Earnings management is a completely legal accounting technique used when producing financial reports that makes the reports appear positive. The management team in charge of producing the financial statements for a company uses the legitimate accounting rules and limitations to manipulate revenue recognition and expenses to give the readers the idea that the company is financially stable.
Companies will use earnings management as a technique to remain consistent with the stockholders' and investors' expectations. If the company knows that their owners prefer the stock price of the company to grow consistently, they may feel pressure to legally manipulate the numbers on the financial statement to do just that.
Fraud is an accounting technique that is illegal. Like earnings management, fraud consists of management manipulating or omitting important financial figures, with the difference being that fraud usually has substantial mistakes that can drastically change the bottom line or stock price of a company. The management team may feel pressure from external forces (the Board of Directors, investors, stockholders) to make the stock price reach a certain level, or to even prevent the company from having a negative net income. When a company commits fraud and is caught, the penalties are substantial. They are usually expected to pay enormous fines to the government and compensate their shareholders, as well as the executives potentially paying time in jail. Once a company commits fraud, it is very difficult for that company to ever succeed in the business world again, as they will not be able to take out a loan or obtain investors' funds. A famous fraud scandal was the Enron Scandal. Enron, an American energy company, was caught in 2002 lying about their profits and completely omitting large expenses in order to inflate their bottom line. The company was caught by the US Justice Department and went bankrupt as a result of the scandal.¹
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