Earning Management and Regulatory Framework - Research Paper Example

“Earnings management, in exchange listed companies, is not fraud but a case of caveat emptor for investors” Earnings are an important aspect of any business organizations and the organizations thrive on the increase in the earnings. Earnings become an important item in the financial statements, which reflects the profitability of the organization. However, in recent times various discrepancies have crept in the financial market and the worth of organizations is not reflected based on the earnings. As a result, it becomes difficult for the investors to choose the right investment, which would provide them with maximum returns and their cause is affected considerably. The paper analyzes the frauds associated with the earning management and cites some cases of frauds in the earning management. A section of the paper also deals with the regulatory framework of earning management in countries like the USA and the UK. Earning management and fraud: The concept of earning management can be defined under three board heads of white, black and Gray. White signifies the beneficial earnings, which are used to enhance the transparency of the financial reports whereas black signifies the misrepresentation of the report and involves fraudulent activities. The gray denotes the manipulation of financial reports, which occur within the boundaries of the compliance, which are done to enhance the efficiency or to provide opportunistic results. Under the gray concept, earning management involves the selection of accounting principles, which helps to maximize the overall utility of the management of the organization. Earning management is initiated by the mangers when they use their judgment in the reporting of the financial statement and alters certain information within the reports for misleading the stakeholders or to influence the outcome of certain contracts, which depends on the stability of the organization in terms of accounting figures. However, all earning management does not involve the misrepresentation of the facts and figures. Certain organizations do not resolve to distortion of figures of the accounting report and allow the investors to distinguish between the various components and they only undertake operations that enhance the value of the information associated with the earnings of the organization. Earning management often proves to be beneficial in determining the long-term value of the organization and at the same, it can be pernicious while concealing the short term value. The concept of earning management is declared as fraud and it violates the rule specified by GAAP when the organization records sales in the accounting reports before they are realized and when the organizations record fictitious numbers under the inventory to overstate them (Ronen & Yaari, 2007, pp.26-28). The accomplishment of earning management is obtained by utilizing the flexibility, which is present in the accounting standards. Organizations mostly manipulate the accounting accruals which involves the non-cash revenues and the expenses, so that the earnings reflect a better performance achieved by the firms. However, the organizations do not involve in the manipulation of cash, and the cash inflows and the outflows of the organization remain unaltered in the statements at the end of a period. Some portions of accruals are modified under the discretion of the management whereas the other portions neutrally reflect the financial performance of the organizations (Babalyan, 2004, p.14). Reasons for manipulation of the financial statement: Organizations get involved in the manipulation of the fraudulent activity of the financial statement owing to a variety of reasons. Other than attaining business goals with the wrong approach, often the organizations carry out such activity because of the opportunities they are provided. Organizations often lack corporate governance within the management and the absence of proper ethical policies in the organization motivates the employees to carry out such tasks. Often the board of directors in an organization fails to monitor such incidents and the number of such irrational cases occurs at an increasing rate. The audit committee of the organizations is also to be held responsible for such acts, because of their inefficiency in finding out the prevalence of such practice in the organization. Often the organizations, which are listed in the exchange cannot obtain much credit because of the unstable economic condition and manipulates the financial statement so that the investors do not lose faith in the performance of the organization. The result of the excessive investment undertaken by the organization also results in loses and forces the top management of the organizations to commit such activities. The organizational culture often guides the selection of choice for the top management in the organization, to choose between the unethical practices of earning a management or adhere to the ethical practice maintained by the organization. Events of fraud in the earnings management of the organization could occur by the aggressiveness exhibited by the top management and the absence of moral values within the employees at the top level of the organization (Reazzey & Riley, 2009, pp.80-82). Earning management and the investors: The effect of earning management is highly significant to the decisions to be taken by the investors. The decisions taken by the investors depend a lot on the expectation of the future growth to be made by the organization and regarding the market value of the product and its demand in the market. The estimation of the future growth of any organization depends on the revenues and the earnings as predicted by the financial statements. However, the manipulation in the financial results can conceal the trend in the future performance of the organization and distort the expectation of the investors regarding the growth, which is assumed by the investors. However, the internal investors of the organization are less influenced by these acts of misrepresentation. However, certain investors interpret the original condition of the firm and they still over-invest with high risk and display their faith in the firm to improve their overall performance. However, such investments have proved to be inefficient and the investors face a lot of difficulty in managing their financial conditions due to such decisions taken by them. The better accounting decisions incorporated by the mangers, on the contrary, reduce the irregularity of information between the managers and the suppliers and in turn leads to better investment decisions. Research conducted by Biddle and Hillary reflects the fact that the constraints of financing the investment are lower for the firms which maintain higher quality in the accounting standards (Nichols & Stubben, 2008, pp.1572-1575). However, investors in the firm should be provided with the correct report regarding the performance of the firm. Because the investors play a crucial role in deciding the fate of top management of any organization, the mangers often prevent to disclose the true picture of the performance of the organization as their position in the organization might be hampered. The position of the investors is significantly harmed by such misrepresentation as they keep on investing in the organization based on the manipulated reports unknowingly and faces financial instability. The mangers to gain profitable investment in different projects make optimistic disclosure before the opening of new equity and do their best in gaining the attention of the investors. In this environment, the investors need to be careful of the fact of misrepresentation and should invest only after determining the validity of such reports made by the top management. Example of Fraud Aggressive Earning Management: The case of aggressive earning management refers to the situation in which the organizations carry out misrepresentation of the financial statements, which are done within the rules specified by GAAP. The organizations often understate the number of bad debts in their statements so that the investors looking to invest in the organization do not lose faith in them. The overall expenditures incurred in the research and development process are also depicted at a reduced rate so that the overall profitability increases (Fong, 2006, p.84). However, the occurrence of such activities eventually turns out to be a case of fraud as observed in the examples of the following organizations. World Com WorldCom originated in the year 1983. The organization faced rapid growth after the merger was effected. In the year 2001, the organization reported a profit of over $1.4 billion, though the organization faced considerable loss. The organization capitalized on all the operating expenses incurred by the company. In the year 2002, the organization reported accounting errors of $3.8 billion and the misstatement of the capitalization was reported to be $ 11 billion. WorldCom incurred various costs regarding the payment of wages and salaries and also undertook various maintenance costs which they did not put on the income statement and as a result, the net income reflected higher figures than the actual. However, the cost incurred by WorldCom was reflected on the balance sheet as the asset of the company. After depicting the cost as asset World Com went to depreciate the cost regularly which meant that they were subtracted from the net income with the gradual passage of time. On the contrary, small portion of the costs featured in the income statement and led to the inflation of the overall profit and the net income. The Securities and Exchange Commission noted these activities to be the act of fraud and the organization faced bankruptcy and the CFO of the organization was fired (Accounting Fraud, 2002). Enron: Enron Corporation, an American energy company faced bankruptcy in the year 2001, because of the scandal relating to the earning management. The shares of the organization hit a high in the year 2000 but dramatically collapsed at the end of 2001. On investigation of the degradation of the value of the share, it was found out that the organization has utilized various loopholes in the accounting process to hide billions of dollars of debt and losses, which resulted from the failure of innumerable projects undertaken by the organization. The organization treated the loss as an asset, and opened up a partnership account and passed the losses to the partnership accounts, which eventually eliminated the losses from the balance sheet of Enron. The sales of the losses were further shown as earnings, which resulted in the mammoth increase of the worth of the company. However, the rules regarding Special-purpose entity as specified in the accounting principles were clear as it mentioned the isolation of the entity from the organization, which has undertaken its creation. Many executives and the top management of the organization were imprisoned based on the case of fraud (Accounting Fraud, 2002). Regulatory framework in UK: The increased number of frauds in the matter of earning management has brought the attention of the UK government and the issue of corporate governance was highlighted by the public and the regulators of the market. In UK, the company law states that the boards of directors are responsible for the process of the financial reporting. The decade of the 1990s witnessed the passage of various laws regarding the corporate governance and among them the Cadbury report envisaged various codes for the best practice and also pointed out the role and responsibilities of the non-executive directors of the organization. After the Cadbury report, the Greenbury code and the Combined code was also released. Though the companies were not under the obligation to adhere to the recommended codes but the London Stock Exchange stipulated that all the firms based in the UK should include a statement, which reflects the compliance of the codes in the annual report published by the company and any areas of noncompliance would to lead to financial fines for the organizations. After the passage of the Cadbury report, most of the UK based firms also incorporated efficient audit committees in the organizations (Lei, n. d, pp.22-25). The combined code also laid down certain principles for the operation of the directors in an organization and had provided the guideline for adhering to providing remuneration to the directors and also held that the organizations should not pay more than the necessary amount to the directors. The rules of corporate governance were passed to stop the discrepancy regarding the misrepresentation of the financial facts of the organizations (THE COMBINED CODE ON CORPORATE GOVERNANCE, 2003). Regulatory framework in US: Audit committees were established in the US since 1978, and the New York Stock Exchange declared the presence of audit committees in the organizations to be solely comprised of independent directors. However, the most important step taken by the US government to bring the organizations under a strong governance system was the passing of the Sarbanes –Oxley Act, which was passed in the year 2002. The act came into force after a series of corporate scandals were observed in the country. The act brought in the new standards of corporate practice and also included sections dealing with penalties for acts which were termed as illegal. Regarding the audit of the companies, the act mentioned all the financial reports of the organizations to include data regarding the internal control of the organization. It was incorporated to confirm the fact that the organizations not only maintain transparency regarding their financial data but also incorporates measures so that they have control in safeguarding their data. The act also specified that it is the responsibility of the auditing firms to review the controls and policies undertaken by the firm and submit a report to the governing bodies and to carry out their tasks without any influence. The act also holds applicable for all the public companies operating in the USA and also to the international organizations which have registered their equity or the debt with the Securities and Exchange Commission of the US. The act also covers a portion of the corporate governance of international firms in the US. The US system of corporate governance has incorporated much rules and codes in comparison to the other nations and the government regularly monitors the operation of the organizations and any discrepancy found are dealt with strict hands by the government (Sarbanes –Oxley essential information, n. d) Conclusion: The study of the paper reveals the fact that the increasing practices of earning management in the organizations have often crossed the limit and has resulted in various fraud activities. The option of earning management appears to be lucrative for the managers who do not maintain corporate ethics and manipulates the financial statements so that the investors do not identify the actual performance of the business. The cases studied in the paper reflect the fact that reputed organizations like Enron and Worldcom have utilized the foot holes in various accounting principles and this has raised concern over the ethics maintained by the organizations. The government of countries likes the UK and USA has incorporated various regulatory frameworks so that the organizations maintain transparency in their actions and the interest of the investors are also protected. The evidence in the analysis of earning management reflects the fact that the violations of the rules relating to the earning management have become matters of fraud and it has alarmed the cause of the investors and the investors’ needs to be careful in matters of investment. References Accounting Fraud. (2002), USA Today, available at: http://www.usatoday.com/educate/college/business/casestudies/20030128-accountingfraud1.pdf (accessed on January, 5, 2011) Babalyan, L.( 2004). Earnings Management by Firms, ethesis, available at:http://ethesis.unifr.ch/theses/downloads.php?file=BabalyanL.pdf (accessed on January, 5, 2011) Fong, A. (2006), EARNINGS MANAGEMENT IN CORPORATE ACCOUNTING: AN OVERVIEW, anu, available at: http://eview.anu.edu.au/cross-sections/vol2/pdf/ch06.pdf (accessed on January, 5, 2011) Lei, K. (n.d). Earnings management and corporate governance in UK, bschool.nus, available at:www.bschool.nus.edu/Departments/.../Seminars/.../kang%20Lei.doc (accessed on January, 5, 2011) Nichols, M, F & Stubben, S, R. (2008), Does Earnings Management Affect Firms’Investment Decisions?, unc, available at: http://www.unc.edu/~stubbens/MS.pdf(accessed on January, 5, 2011) Reazzey, Z & Riley, R. (2009). Financial Statement Fraud: Prevention and Detection, New Jersey: John Wiley and Sons Ronen, J & Yaari,V. (2007). Earnings Management: Emerging Insights in Theory, Practice, and Research, London: Springer Sarbanes –Oxley essential information. (n. d), sox-online, available at: http://www.sox-online.com/basics.html (accessed on January, 5, 2011) THE COMBINED CODE ONCORPORATE GOVERNANCE. (2003). FSA, available at: http://www.fsa.gov.uk/pubs/ukla/lr_comcode2003.pdf(accessed on January, 5, 2011) Read More