What are discretionary costs?

2. Discretionary costs and earnings management

Reduction of discretionary costs is an example of earnings manipulation through real activities (i.e., operating, investing, and financing activities). Note, however, that not every reduction of discretionary costs represents earnings management.

According to the research study by Graham et al (Journal of Accounting and Economics, December 2005), 80% of surveyed CFOs stated that they would decrease advertising, maintenance, and R&D costs to meet earnings expectations.

Because discretionary costs are subject to managementís judgment, they can be used to manage earnings. An organization can decrease its discretionary costs not only to address financial problems but also to smooth its earnings trend. In the latter case, the organization would lower the quality of its earnings.

While the reduction of discretionary costs might seem to be acceptable in the short term, it can have a negative effect in the long run if the company doesnít incur costs necessary for future growth.

To evaluate any reduction of discretionary costs, one can look at the past trend in discretionary costs as well as current and future requirements, based on corporate strategy and market conditions. For instance, to evaluate a trend in advertising costs, one can look at the relationship between advertising costs and sales.†

Letís look at a simple example. Letís assume that the following information is available for Tetto Company (a fictitious entity):

 

20X8

20X9

20X0

20X1

20X2

Sales ($)

200,000

225,000

260,000

250,000

210,000

Advertising costs ($)

21,000

27,000

31,000

30,000

20,000

As we can see from the table above, in 20X2 the company decreased its advertising expenses by $10,000 (or 33%). Letís assume that the company has been facing a tougher competition and expects the competition to increase in the next two (2) years.

To evaluate the reduction in advertising costs in 20X2, letís look at the trend in advertising-to-sales ratio:

 

20X8

20X9

20X0

20X1

20X2

Sales ($)

200,000

225,000

260,000

250,000

210,000

Advertising costs ($)

21,000

27,000

31,000

30,000

20,000

Advertising to sales

10.50%

12.00%

11.92%

12.00%

9.52%

According to the table above, in 20X2 the company reduced its advertising costs to a lower level. However, because the market competition is expected to increase, one could anticipate that the company should have increased its advertising costs. Such a reduction of discretionary costs, therefore, might have been used by the company to smooth its earnings.

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