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The literature has not revealed a general agreement on a single definition of earnings management; however, the definitions provided “differ depending on the instruments of manipulation, on the purpose of the earnings management behaviour and the timing of earnings management” (Goncharov 2005, p.20). The most commonly used definitions in the literature are those provided by Schipper (1989) and Healy and Wahlen (1999) respectively:

[Earnings management is] a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)…A minor extension to the definition would encompass

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“real” earnings management, accomplished by timing investment or financing decisions to alter reported earnings or some subset to it (Schipper 1989, p.92).

Earnings management occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy and Wahlen 1999, p.368).

Schipper (1989) notes that her definition focuses on the external reporting role and that it does not include managerial accounting activities that could be used to change or affect GAAP. Moreover, she adds that her definition views accounting numbers as general information and does not depend on any concept or type of earnings.

Unlike the definition of Healy and Wahlen (1999), Schipper (1989)’s definition provides the possibility of earnings management to occur through real activities management. However, both of the definitions refer to an intervention in the financial reporting process which could be facilitated through the use of managers’ judgements.

Judgment in financial reporting refers to the opportunistic use of estimates and accounting choices that are adopted by managers “to mislead stakeholders (or some class of stakeholders) about the underlying economic performance of the firm”10_{, rather than to provide informative reports and credible signals about the}

financial performance of the firm (Healy and Wahlen 1999, p.369).

10 _{Stakeholders are misled through information asymmetry and manager’s favourable access to}

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Table 3.1 An Overview of Earnings Management Methods

management type Specific method Example

Accounting decisions: Within- GAAP earnings management. Exploiting the available flexibility within GAAP - LIFO vs. FIFO

- Accelerated vs. straight line depreciation.

- Change in useful life of asset - Recording/taking back provisions Accounting decisions: Out-of- GAAP earnings management Not applying/violating GAAP

- Early recognition of revenue (for example, before goods are shipped)

Real transactions Managing earnings by managing real

transactions

- Timing of asset disposals, R&D and maintenance expenses, purchases of inventory (in the case of application of LIFO)

Table 3.1 presents the types of earnings management along with methods and examples about how they are practised. Through within-GAAP earnings management, several accounts, including non-current assets, inventory, receivables, etc. could be managed by managers’ choice of estimates and accounting methods. For instance, estimates are required to be taken for the useful life and salvage value of non-current assets. Similarly, the use of estimates involves bad debt expenses and asset impairment losses. In the same vein, judgement is required in choosing from among accounting methods to report for depreciation (straight line or accelerated), and inventory valuation methods (LIFO, FIFO, weighted-average). For example, during inflationary periods, valuing inventory under LIFO will result in less reported earnings than when they are valued under FIFO. Similarly, switching between

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depreciation methods can result in an increase or decrease in reported earnings12 (Goncharov 2005).

Extreme forms of earnings management could be also practised through out- of-GAAP activities or fraudulent reporting (Dechow and Skinner 2000). Financial fraud is “the intentional, deliberate, misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision” (Dechow and Skinner 2000, p.238). Fraud activities are therefore deliberate manipulations of accounting figures affecting reported earnings. These activities include recording unrealized and fictitious sales, backdating sales invoices, and “overstating inventory by recording fictitious inventory” (Dechow and Skinner 2000, p.239).

Finally, managers can manage real activities to achieve a certain reported earnings target. Rather than affecting accruals, real activities affect cash flows and encompass both operating and investing decisions. Operating decisions might be through the timing of advertising costs, maintenance costs and product shipments to customers, whilst investing decisions are through the timing of sale of non-current assets “and the timing of investing or disinvesting in research and development” (Goncharov 2005, p.23). The conventional perspective in the earnings management literature is that accrual-based earnings management is more prevalent than its real activities counterpart as the latter decisions are more costly (Goncharov 2005), and more likely to be unravelled by auditors (Beneish 2001).

Dechow and Skinner (2000) contend that academics perceive earnings management differently to practitioners and regulators. They argue that the latter

12_{In first periods, lower depreciation expenses are reported under the straight-line depreciation}

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have more aggressive views of earnings management. In order to know whether firms’ managers are engaged in earnings management, Dechow and Skinner (2000) argue that the emphasis should be on managerial incentives. Similarly, Healy and Wahlen (1999) articulate that in order to identify whether a firm is managing earnings, “researchers first have to estimate earnings before the effects of earnings management” (p.370). Describing this as a difficult task, Healy and Wahlen (1999) suggest a common approach where researchers should first identify managers’ incentives and motivations to manage earnings and then “test whether patterns of unexpected accruals (or accounting choices) are consistent with these incentives” (p.370). The following sections tackle the motivations for earnings management followed by the most prevalent techniques used in the literature for detecting earnings management.