Managers are entrusted by shareholders to properly run their companies. Managers are expected to behave ethically and make decisions in the best interest of the shareholders. They are supposed to maintain the long term financial health of the organization by making strategic decisions which enhance firm value. However managers do not always behave in this manner. They make unethical, risky decisions which compromise the financial stability of the organization. Earnings management helps explain the aberrant behavior of managers.
What is Earnings Management?
Earnings management is manipulating a firm’s accounting numbers to mislead the users of financial statements. This practice is typically done to inflate a company’s earnings to give the illusion that its value is greater than it actually is. Managers sometimes participate in this behavior to reach earnings targets so they can receive their bonus.
Causes of Earnings Management
Increase in private control benefits leads to earnings management. Strong legal systems limit insiders to gain private control benefits. If investor protection is strong, insiders enjoy fewer private control benefits which give them less incentive to manipulate earnings. But weak investor protection and an increase in private control benefits creates an incentive to manage earnings.
Ways to Curtail Earnings Management
One technique which can be employed to curtail aberrant behavior by management is to eliminate performance-based compensation. Performance based compensation puts pressure on management to reach the projected numbers so they can get their bonus. This behavior can lead to earnings management and compromise the financial health of the organization. Instead of
Another technique which can be employed to curtail aberrant behavior is to employ stricter penalties for management who do not act ethically. By having stricter penalties and strong investor rights, it can deter management from behaving unethically. If investor protection is strong, management has less private control benefits. This decrease in private control benefits gives management less incentive to act unethically. performance based contracts, I think companies should use outcome based contracts. The outcome based compensation better aligns the goals of management and shareholders. By better aligning the goals of the principle and agent, it well reduce the pressure for management to behave unethically.
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Accounting, Finance, and Business 