The use of accounting tools and techniques to prepare financial statements that present an overly positive or optimistic view of an entity’s operations and activities and financial position for the period in question. Management may, at times, attempt to influence and manipulate the earnings reported in the entity’s financial statements. The main reason behind earnings management is attempts to meet or match certain targets earlier set as expected performance levels, or to exceed such targets, in certain situations, so managers can get better performance gains (bonuses, compensations, etc.)

Earnings management is a form of creative accounting that aims to intentionally and illicitly make financial statements look better. specific strategy of earnings management, income smoothing, whose purpose is to reduce income variability over time and it is mentioned in the literature as a rational behavior that allows accomplishing several purposes in the long term.

Earnings management strategies may be divided into: 1) aggressive accounting policies, aimed at improving income, 2) conservative accounting policies, aimed at reducing income, and 3) income smoothing policies, aimed at increasing income in certain fiscal exercises and at decreasing it in others, with a focus on minimizing its long-term fluctuations.

Therefore, not all forms of earnings management involve illicit means for manipulation of earnings. Income smoothing aims to reduce income variability over time, and is considered a rational behavior that allows management to achieve several, benevolent purposes in the long term. Income smoothing particularly involves the use of accruals to report earnings with an artificially lowered variability.

Generally, for income smoothing, managements set aside reserves in periods of good performance, in order to use them to increase earnings in periods of poor performance, rendering, hence, the reported earnings less variable than the actual economic performance of the entire entity. For that purpose, managers can use both accruals and cash flows, though the latter is costlier and less preferred due to the high costs arising from cash flows manipulation, in addition to its visibility. Therefore, accruals manipulation is preferred in order to normalize the reported earnings series.