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Earnings Management Has Been Used To Boost Stock Prices So That Managers Can ...


Earnings management has been used to boost stock prices so that managers can profit from the share trading but in effect undermine the organization's value. In theory the use of earnings management helps firms to manipulate price earning ratios to, firstly show firm's potential activities, and secondly to restate the value of the firm. However, as a consequence, the earnings created theoretical growth in investment and employment depicting strong growth (Kedia and Philippon 2005; Healy and Wahlen 1999). According to the authors, Kedia and Philippon (2005), Enron used an earnings manipulation model, which has resulted real time inefficiencies, as it does not account for the fundamental value of the firm's equity or account for the allocation of resources.
Wamy's (2004) investigation reveals that Enron "inflated profits by nearly one billion dollars and top employees raked in millions of dollars (they should not have received) through complex and special partnerships to hide debt, inflate profits and to engage in allied unethical and heinous business practices." The company's unique business model depicts human capital as the leveraging point for its investments, instead of fixed assets. Since its people are considered physical assets, it could allocate earnings to these individuals to create higher value for the firm that owns them.
Theorists blame the company's manipulated accounts as the basis for its bankruptcy in 2001. Others (Barlev and Haddad 2004; Wamy 2004) blame it on the transition within the accounting framework. Barlev and Haddad (2004) attribute the shift of accounting practices due to the inclusion of the new paradigm of fair value accounting has increased the pace of reporting in firms. The authors in their research prove that the new paradigm improved full disclosure, transparency and management efficiency mandates. However, the weak control system that governs accounts information contributed to abuse and manipulations. It has allowed Enron to sell its stakes to special purpose entities thereby minimizing reported activities. Since Enron "took the position that as a result of the decrease in its ownership interest, it no longer controlled [SPEs] and was not required to consolidate [SPEs] in its balance sheet." SPEs had been acquired through bank loans and debt issuance, which resulted in high debt to equity ratio, but hidden from the investors. As business transactions at Enron grew, the company is also confronted with its inability to pay for these transactions (Dodd 2002). Further, the company has also abused the fair value framework by using hedging instruments such as changing fair value of assets and liabilities, variable cash flows and foreign currency exposure to emphasize on its valuation (Barlev and Haddad 2004) by recording inaccurate revenue and earnings growth. Enron reported prices and recognized fictitious unrealized gains to account for pretax income worth $1.

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