Faculty of business management and professional

3.2 Flow of Earnings Management A Pattern of Earnings Management B Motivation of Earnings Management C Good side of Earnings Management D Bad side of Earning Management E Implication to

INDIVIDUAL ASSIGNMENT (Earning Management: Is it Good or Bad?)

KELLY WEE KHENG SOON (Student ID: 012010110116)

(DAC 5013: ACCOUNTING FOR CORPORATE DECISION AND EVALUATION)

FACULTY OF BUSINESS MANAGEMENT

AND PROFESSIONAL STUDIES

MANAGEMENT AND SCIENCE UNIVERSITY (MSU)

(MALAYSIA)

TABLE OF CONTENTS

1.0 Introduction

1.1 Objective

2.0 Literature and theories

3.0 Earning Management

3.1 Definition of Earnings Management?

3.2 Flow of Earnings Management

A) Pattern of Earnings Management

B) Motivation of Earnings Management

C) Good side of Earnings Management

D) Bad side of Earning Management

E) Implication to Accounting

4.0 Future Research

5.0 Conclusions

6.0 References

ABSTRACT

Use of accounting discretion to address financial statements seems to be eroding public confidence in the financial reporting process Some managers are abusing GAAP‘s afforded discretion to manage earnings thus reducing the quality of the financial reporting process and ultimately bring adverse effects on resource allocation in the economy Market participants, legislators, regulators, and academics are concerned in order for them to have the need to control financial reporting abuses In this paper, I briefly analyze the recent literature and theories on earnings management and show the techniques used by managers to manipulate earnings I found strong incentives and reasons for managers to report such smooth and increasing earnings by the: a) increase market capitalization; b) enhance management compensation and job security; and c)

reduce the company‘s cost of capital The evidence found suggests that the managers used: a) big bath restructuring charges; b) miscellaneous cookie jar reserves (a hidden reserve that do not

show up on the balance sheet (understating values) which can be used to adjust quarterly earnings reports c) premature and aggressive revenue recognition; and d) creative acquisition accounting and purchased R&D to manage earnings

Keywords: Accounting, Earning Management, GAAP

1.0 Introduction

This research paper is to examine whether earning management is it good or bad Though there

is so many debate about whether it should be accepted to be good rather than bad, however, this research will explain the both side of earnings management Earnings management reduces the quality of financial reporting, it can interfere with the resource allocation in the economy and can bring adverse consequences to the financial market The last few years many cases of severe accounting manipulation occurred leading to the collapse of several major corporations such as Enron, Parmalat, Refco and Worldcom whereby their earnings management need no additional comments because of the damages they brought to the economy This research paper analyzes both, causes and motives of earnings management as well as possible remedies Therefore, it is not surprising that market participants, legislators, regulators, and academics are concerned with the need to control financial reporting abuses Responsible authorities seem to be concerned with the pervasiveness of earnings management Since 1998, after Levitt's speech addressing the need

to control earnings management, the Securities and Exchange Commission (SEC) has been on the lookout for selective disclosure Business Week recently published that the number of

restatements more than tripled in the last 3 years briefly review the recent literature on earnings management and show the incentives as well as the techniques used by managers to manipulate earnings

1.1 Objective

Objective of this paper is to do a research on the definition or meaning of ―Earning Management‖ and how the effect to the good side and the bad side of it and what are the remedies or solution in the future Prior to the research, I will quote some of the previous and recent literature review or theories to explain the said definition, outline the reason for the impact

to appreciate the good and the bad of earnings management I will conclude my paper by summarizing this research paper with strategic aspect of right ethics of accounting policy and recommended solutions thru initial stage of education, training and awareness to accounting students and external users on earnings management within GAAP guidelines and tools to auditors to spot some of techniques used for earning management

2.0 Literature and Theories

Literature review in earnings management proposes different theories for why firms manage earnings Prior to recent scandals in accounting, creating volume of new literature on the quality

of earnings and the earnings management phenomenon At least one aspect of earnings management—income smoothing—has been known and debated since before Ronen and

Sadan‘s 1981 Smoothing Income Numbers: Objectives, Means, and Implications, as attested to

by their excellent summary of a vast number of empirical studies on the subject up to that time One of the theory, Healy and Wahlen (1999) observed that many aspects of this definition deserve additional comments Earnings management occurs when managers use their judgment

in financial reporting and in structuring transactions to alter the financial reports to either mislead some stakeholders about the underlying economic performance of the company or even to influence contractual outcomes that depend on reported accounting numbers referred by (HEALY; WAHLEN, 1999)

Studies of specific earnings management tools and the effect of earnings management on resource allocation was suggested At that time, they urged the accounting profession to consider areas where standards could be altered to decrease the ability to manipulate earnings—places where it would make the most difference in assuring efficient resource allocation Healy‘s evidence that bonus plans motivate earnings management helps students to take contracting theory seriously It opens up a whole new set of considerations in accounting policy choice beyond the disclosure of useful information to investors Watts and Zimmerman (1978) had reffered to the argument that managers alter reported accounting numbers to maximize their bonus, avoid tripping debt-covenants written on accounting numbers or to reduce their firm‘s political visibility Graham, Harvey and Rajgopal (2005) had done a survey with Chief Financial Officers who indicate they manage earnings to maintain or increase the stock price of their firms

A vast literature reffered by (Fields, Lys and Vincent 2001) for references) has validated the Watts and Zimmerman (1978) propositions However, there is managerial incentives to manage earnings to address stock price concerns are relatively under-explored

Accrual accounting will lead to smooth earnings and generate a number that is more useful for investor to predict future earrings compare to cash accounting In order to describe on earnings management I need to define the point at which managers‘ accrual decisions result in too much smoothing and so become earnings management (Dechow and Skinner 2000).Analyze conservative accounting, neutral accounting, aggressive accounting, and fraudulent accounting, I can make distinction between fraud and earnings management (Dechow and Skinner 2000) Dechow and Skinner [2000] contrasted the perceptions of academics, practitioners, and regulators, finding that academics are less disturbed by earnings management (understating the problem due to the belief in efficient markets and difficulty in modeling earnings management) than are regulators and practitioners (who overstate the problem because of the inherent flexibility of GAAP, the existence of full disclosure, and the growing number of creative accounting innovations).In late 1998 the former Chairman of the Securities and Exchange Commission (SEC) Mr Arthur Levitt referred earning management to as a process that has become a ―game of nods and winks‖ among corporate managers, auditors, and analysts (Levitt,

1998, p 14) He put the accounting profession on notice that those who are operating in the gray

area between legitimacy and outright fraud are poisoning the financial reporting process (Levitt,

1998, p 19)

3.0 Earnings Management?

The definition of earning management was given by Schipper (1989, 1992) who defined it as ―… purposeful intervention in the external financial reporting external process with intent to obtain some private gain ―

In accordance to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence the contractual outcomes that heavily depend on reported accounting numbers Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective Earnings management involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics on all earnings Aggressive earnings management is a form

of fraud which differs from reporting error

Most of this happen is when management of the companies need to present and show the earnings at a certain level or certain loopholes in financial reporting standards Practically, the management will alter the numbers to achieve desired aims or to satisfy projections by financial analysts or in other words attempts by management to influence or manipulate reported earnings

by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings.These are fraudulent reporting due to not fulfilling the accounting practice principles with the techniques of revenue recognition, accounting policy change, timing adoption of new standards, write-off, asset sales, provisions, accruals(discretionary) and direct charges to retained earnings Market expectation sentiment, individual bonus, to maintain position in the specific industry All this probable actions is due to downturn in business

Accounting practice principles need to adhere such as integrity of individual Types of Earning Management is a) Unsuitable revenue recognition b) Inappropriate accruals and estimates of liabilities c) Excessive provisions and generous reserve accounting d) Intentional minor breaches

of financial reporting requirements that tied to material breach All of this had been used by some companies to influence the figures by bending the rules rather than breaking them, anticipate or increasing the income reduce or delay the recognition of the expenses and shifting way from debt or losses

3.1 Flow of Earnings Management

Figure (a) Earning Management

Based on the figure (a) as shown above, we can see how the flow of the earning management

We will need to spot the pattern of the earning management Identify what is key driver of

motivation either an earning management is good or bad This will enable us to analyze the good

and bad side nature of the earning management, resulting to the implication of the accounting

principles and financial reporting The whole chronological of the flow will be explained as

below

A) Pattern of Earning Management

1) Big Bath accounting is the process where publicly traded corporations write-off or write-down certain assets from their balance sheets in a single year The write-off will help removes or reduces the asset from the financial books and results in lower net income for that year

2) Income Minimization

3) Income Maximization

4) Income Smoothing

B) Motivations of Earnings Management

1) Contractual motivations

 Bonus plan hypothesis: to manage cash bonus

- Evidence and Findings from Healy (1985)

 Debt covenant hypothesis: to manage debt covenants

- Research thru evidence from Dichev & Skinner (2002) 2) Political cost hypothesis

 To lower political ―heat‖

 Cross-examining report from Jones (1991) 3) Some of the driver of earnings management to meet earning expectations:-

 Significant negative effects on share price and manager reputation if expectations not met

 Other motivations

 Initial public offerings

C) Good Side of Earning Management

There is definitely a good side of earning management if it is properly practice for the benefits of the companies prior to achieving the key performance objective of the companies Good earnings management means ―reasonable and proper practices‖ ―Accounting Subjectivity and Earnings Management: A Preparer Perspective‖ referred by Parfet (2000 p 487) contends: calls attention to ―the context in which decisions are made, where subtle effects from human perceptions and peer pressures, the complexity of combined factors, and

a high-stakes business environment all impact good people who are trying to do their jobs with integrity Good side of earnings management describe in the arguments shown in (1) and (2).It briefly describe, from contracting perspective earnings management was anticipated by the principal when the bonus contract was being negotiated, so that it is allowed for in setting the bonus rate Firstly, lowering contracting costs in the face of rigid and incomplete contracts Secondly, earnings management can reveal inside information to

investors One of the example usually referred to is General Electric Co (GE) as simple announcement by GE of its persistent future earnings is ‗blocked.‖

The two arguments mentioned below on good side of earnings management as below was referred thru online by Robert C Lipe (2001)

1) Incentives given on contracts

a) Bonus is given on net income referring to contract

 Volatility of the new accounting standards may lead to lower net income

 May adversely affect manager effort

b) Debt covenant contracts

 New accounting standards may increase probability of debt covenant violation

 Contract violation is costly, earnings management may be low-cost way to work around

2) Investor-based arguments

Credibly communicate inside information to investors

a) Blocked communication may inhibit direct disclosure of earnings expectations

b) Discretionary accrual management as a way to credibly reveal management‘s inside information about earnings expectations, some of examples :-

 Manager foolish to report more earnings than can be maintained

 Manager reported earnings to an amount management expects will persist

D) Bad Side of Earning Management

Bad earning management means intervention to hide real operating performance Some

of the techniques used that will influence bad earnings management is as follow below based on my investigation from some of the research done in the past

1) Contracting Perspective

From a contracting perspective, we can think that managers manage earnings to opportunistically maximize their utilities Healy (1985) examines that managers act on their self-interest when their bonus schemes are tied to the reported net incomes However, managers not only manage earnings for self-interests but also manage earnings for an efficient contracting Healy (1985) found that managers utilize such information superiority to maximize their wealth on their bonus scheme which suggests that managers might possibly manage earnings to protect their bonuses This is the contract between the firm and the managers Research examining SEC enforcement actions has found that accrual information is a key determinant of the earnings manipulation (Dechow, Sloan and Sweeney, 1996) Therefore, it is reasonable to assume that earnings restatement firms can be characterized as firms who knowingly and intentionally engaged in earnings manipulation

2) Financial Reporting Perspective

Based on Hanna (1999) article in CA magazine review, important point to get across

from this article is that management is tempted to provide excessive unusual, non-recurring and extraordinary charges, to put future earnings in the bank Furthermore, these future earnings are buried in operations This makes it difficult for investors to diagnose the reasons for subsequent earnings increases

Investors and analysts look to core earnings, ignoring extraordinary and non-recurring items Implies manager not penalized for non-core charges, such as write-downs, provisions for restructuring But current non-core charges increase core earnings in future years, through lower amortization and absorption of future costs As a result, managers tempted to ―overdose‖ on non-core charges, thereby putting earnings ―in the bank‖ also called cookie jar accounting Referring to securities market reaction, Hanna found evidence that market uses frequency of such charges as proxy for their misuse lower ERC when greater frequency ( example: Nortel Networks‘ reversals of its excess accruals)

E) Implication to Accounting

1) Earnings management can be good if used responsibly I investigate that even some of the evidence from‖ Arya, Glover, and Sunder (2003) asks the question, ―Are Unmanaged Earnings Always Better for Shareholders?‖: Practice of ―Income manipulation is not an unmitigated evil: within limit it promotes efficient decision‖ [p 111] It is also management‘s ability to distinguish transient changes in income from permanent income better than external users Investing public doesn‘t really want to know what a firm made this year; they are really only interested in its promise for the future Focus had been made

to ensure increase in the income by the management to ensure the performance of the companies

2) Full disclosure helps to control bad earnings management

 Revenue recognition policies

 Unusual, non-recurring and extraordinary events

 Enables investors to better evaluate earnings persistence

 Effect of previous write-offs on current core earnings

4.0 Future Research

Prior to future research, a lot more need to be done to curb all malpractice in the accounting principles, though SEC‘s effort on cracking down on earnings management abuse Proactively approach need to be taken by the profession of public accounting Training schemes need to be given to auditor‘s with annual update on how they are perpetrated What steps need to be taken knowing that there is manipulation of earnings within GAAP and income smoothing such as inappropriate revenue recognition, accounting policy change, timing adoption of new standards, write-off, asset sales, provisions, accruals(discretionary) and direct charges to retained earnings and all the other accounting and fraudulent reporting

Professional code of ethics in terms of credibility, integrity and confidentiality had been questionable without doubts, furthermore, companies or corporations with such practice will lose credibility in the capital markets though facing with new laws to curb such conduct and management practices such as the Sarbanes-Oxley Act Accounting profession have to return to its ethical values traditional, however, the questions is how does this relate to the earnings management debate? How do we restore ―public confidence in [our]…service‖ [p 48]? Awareness and further educating accounting student on what Parfet referred to as earning management (vs manipulation) with the abusive of earning management practices, better help them to share the right ethics practice with their financial managers and other superiors In addition, more effort of introducing tools necessary to identify earnings management techniques

to better equip Chartered Public Accountant (CPA)

Education will reduce the expectations gap between auditors and financial statement users Most firms that fraudulently misstated earnings through earnings management had employed Big Five

public accounting firms as their auditors referred by Robinson-Backmon and Finney (Research

on Accounting Ethics 1999, 5: 77-93) Education thru business and professional publications

could help their readers by publishing articles on how to detect and deter earnings management schemes

There is even suggestion in the future that that since auditors are in the best position to assess a firm‘s earnings quality because of their familiarity with GAAP, the client‘s controls, and its business practices Researchers have proposed that auditors should prepare a ―quality of earnings report‖ on the income statement

Finally, in accordance to the benefits of the investing public (external user) or even students clearer understanding of earning management is (and/more importantly, is not) necessary to ensure an accuracy of understanding towards the future of accounting information