Earnings Management can be explained as the utilization of various techniques of accounting to generate the required results which depict the positive view of the trade related activities and the financial position of the organization. It takes undue advantage of the loopholes of the accounting processes which influence the different items of the balance sheet such as assets, liabilities and earnings.
With the help of this concept, the companies embellish the differences in their income and show exaggerated profits in their monthly or yearly financial statements. Though the differences in revenue and expenditure may be a normal occurrence in the routine business life of the company but it may alarm the investors who want to see its progress and growth. It also has an influence on the share prices of the company as they vary according to the sentiments of the investors.
So, in this essay, the technique of earnings management would be assessed along with its different procedures. Additionally, the examples of various corporate collapses will be quoted to explain the role of auditors to curb this practice. The role of auditors in the failure of the company due to earnings management will also be assessed in this project.
Earnings Management can be described as the deliberate impact on the preparation and projection of financial documents so that the selfish needs of the managerial personnel can be satisfied within the organization. It consists of the alteration of the financial position of the company so that the shareholders can be misguided about its growth policies. It also influences the contractual obligation of the company as it is affected by its growth and developmental strategies (Yang, 2017).
There are certain factors which lead to earnings management. Some of them may be internal factors such as the management pressurizing the accounts and finance departments to meet the annual or monthly targets. Another might be the budgeted figures which if not achieved may adversely influence the performance of the personnel and the company as a whole. The external factors could be the anticipations of the stakeholders to optimize the profits of the company so that they receive maximum returns on their investments. Lastly, the external analysts who forecast the returns of the company before the announcement of the financial results add the burden on the shoulders of the management which it has to accomplish (Wajnsztajn and Heintz,2016).
The management manipulates the figures by using the below mentioned techniques of earnings management:
It is used by the management to increase the earnings and for fulfilling the aspirations of the external analysts with reference to EPS. It is implemented by the management to survive in the industry and to protect the goodwill of the company in the capital market. It is applied to increase the prices of the stock so that more investors can be attracted and growth can be shown in the financial ratios. The ratios related to price –to- earnings ratio (P/E) and earnings per shares (EPS) can be increased for temporary duration with the help of buy back of shares (Hamza, 2015).
Furthermore, it enhances the return on equity (ROE) and return on assets (ROA) by the organization as less assets and low outstanding equity shares remain post buy back at the disposal of the organization. As a result, the financial statistics can be misguide the shareholders if the organization uses ‘shrink the ship’ for manipulating the revenue.
So the Big Bet Technique helps the purchasing company to increase the future and present earnings in a definite manner.
For example, if a company sells an asset with a book value of $2000 Million to another company and it immediately leases it back for 6 years. According to the agreement, it has to pay $400 Million annually for 6 years. The seller lessee has to pay $2400 Million in cash for the lifetime of the asset. In this way, it is a financing arrangement as the motive is to interchange the cash rather than the sale of the aircraft.
The auditors monitor and regulate the capital markets through assuring the shareholders who are interested in knowing the financial position of the company. They play a crucial role in lessening the impact of earnings management. They reduce the variations pertaining to the accounting information by validating the authenticity of the financial statements. They are accountable to diminish the manipulation of cash inflows and increase the dependability of auditing (Mussalo, 2015).
The auditors track the doubtful accounting practices and raise objections on their application by stating their qualified opinions in the audit report. With the help of auditing, the auditors regulate the self-serving choice of the managerial personnel in the depiction of the financial documents. Thus improved auditing may lead to better quality of reported gains. Thus, the auditors act as a precautionary measure to protect the goodwill of the management and the value of the company (Wanyama , 2017).
The auditors improve the validity of the financial documents which are provided by the management through their independent certification of those documents. They implement consistent methods of audit, pursue the views of the second partners and execute training programs for regulating the earnings management. The auditors apply efficient internal control methods to eliminate earnings management (Ibrahim et al., 2015). The auditors protect the interest of the shareholders and decrease their data risk by providing a factual and rational view of the financial statements of the business.
According to Rani, Hussain and Chand (2013) several corporate scandals can be stated where the earnings management technique was used. The current corporate collapses such as HIH Insurance and the demise of Arthur Anderson have questioned the reliability of the financial statements. The collapse of HIH Insurance Group had led to a deficit of around AS$ 5.3Billion thereby making it Australia’s largest corporate collapse. On March 1, 2001 the Australian Prudential Regulatory Authority (APRA) had served notice on HIH to state the reasons for not appointing an inspector under section 52 of the Insurance Act 1973. On March 15, HIH applied to the court for registering itself into provisional liquidation.
Upon the investigation it was discovered that HIH had recorded a shortfall of assets over liabilities amounting to AS$5 Billion out of the total of AS$ 7 Billion in the Balance Sheet. The company had accounted for less than 0.5% of the total assets of the various financial establishments. It was the second biggest non-life insurance company in Australia and the fraud was amongst the largest corporate scams which occurred till date. It had a great impact on the Australian economy and as a result, the Royal Commission was appointed by the Australian Government to investigate this corporate collapse. As a result, the performance of the auditor of HIH, Arthur Andersen and APRA were in question. The verification of these events lasted for more than 18 months and Justice concluded by saying that the deficit of billion dollars had arisen as the claims from the insured events were more than the company really provided for. The factors contributing for the disaster of HIH were under provisioning, poor corporate governance, insufficient valuations of the assets and lack of proper information provided by the auditors and the board to the regulator. It also questioned the failure of APRA in exercising its powers and responsibilities under the Insurance Act (Lane, 2016).
As per the opinion of Dodo (2017) another company which suffered with the corporate collapse was Parmalat. It is one of the cases which lacked sufficient corporate governance structure. The company had also appointed the audit committee but sadly it accepted the accounting procedures which were improper. Furthermore the complexity of the structure of the group added on to the misery. The problem was that the controlling shareholders used to exploit the organization rather than administrating its activities. The company adopted an opaque and arrogant attitude towards its investors and there were several incidences of fraud committed by the management such as lots of cash was recorded in the books but the management continued to borrow money on interests. It puzzled the investors of the company thereby provoking them to withdraw their investments from the company.
The rating agencies reduced the ratings of the company to its lowest prior to the breaking up of the scandal. It increased the worries of the investors as there was no connection between the debt level of the company and the cash stated in its balance sheet. Additionally, the shareholders of the company who also owned it were engaged in handling other projects such as tourism business and soccer team rather than focusing on the management of the core activities which resulted in large debts (Kang, 2015).
Besides this, the company additionally created a wholly owned special purpose entity to adjust the fictitious cash amounting to €4 billion. All the events led to the downfall of the company. The audit committee was also engaged in this scam as they approved the unfair practices performed by the shareholders and the managerial personnel (Wiyadi, Veno and Sasongko,2015).
The case of Royal Ahold, a grocery market chain with its stores located worldwide is a case of poor corporate governance and mismanagement. The company had become successful through its acquiring strategies and expanding itself in U.S, Europe, Asia and Latin America. But in February 2002, its share prices decreased by 7 %. The company denied these numbers and revealed its statistics of growth and manipulated them by decreeing the transparency. In its annual report of 2001, it confirmed its financial crises and negotiated an emergency loan of €3.1 Billion to compensate with its immediate cash requirements. As a result, it had begun the proceedings for disinvestment of its assets in Poland, Portugal and Slovakia (Dowd, 2016).
The key issue with the management of the company was its consistent expansion without introducing any corporate governance changes. The instant success of the company looked attractive to its shareholders but it reduced the opportunities for the auditors and the directors to track the cause of the problems. It was the fault of audit committee who overlooked the manipulations in the numbers.
The audit committee should have been investigated into the affairs of the company including the policies relating to whistle blowing and internal controls. Additionally, the audit committee should have enforced the tough policy regarding the attendance of the members appearing in the meetings of the committee. The members of the audit committee should have been professional. They had to execute the tasks of the board in a serious manner ( Loukianova, Nikulin and Zinchenko,2017).
The case of filing of bankruptcy of Lehman Brothers Holdings with $639 Billion in assets and $619 Billion in debt was the biggest in history as it assets exceeded the previous bankruptcy giants such as Enron and World Com. It was the fourth largest investment bank of U.S. at the time of the filling of its bankruptcy with 25000 employees all over the world.
The history of Lehman Brothers originated back from 1850 and it progressed with 209 registered subsidiaries operating in 21 countries. Between 2003-2004, the company acquired five mortgage lenders along with BNC Mortgage and Aurora Loan Services which targeted on ALT-A loans which did not require complete documentation by the lenders to the borrowers during the period of housing boom in U.S. As a result, the income from the real estate business of the company allowed it to invest in the capital markets with the rate of 56% between 2004-2006. The firm recorded enormous increase in its revenue amounting to $19.3 Billion and net income amounting to $4.2 Billion (Chadha, 2016).
But on 15th September, 2008 Lehman Brothers filed for Chapter 11 insolvency processes. It was the largest bankruptcy case in the history of U.S. with the creditors amounting to $613 Billion. It had a great impact on the Dow Jones Industrial Average which recorded a downfall of 500 Points immediately. As a result, within two hours, securities valuing around US$550 Billion were exchanged and an amount of US$105 Billion was withdrawn from the U.S. Treasury. It led to the closure of the electronic money markets when no response had occurred concerning the same.
Some of the causes for the failure of Lehman Brothers were negligent lending practices and extreme dependence on the credit ratings by the investors. It also figures out the accountabilities of the auditing committees for reducing the rate of corporate scandals and increases the effectiveness of the procedures of corporate governance (Clarke and Dean, 2014).
The responsibility of the auditors is to identify and evaluate the possible threats related to material frauds occurring in the financial statements of the company. It is the duty of the auditors to apply professional skepticism and respond to the probable frauds and report them to the upper management of the company. They should also mention the qualified and adverse opinions regarding the matters in the auditing reports (Consoni, Colauto and Lima, 2016).
In my opinion, it is not appropriate that the auditors should rarely be held responsible for the failure of the company. They form the basis of the risk management framework and the corporate governance structure. The audit committee manages and regulates the internal control system of the company .It is liable to report the frauds arising from misappropriation of the assets and processes and should offer appropriate solutions to be implemented to prevent the errors in the future in the auditing report (Uwuigbe, Ranti and Bernard,2015).
According to ASA 240, the auditors are held responsible for recognizing the possibility of material frauds in the statement of affairs of the company. The auditors are liable to verify the inaccuracies pertaining to the responses of the management and the corporate governance committee. They are accountable for analyzing any possible risks related to the evaluation of revenue in the financial documents of the company. Mostly, the companies create fake revenues by increasing the sales falsely thereby recording the accounting transactions in the books of accounts to increase the amount of assets and cash. With the help of cross verification from the third party to validate the status of these accounts, the assessors would be able to verify if the revenues are fake or genuine (Auditing and Assurance Standards Board, 2015).
Hence the auditors must involve in direct discussions with the stakeholders to examine the dealings of the company and maintain proper control measures to strengthen the risk management framework within the company. They should apply certain steps for reducing the substantial fraud from the financial documents of the company. Thus with the help of independent opinion of the auditors, a true and fair view of the statement of affairs of the company can be provided to the stakeholders (Alabede, 2012).
Thus, to conclude, it can be said that the earnings management adversely impact the revenue generation and may weaken the reliability of the financial statements. It is a strategy applied by the management to affect the revenue generation so the figures can be complemented against an objective. The auditors play an important role in eliminating the risk of earnings management and erroneous reporting of the fiscal statements by the organization. They shall form and apply the auditing processes which help in analyze the risk of material mismanagement.
References
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