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What is earnings management ?

Earnings management is the active manipulation of corporate earnings towards a pre-set target. The target may be a forecast by analysts, or may be determined by management. Earnings management efforts may use techniques that are within, at the edge of, or beyond the boundaries of the flexibility that is present in Generally Accepted Accounting Principles (GAAP).

A more limited form of earnings management, known as ‘income smoothing’ is the taking of steps to hold profits during boom years for use during slower years. ‘Abusive earnings management’ is a term used by the Securities and Exchange Commission in the U.S. to designate earnings management that results in an intentional and material misrepresentation of corporate results. According to a study conducted jointly by Cornell University’s Johnson Graduate School of Management and George Washington University, cookie-jar reserves are a popular method of moving earnings from one year to the next. In abusive situations, companies take excessive acquisition-related charges when things are good, to create a contingency reserve that can be used to enhance earnings when business experiences a downturn. In spring 2002 a well-known document-management company reached a settlement agreement with the Securities and Exchange Commission to restate earnings going back to 1997 in connection with improper revenue-allocation allegations. Earnings management can be harmful to investors. In a worst case scenario it can keep negative items hidden beyond a date when such items would be expected to have been communicated externally.