The issues involved in Earning Management
Nowadays, people tend to overlook the issues of earning management. To the extend until the big company in US, the scandals of Enron being emerge, than people realize the play mode of earning management. Many researchers have their own perception, definition and opinion with regards earning management. Earnings management as define by Paul M.C (2003) is the tools to chose accrual estimates or timing operating decisions in order to meet short-term earnings in a desired direction. In addition, Thomson defines earning management as reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results. Thomson believed that, earning management are not illegal activities, if the financial statement are not misrepresent.
In addition, Namasiku Liandu, (2004), define earning management is principally when companies artificially inflate (or deflate) their revenues or profits, or earnings per share figures. They do this by using aggressive accounting tactics (estimates/policies etc). In other words, it is when companies use creative accounting to create reported figures that show the position (balance sheet) and performance (income statement/profit and loss account) that management want to show. Scott B. Jackson and Marshall K. Pitman stated that "Earnings management" has been defined in various ways. One definition is "purposeful intervention in the external financial reporting process with the intent of obtaining some private gain." Another definition is the "use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting judgments." Yet a third definition is "an intentional structuring of reporting or production/investment decisions around the bottom line impact."
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Earnings management is recognized as 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. (Michael D. Akers, Don E. Giacomino, and Jodi L. Bellovary, 2007).
As mention earlier, earning management is legal, if the financial statement are not misrepresent, however, more companies tend to use earning management to the extend that financial statement are prepared with misstatement and could affect the decision making. This is where it happen in Enron case in US, whereby to avoid company value affected as company having financial problem, Enron show that company in good position, and until the end the company cant hidden their huge losses anymore. This is where fraud occurs. When we have such intention to done something wrong, meanwhile we know the truth, and that wrongdoing could affect the decision making and materially misstated, than the earning management now turn up some sort of engineering accounting or some called "cooking the books" and become illegal activities.
Earning management-reason to commit fraud by implementing earning management
Virtually all managerial activities have a potential effect on earnings, perhaps some researchers agree that every executives must learn how to manage earnings and in that sense constitute earnings management; otherwise, the activities presumably would not be undertaken. It is because; earnings are the most single important item in financial statement. It is signal that help allocation of resource in capital market, to the extent that indicates which company has engaged in value added activities. In fact, the earnings could influence the value of the company, which is if the earnings is low, indicate value of the company also low, and if the earning are high, it is signal that company value also high.
There are several reasons why managers and directors always imply earning management. In fact, imply earning management to the extent of fraud. First, with intention to attract investor and retain existing shareholders. Company need capital to running business operation, instead of using debt financing (take loan), company want as many as possible investors to invest in their company. Invitation of investors could bring cash inflow to the company, thus company could use it in order to running the company or invest into the profitable project. Therefore, in order to attract the investor to invest, companies need to confident the investor that their company is the best for the investment. From point of view investor, this could only happen, if the financial position of the company is strength enough and company could make profit in return to the investor investment.
Thus, to achieve that, several managers and directors tend to use earning management to the extent the presentation of financial statement are materially misstatement. This is supported by Thompson, in their research which is a 1998 survey at conference sponsored by CFO magazine; found that 78 percent of their chief financial officer (CFOs) in attendance had been asked to cast their financial results in better light, though still using generally accepted accounting principles (GAAP). Half of them complied with the request. Worse, however, 45 percent of the group attendees reported that they had been asked to misrepresent their company's financial results, and 38 percent admit with complying. This in fact, shows how the managers and directors are intense pressure to report better earning even the company are not good.
This also can be shown from the scandals of Enron, which the managers are intense pressure to present the company financial statement is good, even the reality is not. In addition, Lehman Brothers announced that its capital position was "strong" just days before it filed for bankruptcy and the mortgage giants Freddie Mac, and to a lesser extent Fannie Mae, were found to be playing games with their accounting and ultimately led to the largest-ever financial rescue until then. Those companies are example of using earning management to the extent that fraud has taken place. In fact, company doing the same thing to retain their existence shareholders. In order to avoid shareholders take out their fund and run away, manager and director presented good financial statement.
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In addition, the other reason for intentionally doing fraud, managers are in conflict with their own interest, whereby to maximize their own compensation. Some researchers has agree that given directors a compensation such as stock could lead to less used of earning management, with the support that, when the directors holding several percentage of the company share, the directors may put their interest aligned with the shareholders interest, however , several researcher has denied it, with draw back, when the directors are holding several percentage of company shares, it could lead to the more earning management, as directors want maximize their compensation.
Based on Walter R. Young, 2003, chairman, president and chief executive officer of the Auburn Hills, Mich., company, he stated that "It's not politically correct to do that all-equity approach anymore," and in fact that nowadays, "if you give options to directors, you're tarred and feathered, cash is back in." In addition, according to the Compustat ExecuComp Database, there are 274 firms that paid directors with stock options in 1992, while the figure climbs to 1,214 in 2002 but then drops again to 1,055 in 2004. During the same period, however, about 660 firms never paid director with stock options and another 102 firms stopped paying stock options to their directors.
As mention earlier, some researcher has agreed, given the shares to the directors could lead to less agency problem, thus less manipulation of earning. Jensen and Meckling(1976), support this by highlight that firms suffering from the agency problem resulting from the separation of management and control can use incentive compensation to help align the interests of the CEO and stockholders. In fact, Morck, Shelifer and Vishny(1988), and McConnell and Servaes (1990) find a positive relation between Tobin's Q and inside director shareholdings. This is because, directors are human being, same as other layman, their duties is to manage the company well, and as a return, the directors are given salary and allowances.
After several researches being done by several researchers, they are agreed that, giving directors holding several percentages of company shares as compensation are more effectives to monitor the directors' behaviors. This is because, when directors holding some percentages of shares, indirectly, he also serves the company for the benefit of their own, which is as shareholders, thus indirectly it could make directors interest aligned with shareholders interest. In fact, when directors put her as shareholders of the company, it could lead to less manipulation of earning and avoid from fraud to be taken place.
On the other hand, some researchers draw back with the issues that given the directors shares of the company also induces executives to become short-term oriented, and therefore firms suffer from severe agency problems when the incentive pay is high. CEO's compensation incentive to stock price is significant positively related to the tendency to misreport accounting information, (Burns and Kedia, 2006). In addition, Berge and Philip (2006), show that when the CEO's incentive pay ranks near the top CEO is likely to sell more shares and realize more stock options in the current year. Add more, Aboody and Kasznik (2000) and Yermack (1997) show that CEOs manage investors' earnings expectations downward prior to scheduled stock option awards in order to increase the value of their awards, and Nagar et al. (2000) present evidence that a firm's discretionary disclosure of accounting data is related to the form of the CEO's compensation.
Moreover, Byard and Li(2005) add more, when stock options are used as a common component of the compensation to the CEOs and board directors, they can comprise directors' independence and ability to monitor CEO's option timing opportunities. Similarly, one can argue that awarding stock options to the directors would reduce their abilities to monitor the CEO's manipulation on earnings. This is because, even directors are not given the shares of the company, the misstatement and fraud could take place, and what more if the directors are holding the shares of the company. The independent of directors might be compromise. Furthermore, directors are the one who know everything in company transaction, probability the directors may doing their duties for the sake of their interest cannot be avoidable.
In fact, as mention earlier, the incentives given as director's compensation, only for short term oriented. In what sense the researchers' argument is, when giving such incentives to the directors, they will intense to manipulate earning for the purpose to increase their compensation. If the companies are not making profit, thus the chance that directors manipulate the earning to increase their incentives might be there. In facts, directors will be the one who choose what accounting methods need to be used. Thus, given directors holding some percentage share of the company seem could lead to the manipulation of earning to the extent that fraud could happen.
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Instead of for retain existing shareholders and attract more investors and to increase the directors compensation, the other reason for earning management to the extent of fraud are due to corporate culture of the companies. According to the Tom Tierney (2002) among the other threat of other recent scandals is a corporate culture that encouraged earnings management. A corporation's culture is symbolize what determines how people behave when they are not being watched, and such behavioral determinates include a set by senior management, the board of directors and the accounting policies that reflect such a tone. For example, Enron, corporate greed and arrogance were apparent in the entity's aggressive use of mark-to-market accounting for its energy trading contracts. Under this generally accepted accounting principle, entities are required to adjust the reported amounts of such contracts and record a gain (or loss) for any adjustment upward (or downward). By optimistically valuing its energy contracts, Enron was able to report significant unrealized gains in its profit numbers. In fact, in the year 2000, more than half of Enron's $1.4 billion of pretax profit was made up of these unrealized gains. As Sherron Watkins, a former vice president at Enron, summarized, overall, investors lost over $60 billion on Enron in just less than two years and Enron went bankrupt without ever declaring or having a poor quarter relative to recurring earnings. (Stephen D. Makar, Pervaiz Alam, and Michael A. Pearson, 2004).
That show how much important the corporate culture in all companies. As mention earlier, corporate culture acts as a mirror of their management and boards' behavior. If at the early stage of the companies' incorporation, the members are concern about these corporate cultures, therefore the worse and bad things could be avoidance. Just look at Enron scandals, the responsibilities of the management are to present the financial position of the companies that reflect the economic reality, however Enron management fail to do so. Same goes to Arthur Anderson, as external auditors, they are responsible as public watchdog, and should perform their duties in good faith and independence, however as weak in corporate culture, Arthur fail to do so, they just let their interest being conflict with their own responsibilities.
On top of that, market expectation and high pressure to maintain the position of the company within the group also distribute to the reason fraud could take place. Based on study by Graham, Harvey and Rajgopal (2005) where the authors interview more than 400 CFOs to determine the factors that drive reported earnings and disclosure decisions, they find that 73.5% of the respondents agree or strongly agree that analysts' consensus forecast of earnings per share (EPS) for current quarter is an important benchmark for their company when they report a quarterly earnings number. In addition, another articles in Fortune, the author claims that during the 1990s, "matching or beating the First Call consensus number came to be the single most watched measure of corporate success"(Fortune, 2003). As for that, it is not surprising that top corporate executives place such a strong emphasis on meeting or beating analysts' expectations (MBE) as a performance and consequences benchmark of the companies.
In fact, Graham, Harvey and Rajgopal (2005), Bartov, Givoly and Hayn (2002), Richardson, Teoh and Wysocki (2004), Matsumoto (2002), among others, had realize this strong corporate concern has caught the attention of academic researchers recent years. Bartov et. al. (2002) examine the capital market rewards to meeting or beating earnings expectations, and they find out a stock market premium to MBE of 2.3% in quarterly returns after controlling for the magnitude of the positive earnings surprise, and an additional 0.5% returns premium for every 1% in earnings surprise to firms that MBE. This premium is economically significant considering the average quarterly return of their sample firms is about 3%. Graham et. al. (2005) found that 80.7% of the interviewed CFOs guide analysts to some degree to manage earnings benchmarks linked to analyst forecasts. Moreover, they also find that managers take a mix of accounting and economic actions to ensure that their earnings benchmarks are met. This study indicates that managers, instead of being mere observers of this MBE game, are active participants and are willing to sacrifice firm value and manage earnings or analyst expectations to guarantee that their earnings objectives are met.
Without consider the consequences in future, many managers now are in pressure to achieve the market expectation, thus lead to the manipulation earnings to the extent that company financial statement are not meet economic reality. This could happen, as mention at earlier stage; managers tend to use mix accounting practice and method in order to meet the target to the extent they willing to sacrifice company value. Moreover, managers need to meet the market expectation in order to maintain their company position within the group. The market will give reward to the company, who can meet the market expectation, and this action indirectly could affect the share price of the company in industry. Thus, to ensure company are the best among the competitors and maintain their position within the group of companies, many directors and managers are willing to manipulate their earnings in order to ensure their company earning achieving or meet the market expectation.
All in all, bring the issue of earning management to the extent of fraud. Those discuss above are several reason of manager or directors implement earning management to the extent fraud could be take place. The wrongdoing only could be recognized if the intention doing that is there. Thus, as what has being discuss above, each researchers has their own opinion, ideas as well perception towards earning management. However, I m believe, all researchers, even at several level being not disagree at some points, they would agree that, earning management to the extent of fraud are totally wrong and give significant impact not only to the shareholders of the company, but to the others users such as public, government, investors and etc.
Impact of earning management to the extent of fraud
Lose of investor and public trust
It cannot be denied, once aggressive accounting apply in companies and trigger the companies to fall down and bankruptcy, it will give a significant impact, not only to the company, as well as to the market, government and country. For example, W.R. Grace and Co. officials learned this the hard way. The company was charged with stashing earnings in reserve accounts in good years and then tapping them in later years to mask actual slowing earnings. (Without admitting to or denying the charges, Grace later signed a cease-and-desist order and promised $1 million to support educational programs that enhance public awareness of financial reporting and GAAP.)
Moreover, McKesson HBOC Inc. was charged with the opposite of Grace. The company allegedly booked premature revenues by including in sales figures a substantial list of contracts that had not been finalized. The Securities and Exchange Commission (SEC) and other agencies are investigating many more cases like these two for earnings manipulation. (McKesson HBOC later fired or accepted the resignations of its chairman and six other top executives, restated previously reported earnings, and instituted new internal accounting procedures.).
Thus, this could lead to the lose of investor trust. The successful of companies, market as well as country, is depend on how the investor trust the stock market, whereby the strong market efficiency could increase the confidence level of investor to invest. However, when stock market are lack of confidence and in fact cannot be reliable, therefore, no more investors want to invest and this situation indirectly could lead to the downturn of economic.
Reliability of final accounts are being compromise
All this while, preparing the final accounts is being done with the intention to present the position of the companies to public, as well as to attract the awareness of investors. The reliability of financial statement is where all users can rely on the information disclose by the companies, and this right should not been violated either by top management or auditors. However, when earning has been manipulated by the managers or directors, and till the end triggers the companies to wound up, soon the reliability of the final accounts could be compromise. In fact, for listed companies, the preparation of financial statement is gone through audit procedure, which is to determine the true and fair view of the financial statement.
Nowadays, either public or investors, there are not fool, there are not looking solely to the earning of the company, but in fact they are looking to the quality of the companies final accounts, for example the corporate social responsibility being done by the company, code of corporate governance and etc. This is to ensure, their interest are not being violated by several group of management for the purpose of their own interest.
Independence of auditors being question and compromise
Another one significant impact of fraud is soon the independence of auditor as public watchdog could be questioned and compromised. As a professional, which give an opinion to the companies financial statement, most users rely on it, in fact those illiterate investors, are making decision based on auditors report. For example, all the big companies who collapse actually did an audit procedure. Enron and World.com are going through the audit procedure, but when an auditors put aside their duties to act in good faith and independence, let their own interest against their duties, what happen in Enron and World.com could happen again.
As professional, auditors should carry their duties accordingly. Public are depend with the auditor opinion in making decision, thus, to avoid public as well as investors lose the trust to this profession, accountant and auditor need to work hard in order to ensure fraud in financial statement could be avoid.
As conclusion, we should bear in our mind, all people nevertheless manager, directors, top executives and as well as auditors. They are allowed to learn how to manage earnings, instead as mention earlier; perhaps they should or must learn how to manage earning in the sense that as influence people in the companies, they should know what they need to do for company in future. They are allowed to choose what method in deriving their earning as giving by General Accepted Accounting Practice (GAAP).
Sometimes, managers don't realize, at first the intention is not to done something wrong, because they are very confident, company could survive for indefinite life. However, there are several factors that we as human being cannot control, thus this factors could lead to the wrongdoing by the managers, which as first they are not intent to do, but until the ends, when that the only way to choose, therefore managers tend to choose it, with the hope everything will turn to be calm and flow smoothly in future.
Moreover, we also need to know, earning management are not wrong as long as intention to misrepresent the financial statement are not there. Instead, earning management are allowed in practice, the fraud happen when managers tend to misbehavior and manipulate the earning, until the true of earning cant be observable. In fact, some researchers has agree that, if managers are not greed in making profit for the benefit or their own, earning management are not the worse thing, but when people are to greed to make profit, and put aside all the risk, till the end the truth cannot be hidden anymore. Than, people realize, even earning management are allowed to being practice, however the issues behind it cannot be overlook and take for granted.
Thus, all people need to learn how to manage earning, therefore cannot be fool by using earning management. Instead, auditor as the watchdog of public need to aware and ensure the issue of earning management to the extent of fraud could not happen again. This in order to ensure the reliability of financial statement especially regarding earning are not being affected and be compromise.
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