The gap between accountants who research earnings management and those who prepare financial statements is enormous.
Earnings management comes naturally to accountants preparing financial statements. They adjust numbers to suit the situation, often without realising it has a name or that anyone considers it questionable. They simply react to what they regard as ordinary business circumstances.
Research accountants, on the other hand, turn these instincts into theories, patterns, hypotheses, concepts and techniques and publish hundreds, even thousands, of papers on the subject. They have created a serious accounting discipline with many silly names.
The first occurs if results are worse than forecast. Management responds with business decisions to improve future results such as cutting expenses. If results exceed expectation, management might hire more staff or spend more to set up future growth. Both objectives being to bring actual results as close to forecast as possible. Researchers call it ‘real earnings management’. Real here, implies that unreal earnings management or fake earnings management exists. It doesn’t.
What does exist is the second occasion, where management secretly adjusts accruals and provisions, again to bring results as close to forecast as possible. Politely researchers call it ‘accruals-based earnings management’. A more accurate name would be ‘earnings mismanagement’. They give the relevant accruals a neutral name: ‘discretionary accruals’. Deceptive accruals would be better.
Researchers then spoil it by giving other techniques in accruals-based earnings management silly names. When losses are important accountants become soaked in the ‘big bath’ without realising they are wet. When a loss occurs, management, with help from their accountants, intentionally makes it bigger by increasing write-offs and provisions. Get the bad news out immediately and make future periods easier to over-perform. Researchers escalate the technique by calling it a theory: the big bath theory.
When profits are abundant and over plan, accountants don’t stay into the bathroom, but move to the kitchen to cook and bake cookies. They help management reduce profits downwards closer to plan again by increasing write-offs and provisions and make it easier to achieve planned results in future periods. Researchers call these adjustments ‘cookie jar reserves’.
To keep culinary imagery alive when stuffing the Christmas turkey, researchers call another technique ‘channel stuffing’. Ship now, worry later. Here management inflates sales to distributors at the end of a quarter or year to increase profits up to expectation. This time, too bad if future periods are more difficult to achieve. Finally, accountants smooth the icing on the Christmas cake with the technique of ‘income smoothing’. When profits are too volatile for the market, management increases and decreases reserves to ensure that profits increase gradually over several years.
Researchers call other types of adjustments not reserves or theories but hypotheses. The bonus plan hypothesis suggests that managers manipulate earnings to earn bigger bonuses. The debt covenant hypothesis suggests that companies adjust earnings to avoid violating loan agreements. They have even invented a rather vague political cost hypothesis where managers adjust earnings in function of political scrutiny. I suppose researchers must have found a company doing this to invent a name.
In naming the last technique, researchers manage to convey the dubious nature of earnings management with ‘classification shifting’. Here management improves operating earnings by classifying normal expenses to ‘exceptional items’, thus giving the impression that the core business is more profitable than it really is.
Having identified the various tactics and given them names, researchers had to invent a theory to explain why managers make all these adjustments. It is obvious that they have more control over the company than the shareholders. Management, after all, runs the company supposedly for the good of the shareholders, but has enough freedom to alter results in its own interests. They call it the ‘agency theory’ where they consider shareholders as principals and managers as agents. They should have stayed in the bathroom and called it the washing theory or in the kitchen and called it the cooking theory.
From here researchers decided to go into still more detail but no longer invent silly names instead obscure names. PAT is not the shortened version of Patricia or Patrick, but positive accounting theory. The opposite might be negative accounting theory but it doesn’t exist, though a normative accounting theory does, but with no connection to earnings management. Positive accounting theory was invented in the late 1970s and explains and predicts the accounting choices management makes within agency theory.
Management obviously has more information about the company than shareholders. Management is inside the company managing it. Shareholders are outside, relying on management to give them information. Researchers call it information asymmetry.
In the end, one cannot help but admire accounting researchers. They have transformed management’s valiant attempts at keeping results close to forecast into a distinct field of accounting, complete with theories and hypotheses using culinary and bathing metaphors.