000/sep/earningsm
anagementandtheabuseofmateriality.html
Hayes, A. (2021, May 19). Big bath definition. Investopedia. Retrieved
October 13, 2022, from
https://www.investopedia.com/terms/b/bigbath.asp
Kenton, W. (2021, September 8). Cookie jar reserves definition.
Investopedia. Retrieved October 13, 2022, from
https://www.investopedia.com/terms/c/cookiejaraccounting.asp
Kraft Heinz fined $62M for accounting fraud. CFO. (2021, November
1). Retrieved October 13, 2022, from
https://www.cfo.com/accounting-2/2021/09/kraft-heinz-fined-
62m-for-accounting-fraud/
Mintz, S. (2016). Ethical Obligations & Decision Making in Accounting +
Connect Access Card. Mcgraw-Hill Education.
Press release. SEC Emblem. (2021, September 3). Retrieved October
13, 2022, from https://www.sec.gov/news/press-release/2021-174
Swaminathan, A. (2022, June 8). Earnings management.
WallStreetMojo. Retrieved October 13, 2022, from
https://www.wallstreetmojo.com/earnings-management/
Take online courses. earn college credit. Research Schools, Degrees &
Careers. Study.com | Take Online Courses. Earn College Credit.
Research Schools, Degrees & Careers. (n.d.). Retrieved October 13,
2022, from https://study.com/learn/lesson/earnings-management-
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