Final answer:
Earnings management consists of techniques to adjust financial reports. Cosmetic techniques affect reports without altering cash flows, such as changing accounting policies, while real techniques, like channel stuffing, impact cash flows.
Step-by-step explanation:
Earnings management involves strategies used by a company's management to manipulate the company's earnings to meet certain targets. These strategies can be categorized into cosmetic and real earnings management techniques. Cosmetic techniques do not have cash flow consequences, whereas real techniques do.
Cosmetic earnings management techniques include:
• Changing the accounting policy: A company might change its accounting policies (like depreciation methods) to improve reported earnings without affecting cash flows.
• Recognition timing: Management may decide to accelerate the recognition of revenue or delay the recognition of expenses to boost current profits.
• Provisioning: Adjusting the estimates for allowances and provisions can inflate earnings without impacting current cash flows.
Real earnings management techniques involve:
• Channel stuffing: Shipping more products than can be sold to report higher sales.
• Changing the sales terms: Offering liberal credit terms to boost sales, which impacts cash flow due to delayed cash receipts.
• Reduction in R&D or maintenance expenditure: Cutting costs on research and development or maintenance can increase short-term earnings but may lead to longer-term cash flow consequences.
Both sets of techniques serve the purpose of portraying the company in a more favorable light by inflating current earnings. Cosmetic techniques do this without immediate cash flow effects, while real techniques are aimed at altering current cash activities with the potential for long-term consequences.