Earnings Management: The Continuum from Legitimacy to Fraud - Research Paper Example

?“Earnings Management: The Continuum from Legitimacy to Fraud” “Earnings Management: The Continuum from Legitimacy to Fraud” College Professor Name Subject Abstract There is a continuous argument in the audit circle on whether earnings management is another form of fraud. Fraudulent financial reporting engages deliberate misstatements or exclusion of figures or dissemination in financial statements as a part of a design to “manage earnings.” An external auditor should pay great attention to ‘earnings management ‘and the ‘quality of earnings and how earnings management is associated to and may be tantamount to fraud. The regulators should offer the external auditors with more assistance and to impart more knowledge on earnings management. Introduction There is a continuous argument in the audit circle on whether earnings management is another form of fraud. As per empirical research carried over by Jiraporn, et al (2007) and Diana & Madalina (2007), since it is within the periphery of GAAP, earnings management is not a fraud whereas empirical research carried over by Jones (2011) and Chia et al, (2007) found that earnings management is another kind of financial reporting fraud. Hence, there is a necessity on the part of external auditors to spot out the variance between the financial reporting fraud and earnings management. “Objectives of the Research” The main objective of this research paper is to enhance the knowledge of the external auditor about earnings management and to assist them to detect the variance between financial reporting fraud and earnings management. To accomplish the aim of this research paper, a thorough literature review was performed. This research has found that a new approach is the need of the hour to make the management’s motive which is the significant motivator for all fraudulent activities. This research paper also makes its recommendations to be followed in the future. In terms of audit of motivations, the external auditors have to review their external auditing. The framers of the standards should provide the external auditors with much frameworks as regards to the audit of the motives of the management. This research paper finds that still more research is required in management integrity and motives. Research Question “The Continuum from Legitimacy to Fraud.” Whether the earnings management is a fraud or not? “Data Collection Method” To accomplish the aim of this research paper, a thorough literature review was performed. This research paper has employed secondary data available from the books, journal articles and websites for carrying out this research. Secondary data have significant benefits over primary data as it has information explosion and large quantum of existing data. Further, there is no much cost associated with the collection of secondary data and is also not time consuming. Since there is availability of large volume of secondary data, which offers great insight about the research topic than that of primary data, hence, this research essay gives more significance to the secondary data. (Churchill & Lacobucci, 2009, p.142). “Reliability and Validity” This research essay has relied on the reliable and valid secondary data which has helped to address the research question. Normally, the reliability and validity are corroborated by details of the data source which offer about the details of how data were gathered and processed. Reliability means if research findings apply to other researches on the subject, does it gives the same results and if not, why? As this research mostly employing empirical evidence published previously that connotes result gathered from reliable source will be dependable. To be reliable findings, there should not be any inaccuracy from secondary data, no data bias and no data error. This is anxious with whether the outcomes are really about what they seem to be about. Validity is not calculated by the sole statics but the body of research that reveals the association between the test and demeanor it is planned to quantify. “Meaning of Fraud” As per Wells (2009), the meaning of fraud consists of four elements namely a material fake report, with an aim to mislead, dependence on the phony statement by a sufferer and consequential damages due to it. Wells is of the opinion that a fraud is one where there is an obvious misleading statement with an aim to cheat, with corroboration that the victim relied on the misleading statement and due to that, there is an occurrence of damage to the victim .(Lord ,2010,p.5). As per Jones (2011), fraud involves infringement of regulatory structure or breaking the law. Thus, fraud can be explained as an illegal and deliberate act perpetrated by the fraudster to misuse or to steal the resources of the victim organization or properties, and the fraudster can conceal his fraud or theft by camouflaging the real nature of the business transactions. As per SAS 99 (Statement on Auditing Standards), fraud is defined as a deliberate act that ends in an obvious misreporting in financial statements that are subject to an audit by an external auditor. (Audit Standard Boards, 2002). There is a vast difference between error and fraud. As per SAS (Statement on Auditing Standards), an auditor pays much significance to the fraudulent acts that result in an obvious misstatement of the financial statements. There are two types of misstatements in financial reporting. They are misstatements emanating from misappropriation of properties of a business and misstatements due to deceitful financial reporting. Fraudulent financial reporting engages deliberate misstatements or exclusion of figures or dissemination in financial statements as a part of a design to “manage earnings.” Accounting mismanagement refers that reported accounting figures do vary from what they ought to be if they not impacted by accounting error. An accounting error is one where an accounting transaction is omitted carelessly from the accounting records without intention to mislead or non application or misapplication of an accounting standard. On the discovery of an accounting error or fraud, the accounting misstatement is normally divulged and fine tuned when the fraud or error is ultimately identified or discovered. Hence, it is the duty of an external auditor to design and plan the audit to have adequate assurance of identifying poignant accounting statement errors or fraud. (Lee, 2007, p.214). The Earnings Management – The Continuum from Legitimacy to Fraud The phrase earnings management includes a broad range of both illegitimate and legitimate acts of management that impact the earnings of the entity. Earnings management can be perpetrated either through legitimate managerial actions or through the fraudulent financial reporting. Earnings management is more concerned with how the role of the auditor in improving the reliability of financial statements, which is impacted by different manners in which earnings, can be administered. Is Earnings Management is Ethical? No one disagrees that the creation of fictitious transactions at the right side of the earnings management continuum is disreputable. However, there is always a vibrant discussion on what is ethical and what is not. For instance, business managers and their auditors always differ what tantamount fraudulent as regards to non-GAPP reporting. For instance, CFO of WorldCom strongly advocated the capitalizing of $3.8 billion incurred for local phone access charges as capital expenditure instead of treating it revenue expenditure. Thus, CFO of WorldCom was of the view that fraudulent reporting was not only in adherence with GAAP but also ethical. Another issue in earnings management is that when a company wants a change in accounting, how can a demarcation line be drawn between deceptive and adequate disclosure and how to assess whether the strategic timing of revenues and losses incurred by a company is prudent business practice or fraudulent. (Albrecht et al, 2010, p.191). It is to be noted that earnings management falls within the GAAP and is one of the guises of accounting maneuvering. Accounting manipulation is the employment of management’s authority to design financial transactions or to make accounting choices so that it can impact the chances of transfer of wealth between the society fund managers or providers and the company. (Stolowy and Breton, 2003, p.20). As per Guan et al (2006), earnings management is the process of initiating obvious actions within the limits of GAAP so as to accomplish a targeted level of desired earnings. Earnings Management versus Fraud: Evidence from past empirical studies It is the belief of some researchers that earnings management will not fall under the fraud but will constitute a legal or ethical exercise that improves the quality of the information offered to readers of the financial statements. As per Demski (1998), earnings management is advantageous since it obviously improves the info value of earnings. Davis –Friday and Frecka (2002) are of the view that earnings management is falling within the ethical and legal parameters. The results of the research done by Hunton et al.(2004) reveals that earnings management in less translucent provinces will enhance the stock price and will not injure the repute for reporting reliability and however , in more translucent regimes , it is likely to injure both reputation and stock price for reporting integrity. As per Diana & Madalina (2007), it is a matter of elucidation as manipulation is not fraud. Jiraporn, et al., (2007) found that no accrual of private advantages to the management and hence, it is not injurious to a company’s value. However, some other researchers are of the view that the earnings management is another guise of fraud, and it is to be eschewed. When managers employ their judgment in financial statements, they can fabricate the transactions to vary the financials to either to influence the contractual results or to misinform stakeholders about the basic financial performance of the company, and then such strategy is nothing but fraud on the stakeholders. (Rezaee & Riley, 2009, p.80). “The direction of earnings management” As per Beneish (2001), there is no uniform consent on what is earnings management and this demonstrates the intricacy that auditors may witness in deciding earnings management incentives. It is observed that only variance between fraud and earnings management is the adherence with regulations. However, Shah (1996) is of the opinion that adherence with the regulations is not a guarantee that financial reports are honestly reported about the present financial status of a company. To decide whether or when the demeanor in the management of earnings continuum surpasses the border to fraud from legitimacy in a particular scenario which is not always simple and that at some juncture in the continuum, the rationale behind the earnings management may become vibrant enough to end in fraud. (Public Oversight Board, 2000, p.79). The course of earnings management if it impacts reported revenues, is solely reliant on the benefits available to the managers of the company. (“Chia et al, 2007, p.180”). As per Kamel and Elbanna (2010), for the involvement in earnings management , three factors can be regarded as its main motives namely, the readily accessibility of earnings management practices ,the presence of impetus and pressures to engross in financial reporting frauds and the existence of feeble corporate governance, which heartens the engagement in earnings maneuvering. The Methods Perused to Manage Earnings As per Pourciau and Schaefer (995), a preference from a menu of treatments that are acknowledged under GAAP like FIFO v LIFO for stock valuation. As per Amir and Livnat (1996), a choice on the timing of espousal of a new standard. As per McVay (2006), a decision calls when GAAP needs approximation like appreciation .As per Radhakrishnan, and Su (2006), a taxonomy of items as below or above the line of operating incomes or incomes from the continuing operations so as to differentiate determined earnings from transitory earnings . Organizing transactions to accomplish required accounting results like what Xerox did by employing a Portfolio Asset Strategy to dispose of the lease contract in its Brazilian subsidiary after the discontinuance of its capital leases in favour of operating leases. As per Marquardt and Wiedman (2005), issuing costly contingent convertible debt, which has no impact on diluted earnings per share under SAFS 128 until the contingencies are satisfied. As per Williams (2000), planning mergers to be eligible for the pooling method. As per Gordon and Henry (2005), having transactions with the related or associated parties. For instance, Refco purportedly parked $430 million at Liberty, a company which is affiliated with Refco’s CEO. As per Muller (1999), deciding whether to capitalize expenses like cost associated with the brand names. As per Gunny (2005), timing the accounting of expenses and income by employing sale of properties so as to show smooth earnings. As per Zang (2007), a real investment and production decision like minimizing R&D overheads or impacting administrative and selling overheads. As per Riedl and Srinivasan (2006), managing the translucent of the financial presentation. As per Smith and Emshwiller (2003), the immediate response of some of the analyst and reporters of Wall Street to Enron footnote revelations of its special-purpose entity. As per Lee, Petroni and Shen (2006), instead of reporting the earnings on the performance statement, reporting the earnings as comprehensive income on the statement of equity. (Ronen & Yarri, 2009, p.33). Auditor’s Role in Preventing the Earnings Management Manipulations There is always a close link between fraud and management. To detect the fraud which is conducted on a continuous basis, the auditor should be provided with guidance for the uncovering of fraud. An external auditor should pay great attention to ‘earnings management ‘and the ‘quality of earnings and how earnings management is associated to and may be tantamount to fraud. Hence, there is a need on the part of an external auditor to engage in forensic-type of audit engagement, mainly to enhance the chance for the auditors to uncover the fraudulent financial irregularities in reporting the same. Legal cases against auditors who failed to stop earnings misappropriation and other managerial transgressions are in practice for long time. Palmrose (1988) detailed about 472 litigations against giant audit firms for audits carried over by them from 1960 to 1985. It is the duty of the external auditor to see whether there exists a well-structured corporate governance practice in the company to prevent earnings management fraud. As per Klein (2002), the characteristics of the board like independence of an audit committee will result in lower scales of discretionary accruals. (Zhou, 2011, p.403). As per Coffee (2006), though the auditors are public watch dogs, since auditors are being paid by companies are never legitimately sovereign of their clients. Auditors should instruct their client with seriousness that in no way they would encourage or support their earnings management fraud, even if they lose their assignment. Dyck, Morse, and Zingales (2009) find very feeble corroboration of incentive to blow the whistle. From regulator side, strong regulations and accounting norms are essential to stop the earnings management frauds. SOX provisions should contain more stringent provisions to punish the earnings management fraud. (Klein, Daiko & Wang, 2012). “Findings and Recommendations “ There should be increased awareness among external auditors about the earnings management and they should have adequate knowledge to differentiate financial reporting fraud and earnings management. Re-evaluating various empirical studies demonstrated mixed findings as regards to whether earnings management can be regarded as an ethical act. Some empirical researchers argue that since earnings management is within the GAAP, it is a legal act and totally diverge from fraud. Some other empirical researchers are of the view that there exists very thin line between fraud and earnings management and since it is an unethical act, it should be always discouraged by the external auditors. There is a need to codify the existing regulations to bring all the methods perused by the fraudsters to manage the earnings within its framework and should notify that all such acts will be regarded as frauds, which will give ample authority to external auditors to detect and prevent it. Thus, the regulators should offer the external auditors with more assistance and to impart more knowledge on earnings management. Further, there is a need for more empirical studies on motivations, integrity of the management and the ways and means to find out earnings management frauds. (Kassem, 2012, p.33). References Albrecht, W S, Stice E K & Stice, D. (2010). Financial Accounting. New York: Cengage Learning. Auditing Standards Board. (2002). Statement on auditing standard No 99: Consideration of fraud in financial statement in Barbados. Managerial Auditing Journal, 20(1), 284. Churchill, GA. & Lacobucci, D. (2009). Marketing Research. Methodological Foundations. New York: Cengage Learning. Kassem, R. (2012). Earnings Management and Financial Reporting Fraud. American Journal of Business and Management. Vol (1), No (1), 30-33. Klein L, Daiko V & Wang M. (2012).Regulating Competition in Stock Markets. New York: John Wiley & Sons. Lee, T A. (2007). Financial Reporting and Corporate Governance. New York: John Wiley & Sons. Public Oversight Board. (2000). The Panel on audit effectiveness report and recommendations. August, p.76. Rezaee, Z & Riley, R. (2009) Financial Statement Fraud: Prevention and Detection. New York: John Wiley & Sons. Ronen, J & Yarri, V. (2009). Earnings Management: Emerging Insights in Theory, Practice and Research. New York: Springer. Stolowy, H. & Breton, G. (2003). Accounts Manipulation: A Literature Review and Proposed Conceptual Framework. Review of Accounting and Finance, 3(1), 20. Zhou, D. (2011). Applied Economics, Business and Development .New York: Springer. Read More