Concept Of Earning Management: Techniques, Issues, And Role Of Auditors

Issues Leading To Earning Management

Discuss about the Concept Of Earning Management.

Every company that carries on an economic activity runs with an ultimate goal to make money. Apart from making profits throughout the accounting year, the accountants and management want to present the company’s profile to the public in an attractive manner to lure the investors for investment and public so that shares can be sold. If this doesn’t happen naturally, the management thrives on manipulating the accounts. They try to even out the earnings by window dressing the timing of revenues, payments, incomes, expenses, losses and gains. It’s like creating a perfect looking book of accounts by using several techniques and original set of books. Although this technique is legal, it may damage the performance and even lead to collapse and crash if done improperly (Lowe, McKENNA, & Tibbits, 2011).

If the management has chosen to imaginatively manipulate the accounts, then there should stand some reasons for that. Various issues re-identified, some major being:

• The company might have projected a goal or an aim for certain near or time frame. On being unable to achieve that target, it may feel the requirement to transfer the revenues or expenses of one accounting period to another. By doing this is using the accounting policies and procedures in a unique way to show the accounts in the way they were expected as per the targets.      
• Unlike the goals said aloud to the public in the previous paragraph, sometimes there may be a situation where a company, sets its internal targets for every department or process on which the whole budget lies. The respective department or process that cannot achieve the targeted result would look ulterior and harm the whole budget. In order to avoid that, the accounts related to that particular part are customised (Lowe, McKENNA, & Tibbits, 2011).

As market movements are bound to affect every entity, be it directly or indirectly, the growth and income patterns of a company show severe ups and downs. It creates a reluctance in the mind of investors and creditors to extend finance. To smoothen out the earning patterns, the company goes on adopting earning management (Rose, 2017).

• Leave aside the existing stakeholders, every organisation wants to grow and in order to do that, they want to attract as many potential investors and shareholders as possible. In the process of doing this, the company starts to window dress the existing profits by bringing stability in their time frame of achievement.

In this technique, the company tries to bring evenness in the income generating pattern. This technique can be helpful if the company recognises the expense for a certain transaction on estimate basis in an accounting year, but the actual payment for the same is made in another accounting period and that too less than what was estimated. As a result, there lies a reserve of the expense that was over than actual. The company may use this extra expense in the accounting period in which its earnings go more than normal to show evenness and avoid recognising the loss in the year which goes either in loss or turn to be less income generator (Rose, 2017).

Discretionary accrual stands abnormal accruals. The term discretionary stands for open or at the option of. The management is on the footing to estimate certain accruals regarding an accounting period. This is different from normal/non-discretionary accruals because normal accruals aren’t manipulated and aren’t affected by management’s judgement. The discretionary accruals allow the management to understate or overstate the financial position by manipulating the whole accounts by adding accruals into it (Rose, 2017).

Popular Techniques Of Earning Management

Big bath tends towards the technique wherein the loss estimates like impairment, restructuring etc. are done on a large scale than approximately estimated. This is based on the mindset that if something bad is going to happen, it should be reported at a single time. If the actual loss turns out to be lesser than the expectation, then the actual position would look better than targeted. It acts like bliss in future because if the estimated loss would have been shown lesser than approximate than the targeted position would have appeared deteriorated (Graham, 2014).

Big bet on future comes into play when a company is acquired by the organisation. By using big bet, the company writes off the complete expense incurred on the research and development of the company acquired in the year of acquisition only rather than writing off over a period of time. As a result, the future earnings get a boost and are more than they actually would. Its other way includes merging the current earnings of the acquired entity into the overall earnings of the acquiring company which balances out the writing off charges and shows a boost in growth because of acquisition.

In this technique, the company generally repurchases its own shares, in order to minimise the no of shareholders. This in a way doesn’t change the earning of the concern because according to current accounting standard the profit or loss on repurchase of own shares isn’t reflected in accounts. But it affects the company’s position otherwise by improving the earning per share; this helps in removing stagnancy and provides the company to highlight the targeted earning per share with requisite growth (Graham, 2014).

When an entity works as a conglomerate and has other subsidiaries working as a group with it, there may lay certain subsidiary(s) which may be performing lower than the expected and negatively affecting the overall earnings. As a result, the company may decide to sell or spin off the subsidiary. It may even create a special purpose entity for the financial assets of the underperforming subsidiary. As a result, the assets and liabilities of the concerned subsidiary will be removed from the consolidated balanced and be deemed as sold (Graham, 2014).

By using this technique, the management can mould its unusual profits or losses of a particular accounting period. The management can sale an asset and lease it back and recognise the gain/loss on the sale of the books of account.

Sale And Leaseback

There can be either outright sale of an asset or a transaction wherein the company sells an asset and immediately leases it back. Both ways it gives the company a chance to make losses or gains as required (Rose, 2017).

There is always an ever-going debate about whether earning management is legal or not. But many scholars believe it to be a legal practice. However, where the auditors are concerned, they stand in a position to give an opinion about the truthfulness and fairness of the information stated in the books of accounts (Tricker, & Tricker, 2015).  Any technique of earning management contributes in manipulating the actual state of the accounts and is intentional. As it’s well versed that any intentional fraud is hard to capture by the auditor than the unintentional ones, same becomes the case of earning management. In order to add to the beauty of financial statements management usually resorts to some level of manipulation and that becomes difficult for the auditor to catch. Although earning management is not a fraud but it would have created a difference in the auditor’s opinion if it was known to him that accounts have been window-dressed (O’Callaghan, & Graetz, 2017).  The auditor is required to know the difference between frauds and earning management to provide his opinion on a better front. The auditors need to find the reason behind every finding they observe; as it’s the only way they can spot whether an intentional manipulation is fraud or earning management (Davies, 2016).

Even if earning management is counted as an ethical practice and within the boundary of accepted accounting principles, there may stand a chance wherein due to this practice the corporates have faced detrimental repercussions (Lowe, McKENNA, & Tibbits, 2011). Various famous scandals are there that witness that many times earning management eventually takes the shape of fraud. This brings another responsibility on the shoulders of the external auditor to even report the cases of any manipulations noticed in the books of accounts even if they seem to bring no harm, as later they might bring trouble to the concern. Though, the auditor is not responsible for anything if he has done his work with due diligence and has gathered sufficient and appropriate audit evidence before framing an opinion. As his responsibility is to give reasonable assurance based on what he has observed, provided he did it with vigilance and due diligence. He is not responsible for the preparation of the books of accounts that lies with the organisation itself. However, if during the course of the audit, auditor finds some discrepancy in the accounts or he is personally interested anyhow in the company, it calls for an irregularity in the conduct of audit by him (Argenii, 2015).

Role Of Auditors

1. Enron scandal: Enron is a Houston based company dealt with energy services. Its CEOs Jeff Skilling and Ken Ley were the main conspirators behind the earning management technique and turned it into a fraud. They framed special purpose entities and creatively used the financial reporting techniques to keep billion dollars’ debt that arose from unsuccessful contracts and projects out of the balance sheet. Its auditor Arthur Andersen was even found to have not performed audit diligently and properly (Murphy, 2009). Because of these thousands of employees lost their jobs and retirement accounts and the shareholders lost around $74 billion. According to research, an employee Sherron Watkins, whistle blown the whole malpractice and got them red-handed in front of everyone (Masuch, 2015). Adding to the fire, the sudden rise in share price added to the scepticism. As a consequence, both the key fraud makers were sentenced for 24 years and the auditor was held guilty for helping in manipulating the accounts. The company got filed for bankruptcy (Liu, & Wilson, 2012).
2. Waste management scandal (1998): it is also a Houston based company which is traded publicly. It’s a waste management and environmental services company. It made the fake reporting of around $1.7 billion of earnings. In order to restate the earnings, the company’s founder, as well as CEO and chairman, Dean L. Buntrock and other top-level administrators, tried to show higher earnings by falsely ascending the depreciable life of their balance sheet’s plant, property and equipment. When the company got under the safe hands of new management and CEO, their scrutiny and analysis of the false accounts revealed the restatement done by the former team with the help of auditor Arthur Andersen. Penalties hit both the auditor and the company being $7 million fine by SEC and settlement of $457 million being shareholder class action suit respectively (Iraya, Mwangi, & Muchoki, 2015).
3. WorldCom scandal (2002): WorldCom used to be one of the well-celebrated telecommunication companies with more than $30 billion in annual revenue. It used the practice of earning management in a fraudulent manner by making fake accounting entries to underreport line cost by capitalising them instead of treating them as an expense and at the same time hitting revenues high. Company’s CEO Bernie Ebbers was held guilty for the huge misstatement and was penalised by 25 years of imprisonment. He even was pleaded for filing false documents. Along with penalising him, the company was also filed for bankruptcy (Barlow, & Clarke, 2017).
4. HealthSouth scandal (2003): HealthSouth being a sound publicly traded U.S. Company, famous for providing health care services was taken on the verge of destruction by CEO Richard Scrushy. As one of the issues leading to earning management seen in the earlier sections, CEO in a pressure to meet the shareholders’ expectations made a fake inflation in the earnings by $1.4 billion. He even used this fraud done by him for his further personal benefit by selling the shares he held one day before the company posted a deep loss resulting in falling share prices. This act raised a suspicion and he got caught. The CEO even was found to have bribed the then Governor of All his wrongdoings got him imprisoned for seven years,

All these well-known corporate scandals led the reality of poor governance and poor practices shout loud. After the shameful collapse of Enron and other corporates, U.S. Congress passed an act called Sarbanes-Oxley Act (Argenti, 2016). This act demands corporates to improve their governance and completely disclose all the financial matters and requisites in an improved manner. It brought a responsibility on the management and external auditors to report whether the company’s internal controls are adequate or not. Hence, in any case, the auditor, is aware of the circumstances involving earning management that can lead to fraud or are done with intent to commit fraud, must report them. Any failure on the part of the auditor to comply with this requirement may cause him to be legally dealt with (Ooghe,& De Prijcker, 2008).

Increased costing of their business- The failure to comply with the applicable rules by these companies was also the major reason for the collapse. For instance, Penalties hit both the auditor and the company being $7 million fine by SEC and settlement of $457 million being shareholder class action suit respectively in the Waste management scandal (1998).

These are several collapses which have drastically affected the economic and industry at large. However, after analysing all these companies, it is inferred that these companies were lacking with the proper nexus between the organizational growth and economic development at large. If these companies could have implemented the proper strategic plans and effective business decisions then it would have increased its return on capital employed. The Auditors compliance program and their internal control system were also the weak which divulges the biggest reason for the failure of this business organization (Perry, 2011).

Earning management stands to be an internal step taken by the top-level management to make manipulations within the books with intent to make the financial statements look appealing. Along with the external auditor, the company needs to have an audit committee and an internal audit function. The internal auditor is under the duty to check whether the company’s controls are adequate or not. This ensures the safeguarding of assets, compliance with rules and regulations, meeting targets set and continuance of operations with effectiveness and efficiency. The internal auditors are much into the organisation and are in a better position to look for any conspirator of frauds in the veil of earning management. If the proper audit program and effective work functions are undertaken then it will not only increase the overall output of the company but also assist management of companies to mitigate the possible business risk (John, 2016).

Some popular corporate collapses

However, the external auditor is not expected to directly rely on the observations and work of internal auditor unless they have the reasons for same. The external auditor is an independent party and must make an unbiased report (Sharma, & Mahajan, 2012).  If he indulges in any kind of conflict of interest, he may be pleaded as being guilty. That means until and unless he is a party to fraud he cannot be held liable for any collapse happening for either reason, be it fraud or fraud disguised as earning management (Laitinen, 2012). These external auditors evaluate the business process and financial reporting framework as independent auditors. They help the company to evaluate all the possible problems and financial reporting issues which company might face due to non-effective accounting policies and internal and financial recording standards in their books of account (Kiviluoto,  & Bergius, 2012)

There are seen corporate collapses where the auditors are rarely found guilty. One of the obvious reason being, the auditors have performed as per the expectations and with applications of all auditing principles including integrity, accountability, confidentiality, rigour, professional scepticism (Weir, & Laing, 2011).  They have considered all the auditing standards that are applicable to the respective client’s case. If there had been no biases or unethical practice on part of the auditor, they he cannot be held accountable for company’s failure. So, in a brief sense, it’s appropriate to keep the accountability on management’s head if the auditors aren’t involved as a party to fraud. These corporate collapses have shown several hidden possible actions which could have been taken by these companies to stop their collapse. If the proper audit program and transparent reporting frameworks were used by these companies then it would have saved a high amount of capital from the possible losses (Kangari, Farid, & Elgharib, 2012).

Conclusion

With the changes in the reporting frameworks and adoption of the international accounting frameworks accountant and auditors should use equal parameters to record and reporting of the books of account of companies. It is observed that auditors have needs to follow several intents in his recording frameworks with a view to increasing the effectiveness of the audit program such as principles including integrity, accountability, confidentiality, rigour, professional scepticism. Now, in the end, it could be inferred that this corporate collapse could be restrained by the company by using the effective recording and reporting frameworks.

References

Argenii, J. (1976). Corporate collapse.‘The causes and symptoms.

Argenti, J. (2016). Corporate planning and corporate collapse. Long Range Planning, 9(6), 12-17.

Barlow, M., & Clarke, T. (2017). Blue gold: the battle against corporate theft of the world's water. Routledge.

Davies, A. (2016). The globalisation of corporate governance: The challenge of clashing cultures. Routledge.

Graham, H. (2014). When the company causes harm: Effective corporate sentencing in a justice system based on individual fault.

Iraya, C., Mwangi, M., & Muchoki, G. W. (2015). The effect of corporate governance practices on earnings management of companies listed at the Nairobi securities exchange. European Scientific Journal, ESJ, 11(1).

John, A. (2016). Corporate collapse: The Causes and Symptoms.

Kangari, R., Farid, F., & Elgharib, H. M. (2012). Financial performance analysis for construction industry. Journal of Construction Engineering and Management, 118(2), 349-361.

Kiviluoto, K., & Bergius, P. (2012). Exploring corporate bankruptcy with two-level self-organizing map. In Decision Technologies for Computational Finance (pp. 373-380). Springer, Boston, MA.

Laitinen, E. K. (2012). Prediction of failure of a newly founded firm. Journal of Business Venturing, 7(4), 323-340.

Liu, J., & Wilson, N. (2002). Corporate failure rates and the impact of the 1986 insolvency act: An econometric analysis. Managerial Finance, 28(6), 61-71.

Lowe, J., McKENNA, J. O. H. N., & Tibbits, G. (2011). Small firm growth and failure: Public policy issues and practical problems. Economic Papers: A journal of applied economics and policy, 10(2), 69-81.

Masuch, M. (1985). Vicious circles in organizations. Administrative Science Quarterly, 14-33.

Murphy, J. (2009). Turning around failing schools: Policy insights from the corporate, government, and nonprofit sectors. Educational Policy, 23(6), 796-830.

O’Callaghan, T., & Graetz, G. (2017). Introduction. In Mining in the Asia-Pacific (pp. 1-15). Springer, Cham.

Ooghe, H., & De Prijcker, S. (2008). Failure processes and causes of company bankruptcy: a typology. Management Decision, 46(2), 223-242.

Perry, S. C. (2011). The relationship between written business plans and the failure of small businesses in the US. Journal of small business management, 39(3), 201-208.

Rose, G. (2017). Australian Law to Combat Illegal Logging in Indonesia: A Gossamer Chain for Transnational Enforcement of Environmental Law. Review of European, Comparative & International Environmental Law, 26(2), 128-138.

Sharma, S., & Mahajan, V. (2012). Early warning indicators of business failure. The Journal of Marketing, 80-89.

Tricker, R. B., & Tricker, R. I. (2015). Corporate governance: Principles, policies, and practices. Oxford University Press, USA.

Weir, C., & Laing, D. (2011). Governance structures, director independence and corporate performance in the UK. European Business Review, 13(2), 86-95.