Earnings Management

Keywords: Quality of Earnings, Regulatory context and response, Motivations and incentives of Earnings management, Methods/Techniques of Earnings Management, Accounting Assignment Writing

Introduction – Earnings Management

McKee (2005) stated that Earnings are the net income or profit of the company and ‘earnings report’ set the investor exceptions’ and affects the stock prices in the market. Earnings management is a process of influencing the financial reporting in a legitimate way.

Companies with steady and constant income have stable share price and investors’ confidence is high for such companies. The company share price is directly linked to its Earnings and share price fluctuates with the earnings reports of the company.

Jones (2011) explained that Earnings Management is a technique to take advantage of accounting standards as it is processed to apply accounting rules in a legitimate way to manipulate and recognise the expenses incurred and revenue generated by the company. The financial reports reflect the financial position of the business and earnings tweaking affects the true financial position of company.

The problem associated with earnings management is that companies remove the fluctuation in the financial statements and the streamline the financial reports to meet investor expectations. Venezia & Wiener (2012) highlighted that companies apply earnings management techniques in an effort to influence the financial position of the company. The key motive of using earnings management technique is meeting the targets in line with investor expectations.

Regulatory context and Earning Managements

Ronen & Yaari (2008) described that the Securities and Exchange Commission (SEC) regulates the Earnings management and if excessive Earnings management takes place it may issue fine and takes legal actions. The SEC labels the Earnings management as ‘deliberate and quantifiable twisting of the financial results’.

Earnings management is a technique to alter company Earnings in order to mislead stakeholders or meet the obligation, which is based on company financial reports. The Earnings management question the creditability of Earnings quality as well as the financial report weakens its impact on stakeholders. However, the changes made are completely in accordance with accounting standards and it is difficult to be detected by stakeholders without accounting rules knowledge (Rajgopal, Graham, & Dichev, 2012).

Earnings management effect on Quality of Earnings 

Riahi-Belkaoui (1999) discusses that the quality of Earnings means the application of accounting rules by the management in accordance with accounting standards. It represents the choice made by the management in terms of accounting rules and their impact on the income of the company. Earnings management deemed to have negative perception and quality of Earnings is assumed to distort because of tweaking the accounting principles.

The Earnings management practices damage the quality of financial reports and investors believe the financial position does not reflect the economic reality. Hendry (2013) added that the Earnings quality encloses as an important element of the financial reports and reflects predictability of cash flows and economic impact on the entity. The process of smoothing in terms of income stability is achieved with the help Earnings management.

Motivation and incentives of Earnings management

There are numbers of reasons Earnings management practices are used which include organisation and industry factors. For example, the analyst may forecast about the performance of the company. In order to meet industry expectations, company may tweak accounting principles to meet the expectation of the investors. The other factors may include contractual obligations or competitive pressure in the market.

Management looking for merger or acquisition and in efforts, company may apply Earnings management technique to increase its share price. The company management may improve the Earnings position in order to report the better Earnings for compensation or budget setting (Rajgopal, Graham, & Dichev, 2012).

Chen (2008) commented that the management motivation for Earnings management includes reporting the result, which covers up the situation. Sometimes, the management may report the income through the application of Earnings management for bonuses or promotions. The incentives and motives of earning management are stability of share price, maintain the certain ration or to meet the debt convents as well as beat the expectations of the investors.

Regulatory Response and detection of Earnings management practices

The SEC considers that Earnings management has an adverse effect on financial reporting as it masks the true impact of management decisions. The investors may not be able to detect the Earnings management practices due to nature complex accounting rules.

The security and exchange commission (SEC) have different SAB issued to address the problem arising due to excessive Earnings management. For example, SAB 99 and SAB 100 were issued to address the problem of materiality as well as treatment of impairment charges. Moreover, SAB 101 and SAB 102 were released to tackle the situation of revenue recognition as well as loan loss allowances to address the Earnings management (Griff, 2014).

The key areas of analyses earnings management techniques are ‘Accruals and Earnings’, ‘Discretionary cost’ and ‘Valuation techniques’ (Ahrens, 2010).

Accruals and Earnings, discretionary costs and Valuations

McKee (2015) elaborates that the cash flows are important numbers to determine the future value of the company. The net assets on the balance sheet represent the fair value of the business. However, the cash flows reports may be compromised by reported Earnings of the company.

When the valuation of the company is required, it is important that all assets and liabilities reflect an actual estimation of cash flows. The timing of the cash flows is an important factor to determine the reliability of the cash flows.

There are two principles to overcome Earning Management problem attached with cash flow are ‘revenue recognition (ASC 605)’ principles and ‘matching principles’. First, in case of revenue recognition, it states that revenues recognition when company has delivered the product and when cash receipts is certain.

Whereas in the case of matching principle, it states that revenues generated in one period should be matched against the costs in the same period. The cash flow generated over the longer period will be same, but, in the short term, the accounting principles applied show significant differences.

For example, the deferred taxation (FAS 109) or inventory valuation (ASC 300) affects the earnings report of the company. The managerial discretion over the accruals may affect the revenues reported and this may not reflect the true and fair position of company assets (Jones, 2011).

Ahrens (2010) explained that discretionary accruals cost is much dependable on the accounting rules choice of the company. The discretionary cost cannot be read directly from financial statements of the company and therefore, it is important the actual discretionary costs should be reported in fair and accurate manner.

If the costs are not reported in the same period, then it may report the revenues in excess. Similarly, revenue recognition is an important area because if company recognizes revenue in advance, then the financial statement may include revenues, which are not earned.

Method/Techniques used for Earnings management

There is a number of the method used to manipulate the Earnings of the company.  The techniques include ‘cookie jar’, ‘big bath and big bet practices’, and ‘flush accounting. The Earnings management practices are applied to operating activities, merger and acquisitions, revenue recognition, reserve valuation and immateriality (Ferraro & Mcpeak, 2000).

Cookie Jar Reserve Technique

According to Rajgopal, Graham, & Dichev (2012), in the ‘cookie jar reserve’ method, the accrual accounting principles are applied. It states that management can record future transactions in a current financial year. Nevertheless, the future estimation may not be accurate and recording the obligations may contain significant uncertainty. The uncertainty increases the complication of the situation and it difficult to predict the future cash flows with certainty.

The General Accepted Accounting Principles (GAAP) proposes the management should make a single estimate rather than taking the range of estimates. The selection of single figure gives an opportunity to Earnings misrepresentation. The estimation gives an opportunity to record a number of expenses and build a financial slack in the processes (financial reporting). Some of the common areas for cookie in the jar techniques are estimating bad debts, allowances, and inventory and pensions funds (Griff, 2014).

Big Bath Practices

The second technique for Earnings management is ‘Big Bath Practices’. When companies restructure or eliminate its operations then potential cost incurred for the business. The US GAAP (ASC 830) allows the companies to charge the structuring cost against the Earnings. The ‘cost of implementing’ charges against the income of company and reported them as operational changes, and thus, enhances the company performance in the eyes of the investors (Venezia & Wiener, 2012).

Hendry (2013) stated that the US GAAP arise the Earnings management problem as companies get away through reporting the restructuring loss with single item. The charging of loss based on estimation as result of restructuring does not reflect true and fair values. This technique is classified as ‘income smoothing’. For example, writing off the loss on an asset at market value which is below the current book value. The big bath technique is applied to operational expenses, debt restructuring as well as loss on the disposals of assets.

Big Bet practices (Creative Accounting for Acquisition)

Under big bet practices, company purchases another company and considers it as a future investment. This purchase report as investment as it is expected to increase the company Earnings. Under GAAP (ASC 805), the acquisition should be reported under the purchase method used.

In the big bet technique, the research and development of the company acquired can write off in the process of acquisition. This helps the company to write off cost against the revenue from current period and the future Earnings will be higher (Hendry, 2013).

Jones (2011) stated that the Earnings of the company acquired can be integrated into the Earnings of the parent company, which results in Earnings boost for the parent company.  The acquisition of the company provides an opportunity to report increased earnings. The Earnings management is technique is usually witness when companies acquire another company and writes off cost and consolidation revenue to report different results.

Earnings Management and Flushing technique

In the light of GAAP (ASC 105), if investment made by the company has less than 20% value in the stock of other company, then it is classified as ‘reflexive investment’. In such context, the share of investee net income does not have to be reported in the financial statement of investing company.

These investments are disclosed as trading securities or available for sale securities. The income from trading securities is reported in the income statement and investment available for sale is considering comprehensive components for the income and thus, reported under the net income (Mulford & Comiskey, 2011).

The income raised from sales of the instruments reported in operating income. The categories are securities, which have gained or lost value, the intention of the holder of securities as well as impaired value of the securities (Hendry, 2013).

Income Statement and Balance Sheet Items — Earnings Management

Operating and non-operating items in income statement

The two types of Earnings concern with income statement of the company. First, the operating income generated from the operations of the business (ASC 280) as ‘Going Concern’. Secondly, the non-operating income which does not relate to future expected earnings (Riahi-Belkaoui, 1999).

Griff (2014) explained that GAAP helps to differentiate which of the income can be classified as operating and non-operating. The components of the income statement are considered as part of non-operating expenses could be classified as special expenses or charges, discontinued operations, unexpected gains or loss or effect of cumulative changes in the accounting treatment by the management.

Therefore, there are a number of areas where business Earnings can be misrepresented when deciding for decision for the business. For example, the disposition of manufacturing facilities may represent major changes in the operations of the company. The expenses could be either classified as discontinuing operations or special charges incurred.

Earnings management and Non-cash items

The costs associated with depreciation and amortisation effect Earnings reporting of the company. The non-cash expenses (ASC 270) are usually written off in the financial statement over the expected period in which benefits are earned.

The three categories are amortisation expenses (trademarks, goodwill), depreciation expenses (building, plant and machinery), as well as the depletion of the assets (natural resources) in terms of expenses (Mulford & Comiskey, 2011).

The method selection to write off the expenses result in either lower or higher value to charge the expenses in the income statement as well as the period for which the charge has incurred. Moreover, the company policies to determine the salvage value and useful life of the asset have a major impact on the income statement of the company. These policies directly affect the financial statements of the company and present the opportunity to manipulate the assets (Ronen & Yaari, 2008).

Fixed Assets treatment and Earnings management

Venezia & Wiener (2012) stated that the disposal of long-term assets on the balance sheet can result in the recording of gains or loss on the assets. The first scenario company needs to address with sale of the assets is that it either a gain or loss on the asset disposals. The accounting polices result in manipulation of the profit or income of the company.

For example, the assets carried on the balance sheet of the company have a book value of $20 million whereas from a sale of the assets may yield $30 million. Therefore, the sale of the asset will affect profit for the company. Similarly, the Goodwill (ASC 450) valuation could give the different results for the income statement.

Hendry (2013) discussed that this gives management an opportunity to manipulate Earnings through charging different expenses value to the income statement. The leaseback of assets gives management an opportunity to record either loss or gain.

The opportunity to improve or manipulate the Earnings gives the company an opportunity to change the reported income. Furthermore, the depreciation policies change (ASC 360-10) also has major impact on the company income statement and affect the reported earnings of company.

Debts and Derivatives treatment

The debts and derivatives impact reported earnings of the company. If the company have long-term debts and recorded on the balance sheet at a different value, the company selling the instruments will result in differences in terms of gain or loss for the business.

GAAP does not involve the reporting of profit and loss separately and separate classification is not required. Another area of concern is derivatives, which is the useful tool for managing business risk. The derivatives are financial instruments based on the value of assets or market indicators. The companies holding the derivatives should report them on the balance sheet as an asset as per requirement of the GAAP (Ahrens, 2010).

Derivatives provide an opportunity for Earnings management. For example, a company holding a large number of bonds which will affect the income statement of the company. If the interest rate goes up, an increased expense paid on the bond and vice versa. Similarly, if the interest expenses decrease then company can record lower interest rates (Jones, 2011).

Conclusion

Earnings represent the success of business operations along with value addition. The Earnings of the business sends direct signals to the market and set investor expectation and confidence level in the company. The earnings are most important decision making factor for the investor in order to invest in the company as well as management promotion and bonuses are linked to Earnings of the company.

In efforts to report constant earnings, management applies the technique of ‘Earnings Management’. Earning management involves the tweaking the financial report in a legitimate way. The SEC commission does not favour the Earnings management techniques and if companies apply too much misrepresentation, the fines for such practices have been imposed on companies.

The Earnings management involves the reporting the Earnings which does not represent the actual position of economic resources under legal manners. The Earnings management reporting discredits the effectiveness of financial reports.

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