Earnings Management and Reporting Techniques - Essay Example

Earnings management Contents Contents 2 3 Introduction 3 The objective(s) of the report 3 Background of the topic 3 The importance of the topic 4 Main body of the report 5 Review of related works 5 Discussions and analysis of the research problem 9 Conclusion and recommendation 11 References 13 Abstract Earnings are key indicators of the business activities and financial performances of a company. Since, the value of the stocks of a company are measured on the basis of the present value of the future earnings of the business, therefore, the existing and potential investors and analysts primarily consider earning as an important component for determining the investment attractiveness of the stocks of a particular company. The companies with low earning prospects generally have low share prices as compared to those with high earning prospects, therefore, earnings management plays a crucial role in determining the share prices of a listed company and also impact the direct allocation of resources buy the company in the capital markets. This paper is written with the aim of researching on the earnings management and reporting techniques, focusing on the big bath technique of earnings management. Introduction The objective(s) of the report The main objective of the report is to understand the process of earnings management, especially the big bath technique of earnings management which is commonly used by companies and their managers to manipulate the reporting of the earning of the company. Background of the topic Earnings management is an important aspect of the financial management of any company. Earnings being crucial elements of the financial statements of a business, the evaluation and management of different types of earning are done by the management of any firm to ensure that the stock prices of the business remains high in the capital markets. There are many techniques that are traditionally a contemporarily applied for the management, manipulation and accounting of earnings in the financial statement publication of an enterprise. The importance of the topic The study of the topic of earnings management and the much debated technique of earnings management and manipulation which is the big bath technique is critical in the contemporary corporate world. The management of earnings can have key influences on the political and regulatory structures of a country, the economic systems and prospects in the country and can also alter the functioning of industries as well as the investor groups of the business. Additionally, it may lead to crisis situations like financial downturns, extended low periods in the economic and business cycles and can also threaten the interests of the stakeholder groups of a business1. The use of manipulative techniques in earnings management can play a key role in misleading the investors and analysts in relation to the determination of the investment profile and investment attractiveness of the stocks of the company. Main body of the report Review of related works Earnings denote the profits earned by a company2. The earnings are vital items which are added in the financial statements because they represent the extent to which the business engages in value adding activities and also indicate the way direct resource allocation is done in the capital markets3. The analysis and investors generally consider the earnings of the company to determine the investment preferences of a stock and thus, the stock prices are largely controlled by the earnings as reported in the annual reports4. The earnings determine the value of the stocks of a company which in turn are crucial in determine the investment possibilities of the company5. The stocks of any listed company can be measured through the use of the present value of the future earnings that are to be generated by the business activities6. Since, the financial statements are the only medium through which the stakeholders come to know about the financial performance of the business, the representation of the facts remain a major concern for both the companies as well as the stakeholder groups7. Earnings management can be identified to be a legal and responsible management decisions making and financial reporting that are aimed at achieving predictable and stable financial results for the next evaluation period8. Many companies use the manipulative techniques of earnings management as a way of avoiding any kind of reported red link and for maintaining earnings growth so that the financial performance is displayed as optimistic and stable9. Often these strategies are used by the management to try to deliberately manipulate the earnings of the firm to match the pre-determined target level of the earning value set for the accounting period or financial year10. This process is seen as a way of smoothing out the incomes over consecutive period of evaluation and an accounting expert can actually manipulate the incomes and other earnings in a company in various ways while remaining within the boundaries of legal and ethical practices of accounting.11 The big bath earnings management technique is a strategic tool that is used by the management of a company to maximize value for the business and minimize the financial risks that are faced by the company12. The managers of a company attempt to manipulate the actual earnings in the business for a financial year by applying specific accounting techniques which distort the actual application of GAAP to represent both present and future value of earnings of the company13. The big bath technique employs the strategy of mapping the income statement of a company so that the poor financial performance in that period can be made to look worse. This strategy is often implemented when the company has faced a bad year in terms of financial performance so that in the next year the business can show higher earnings for the period by adding up the undisclosed earnings of the company in the current reporting year14. The technique is seen as a way to satisfy the personal interest of the executives and managers rather than the interests of the stakeholders of the company15. This is because the increase in earnings shown in the next year is likely to influence large bonuses for the upper level executives of the company16. Sometimes, the new CEO of a company uses the big bath system as a strategy for blaming the poor financial performance on the previous CEO of the business and then takes the credit for good financial performance of the company in the next reporting year17. Discussions and analysis of the research problem The research analysis shows that though the techniques of earnings management like the big bet technique, the big bath technique and the cookie jar reserve technique are questioned because of their morality and ethicality, yet these techniques cannot be termed as illegal in nature. This is because; the management has the right to choose between different techniques of earnings management for taking their corporate and financial decisions18. The management of earnings also holds significance in taking managerial and corporate decisions due to which the managers of a company also have considerable incentive in managing and controlling earnings. The management of a business can achieve earnings from the perspectives of operating decisions or accounting choices because they have sufficient flexibility in using any of the two strategies19. The big bath technique in earnings management and accounting works as a system in which one time charge is incurred by the company against the income for that year so that the asset values are reduced, this strategy results in the reduction of expense in the future evaluation periods for the company20. As such, the big bath system is used to remove the assets of the company from the financial statements or books thereby enabling the company to show lesser amount of income in the income statement of the business for that particular year. The main objective of this technique is to “take one big bath” in the current accounting period so that higher net incomes can be shown in the successive years of evaluation and accounting21. The firms which practice the big bath earnings management technique are often criticized for working towards the satisfaction of the personal interests of the high level management. The companies tend to manipulate the income reporting to such an extent that they are ultimately overloaded by expenses that are attributed to the use of these kinds of earnings management techniques.22 The big bath technique acts in masking and smoothing the income differences of a company in two consecutive periods of evaluation. The process seems to be non-compliant to the accounting standards and as such is much opposed by the external auditing entities23. Conclusion and recommendation While the companies tend to use manipulative earnings management and accounting techniques for showing higher earnings, these techniques seem to be unethical from the perspective of the investors, customers and other stakeholders of the business because these manipulative techniques encourage misleading and non-transparent behavior on the part of the corporate entities. Most of the companies operating in the modern highly competitive business environment are inclined towards the use of manipulative techniques of earnings management and accounting so as to distort the actual financial information and results and show that the company is in a capable financial position to ensure high future earnings. However, these kinds of techniques are often criticized and questioned by rigorous national and international accounting standards, audit committees, international regulatory bodies. Though, the earnings management techniques like the big bath technique is seen as a tool which is used for the achievement of the self-interests of the management of a company yet it can be identified that this technique may also be useful for the stakeholder groups of the business it is implemented in an ethical and compliant manner by the company24. If ethically used under the guidelines of a sustainable and fair corporate governance system, the big bath technique for earnings management can actually lead to the welfare of the stakeholder groups. Thus, the big bath earnings management technique can be termed to be unethical but it cannot be termed as illegal because the technique uses processes and strategies that are in line with the existing accounting principles and standards. References Amat, Oman. & Cereira Gowthorpe. “Creative accounting: Nature, incidence & ethical issues”. Economics Working Papers 749. 2004. Arnold, Peter. "Global financial crisis: The challenge to accounting research", Accounting, Organizations & Society Vol. 34 (2009): 803-809. Ball, Ray. “Accounting Informs Investors & Earnings Management is Rife: Two Questionable Beliefs". Accounting Horizons, Vol.27 (2013): 847–853. Bauman, Charles. & Ricardo Halsey. “Do Firms Use the Deferred Tax Asset Valuation Allowance to Manage Earnings?” Journal of American Taxation Association, Vol. 23 (2009): 27-48. Beaver, Willliam. H. "Perspectives on recent capital market research". The Accounting Review, Vol. 77(2002): 453-474. Brennan, Michael & Anjan V. Thakor. “Earnings management, Shareholder Preferences & Dividend Policy”. Journal of Finance, Vol. 45 (2000): 993-1018. Bushman, Robert & Wayne Landsman. "The pros & cons of regulating corporate reporting: a critical review of the arguments", Accounting & Business Research, Vol. 40(2010): 259-273. Chenheiter, Masou. & Nelofar Melumad. “Can Big Bath & Earnings Smoothing Co-exist as Equilibrium Financial Reporting Strategies?” Journal of Accounting Research, Vol. 40(2002): 761-796. Christensen, Julliver. "Conceptual frameworks of accounting from an information perspective ". Accounting & Business Research, Vol. 40 (2010): 287-299. Cook, Adams. “Emission rights: From costless activity to market operations". Accounting, Organizations & Society Vol. 34(2008): 456-468. De la Torre, Ignacio. “Creative Accounting Exposed”. London: Palgrave Macmillan. 2009. Deegan, Charles. “Financial Accounting Theory”. New York: McGraw-Hill Education. 2014. Elliot, Larry. & Richard Joseph Schroth. “How companies lie: why Enron is just the tip of the iceberg”. Melbourne: Crown Business. 2002. Healy, Peter. & Wahlen, Johnson. "A review of the earnings management literature & its implications for standard setting". Accounting Horizons, Vol. 13(1999): 365-383. Landsman, Weasley. "Is fair value accounting information relevant & reliable? Evidence from capital market research”. Accounting & Business Research, Vol. 14(2007): pp. 19- 30. Laughlin, Cooper. "Critical accounting: nature, progress & prognosis". Accounting, Auditing &Accountability Journal, Vol. 12(1999): pp. 73-78. Nikolai, Bazley, & Jefferson Jones. “Intermediate Accounting”. New York: South-Western College Publishing. 2010. Oliveras, Egati. & Amat Oisheun.  “Ethics & creative accounting: Some empirical evidence on accounting for intangibles in Spain”. UPF Economics & Business Working Paper, 732. 2003. Peek, Et al. “The Use of Discretionary Provisions in Earnings Management: Evidence from the Netherlands”. Journal of International Accounting Research, Vol. 3(2004): 27-43. Rankin Michaela, Stanton Patricia. McGowan Susan., Ferlauto Kimberley. & Matthew Tilling. “Contemporary Issues in Accounting”. New York: John Wiley & Sons. 2002. Ronen, Joshua. & Varda Yaer. “Earnings Management: Emerging Insights in Theory, Practice, & Research”. Stamford: Cengage. 2009. Scott, William. “Financial Accounting Theory (5th Edition)”. New Jersey: Prentice Hall. 2009. Whittington, Geoffrey. "Measurement in Financial Reporting", ABACUS, Vol. 46(2010): 104-110. Xie, Biaeo., Wallace, Davidson. & Peter DaDalt. “Earnings management & corporate governance: the role of the board & the audit committee”. Journal of Corporate Finance. Vol. 9(2003): 295– 316. Read More