The Continuum From Legitimacy To Fraud - Research Paper Example

 The Continuum From Legitimacy To Fraud Introduction According to McKee, earnings management involves the financial reports and accounts exploitation by management of a firm to alter the view of a company from its present financial position. It is sometimes known as creative accounting, and the downfall of most companies is blamed for fraud and violations of accounting procedures. Management of earnings, over the past years, received negative publicity from the several corporate scandals injurious to the firms. Examples of the affected corporate firms are Enron and WorldCom, which illustrate how opportunistic earnings resulted in the greatest bankruptcies in the history of the US. However, there are claims that earnings management has some beneficial uses too (McKee, 2005). Evidence empirically shows that earnings managing firms have an inverse relationship with agency costs, but when combined, management of earnings is not detrimental on an average. Consequently, several earning management stimuli, evidence for and against each theory of stimulus, and recognition of earnings management are analyzed. Firm managers are to a certain extent allowed to choose suitable reporting systems, approximates and disclosures concerning the firm's business economics. This enables the financial reports to portray more valuable and useful information to the users. Since both auditing and accounting are not exact science, the management of a firm has a mandate to settle on how financial reports information is presented. Therefore, when the managers’ decisions on reporting methods and estimates are inaccurate, risks in management of earnings occur (Cozby, 2009). This can adversely influence the opinion of users who depend on the information of these financial reports. Earnings management is an emerging issue in the field of accounting given the latest Enron and WorldCom corporate failures. Earnings management can either mislead users on the firms’ economic performance or affect contractual results dependent on the financial report. This practice comprises an array of activities from fraudulent to conservative accounting with the former being an extreme form with adverse outcomes, which are punishable by law (Ronen & Yaari, 2011). Earnings Management Stimuli Motivation of capital markets The accounting information is useful in the capital markets in influencing the stock price in the interim, and for this reason, managers alter the information to influence their firms’ performance in the stock market. The key incentive for earnings management is to promote investment in a firm through purchase of shares in the capital market. Many firms post unanticipated positive accruals, which enhance prior to initial public offer (IPO) and acquisition financed by stock. These situations increase the use of earnings management to boost incomes, making them more viable than those of other firms (McKee, 2005). Past studies of firms indirectly concur with this argument by stating that ownership of lower institutions represented by interim oriented investments with much stress on stock prices over lasting gains. In opposition, some studies illustrate the inducement of understating earnings before a management buyout. Ronen and Yaari in their study support a hypothesis showing that unanticipated negative accruals depict a decreasing income, making the buyout cheaper and easier. This permits the management of a firm to propose a price that emerges as reasonably beyond the market price but beneath the actual worth of the firm. This market price does not show the real firm’s economics (Ronen & Yaari, 2011). Another motivation reason for capital markets is to show that the earnings of the firm have met the requirements of financial management or analysts. There are firms that hardly meet or surpass the forecast of a financial analyst; hence, the management alters the earnings upwards in order to satisfy the forecast (Trochim & Donnelly, 2008). Besides, firms should avoid loss making and attain constant growth of earnings as this leads to reported earnings smoothing. The forecasting of earnings can be improved by smoothing giving firms an incentive to carry out earnings management. According to Ronen and Yaari, constant yearly growth of earnings is positively related to the pricing of the premium of a firm. Lastly, another motivation is swaying a category of investors’ expectations. An example are institutional investors that are convinced to invest in profitable firms with a high portfolio turnover. Therefore, accounting information will be manipulated to show better returns by the firms. Management Reimbursement Contract Stimulus The theory of management compensation (bonus plan) asserts that managers tend to use management earnings to boost their compensations since these bonuses depend on the earnings of the firms. This increases the income of the management, but if it is impossible to alter the earnings to meet a target, managers can later reduce the current earnings to increase future earnings (Anfara & Mertz, 2006). Additionally, managers can reduce the expenses on research and development expenses in the last year of their term to boost earnings, hence their payout on exiting the company. Motivation of Lending Contracts Several firms have dishonored their debt covenants by use of accruals to boost the annual income, hence postponing the debt covenant violation further. Creditors ensure their debt is repaid by restricting dividends payment, repurchasing of shares, and offering of additional credit. These restrictions are placed on the basis of information from the financial statements. The hypothesis is that companies with enormous debts have an inducement to manage their earnings to avoid breaching the debt contracts (Zikmund, Babin, Carr, & Griffin, 2010). Regulatory Motivations Industries such as banking and insurance are examined for conformity with regulations associated with the accounting figures and ratios. Firms in these industries are required to have adequate assets or capital to fulfill their liabilities. Utility firms are allowed to make a standard return on their investment. Banks that close near their minimal requirement overstate their provisions for loan loss and understate their bad debts to increase their investment portfolio. Insurance companies with financial difficulties manage their earnings by understating their transaction reinsurance and reserves for claimed losses (Trochim & Donnelly, 2008). Motivation of Political Cost The hypothesis of political cost is to cut prices or payment of penalties by firms violating this regulation. Firms, therefore, can manage their earnings to appear less profitable, reducing their risk politically. The industrial firms advocating import levy and restrictions tend to postpone their accruals that boost incomes (Zikmund et al., 2010). Conclusion Many studies taken establish that there are various factors that motivate managers to employ earnings management. Management of earnings influences several business areas, especially the firms’ third parties such as creditors and shareholders who rely on the information provided by the financial report. GAAP permits earnings management up to a level, making it in an important aspect, in auditing and accounting. Assessing the degree of earnings management is hard because of the sensitive nature of the research concerned and flawed measurement models. Activity 4: External, Internal and Construct Validity All research methods including qualitative and behavioral ones have some limitations in comprehensive exploring of the research questions. In understanding a concept, the qualitative method is employed, and behavioral methods are more appropriate in testing of causal deductions (Arnold & Clinton, 2008). Therefore, these limitations, which are intrinsic to a sole method, can be dealt with by use of one or more corresponding methods. An example is the inadequacy of the qualitative method to evaluate causal relationships; however, because of a greater internal validity offered by behavioral experiments, it is the most adequate. Conversely, external validity of behavioral experiments is limited, making use of multiple methods in a research more suitable to a sole method. The inferiority of a single research method necessitates employment of triangulation, which entails a combination of research methods in examining a research question (Arnold & Clinton, 2008). Triangulation assists researchers in enhancing their findings in a deeper presentation of a phenomenon. An example of triangulation is using combined research methods, qualitative and quantitative ones. One benefit of triangulation is evident in earnings management, where archival studies on the topic have failed to prove that managers misstate the firms’ earnings convincingly. Archival research employs the use of secondary data, making it difficult to determine proxies of managing of earnings. Several models developed for this proxy are unable to distinguish accurately amid opportunistic behavior of managers and true performance. Another archival research limitation is the inability to tap the managers’ incentives into earnings management. This research type has founded its argument on economic theory in an attempt to explain the occurrence of earnings management (Cozby, 2009). It is hard to confirm beyond doubt that firms with the motivating factors such bonuses, debts covenants and political reasons undertake earnings management because of these factors. Behavioral researches have tried to handle these shortcomings by giving proof of the behavior of earnings management, which has greater construct validity (implying easily to measure and define) than archival perspective. However, behavioral methods are prone to threats associated with construct validity (Arnold & Clinton, 2008). In order to construct validity of a research method, the strengths and limitations of both internal and external validity are considered. Triangulation and multi-research methods are essential as they minimize the shortcomings of a single method. These methods also have their limitations, but they are less intensive than single methods. Earnings Measurement Reliability Several methods can detect and measure earnings management empirically. The most discretional method is the discretional accrual, which assumes that managers can depend on their discretional ability concerning some accruals to use as the proxy testing of earnings management (J. W. Creswell & J. D. Creswell, 2009). Another method is single accrual where only one of accrual types, say depreciation estimates, exists. This method is ineffective because of difficulty in establishing the exceptional accrual required to manage earnings. In the distribution method of earnings management testing, loss reporting is avoided (McKee, 2005). References Anfara, V. A., & Mertz, N. T. (2006). Theoretical frameworks in qualitative research. Thousand Oaks, Calif: SAGE Publications. Arnold, V., & Clinton, B. D. (2008). Advances in accounting behavioral research: Volume 11. Bingley, UK: Emerald JAI. Cozby, P. C. (2009). Methods in behavioral research (10th ed.). Boston: McGraw Hill Higher Education. ISBN: 9780073370224. Creswell, J. W., & Creswell, J. D. (2009). Fast fundamentals: Mixed methods research: Developments, debates, and dilemma. San Francisco: Berrett-Koehler Publishers. McKee, T. E. (2005). Earnings management: An executive perspective. Mason, Ohio: Thomson. Ronen, J., & Yaari, V. (2011). Earnings management: Emerging insights in theory, practice, and research. New York: Springer. Trochim, W., & Donnelly, J. (2008). The research methods knowledge base (3rd ed.). Mason, OH: Cengage. ISBN: 9781592602919. Zikmund, W., Babin, B. J., Carr, J. C., & Griffin, M. (2010). Business research methods (8th ed.). Mason, OH: Thomson/South-Western. ISBN: 9781439080672. Read More