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

 Earnings Management: The Continuum from Legitimacy to Fraud Introduction Currently, fraudulent auditors’ reports and many other options of fraud occurrence in the process of money earning cannot be denied. Fraud in earnings management can occur on the following reasons: fraudulent financial reporting (financial misstatements) or misappropriation of assets. To define “earnings management” one can say that this term refers to legitimate and illegitimate actions by management, exerting a negative influence on the entity’s earnings. Thus, it is appropriate to define this term under the following conditions: both legitimate managerial activities on the one hand and the spectrum of fraudulent financial reporting on the other hand. A scope of qualitative issues Various managerial activities can be hazardous for earnings allocation and distribution and earnings management can be a challenging issue. Different earnings management activities are focused on legitimate choices focused on account provision for transactions and for other events (e.g. when accounting estimates and judgments are in compliance with generally accepted accounting principles (GAAP). Legitimate management decisions can be influential for reported earnings. There is an intentional measure taken in the process of earnings management, such as fictitious transactions constituting constitute fraud. There are many cases, when the right-of-return privilege has been concealed from the auditor and fraudulent reporting occurs. It is appropriate to focus on exact facts and their influence on occurrence of fraud earnings management. Further consideration is devoted to the internal and external influential factors in the area of earnings management. Of course, the main emphasis is made on legal basis of earnings management and processing, but very often some other secondary triggers can evoke a reason for fraud. Therefore, in the process of earnings management there are many different activities, which cannot be easily classified. There is a continuum ranging from legitimacy to fraud. There are many factors, which exert influence on earnings management. Under certain conditions GAAP is focused on effects disclosure of these decisions in certain financial statements. There is a need for disclosure under the SEC’s rules and regulations for MD&A (Keim and Grant, 2003). GAAP distinguishes legitimate earnings management from fraud. Nevertheless, it is an ambiguous question if to decide whether the process of earnings management continuum is above the limit of legitimacy and is closer to fraud or not. Levitt (1998) claimed: “Accountants are wise enough to know they cannot anticipate every business structure, or every new and innovative transaction, so they develop principles that allow for flexibility to adapt to changing circumstances. That's why the highest standards of objectivity, integrity and judgment can't be the exception. They must be the rule”. World practice of accounting management has many different examples illustrating fraud in management practices. Thus, a well-known example of Enron illustrates malpractice of the company, which used different dubious practices in accounting, e.g. third party investors, subsidiary accounting etc (Gallhofer & Haslam, 2003). Fair policies in accounting are the utmost question for the modern companies. Earning management illustrates goodwill of the company. There are different legal documents regulating fair policies in accounting management and earnings management. The Sarbanes-Oxley Act is directed on accurate and reliable corporate disclosures provisions (Keim&Grant, 2003). Auditor involved should develop his practice with respect to the following regulations: “remaining alert, through observation and making inquiries as necessary, for evidence of noncompliance with relevant ethical requirements by members of the engagement team, determining the appropriate action if matters come to the engagement partner's attention that indicate that members of the engagement team have not complied with relevant ethical requirements, and forming a conclusion on compliance with independence requirements that apply to the audit engagement” (Statement on Auditing Standards, 2010). There is no doubt that auditors should be much focused on fraud detection and its distinguishing from legal practices in earnings management. There are many external factors, which can intensify the possibility of fraud occurrence, such as pressures within and outside the entity. There is a famous expression by Chairman Levitt: “Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices” (Levitt, 1998). It is evident that earnings management and auditing requires numerous improvements in financial reporting. Personal factors are also influential triggers of a potential fraud. Thus, it should be taken into account that the system of rewards to management is not of efficient level and managers may feel at a great loss and try to gain profits in the process of fraudulent actions. Concealment is another obvious fact of fraud. Auditors can be cheated and facts of fraud will be concealed from them for sure. There are three parties in a mutual interaction: stakeholders, boards of the directors, managers, auditors. Fraudulent practices happen because of flexible and shabby practices of earnings management. Conclusion To meet financial goals boards of directors are subjected to external pressure from stakeholders and they are forcing their management team to introduce fraudulent practices to ensure financial growth of the company. This is a kind of a vicious circle and legitimate practices in earnings management can cut this Gordian knot. Accountants and managers should develop their professional practices wisely enough to preserve goodwill of the company. Moreover, the avoidance of flexibility of earnings management is the dominant concern for every business structure. On the other hand, it is necessary for any company to be able to adapt to changing circumstances. Objectivity and fair judgment and analysis in the process of earnings management is a must. Therefore, any accounting management company should be focused on various aspects of its practices, but the ethical concerns and legitimate practices should be beyond fraud and legitimate practices of earnings management should be the main concern for the managers, accountants and others involved in this process for sure. Modern researchers and scholars are focused on development and improvement on auditory practices and earnings/financial management. Consequently, a legal basis for fraud disclosure is focused on development of regulations of earnings management. Moreover, maintenance and control at the governmental and the local level over earnings distribution, analysis etc. On the basis of GAAP legitimate earnings are classified with respect to management and fraud. It is interesting to mention that earnings management continuum is often above the limit of legitimacy and is closer to fraud. References American Psychological Association. (2010). 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