Earnings Management and Fraud

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The generally accepted accounting principles (GAAP) provide a flexible approach to the choice of accounting policies and estimates by management. The IASB Framework for the presentation and preparation of financial statements claims that information should be relevant and faithfully represented. As such, the reported accounting numbers should inherently be neutral and free from error to represent faithfully the economic phenomena that it intends to describe.

This ideal situation is present in perfect and efficient markets where financial statements convey complete relevance and reliability so as to channel resources efficiently to the firm. A crucial component of financial statements is the accounting earnings. In efficient markets, reported earnings are expected to reflect the firm's underlying performance. Consequently, there is no conflict between management and the users of information over accounting judgment exercised in financial reporting. In this sense, there is indubitably no horizon for earnings management in a perfect market.

Unluckily, our world is far from perfection and accordingly, there is inefficiency prevailing in our capital markets. Significant issues such as information asymmetry and agency costs dominate the markets. Managers possess firm-specific information that gives them a strategic advantage over outside users of accounting information. It predictably allows managers to have discretion over the way the present accounting information to outsiders. As a consequence, managers can report accounting earnings in a way that either reflects the firm's underlying performance or that is desirable to managers. This practice is known as earnings management and has been of extensive interest in the accounting literature.

As Beneish (1999, p.24) postulates, "The extent to which earnings are manipulated has long been of interest to analysts, regulators, researchers, and other investment professionals." Healy and Wahlen (1999) highlight the pervasiveness of earnings management among listed companies and its heightened significance for market participants, regulators and accounting practitioners and researchers. Earnings management was thrust into the spotlight in the midst of large financial scandals that hit the US in the onset of the twenty-first century. Corporate debacles such as Xerox, Tyco, Enron and Worldcom undermined public confidence in financial reports and disclosures. Consequently, the need to detect earnings management topped the priorities of regulators, analysts, accounting researchers and practitioners. The detection of regular earnings management helps these parties to take corrective actions and to monitor the phenomenon so that it does not dampen confidence in financial markets.

2.0 Literature Review

This chapter is based on the extant literature of earnings management. It provides a conceptual framework for the empirical study on the detection of earnings management using discretionary accruals.

2.1 What is Earnings Management?

There have been different attempts in extant accounting literature to define earnings management and the lack of harmony on a proper definition has led to several interpretations of the phenomenon. This disagreement highlights the various attempts to detect earnings management and to understand the motives behind this practice.

Schipper (1989, p.92) draws emphasis on the managerial intent to knowingly influence and manage earnings. He propounded one of the first definitions of earnings management in accounting literature, and he states that:

"By earnings management I really mean disclosure management in the sense of a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain in contrast to, say, merely facilitating the neutral operation of the process."

Similarly, Healy and Wahlen (1999, p.368) postulate that:

"Earnings management occurs when managers use 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 numbers."

Both definitions are of general acceptance accounting literature. The definition put forward by Schipper (1989, p.92) underlines the opportunistic behaviour of management in the preparation of financial statements in terms of the management intention to earn a private gain. The second definition also emphasises on the opportunistic perspective in the sense that managers can exercise their discretion to mislead stakeholders. This precludes the information perspective that earnings management can be used as a signaling mechanism. The ability of management to mislead stakeholders stands if there is informational asymmetry between managers and other stakeholders and earnings management is not transparent the outsiders.

In addition, Healy and Wahlen (1999, p.368) advocate that managers can exercise judgment in preparing accounting reports and in some cases; they may have discretion to choose among different accounting estimates for a transaction. A simple example would be that a manager must select between straight-line or reducing balance methods in order to estimate depreciation. Managers may also structure corporate transactions such as equity investments or business combinations to modify the outcome of their financial report. Both definitions have been criticised on the grounds that the managerial intent cannot be directly observed (Ning 2005, p). For instance, it is difficult to know whether earnings have been managed to deceive stakeholders or to benefit from contractual outcomes.

Mulford and Comiskey (2002, p.59) and Scott (1997, p.265) are of the view that earnings management can act as a signaling mechanism and that accounting earnings are informative to users. In this regard, they contend that the choice of accounting policies and estimates by managers convey credible signals of the firm's prevailing performance. Mulford and Comiskey (1996, p.360) define earnings management as the 'active manipulation of accounting results for the purpose of creating an altered impression of business performance'. The modified impression created by managed earnings does not ineluctably imply that they are less meaningful. For instance, it could be that managed earnings produce better signals for the future expected earnings and reflects more the financial risk than unmanaged earnings.

2.2 Earnings Management and Fraud

The GAAP permits a certain degree of flexibility in the interpretation of financial accounting numbers. A legal interpretation is one, which maintains the spirit and intent of the accounting standard. Interpretations may be incorrect without being fraudulent. Fraud occurs when there is an intention to deceive, which undeniably causes the act to be illegal. Fraud is defined as "the intentional misstatement or omission of material facts or accounting data, which is misleading and when considered with all information made available, would cause the reader to change or alter his or her judgment" (The National Association of Certified Fraud Examiners).

The difference between earnings management and fraud is not obvious to everyone. Brown (1999) stipulated that there is often a narrow line that separates the two. Dechow and Skinner (2000) distinguish between fraudulent reporting and financial reporting, which fall within the GAAP. They posit four types of accounting practices and choices that can provide a conceptual distinction between the earnings management and fraud. On one side, there is fraudulent financial reporting, which arises as the GAAP is violated. In contrast, the other three categories describe accounting choices that fall within the GAAP namely: Conservative accounting, Neutral accounting and Aggressive accounting. So, Dechow and Skinner (2000) put forward that earnings management remains within these three types of categories that fall within the GAAP whilst fraudulent accounting occurs when the GAAP is violated. For instance, the recording of fictitious sales and inventory violates the GAAP is clearly an accounting fraud. Conversely, the underestimation or the overestimation of the provision for bad debts happens within the GAAP and may result from earnings management. In many cases, it is difficult to assess whether the accounting judgments that take place within the GAAP are legitimate or result from earnings management with the managerial intent.

2.3 Evolution of Earnings Management Research

2.3.1 Early Capital Market Research

Earnings Management attracted interests since the 1960's when researchers studied the Mechanistic Hypothesis. This hypothesis posits that there is a mechanical relationship between reported earnings and stock prices. It relied on the assumption that investors base their decisions on the face value of financial statements. Consequently, they are likely to be deceived by financial information because the reported earnings used to forecast stock prices are merely mechanical. Ball (1972) and Kaplan and Roll (1972) observed that stock prices are affected by the changes in accounting methods. They made an assumption that investors based their decisions only upon accounting earnings to anticipate stock prices and they had only the financial statements of the company as information. Ball and Brown (1968) stipulate that positive changes in earnings translated into favorable abnormal share return whereas negative changes in earnings resulted in adverse abnormal share return regardless of changes in present value of cash flows. The Mechanistic Hypothesis therefore, demonstrates that the presence of earnings management can systematically mislead market participants who use reported earnings to predict share prices.

In contrast to the Mechanistic Hypothesis, the Efficient Market hypothesis (EMH) developed by Fama (1970) asserts that there is no relationship between accounting earnings and stock prices. The hypothesis states that the stock prices entirely reflect all the available information in an efficient capital market. Holthausen and Leftwich (1983) support that managerial discretion is not significant in efficient capital markets, since there are no costs associated with information and it is available to all market participants. Moreover, the market participants are able to see through the effects of managed earnings, which originate from managerial discretions. As such, the market players cannot earn any abnormal share return, whether earnings management has occurred or has not occurred (Mayer-Sommer 1979; Hines 1982). In this regard, there are no grounds to manage earnings in an efficient capital market.

2.3.2 Positive Accounting Research

In the late 1970's up to 1990, the focus on earnings management turned to non-capital market research. The EMH and the Mechanistic Hypothesis fail to explain the motives that push managers to manipulate earnings. The Positive Accounting Theory (PAT) propounded by Watts and Zimmerman (1978) reveal the internal contractual incentives that cause managers to engage earnings management in contrast to the capital market incentives. According to the theory, the firm is a nexus of contracts and managers want to lessen contracting costs with other contracting parties. In addition, managers and the other parties are rational and will choose accounting methods that will shape contractual results for their own benefit. As such, managers will have an opportunistic behaviour when there is flexibility in the choice of accounting methods and will want to maximise their wealth.

The theory rests upon three major hypotheses namely the bonus-plan hypothesis, the debt covenant hypothesis and the political costs hypothesis. Much of the earnings management literature relies mainly on the three hypotheses of PAT and much empirical research of earnings management has tested their implications (Healy 1985 and Sweeney 1994). PAT is based by the agency theory in the sense that shareholders use management compensation contracts to prompt managers to maximise the value of the firm and subsequently the shareholders' wealth. Managers are likely to manipulate and exercise discretion over accounting numbers in order to influence the outcomes of management compensation and the debt contracts and to reduce the political costs (Watts and Zimmerman 1978).

2.3.3 Modern Capital Market Research

In the last two decades, the interest to study capital market incentives to manage earnings was renewed. Dechow and Skinner (2000) pointed out the reasons for the move back towards capital market research. Since the 1990's, there are strong grounds to believe that markets are not at least semi-strong form efficient which were previously asserted. Also, the perception that investors are rational in their choices has been criticised. In addition, accounting measures are widely being used as benchmarks in stock valuation. Consequently, stock prices have become more sensitive to accounting numbers such as earnings. For example Teoh et al (1998a, 1998b) studied earnings management in the event of initial public offerings (IPOs) and seasoned equity offerings (SEO's). Burgstahler & Eames (1998) examined earnings management and analysts' forecasts to achieve zero and small positive earnings surprises.

2.4 Incentive to Manage Earnings

2.4.1 Contracting Incentives

2.4.1.1 Management Compensation Contracts

There is a substantial body of earnings management research that studies management compensation incentives to manage earnings. According to PAT, shareholders will contract with managers in order to line up manager's interest with that of the firm and eventually to that of shareholders (Watts and Zimmerman, 1978). These contracts usually take forms of compensation agreements and bonus plans that are based on earnings. This nexus between management compensation and reported earnings has opened a door for managers to manipulate earnings in an opportunistic perspective. Healy (1985) conducts one of the first studies of management compensation. In fact, he tested the bonus plan hypothesis promulgated by Watts and Zimmerman (1978). His findings concluded that managers react opportunistically to reported push earnings higher in order to increase the compensation that they will receive.

Holthausen et al. (1995) findings oppose the view of Healy (1985). Indeed, they report that most managers use income-decreasing earnings management to increase future compensation. In fact, bonus payments amount to a percentage of the earnings, but are subject to a ceiling and a floor. As a consequence, there are no compensations if earnings fall below the floor and bonus payments are capped at the ceiling. In case where reported earnings do not fall between the ceiling and the floor threshold, managers tend to shift current earnings to future periods in order to increase compensations in the future. Despite the polarised evidence about whether managers use income-increasing or income-decreasing earnings management, management compensation contracts are undeniably an impetus for managers to manipulate earnings.

2.4.1.2 Debt Contracts

Debt contracts provide a stimulus for managers to engage in earnings management. This argument stems from the debt hypothesis propounded by Watts and Zimmerman (1978). The linkage between debt contracts and accounting earnings has drawn interest since a firm with high earnings and lower leverage undoubtedly is more attractive to lenders. In fact, Watts and Zimmerman (1978) posit that managers try to avoid violating debt covenants by the exercise of their discretion over accounting earnings. This is justified by the claim that managers manipulate earnings to avoid the costs associated with the violation of debt contracts and also to alleviate the constraints of such agreements.

De Fond and Jiambalvo (1994) provide evidence that managers increase earnings a year before the breaching of debt covenants. Management pushes earnings upwards with a view to persuade creditors about the favourable financial position of the firm and subsequently to avert falling in technical default. On the contrary, some studies have shown that managers use income-decreasing earnings management when their firms approach covenant violation. DeAngelo and Skinner (1994) advocate that managers of financially distressed firms are likely to curb accounting earnings, in an attempt to renegotiate more favourable terms for the debt contracts and to palliate their constraints.

2.4.1.3 Regulatory Incentives

2.4.2 Stock Market Incentives

The stock market incentives to manipulate reported earnings have increasingly been in the limelight. The connection between earnings management and stock market reactions acts as a catalyst for managers to turn to strategies to manage earnings.

2.4.2.1 Analysts' Forecasts and Earnings Benchmark

There is emerging concern of capital markets by managers, especially in terms of rising wealth and compensation linked with stock markets. However, the focus has been drawn towards earnings management as a means to meet or beat analysts' forecasts. Bartov et al. (2002) find that listed companies that meet or beat analyst's forecasts experience higher returns, even if this is attained through earnings management. Degeorge et al. (1999) support this argument and postulate that small negative earnings and small decrease in earnings are hardly observed, which is not normal. On the opposite side, small positive earnings and small increases in earnings are most commonly observed, which is once more irregular.

Burgstahler and Dichev (1997) used earnings benchmarks to detect earnings management: zero earnings and previous year earnings. They provide evidence that managers are encouraged to avoid reporting losses and falls in earnings relative to the benchmarks. The study also finds that managers boost earnings by manipulating cash flow from operations and changes in working capital. Matsunaga and Park (2001) find that listed companies that fail to meet earnings benchmarks have adverse repercussions on stock returns and valuation. Management exercise discretion on reported earnings to meet earnings benchmarks to avoid negative stock returns.

2.4.2.2 Equity Offerings

Researchers have studied earnings management and its implications in equity offerings. Managers of listed firms may engage in earnings management ahead of Seasonal Equity Offerings (SEO) in an endeavour to raise share prices. By the same token, companies that are offering their shares for the first time to the public through an Initial Public Offering (IPO) may manipulate earnings figure in prospectuses with a hope of obtaining higher share prices. In fact, managers use discretionary accruals to hike up reported earnings at the time of IPO's (Teoh et al., 1998c). Similarly, other findings have shown that companies underachieve in the years following the IPOs and SEOs (Teoh et al., 1999a; Teoh et al., 1998b). The upsurge in earnings at the time of IPOs and SEOs demonstrate that managers have heightened reported earnings in order to gain better share prices.

2.4.3 Firm-specific Incentives

Firms have some characteristics that can motivate managers to engage in earnings management. Indeed, firm-specific incentives can be numerous and as a result only a few are discussed in this paper.

2.4.3.1 Profitability

Managers are likely to make financial decisions based on the future level of earnings. If a company has low earnings and expects it to be higher in the future, managers are stimulated to exercise discretion over earnings and raise the current reported earnings. In fact, managers borrow future earnings for the present when profitability is currently low. White (1970) observes that companies with decreasing earnings have more incentives to smooth earnings. Ashari et al. (1994) assert that managers tend to manage earnings when their profitability is low and when earnings volatility has worsened. On the contrary, if a firm currently experiences high earnings and that managers believe that future earnings will plummet, they are likely to manage current earnings downwards. In this sense, they are saving present earnings for the future when profitability is currently high.

2.4.3.2 Company Growth

The extent to which firms can expand their operations is another impetus to manage earnings. Indeed, some researchers have shown that growth and risks are associated with earnings (Collins and Kothari, 1989). Beaver et al. (1998) prove that expansion opportunities act as a stimulus for earnings management practices. Increased growth perspectives are likely to cause more fluctuations in earnings which might not display a good signal to investors in terms of higher risks. Subsequently, managers are motivated to smooth earnings during growth period since the increased risks are detrimental to the cost of capital of the company.

Firth et al. (2007) are of the same opinion and highlight that rapidly booming companies are likely to manage earnings, in contrast to well-established companies. They also point out that earnings management is hardly detected by analysing the operations of expanding companies. Young (1999) underlines the positive relationship between company growth and discretionary accruals. He further advocates that this is explained by the large working capital accruals of growing companies.

2.4.3.3 Operating Performance of the Firm

Managers' temptation to exercise discretion over earnings also hinge upon the operating performance of the firm. The operating performance is not similar to profitability. Operating cash flows are used as a measure of operating performance in contrast to earnings, which reflect profitability of the firm (McNicholos and Wilson, 1988). Managers are stirred up to manage earnings upwards when the company's operating performance is unfavourable. In some cases, managers may be encouraged to mitigate earnings, especially if operating cash flows are unusually low and this practice is known as the taking a bath strategy. Contrariwise, when firms have extreme operating performance, managers are inspired to depress current reported earnings. Young (1999) reports that high operating cash flows are negatively connected with discretionary accruals.

2.4.3.4 Company Size

Earnings management behaviour is undeniably motivated by the firm size. The political costs hypothesis propounded by Watts and Zimmerman (1978) examines the relationship between firm size and earnings management. The hypothesis postulates that larger companies are likely to attract political attention which takes form in terms of regulations and taxes. They posit that managers of larger firm are encouraged to manage earnings in order mitigate the political attention and as a result, the costs associated with it.

However, this view is not shared by Holland and Jackson (2004). They underpin that large firm are, in reality, motivated to abstain from earnings manipulation. They stress that the disincentive to manage earnings arises because of the intensified scrutiny which comes from the stock market participants, regulators and the media. Bathke et al. (1989) depicts that larger companies have more stable earnings. In this respect, larger firms tend to practice less earnings management because they have the potential to diversify risk and stabilise growth which in turn, reduces volatility in earnings.

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