Alternative Earnings Management Techniques: What Audit Committees and Internal Auditors Should Know

Abstract

The desire to meet analysts' earnings expectations has driven companies to abandon credible financial reporting by stretching the boundaries of generally accepted accounting principles (GAAP), and even making operational and investment decisions that compromise future financial performance. Although external auditors have made strides in curtailing GAAP‐based earnings management, real earnings management (REM) has been adopted by management who hope to improve reported earnings. Such behavior should be of concern to audit committees (ACs) whose responsibilities extend beyond simple compliance with GAAP, to include ensuring that financial information is credible enough to facilitate risk assessments and to maintain effective internal control systems to monitor the effective use of resources by management to maximize long‐term shareholder wealth.The purpose of this article is to increase awareness about the nature, extent, and consequences of management's use of REM to meet Wall Street expectations. We also discuss company and governance attributes that are associated with REM so that ACs and internal auditors (IAs) are able to identify circumstances in which REM is employed to generate earnings that satisfy Wall Street. Specific techniques to detect REM are provided, as well as disclosure alternatives that the AC may use to assist financial statement users in assessing current‐ and future‐period financial performance. © 2017 Wiley Periodicals, Inc.