Earnings management is a euphemism for methodologies in accounting that follow the letter of generally accepted accounting practices, but are not necessarily in keeping with the spirit of those practices. Sometimes referred to as creative accounting, earnings management is an attempt to present the financial information in the most positive light, usually by downplaying any negative elements to the point that they are extremely difficult to detect. This questionable practice is sometimes used to attract investors, keep current investors happy, and in general project an image of the business that is not the complete truth.
One of the aspects of earnings management that allow the practice to be somewhat successful in misrepresenting the true nature of a financial situation is that the information that is presented is generally correct. However, that information is presented without taking into account any other relevant facts that would provide a more balanced and accurate picture of the status of the company. For example, the company may release a document to investors that hails the fact that unit sales were up by 25% in the most recent quarter, while failing to mention that that the upswing in sales was due to a price drop that essentially left the level of generated revenue unchanged from the previous quarter.
The more successful instances of earnings management focus on telling just the right amount of truth in the form of isolated facts, while downplaying or omitting other data that would allow investors and others to understand the actual financial status of the business. This creates a situation where the accounting records are technically complete, and do contain entries for all financial transactions. However, the issue of where in the accounting records those entries are posted, and thus how they are presented, is subject to questioning. Only by conducting an audit with the aid of an outside accounting firm can these types of accounting irregularities be identified.
In recent years, earnings management has come under closer scrutiny by investors and by government regulatory agencies. The use of this practice has led to situations where investors ultimately lost a great deal of money, since they made investments based on the manipulated information supplied to them. As a result of recurring instances of this type of creative accounting, many governments are taking steps to refine regulations related to business accounting and accountability, making it somewhat harder to utilize loopholes in the current processes to offer investors and others a partial and overly-optimistic perception of the true financial situation.
