Finance and Accounting: Business Financial Crime - Research Paper Example

Business Financial Crime Introduction: Financial crimes occur in businesses when any kind of falsification takes place in the accounting measures. This is generally carried out intentionally by the financial management team of a company for the purpose of convincing others with financial results that are false, thereby increasing the value of the company in the industry. Such crimes may include basic company frauds, falsified claims of travel or entertainment, cheque fraud, identity fraud, misappropriation, computer related crimes, or frauds and manipulations in financial statements (Pickett & Pickett, 2002, pp.1-6). Earnings management is one of the most popular measures of financial business crimes, occurring in companies on a habitual basis. It can be defined as a process of intentional interference of the management in the establishment of the earnings of a business, misrepresenting the data to show better results than they actually are. Several reasons lead to management of earnings which include manager’s compensation, raising stock price, or pushing for government funding. There are different strategies available that managers can use for the purpose of earnings management and hence satisfy their selfish objectives (Wild, 2006, pp.86-87). With regard to the increase in financial crimes in businesses, and several instances of earnings management being reported, this study focuses on the literature of earnings management and analyzes the cases reported to draw a conclusion with a view on the concerned topic. Earnings management, in exchange listed companies, is not fraud but a case of caveat emptor for investors. Earnings Management: An Overview Earnings management is the process of intentionally misrepresenting financial data in the accounting measurements such that the company can show greater profits and more value than it actually has obtained. The process can be “cosmetic” where managers influence accruals without affecting cash flows or it can be “real” where cash flows are acted upon to manage earnings (Wild, 2006, pp.86-87). There are three usual strategies that managers can exploit for earnings management. These include either increasing the current income, or taking a “big bath” by decreasing the current income, or income smoothing. Increasing the current income is done to represent a company more positively (Wild, 2006, pp.86-87). It can be done for a long period of time. In cases of growth, the accrual reversals are lesser than the current accruals, thereby increasing the income. The big bath strategy involves taking many write-offs in a time when performance is poor. Because of the unusual nature of the big bath, users generally discount the financial effect. In income smoothing, the managers enhance or reduce the reported revenue to reduce its volatility (Wild, 2006, pp.86-87). The process of income smoothing has been found to be an efficient process that is capable of revealing private information of the financial teams working in an organization. At the same time, stakeholders and financial analysts, who determine the financial status of a company depending on such information, can be misrepresented through the wrong information provided by this method. The purpose of such misrepresentation has been associated with the companies’ tendencies to achieve higher returns of profits. It can be understood that if a company presents itself to be in a financially good and stable position within an industry, greater number of shareholders would invest in the company and the returns of the company would also be high. Studies also reveal that companies that have been able to present their earnings to be smooth have obtained higher number of investors in comparison to those companies that have lesser smooth earnings. However, the problem arises with the method when in the long run the investors would look for the actual status of the company. Misrepresenting or presenting smooth earnings might impress the investors for a particular moment of time, thus benefitting the company in the short run, but the process proves to be risky for the company in obtaining gains in the long run (Aflatooni & Nikbakht, 2010, pp.56-58). Thus one issue that gets revealed from the above study is that in spite of the fact that earnings management proves to be a wrong method or approach for any company to improve its financial figures, yet when companies do apply these methods, they tend to achieve more gains in terms of their profits, or the investors from the investors. This would mean that expectations exist from the investors as well as the organizational members and everyone wishes to see the company’s figures rising and to be at a high position in comparison to other companies in the industry. Thus when the figures are manipulated, in the short run, the investors also do not find it necessary enough to actually learn the true financial status of the company. These attitudes seem to encourage the process of earnings management more among the financial teams within the companies to follow these methods. The maximum opportunities for earnings management lie in areas of revenue recognition, valuation of inventory, estimations of provisions like bad debts, and charges like restructuring or repair of assets. Important methods of earnings management include “Income Shifting” and “Classificatory Earnings Management” (Wild, 2006, p.89). The process of income shifting moves the income from one period to another. This is done by accelerating or interrupting the revenues or expenses. This often results in turnaround of the effect which is why this is very useful in the process of income smoothing. Earnings can also be managed by selectively classifying incomes and expenses in particular parts of the income statement. A common form of classificatory earnings management is to report expenses along with such unusual items that are given lesser importance by analysts (Wild, 2006, p.89). It is very important to identify and adjust the earnings management in the financial statement analysis because these distort the financial reports of a business. Before any conclusion is drawn by an analyst on whether a company is managing earnings or not, an analyst should check the incentives of the company, the history and reputation of the management, and the opportunities available for earnings management. Earnings are not supposed to be managed if managers do not get incentives for doing so. The integrity of the management is essential to be assessed through the study of past records of the company, the financial reports and the audits, etc. The nature of a business also needs to be judged which determines the opportunities available for a company to follow management of earnings (Wild, 2006, pp.89-90). The diplomacy and the judgment of a company’s management on the earnings of the company are significant in the assessment of an earnings management in any particular organization. For the purpose of the testing, researches are designed accordingly. Relationship between the accruals of the finances and the factors that can explain them is one way in which the earnings management can be tested and measured. Definite accrual policies might also be planned for the purpose. Individual accrual policies are judged and the earnings management can be assessed. Moreover, the impacts of the earnings of the company can be studied to realize how the management of those earnings influences the organization’s organizational system and profits (Bissessur, 2008, pp.57-58). Cases Reported on Earnings Management: Reported earnings have great power to influence the activities of a firm and hence affect the decisions taken by the management. It should be the responsibility of any company, therefore, not to involve in financial crimes, or keep management earnings within limits. The practice of earnings management ultimately leads a company into problematic situations. Let us reflect on a few examples (Mulford & Comiskey, 2002, pp.57-58). It has been obtained through studies that companies in general tend to get involved in earnings management with intentions to either influence the prices of stocks in a positive manner, to gain bonuses on the earnings that the company earns, appearing to be highly profitable and thus gain financing of debts at lower costs, or to avoid any kind of political influences in the management process (Wahlen et al, 2010, p.393). A case of Cisco Systems is known, where on measuring the performance of earnings of the company for consensus earnings, it was found that the per-share earnings of the company was $0.18, whereas analysts’ estimation was to be $0.17. It was found to be a continuous process where the figures had been exceeding the analysts’ estimates. This could be happening by chance, but such possibilities were less. To this issue the chairman of the Securities and Exchange Commission found the earnings management process to be problematic (Mulford & Comiskey, 2002, p.58). It can be understood that when analysts estimate figures or financial performances for a company, they take into consideration several factors and reach to an analyzed result. Thus when actual results do not match with the analyzed results, it creates problems for the company and initiates doubts on the measures that are taken by the company that might have led to the improved figures as presented. Earnings management consists of actions that meet or exceed the profit projections of a company. If the annual report of any company is picked up, it can be seen how important it is for a company to show consistent and increasing earnings. In a management discussion, the annual report of Tenneco Company expressed that the strategic actions of the company were measured and guided accordingly to deliver high increases in incomes and profits. Eli Lilly had noted that it had experienced earnings for thirty three years without a break. The annual report of Bank of America stated, “Increasing earnings per share was our most important objective for the year” (Jennings, 2008, p.258). This need for the different companies tend to force the financial management teams to get indulged into the earnings management processes that have become highly significant in the operations of today’s organizations. ABS Industries was known to document bill and hold sales in the absence of customer wishes. The product that was recorded to be sold was not even billed. There was no assurance for the purchase of goods. Even the copies of invoices for the clients were damaged so that the billing could not be done. There was another company called Aviation Distribution Incorporation which had recorded income on goods that were neither billed nor shipped. Moreover to hide such activities, false invoices and buy orders were prepared. Health Management Incorporation was known to overstate inventories in order to increase the earnings (Mulford & Comiskey, 2002, pp.69-70). Research on German companies has shown that companies have become more aggressive in increasing earnings around their initial public offerings date than during any other time. The argument lies that the managers have incentives to increase earnings to support high prices of stock. Investors cannot understand the extent to which companies engage themselves in earnings management. This ultimately leads to a negative elongated post IPO performance (Gregoriou, 2006, p.282). Survey reports also indicate that very few companies actually take any initiative to lessen the use of earnings management and thus remove its negative impacts on the company in the long run. A survey on 100 companies reflected that only 17 companies out of them responded to the measures for protection of the company. It was found that only in about five firms, training courses were involved that addressed the issues related to earnings management. Nine of these firms were found not to have any training processes in this context. More than 50 percent of the responding firms in the survey were found to have no associations with any kind of training measures or measures for understanding the earnings management and its implications (Akers, Giacomino & Bellovary, 2007). The above studies as well as the survey indicate that the process of earnings management has been incorporated in most of the accounting firms as a common process intending to bring benefits to the company. It can be understood that while the process remains in a limited state, it might be acceptable as one of the measures of company management. However, excess of this process can lead to the company’s reputation being harmed in the long run. It might also prove to be difficult and problematic for the company and its management to keep the analysts as well as the investors cheated for longer periods of time through manipulative figures. Earnings Management and the Business Financial Crimes: Earnings management seems to be a resourceful behavior which is meant to trail some objective that has been estimated from before. For example, if a company earns profits less than what had been estimated, then it may try to adopt management of earnings to show an overstated income (Ronen & Yaari, 2007, p.14). Overstating incomes and properties and understating expenses and liabilities are the common forms of financial frauds. Management generally commits these frauds owing to the pressure they have to suffer to meet estimated figures. This pressure may arise from the analysts, or may be the shareholders, or it may also be the result of unreal sales goals, or other budget or compensation plans that are prepared internally (Jackson, Sawyers & Jenkins, 2008, p.14). Thus the primary reason for a management team getting involved in earnings management is the expectation that a company has for its gain of profits. The earnings management could be found and used as an easy means for the company’s management for improving the figures and presenting it to the world (Markham, 2006, p.400). Financial statement frauds can prove to be much more costly than any other types of frauds, because its effects are not only on the numbers but on the business decisions as a whole (Coenen, 2009). Frauds may occur from pressures, available opportunities, or personalities (Jackson, Sawyers & Jenkins, 2008, p.15). There is a variety of methods available for management earnings. The different areas where a manager can make use of management earnings include writing of inventory, recording sales, and delaying invoices, putting off expenditures and so on (Jennings, 2008, p.258). The possible earnings management techniques include changing methods of depreciation, changing periods of amortization, estimating accruals of obligations, judging amounts of inventory write-offs, and so on (Mulford & Comiskey, 2002, p.65). Whether earnings management is good or bad depends on the character of steps taken by the management of a company. It is understood that earnings management is adopted in any company not for the purpose of making it a business financial crime, but for meeting company expectations or forecasts. If the effects are accepted, then the process may benefit the shareholders as well as the company. However it is necessary that details of earnings management are disclosed so as to have an obvious idea that the system is not benefitting at the expense of others (Mulford & Comiskey, 2002, pp.82-83). Conclusion: Going through the details of what earnings management is and how it is leading to business financial crimes, it can be understood that earnings management is not meant for criminal purpose, but it is used by different companies in a way which is leading to criminal activities. Taking some measures to meet the forecasts could be accepted if they do not harm the company or its stakeholders. However, it is of serious concern for businesses because managements coming under pressures are using techniques which are unacceptable in nature. Moreover, these steps are creating severe problems both for the company as well as for the stakeholders. Hence, even if earnings management is not referred to a as a fraud, but owing to its effects it is necessary that investors remain beware of measures applied in the accounting measures of a company and invest accordingly. The different reporting of the processes of earnings management being applied in different accounting firms clearly reflect the increasing use of the method for presenting a good and stable financial status of the company. Thus, it is in very few cases that companies take active measures against such approaches. Rather companies are found to indulge into such measures for the purpose of improving their financial status as they would present to the stakeholders and the investors. However it has also been obtained from the study that in the long run, the earnings management involving excess manipulation of data proves to be problematic for the company with respect to its reputation as well as the management. Thus from the study it can be said that companies using the process of earnings management is common and using it without impacting the investors or the company’s organizational goals, might be accepted to a certain extent. However, organizations also need to keep into focus that they do not misuse the process impacting the growth of the firm in the long run. References 1) Aflatooni, A. & Z. Nikbakht (2010), Income Smoothing, Real Earnings Management and Long-run Stock Returns, Business Intelligence Journal, Vol.3, No.1, pp.55-74, available at: http://www.saycocorporativo.com/saycoUK/BIJ/journal/Vol3No1/Article_4.pdf (accessed on December 29, 2011) 2) Akers, M.D., Giacomino, D.E. & J.L. Bellovary (2007), Earnings Management and its Implications, nysscpa, available at: http://www.nysscpa.org/cpajournal/2007/807/essentials/p64.htm (accessed on December 29, 2011) 3) Bissessur, S.W. 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Yaari (2007), Earnings Management: Emerging Insights in Theory, Practice, and Research, New York: Springer 12) Wahlen, J.M. et al (2010), Financial reporting, financial statement analysis, and valuation: a strategic perspective, Connecticut: Cengage Learning 13) Wild (2006), Financial Statement Analysis 9E, New York: Tata McGraw-Hill Education Read More