Literature Review :earnings management

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Literature Review

Introduction

Stakeholders such as investors, managers and others use financial statements to assess the financial performance of organisations in order to make economic decisions. In essence, corporate managers are expected to professionally and ethically apply standards that best portray the real financial performance of a company. However, corporate managers have exploited the choices provided by the International Accounting Standards by exercising excessive discretion in financial reporting. According to Kriengkrai et al. (2006), the International Accounting Standards (IASs) together with government Acts leaves companies’ managers and controlling owners with extensive discretion to manipulate reported earnings in order to disguise true firm performance. Thus, it can be said that communications between firms and users is sometimes deliberately distorted by practices of managers (Gowthorpe and Amat, 2005). This activity of distorting accounting information is referred to as earnings management. The victims of earnings management are, obviously, the existing and prospective financial statement users including equity investors, bankers and the like (Lo, 2008).

Definition of earnings management

There is no generally accepted definition of earnings management at present. Different authors have come up with different definitions of earnings management. One of the most used definitions of earnings management is provided by Schipper (1989). She defines earnings management as “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gains.” The intervention in the financial reporting process corresponds to the exploitation of discretionary accruals (Islam et al. 2011). Discretionary accrual reflects managerial choices while the non discretionary accrual captures the impact of business conditions (Chan et al. 2006). For example, if the allowance for doubtful debts were changed because of management’s personal interest, the change in accruals would be classified as discretionary.

The explanation of earnings management provided by schipper (1989) is partial. Hence, she included a minor extension to the definition which would encompass “real” earnings management, accomplished by timing investment or financing decisions to alter reported earnings. Schipper’s definition of earnings management leads to the conclusion that earnings management can be dichotomized into accrual based earnings management and real earnings management.

Accrual based earnings management

A simplistic definition of accrual earnings management is where accruals are manipulated with no direct cash flow consequences (Roychowdhury 2006). Accruals earnings management involves changes in accounting methods, policies and estimates. For instance, changing the estimates of provision for bad debts and changing depreciation methods or changing estimates of useful lives of depreciable non-current assets. Nonetheless, schipper (1989) reported that accrual based earnings management unlike real based earning management is extremely transparent particularly in the year of change and therefore such activities may be unmasked by auditors and regulators. Also, what makes accountants renounce to the use of accrual based earnings management is the great deal of disclosure requirements. For example, to change the estimates of provision for bad debts disclosures would be mandatory.

Real earnings management

Schipper (1989) in her definition mentions that real earnings management is achieved by timing financing and investment decisions. However, subsequent definitions of real earnings management points out that real earnings management can as well be accomplished though timing of operational decisions (Roychowdhury, 2006). Therefore, manipulation of accounting figures can be achieved by changing the timing of certain transactions whether it is operational, investing or financing decisions (Ahadiat et al. 2012). An example of operational real earnings management includes offering discounts to customers at year end to move forward sales from next period to current period. Likewise, reduction in current year research and development expenditures is an instance where investing real earnings management has been exercised.

The problem with real earnings management is that it is difficult or sometime almost impossible to distinguish whether a “real” decision has been undertaken to maximize shareholders value or merely to manipulate earnings (Schipper, 1989). This is because real earnings management is not observable within the financial statements. However, according to Sun and Rath (2010) real transactions may require disclosures which makes managers discretion easy to monitor. Despite the disclosure requirements real earnings management remains hard for outsiders to detect especially in years after the initial change (Schipper, 1989).

Real earnings management is quite costly for a firm, since the likelihood of undesirable cash outflows in both the current and the forthcoming periods due to managers’ initiative to improve earnings in the current period (Cohen and Zarowin 2010). For instance, acceleration of timing of sales through lenient credit terms will temporarily increase sales volumes hence earnings. However, more lenient credit terms will result in lower cash flows in the current period. Similarly, reducing advertising expenses will undoubtedly boost current period earnings but at the risk of a decline in future cash flows. Cohen and Zarowin (2010) also acknowledged that with the enactment of the Sarbanes Oxley Act, accrual based earnings management has become costly because of the penalties imposed on firms if held accountable. Thus, following the requirements imposed by the Sarbanes-Oxley Act managers may have changed their preferences for the mix between accrual based and real activities to manipulate earnings (Graham et al. 2005).

Fraudulent Accounting

It is important to point out that earnings management can sometimes be fraudulent in such that it exceeds the scope stipulated by the International Accounting Standards. Enron is an instance where the company was held to have taken earnings management practices to a fraudulent dimension. Dechow and Skinner (2000) documented several examples of fraudulent financial reporting namely recording sales before they are realizable, recording fictitious sales, backdating sales invoices and recording fictitious inventory Other common examples of fraudulent accounting techniques regarding revenue include sham sales, false confirmations, premature revenue recognition before all terms of the sales are completed and the like (Beasley et al. 2000). It can be deduced that fraudulent financial reporting is outside the boundary of the International Accounting Standards.

Most cases of earnings management leading to fraudulent accounting such as Enron and WorldCom are prior to the implementation of the Sarbanes-Oxley Act (2002) and other corporate governance set of guidelines. However, despite severe consequences of violating International Accounting Standards, managers have not abandoned the fraudulent manipulation of accounting results. The world has incessantly experienced corporate accounting scandals such as American Insurance Group scandal, Lehman Brothers scandal and many more. A current accounting scandal involves UK largest Retailer by sales, Tesco. Tesco is alleged of inflating its first half profits by approximately £250 million by accelerating recognition of commercial income and delayed accrual of costs.

Consequences of earnings management

Based on a comprehensive literature review, Dechow et al. (1996) uncovered that firms alleged of earnings manipulation will experience an average stock price plunge of approximately nine percent at the initial announcement. This fact can be supported by the recent accounting scandal involving Tesco where the share price dropped by eight percent after the announcement of the financial fiasco. Any downfall in stock prices can be associated with a tarnished reputation of the firm.

Apart from the capital market consequence, directors engaging in earnings management might experience penalties and other civil and criminal litigation as well as being barred from ever serving as a director subject to the Sarbanes Oxley Act 2002 and the Securities and Exchange Commission Act of 1934 (Fich et al.2007)

Tendeloo et al. (2008) argued that auditors’ reputation will be negatively affected if auditors fail to detect a firm violating the International Accounting Standards. Tendeloo et al. (2008) further argued that litigious actions or disciplinary sanctions may as well be inflicted on audit firms. Arthur Andersen, one of the big five auditing firms at that time was negatively affected by tarnished reputation and legal actions because of it was held guilty in the auditing of Enron.

Incentives of Earnings Management

  • Personal gain

According to Feng et al. (2011) CFOs may instigate manipulations of accounting figures for direct personal monetary gain. The former Chairman of the Federal Reserve Board, Alan Greenspan, postulates that many company executives artificially boost reported earnings in order to yield stock market gains. Jacob et al. (2007) mentions that corporate managers are mainly bothered about the reported earnings since many bonuses and compensation schemes are based on earnings reported. Therefore, it is in the best interest of the managers to manipulate revenue, expenses and profit figures to achieve their personal gain. It is interesting to note that corporate managers most likely manage earnings during the last quarter of the accounting period (Jacob et al. 2007). This may be because the last quarter gives managers a better picture of the overall performance of the firm and hence their bonuses. Schipper (1989) states that if we are to reduce managers’ incentives to manipulate earnings, compensations and bonuses should not be associated with earnings.

  • Tax regulations

Guenther (1994) states that mangers sometimes accelerate a tax deduction from a future year into the current year to reduce taxable income. In addition to accelerating expenses, managers can also postpone taxable income by deferring the recognition of revenue. For instance, holding up the consignment of goods so that title is not passed at year end. The fact that accounting income is closely related to taxable income, it can be argued that a downward manipulation of earnings would eventually lead to a reduction in tax liability. According to Eilifsen et al. (1999) a reduction in the tax is obtained by disclosing low earnings, but then the cost of capital would augment. The cost of capital would rise because of a cutback in earnings. To reduce tax based earnings management, tax related standards can be amended. For instance, firms should be required to use capital allowances rates instead of using a judgmental rate for depreciation.

  • Capital market motive

The fact that investors will be reluctant to contribute capital to firms with low earnings, firms trading their stocks on the stock exchange have an incentive to manipulate earnings in order avoid drop in stock prices (Burgstahler et al., 2006). According to Healy et al. (1999), the prevalent use of accounting information by investors and financial analysts to value stocks can create an incentive for managers to manage earnings in an effort to influence short-term stock price performance. Actually, the incentive for corporate managers to avoid stock price downfall is linked to personal gain. Since corporate managers own shares in the firm they are very likely to engage in earnings management to avoid stock price drop (Burgstahler et al. 2006). It can be noted that managers would not only manage earnings to avoid stock price fall but also to induce the stock price to soar so that they financially benefit.

  • Contracting motivations

Earnings are sometimes managed to fulfill contractual obligations. According to Lev (2003), loans, customer-supplier agreements and other debt convents often impose legal restrictions on the borrower such as minimum ratio of earnings. He further went on stating that violations of such stipulations may lead to revisions in the term of contracts. To avoid adverse revisions of contractual agreements, managers have the incentive to make income-increasing accounting choices (Jiambalvo, 1996). Jiambalvo (1996) also mentions that because the reconstruction of debt covenants can be costly managers manipulate earnings in order to avoid assets being seized or acceleration of the maturity of debt contracts.

  • Regulatory motivations

According to Healy et al. (1999), accounting information is used in many industries to regulate and monitor performance of firms. For instance, the banking industry is one of the sectors that face regulatory monitoring that is tied up to accounting information. Consequently, corporate managers have incentives to manipulate accounting information that will be of interest to regulators. To keep the minimum regulatory capital banks managers have an interest to manipulate accounting variables connected to the regulatory capital ratio. Other forms of regulation can also provide firms with incentives to manage earnings. For example, it is alleged that managers of firms susceptible to an anti-trust enquiry or other adverse political consequences have motivations to manipulate earnings to seem less profitable Watts and Zimmerman (1978).

Ethics in accounting

In a similar way to other professional disciplines, ethics are equally very important in the accounting discipline. In accounting, ethics is becoming indispensable because of mounting accounting scandals. Joost (2011) states that because of financial scandals and fraud in companies like Enron and WorldCom and the subsequent demise of Arthur Anderson, accounting ethics has become a much researched subject. As a result of accounting scandals, the accounting profession's integrity and reputation are endangered notably when relapses in ethical conduct take place (S. Kerr and Smith, 1995).

The true origin of accounting scandals and the subsequent lost of reputation of the accounting profession is the result of questionable accounting practices exercised by management to manipulate financial statements. Hence, the field of accounting ethics was put in place to deal with questionable accounting practices as to whether specific accounting practices are morally justifiable (Onyebuchi et al., 2011). However, the field of accounting ethics has not seen significant growth despite recurring accounting scandals. Yet, some timid steps have been taken by professional bodies to incorporate ethics education in accounting curriculum. For instance, professional bodies such as the National commission on Fraudulent Financial Reporting and the American Accounting Association Committee have advocated the need to integrate accounting ethics as part of the college and university education (Loeb, 1994).

History of accounting ethics

Accounting ethics was initially pioneered by Luca Pacioli. Renowned as the father of accounting, he emphasised on marking every transaction so that people will always remember to be ethical. During his time he used the expression ‘El suo sancto nome hauera mete’ which can literally be translated as “to have the knowledge of his holiness on their minds.” This statement demonstrates the early contribution made by Luca Pacioli to accounting ethics (Fischer and M. J, 2000). The field of ethics in accounting was later extended with the intervention of professional associations, governments and individual companies. For instance, the American Accounting Association initiated a project on professionalism and ethics that is conducting annual seminars on ethics education for academics and professionals and is collecting ethics-related cases that will be available for use by accounting professors (Langenderfer et al., 2006). The growing relevance of ethics to the accounting education is incessantly recognised by the American Accounting Association until now (Sangster, 2014).

The government equally played its part in reducing the mounting accounting scandals through ethics. The administration of various countries exercised their executive powers and enacted Acts which encompassed mandated ethical changes that impact accountants’ judgements (Thomas, 2004). For example, in America congress enacted the Sarbanes-Oxley Act of 2002 which contains the most extensive reforms over financial reporting, corporate governance and auditing. Likewise, individual business firms have established their own company’s ethical codes of conduct (Kerr and Smith, 1995). Last but not least, the International Ethics Standards Board for Accountants (IESBA), formally known as the ethics committee issued code of ethics for professional accountants. Nonetheless, it is up to professional bodies such as the ACCA to ensure compliance with ethical codes of their members.

After reviewing the literature, one of the most prominent ways that could assist in curtailing accounting scandals is to integrate accounting ethics education within the accounting curriculum. According to Smith (2003), new laws such as the Sarbanes Oxley Act though helpful did not contribute to restore the lost confidence in accounting practitioners. As stated by Adkins and Radtke (2004), despite ongoing calls for professional effective codes of ethics, the credibility crisis is still making surface. Jooste (2011) mentioned that various studies carried out called for changes in accounting education to incorporate ethics because of the duty of the accounting profession and their answerability to the public Thus, the most workable answer to this issue appears to be ethics education.

Importance of accounting ethics education

Ethics education can assist accounting practitioners to resolve ethical dilemmas, allowing them to ensure that only morally justifiable accounting practices are exercised. According to Triki (2012) it often happens that individuals engage in unethical activities without knowing it. Triki further stated that it is crucial that before engaging in the ethical decision process, individuals recognize the presence of an ethical issue. To raise awareness of accounting practitioners of specific ethical issues, teaching accounting ethics to students is vital. For instance, to make the right ethical choice, the American Accounting Association (AAA) proposed the utilisation of video presentations to expose students to some of the ethical problems they may come across in the work environment, and provide guidance in dealing with such situation (Kerr and Smith 1995).

Evaluation of accounting ethics education

According to Adkins and Radtke (2004), in spite of persistent call for accounting ethics education, manipulation of earnings is still a phenomenon. According to Bampton and Maclagan (2005), those who claim to be concerned to the teaching of ethics, often say that there is inadequate room in the curriculum for the ‘luxury’ of ethics teaching. Despite of the demand for more ethics in the classroom, there is a surprising diversity of opinion whether ethics training and education is of value at all (Thomas, 2004). Some people consider that accounting ethics education is valueless and a waste of time because most accounting instructors usually do not have the training or preparation to teach ethics (Loeb and Rockness, 1992). Although accounting students have been to some extent exposed to ethical issues, it has often been limited a discussion of the profession's ethics code in the auditing course (Kerr and Smith 1995). A 1972 study conducted by Loeb and Bedingfield investigated how and in which accounting courses ethics was being taught. Their study revealed that most ethics education was taught within the auditing curriculum, implying that ethics in accounting was indeed neglected.

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