Financial Management VS Fraud - Essay Example

Financial Management VS Fraud (Name) (University) Abstract The key issue surrounding accountings research is the degree to which management becomes a fraud financially and the level to which it is permitted to run reported earnings. This paper explains what financial reporting and earnings management entail, their distinguishing framework as offered by the existing literature, the reason why management intent and accounting standards cannot provide enough differentiation between both and how they overlap in some cases. 1.0 Introduction According to FASB, (1984), financial reports play an essential responsibility in communicating information on finance in a credible and or timely manner. Earnings numbers, key elements of these annual reports is used by outsiders for decision making regarding the company. To increase or decrease existing earnings in comparison to their ‘unmanageable point, managers have incentives and the ability to run reported earnings. Even with the attempts made in providing frameworks to differentiate financial reporting fraud from earnings management behavior, there has not been any agreement so far. Most frameworks argue that complying with accounting regulations and management intent can offer a defined distinction between financial fraud and earnings management. In support of the argument, the following are considered: 1. Definition and features of management in earnings 2. Definition and features of financial fraud 3. Common frameworks for distinction between earnings management and financial reporting fraud 4. The overlap within earnings management and financial reporting fraud Definition and Features of Earnings Management There are several ways to define management of earnings. For example, Wahlenand Healy (1999), argue that earnings management takes place in the case where managers exercise judgment in organizing financial report transactions to adjust them in order to manipulate outcomes of contracts that relying on accounting numbers reported or otherwise mislead stakeholders on the causal company’s economic performance. However, other researchers suggest that earnings management occurs for the sole function of signaling. This means that reported earnings can be a source of information of management’s user’s choice of accounting for estimates or policies are thought to be realistic signals of the basic economy of a firm. For example, according to Schipper (1989), earnings management means “disclosure management”, to mean a focused intervention to the process of external finance reporting, with an aim of acquiring personal gain for managers or shareholders. Earnings management can also occur when managers apply their authority over members of accounting with or in absence of restrictions (D. Fields et.al, 2000). The above definitions also highlight common features in earnings manipulation practices. First, they underline that behavior of earnings management refer to deliberate and purposeful actions undertaken by management with the aim of adjusting reported earnings. Hence, earnings management differs from unintentional errors, like incorrect entering of numbers in accounting. The second feature states that earnings management is achievable through business transactions or accounting system of the company. Reported earning is artificially affected when managers use this method. It involves using judgments or estimates acceptable by accounting regulation, such as obligations for pension benefits, recovering of long term assets values and predictable lives and other benefits of post-employment, bad debt losses, deferred taxes and impairments of assets. It is can be achieved by also making alterations in standard and methods of accounting, which include prospect to hinder changes from FIFO to LIFO or rather inventory valuations’ weighted average. This is referred to as real earnings management due to its attempts to manage flows of cash thus expenses and revenues associated with operations. It includes manipulation of real transactions to adjust reported earnings by planning them in a way to obtain desired results. Examples include changing production, reducing prices, discretionary expenditures, inclusive of SGA and R&D and debt-equity swaps. Definition and Features of Financial Reporting Fraud According to the United States National Commission for financial reporting fraud (1987), financial reporting fraud is a reckless and intended conduct even when done by omission or act by a material act to misleads statements of finance (Rocco.1998). Comiskey and Mulford (2002), argue that financial reporting becomes fraudulent when an intention to deceive is conceived prior to deceiving users of financial statements materially. According to Prosser (1971), elements of fraud include; representation mad; using false knowledge; false representation of a material fact; a person acts by representing; and person in acting gets destroyed by their reliance. There are four common features in any fraud case (Wells, 2009): subsequent damages reliance on the false statement by the victim, intent to deceive and a material false statement. According to Ali and Mahdi (2009), fraud is the intended distortion of financial statements by a person external or internal to power carried out to hide misappropriation of assets for gain. It can be undertaken for the organization (tax fraud) or against organization (financial reporting fraud) and can be carried out by people outside organization (customers or venders) or inside organization (management or employees). Common Frameworks for Distinguishing Between Earnings Management and Fraud Previous literature regarding financial reporting fraud and earnings management explicitly or implicitly explain that complying with management intent and standards are the most essential factors of distinction between earnings management fraud. Skinner and Dechow (2000), argue that differing types managerial options can be characterized, stressing a clear distinction in concepts between fraudulent accounting practices-which display clear intentions of deception. However, they explain that without objective evidence of intent, it is difficult. Briton and Stlowy (2004), provide a framework of distinction of the terms above by defining earnings management as the use of management’s authority to plan transactions in order to ensure possibilities of transfer of wealth between managers, fund providers or company and society. In this framework, manipulation falling outside standards and law constitute fraud, while activities of earnings management, creative accounting or big bath accounting remain within law. Yaping (2005) offers a framework for earnings manipulation that provides three forms; creative accounting, earnings management fraud and earnings management. According to the existing framework, earning frauds done via practicing authority accorded laws of corporate and accounting standard or organizing activities in a manner that anticipates value of the firm is not negatively affected, hence referring to this as earnings management or it becomes a manipulation. According to Rath and San (2008), earnings management can be classified on the basis that literature has defined discretions of management that fall under acceptable accounting principles (GAAP), to be earnings management while commission of security exchange (SEC) stretches the scrutinizing of earnings management criteria to clear fraudulent accounting. The Overlap between Earnings Management and Financial Fraud Firms take actions ranging from decisions within accounting principles to absolute fraud in order to adjust their financial results. This view draws to distinguish financial fraud from legitimate earnings management. Determining when or whether the character in earnings management crossed legitimacy line to fraud aunt an easy task due to various reasons; First, in some cases, financial fraud and earnings management have same elements. For example, they both have the objective of deceiving and misleading the financial information users. According to Lougee and Perols (2011), both have same objective but differ in that earnings management is within acceptable accenting principles whereas fraud is outside general accounting principles (GAAP). Secondly, earnings management practices through accounting accruals normally result into a fraud. Sweenery, Sloan and Dechow (1996) argues that most firms with an increasing number of accruals to either deal with the reversal of this aftermath or surrender to a fraud to make up for the reversal. Previous year accruals might cause firms to lack ways of managing earnings, thus when handling their reversal, managers may engage in fraudulent activates (Beneish, 1997). The third reason is the fact that they are both driven by similar incentives. Research shows that components of cash flow and earnings are ran to meet analysts forecast (Burgstahler and Dichev, 1997). Firms also engage in earnings management to shun debt covenant or maximize on their compensation (Balsam, 1998). The form reason is the huge number of accounting policies in that during application there is no clarity beyond the level of legality or illegality of a policy. For example, estimation of expense may be legal if realistic and within spirit of accounting but illegal if the amount estimated is extreme... All reasons above make the establishment of a distinction between fraud and earnings management a challenging task. As both entail the intention of deception and considering that the establishment of the intent conceit, apart from the section of perpetrators, this difference cannot be established through managerial intent on its own. Conclusion Financial reporting fraud and earnings management have many features in common, such motivation of gaining private gain and aim to deceive. Previous attempts to distinguish the two terms rely on the factors of compliance with accounting standards and management intent. However; it is not possible to measure management intent unless they state to be acting with the intention to deceiving financial information users. Complying with accounting regulations is at a position to provide an easy distinction between these behaviors as there are standards of comparison. However, in many cases standards state clearly when they are applying estimations so judgment remains in the bounders of standard principles of accounting. Earning management is also taken by maneuvering real business of the firm’s transaction. However, this further complicates distinguishing process. This paper justifies more study to look into the previous frameworks for distinction between financial fraud and earnings management. References Amar, A. B., & Abaoub, E. (2010). Earnings Management Thresholds: The Case in Tunisia, Asian. Academy of Management Journal of Accounting and Finance, 6(2), 35-5 Badertscher, B. A. (2011). Overvaluation and the choice of alternative earnings management mechanisms. The Accounting Review, 86(5), 1491-1518 Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of accounting and economics, 24(1), 99-126. Baker, T., Collins, D., & Reitenga, A. (2003). Stock option compensation and earnings management incentives. Journal of Accounting, Auditing & Finance, 18(4), 557-582. Beneish, M. D. (1997). Detecting GAAP violation: Implications for assessing earnings management among firms with extreme financial performance. Journal of accounting and public policy, 16(3), 271-309. Bartov, E., & Mohanram, P. (2004). Private information, earnings manipulations, and executive stock-option exercises. The Accounting Review, 79(4), 889-920. Brown, L. D. (2001). A temporal analysis of earnings surprises: Profits versus losses. Journal of Accounting Research, 39(2), 221-241. Cohen, D. A., & Zarowin, P. (2010). Accrual-based and real earnings management activities around seasoned equity offerings. Journal of Accounting and Economics, 50(1), 2-19. Dechow, P. M., & Skinner, D. J. (2000). Earnings management: Reconciling the views of accounting. Danos, P., Holt, D. L., & Imhoff, E. A. (1989). The use of accounting information in bank lending decisions. Accounting, Organizations and Society, 14(3), 235-246. Erickson, M., Hanlon, M., & Maydew, E. L. (2006). Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research, 44(1), 113-143. Fields, T. D., Lys, T. Z., & Vincent, L. (2001). Empirical research on accounting choice. Journal of accounting and economics, 31(1), 255-307. Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate reporting. Journal of accounting and economics, 40(1), 3-73. financial Healy, P. M. (1985). The effect of bonus schemes on accounting decisions. Journal of accounting and economics, 7(1), 85-107. Jones, M. J. (2011). Creative accounting, fraud and international accounting scandals. John Wiley & Sons. Read More