Accounting Earnings Management - Term Paper Example

s 21 May, Accounting Earnings Management Today is the world of severe competition which makes all the players in both global and domestic market, makes insecure and fight for the market share. It is because of this insecurity and fear of loss, that management these days, do not let go any alternative that can make them fake a better and secured position. Hence, companies do not even mind deceiving their stakeholders by playing with numbers. But, while landing for this option, companies completely ignore the hard core fact that the short term gains by managing earnings will result in long term costs which will not only harm their financials but their reputation and future too. Despite this, the practice has been a part of financial reporting for ages, however, now is the need to segregate little manipulation of figures in financial statements from the criminal acts of deceiving users of financial statements. This essay will focus on various aspects of earrings management, initiating with a brief explanation of what the practice is, how companies manage earnings and what is the need for such a practice. The climax will include IAS37 requirements’ ability to narrow down the scope for earnings management and my opinion on whether the practice should be completely eradicated. What is earnings management? Managing earnings simply means showing an artificial or pseudo increase or decrease in revenue, profits, and earnings per share figures in the financial statements of a company. Obviously this practice is allowed only within the boundary set by the Generally Accepted Accounting Principles (GAAP). In other words, companies employ their creative skills to manage figures that can help them design financial statements to depict a position of a company which the management wants to display (Alexander, et.al., 2009, p.779). The question that arises now is how does a company’s management manage earnings and what is the motivation behind it? This leads us to the following text which will briefly answer these questions. How do companies manage earnings? The companies are given with various options to manage earnings. The most common practice revolves around the GAAP and is most targeting accruals. To explain the concept, I have chosen few most common techniques that several companies’ management at different times, to give the desired, healthy look to their financial position. Big bath: When a company wants to avoid showing successive losses each year, it resorts to show a onetime restructuring cost which is huge enough to oppose the losses during the past couple of years. This is termed as taking a ‘big bath’ (Alexander, et.al., 2009, p.778). Cookie jar: Companies use this technique to either overstate bad debt expense or understate revenues so that the company’s financials remain on safe side in the successive years. The management decides to overstate the bad debt expense, when the revenues touch a record height. This is done, so that even if the revenues go down, the bad debt expense recorded will be low. Companies also understate their revenues to give an inflated look to the unearned revenues. This is done to provide cushion to the possible fall in revenue in the subsequent years. (Alexander, et.al., 2009, p.778). Another way in which companies manage their earnings is by managing their transactions. They might want to increase their revenue right close to the year end, so that they can show operational efficiency. This particularly happens when companies are in growth stage and in severe need of additional financing (Alexander, et.al., 2009, p.778). What drives companies to manage earnings? I believe that there can never be one reason which drives earnings management; rather there must be a cluster of reasons which motivates such a behavior. There are various external and internal factors which pressurize the companies to manage earnings (Duncan, 2001). I will very briefly discuss these factors in the following paragraphs. Companies bear high pressure from external factors to manage their earnings so that they can have positive growth forecast and performance appraisal by both; stock and credit analysts. Companies are also under pressure to maintain an edge in revenue and market share so as to compete effectively. Moreover, there are various contractual requirements in the shape of debt covenants, where a company has to maintain a specific EPS or debt ratio etc. Another huge pressure that the management bears is by the stockholders’ expectations to continually raise the stock price in the stock market (Duncan, 2001). Hence, under such immense pressure, the companies resort to managing their earnings instead of exhibiting their actual ability in any situation. Internal factors include culture and personal motivations of the management to give a healthy glow to their financial statements. Most of the times, companies have such culture that adopts a short term focus on performance, disregarding the long term consequences. This approach puts the management under pressure to devise unrealistic plans, assuming that unless the bar would be raised, the employees would not work to achieve it (Duncan, 2001). They support this behavior by promoting and compensating individuals who are able to meet the management’s expectations. Hence, due to constant pressure from superiors, management takes refuge into playing with numbers to give their desired appearance to the financial statements. Here, I would substantiate my point with the help of an example, which has not only created history in accounting frauds, but also has proved that, desire for managing earnings gets instilled into the organizational culture by top management. One such example is Enron, whose management was accused of showing inflated profits and hiding debts of more than $1 billion, by employing unlawful accounting practices. Not only this, but they were also accused of bribing the government and manipulating the energy markets in Texas and California (Nakayama, 2002). With the collapse of such an empire, a share which was of $90 in 2001; was worth stones by the end of the same year. The reason behind Enron’s collapse can be idealistically placed into different categories, but the root of the collapse was inculcated within its organization culture, where the top management did not encourage employees who could bring about better performance, but motivated employees to show better results by hook or by crook. It was the blind desire of the top management to keep the stock prices high, which forced the executives to resort to illegal practices. However, despite all their efforts, the collapse not only crashed their market performance but also the credibility of their employees. The question that arises now is to what extent does the law hinder earnings management? IAS37 has laid requirements for companies to fulfill, so that managing earnings can become a bit trickier path for the management to adopt. It reduces the scope for managing earnings by establishing strict rules and definitions for accounts like provisions, restructuring, contingent liabilities and assets. IAS 37 requires companies to disclose complete information like name, time, uncertainty, assumptions and reimbursement for each class of provision, in the notes to financial statements (IAS Plus, 2010). Hence, by providing clear guidelines to treat accounts which provide room for manipulation by the management, IAS 37 requirements do narrow down the scope of earnings management. However, the practice cannot be altogether hindered. Should earnings management be eradicated? The question so posed cannot be answered by keeping one party’s perspective in mind. Each stakeholder’s response to earnings management has to be undertaken. Beginning with the economic point of view, managing earnings helps companies to establish a stronger position, which is turn improves activities in the stock exchange, eventually, attracting foreign investment for the country. From the management’s point of view, manipulating figures helps them generate more wealth for the owners, in other words, greater ROI. From the investors’ and creditors’ point of view, it, on one side, provides lucrative offers for putting money on, however, in actuality; the company feigns being an attractive opportunity. This analysis makes it clear that managing earnings apparently is a profitable option for all, the economy, the company and all its stakeholders. But, in the long run, each stakeholder will have to pay the price for being short-sighted. It is unbelievable to expect even that earnings management would get eradicated completely, (Collier, 2004), however, auditors and regulatory authorities should devise such policies and plans that choke up the room for managing earnings to an extent that it becomes a horrendous fraud. I believe that, earnings management can help newer companies to acquire growth, and to prove their worth in terms of EPS, revenues etc. however, an innocent act of manipulating few figures to give a safe position, transforms into huge frauds due to unimpeded superficiality and lack of consistent reality check. I am of view that earnings management is a need of companies today, otherwise, neither economy nor companies will be able to keep up with the fast growing expectations of the stakeholders, but at the same time, it is harmful for all in the long-run. Therefore, I believe that the scope of earnings management should be narrowed down to such an extent that it becomes quite a tough task for the management to fake good health through their financial statements. I support proactive approach which is far-sighted and results in slow but consistent gains. References: Alexander et.al., 2009. International Financial Reporting and Analysis. 4th ed. London: Thompson Learning, pp.772-791 Collier, J., 2004. Aggressive Earnings Management- Is it still a threat? The Institute of Chartered Accountancy, London [Online] Available at: www.frc.org.uk/images/uploaded/documents/aggrressive.pdf [Accessed 15 May 2010] Duncan, J.R., 2001. Twenty Pressures To Manage Earnings. The CPA Journal, [Online] Available at: http://www.nysscpa.org/cpajournal/2001/0700/features/f073201.htm. [Accessed 15 May 2010] IAS Plus, 2010. Summaries of International Financial Reporting Standards. IAS Plus [Online] Available at: http://www.iasplus.com/standard/ias37.htm [Accessed 15 May 2010] Nakayama, A., 2002. Lessons from the Enron Scandal. [Online] Available at: http://www.scu.edu/ethics/publications/ethicalperspectives/enronlessons.html [Accessed 15 May 2010] Read More