1. Introduction
Generally accepted accounting principles (GAAP) offer some flexibility in preparing
the financial statements and give the financial managers some freedom to select among
accounting policies and alternatives. Earning management uses the flexibility in
financial reporting to alter the financial results of the firm (Ortega and Grant, 2003).
In other words, earnings management is manipulating the earning to achieve a
predetermined target set by the management. It is a purposeful intervention in
the external reporting process with the intent of obtaining some private gain
(Schipper, 1989).
Levit (1998) defines earning management as a gray area where the accounting is
being perverted; where managers are cutting corners; and, where earnings reports
reflect the desires of management rather than the underlying financial performance of
the company.
The popular press lists several instances of companies engaging in earnings
management. Sensormatic Electronics, which stamped shipping dates and times on
sold merchandise, stopped its clocks on the last day of a quarter until customer
shipments reached its sales goal. Certain business units of Cendant Corporation
inflated revenues nearly $500 million just prior to a merger; subsequently, Cendant
restated revenues and agreed with the SEC to change revenue recognition practices.
AOL restated earnings for $385 million in improperly deferred marketing expenses