The management of a company has two types of motivations or incentives for manipulating financial reporting through accrual discretions: capital market incentives and contract based incentives.
- Capital Market Incentives: Financial reporting affects the price of a company’s stock and the price of its bonds. Therefore management has the incentive to exceed the market expectations. Management may attempt to manipulate net income in order to meet analyst forecasts. Management may also become more publicly pessimistic as its fiscal year progresses, in order to generate positive earnings surprises later in the year, as positive earnings surprises tend to elevate stock prices.
- Contract Based Incentives: When management is heavily compensated with stock or has bonuses tied to earnings then incentives exist to manipulate financial statements. In addition, companies with debt may be motivated to manipulate financial statements in order to maintain debt covenants.