Earnings management in the process of preparing corporate financial reports

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Earnings management in the process of preparing corporate financial reports










Chapter One: Introduction

  • Background

In financial markets, information is the cornerstone on which rests the whole system, so that prices can adequately train and protect the position of those who act in them. The regulation of financial markets and their agents must ensure the correct and necessary information transmission (Nelson, Elliott & Tarpley, 2002) so that investors and analysts can form sound and reasonable judgments for their investment or divestment decisions and  transparency in erecting fundamental principle by which the market passed all relevant information for investors. This information must be accurate, truthful, equitable and be transmitted symmetrically. When these conditions are met, market participants can correctly judge listed companies and taking appropriate decisions, assuming the risks inherent in the market (Cheng and Warfield, 2005).

For example, in October 2001, the first news of accounting irregularities at Enron resulted in, one of the most acute crises of business confidence in US history. Some big names made headlines accounting scandals such as WorldCom, Shell, Coca-Cola, fruit handling their accounts, with the intention of altering the outcome. These examples prove that creative accounting involves harnessing the possibilities that accounting standards provide for the submission of information (Blake, Oliveras & Amat, 2013).

This expression, in recent times, has become part of the accounting language and has brought great consequences both financially and in economic and tax. Earning management refers to the use of accounting techniques to produce financial reports that may paint an overly positive picture of a company’s business activities and financial position. Creative accounting is a form of earnings management and is a phenomenon that is on everyone’s lips and has continually appeared in the press by the series of financial scandals that have become famous worldwide, such as Enron, Worldcom, Parmalat, among others. Regarding this, we ask: Creative Accounting is the basis of financial scandals so notorious? or is it a magic tool, legally, can get better results? Users of information and their information needs are varied and therefore forms of presentation of financial statements may also be. Depending on the company, this information can be tailored to reflect an image according to what users want to see, not necessarily always being real or better. Think that creative accounting is a mere fraud, takes away wit who knows how to use the possibilities that the same accounting standards and generally accepted criteria offer (Cardoso & Fajardo, 2014).

The objective of financial reports is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (Cheng and Warfield, 2005). Financial reports prepared for this purpose meet the common needs of most users. However, financial reports do not provide all the information that may be required for users, for the purpose of making economic decisions, under which reflect mainly the same financial effects of past events and do not necessarily provide non-financial information (Easterwood, 1998).

The financial reports show the results obtained by the management staff or their responsibility for the management of the resources entrusted to it. Users who wish to evaluate the management personnel or their degree of responsibility in the administration, made the above in order to be able to make choices of an economic nature. This may include, for example, hold or sell their investment in a particular company or if they confirm or replace the management staff. Some entrepreneurs and traders with the permission of their public accountant, usually prepare “special” financial statements for presentation to specific users (Baker and Hayes, 2004).

Research Aim

The aim of this study is to analyse what Earnings Management is and how and why it unfolds.  The role of earning management in the process of preparing corporate financial reports will also be analysed.

  • Research Objectives

The objectives of this research are:

  • To develop an understanding of the concept of earnings management
  • To analyse the earnings management measurement techniques
  • To investigate the incentives behind earnings management
  • To examine the use of earnings management in preparing financial reports through case study.
    • Research Questions

The research focuses on answering the following research questions:

  1. What is earnings management?
  2. How do account handling or creative accounting relate to earning management?
  3. How does earnings management helps organisations in preparing financial reports?
    • Research Structure

The structure of this thesis is organized as follows:

  1. Chapter 1 Introduction

This chapter will provide an overview of the background of the study,  aim, objectives and  research questions.

  1. Chapter 2 Literature Review

This chapter will present a review of relevant literature discussing the role of earnings management and its concept.

  1. Chapter 3 Research Methodology

This chapter will present the development of the methodology for this research study. The operational definitions, scaling, data collection methods and sampling for this study will be discussed. The statistical techniques and tests will also be discussed.

  1. Chapter 4 Results and Discussion

This chapter will present the normality and descriptive statistics of the data from this research study. After this is the outcome of the study and its implication will be discussed.

  1. Chapter 5 Conclusion

This chapter will present the conclusions of this research study. The contributions of this research to the field, recommendations and limitations of this study will also be stated.

Chapter Two: Literature Review

2.1. Introduction

This chapter will present analysis of the literature based on financial reporting and earnings management. Various studies are reviewed in this chapter and the idea of earnings management is presented.

2.2 Corporate financial reporting doctrine

The preparation of financial statements should aim to reflect the true picture of the results of financial statements and of the economic and financial situation of the company. This can facilitate financial advisors in decision-making about the management; however, provide the situation in most convenient times for business interests (McNichols & Wilson, 1988).

The concept of earnings management appears strongly with regards to recalling the permissiveness that provides accounting standards when interpreting certain economic events. This is based on the desire to influence the perception of business risk with participants in financial markets. Its purpose is to alter risk measures, such as changes in earnings per share (increasing or decreasing income or expenses) and debt / equity ratio (McNichols & Wilson, 1988).

There are various definitions referring to the accounting manipulation. First, it is defined as an “intervention in the process of preparing financial and accounting information, with the clear purpose of obtaining any personal gain” (Ayres, 1994). It is considered that manipulation occurs when managers make use of discretion and subjectivity inherent to their position in the preparation of financial statements in order to mislead investors and adjust the figures to requirements imposed based on accounting data contracts (Ayres, 1994).

2.3. Concepts of earnings management

Internationally, the literature uses a variety of terms to refer to accounting manipulation (Easterwood, 1998). This section will define and distinguish the term ‘accounting manipulation’ is related to two situations (Arrow, 1973):

  1. a) The first collects the set of measures aimed at affecting the balance sheet, taking advantage of the gaps in accounting standards and their permissiveness to express economic facts in different ways, which is known as creative accounting (Arrow, 1973).
  2. b) Measures to manage the accounting gain, i.e., what is known as earnings management. In this sense, is the ability to increase or reduce the current and future net benefit? Within profit management are two new concepts: income smoothing (or smoothing results) and big bath (or depression result because current attempts to reduce benefits in order to increase future).

The authors like Fagbemi & Olaoye (2014) and Malhotra (2013) argue that research so far has focused too much on the benefit that increased stock price reports to managers, regardless of the economic consequences of the corresponding changes in risk. While it is true that increase in value can lead managers to falsify accounts, according to the authors, they do it for the increased risk that carries with it: when changes in the value and risk are considered, the latter show a relationship earnings management evident, whereas the first is ambiguous (Fagbemi & Olaoye, 2014).

The authors find that if counterfeit bills reduce the risk or not affected, the risk-benefit ratio is maintained. However, if you increase both the value and risk, which is most common, the risk is clearly a factor. Therefore, they insist, the determinant of earnings management is the change in risk and no change in value.  Some studies (Popescu & Ashrafzadeh, 2013 and Cardoso & Fajardo, 2014) show that incentives in the form of actions can lead managers to falsify accounts due to changes in the value that is associated with earnings management. But, as the authors remind here also takes into account changes in risk.  For example, managers will be more or less willing to take risks in terms of expectations to sell its stake before the accounting manipulation.

2.3.1. Opportunistic vs. informative perspective

Creative accounting that transformed the annual accounts “that must be” assumed that there is an absolute standard of accounting truth can be achieved if the rules are fairly applied. Similarly, reference to the ideal that the transactions should be reflected “in a neutral and consistent manner” in which neutral means a need for fairness (Baber, Fairfield & Haggard, 1991).

Authors, who are wary of the interests of management to explain the creative accounting approaches, often rely on positive accounting theory and in particular, in the opportunistic perspective. Opportunistic perspective refers to the condition when the decision provided by the management not based on maximizing the value of the company, but an increase of wealth management. The following opinions are noteworthy.

Creative accounting is essentially a process of using rules, where flexibility and omissions within them, can make the financial statements look somewhat different from what was established by those standards. It consists of mulling over the rules to find a loophole. (…)  Do not have any hesitation, creative accounting is negative. It distorts the results and financial position, and according to the theory, it seems an increasingly common practice (Ayres, 1994).

Continuing this critical view of creative accounting, and based on cases of different companies that went bankrupt shortly after filing financial statements that seemed solid, shown respect: These great, and unexpected, corporate collapses are explained in a way by using the techniques of creative accounting or financial engineering (Baker and Hayes, 2004).

In UK, there is also a critical view of creative accounting. For example, Dye (1988) defines creative accounting as “an accounting system and moulded to the needs of corporate image” and is caused by speculative short-term thinking. For others, creative accounting is the art of manipulating the information that companies provide to external users without being able to see this performance, both arising from the existence of a strong asymmetry of information, such as the flexibility allowed in the rules accounting (McNichols & Wilson, 1988).

Several books like Ronen & Yaari (2008), McKEE (2005) and Giroux (2004), mainly Anglo-Saxon, have addressed the issue of creative accounting from different perspectives. First, from the perspective of a business journalist observed that companies have a desire to hide information that affects the outcome. It is believed that companies have incentives to present some actual numbers below: The items shown twice a year to the investing public, have all been changed to protect the guilty (hide guilt).  In fact this is fraud is entirely legitimate creative accounting and will is also observed for items related to managing the assets of the company (Nelson, 2003).

This issue is addressed from the perspective of accounting as well, where it is argued: that the accounting process is to deal with different types of opinion and to resolve conflicts between different approaches to the presentation of the findings of fact and financial transactions, (…) and this flexibility facilitates the manipulation, deceit and misrepresentation. These scrupulous elements for accounting profession activities begin to be known as’ creative accounting. Here the flexibility offered by the regulations to reflect an economic fact, which could lead to express themselves in a way that benefits the company, but it is within the law stands (Louis, 2004).

From the perspective of investment analyst, it is noted that creative accounting accommodates distort reality: “It is quite possible to lose money if the accounts of a company followed to the letter the accounting principles generally accepted in the UK, but the picture presented is so misleading that it is unable to interpret it correctly and as a result fail to see that the company is financially vulnerable or its profits are unsustainable (Malhotra, 2013).

2.4. Earnings management and benefit management

Earning management and benefit management are widely used terms in the accounting manipulation, especially in studies in the United States. It is often linked to the techniques that are within the limits of the Generally Accepted Accounting Principles. Regulator’s perspective indicates that companies use the term “management benefit” when management uses its criteria to be confused about the economic reality of the company or to influence contractual outcomes that depend on accounting information (Dutta & Fan, 2014).There also are studies that attempt to establish a theoretical basis to justify the behaviour of managers based on the existence of a significant information asymmetry between managers and investors (refs). In all these works, the benefits and optimal management behaviour management arises to maximize their expected utility considering the utility of managers is a function of both the remuneration received as security to keep his job (Cormier, Lapointe‐Antunes & McConomy, 2014.

Thus, the literature indicates that there are two basic reasons for an outcome management: firstly, to encourage investors to buy shares in companies and, secondly, to increase the market value of a company. In the same vein, there are several reasons for benefit management.  Some authors consider being the choice of accounting policy by the company to achieve a specific goal in terms of net profit.

With regards to the theoretical basis for the management of benefits, it is noteworthy work that introduces the idea of managing the results would be a rational and logical behaviour by managers so that they get more confidence contribution from shareholders and lenders.

Conceptually, benefits management can have a double interpretation:

  1. a)Management of the benefits from the revenue management, in order to reduce the volatility of net benefits end over the years and may have the perception that investors in the capital markets (this would be smoothing is considered income or income smoothing).
  2. b)Management of profit sacrificing current performance in order to improve the future of the company (this would be big bath).



2.5. Conclusion

As previously stated the practice of creative accounting is given by the intention to impress with financial statements that project a solid and sustained growth and steady ascent. Auditors may consider reflect on the extent to which the accounts present a true and fair view, as a result of pressure from their clients in relation to creative accounting. Also, auditors have the opportunity to observe closely and deeply enough to assess the behaviour of a large number of companies, also have the technical ability to understand what are the tools of creative accounting that are being used and are also encouraged to identify and attempt to control the practice of creative accounting firms that audit.




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