Do Banks and Companies Misstate Profits through Accounting Techniques - Term Paper Example

Do companies misstate profits through accounting techniques? I. Introduction Recently, the four largest Australian banks have been under scrutiny. A month ago, media reported that Australian banks have earned record profits in 2010 (Bell 2010). Yet, just a few months earlier in 2009, Elliot (2009) in an Australian Broadcasting Corporation report described Australian banks to be as bad as AIG, a bank associated with both the US and world crises, an allusion that Australian banks are in crisis and that the supposed crises of Australian banks would lead to an economic crisis in Australia. The rapidity with which banks are able to project a bad or rosy financial picture suggest that businesses are able to window dress their books quickly. Are banks and private companies misstating company figures to make it appear that they are either losing or earning lower profits through accounting techniques? Companies employ accountants to make financial reports. Thus, from the perspective of accounting, what can we say on the situation? Are accountants being used by banks to misstate company profits? On a related point, how do we assess the “earning management techniques” with regard to their potential to be used by companies to understate company profits? In relation to the said issues, what do the professional ethics for accountants require for accounting professionals on the matter? What are some of the relevant literature on the issue? II. Literature review Some of the relevant materials on the subject matter being addressed by this work were the works of Mitre and Rodrigue (2002), Turner and Wheatley (2003), Laux (2003), and Lev (2003). Mitra and Rodrigue (2002, p. 185) defined earnings management as management’s “intentional and opportunistic manipulation of financial reports for personal gain”. According to Mitra and Rodriguqe (2002, p. 185), there are three ways of earning management: via structuring of revenues and expenses, changes in accounting procedures, and accruals management (Mitra and Rodrigue 2002, p. 185). However, Mitra and Rodrigue (2002, p. 185) had stressed that accruals management is the most damaging to the usefulness of accounting reports because investors are made unaware of the extent of accruals. Nevertheless, Mitra and Rodrigue (2002, p. 185) clarified that earnings management does not always a negative connotation because management may have implemented an earnings management to provide a conservative or more realistic earning figures based on the GAAP or Generally Accepted Accounting Principles. Mitra and Rodrigue explained (2002, p. 185) that opportunistic behaviour arise from earnings management because it is empirically difficult to differentiate earnings management that is opportunistic from what is done in the interest of a conservative portrayal of the company situation. The Mitra and Rodrigue (2002, p. 185) assessment is that management or researchers “generally take an opportunistic perspective” in view of the difficulty of separating legitimate from what is illegitimate in earnings management. Turner and Wheatley (2003, p. 61) acknowledged that current accounting principles, auditing standards, and SEC reporting regulations allow managers to implement an “inappropriate earnings management”. To support their claim, the authors identified 34 companies that published financial misstatements but which also corrected the misstatements a year later (Turner and Wheatley 2003, p. 61). According to the authors, management subsequent “correction” of “astute control over the creation of a misstatement” benefits a company just as a misstatement may have been deliberately made in the interest of the company. The authors narrated that the Financial Executives Research Foundation reported that the number of companies restating published financial statements due to an error were higher than earlier figures: the figure of 464 for the 3-year period 1998-2000 for the United States was higher than the earlier 10-year period (Turner and Wheatley 2003, p. 61). Turner and Wheatley (2003, p. 61) pointed out that while “restatements may well have been correcting unintentional errors”; some of the companies may have engaged in “earnings management”. Laux (2003) take a different tack on earning management and asked: is earnings management a friend or foe? However, the work of Laux (2003) actually contains three main points. Laux’s (2003) first point is that earnings management is not new. According to Lau (2003, p. 73), at least one aspect of earnings management has been known even before 1981 and cited the work of Ronen and Sadan (1981) as authors who made a summary of empirical studies on earnings management that have been written as of 1981. Laux’s (2003) second point is that earnings management is an expected outcome of following the GAAP or the Generally Accepted Accounting Principles. This is because the GAAP guidelines offer flexibility in how a financial report is presented (Laux 2003, p. 73). Laux (2003, p. 74) asserted that earnings management is a natural outcome of flexibility or choices inherent in the GAAP and that, “exercised with appropriate economic judgment”, earnings management is actually a “friend” to both accountants and non-accountants. Earnings management is a friend to accountants because accountants would have a choice on how economic reality can be represented better (2003, p. 74). At the same time, earnings management also provides a way for stockholders to maximize their wealth. For example, given a financial management objective of maximizing wealth, earnings management through income smoothing can reduce variability in expected cash flows to prevent the drive-down of equity costs and so that share price can be maximized (Laux 2003, p. 74). Laux (2003, p. 74) described “income smoothing” as a form of earnings management. Further, Laux (2003, p. 74) argued that recent changes in compensation structures increased the inducement to earnings management in order to maximize short-term stock price. Worse, the capital markets’ emphasis on short-term profitability makes earnings management a way of life for business (Laux 2003, p. 74). Adopting the perspective of Parfet, Laux (2003, p. 74) said that a distinction can be made between “intervening to hide real operating performance” and “good” or “reasonable and proper practices”. Thus, the real issue is not earnings management but between fraudulent reporting and the use of GAAP-approved choice (Laux 2003, p. 74). On this matter, Laux (2003, p. 75) pointed out that in addressing the use of earnings management for fraudulent practices, the solution would lie in raising the ethical bar once more. Finally, Laux’s (2003) third point is that earnings management is not necessarily detrimental to efficient capital markets. Laux (2003, p. 74) asserted that when earnings management are able to show the transient from the permanent, then earnings management can actually promote capital efficiency. In view of the three main points, Laux (2003, p. 75) suggested that it is useful for both the accounting academicians and the public to have a handbook on earnings management techniques and how each industry practices financial reporting. Lev (2003) identified some of the relevant points related to earnings management. First, manipulation of earnings is playing a major part in widening the gap between earnings and taxable income (Lev 2003, p. 27). Second, the number of earnings restatements by public companies has been increasing (Lev 2003, p. 27). Third, the number of firms beating financial analyst forecasts has been increasing as well (Lev 3003, p. 28). Fourth, determination of corporate financial statement involves judgment on earnings and cost items, estimates based on historical trend, estimates as work is performed, changes in estimates, and assumptions on the purchasing value of a currency (Lev 2003, p. 30-31). Fifth, fraudulent earnings figures can only be identified relative to true earnings but accounting has options on how true earnings can be presented, there can be several interpretations on what would constitute true earnings, and there is a role for judgment (Lev 3003, p. 30-31). Sixth, with time, earnings rely less on judgment and their consistency with reality can increase (Lev 2003, p. 31). Seventh, there can be GAAP-consistent as well as GAAP-violating manipulations that can be made to affect investor perceptions on corporate earnings (Lev 2003, p. 34-35). Eight, earning manipulation is often perpetrated to portray business as normal and facilitate fundraising by enterprises or satisfy contractual arrangements (Lev 2003, p. 36). Ninth, financial restatements are allowed in the accounting profession (Lev 2003, p. 38). Finally or tenth, earnings manipulation is prevalent but except for some cases, it is hard to detect and prosecute (Lev 2003, p. 48). Gul (2006, p. 61) identified the issues and challenges surrounding the accounting professions. The issues and challenges are in the key areas of accounting standards, independent audit, regulatory systems, and corporate governance systems. The GAAP or the Generally Accepted Accounting Principles (GAAPs) have been criticised because they principles use historical cost accounting given that market focus on value (Gul 2006, p. 61). In reporting earnings, accountants face companies who want to announce earnings that bolster their stock price and analysts who want to anticipate the numbers so they can advise their clients and build their credibility in the process (Gul 2006, p. 62). The other factors that provide impetus for companies to manage earnings are the need for managers to be paid a bonus, to address debt requirements, to negotiate union contracts, or avoid political and regulatory requirements (Gul 2006, p. 62). Meanwhile, according to Gul (2006, p. 62- 640, there are five types of earnings management that companies can use. The first type of revenue management is known as “big bath charges” that takes place as companies understate current earnings to guarantee that they can report an outstanding performance in the future for the purpose of bolstering stock price or encouraging a frenzy of stock purchases in favour of their company (Gul 2006, p. 62). The second type of revenue management is known as “creative acquisition accounting” (Gul 2006, p. 63). Gul (2006, p. 63) described “creative acquisition accounting” as the tricks companies use to protect future earnings figures at the time of company acquisition. One way to achieve this, for example, is through writing off items like R&D expenditures and the like so future earning numbers will be inflated by the write-off (Gul 2006, p. 63-64). The third type of earnings management is known as “miscellaneous cookie jar reserves” (Gul 2006, p. 64). One example of this is through overestimating future liabilities to create a fund that can be used to create an earnings picture (Gul 2006, p. 64). The fourth type of earnings management is known as “materiality” (Gul 2006, p. 64). The technique involves deliberately recording errors so future earnings can be inflated (Gul 2006, p. 64). Finally, the fifth type of earnings management is known as “revenue recognition” and involves scheduling when to reflect sales and costs to put revenues and profits into the desired periods (Gul 2006, p. 64). Gul (2006, p. 65) pointed out that most of the earnings management arise because management can use accruals, i.e., Earnings – Cash Flow + Accruals. Although not all accruals are associated with opportunistic earnings management, managers can use accruals to alter the earnings picture of the firm (Gul 2006, p. 65). Rules-based versus principles-based accounting system can affect the extent to which companies can use earnings managements (Gul 2006, p. 67). Clear and specific rules can lead to adhering to the letter of the standard while rules based on principles can lead only to adherence to the spirit of principles. The current International Financial Reporting Standard (IFRS) is an example of principles-based standards in accounting (Gul 2006, p. 67). At the same time, countries have their own variety of GAAP or Generally Accepted Accounting Principles (Gul 2006, p. 67). The said countries include Australia, Germany, and Japan (Gul 2006, p. 67). On the other hand, it is mandatory for European Union Countries to adopt the International Financial Reporting Standards (IFRS) that currently serves as the closest to a global GAAP (Gul 2006, p. 67). Gul (2006, p. 68) pointed out that independent auditors have an important role in the process, whether the standards or principles are observed in the accounting process. Unfortunately, however, Gul (2006, p. 68) pointed out the several studies provide evidence that companies have engaged in opinion shopping in choosing the independent auditors for their firms. We now go to the analysis of the problems addressed by this work. III. Analysis The literature we have discussed indicate that cases exist where fraudulent reporting of earnings and profit takes place. However, even if this is the case, it does not seem that a company would be able to sustain the fraudulent activity for so long because in one way or the other the fraudulent presentation of earnings and profits is bound to be discovered. The discovery of fraudulent reporting comes as stocks failed to yield a respectable dividend or as independent auditors finally report an error or misstatement for an earnings report failure to adhere to generally accepted accounting practices. Of course, this is to say that there is no need to combat fraud in the reporting of company earnings and profit. Even if fraudulent reports or presentation of company earnings and profit are bound to be discovered, the continuing need to combat fraud remains. The social costs of fraud includes the misstatement of company earnings and profit the can cause the overvaluation of stock prices. People will not be getting their money’s worth and a lot of people can lose money. People could have purchase the stocks of the fraudulent company making fraudulent reports and by then they would have already lost their money. At the same time, there can be the less unscrupulous but unscrupulous just the same who may engage in earnings management or managed reporting of company earnings. The motive for managed reporting may involve optimizing returns for corporate fund-raising especially as the short-term financial picture are unable to represent the long-term trend in profitability. Yet, it is not the accountant’s role to sell stocks nor paint a rosy financial picture of the company. The role of the accountant is to assess the financial condition of the company or provide the basic data that would indicate a company’s financial condition. It is not the role of the accountant to paint a rosy picture of the firm so the firm is able to raise funds for its operations. The role of the accountant is to paint an objective financial condition of the company consistent with the generally accepted accounting practices. Yet, at the same time, there are options available to the accountant on how the firm’s financial conditions would best be represented. Should the accountant describe the financial condition of the firm consistent with the firm’s likely long-term picture or with the firm’s financial difficulties at a particular time moment? The accountant’s answer to question will likely determine his or her judgment on how he or she would describe the firm and what methodology he or she would use to describe the firm consistent with the generally accepted accounting principles or GAAP. An accounting book by McKee (2005), differentiates between legal and illegal earnings management which also known as “cooking the books”. McKee (2005, p. 1) defined earning management as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”. McKee (2005, p. 1) stressed that “earnings management is not to be confused with illegal activities to manipulate financial statements and report results that do not reflect economic reality. At the same time, McKee (2005, p. 1) recognized that executives are confronted with tremendous pressure to cross the line between legal and ethical earnings management to “cooking the books”. McKee (2005, p. 2) even reported that in 1998 for example, a survey indicated that about 45 percent of accountants surveyed were asked by their employers to misrepresent their company’s financial conditions and 38 percent of those surveyed admitted complying with their employers’ demands. McKee (2005, p. 2) concluded that the practice of earnings management is a pervasive phenomenon in the accounting profession. Under Section 100.1 of the International Ethics Standards Board of Accountant (IESBA) Code of Ethics for Professional Accountants, the International Federation of Accountants (2010, p. 9) defined that “a distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest”. Section 100.1 of the IESBA Code of Ethics further said that, “therefore, a professional accountant’s responsibility is not exclusively to act in the public interest”. Faced with the prospect of using his work for possible window dressing for fraud, Section 100.2 (c) most likely applies, “apply safeguards, when necessary to eliminate the threats or reduce them to acceptable level” in order that “compliance with the fundamental principles is not compromised”. The APES 110 Code of ethics affirms the standards of the IESBA (APESB 2010, p. 12). Citing Section 100.5 of the IESBA, the APES 110 points out accountants are required to comply with the following fundamental principles: 1. Integrity or to be honest. 2. Objectivity or not allowing bias, conflict of interest or undue influence of others to override professional or business judgment. 3. Professional competence or to act based on current developments in practice, legislation and techniques 4. Confidentiality or respect for the confidentiality of information 5. Professional behaviour or complying with relevant laws and regulation and avoiding any act that discredit the profession. Under Section 310 of the IESBA, APES 110 recognizes that employers may be under pressure by clients to facilitate unethical or illegal earnings management strategies, lie to regulators and auditors, misrepresent facts, and related acts but APES 110 citing Section 310 of the IESBA, affirms that that the fundamental duty of the accountant is to support only the legitimate and ethical objectives of employers (APESB 2010, p. 124). Consistent with this, the APES 110 Code of ethics invoking Section 310.3 of the IESBA, prescribes that Australian accountants must implement steps to reduce or eliminate threats to ethical practice of accounting by obtaining advice from authorities within the employing organisation, independent professional advisor or relevant professional body, availing dispute resolution processes, and seeking legal advice (APESB 2010, p. 124). Thus, it is clear that based on the IESBA and APES 110, the accountants professional conduct is circumscribed within acts that promotes public interest even as he or she provides services to clients as an accountant. In summing up, while earnings management is practiced in the accounting profession, there are ethical and non-ethical earnings management as an accountant seeks for the best ways to present the financial or economic condition of the company. However, international professional accounting ethics as well as accounting ethics in Australia requires that accounting professionals uphold their responsibility to uphold public interest and resist pressures and overtures from employers to “cook the books”. IV. Conclusion and Recommendation Thus, with regard to the question: are banks and private companies misstating their company figures? The obvious answer to the question is that it is very likely as earnings management is pervasive. However, while some of them may be illegal or unethical, some of the earnings management may be consistent with accounting procedures. Are accountants being used to misstate company profits? The answer to the question is most likely based on the discussion of this work as well as on the survey reported by McKee (2005). On the question of how do we assess “earnings management techniques” with regard to their potential to be used by companies to understate company profits, the answer to the question is that the potential is very high even if some of the companies may have no malice for the misstatement in view of several judgments and interpretations that can be made based on a set of figures. Nevertheless, accounting code of ethics require that an accountant uphold the public interest. In line with the discussions of this work, the key recommendation of this work is that accountants must continually arrive at unities to have a common method for presenting the short-term and long-term financial condition of the company. This work hereby the support the move from working within “generally accepted accounting principles” to “common accounting techniques”. However, moving into the direction will require some time and the movement may not take place now but in the long run. Reference APESB (Accounting Professional & Ethical Standards Board), 2010. APES 110 Code of ethics for professional accountants. Bell, A., 2010. Banks regroup for funding challenge. Trading Room News, 23 December. Available from: http://www.tradingroom.com.au/apps/view_breaking_news_article.ac?page=/data/news_research/published/2010/12/357/catf_101223_164500_2775.html [Accessed 14 January 2011]. Elliot, T., 2009. Why Australia’s banks are almost as bad as AIG. ABC the drum unleashed, 19 March. Available from: http://www.abc.net.au/unleashed/31286.html [Accessed 14 January 2011]. Gul, F., 2006. Some emerging issues and challenges facing the accounting profession. The International Journal of Accounting, Governance & Society, 1, 61-77. International Federation of Accountants, 2010. Handbook of the code of ethics for the professional accountant. New York: International Federation of Accountants. Laux, J., 2003. Earnings management: Friend or foe? Journal of Business & Economic Research, 1 (11), 73-76. Lev, B., 2003. Corporate earnings: Facts and fiction. Journal of Economic Perspectives, 17 (2), 27-50. McKee, T., 2005. Earnings management: An executive perspective. South-Western Educational Publication. Mitra, S. and Rodrigue, J., 2002. Discretionary accounting accruals: A methodological issue in earnings management research. Journal of Forensic Accounting, Volume 3, 185-206. Parfet, W., 2000. Accounting subjectivity and earnings management. Accounting Horizons, 14 (4), 481-488. Ronen, J. and Sadan, S., 1981. Smoothing income numbers: Objectives, means, and implications. Massachusetts: Addison-Wesley Publication Company. Turner, J. and Wheatley, C., 2003. Stealth earnings management: Counting the same beans twice. Journal of Forensic Accounting, Volume 4, 61-76. Read More