LOS a: Describe incentives that might induce a company's management to overreport or underreport earnings.

The satisfaction of debt covenants and profit estimates are strong incentives to overstate earnings. Since stock prices tend to follow earnings over time, the use of stock for compensation could drive executives to inflate profit numbers. However, a company attempting to get trade relief is more likely to underreport earnings.

Steady earnings growth can be a sign of manipulation of the numbers. It is not a sure sign, but of the choices, the earnings growth is the only one that presents a yellow flag with regard to earnings quality. The LIFO method is considered more conservative for the income statement than FIFO; FIFO is preferred on the balance sheet statement – neither is exclusively more conservative. Most fixed assets are carried at book value – that fact alone says nothing about a company’s financial reporting.

Understating assets could make the return on asset ratio, a measure of profitability, look more attractive. Overstating sales or equity would make profit margins and ROE look lower, or less attractive.