Earnings management

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Earnings management

  1. 1. Earnings Management,<br />Mohammad Jafariramsheh<br />July 2011<br />Introduction<br />In order to discuss earnings management and what its effects are on business and whether or not it's a good thing, we must first understand what earnings management really is. Earnings are one of the most important things in the financial statement. Increased eranings represent a rise in company value, while decreased earnings indicate a decline in that value. Regarding the importance of earnings, there is no wonder that the company managers are highly intrested in how earnings are reported. In the companies where managers attempt to alter and misrepresnt the financial performance or the true income and assets in order to present a more favorabale image of the company, earinings managemnet occurs. Generally, incentives for earnings management include explicit contract such as bonus plans, and debt covenants, implicit contract, capital markets and need for external financing, the political and regulatory process, and some specific circumstances such as earnings decreases or losses. Earnings management may lead to misrepresentation of financial information as a result of conflicting interests between the agent and principle. The paper discuss earning management concept and the question “ Is earnings management good or bad?”. <br />Literature Review<br />Much of the literature about earnings management presents some information about the most important questions asked by standards setters, involving whether earnings management is commonplace and ordinary or occurs infrequently and rarely, which accruals are the focus of earnings management and what are the effects on resource allocation decisions. This information is necessary to evaluate the pervasiveness of earnings management and the integrity and truthfulness of financial reports.<br />The focus in the past research of earnings management has been mainly on finding whether earnings management exists and when. Researchers have examined a wide range of measures of earnings management and samples from firms where the motivations to manage earnings are expected to be high. Studies have shown that earnings management does exist and it occurs for different reasons. These reasons include influencing capital market expectations and valuation, to increase management’s compensation, to avoid violating contracts written in terms of accounting numbers, and to reduce regulatory costs and some other reasons that will be discussed in the next parts.<br />Research has approved that earnings management as a problem needs more attention by standards setters and regulators, but before these they can try to fix the situation, they will need to do a broad research to determine which accounting standards are being managed, the frequency and impact of earnings management, and what factors limit earnings management. <br />Although we are known that earnings management exists, it is difficult to report and document it. The main reason being that to prove that earnings have been managed researchers must first determine what earnings should have been before the effects of earnings management. One approach that has been used is to identify conditions in which managers’ incentives to manage earnings are high. <br />It is clear that earnings management is still a new topic that it is only beginning to be explored. Future research will not focus simply on whether or not earnings management exists, but will expand the questions to include the dimensions and frequency of the earnings management and the effect that earnings management has on stock prices and resource allocation.<br />Analysis and Findings<br />Earnings management is the process by which management can potentially manipulate the financial statements to represent what they wish to have happened during the period rather than what actually happened (Scott 2009). Earnings management occurs in corporations where managers attempt to present a more favourable financial picture of the company performance through discretionary accruals (Aini, Takiah, Pourjalali & Teruya, 2006). Managers use flexible accounting principles to manage earnings (Davidson III, Jiraporn, Kim & Nemec, 2004). Previous studies on earnings management mainly focus on identifying incentives for managers of listed companies to manage earnings (Bauwhede, Willekens & Gaeremynck, 2003). Incentives for earnings management include explicit contract such as bonus plans (Gaver, Gaver & Austin, 1995) and debt covenants (DeFond & Jiambalvo, 1994), implicit contract (Bowen, DuCharme& Shores, 1995), capital markets and need for external financing (Teoh, Welch & Wong, 1998a), the political and regulatory process (Han & Wang, 1998) and some specific circumstances such as earnings decreases or losses (Burgstahler & Dichev, 1997). Earnings management may lead to misrepresentation of financial information as a result of conflicting interests between the agent and principle.<br />Two of the most important researches and articles about earnings management are done at the end of 1990s and current decade by Schipper at 1989 and Healy and Wahlen at 1999. <br />“the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about a desired level of reported earnings.”( Schipper, 1989)<br />And Schipper defines earnings management from accounting numbers view as:<br />“…a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process).”…”A minor extension of this definition would encompass ‘real’ earnings management, accomplished by timing investment or financing decisions to alter reported earnings or some subset of it.”<br />Schipper’s definition of earnings management was limited to the external financial reporting process. Schipper also believes that in a view of accounting numbers as information, earnings management in other words can be expressed as disclosure management as a result of managed earnings is the intervened external financial reporting.<br />‘Earnings management occurs when managers use judgment 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 reported accounting numbers’ (Healy and Wahlen, 1999, p.365).<br />Healy and Wahlen’s definition of earnings management further structure managers’ intention to guide the external view to mislead the shareholders about firms’ financial performance. Healy and Wahlen defined three different incentives for earnings management: capital market expectations and valuations, contracts written in terms of accounting numbers and antitrust or other government regulation. They concluded that research has not been able to help standard setters in their attempts to control earnings management nor to provide evidence on the extent and scope of earnings management practices.<br />In this part, some points about good and bad side of earnings management according to Scot(2009) and Hanna(1999) will be described.<br />Good Side of Earnings Management<br />Contract-based arguments(Scot 2009)<br /><ul><li>Earnings management gives firm some flexibility in the face of rigid, incomplete contracts.
  2. 2. Contract violation is costly, earnings management may be low-cost way to work around.</li></ul>Investor-based arguments(Scot 2009)<br />To communicate inside information to investors<br /><ul><li>Blocked communication may inhibit direct disclosure of earnings expectations.
  3. 3. Discretionary accrual management as a way to credibly reveal management’s inside information about earnings expectations.
  4. 4. Manager foolish to report more earnings than can be maintained.
  5. 5. Manage reported earnings to an amount management expects will persist.</li></ul>The Bad Side of Earnings Manegement<br />Financial Reporting Perspective(Hanna 1999)<br /><ul><li>Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items.
  6. 6. Implies manager not penalized for non-core charges, such as writedowns, provisions for restructuring.
  7. 7. But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs.</li></ul>Recommendation<br />To the Auditing Standards Board:<br /><ul><li>It is recommended that the ASB develop stronger and more decisive auditing standards to effect a considerable change in auditors’ performance and improve the possibility that auditors will detect fraudulent financial reporting.
  8. 8. Discussion by supervisory engagement personnel (including the auditor with final authority, usually the engagement partner) with other engagement team members about the vulnerability of the entity to fraud. This discussion should cover what is expected of team members in dealing with a potential for fraud in the specific areas of the audit assigned to them. An important objective of these discussions would be to identify the appropriate engagement team members to address the potential for fraud (e.g., the engagement team members who should interview company personnel) and how their work is to be supervised and reviewed.</li></ul>To audit firms:<br />It is recommended that audit firms:<br /><ul><li>Begin working immediately with the notions in the recommendations to the ASB to increase the auditor’s ability to identify and detect financial statement fraud. The results of those attempts should be shared with the ASB for consideration in developing its standards, with the purpose of speeding the standard-setting process up.
  9. 9. Develop or expand training programs for auditors at all levels oriented toward responsibilities and procedures for fraud detection. These programs should emphasize interviewing skills and the exercise of professional skepticism, as well as testing techniques. They also should emphasize (especially to staff and in-charge personnel) that misappropriation of assets is a significant risk and that being alert to its possibility at any level in an entity is necessary. Training programs should include case examples of how defalcations might be effected, the types of controls over the safeguarding of assets that are effective in preventing and detecting defalcations, and how defalcations are concealed. Special emphasis should be given to how information technology might be used to misappropriate assets and disguise the results.</li></ul>To audit committees:<br />It is recomended that audit committees:<br /><ul><li>Request management to report on the control environment within the entity and how that environment and the entity’s policies and procedures (including management’s monitoring activities) serve to prevent and detect financial statement fraud. Such reporting should acknowledge, in explicit terms, that fraud prevention and detection are primarily the responsibility of management. It also should help audit committees assess the strength of management’s commitment to a culture of intolerance for improper conduct. Furthermore, audit committees should seek the views of auditors on their assessment of the risks of financial statement fraud and their understanding of the controls designed to mitigate such risks.
  10. 10. Accept responsibility for confirm that the auditors receive the necessary cooperation from management to carry out their duties in accordance with the strengthened auditing standards to be developed by the ASB.</li></ul>And the last one is to "make sure investors' expectations are based on reasonable assumptions. If they are not, you need to do a better job of communicating the underlying realities of your business. If their expectations are reasonable and you miss the target, that's just a fact of life that you have to explain and you should have to explain it, not cover it over."<br />Conclusion<br />In the literature review we had many definitions of earnings management. Generally, it can be defined as misrepresentation of finanacial reports in order to either mislead shareholders or affect contractual outcomes depended on reports. Moreover, motives for managers to manage earnings were mentioned in this paper like explicit contract such as bonus plans, and debt covenants, implicit contract, capital markets and need for external financing, the political and regulatory process, and some specific circumstances such as earnings decreases or losses. Earnings management is a manager’s choice of accounting policies that achieves some specific objective. Even under GAAP, managers still retain some flexibility in accounting policy selection that may be able to positively impact their personal satisfaction and/or the market value of their firm. <br />Is Earnings Management “Good” or “Bad”?<br />Earnings management is “bad", in the sense that it reduces the reliability of financial statement reports. Managers change reported earnings for reasons that are not clear. Howeves, there is a dependence on earnings management to translate inside information into public information, as the costs of uncovering inside information are often very high. <br />Earnings management does have a “good” side, fortunately. This relates to efficient contracting. When a contract imposes strict or incomplete terms on a manger, earnings management can provide an option of flexibility, so long as it excludes a manager’s opportunistic (self-interested) motivations. <br />Additionally, earnings management can serve as a way to “unblock” communication to outsiders. Blocked communication exists when it is very difficult and costly to translate a manger’s skilful expertise about a firm to the board of directors and/or investors. By using the financial statements to communicate the financial health of the firm, earnings management can be used to inform outsiders of management’s inside information as per their exercised expertise. Earnings management that makes the company look better than it really is may result in disappointing for the single investor and potentially leads to a welfare loss in society when the resource allocation is distorted. A more specific knowledge of occurrence of earnings management supposedly increases the awareness of the investor and thus leads to better investments and increased welfare. Therefore, earnings management can entail both bad and good consequences for both external and internal side of a company depending on how they use and implement it.<br />References<br />Ethics & Earnings Management, Leon Timmermans, 2010<br />Earnings Management, Scot, 2009<br />EARNINGS MANAGEMENT, FRAUD, AND COMPENSATION, MICHAEL GOMBOLA, PH.D., March 2008<br />Earnings management, S. Verbruggen, J. Christaens, and K. Milis, 2008<br />A Different Perspective of Earnings Management, Ning Yaping, 2006<br />Perspectives of Earnings Management, C. Kevin Pan, 2006<br />An Investigation of Earnings Management through Marketing Actions, Craig J. Chapman Thomas J. Steenburgh, July 2010<br />Earnings Mangement, Jonas Sophr, 2005<br />Earnings management and investor protection, Christian Leuz, Dhananjay Nanda, Peter D. Wysocki, 2002<br />ACCOUNTING SUBJECTIVITY AND EARNINGS MANAGEMENT, William U. Parfet<br /> Surplus Free Cash Flow, Earnings Management and Audit Committee, RINA BR BUKIT AND TAKIAH MOHD ISKANDAR, 2009<br />The Theoretical Framework of Earnings Management, Ning Yaping, 2005<br />CEO incentives and earnings management, Daniel Bergstresser, Thomas Philippon, 2004<br />Earnings Management and Firm Performance, GUOJIN GONG, HENOCK LOUIS, AMY X. SUN<br />Earnings Management by Firms, Levon Babalyan, 2004<br />INCOME SMOOTHING, REAL EARNINGS MANAGEMENT AND LONG-RUN STOCK RETURNS, Abbas Aflatooni, Zahra Nikbakht, 2009<br />

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