Earnings management can be defined as the planned timing for the expenses, revenue, losses as well as gains for earnings smoothening over a number of years. It might encompass premature recognition of expenses or income along with deferral of the same in order to manipulate the financial results of the company (Ali & Zhang, 2015). Hence, the treatment of accounts which reflects the higher reported income or even may present a positive side of the organization in a legal way is termed as earnings management. Sometimes it is confused with manipulation of accounts and is considered illegal but it actually is misinterpretation of the financial reports. Most of the companies use the accounting guidelines and principles to cast their financial results in better light.
The major issues related with the use of earnings management is centered on the ways companies manage their earnings, the ways in which earnings management is measured through implementation of GAAP which needs management to make necessary judgments along with anticipations along with necessary earnings management implications (Astami, Rusmin, Hartadi & Evans, 2017). The paper will also reveal that this implies that in the GAAP, choices can be deemed as earnings management in case they are employed to cover the true economic performance that bring back to the managerial intention of earnings management.
Techniques Used in Earnings Management and its Related Limitations
Several earnings management techniques are employed by the companies in order to manage their earnings in a better manner. Such earnings management techniques are employed in order to enhance the performance of the organizations in the perception of the stakeholders (Badolato, Donelson & Ege, 2014). The major motives behind earnings management conducted by the organizations is to enhance the stock market incentives, concealing or signaling the private information, internal motives, political expenses, lending contacts, management compensation contracts as well as regulatory issues. The major objective of employing the earnings management techniques is to improve its stakeholder’s wealth like owners for the reason that they are appointed by board of directors and they are appointed by owners (Bruynseels, Krishnamoorthy, Van Peteghem & Wright, 2016). In order to improve the benefits of the company’s owners, management might employ earnings management for meeting the analysts forecast in the present or future periods. However, the analysts recommendation direction regarding a company can be biased towards management’s decision in earnings management. There are various techniques of inflating the earning in the process of earnings management such as:
Big Bath is an earnings management technique that is used by organizations in order to remain competitive, some of the companies tend to restructure themselves or in simple words eliminate certain operations. In the case, GAAP allows them to put the possessed charge against their income as the price paid for restructuring (Bryan & Mason, 2016). Generally, it seems to have negative effect due to company’s incompetence but if viewed positive, it may strong react rebound stock prices. In other words, it is reporting all the losses due to restructuring process and getting it out of the way. Being charges based on estimates, it is better to record highest possible losses in order to avoid any surprises regarding earnings in the later stage.
Cookie Jar Reserve can be considered as accounting process the recording at accrual basis is not unusual wherein the obligations are recorded beforehand of the actual payment. This is a certain type of accounting practice in which the management selects a high possible expense and it record it in current fiscal year which leaves its future fiscal period with less expenses recorded (Chee, Phua & Yau, 2016). Hence, it creates a cookie jar to tap the earnings and boost growth in the later period.
Earnings management technique of big bet on the future is the term which is generally used for the company which acquires another company. It is a bid which the acquiring company makes as it may elevate its value in the market. In their books of accounting, the acquirer records acquisition under ‘purchase’. Therefore, this technique includes writing off a significant part of purchase price against current earnings in the period of acquisition in order to keep the future earnings free from such charges. Another technique is to consolidate the earnings of the acquired company with that of the earnings of parent company (Eilifsen & Knivsfl?, 2016).
Sale/Leaseback earnings management technique is used in case the company sells their asset only to lease it back. Now as per the lease being it capital or operating the GAAP has its own set of rules. In this case, the losses occurred from sale/leaseback is recorded in the seller’s book with immediate effect. Gains on the other hand are amortised into income throughout the life of the asset if considered under capital lease and proportional to the payment in case of operating lease.
Flushing the investment portfolio is another earnings management technique that takes place when a particular company buys shares of another companies but it is less than 20% and is termed as passive investment. In such case GAAP does not permits the investing company to include the profit share of investee company in its own earnings. As per GAAP, any change in share value during a fiscal period is adjusted with operating income. But in this technique, when earning is needed, the shares are sold at unrealized gain and vice-verse when the company seems to reflect lower earnings.
“Shrink the Ship” is an earnings management technique that is used in case of share buyback, the companies do not intend to record the profit/loss in income statement due to rules of accounting, as income earned from outside transactions when equity is involved is the only case when earnings could be registered from buying or sell of stocks. But in this case, though it does not affect earnings but earning per share. It generally elevates the growth rate of earnings per share in the years yet to come.
“Throw Out A Problem Child” is another earnings management practice of eliminating a subsidiary which has been dragging down the earning of the company and may drag it down further in the future. In this case the subsidiary is sold and the profit/loss is recorded in income statement and in case the loss is huge, a spin-off is considered where it is distributed among the current shareholders. Other method includes creation of special-purpose entity where the financial asset is transferred as its profit/loss is not transferred into consolidated financial statement.
Auditor Initiatives in Dealing with Earnings Management Practices and Corporate Collapses
The auditor has the responsibility of recognizing fraud within the financial statement audits of companies. They are also aware and control the fraudulent financial reporting that includes intentional misstatements or omissions of financial statements disclosure in order to deceive the users of financial statements (Khalil & Ozkan, 2016). The auditor also manages accounting fraud that facilitates in controlling earnings management within organizations. Moreover, the auditors’ pf the companies implement two important earnings management detection and dealing approaches that can control the fraudulent misstatement of financial statements by companies. These techniques implemented by auditors are explained in the accrual method approaches of dealing with earnings management.
There are certain instances, in which it could be observed that the auditors are not held liable for the failures and scandals of various corporate entities (Kothari, Mizik & Roychowdhury, 2015). One such instance could be observed in case of Tesco Plc, which is a leading UK retailer involved in selling various kinds of retail products. The firm that carries out the audit work of Tesco is PwC. It has been found out that Tesco has bribed PwC with an amount of ?10.4 million for signing off its financial statements in 2013. Despite the fact that PwC has raised some concerns regarding the suspect rebates, it still gave clean audit to the organization. Thus, the failure of PwC in identifying the problem is hardly an isolated instance. In case, the accounting scandals do not cover the headlines like those in case of Enron and Worldcom Group, it is not because that they do no longer exist; instead, it has emerged in the form of routine (Wan Mohammad, Wasiuzzaman & Nik Salleh, 2016).
Another instance could be identified in case of Bankia, which is a Spanish multinational operating in Europe. Due to this, the issue was highlighted to the Spanish court where it was proven that the organization had misstated its finances after it went public in 2011 and ten months before nationalization (Tsipouridou & Spathis, 2014). In both the situations, the auditors of the respective organizations have certified their financial statements despite the fact that they are overstated. However, the failure of these organizations in terms of disclosure did not have much effect on their auditors.
Aggregate accrual method approach is used by the auditors through employing certain suggestions on the accruals. Accruals are deemed to be likely outcomes of the exercising managerial discussions or might result from certain changes within an organization economic condition (Lennox, Wang & Wu, 2017). To control and detect earnings management techniques regression model will be employed based on the variable. This is for the reason that total accrual along with independent variables include sales plant, property and equipment. Moreover, to decrease the chances of earnings management through referring change in sale along with change within the level of plant, property and equipment.
The auditors are making great attempts these days in dealing with the earnings management issue along with manipulation of the accounting income amounts. This contributes to the process to rule-based foundation of accounting standard setting and this is also considered as principles-based system (Lin, Hutchinson & Percy, 2015). However, misinterpretations of principles along with wrong judgments are observed to be the uncertainties in dealing with concerns related to earnings management along with fraudulent financial reporting. The approaches that are used by the auditors in dealing with excess use of earnings management by the companies are explained under:
- Principle based and Rule based accounting- This accounting process encompass a situation in which concise statement related with substantive accounting principle is relied on the accounting objective that is being incorporated within the integral part of the standard. Moreover, certain internal inconsistencies are involved within the standard (Miko & Kamardin, 2015). In contrast, the rule-based accounting is also employed by the auditors in dealing with the issue of earnings management. This implies to specific details with an initiative to deal with several foreseeable along with likely contingencies as possible within the process of standard setting. In the rule-based system, the accounting standards for managing issues of earnings management are wide and much longer. This offers an arbitrary criterion for the accounting treatments which facilitate organisations to develop their transactions in dealing with unfavourable financial reporting through earnings management. This accounting technique also focusses on protecting an increased positive outcome than reflected by the reality (Persakis & Iatridis, 2016).
- Specific accrual method approach is employed by the auditors in order to measure the distortions or preconditions within the financial statements. For instance, the auditors within the banking and insurance organizations employ specific accrual earnings management techniques in order to manage the earnings created by banks (Tsipouridou & Spathis, 2014). These techniques facilitate the auditors to serve for loan losses and in addition the insurance organizations also generate the reserve against certain claim losses. Implementation of this model also facilitates the auditors in analysing that higher values indicated by financial statements of companies has higher manipulation probability.
- Special purpose entities- Another widely employed earnings management approach in dealing with fraudulent financial reporting and transactions encompass special purpose entities (SPEs). Such entities are generated to address specific, narrow and temporary objectives focused on dealing with financial risks such as bankruptcy or failure of companies (Wan Mohammad, Wasiuzzaman & Nik Salleh, 2016). These are specifically employed by the auditors in dealing with a specific financial reporting, taxation or regulatory risks arising from earnings management. SPEs are generally used by the auditors within complex financial engineering techniques. This earnings management addressing initiative have a major objective of tax avoidance or the financial statements manipulation. For instance, Enron is a company in which auditors considered employing SPEs in addressing earnings management failure in this company (Peterson, Schmardebeck & Wilks, 2015).
Auditors Responsible for Business Collapse
Several previous reasechers and evidences of corporate failure has evidenced that there is a great role of auditors in company’s earnings management. Increasing accounting scandals that is observed in Enron Case has investigate the auditors’ role in approving earnings management in companies (Garven, 2015). It has also been observed that numerous factors impact subjective judgement of auditors in analyzing the interpretation of GAAP “Generally Accepted Accounting Principles” through client management. These auditors might attain the incentives that bias the interpretation of GAAP for attaining target earnings. Many evidences gave been found where the auditors approach of not addressing poor earnings management has resulted in corporate failure. It is also investigated that the auditors reporting in the countries are related ith different discretionary accrual levels that is proxy for earnings management (Greiner, Kohlbeck & Smith, 2016). This also analyses the effect of the size of the auditors’ measurable qualifications in dealing with earnings management and along with financial distress within implementation of earnings management. Auditors offer independent verification of manager developed financial statements that can facilitate in revealing the report breaches within a company’s accounting system. Audit quality is focused on maintaining the credibility of financial disclosure that decreases cost of capital.
Auditing is also deemed to impact the earnings management adopted by several organizations. The effect of audit quality on earnings management has been tested by means of discretionary accruals and the discretionary accruals of organizations under big 6 auditors are lesser than discretionary accruals of organizations of non-big 6 auditors (Gu & Hu, 2015). Through this approach the auditors did not test for income decreasing discretionary accruals and just for the income increasing earnings management. Auditors all over the world reported that the audit quality and public ownership serves as constraints of the income decreasing earnings management and not on income increasing earnings management. From analyzing the corporate collapse case of Toshiba Company, it has been observed that the auditing decreases positive bias within the pre-audit net earnings along with net assets (Haislip et al., 2017). The auditors are observed to be sensitive to the techniques for earnings managements by means of both the income increasing accruals along with income decreasing accruals, the auditors are also responsible in analyzing the management incentives for the earnings manipulation in organizations.
In case the auditors fail to explain the future earnings problems within the high accruals by means of either their audit opinions or by means of auditor changes. This scenario has resulted in the corporate failure of Toshiba (Hayes, 2014). In addition, it is also gathered that the auditors also do not alert investors regarding future earnings issues related with increased accruals. Based on the same, it is suggested that the auditors and the management always virtually deal with issues related to earnings management before the opinions are issued. In evaluating whether skilled and informed opinions are important earnings management function, there are no instances that auditors employ their viewpoints in making the financial statement users alert regarding excessive use of earnings management and consequences related with the increased positive accruals. The findings are observed to be inconsistent with earnings management and the auditor-conservatism explanations for the audit opinion or accruals relation (Huang, Roychowdhury & Sletten, 2018).
Certified auditors of the organization ensure that there does not exist within material impact on the particular items or on overall picture of financial statements and there is a limitation in their possibility in order to formulate a suitable opinion. References to qualified audit report have increased frequency over the past few years globally. Due to the poor earnings management practices, Oracle of Omaha turned out to be a victim of doggy accounting. Profit guidance is observed to be high in this company and it was observed that it has been overstated. Moreover, overstatement of rebate income is also carried out that it world deceive from its suppliers. The auditors are held responsible for a huge umber of corporate losses because of several reasons (Huguet & Gand?a, 2016). For instance, the KMPG auditors were alleged for failing to scrutinize reserves of loan-loss at Tierone that led to failure of the bank. A gap has also been sobered in which the investors disregard the auditors and make less effort to realize about their work. In case it is observed that the companies are involved in aggressive earnings management. Auditors of the organizations are deemed t have a major role in modern capitalism. However, it has also been observed that in case of voluntary audits, accountants were rarely held responsible for the misuse of earnings management by organizations (Isa & Farouk, 2018). Conversely, from failure of companies explained above it is evident that the modern audit does not attempt to offer opinion on financial statements accuracy in conformity with GAAP.
The objective of this paper was to analyze the earnings management in organizations along with evaluating the techniques that can facilitate in dealing with the practices of earnings management. It is gathered that the companies which uses this technique have various reasons of using the same but the primary motive is to reflect earnings to be more predictable while hiding the volatility of the same. The major objective of employing the earnings management techniques is to improve its stakeholder’s wealth like owners for the reason that they are appointed by board of directors and they are appointed by owners. In order to improve the benefits of the company’s owners, management might employ earnings management for meeting the analysts forecast in the present or future periods. The paper also revealed that the auditors approach of not addressing poor earnings management has resulted in corporate failure. It is also investigated that the auditors reporting in the countries are related ith different discretionary accrual levels that is proxy for earnings management. This also analyses the effect of the size of the auditors’ measurable qualifications in dealing with earnings management and along with financial distress within implementation of earnings management.
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