Earnings management paper


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Earnings management paper

  1. 1. Earnings Management Paper
  2. 2. The single most important item on a company‟s financial statement is their earnings.Sometimes referred to as a company‟s net income or “bottom line”, earnings are the oneindicator as to how a company performed throughout the period and added value to its overallwell-being. Earnings are revenue minus with all the expenses the companies occur during thecurrent period. Earnings are also described as the gain archive by the company for the currentperiod. Outsiders especially investors and analysts look to company‟s earnings to determine theattractiveness of a particular stock of a company. Companies with poor earnings prediction will typically have lower share prices compareto those with better prediction. The price of the stock are positively correlated with demand ofthe stock. More demand will lead to higher stock price and the higher stock price of thecompany, the better the company are. The combination of both, earnings and management givemeans of profit manipulation that can only been done by people who have power to control andmanaging the company. Given the importance of a company‟s earnings, it is not surprising that the manner inwhich a company‟s management is always very interested in how their earnings are reported.Company executives are in a position to make decisions with how accounting choices are madeand how earnings are managed. Earnings management is not a new issue. It‟s been using by thecorporation since the old time before the technology such as computer even created yet. Therewas many type of how earnings are manage or in other word, being manipulate in order to getthe right earnings at the right times (Chapman, 2009). Managing a company‟s earnings is not an illegal activity and can be used as one of thecompany‟s strategy to archive better future but there is a lot of pressure on company executives
  3. 3. to manage earnings in order to reach their full potential. In the case of earnings management, it‟sbeen used as a strategy by the management of a company to intentionally manipulate thecompanys earnings so that the figures match with what they want. For example, in order to gaintrust from the bank to obtain a loan, the management manipulate the company‟s earning to lookgood even if the company are not. However, if it is for the purpose of tax, the earnings aremanage to look bad in order to reduce the amount of tax expenses that need to be paid for thecurrent year. Simply put, the practice of earnings management is carried out for the purpose ofincome smoothing (Chapman, 2009). Therefore, rather than having years of exceptionally goodor bad earnings, companies will try to keep the figures relatively stable by adding and removingcash from reserve accounts. It is one of the techniques of earnings management. On the other side, earnings management is not favorable by all of the financial reportingusers except the management since they are the people who orchestrate it. For sure, beingcheated regarding the information that should be obtain are not the favorable things that by allpeople. In other words, earnings management is also misleading all the users regarding thecompany‟s earnings. Regarding the complexity of the preparation of accounting report, thepractices of earnings management are continuously being reviewed and implemented. It‟s alsodifficult to determine whether the company is manipulating its earnings or not (Chapman, 2009).This is because of highly confidential information of how a company compiles its financialreports. Individuals that are typically aware of the methods used in earnings management areonly the individual who adopted the method, which is usually the chief executive officer or CEOand chief financial officer or CFO.
  4. 4. As stated by the investor Warren Buffett, "Managers that always promise to "make thenumbers" will at some point is tempted to make up the numbers” (Chapman, 2009). The functionof auditor are supposedly to detecting such misused in order to protects shareholders interest butbased on several previous case of big corporate scandals, its show that how careless the auditoreven though some of well establish auditor to detect that misused or purposely not detected thatissues. Some examples of earnings management and also the practitioner whose misused thistechnique that lead them to failure that been stated by Agrawal and Chadha (2005) are includedoffensively recording revenues as done by Xerox, Bristol-Myers, recording uncollectible sales aswas done by Merck, not to mention the practice of hiding expenses as was done by WorldComand using special purpose vehicles to overly inflate income that Enron participated in. There are many phrases or words can be describing earnings activities and no standardthat universally accepted for the definition of these terms. Some of those terms are incomesmoothing, accounting hocus – pocus, financial statement management, the numbers game,aggressive accounting, reengineering of income statement, juggling the books, creativeaccounting, financial statement manipulation, accounting magic, borrowing income from thefuture, banking income for the future, financial shenanigans, window dressing. Some theearnings management is legal which is can be accepted worldwide due to the low level ofmanipulation and some are illegal due to high level of manipulation and intention to trick thestakeholders (Agrawal, Chadha, 2005). This form of earnings management is also called cookingthe books and is illegal. The applications of earnings management are kept in using by all around the worlds eventhough several corporate scandals which misused of earnings management arise. Agrawal and
  5. 5. Chadha (2005), mention that, reason for using earnings management are due to marketincentives, contracting incentives and regulatory incentives. Market incentives are regarding to meet with analysts‟ expectations which are importantin order to keep the company name at the established position. The reason is to smooth earningstime‟s series even when it‟s affected by periodic figure such as seasonal sales. It‟s not like thecompany not good when it is not in seasonal period, but then, the sales will definitely boost whenit‟s come to seasonal. If the seasonal period is not even at the right time, therefore, managementof earnings is needed in order to smooth the earnings for the company. Contracting incentive are include as managing earnings of which in order to avoidviolating loan agreement that are written in terms of accounting numbers. In order to gain faithfrom the lender and to archive the optimal credit term, management of earnings is needed. Notall the time the company account might look as good as it‟s expected and if it is not, doesn‟tsimply mean that the company is in the bad position. Other than that, it‟s also managing earningsto maximize earnings based management compensation (Vadiei Nowghabi & Anbarani, 2012).. Regulatory incentiveshave been in practice in order to avoid industry regulations such asto reduce the risk of political exposure and also to take advantage of certain governmentalbenefits such as subsidy.Earnings management is not specifically stated for certain types ortechniques only. There are several types of earnings management and techniques that can beused by a company through their operations. One of the very popular techniques of earningsmanagement is called “Cookie Jar”. This technique is function such as save some revenue in agood year as a backup for losses that might incurred in the bad years. It‟s all depending on thesituation and stability of the company during the years. If the performance of the company is
  6. 6. better, therefore the expenses can be recognizes during the year but somehow, if it is not a goodyear, the expenses can be recognizes next period to ensure the performance of company is goods. Other popular techniques is also been called big bath. This technique or strategy is tomake bad income statement look even worst. This technique is a technique that used by blamethe previous manager that already sign out as to ensure the company performance for next yearare booms. This type of technique is used by the new manager which is appointed before the endof the period. The new manager put blame to the previous manager by incurred as manyexpenses as they can write off to ensure that next year, company can even perform better thanthis year. Capitalization practice is also other type of earnings management. This type of earningsmanagement is used to manipulating intangible assets such as research and development. Cost tocapitalize research and development are very subjective and only based on judgment. A companymight have possibility to allocate more expenses to the research and development project toreduce current operating expenses. Therefore the expenses might only amortize through the lifeof the assets and it‟s usually only a small portion. There are also other types of earnings management that can be applied by all the managerof the company to ensure the safeguard of the company‟s income. Some earnings managementare used in merger and acquisition, some are used in recognition of revenue, materiality conceptthat been misapplied, reserve that been charge one time and also other earnings managementtypes(Vadiei Nowghabi & Anbarani, 2012)..
  7. 7. Some earnings management is done for the benefit of all stakeholder and some are donefor their personal benefit. The bad side of earnings management can also been called as fraud asthe intention is not to manipulate figure for the whole benefit but for their own benefit. Thecontrollers of earnings management are depending on the management party of the company andhow they predict and forecast the future of the company to ensure the optimal return is able toarchive. Management especially manager have a better knowledge regarding to the companyfuture compare to others. That‟s the reason of why, earnings management are still allowed eventhough this benefits are always been misused as the way of cheated stakeholders and most of all,for personal benefit (Vadiei Nowghabi & Anbarani, 2012). There were several scandals that involve manipulation or earnings management thatinvolve several cases that affected not only that country but also all around the world. The mostinfluence scandals in the history of corporation are the collapsing of Enron in2001. Enron have avery big influence to the corporate world that also evolves the way of how the corporategovernance are maintained and implement. The ethical issues of auditor are also in question werestill; even Enron was audited by one of the biggest audit firm which called Arthur Anderson.One of the most important argument that been brought up are the issues of why earningsmanagement are still allowed even if it‟s been misused by several parties. Even thought, beforethe scandals exposes, Enron maintain their goodwill by winning several awards regarding theirgood corporate governance. Enron Corporation was born in the middle of a recession in 1985, when Kenneth Lay,CEO of Houston Gas Company, engineered a merger with Internorth Inc. The new company,which reported a first year loss of $14 million, consisted of $12.1 billion in assets, 15,000
  8. 8. employees, the nation‟s second-largest pipeline network, and a towering mountain of debt. Enronwas a typical natural gas firm with all the traditional trappings of a highly leveraged, “oldeconomy” firm competing in the regulated energy economy. Teetering on the verge ofbankruptcy in its early years, Enron had to fight off a hostile takeover attempt. It also incurredembarrassing losses on oil futures, which its traders in New York covered up in their reports tothe Houston headquarters. Its old economy strategy did not excite the stock market. This wouldchange dramatically, however, during the 1990s, when Jeffrey Skilling replaced Richard Kinderas the CEO (Kadlec, 2001). With the appointment of Skilling as CEO, Enron‟s culture would begin a radicaltransformation. By 2000 it had become “the star of the New Economy,” emerging as a paragonof the intellectual capital company with an enviable array of intangible resources, includingpolitical connections, a sophisticated organizational structure, a highly skilled workforce ofsophisticated financial instrument traders, a state-of-the-art information system and expertaccounting knowledge. In 1999, Enron was named by Fortune as “America‟s Most InnovativeCompany,” with business people and academics referring to Skilling – “The #1 CEO in theUSA” – proselytized at technology and leadership conferences across the United States abouthow Enron was not only embracing innovative theories of business but also making a lot ofmoney doing so (Morley, 2009). How fraud occurs within organizations can be understood by examining the elements thatcomprise such actions. At an individual level, SAS No. 99 (Consideration of Fraud in a FinancialStatement Audit) issued by the Auditing Standards Board indicates that the occupational fraudtriangle comprises three conditions that are generally present when a fraud occurs. These
  9. 9. conditions include an incentive or pressure that provides a reason to commit fraud (personalfinancial problems or unrealistic performance goals), an opportunity for fraud to be perpetrated(weaknesses in the internal controls), and an attitude that enables the individual to rationalize thefraud (AICPA, 2002). While the fraud triangle focuses on individual-level constructs of fraud,such as localized instances of cash or other asset appropriation by employees, the Enron examplehighlights fraud at the organizational level as well as systemic organization-wide fraud andcorruption (Kadlec, 2001). Management controls refer to the tools that seek to elicit behavior that achieves thestrategic objectives of an organization, such as budgets, performance measures, standardoperating procedures and performance-based remuneration and incentives. While Enron‟sdemise has been portrayed as resulting from a few unscrupulous rogues or „bad apples” (thephrase used by President Bush) acting in the absence of formal management controls, Enronfeatured all of the trappings of proper management control, including a formal code of ethics, anelaborate performance review and bonus regime, a Risk Assessment and Control group (RAC), aBig-5 auditor, and conventional powers of boards and related committees. This controlinfrastructure was widely lauded right up until the demise of the company (Morley, 2009).Thethree core pillars of Enron‟s management control system were the risk assessment and controlgroup, Enron‟s performance review system and its code of ethics. Risk Assessment and Control Group: An integral part of Enron‟s management controlsystem was the Risk Assessment and Control group or RAC. RAC was responsible for approvingall trading deals and managing Enron‟s overall risk. Every deal put together by a business unithad to be described in a Deal Approval Sheet, which was independently assessed by RAC
  10. 10. analysts. Deals required various levels of approval from numerous departments, includingapproval from the most senior levels, even from the board of directors (Morley, 2009). Enron‟s Performance Review System: Another vital link in Enron‟s management controlswas the Peer Review Committee or PRC system. The intention of the PRC system was to alignemployee action with the company‟s strategic objectives, retaining and rewarding superiorperformers on a fair and consistent basis. Under the PRC system, every six months eachemployee received a formal performance review, based on formal feedback categories includingrevenue generation, and was assigned a final mark from one to five. Feedback came from varioussources including the employee‟s boss, as well as from five co-workers, superiors orsubordinates that the employee selected. The bottom 15 percent, no matter how good they were,received a “5” which automatically meant redeployment to “Siberia,” a special area where theyhad two weeks to try to find another job at Enron. If they did not – and most did not – it was “outthe door.” (Morley, 2009) Code of Ethics: Enron‟s code served as a behavioral control intended to prohibit a rangeof unethical behaviors. The code stressed the following four key principles: communication,respect, integrity and excellence, and included phrases such as “we treat others as we would liketo be treated ourselves”, “we do not tolerate abusive or disrespectful treatment” and “we workwith customers and prospects openly, honestly and sincerely”(Kadlec, 2001). What Enron clearly demonstrates is that once employees align themselves with aparticular corporate culture – and invest heavy commitment in organizational routines and thewisdom of leaders – they are liable to lose their original sense of identity, and tolerate andrationalize ethical lapses that they would have previously deplored. Once a new and possibly
  11. 11. corrosive value system emerges, employees are rendered vulnerable to manipulation byorganizational leaders to whom they have entrusted many of their vital interests. The Enrondemise, then, points to numerous risks associated with degenerate cultures: the risk that a culturemotivating and rewarding creative entrepreneurial deal making may provide strong incentives totake additional risks, thereby pushing legal and ethical boundaries; resistance to bad news createsan important pressure point of culture; and internal competition for bonuses and promotion canlead to private information and gambles to bolster short-term performance. At Enron, these risksultimately subverted the company‟s elaborate web of controls (Kadlec, 2001). Enron offers a number of important insights for managers. Firstly, it underlines the vitalrole of top management leadership in fostering organizational culture. Secondly, withinorganizations, the impact of culture and leadership on even most the sophisticated managementcontrol system must not be overlooked or minimized. It is often too easy to consider cultural andmanagement control systems separately, with cultural being a soft issue and managementcontrols a hard one. Lastly, the Enron scandal stresses the importance for management to not abandoningprofessional integrity. Perhaps, the most important lesson for managers to take away is to usepersonal cultural capital to find a working environment that matches one‟s personal values andprinciples. Enron should serve as a wake-up call for managers in all organizations.Other thanEnron, WorldCom are also one of the big corporate scandals that lead to their collapsing thatlead to more study and argument on the use of earnings management as one of company strategyor manipulation.
  12. 12. WorldCom, the number two long-distance telephone provider, announced $3.8 billion inimproperly booked expenses for 2001 and 2002. And in August 2002, the company disclosed anadditional $3.3 billion in accounting errors. As a result, the company will be forced to restateearnings for 2000 as well (Simons, 2002).The fraud perpetrated at WorldCom did not take place at the lower levels of the organization.When invoices were paid, they were properly coded to an operating expense account. TheArthur Andersen staff auditor tracing an invoice through the accounts payable system would notfind this fraud. Instead, huge amounts were reclassified by upper management as capitalexpenditures. For example, $500 million in undocumented computer expenses were logged as acapital expenditure. In addition, line costs were not expensed as required by Generally AcceptedAccounting Principles (GAAP). Audit authorities say that WorldCom‟s fraud was so basic it should have been obvious tothe firm‟s external auditors, Arthur Andersen. Expenses disguised as capital expenditures areone of the first things an auditor would examine. Evidence was produced in the court caseagainst the public accounting firm that Andersen did not verify WorldCom‟s treatment of linecosts. Rather, it relied on management‟s representations. The U.S. District Court held thatAndersen would have uncovered the fraud if it had conducted the required review before issuingits audit opinion. The Court held that the Andersen audit opinions included in WorldCom‟syear-end financial statements materially misrepresented the company‟s financial condition(Simons, 2002). It would take three internal auditors to uncover the fraud. The team of internal auditorssoon stumbled onto the issue of capital expenditures. They discovered that $2 billion that the
  13. 13. company said in public disclosures had been spent on capital expenditures during the first threequarters of 2001 had never been authorized for capital spending. Concerned that CFO Sullivanmight try to cover up the fraud, Ms. Cooper and Mr. Smith met with Mr. Bobbitt, the head ofWorldCom‟s audit committee. The audit committee then took steps to remove both Sullivan andMyers. Mr. Sullivan was fired and Mr. Myers resigned. And the next evening, WorldComannounced that it had inflated profits by $3.8 billion over the previous five quarters. WorldComhas since filed for bankruptcy. With $107 billion in assets, WorldCom‟s bankruptcy is thelargest in U.S. history, larger than even that of Enron Corporation (Simons, 2002). The nonprofit industry is not immune to earnings management or nor does it have anyshortage in pressure to perform. Nonprofit colleges and universities have increasingly changed tousing performance-based compensation that encourages enrollment and admissions offices toentice enrollees in an effort to increase enrollment numbers. Marty Mickey, V.P. for FinancialServices at National-Louis University has noted that he has seen a marked increase in the amountof incentives offered to the enrollment representatives of nonprofit universitiesin order to remaincompetitive which in turn results in them acting more like the enrollment offices of for-profituniversities. Lori Sundberg, the Controller and Associate Vice President of Budget and Planningfor Lake Forest College notes that earnings management in non-profit, higher education canhappen but is rare. She states that the field of higher education prides itself on transparency andnoted how she will collaborate with colleagues at other colleges about the results of their auditsand how other schools handle similar issues. Ms. Sundberg‟s comments were echoed by DorisDumas, Associated Controller and Director of Payroll at Lake Forest College. Doris stated thatwhen faced with a reporting issue, she will often turn to her counterpart at another school forguidance.
  14. 14. Earnings management are only become useful when the management able to fixed itafterward or only done it if the result are more certain as one way of to ensure the operation andearnings are smooth. This is because only the management has the best knowledge regardingcompany operation. To let them manipulate the earnings are good in other view because thereaction of the investor regarding the value of the company are very sensitive. Corporatescandals around the world leads to better review and application of how to derive business moreproperly and transparently. The biggest case that gives impact on the world‟s corporate culturesuch as Enron leads to change in several standards accepted around the world.
  15. 15. ReferencesAgrawal, A., & Chadha, S. (2005). Corporate governance and accounting scandals. Journal of Law and Economics, XLVIII, 371-406. Retrieved from https://www.bama.ua.edu/~aagrawal/restate.pdfAICPA. (2002, December). Summary of sasno. 99. Retrieved from http://www.aicpa.org/InterestAreas/ForensicAndValuation/Resources/FraudPreventionDe tectionResponse/Pages/Summary of SAS No.aspxCaro, M.E, Santora, J. C., & Sarros, J. C. (2007, Autumn). Succession in nonprofit organizations; an insider/outsider perspective. SAM Advanced Management Journal, 72(4), 26+ Retreived from http://www.uiu.edu:2319/ps/i.do?id=GALE%Chapman, C. (2009). The effects of real earnings management on the firm: Its competitors and subsequent reporting periods. (Doctoral dissertation, Northwestern University)Retrieved from www.kellogg.northwestern.edu/accounting/papers/Chapman.pdfKadlec, D. (2001). Power failure. Time Magazine, Retrieved from http://www.time.com/time/magazine/article/0,9171,1101011210- 186639,00.html#ixzz0updclQaTMorley, M. (2009). The enron fraud: Why didnt anyone see it?. Retrieved from http://www.thegaap.net/articles/The_Enron_Fraud.htmlSimons, D. (2002, July 08). Worldcoms convincing lies.Forbes, Retrieved from http://www.forbes.com/2002/07/08/0708simons.html
  16. 16. Vadiei Nowghabi, M. & Anbarani, S. (2012, June). Survey some of the factors influencing ethical judgments of the earning management. International Journal of Accounting and Financial Reporting, 2(1), 203+, Retrieved from http://www.uiu.edu:2319/ps/i.do?id=GALE%7CA309069153&v=2.1&uiu_henderson&it =r&p+GPS&sw=w