Incentives to Resort Extreme Earnings Management - Essay Example

Earnings Management Earnings management can be defined as a strategy to manipulate the earnings of the firm by the management of the company. In order to present an attractive outlook of the company to the shareholders and other stakeholders, management of the company deliberately applies some tactics so that the earnings of the company can provide a better insight of the company. Earnings are considered as the biggest indicator of the financial performance of the company such that the share price of the company depends highly upon the earnings forecast (Watson and Head, 2009). Stock price tend to remain stable or increase or decrease as per the earnings of the company. Management of the companies are very well aware of the importance of the earnings which is actually the driving force behind share price movements (Baker and Martin, 2011). In this way, earnings are managed by the management to attract more investors. Incentives to resort extreme earnings management Following are some incentives due to which the managers resort to extreme earnings management. These incentives are discussed as under: Analysts’ Forecast The earnings forecast made by the financial analysts is of extreme importance such that majority of the investors take their positions based upon the analysts forecast. These forecasts include not only the upcoming earnings but also take into consideration various different aspects such as size of the firm, growth rate of sales, earnings and assets, operating performance of the company, cash utilization and its resources etc. When these forecasts are made by the analysts, investors then come into action in order to take their decision whether to hold a particular stock, or sell that stock or buy that one. Under such circumstances, management of the company tries to reflect such earnings in their financial statements which can meet the expectations of analysts’ forecasts so that the impressive performance of the company can be portrayed to the investors and their investments can be attracted (Berk and DeMarzo, 2010). Contractual Reasons Contractual reasons come into action when the firm has made contracts with the providers of finance such as banks, financial institutions or even the investments banks on behalf of the public. Since these fund providers are cautious regarding their principal amount that they have lent to the company as well as the interest payments that they wish to receive, therefore, they always take a closer look at the financial performance of the company especially the performance of the earnings. If the earnings of the company are generated with a healthy growth rate, then these lenders would remain satisfied that their principal and interest amounts are secure. Under such circumstances, when the management of the firm observes its own financial performance and believes that it may not be able to satisfy the lenders due to lack of earnings, then they try to manipulate the earnings so that it can provide reasonable earnings to the lenders in order to keep them satisfied regarding the earnings performance of the company (Eckbo, 2008). Implicit Contracts Implicit contracts are those contracts which are not the written contracts. These types of the contracts are considered as quasi contracts. Companies form these contracts with suppliers and other stakeholders of the business so that it can reap other business advantages for them. For instance, suppliers of the business take a thorough look at the performance of the company. The most obvious indicator for such financial performance is the earnings reported by the company. Suppliers keep considering the earnings presented by the management so that they can take business decisions in the light of the earnings prospects of the company. Decisions such as discounts allowed, bulk quantity, longer terms etc. are of crucial importance for both the suppliers and the companies. Thus, in order to keep the better business terms with the suppliers, management of the companies manipulate the earnings in order to align it with the expected earnings forecasted by the suppliers (Brigham and Ehrhardt, 2010). Initial Public Offer Initial Public Offer (IPO) is also one of the major reasons why the firms undergo into earnings management. IPO is the offer made by the companies in order to attract more investments in the business especially from the general public. The general public is provided a document in which different areas of the business are highlighted including its financial performance, position and upcoming forecasts. Since earnings is the most defining trigger of the financial performance of the firms and every potential investor takes a look at the earnings before every other consideration. In this way, the earnings play a key role in attracting the investments through IPO. Under such circumstances, management deliberately reflects the manipulated earnings in order to prepare a well attractive IPO so that it can attract full subscription of shares. Stuffing the Channels Stuffing the channel is considered as a better approach for earnings management and remains quite effective for any single period as it is quite difficult to detect. In order to detect the sales through stuffing channels, full disclosures are required to be made which consists of sales with respect to different variables such as sales by product, by region, by segment etc. After that a very carefully designed sales analysis may likely to detect such uncommon sales trends (Fields, Lys and Vincent, 2001). Companies generally do not provide the full disclosure of their sales unless otherwise required by the auditors or accounting standards such as IFRS or GAAP. Another major issue that can be faced by the companies undertaking the stuffing the channel approach can be the resistance posed by the wholesalers or distributers to keep up so much inventory of the firms. Not being the employees of the firm, these wholesalers or distributers can also provide this information to the regulators or other business media. On a one off event of such kind in which the firm is ready to bear their cost of carriage etc. then these wholesalers and distributers may not create any disturbance for the ultimate goal of the management which is to manipulate earnings. On the other hand, if the strategy of stuffing the channel approach is considered for using in more than a year, following are the reasons that can fail this strategy: Reversal of Accruals The sales of the next year would likely be reduced due to stuffing the channel strategy. Thus, in order to increase more sales in the next year, huge stuffing would then be required in order to inflate the sales. Physical Limitations There are chances that storage and places reserved by the wholesalers may not be sufficient for this practice of stuffing the channels. Excessive Cost Wholesalers and distributers will not allow stuffing their channels free of cost. In this way, it would become extremely costly for the firms in cases where they have to pay the storage and carrying cost. On the basis of the above discussion, it can be concluded that stuffing the channels practice can be fruitful for the company in a single year time horizon. However, if this strategy is considered for a longer period of time, then the company cannot reap the benefits as intended due to heavy cost of storage and fear from regulatory authorities. Cookie Jar Accounting Cookie jar accounting can also be an effective tool for earnings management as it is not easy of being detected. Disposal of assets may have either gains or losses but there is a flexibility provided with the extent of their disclosure. Since full disclosure of the earnings is not required by GAAP, therefore the firms have the advantage of overprovisions of their disposal losses. However, at the time of reversal of provisions of such losses, there would be the gains of same amount being disclosed in the financial statements which would fulfil the objective of the firm to increase earnings. There are chances that full disclosure of uncommon and special items may inform to the market participants of efficient market that cookie jar accounting is somehow involved in the financial statements of the firm (Elliott and Hanna, 1996). Even if the firms can deceive the market participants regarding the use of cookie jar accounting and do not provide full disclosure of such reversal, the regulatory authorities can detect such issues if they find sufficient suspicions regarding this activity followed by the firms which may lead to further investigations and other punitive actions by the regulators can also be expected. Cookie jar accounting can be an effective tool for earnings management provided if it used responsibly by the management as well as in a controlled manner so that the firm can prevent itself from the eyes or regulators and market participants (Jaffe and Ross, 2004). On a concluding note, cookie jar accounting may provide the desired benefits in the form of earnings management to the firms only in case of one off application and without misuse. Otherwise, the firms might have to undergo strict penalties from the regulators. Impairment of Assets Impairment of assets occurs when expected benefits to be obtained from a particular asset become unlikely. Generally, assets are depreciated over their useful lives in a systematic way which shows the decrease in the value of the assets due to its consumption (Graham and Harvey, 2001). However, under such circumstances, when consumption is not made and an incident occurs which reduces the value of the assets, then that asset would be defined as being impaired. Such impairment loss would be charged to the statement of financial performance. Depreciation in the value of assets occurs with a systematic manner however impairment can be made at any point of time in the reporting period. Accounting standards such as GAAP and IFRS provides the guidelines to the management of the companies regarding the timings and situations when it becomes necessary for them to test the assets for any impairment loss (Gassen and Sellhorn, 2006). IFRS requires the management to conduct the impairment test for all the substantial non-current assets annually in order to check whether their value in use is greater than or equal to its recoverable amount if the asset had to be disposed. On the other hand, according to GAAP, it is quite unrealistic to conduct impairment test for every asset or class of assets every year. Rather GAAP provides another criterion for such review of asset for impairment purpose. According to this, GAAP requires the management to identify such incidents, circumstances, or situations which indicates that the carrying value of the assets or class of the assets may not be recovered (Ashbaugh and Pincus, 2001). Following are the broader guidelines provided by GAAP in order to conduct the impairment review test for a single asset or class of assets. 1. There is a considerable decrease in the market price of the asset or class of the assets. 2. There is a considerable unfavorable change in the way the asset is to be used as well as the physical condition of the asset. 3. There is a considerable unfavorable change in the legal factors associated with the asset or any change in the business climate which can hamper the value of the asset significantly. 4. There is a considerable increase in the cost of assets realized greater than the expected cost of the asset at the time of acquisition or construction feasibility. 5. There is a considerable increase in the current period loss or history of losses pertaining to that particular asset or continuing losses are projected pertaining to that asset or class of assets. 6. There is a strong belief that the asset or class of the asset might have to be disposed of before the expected useful life of the asset or class of assets Effect of Impairment Losses on Financial Performance and Position Impairment of assets can cause significant losses to companies such that their financial performance and position can be hampered significantly. Financial performance of the companies can be deteriorated as the net income is massively decreased due to the huge impairment losses booked by the companies in their statement of comprehensive income. Not only this, earnings per share becomes is worsened due to this impairment effect which is the highly significant indicator for the financial performance of any company as the analysts and the investors track earnings per share on top of every other performance indicator. As far as the financial position of the companies, is concerned, impairment of assets weakens the statement of financial position drastically such that the total value of the assets is sabotaged by a considerable amount. A weak balance sheet reflects that the company has not utilized its assets or its assets are not worthy enough to make any further investments in the business. Real World Examples If the real world examples relating to impairment of assets are taken into consideration, then the most recent examples can be of PSA Peugeot Citroen and Vodafone such that both these firms are massively affected by the significant impairment losses. PSA Peugeot Citroen reported an impairment loss of €5 billion in the year 2012. This loss is realized because the firm was quite disappointed regarding the future of the automobile industry in Europe. This impairment loss recognized by PSA Peugeot Citroen can be reflected in its statement of comprehensive income when its net loss increased to around €5.01 billion in 2012 as compared to the net income of €588 million in the preceding year. Earnings per share of the company also experienced significant downgrades such that it came up to €15.60 loss per share in 2012 as compared to €2.64 earnings per share in the year 2011. Around €3.05 billion decrease in total assets of the firm is also reported by PSA Peugeot Citroen is its statement of financial position. This indicates that how badly impairment losses have disturbed the financial statements of PSA Peugeot Citroen and so do the future prospects of the company. If the impairment charge for Vodafone is taken into consideration, it can be noted that in the last fiscal year the company had booked around £6 billion impairment of its assets. The major reason behind such impairment was the debt crisis of Eurozone especially relating to Spain in which Vodafone had to record around £3 billion impairment loss. The rest of £3 billion relates to other territories such as Japan, China and France where the telecom industry is unlikely to provide further growth opportunities. Under such circumstances, Vodafone has been actively concentrating on the emerging markets such as India and South Africa from where it is making the majority of its revenues. If the statement of comprehensive income of Vodafone is taken into account, it can be noted that the company has reported the decrease of around 40% in its net earnings with a figure of £5.6 billion in total. Conclusion On a concluding note, it can be a very difficult decision for the entities to report impairment losses especially relating to such huge amounts. However, in the broader interest and future of the companies, the management has to take these unwanted decisions which later on lead to the improved business and financial performance of the company. References Ashbaugh, H. and Pincus, M., 2001.Domestic accounting standards, international accounting standards, and the predictability of earnings. Journal of Accounting Research, 39(3), pp. 417–434. Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. Berk, Jonathan B. and DeMarzo. Peter M., 2010. Corporate finance. 2nd ed. New York: Prentice Hall. Brigham, Eugene F. and Ehrhardt, Michael C., 2010. Financial management: theory and practice. 12th ed. New York: Cengage Learning. Eckbo, Bjørn Espen., 2008. Handbook of corporate finance: empirical corporate finance. Oxford: Elsevier. JR Graham and CR Harvey, 2001. The theory and practice of corporate finance: evidence from the field. 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