Module: Financial Reposting
Course: MSc International Accounting Finance
Date of Submission: 11 December, 2017
Table of Content
Name of Topic Page
Motives Behind Earnings Management 04
Methods for Manage Earnings 05-06
Role of Corporate Governance 07-08
1.1 Earnings Management
Every company has to produce its financial statements in order to know the actual financial position of the business. For preparing the financial reports, businesses use different strategies of which earnings management is one. The income or profit is referred as the earnings of a firm and business has to manage the earnings. Earnings management is defined as the use of accounting techniques to prepare financial reports which presents overall scenery of a firm’s operational activities and financial position. It is considered as a firm’s strategic tool for maximizing firm’s value as well as reducing cost. Earnings management may represent the false view of a company’s good financial position in order to get the attraction of shareholders.
Earnings management can be divided in two categories-
Real earnings management
Accrual earnings management
1.1.1 Real Earnings Management
When a business manages its earnings through deviating from the normal business activities in order to obtain the expected profit level, it is defined as the real earnings management. Firm may deviate from its operating, investing or financial activities by, for instance, altering the level of expenditures such as research and development expenses and selling and administrative expenses. Real earnings management has a negative consequence on the firm’s future activities.
1.1.2 Accrual Earnings Management
When a business manages its earnings through altering the accruals level in order to obtain the desired level of earnings, it’s called the accrual earnings management. “The primary objective of accruals is to demonstrate the true performance of a firm by recording revenues and expenditures to the period in which they are incurred, rather than presenting the cash in and outflows. For example, deferred revenue is an accrual which is reported when the cash flow from a sale is received before the recording of the sale” (FASB 1985, SFAC No. 6 Para. 139 and FASB 1985, SAFC No. 6, Para. 145).
2. Motives behind Earnings Management
Earnings management has a diverse range of reasons with the intention to satisfy the investor’s expectation regarding the profit of the business. The followings are some reasons for what any company pursue the earnings management strategy.
2.1 Stock Market Incentives
Company’s financial performance is assessed by the stock market analysts. Investors take decision by observing the report of stock market analyst whether any firm’s financial position is satisfactory or not. Any company wants to achieve the stock market incentives by showing an excellent performance of meeting the obligations pushed towards the earnings management. Using earnings management a firm can show the highest level of earnings that a shareholder generally expects. If the actual financial result is lower than the expected than managers make the profit in a higher level.
2.2 Signaling or concealing private information
Earnings management is, by definition, a process of altering financial information in order to achieve certain goals. Failing firms engage in earnings management and alter their annual accounts to conceal their financial struggle without immediately measuring the consequences on stock price or CEO compensation. The growth signal combined with another signal such as a stock split might be an effective way of communicating private information.
2.3 Political costs
Firms can also manage reported earnings by changing financial statements in order to influence shareholders’ opinions and decisions. Governmental regulations and tax laws, when company makes use of financial reports, are obvious candidates to be analyzed as possible sources of earnings management motives. It can be valuable to companies to seem more/less profitable to escape from governmental interference. When accounting numbers are the basis for tax calculation, there might be large tax avoidance incentives for earnings management.
2.4 Avoiding Financial Distress
Financial distress is occurred when a company becomes unable to meet the obligations of its creditors. In this condition, the managers of a company get highly stressed because of the increased chances of bankruptcy, which actually motivate them to engage in earnings management. Mangers of a distressed firm do the earnings management in order to get overcome from a bad period.
3. Methods of Earnings Management
Firms use different type techniques of earnings management. These are described as follows-
3.1 Big Bath Techniques
“Big bath” technique is used when managers are required to report badly news (e.g., loss from substantial restructuring), making poor results look worse is an acceptable approach of avoiding possible earnings surprise in the future (Pourciau, 1993). Tokuga and Yamashita (2011) defined “big bath” as “the attempt to increase reported earnings in subsequent periods by charging items that may have a negative future impact to expenses in the current period, further worsening current period business results in an accounting period in which results are bad.”
Sometimes a company cannot avoid major irregular expenses, such as writing down assets, discontinuance of an operating division, or closing down an operating segment, and establishing restructuring reserves (Rahman, Moniruzzaman & Sharif, 2013).
3.2 Cookie Jar Reserve Techniques
“Cookie jar” is slang for a reserve of cash that is not disclosed in a company’s financial statement or listed as funds earmarked for a liability that does not currently exist. The term may be derived from the practice of a company of dipping into the “cookie jar” of reserves whenever convenient. Cookie jar accounting is used to create cash reserves in good years to ensure that the money can be used to offset poor earnings in bad years. This practice involves smoothing reported earnings by taking reserves against losses during profitable periods and using reserves during unprofitable periods. Management must estimate and record obligations that will be paid in the future as a result of events or transactions in the current fiscal year based on accruals (Rahman, Moniruzzaman, ; Sharif, 2013).
3.3 “Big Bet on the Future” technique:
When an acquisition occurs, the corporation acquiring the other is said to have made a big bet on the future. Under Generally Accepted Accounting Principles (GAAP) regulations, an acquisition must be reported as a purchase. This leaves two doors open for earnings management. In the first instance, a company can write off continuing R;D costs against current earnings in the acquisition year, protecting future earnings from these charges. This means that when the costs are actually incurred in the future, they will not have to be reported and thus future earnings will receive a boost. The second method is to claim the earnings of the recently acquired corporation. When the acquired corporation consolidated with parent company earnings, then immediately receive a boost in the current year’s earnings. By acquiring another company, the parent company buys a guaranteed boost in current or future earnings through big bet technique.
3.4 “Flushing” the investment portfolio
To achieve strategic alliance and invest their excess funds, a company buys the shares of another company. Two forms of investment are trading securities and available for sale securities. Actual gains or losses from sales or any changes in the market value of trading securities are reported as operating income where as any change in market value of available for sale securities during a fiscal period is reported in “other comprehensive income components” at the bottom of the income statement, not in operating income. When available for sale securities are sold, any loss or gain is reported in operating income. Write off of long term operating Assets. The cost of long term operating assets used or consumed is recorded as an amortization (intangible assets-goodwill, patents, copyrights, and trademark), depreciation (tangible assets-buildings, machinery, equipment) and depletion expense (natural resources-timber, coal, oil, natural gas) over the periods expected to be benefited. Management has the discretionary power when selecting the write off method; write off period; estimating salvage value. It is not necessary to record depreciation or amortization expense if the long term operating asset changed to non operating asset.
3.5 Write-off of Long-Term Operating Assets
A company can temporarily boost its earnings by selling long-term assets with unrealized gain or loss. When the real earnings of a company cannot meet analyst expectations, managers would likely attempt to boost reported earnings to the expected level by selling assets. Conversely, when the real earnings of a company is higher than expectations, the company would attempt to drop reported earnings to the expected level by selling lossmaking assets (Tariverdi & Teimoory, 2013). For example, a building owned by a company is reflected in the balance sheet at $50 million, but it is really worth $100 million. When the building is sold, the $50 million gain will enhance the current period’s earnings.
3.6 Shrink the Ship
Companies sometimes decide to repurchase (or buyback) their own share. Stock buyback allows companies to invest in their own company. However, this practice is banned in some countries. Countries such as the US and the UK allow a corporation to repurchase its own stock by distributing cash to existing shareholders in exchange for a part of the company’s outstanding equity. Some researchers argued that executives use this method (stock buyback) as a tool to improve earnings per share number (Grullon & Ikenberry, 2000; Brav & Graham, 2005; Hribar, Jenkins & Johnson, 2006).
4. Role of Corporate Governance in Earnings Management
Effective corporate governance is essential if a business wants to set and meet its strategic goals. A corporate governance structure combines controls, policies and guidelines that drive the organization toward its objectives while also satisfying stakeholders’ needs. A corporate governance structure is often a combination of various mechanisms.
4.1 Internal Mechanism
The foremost sets of controls for a corporation come from its internal mechanisms. These controls monitor the progress and activities of the organization and take corrective actions when the business goes off track. Maintaining the corporation’s larger internal control fabric, they serve the internal objectives of the corporation and its internal stakeholders, including employees, managers and owners. These objectives include smooth operations, clearly defined reporting lines and performance measurement systems. Internal mechanisms include oversight of management, independent internal audits, and structure of the board of directors into levels of responsibility.4.2 External Mechanism
External control mechanisms are controlled by those outside an organization and serve the objectives of entities such as regulators, governments, trade unions and financial institutions. These objectives include adequate debt management and legal compliance. External mechanisms are often imposed on organizations by external stakeholders in the forms of union contracts or regulatory guidelines. External organizations, such as industry associations, may suggest guidelines for best practices, and businesses can choose to follow these guidelines or ignore them. Typically, companies report the status and compliance of external corporate governance mechanisms to external stockholder.
4.3 Independent Audit
An independent external audit of a corporation’s financial statements is part of the overall corporate governance structure. An audit of the company’s financial statements serves internal and external stakeholders at the same time. An audited financial statement and the accompanying auditor’s report helps investors, employees, shareholders and regulators determine the financial performance of the corporation. This exercise gives a broad, but limited, view of the organization’s internal working mechanisms and future look
4.4 Small Business Relevance
Corporate governance has relevance in the small business world as well. Internal mechanisms of corporate governance may not be implemented on a noticeable scale by a small business, but the functions can be applied to many small businesses nevertheless. Business owners make strategic decisions about how workers will do their duties, and they monitor their performance; this is an internal control mechanism — part of business governance. Likewise, if a business requests a loan from a bank, it must respond to that bank’s demands to comply with liens and agreement terms — an external control mechanism. If the business is a partnership, a partner might demand an audit to place reliance on the profit figures provided — another form of external control.
Earnings management is a technique for satisfying its internal users of a firm as managers. But it will bring benefits to all the stakeholders of a firm if it is used ethically. So, to get a highest level of output of earnings management, it should be taken as for the welfare of all of the related users rather than only for the personal motives of managers. Also, any company uses earnings management should be aware of both of its positive and negative consequences. Business should improve the corporate governance to constrain an effective earnings management strategy. The operations of earnings management may affect the decisions of the investors or creditors by providing false financial position.