Conflicts In Earnings Management - Essay Example

 Conflicts in Earnings Management Abstract In the contemporary business environment, the effect of manipulated accounting figures has proven to be devastating for a company as well as other associated parties. It should be taken into consideration that the financial losses caused due to accounting frauds, such as, misrepresentation of financial statements, are humongous. Such setbacks are detrimental not only for the company, but also for the economy as a whole. Preventing such accounting frauds has become the priority of auditors as well as other accounting regulatory bodies. As a result, a number of regulations have been formulated to monitor the way in which accounting is done within an organization. However, accounting frauds are still prevalent with those regulations in place, particularly due to the ever increasing interests of human beings as well as weaker internal control and corporate governance framework. It has to be kept in mind that financial information serves as an important tool of guidance, enabling decisions makers to make well-informed decisions. Therefore, it becomes imperative for companies to set up a robust internal control system in order to present a fair and transparent reflection of the companies' performance to the market participants. Introduction Empirical studies suggest that managers have the propensity to report earnings that exceed the forecast of analysts, precisely because negative earnings surprises tend to trigger adverse market responses and critical judgment of managerial ability and performance (Alves, 2012; Badertscher, 2011). This fact leads companies to implement strategies that reduce the likelihood of undershooting expectations of the analysts. Several authors have explained that companies may avoid reporting negative earnings in a number of ways. One of those ways is to apply discretionary accruals in order to manipulate earnings in the positive direction, which is also referred as accrual based earnings management (Badertscher, et al, 2009; Cohen, Dey & Lys, 2008). Another way is to adopt the real earnings management technique, where managers undertake actual economic actions so as to maintain accounting appearances. Although earnings management technique is employed only to meet forecast of the analysts, it entails a fair share of consequences when this technique abused (Gerakos, 2012, Hunton, Libby & Mazza, 2006). This fact leads the researcher to comment on accounting fraud, whose occurrences has plagued the world economy significantly. Accounting fraud can be committed by individuals in the form of implementing earnings management techniques frequently or by abusing the creative accounting methods. There are a number of motives that might compel an individual to take such an action (Das & Kim, 2011). Firstly, companies might resort to account manipulation strategy in order to conceal their poor financial condition in front of the market participants so as to prevent propagation of a negative signal (Cornett, Marcus & Tehranian, 2008; Desender, et al, 2011). On the other hand, resorting to accounting manipulation techniques can also be associated with personal interests of the managers, where their compensation depends on earnings generated by a company in a particular year. In this case, managers may report the company earnings to be far higher than the actual amount in order to rip the benefits that come in the form of profit based compensation. However, accounting fraud has often given rise to severe consequences in the form of inefficient pricing of equity and debt precisely because it generates unrealistic expectations. Unrealistic expectations in turn significantly affect decision making ability of the investors and any other interested parties. Consequently, wrong decisions taken by the investors result in huge financial loss, which thereafter becomes a domino effect, deteriorating stability of the entire economy. This is one of the many reasons and perhaps the most significant one that justifies the situation of the present day world economy, which is very fragile and sensitive. Empirical investigations have also pointed out that presenting falsified information within financial statements and annual reports damages current state of the economy by leading the users of accounting information to make faulty decisions. Nonetheless, some managers reap maximum benefit out of such manipulations, thereby comprising on stability of both the company and the economy as a whole. It has also been noted that managers tend to overlook the accounting standards and choose those techniques that enables them to meet their ends and expectations. Although this approach seems to be profitable in the short-term, it has always proven to be destructive for the company in long run. Accounting manipulation is an issue that has become contagious over the due course of time as well as increasingly complex. Owing to this fact, a number of regulations have been formulated by accounting regulatory bodies, which are directed towards identifying and eliminating accounting fraud. Although these regulations have proven to be beneficial in terms of keeping a check over abusive accounting practices, there still have been few cases of accounting fraud that have come to the light. These facts form the context of this particular research, where the researcher would be mainly emphasizing on problems created by presenting falsified figures, misrepresenting accounting data and abusing creative accounting techniques with the underlying aim of recognizing a common problem. Effects of prior earnings management practices Earnings management practices are employed frequently by the company managers in order to avoid negative earnings surprises, which prevents propagation of a negative signal throughout the market (Ho, Liu & Ouyang, 2012). In addition to that, managers also have another string motive to adopt earnings management technique and avoid negative earnings surprises because these entail negative responses from market participants (Choy, 2012). Furthermore, empirical researches have revealed that companies that meet or beat forecast of the financial analysts are able to experience a considerably higher return during the earnings announcement date compared to those companies that report negative earnings surprises (Magrath & Weld, 2012; McNichols & Stubben, 2008). Moreover, it has also been reported that companies with positive earnings surprises realize substantially higher returns and market values over the subsequent quarters (Das & Kim, 2011). These positive earnings surprises are reported with the help of earnings management methods. Although earnings management techniques are legitimate, this technique comes with its fair share of consequences (Ewert & Wagenhofer, 2005; Llukani, 2013). The following effects have been analyzed on the basis of inter-temporal relation between accruals and the supposition that earnings management is not free. It can be realized from the following effects that prior earnings management adversely affects the current cost of earnings management as well as flexibility that is available to managers in three separate ways mentioned below. Reversal Effect: Given the fact that discretionary accruals need to have a sum of zero over a company's life, it is imperative that inflated earnings reported in one quarter must reverse in the following quarters. These reversals always reduce the reported earnings in subsequent quarters. For example, in 2002, a company called Amdocs Limited was charged with the allegation of understating reserves for doubtful accounts in the financial year 2001. When those doubtful accounts became uncollectible in 2002, the company was compelled to write them off. As a result of these write offs, the company's earnings dropped significantly in 2002, which in turn triggered the lawsuits. Such circumstances occurred due to an earnings management technique adopted by the company managers, which instead of proving to be beneficial for the company, had led them to incur huge losses (Dechow, et al, 2012). Constraints effect: Due to the fact that a company's net operating assets as well as accruals are very closely tied to business operations, companies that have unusually high levels of accruals with respect to their operating activities are perceived either as overstating their values or inefficient in utilizing assets. Such perception in turn will stir up suspicion of the auditors, regulators as well as analysts. Hence, it can be said that acquiring accruals beyond the limit can prove to be costly for a company. In contrast to the reversal effect of positive accruals that always has the propensity to reduce the current reported earnings, the unreserved positive discretionary accruals restrict a company's flexibility only if its present pre-managed earnings are lower than certain targets such as, the forecasts of an analyst. In this case, it becomes imperative for the company to manage its earnings. This means that unreserved discretionary accruals puts a limit to the accruals that can be incurred, which in turn increases costs for the company (Dechow, et al, 2012). Ratchet effect: In addition to the constraint and reversal effects, earnings management in the ongoing quarter raises expectations of the investors and analysts regarding future earnings as well as performance benchmark of the subsequent quarters. Provided the fact that the pre-managed earnings in two quarters are the same, inflated earnings by a certain dollar amount in first quarter can reduce the earnings in the second quarter, if the managers fail to inflate earnings in the second quarter by the inflated amount of the first quarter. This strategy in turn increases the cost of earnings management and gives rise to domino effect, which is why probability of the company to miss the benchmark in subsequent quarters increases by a certain margin (Dechow, et al, 2012). The analysis conducted in this section suggests that both discretionary and non-discretionary accruals that have been incurred by a company in the previous quarter have a significant impact on the reported earnings as well as flexibility in the ongoing quarter. On the other hand, given the fact that non-discretionary accruals are normally a function of the company's business operations and the market's anticipated level of accruals includes reversal effect of the accruals, the present quarter earnings management flexibility is restricted only due to discretionary accruals accumulated in the previous quarters (Roychowdhury, 2006; Shih-Wei, Fengyi & Wenchang, 2012). It has to be kept in mind that the reversal rate of accruals is the actual determinate of the number of following quarters that will be affected by the three effects of accruals mentioned above. A sluggish reversal rate will cause the present accruals to reverse in the subsequent quarters, thereby impacting upon the reported earnings of that specific quarter. The sluggish rate of reversal will also lead to amplification in number of the quarters whose flexibility limits are reduced by the current accruals. Therefore, it will lower the discretion of the company's manager in those quarters. As a consequence, a company's flexibility in any particular quarter is a function of its previous discretionary accruals as well as the reversal rate of those accruals (Dechow, et al, 2012). This fact justifies the statement that although earnings management is a legitimate activity performed by almost every company manager, it will lead the company to incur severe losses when the manipulated earnings are not dealt with appropriately in the subsequent quarters. As a result of improper earnings management, accounting expectative often tend to complicate the accounting figures in the financial statements of companies, which in turn makes it difficult for the users of those financial information to interpret the data and make sound decisions. Though earnings management cannot be necessarily termed as a fraudulent activity, yet it certainly is a form of legitimate accounting manipulation, which if not done properly may lead to severe consequences. These facts has influenced the researcher to perform an in-depth research on actual accounting misstatements, where companies tend to falsify the figures in their accounting books so as to make them appear prospective for investment in front of the market participants (mainly investors). Accounting misstatement and its corresponding impact Financial and accounting information is a touchstone of the economy. Inadequate financial and accounting information may forbid decision makers from making any decision on the economy of their respective country. The ultimate purpose of accounting and financial information is to provide an idea to the users of such information and facilitate informed choices. Putting this fact in the context of a company, it can be said that accounting and financial information enables interested parties such as, investors, to make an assessment of the financial position of a particular company and thereafter make an informed choice whether or not to invest in the same. Any false information may lead the investors to invest in an unprofitable company, which may lead to them incur huge losses. False information is reported sometimes by mistake and in some cases with full intention, which is termed as fraud or in generic terms, accounting fraud. When these accounting frauds come into light, investors gradually start withdrawing their investments from those companies, which ultimately results in the company's failure. There are several distinct definitions of accounting information manipulation. Accounting information manipulation in this context is termed as accounting misstatement or in other words, intentional fraudulent financial reporting. Fraudulent account reporting is defiance of the accounting standards in the form of manipulation of accounting figures, creating a false representation of a company. The fundamental purpose of accounting misstatement is to mislead investors by publishing financial reports that do not give a fair representation of a company's financial performance and position. Accounting figure manipulation prevents investors from making well-informed decisions. As a consequence, it is imperative for the auditors (both internal as well as external) and regulators to identify cases of accounting fraud and prevent the same before publication of a company's financial reports. Several models have been developed by academic scholars that have the capability to predict any form of manipulation of accounting figures. Despite this fact, accounting fraud is still being reported by companies and has proven to be very destructive. The major forms of accounting manipulation are earnings management, creative accounting and income smoothing practices. Other similar forms of accounting manipulation techniques adopted by the managers are big bath accounting, aggressive accounting, accounting errors and irregularities as well as fraudulent financial reporting. Application of some of the above mentioned techniques are acceptable if they are well within the accounting standards. Then again, if the accounting standard is exceeded, then it becomes a serious fraud, where the company has to face severe consequences. The worst of which is humongous loss and imminent bankruptcy. This fact holds true for a number of companies and the one which is the most famous is that of WorldCom. Incentives of accounting manipulation According to the comments of experiential research scholars, there are several factors that incentivize accounting officials or managers to manipulate accounting figures. Amplifying price of the company's shares, managerial remuneration and commensuration schemes, conformity to the clauses of debt covenants, reduction of certain costs due to organizational or political reasons, reducing the payment of taxes and providing a better picture of the company's performance and financial situation to the market participants to avoid propagation of negative signals are some of the factors that incentivize managers to manipulate accounting figures within the company books. The basic benefit derived from proper accounting and financial information is lowering of financial cost of the projects undertaken by the company. Nevertheless, one of the incentives for manipulating accounting figures is to obtain resources at the lowest possible cost. Although adopting such practices makes the company look profitable, it is only a short-term benefit. In the long run, such practices prove to be fatal for the company's operational life. Impact and consequences of accounting misstatement As long as the control mechanisms within organizations are weak and the standards of accounting are too flexible, accounting fraud will be inevitable. Considering the fact that the world has become globalized, any positive or negative event has an all-encompassing effect. Accounting fraud is mostly committed in developed countries and unless personal interest of the human beings is reduced therein, accounting fraud will continue to occur. Given the fact that the American economy is highly dominant, any fraudulent activity and subsequent outcome affects other countries and their economies as well. Quantifying the cost of occupational fraud is a highly imperative as well as challenging endeavor. However, arguably the actual cost of accounting fraud is incalculable. The intrinsically clandestine nature of fraud suggests that many cases will never come to the light and the full amount of losses will never be recovered, quantified or reported. As a result, any quantification of occupational fraud costs will be at best approximations. Collapse of giant companies in the US has triggered a massive shockwave in economies all over the world. Inadequate preventive measurements can be cited as a reason for inevitability of the accounting frauds. Accounting misstatements have cost the investors billions of dollars over the last decade or so. Accounting statements manipulation and fraud has received substantial attention from the press, investors, public, regulatory bodies and financial communities precisely because of high profile fraud cases that have been reported such as, those of Xerox, Cendant, Lucent, WorldCom, Sunbeam, Enron Corporation, Tyco and Adelphia. The top level executives of the above mentioned companies were accused of misrepresenting accounting figures in the company books. Most of them were indicted and subsequently convicted. The collapse of energy giant Enron alone caused a loss of $70 billion in market capitalization, which proved to be devastating for numerous investors, pensioners as well as employees. The collapse of WorldCom due to accounting fraud is the biggest bankruptcy witnessed in the American history. According to Cotton (2002), the combined loss of market capitalization due to the accounting manipulations done by WorldCom, Tyco, Enron, Global Crossing and Qwest is estimated to be about $460 billion. The information brought forth in this section implies that market participants suffer hugely because of accounting misstatements. As a result of such fraudulent activities, the organization as well as the society has to incur a substantial amount of capital loss. It is apparent that accounting manipulations will continue to deteriorate stability of an economy in multiple areas, which enables the rich to become richer while the poor becomes poorer. Having done a rigorous study of the accounting manipulations, the fundamental problem that can be identified is weak internal control within companies, which can be arguably stated as the major reason behind occurrences of the fraudulent activities. The case of WorldCom From 1999 until 2002, WorldCom had suffered a massive accounting fraud, which is probably the largest accounting fraud witnessed in the history of the US. As massive as the fraud was, it was committed in a comparatively mundane way, where more than $9 billion unsupported or false accounting entrees were made in the company's financial books for achieving favorable reported financial results. The fraud did not involve the company's technology, network or engineering. A majority of WorldCom's employees did not have any idea of the accounting fraud. On the contrary, the accounting fraud occurred as a result of intended violations directed by certain top level executives based in the company's headquarters in Clinton, Mississippi. Such violations were a collaborative effort of a number of personnel in the company's accounting and financial departments in several locations. The accounting fraud was a consequence of ways in which the top level executives operated within the company. They overlooked the accounting regulations and chose to adopt their own accounting techniques in order to fulfill personal interests. That the fraud continued as long as it did, it was largely due to the lack of courage shown by other employees to blow the whistle and foreground the misconducts taking place within the company's accounting and finance departments. Moreover, improper audit conducted by both internal as well as external auditors and inefficient financial system control can also be cited as reasons for such an enormous accounting fraud. The setting wherein this fraud occurred was marked by severe failure of corporate governance and internal control (SEC, 2003). WorldCom's inappropriate accounting had taken two principal forms; minimization of the company's reported line costs and overstatement of the reported revenues. The underlying objective behind these efforts was to keep reported line costs to approximately 42% of revenues and to maintain reporting double digit revenue growth even when the actual growth was considerably lower (SEC, 2003). In order to be able to achieve its objectives, WorldCom resorted to implementation of the creative accounting techniques. Creative accounting can be defined as the application of accounting knowledge in order to influence the reported accounting and financial figures while remaining within the jurisdiction of accounting regulations so that instead of portraying actual financial position of the company, officials are able to present information to the stakeholders that is desired by the management. The application of creative accounting is acceptable as long as it falls within the jurisdiction. Even so, if the jurisdiction is not followed, then the application of such a method may give rise to accounting frauds. This fact holds true for WorldCom. The underlying reasons for managers to resort to the application of creative accounting knowledge are the need to meet internal targets, that of meeting expectations of shareholders as well as stakeholders, the necessity to provide income smoothing and the requirement for window dressing for an IPO or a loan, during taxation or change of management (Shah, Butt & Tariq, 2011). In order to meet the above mentioned needs, managers have often abused the technique of creative accounting. The reasons behind such audacious act are weak corporate governance framework as well as inadequate internal control within an organization. In such organizations, mangers have the propensity to overlook the accounting regulations and choose their own accounting methods that allow them to obtain desired results, thereby compromising on performance of the company. This is the common problem that serves as a catalyst to all problems that are discussed in this study. Importance of internal control in preventing accounting fraud In actuality, the term control is a touchstone for identification of fraud in accounting and financial information. Hence, if the internal control is managed appropriately, then the company will be able to provide a transparent view of its financial position to the market participants. A robust internal control will enable the users of accounting information such as, investors and creditors, to make informed decision regarding a company or the economy as a whole. If such is not done, then resources maybe improperly allocated, which can prove to be devastating for the investors as well as the company. Internal control plays a crucial role in preventing investors as well as company managers from making irrational decisions. In addition, existence of a robust internal control within a company will prevent any misappropriation of asset and misstatement of accounting figures within the company books, before the financial statements are published and henceforth distributed to the public. Empirical researches done in this field have consistently claimed that an effective and efficient internal control system is a robust means of identifying, preventing and correcting frauds and errors. Nevertheless, the presence of a robust internal control does not alone guarantee the complete prevention of accounting fraud. It is imperative for companies to have strategic and efficient anti-fraud control in place within their organizational framework, which will function in complete collaboration with the internal control and ensure fair and transparent representation of a company's performance (Isa, 2011). Conclusion Accounting fraud has become a global problem. The financial losses incurred by companies because of accounting fraud are huge and should be prevented at the earliest. However, it has to be kept in mind that preventing frauds in accounting statements can prove to be costly. This is precisely why the companies tend to avoid investing in setting up detection system that would identify accounting fraud. Companies that resort to fraudulent activities may benefit materially in the short-term but in long run, such strategies always prove to be harmful. The personal interests of company officials have a key role in influencing them to indulge in such practices. As a consequence, this problem has become increasingly complex and the regulators and auditors are unable to prevent such activities from taking place. Weak internal control can be attributed to these fraudulent occurrences. 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