In the last few decades the world economy has changed. Undoubtedly, major factors on its shape had globalization, business integrity and technology. These processes changed the functioning of small, medium, and big businesses. In the beginning of 21st century there are many spectacular cases that are related to earnings management frauds. These events unbalance worldwide economy; they bring lack of trust to investors for market stock and this leads to misleading information about earnings. These false audits and created abuses brought an opinion that stockholders will do absolutely everything to increase their profit. In fact, I have come to believe that earnings quality is one of the most important aspects in financial world in the present day. Management earnings play a crucial role for income statements and balance sheets, as they directly affect stock markets, banks, investors, creditors and many financial institutions.
The purpose of this research paper is to answer the question what earnings management is and how managers and auditors follow the rules using the guidelines of this tool. Why is it so important? Earnings are an amount of profit that company produce in a certain period of time.”Earnings quality refers to the ability of reported earnings to reflect the company’s true earnings, as well as the usefulness of reported earnings to predict future earnings”. Financial statements are used in knowing and predicting the condition of the company to be able to make a choice about stocks, notes, and others liquid assets. Financial statements also refer to consistency, stability and stamina in report earnings. Accounting does not know one simple evaluation method for calculating and showing earnings. That is why it is so difficult to measure them and compare them through the markets. Earnings appear in various figures: net income, revenues, operating earnings and etc. Very often these factors do not mean anything to anybody and they do not contribute for useful information about a company’s status. I would like to answer what reasons and motives drive managers to earnings management. I think that motives and intentions are very important and they can affect our thoughts that lead to our actions and behavior. I will then discuss the conceptual framework for earnings management and its manipulation techniques. In the past years audits have put more a stronger focus on fraud detection and fraud deterrence. This auditing effort has started giving better results. The numerous of earnings frauds start decreasing. However, there is still a big percentage of companies that use management earnings in the wrong way, that is why I would like to show what technique auditors can use in detecting fraud in management earnings.
On account of many frauds and bankruptcies of big firms in the United States and Europe, there has been a rise in interest of quality of financial statements and financial reports through auditors. The term, earnings management is not new, it has been used in previous years. Mrs. Katherine Schipper was one of the first who define earnings management. She defined it as: “â€¦.purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain” (Schipper). Another but more sophisticated explanation was provided by Healy and Wahlen: “Earnings management occurs when managers use judgments in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on the reported accounting numbers” (Healy and Wahlen). In simple words, it is manipulation of a firm’s earnings (directly or indirectly) to meet shareholders and investors expectations in certain periods of time. I found many different views and perspectives about earnings management. I infer that definition of earnings management suffers from lack of consensus about the definition of earnings management. It kindly understandable that many scholars interpret this term differently. For many people it is just a creative managerial resource that shows a company from its best side. Nevertheless, in my opinion Scott provides the best definition: “the choice by a manager of accounting policies so as to achieve specific objectives. Earnings management can be fundamentally classified as either accounting related, involving the manipulation of accounting records through aggressive or fraudulent applications of accounting principles, or operating related, involving choices made by management regarding the timing of investment or operating activities, with the result that reported earnings are influenced by these choices” (Scott).
We can recognize various motives for earnings management. Certainly, it is not a safe operation and it binds to risk of damage a reputation and criminal responsibility. Companies will engage in this practice only if they must and it is their last option and choice. We can select and identify the five the most common motives for this process: stock market benefits, hiding private information, political costs, internal motives, and making CEO look better.
The stock market relies on information, which means that investors want to know the forecast of the financial side of the company before they buy stock. Interaction between those two bodies is very high because investing in stock is a very risky action. Investors often invest in successful and potentially profitable firms. Firms need to look good and strong in various financial analyzes. These elements can easily push firms towards earnings management. By meeting expectation of investors, companies expect higher returns, which will result better cash flow and stability for a company. On the other hand, by showing negative income and pour income statement a firm exposes itself to a dramatic decrease in the company’s value and capital. Which gives negative stock revenue. The stronger incentive then the higher probability that managers will use earnings management to increase its income, which will have effect on better forecast analysis for company (Payne and Robb). To sum up, company approach earnings management fairly easy because they want to stay in “game” and they expect their rival to do the same thing.
Concealing private information is process whereby hiding some information managers achieve their goals. It is difficult to explain the practices of firm’s accounting to the public participants. If the investors cannot recognize a method of accounting they more likely will not invest their assets in the firm. To improve information of the company, managers may adopt simpler and clearer methods which result changing in earnings frequently (S. Verbruggen, J. Christaens, and K. Milis).
The next factor that can influence financial statements is government. Tax laws and different kinds of government regulations may affect greed for changes in management earnings. Big companies do not want to big affect by politicians and control by governments. As long as politicians do not point at firms for lack of liquid or inefficient stock shares, companies do they work. Financial reports are very often tasty morsel for politicians.
One of the most influential factors in my opinion is making the CEO look good. It happens because of the greed in people, especially for CEO or CFO and their obsessions with their reputation. It usually exists when a company changes its CEO or when the CEO retires and he or she likes to leave good impression after its management, which of course result in a big amount of bonuses.
Last example of a motive for earnings management is internal motives. Even if a company does not have to show its operations and earnings to stakeholders or government, it can still use this powerful tool to reach its yearly goals and to attain its performance plan.
I will focus now on practices, procedure and trick that managers use. How do firms manage earnings? The easiest and the fastest way to hide or show a lot of profit in financial data is by using accruals. According to J. Jones and his work in “Earnings management during important relief investigations”, most of the companies use unexpected accruals or very similar to those that they use in their books to make up a difference between its actual assets to its goal. He appointed each of their methods to various types of categories. Various types of these methods are earnings management through: specific accruals, disclosure and ‘real action’, cost allocation and structure of transaction which refers to alter financial data.
The first type of procedure that a firm can use is earnings management through specific accruals. It happens very often that management can use specific accounting standards in its financial statement because a firm can find itself in special situations or in special industry. These specific situations offers more room for different choices of management because law or rules are not very specific. As a result it gives enough reasons to boost up firms earnings. This free choice of interpretation for accountants brings attention to auditors and their investigations. Examples of these practices are commonly known in banks, insurance and property industry. In these industries firms can fairly easily managed loan’s losses, valuation of property or pensions.
The second type of common practices in earnings management is cost allocation. Firms can shift its income by allocating costs to different activities. It can occur when cost, revenue or an item is moved from other subsidiaries to another area with additional tax or a different accounting method. Sometimes firms use charitable organization to get additional options in moving earnings. In keeping with Jones and Robert’s research (2006)”charities use the allocation of joint costs to smooth the program ration, an often used indicator of charity efficiency” (Jones and Robert).
Mostly, investors bring their attention to core financial data, that is why it is useful for companies to shift some expenses from main financial data to ‘special items’. It happens because in core financial data revenues and expenses are not summed up with revenues and expenses, for special items, which can give space for earnings management. Large portion of scholars agree that income shifting through different categories and reinvesting earnings result in optimization of taxes and report earnings.
Earnings management uses its “tricks” through disclosure. Managers usually use prior earnings amounts to evaluate current earnings in stock option. Under SFAS No 123 company should recognize pro forma stock option as an expense but firms manage this as a stock option in a footnote. In fact, this practice can reduce public criticism because eventually the CEO will compensate it and stock’s value can reminds the same, high. Back before 2002,multiple firms in United States commonly used this procedure.
‘Real activities’ management has a different purpose of earnings management than previous methods. Firm’s real activities can by balance up and down by changing a structure of transaction to be or not be able to apply certain accounting standards. Form of this practice can be seen when an organization cuts its budget, or selling price, or adopt just-in-time discounts. Real manipulation happens when company deviate from normal business practices and undertaken with primary objective of meeting certain thresholds. (Roychowdhury 2006). Many evidence show that increase in sales results in price discount giving by companies, engage in overproduction reduce cost of goods sold. Everything is a results of specific and strict goal for a firm. Also, very clear examples provide just-in-time adoption changes in debt and tax incentives when an organization experiences different practice for LIFO and FIFO that relates directly to income smoothing.
A different way of using real activities is timing corporation’s accounting decisions. Firms give money for charity foundations, which result in grants. The time gap between deposits and payout results in possibilities of earnings management. Petrovits put it well by saying “firms with high stock price sensitivity and small increases in earnings make the most income-increasing foundation funding choices. Firms with increasing earnings despite of large income-decreasing foundation funding choices in the current year are more likely to increase earnings in subsequent periods, consistent with the use of cookie jar reserves and earnings smoothing” (Petrovits).
Relatively, managers can smooth earnings income by cash flow. Playing with accruals and changing them are most common practice. Especially, when discretionary accruals and derivatives accruals are easy to manage. If a company’s portfolio has a large notional amount and lower levels of discretionary accruals, it will suggest that both of those accruals were modified to smooth earnings.
Is it ethical to use earnings management? I think that this practice is probably one of the most important ethical issues facing the accounting profession nowadays. Management usually has to decide either play a fair game and try to stay in frame of accounting rules or maximizing its profit using every tool that managers can use. The problem is never black or white; it is more like a grey side of earnings management, which can raise ethical issues. In a broad debate about ethical issues in ethics one side claim that: “earnings management undertaken solely to enhance personal goals is generally viewed as unethical” and the other side conclude that the ethics are both unethical and ethical, it depends of business goal. Others say that it is completely unethical.
Having said that the ethical consequences of managing earnings whether it has positive or negative influence of the moral aspects and management behavior. According to my research, intentions are the most influencing factor for decisions. Which can be later judge as ethical or not. Research by Nelson et all (2003) concluded that it is common practice to use earnings management nowadays. The study shows that daily activity of companies results in reducing accruals from previous periods, modifying depreciation, deferring bills, sales transaction and changing classification of income statement. The sample of 515 auditors and their list seems never ending. I can only assume that “small”, “careless” mistakes are made every day. Those practices can lead to many consequences in the future. Managers can do multiple things to benefit a company. These advantages can have positive and negative outcomes. Stock value, bonus pay for managers and etc. are only on one side of the equation. The other side is more harmful because being detected for fraud will decrease in value of stock, loss of reputation for company and management, and trail for manager. “If earnings management is considered unethical by financial statement users, then managers’ and companies’ reputations may suffer and companies’ credibility in the financial markets may be damaged” (Kaplan,2001). Kaplan’s investigation showed that it is difficult to decide if earnings management is unethical because we have to look at each case from various perspective whether it was intentional or not. I inferred that company will always try to maximize its profit because it is the whole purpose of a function of a company and we have to define very special and details rules to prevent those practices. By making clear standards, accountants are able to reduce unethical behavior to minimum. Nevertheless, it will always be something new and something that accounting has not defined yet. In business everybody needs to find a balance. I see a need for schools to teach future auditors and managers about ethics and establish diligent punishments for corrupt accountants and provide good audited policies for organization in business worlds.
Many scholars say that earnings management is an issue and a large portion of their studies focuses on the causes, consequences and detection of this subject. Relevant fact in researchers studies is that flaw in earnings management is not easy to detect. For detection auditors use various techniques, which are not perfect and usually are miss specified. As I mentioned before accruals are the most common methods that accountants use. It is because; this method is handy and more flexible than other (like changing LIFO and FIFO). One of the most recognizable techniques is to ” isolate the ‘discretionary’ portion of the accrual component of earnings”. This technique is very common but still it consists of a lack of power because of poor ability to isolate specific accruals, which has an unspecified correlation between variables. Many alternative techniques have been found in recent years but they have small improvement over this main method. One of them has a purpose for identifying discretionary accruals by Dechow and Dichev, 2002. Another method is matching procedures, which helps with misspecification but it is useful only it matches relevant procedure with accurate variable. The whole purpose of finding work method for detection earnings management is manipulation in accruals, auditors will face difficulties in detection of frauds in financial statements until they do not find perfect model to use.
Conclusion: start here please
Many accounting scandals shows importance of credible financial reporting. Earnings management is very accessible and common in business in XXI century. Many times when somebody talks about management earnings people think that it is something wrong and negative but it can be very positive and legal. Management earnings is a tool which help accountants to show company’s financial condition in favorable way. Law of accounting regulate many rules and say how to interpret financial law. Of course accountants have many option to manipulate and smooth their income. However, size of the firm has positive impact on earnings management because big companies have strong internal control system and well define mechanisms. They also corporate with CPA firms which they care about their reputations. These elements have decrease probability of earrings management however the large companies can also face more pressure for positive reports. They have wider range of accounts, more bargaining power and stronger power to manipulate earnings.
Certainly, motives are the key elements for earnings management. They explain most of managers behavior. Motives consider just two choices. They are either favorable or no favorable for organization. I would add something in this paragraph, help me out my senior!
Accounting changes every day, managers face those changes in procedures as well. Government and financial organization should look towards internal issues like audits rather than external factors. Controllers should put more pressure on audit because less audit attentions equals more fraudulent earnings management in business. Detection in earnings management is an important issue as well and I hope I highlighted that problem. It has many limitation and I think that researcher should work on more data collection and less biased methods.
In closing, I recognize an ethical trade-off throughout organizations. When one firm does something correct and the other sees opportunity to increases its profits even though it can be unethical. The problem is that many companies do not look for the long perspective but short term profit which usually results in frauds and unethical behavior. Earnings management is a very sophisticated and powerful tool used commonly nowadays.