Earnings Management: Techniques, Impacts, And Detection Strategies

The Importance of Company Earnings

Discuss about the Accrual-Based And Real Earning Management Political.

The profitability or earnings of the company is regarded as the most significant part of the company’s financial statement. It shows how the company is involved with the with its value maximization activity. The primary factor which reflects the company’s health is its earnings which is also positively proportional to its value and also gains confidence of the shareholders. Therefore, reflecting the financial reports in positive light is the most imperative function of the management of a certain company (Aris et al., 2015).

The management of a particular company while carrying out the accounting process to derive the financial reports also calculates the future estimates. Here, the accounting standard provides various process to record a transaction and the managers can choose one of them. However, the outcome of the report is totally dependent on the process chosen. However, sometimes the managers try to present their reports in the most positive way possible by overstating their earnings; this practice is known as earnings management (Bessis, 2015). This practice is generally not encouraged across the globe as it is seen to deceive the stakeholders. Hence, there are techniques of managing ones’ earnings and standards followed to counter the same, which will be discussed later.

Earning Management is an attempt of reflecting the better side of the company by overstating the earnings of the company to soothe the future journey of the entity using loopholes in accounting techniques (Beuselinck&Deloof, 2014). It is generally considered as manipulation of financial statements but is actually using the deficits of accounting policies. The main reason of managing the earnings lies with being more predictable in the future while walloping the volatility. There has been a belief that the investors are more interested in the companies which reflects a steady growth rather than those which reflect volatility as people tend to take low risk. However, the managers who put a huge effect in overstating their earnings must put the same effort in planning business strategies for long-term growth. There are several techniques through which the earning can be managed such as:

• Cookie Jar Reserve- The accounting process require the accountant to record the transaction in accrual basis in which the payment is shown in the books even before the payment is done. In this case, the managers find a loophole and records the highest possible expenses as per their estimation (Beyer, Guttman &Marinovic, 2014). In this process the highest expenses are recorded in the current fiscal year but leaves the future fiscal period from such expenses to be recorded later. Hence, it can be said that the manager through this practice creates the cookie jar for earnings to boost the growth in years yet to come.
• Big Bath- As the market becomes more competitive, sometimes the companies tent to eliminate their certain operation which is not performing well by naming it restructuring of the entity. As per the GAAP, it allows the manager to charge the cost of the change against the company’s income. It is against the company’s reputation in the market as it can be seen as uncompetitive but if the same is taken in positive way by the shareholders could also boost its share prices. It is a simple way of putting the losses occurred during the restricting process in current fiscal report and save the future reports from such losses and expenses. Hence, in other words, it refers to the recording of the highest loss so the future earnings remain safe.
• Big Bet on The Future- The term ‘big bet on the future’ is referred when a company acquires another believing that the acquired company will perform well in the future. It can be considered as the risk which the acquiring company takes after analysing the value of acquired entity. As per the accounting standards, such transactions are needed to be shown as ‘purchase’ (Black et al., 2017). Hence, the acquirer generally write-off the major portion of the purchase against the current income so as to keep their future earning free from any debt. Moreover, they also consolidate the earnings from the acquired company in their own income.
• Flushing the Investment Portfolio- When a company buys less than 20% of the stake in another company, the rules of accounting forbids the investor from recording the profit from investee company to be shown in investor’s earnings (Patrick, Paulinus &Nympha, 2015). It is expected to be included in the operating income. But the managers are observed to manage their earning s by selling the stakes at unrealized gains or losses as per their requirement at the time.
• Throw Out A Problem Child- It is mainly practiced when the subsidiary of the company is dragging down its earning and is estimated to do same in the future. It is the process of eliminating such subsidiary by selling it generally in loss. The loss occurred is recorded in the income statement but in case the loss is huge, it is distributed amongst the shareholders which is also termed as spin-off (Braam, Nandy, Weitzel &Lodh, 2015). However, much more effective method of hiding such loss is creation of special-purpose entity where the loss is transferred and is also not reflected in the consolidated statement.
• Sale/Leaseback- It is much more complicated techniques where the company immediately leases back the asset it soldand record the losses (if any) in its books. However, in case of profits, the same is amortised through the earnings during the asset’s life if the same is under the capital lease and in case of operating lease it is amortised in proportion to the payment (Liu, 2016).
• Shrink the Ship- The accounting standard does not permit a company to record the profit/loss it incurred during the share buyback in its income statement. It only allows the same if the company has transacted with outside party. However, instead of effecting the earning the company uses it to elevate its earning per share from the stock which eventually increase the value the company in the market (Nazir &Afza, 2018).

It is gathered that the auditors make attempts to deal with the practices regarding earnings management and it is deemed that many companies collapse within which the earnings management practices are used. It is evidenced that several huge corporate forms like Enron and Satyam company dealt with bigger challenges related with toughest policy issues concerned with any financial failure of companies. It is also observed that this company is dealing with addressing suchdisclosure concerns (Bratten, Payne & Thomas, 2016). The earnings management issue has been evidenced in the situation faced by Enron Company over past yearsdue to their increasing earnings misstatement. In addition, another example related with collapse of earnings management practices is evidenced that took place due to weak consolidation rule which is prescribed by enhanced and leveraged “Special Purpose Entities (SPE)”. These were focused on accomplishing many projects in which the liabilities and assets were not signified in the organizations balance sheet. Satyam collapsed due to the losses that took place from many SPEs that were developed (Chen, Cheng, Li & Zhao, 2018). Earnings management practices implementation that includes discretionary accruals, cookie jars, shrink the ship, big bath, big bet on future, troughing out a problem child, flushing, leaseback and sale might also have a bad effect on most of the businesses.

The Role of Accounting Standards in Financial Reporting

It is evidenced that there is a chance of high damage to the companies that are associated with earnings management and related guidance’s. Earnings management techniques impacts organizations in a situation they deal with it in order to obtain short term results other than short term growth and sustainability. There are numerous adverse impacts of ineffective earnings management quality that is implemented by organizations. This might lead to enhanced cost of capital because of increased price earnings ratio. In addition, techniques of earnings management might also result in some harms to organizations those use them for this can result in negative attitudes of analysts that follow the organization and effects of bid-ask spreads (Dimitras, Kyriakou&Iatridis, 2015). For such causes, it can be gathered that evaluating an instance of Enron and Satyam Corporate failure can clarify that earnings management of a material amount encompass fraudulent financial reporting. Moreover, this must be pressured effectively by government regulators as well as external auditors.

For addressing the concerns those are associated with earnings management that further leads to losses within businesses, the, members of audit committee focus on employing some accounting policies that are elaborated below:

• Recognising every transaction that requires management for developing a better anticipation of judgement. For example, a company that elaborates its accounting process for inventory is significant as it has increased its selling products over a period ad is also considered as fact sales.
• Associating the choices that are present with the management in IFRS to be responsible for transactions of organizations. In addition, the auditors consider the same to be important to identify the potential that is provided by a particular earnings management selection (Fisher, Gavious& Martel, 2016).

Rather than these control techniques for earnings management, the auditors take into account the most efficient way in which earnings can be controlled is by means of setting highlyrigid accounting standards. In addition, this can also have negative impact as managers consider real earnings management which encompass suboptimal, abnormal as well as other business practices in order to change reported earnings (Healy, Serafeim, Srinivasan& Yu, 2014).

In account for the legal system and absence of accounting in capital market infrastructure within transitional economies earnings management is deemed to be adverse. The emerging economies are likely to deal with such larger concerns in supervising accounting decisions of managers. The introduction of the international accounting practices long with standards in the organizations has ensured this has enhanced decreasedtransactions cost, enhanced market liquidity as well as increased pricing efficiency. This decreases the level of earnings management and the auditors ensures that the organizations need to implement international accounting standards which can further facilitate in earnings smoothening. The auditors also take inti account that the corporate businesses need to implement international accounting standards which can further consider revising accounting standards in a better manner (Jacoby, Li & Liu, 2016). This is for the reason that there are decreased loopholes in order to manipulate earnings. They are increasingly cautious in recognizing earnings manipulation activities of companies within which their interdependence is made sure. The auditors are also focused on the consciousness and morality of stakeholders that can convert such malpractice into a better practice. This is in a situation where motivations behind the earnings management does not involved any unethical intentions.

Earnings Management Techniques

The auditors are accountable for identifyingfrauds in financial statement audit of organizations. They are also aware and maintain control fraudulent financial reporting. This encompass international omissions or misstatements related with disclosure of financial statements in order to deceive the financial statement users. The auditor monitors accounting fraudwhich facilitates in controlling earnings management in companies (Saleem, Alifiah& Tahir, 2016). In addition, the auditors of organization implement two major earnings management detection along with dealing strategies which can control the fraudulent financial statements misstatement by organizations. Such processes employed by auditors are elaborated below:

Approach of AggregateAccrual Method: The auditors use this model by means of using some suggestions on accruals. These are considered to be anticipated outcomes of the exercising managerial discussions. This might also happen from some changes in a company’s economic situation. In order to detectacontrol, the techniques of earnings management regression model are used relied on such variable. This is due to the fact that overallaccrual as well as independent variables encompass sales property, plant and equipment. In addition, for decreasing earnings management chances by referring change in sale and change in the property, pant and equipment level.

Specific accrual method approach:This model is used by auditors for measuring any distortion or preconditions in thefinancialstatements. For example, the auditor of banking and insurance companies use particular accrual earnings management processes for dealing with the earnings developed by financial institutions (Tabassum, Kaleem & Nazir, 2015). Such approaches persuade the auditors to serve for losses in loan and moreover the insurance companies also develop reserve against the claim losses. Use of this model by companies also supports auditors in evaluating that increased values of the financial statements by organizations has increased chance of manipulation.

All the corporate organizations auditors are deemed to be the watchdogs but over the previous few years and they are centered on the organizations services they audited than making sure effective information flow to its investors. The auditors attain authority which in case after analyzing the organizationsfinancial reports, incase they do not real any type of materialconcerns in the financial statementsthat the report is published along with standardized assurance statements (Capalbo et al., 2017). This can ensure that the auditors consider the company’sfinancialstatements to be represented fairly in consideration to materiality and in compliance with GAAP principles. Auditors are basically employed by directors andinvestors of a specific organization to realsie of the company’s financial situation facilitates n understanding if its financial situation is maintained following all accounting rules. Responsibility of an auditor is to offer the stakeholders with the company’s fair value. For this reason, the auditing quality is of increased importance that facilitates in recognizing error within accounting process and facilitates in recognizing if certain records are not prepared as per accounting standards (Chu, Dechow, Hui & Wang, 2016). The auditor’s effort impacts the opportunity that an individual will identify the existing issue in which independence of the auditor effects the chances of reporting these issues. Therefore, auditor’sindependence impairment serves asanaspect of earnings management that is a topic for research. This is exposed to several aspects that includes auditors fee, importance of consumers, auditing tenure along with other services. It can also be concluded that there is absence of evidence on earnings management-based audit initiatives. A highly competitive auditor has capability of understandingreports in an efficient manner and arelikely to recognize anyoverstated earning (De Jong, Mertens, van der Poel & van Dijk, 2014). Conversely, an auditor’s effort has inverse impact on earnings management. The major cause of this low availability level of evidence is because of audit hours unavailability.

Impacts of Ineffective Earnings Management

Auditors put their reputation at stake and their work is deemed to be an unethical conduct in case their consumer revealed overstated earnings or organizations. However, in a situation where it is vice-versa no actions are considered for it. In addition, there exist regular disagreement among the auditorswith their consumers as former deals with asymmetric loss (Gavious& Martel, 2016). The earnings management might be gauged through anticipating abnormal accruals along with increased auditor’s effort is needed to decrease the managers practice regarding earnings overstatement. Conversely, in such scenario if audit hoursare lower than such abnormal accruals will be casual. Internal auditing is highly complex to realize for this can be biased. In a situation, the auditor can put increased effort for curbing earnings management chances through the managers. For this reason, a positive relation among earning management along with audit hours might be considered (Norden &Stoian, 2014). In addition, if managers focus on managing their earnings then it might try to encompass the auditors in their plan for facilitating them in in excreting less effort. In such situation a negative image might be drawn among the relationship of audit hours along with earnings management. For this reason, it might be derived that audit effort can decrease earnings management chances.

Taking the instance of Greece, the have generated an accounting body named SEOL, a self-regulatory audit profession. This accounting body needs all the engaging partner to report regarding the hours of audit to SOEL (Gounopoulos& Pham, 2017). For tracing ay missing hours, the body matches the organizationsauditor against the database. It also suggests its partners to report regarding the hours of audit to SEOL. In order to trace any missing hours, the body matches the organizations auditors against the database. It also suggests its partners to not retire till the audit data is submitted. It also has techniques to recognize the inaccuracies within the audit report. Conversely, in case one fails to report or inaccuracies are recognized within data report than it is deemed to experience penalties.

Based on the responsivity of an auditor, it is their primary responsibility to offer a fair value of the company to the stakeholders. The investors are highly dependent on the auditors for the investment along with any negligence from the later might not only result in losses but can also result in shareholders to lose their confidence withinauditors. Additionally, it relies on the ethical background related with the auditors to excerpt effort within their audit. Moreover, implementing the Greek techniques of gauging audit hours can also control any efforts made to manage earnings and can prove to act as an evidence against the auditor responsible for assimilating the managers within their unethical plans.

Controlling Earnings Management: The Role of Auditors

Conclusion

The accounting standard provides various process to record a transaction and the managers can choose one of them. However, the outcome of the report is totally dependent on the process chosen. It is gathered from the paper that it is generally considered as manipulation of financial statements but is actually using the deficits of accounting policies. The main reason of managing the earnings lies with being more predictable in the future while walloping the volatility. There has been a belief that the investors are more interested in the companies which reflects a steady growth rather than those which reflect volatility as people tend to take low risk.

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