Business Financial Crime: Earnings Management - Essay Example

?Business Financial Crime: Earnings Management Introduction: Financial crimes occur in businesses when there is any kind of falsification taking place in the accounting measures. This is generally carried out intentionally for the purpose of convincing others with financial results that are false, but would increase the value of the company in the industry. Such crimes may include basic company frauds, falsified claims of travel or entertainment, cheque fraud, identity fraud, misappropriation, computer related crimes, or financial statements frauds (Pickett & Pickett, 2002, pp.1-6). Earnings management is one of the popular measures of financial business crimes occurring in companies on a habitual basis. It can be defined as a process of intentional interference of the management in the establishment of the earnings of a business, misrepresenting the data to show better results than they actually are. Several reasons lead to management of earnings, which include manager’s compensation, raising stock price, or pushing for government funding. There are different strategies available that managers can use for the purpose of earnings management and hence satisfy their selfish objectives (Wild, 2006, pp.86-87). Earnings management, in exchange listed companies, is not fraud but a case of caveat emptor for investors. With regard to the increase in financial crimes in businesses, and several instances of earnings management being reported, this report would try to focus its study on the literature of earnings management and analyze the cases reported to draw a conclusion with a view on the concerned topic. Earnings Management: An Overview Earnings management is the process of intentionally misrepresenting financial data in the accounting measurements such that the company can show greater profits and more value than it actually has obtained. The process can be “cosmetic” where managers influence accruals without affecting cash flows or it can be “real” where cash flows are acted upon to manage earnings. There are three usual strategies that managers can exploit for earnings management. These include either increasing the current income, or taking a “big bath” by decreasing the current income, or income smoothing. Increasing the current income is done to represent a company more positively. It can be done for a long episode. In cases of growth, the accrual reversals are lesser than the current accruals, thereby increasing the income. The big bath strategy involves taking many write-offs in a time when performance is poor. Because of the unusual nature of the big bath, users generally discount the financial effect. In income smoothing, the managers enhance or reduce the reported revenue to reduce its volatility (Wild, 2006, pp.86-87). The maximum opportunities for earnings management lie in areas of revenue recognition, valuation of inventory, estimations of provisions like bad debts, and charges like restructuring or repair of assets. Important methods of earnings management include “Income Shifting” and “Classificatory Earnings Management”. The process of income shifting moves the income from one period to another. Accelerating or interrupting the revenues or expenses does this. This often results in turnaround of the effect, which is why this is very useful in the process of income smoothing. Earnings can also be managed by selectively classifying incomes and expenses in particular parts of the income statement. A common form of classificatory earnings management is to report expenses along with such unusual items that are given lesser importance by analysts (Wild, 2006, p.89). It is very important to identify and adjust the earnings management in the financial statement analysis because these distort the financial reports of a business. Before any conclusion is drawn by an analyst on whether a company is managing earnings or not, an analyst should check the incentives of the company, the history and reputation of the management, and the opportunities available for earnings management. Earnings are not supposed to be managed if managers do not get incentives for doing so. The integrity of the management is essential to be assessed through the study of past records of the company, the financial reports and the audits, etc. The nature of a business also needs to be judged which determines the opportunities available for a company to follow management of earnings (Wild, 2006, pp.89-90). Cases Reported on Earnings Management: Reported earnings have great power to influence the activities of a firm and hence affect the decisions taken by the management. It should be the responsibility of any company, therefore, not to involve in financial crimes, or keep management earnings within limits. The practice of earnings management ultimately leads a company into problematic situations. Let us reflect on a few examples (Mulford & Comiskey, 2002, pp.57-58). A case of Cisco Systems is known, where on measuring the performance of earnings of the company for consensus earnings, it was found that the per-share earnings of the company was $0.18, whereas analysts’ estimation was to be $0.17. It was found to be a continuous process where the process had been exceeding the analysts’ estimates. This could be happening by chance, but such possibilities were less. To this issue the chairman of the Securities and Exchange Commission found the earnings management process to be problematic (Mulford & Comiskey, 2002, p.58). Earnings management consists of actions that meet or exceed the profit projections of a company. If the annual report of any company is picked up, it can be seen how important it is for a company to show consistent and increasing earnings. In a management discussion, the annual report of Tenneco Company expressed that the strategic actions of the company were measured and guided accordingly to deliver high increases in incomes and profits. Eli Lilly had noted that it had experienced earnings for thirty-three years without a break. The annual report of Bank of America stated, “Increasing earnings per share was our most important objective for the year” (Jennings, 2008, p.258). ABS Industries was known to document bill and hold sales in the absence of customer wishes. The product that was recorded to be sold was not even billed. There was no assurance for the purchase of goods. Even the copies of invoices for the clients were damaged so that the billing could not be done. There was another company called Aviation Distribution Incorporation, which had recorded income on goods that were neither billed nor shipped. Moreover to hide such activities, false invoices and buy orders were prepared. Health Management Incorporation was known to overstate inventories in order to increase the earnings (Mulford & Comiskey, 2002, pp.69-70). Research on German companies has shown that companies have become more aggressive in increasing earnings around their initial public offerings date than during any other time. The argument lies that the managers have incentives to increase earnings to support high prices of stock. Investors cannot understand the extent to which companies engage themselves in earnings management. This ultimately leads to a negative elongated post IPO performance (Gregoriou, 2006, p.282). Earnings Management and the Business Financial Crimes: Earnings management seems to be a resourceful behavior, which is meant to trail some objective that has been estimated from before. For example, if a company earns profits less than what had been estimated, then it may try to adopt management of earnings to show an overstated income (Ronen & Yaari, 2007, p.14). Overstating incomes and properties and understating expenses and liabilities are the common forms of financial frauds. Management generally commits these frauds owing to the pressure they have to suffer to meet estimated figures. This pressure may arise from the analysts, or may be the shareholders, or it may also be the result of unreal sales goals, or other budget or compensation plans that are prepared internally. (Jackson, Sawyers & Jenkins, 2008, p.14). Financial statement frauds can prove to be much more costly than any other types of frauds, because its effects are not only on the numbers but also on the business decisions as a whole (Coenen, 2009). Frauds may occur from pressures, available opportunities, or personalities. (Jackson, Sawyers & Jenkins, 2008, p.15). There are a variety of methods available for management earnings. The different areas where a manager can make use of management earnings include writing of inventory, recording sales, and delaying invoices, putting off expenditures and so on (Jennings, 2008, p.258). The possible earnings management techniques include changing methods of depreciation, changing periods of amortization, estimating accruals of obligations, judging amounts of inventory write-offs, and so on (Mulford & Comiskey, 2002, p.65). Whether earnings management is good or bad depends on the character of steps taken by the management of a company. It is understood that earnings management is adopted in any company not for the purpose of making it a business financial crime, but for meeting company expectations or forecasts. If the effects are accepted, then the process may benefit the shareholders as well as the company. However it is necessary that details of earnings management be disclosed so as to have an obvious idea that the system is not benefitting at the expense of others (Mulford & Comiskey, 2002, pp.82-83). Conclusion: Going through the details of what earnings management is and how it is leading to business financial crimes, it can be understood that earnings management is not meant for criminal purpose, but it is used by different companies in a way which is leading to criminal activities. Taking some measures to meet the forecasts could be accepted if they do not harm the company or its stakeholders. However, it is of serious concern for businesses because managements coming under pressures are using techniques, which are unacceptable in nature. Moreover, these steps are creating severe problems both for the company as well as for the stakeholders. Hence, even if earnings management is not referred to a as a fraud, but owing to its effects it is necessary that investors remain beware of measures applied in the accounting measures of a company and invest accordingly. Bibliography Coenen, T.L. (2009). Expert Fraud Investigation: A Step-by-Step Guide. United States: John Wiley and Sons Gregoriou, G.N. (2006). Initial public offerings: an international perspective. United Kingdom: Butterworth-Heinemann Jackson, S.R. Sawyers, R.B. & Jenkins, J.G. (2008). Managerial Accounting: A Focus on Ethical Decision Making. United states: Cengage Learning Jennings, M.M. (2008). Business Ethics: Case Studies and Selected Readings. United states: Cengage Learning Mulford, C.W. & Comiskey, E.E. (2002), The financial numbers game: detecting creative accounting practices. United States: John Wiley and Sons Pickett, K.H.S. & Pickett, J.M., (2002), Financial Crime Investigation and Control, United States: John Wiley and Sons Ronen, J. & Yaari, V. (2007), Earnings Management: Emerging Insights in Theory, Practice, and Research. New York: Springer Wild. (2006), Financial Statement Analysis 9E, New York: Tata McGraw-Hill Education Read More