Earnings Management In Corporate Entities - Dissertation Example

Earnings Management In Corporate Entities Problem ment Earnings management is a form of creative accounting that has been discussed widely inaccounting literature over the past twenty years. Earnings management could lead to creative accounting, but it could also be carried out in a legal manner and way. To some schools of thought, earning management is an inevitable element of accounting and managing. This is because managers have to set targets by forecasting profits and working in the year to meet it. However, in the quest to meet the targeted forecast, there are constraints which might lead to the need to manipulate some elements of the financial accounts at the year-end in order to appear to have met the targets that are set. From the argument that earning management is inevitable, it is conclusive that the managers and persons charged with the day-to-day management and running of a business have the obligation and need to carry out earning management. However, to a large extent, the success or failure of earning management depends on three classes of stakeholders: corporate governance, internal audit and external audit. It is therefore propitious to study and identify the main elements and structures of earning management and how it relates to these triumvirate stakeholders. Research Aim and Objectives The aim of this research is to examine the role of corporate governance, internal audit and external audit in the UK in earning management activities in the UK. In attaining this end, the following objectives would be explored: 1. A critical analysis of the relationship between earning targets and earning management. 2. Examination of the relationship between accrual choices and beating and meeting forecasts in creating earning management issues. 3. An evaluation of the role of corporate governance and internal audit in detecting and dealing with the accrual choices and forecasts in earning management issues 4. An assessment of the role of external auditors in detecting accruals problems and how it affects earning management. Rationale for Research This research is an opportunity for the researcher to apply the concepts and ideas of the taught cause of the Master's Degree program to a practical problem in the real life. It would enable the researcher to apply important ideas and concepts in solving a real-life problem and this would inevitably add up to the knowledge base of the topic and subject of earnings management. The research would build on important ideas and research that was carried out on the topic in the past. It would enable the research to undertake a fresh inquiry into the matter of earnings management and get new perspectives and ideas into the topic. Finally, the research is in partial fulfillment of the researcher's Masters Degree. This is a mandatory element and structure for the completion of the Master's Degree program. It is, therefore, being turned in to meet the mandatory requirements of the course. Literature Review This section would undertake a basic inquiry into the fundamental concepts that are going to be discussed and analyzed in the actual research. The section would look at the important variables and elements and what they mean prior to the commencement of the study and the definition of the methodology to be used. Definition of Earning Management "Earning management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports either to mislead some stakeholders about underlying economic performance of the company or to influence contractual outcomes that are based on reported accounting numbers" (Ronen and Yaari, 2011: p26). Basically, a company has targets and that it needs to meet. A company's managers often get targets and standards that they should meet in the short term and the long run. With that at the back of their minds, managers work hard to meet these targets. However, in doing this, there are so many constraints and variables that a company's management ought to be sensitive to. This includes the need for the satisfaction of all stakeholders and all groups of people. Hence, it can be said that managers work from the known to the unknown. In other words, they are given targets and they work through all eventualities and activities to meet the targets that have been given to them. The famous question arises as to what happens when the management fails to meet the targets that have been given to them. Would a manager be so honest to turn in the real figures and get disdained and lose his career without a fight? Or would a manager try to find ways and means of dealing with the situation through the use of further tightening of the reporting figures to attain the end that has been given to them? Naturally, most managers find ways of smoothing figures by utilizing and sometimes abusing the loopholes in the system of reporting and accounting. Mulford and Comiskyu argue that “given that managers can choose accounting policies from a set (eg. GAAP), it is natural to expect that they will choose policies so as to maximise their own utility and/or market value of the firm” (2010: p81). Thus, most managers would influence the use of different techniques that would present the figures for the period as though they met the targets that were given to them at the beginning of the period. "Companies manage earnings whey the ask: how can we best report desire results? Rather than how can we best report economic reality (the actual results)" (Marnet, 2009: p35). This indicates that earning management refers to a situation where managers report figures to reflect the desired end rather than what actually happened in the period. Earning management is about how to manipulate figures to an expected end. This is because of the flexibility of management to choose attractive accounting methods ahead of some fixed and predetermined methods of disclosing figures (Belkaoui, 2011). Accounting Elements in Earnings Management Belkaoui (2010) identifies that earnings management is carried out through the inherent loopholes in the concept of accruals which is the basis of accounting. From the accounting equation, there are two ways of deriving Total Accruals. Total Accruals = Reported Net Income – Net Cash Flows from Operations ----------- (1) Alternatively Total Accruals = Non-discretionary Accruals + Discretionary Accruals -----------------(2) From these two basic equations of accounting, the net gains or the net profits under accrual accounting is as a result of a simple deduction of income fewer cash flows. Now, this appears to be objective and straightforward. However, it is not so fixed or laid out. When you examine the equation (2) closely, you can deduce that the total accruals or the identification of net income and net cash flows from operations are done through a combination of discretionary and non-discretionary elements. The non-discretionary elements of accruals are objective and hence, they are fixed. However, the discretionary elements are subjective. In other words, the managers are the ones who will have to decide on which methods to use to account for these subjective accruals. Belkaoui (2010) identifies that there are some elements of the financial statement that are susceptible to being used for earning management. This include: 1. Depreciation: Generally, depreciation is seen as a change in estimation technique, rather than a change in accounting policy. Hence, a company's management might be able to change it if there is sufficient reason to do so. This could be done with some degree of flexibility and used opportunistically. 2. Loan Loss Reserves: These are also elements that are fixed by management rather than the board or top level directors. Thus, a company's management can either expand or shrink it if it would bring about some degree of advantage and get them closer to meeting the targets that were set for them at the beginning of the period. 3. Deferred Tax Valuation: The method used to value deferred tax can be varied opportunistically. This can be used for a high degree of earnings management (Bissessur, 2011). Thus the management of a business can either sanction an aggressive or conservative accounting system if the earning targets that are set for them and the accounting realities make it imperative for them to do so (Bissesur, 2011). Inducers of Earning Management A company is running through a series of corporate decisions. These decisions are in sync with the company's corporate governors' standards and expectations. Users of financial statements and other stakeholders often expect a company to do well. Hence, managers come up with targets and standards. Typically, standards include "forecast earnings" which include how much the firm needs to attain and rise in the period through sales (Salter and Sharp, 2012). The sensitivity of setting forecasts is to ensure that the firm maintains a stable earning. When earnings fall below the previous year's earnings, the earning per share would drop and the company would not be very attractive to investors (Willekens and Sercu, 2010: p16). However, in reality, this forecast earning might not be the same as the actual earnings of the company. This means that the people charged with management would either have to come up with an explanation for very high disparities or they would risk being replaced (Salter and Sharp, 2012). Hence, most of these managers end up finding ways and means of making the actual earnings appear to be as close as the targeted amounts wherever possible. Corporate Structures and Earning Management As identified above, a company's top level directors are the ones who set the annual targets for the company's managers. Professor Millichamp (2011) identifies that a company is formed through a situation where the shareholders or owners pool their resources to form the capital for the entity. Hence, the company effectively belongs to these shareholders and they always need to supervise activities of the company when it starts operating. Thus, directors are the main representatives of the owners and they set targets and standards for the company (Millichamp, 2011). The directors operate as a board which is more superior than the managers who run the day-to-day affairs of the company. The board of directors is representatives of shareholders who play an oversight role over the company's managers. "An effective board is a board that constraints earning management and financial reporting manipulations" (Willekens and Sercu, 2010: p16). Thus, the board of directors would have to ensure that the company's managers do not indulge in earning management practices which are seen as unethical and misleading. The independent board of directors has the obligation to ensure that there are proper supervision methods and systems that keep the managers in check (Willekens and Sercu, 2010: p16). Thus, the board of directors is required by the COSO framework to appoint an audit committee and a risk management committee to undertake the supervision and assessment of risks and potential issues in the running of the company. This leads to the formation of the internal audit team in the organization. On the other hand, Millichamp identifies that the Company's Code of Britain requires companies to conduct annual audits to ascertain the truth and fairness of the accounts presented by the directors (2011). Thus, the external auditors work with the internal audit team to identify the possibility of earning management and other issues in the operation of a firm. Research Matters From the literature review, it is expected that the Board of Directors finds independent ways of ascertaining and dealing with earning management and profit smoothing efforts in the operation of firms. They also need to identify the weaknesses in the firm and report on them. Internal auditors are deployed by firms by the people charged with corporate governance to examine activities of a firm. In theory, this means that earning management is not likely to occur in a firm. However, it happens and people report it in numerous activities in most companies. Methodology This portion of the research would examine the research methodology and approach that would be used to conduct the inquiry into the topic. This section would cover the definition of research variables, research data collection, data analysis, discussions, and conclusions. Variables of the Research According to Kothari, "the dependent variable is the output or effects which are tested to ascertain its role in the causation of something" (2005: p44). On the other hand, the independent variable is the inputs or the causes that are examined to find out if they are the cause of the issue or not (Kothari, 2005). In modeling the research, the occurrence of earning management would be the dependent variable. In other words, it would be output that would be tested to ascertain the actual causes and roles of the other stakeholders. The independent variable, which is the examination of inputs or weaknesses that lead to earning management would include the role of three parties: 1. The Board or Corporate Governance Elements 2. Internal Audit Team 3. External Audits Data Collection The data for the research would be collected through external auditors. A sample of firms to be studied would be defined after interviewing three different external auditors who have detected pervasive earning management trends. Through these external auditors, there would be the examination of the earning management trends and the role of external auditors, internal auditors, and the board would be determined. For each of the firms, a minimum of three businesses involved in earning management practices would be examined. A total of ten firms involved in earning management practices would be examined to ascertain the various roles played by the three parties involved in the study. Did they condone or did they prevent it? And how did they do it? The data would be compiled and studied critically. Data Analysis Once the data is collected, there would be a statistical model that would be formulated that is appropriate to the analysis and evaluations. Findings would be examined and critiqued using the statistical model that would be chosen. The statistical analysis would lead to the identification of dominant patterns and trends in the role of the three groups of stakeholders in detecting and dealing with earnings management. Interpretation The findings and conclusions from the statistical analysis would be used for theorization. In other words, the dominant trends and findings would be used to establish actual trends and postulate future patterns and generalized trends that were observed. Ethical Considerations The issue of earning management is very sensitive. Companies involved in earning management would not be very interested in divulging important and sensitive information about their activities and practices. This means that the researcher would have to be very careful in how to solicit for information. As a solution to this, the researcher would assure the participating auditing firms that the information would not be divulged to third parties and everything would be used for research purposes only. In order to do this carefully, there would be a 'Chinese Wall' that would be built between the researcher and the firms under review. Hence, the researcher would not even solicit for the actual names of the firms involved. The information would remain privileged with the participating auditing firms. However, the researcher would send soliciting questionnaires and queries that have open and blank requirements. Post-Research Implications The research would culminate in the statement of numerous patterns and the theorization of trends and generalities. Since the actual identity of firms involved would not be divulged, the companies involved would not be known. However, general patterns would be deduced from the research. The research would also aim at identifying future matters that deserve to be researched by other works that were not covered by the study. Timescale & Plan The research would be conducted over a period of 8 weeks. The following activities would be carried out in each week. Activity/Week W1 W2 W3 W4 W5 W6 W7 W8 Acceptance of Proposal Design of Research Materials Discussions with Respondents Completion of Introduction Completion of Literature Review Commencement of Field Work Compilation of Field Works Write Up Presentation of Draft Corrections Authorization/Completion Resources and Costs Activity Description Costs Communication with Respondents Discussions with companies and partners to be involved in study £500 Transportation Costs Moving to and fro to meet participants £800 Stationery Prints and other Discussions £700 Three Focus Group Interviews with Senior and Junior Auditors involved in some of the Events Focus Group venue costs and refreshments £1,000 Total £3,000 References Belkaoui, A. R. (2010) Accounting: By Principle or By Design? Darby, PA: Greenwood Publishing Group. Belkaouui, A. R. (2011) Accounting Theory Mason, OH: Cengage Bissessur, S. W. (2011) Earnings Quality and Earnings Management.: The Role of Accounting Accruals New York: Rozenburg Publishers. Kothari, C. R. (2005) Research Methodology New Delhi: New Age Publishing. Loughney, J. (2011) Coporate Governance Cambridge: Cambridge University Press. Marnet, O. (2009) Behaviour and Reality in Corporate Governance London: Routledge Millicamp, B. (2011) Auditing London: Hodder Education. Mulford, C. and Comisky, E. (2010) The Financial Numbers Game: Detecting Creative Accounting Hoboken, NJ: John Wiley & Sons Ronen, J., and Yaari, V. (2011) Earnings Management: Emerging Insights in Theory, Practice and Research London: Springer. Salter, S. B. and Sharp, D. J. (2012) Advances in Internal Accounting London: Elsevier. Willekens, M. and Sareu, P. (2010) Corporate Governance at the Crossroads London: Intersentia. Read More