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

 Earnings Management: The Continuum from Legitimacy to Fraud Introduction The term earning management covers all the legitimate and illegitimate actions by the company's management that affects the earnings of the firm. The profit of the company is known as Earnings. The analysts and the investors check the earnings of the company to determine the position of the stocks of the company, so Earnings management is also known as smoothing of profits or creative accounting. There are different ways of managing earnings of a company. Though there are extensive accounting rules and policies to control and monitor the books of accounts or financial statements, yet some amount of flexibility or freedom is allowed. In accounting, freedom of choice is necessary to increase the efficiency of the accounting procedures However if companies want to use such methodologies for manipulating or inflating their earnings, then they can do so using creative accounting methods (Loughrey, 2011, p. 225). Earning management is a critical part of financial accounting because it provides information to the users of financial statements for interpreting and deriving conclusion about the performance of the company. Creative accounting practices are such malpractices in accounting which may be legal and in accordance with the existing standards but may not be in line with the true spirits of the rules laid down under accounting standards. In other words, when financial statements are prepared by the relevant managers of a company that is inconsistent with the purpose or intention of the existing accounting standards, then it is said to be a practice of creative accounting. The managers do so by taking advantage of the flexibilities available in the letter of the rules in accounting standards practices (Sharma, 2009, p. 82) It is not very easy to define earning management. Still, three elements can be regarded as key elements of earning management. They are: Flexibility: Accounting is always associated with flexibilities present in it. While accounting one can use their discretion to choose their own preferred way of recording sales or turnover of the company, the method of depreciation to be used by the company, the method of valuation of inventory, etc. This type of flexibility helps the managers of a company to represent the true and fair view of the company’s affairs and its earnings in the financial statements. Account Management: Accounting policies can be utilized by the managers of a company to accomplish the objectives of the management of the company and may not fulfil the essential requirements of the users. It can thus be used as a tool that can be managed and not as a means to provide true and fair view of the company. Interests of Managers: In theory, accounting information should provide relevant information to the users which can be used by them for various decision making process. Whereas in practice, earning management is more for the interest of managers rather than for the benefit of its users. Brief Literature Review Earnings management is a term which acts as a substitute for creative accounting. Trying to manipulate the earnings which are reported by the managers of a company, by taking help of some specific accounting process, is termed as earnings management. The company does so to influence its earnings in a short term horizon (Coenen, 2009). Earnings management makes use of accrual accounting. However, the main issue regarding this is that it becomes very difficult to differentiate between regular accrual accounting and earnings management (Larcker, & Tayan, 2011, p. 164). Now since management has discretion in earnings management, it can lead to fraudulent activities like wrong representation of data in the financial statements. Accounting standard boards have been striving hard to combat earning management practices followed by the companies. The accounting standards are revised often to help fill its loopholes. More and more regulatory measures are taken to keep a track on how the financial information is reported by the firms. These measures taken are proving quite effective in preventing current creative accounting practices, but the question is whether it will be able to stop these malpractices completely or not. It is indeed very difficult to put an end to earning management practices in future (Arnold, 2011, p. 167). There have been many instances of using earning management tools in different business entities. Creative accounting practices often leads to fraudulent activities and they do not happen in a vacuum. Many different parties are involved in these practices who are interested to resort to such creative accounting methodologies for their own interests. These parties include managers, regulators, auditors, shareholders, merchant bankers, etc. Creative accounting is more likely happening when a company is passing through hard times financially (Jones, 2011, p.22). Some of these evidences of creative accounting leading to fraudulent activities by companies are mentioned below: Waste Management Scandal: Waste Management Inc. is a US based company. It deals with businesses like waste management, environmental services, etc. in USA. The company was involved in a fraud resulting from creative accounting practices. It under mentioned its depreciation expenses by a huge amount in its financial statements leading to a large inflated profit figure, helping in their personal cause (Brooks, & Dunn, 2009, p. 127). The Downfall of ENRON: ENRON was one of the leading companies in USA and was well known for its innovation and aggressive approach towards market. It filed its bankruptcy in the year 2001. The reason behind this huge debacle of ENRON was its use of creative accounting leading to malpractices in its accounting policies. ENRON was able to cover up for their losses for many years by not mentioning many of it’s off the book transaction which were suffering loss (Hedlund, 2011, p. 10). The shareholders and investors of the company were unaware of those facts and the share prices continued to build up. The auditors and other regulators did not look into this matter in details which ultimately resulted in the fall of ENRON (Madura, 2009, p. 11-12). WorldCom: WorldCom was another US based company which was alleged of fraudulent accounting practices. It was one of the largest telecommunications company and is a part of the Verizon Communications Group today. It is now called as MCI. Inc. Huge debt and their corporate culture were the reasons behind their malpractices. WorldCom misrepresented their profit figures to an amount equalling $9 billion taking help of creative accounting practices (Dartmouth, n.d.). Problem Statement The problem of this study is to deal with the negative impact of earning management practiced by different organizations and how it leads to fraudulent activities conducted by them. Purpose Statement The purpose of this study is to analyze the different aspects of earning management, and the fraudulent practices followed by a company. The paper would focus on allegations and reports of earning management practices in different organization. Earning management tools are utilized to represent a healthy financial image of a company before the investors, but it is considered illegal when these tools are used to inflate the profit figures abnormally or show fake expenses in the books of accounts to reduce the yearly tax amount. So the journey of earning management from legitimate to fraud practices has been analyzed in this study. Research Questions Question 1: Can the organization become bankrupt in the future due to excessive use of earning management tools or creative accounting practices? Hypothesis: HO: Earning management practices followed by organizations has no relation of it being bankrupt in future. HA: Excessive use of earning management practices by the organizations can lead to its bankruptcy. Question 2: Does the organization knowingly get into fraudulent practices for inflating their profits, while applying earning management tools in their financial analysis? Hypothesis: HO: They are not aware of the fraudulent practices while using earning management tools. HA: They knowingly get into fraud by using earning management tools, for displaying higher profits to the investors. Question3: What is the influence of the recent accounting practices on the corporate managers and accountants? Hypothesis: HO: There is no influence of the recent accounting practices on the corporate managers or accountants. HA: The recent accounting practices have a significant impact on the corporate managers and accountants. Conclusion Earning Management is an appalling challenge to the profession of accounting. It is a problem which is not centered to certain specific countries but all the nations of the world. The managers of the companies are motivated to use earning management tools in financial reporting of the company in many ways as discussed earlier. It is not true that earning management is always bad and many arguments in favor of it are quite evident, but managers are often attracted towards using it in their own personal way (Chaturvedi, 2009, p. 83). The purpose of earning management and its usage in the organizations, from legitimate to fraudulent practices had been analyzed in this study. Hypothesis has been formed to evaluate few important questions in relation to usage of earning management and the performance of the organization. With the changes in accounting policies being adopted by a company, it creates both a favorable and unfavorable view about the company. So it can be quite misleading for the investors and shareholders of the company. Hence stricter rules must be employed to curb the available choices of accounting policies (Oliveras, & Amat, n.d, p.14). References Arnold, V. (2011). Advances in Accounting Behavioral Research. West Yorkshire: Emerald Group Publishing. Brooks, L. J., & Dunn, P. (2009). Business & Professional Ethics for Directors, Executives & Accountants (5th ed.). Connecticut: Cengage Learning. Chaturvedi, S. (2009). Financial Management: Entailing Planning for the Future. New Delhi: Global India Publications. Coenen, T. L. (2009). Expert Fraud Investigation: A Step-By-Step Guide. New Jersey: John Wiley & Sons. Dartmouth. (No date). WorldCom: Who’s really gonna notice $9 billion dollars anyway? Retrieved from: http://mba.tuck.dartmouth.edu/pages/faculty/syd.finkelstein/case_studies/03.html. Hedlund, S. (2011). Invisible Hands, Russian Experience, and Social Science: Approaches to Understanding Systemic Failure. Cambridge: Cambridge University Press. Jones, M. (2011). Creative Accounting, Fraud and International Accounting Scandals. New Jersey: John Wiley and Sons. Larcker, D., & Tayan, B. (2011). Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences. New Jersey: FT Press. Loughrey, J. (2011). Corporate Lawyers and Corporate Governance. Cambridge: Cambridge University Press. Madura, J. (2009). Financial Markets and Institutions (9th ed.). Connecticut: Cengage Learning. Oliveras, E. & Amat, O. (No date). Ethics and Creative Accounting. Retrieved from: http://upf.academia.edu/EsterOliveras/Papers/895515/Ethics_and_Creative_Accounting_Some_Empirical_Evidence_on_Accounting_for_Intangibles_in_Spain. Sharma, B. S. (2009). Accounting Management: Information for Decisions. New Delhi: Global India Publication. Total Number of Pages: 12 Read More