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Earnings management is not a new issue. It's been using by the corporation since the old time before the technology such as computer even created yet. There was many type of how earnings are manage or in other word, being manipulate in order to get the right earnings at the right times. Before earnings management is discuss further, what is the definition of earnings management. Basically, earnings are the net profits of a company. Based on Investorwords.com, earnings are revenue minus with all the expenses the companies occur during the current period. In other words, gain archive by the company for the current period. Outsiders especially investors and analysts look to company's earnings to determine the attractiveness of a particular stock of a company. Companies with poor earnings prediction will typically have lower share prices compare to those with better prediction. The price of the stock are positively correlated with demand of the stock. More demand will lead to higher stock price and the higher stock price of the company, the better the company are. On the other side, management mean managing or being manage based on oxford dictionary. It can also be further categorizes it as manipulation. The combination of both, earnings and management give means of profit manipulation that can only been done by people who have power to control and managing the company. Investorwords.com defines it as manipulation of company's financial earnings either directly or through indirect accounting method.
There was a reason for something to be happen or created for sure. From the perspective of Thomson (2000), it is not an illegal activity and can be used as one of the company's strategy to archive better future but there was also be misused. In the case of earnings management, it's been created as a strategy by the management of a company to intentionally manipulate the company's earnings so that the figures match with what they want. For example, in order to gain trust from the bank to obtain a loan, the management manipulate the company's earning to look good even if the company are not. However, if it is for the purpose of tax, the earnings are manage to look bad in order to reduce the amount of tax expenses that need to be paid for the current year. In other words, the practice of earnings management is carried out for the purpose of income smoothing. Therefore, rather than having years of exceptionally good or bad earnings, companies will try to keep the figures relatively stable by adding and removing cash from reserve accounts. It is one of the techniques of earnings management.
On the other side, earnings management is not favorable by all of the financial reporting users except the management since they are the people who organize it. For sure, being cheated regarding the information that should be obtain are not the favorable things that by all people. In other words, earnings management is also cheating all the users regarding the company's earnings. Regarding the complexity of the preparation of accounting report, the practices of earnings management are continuously adopted. It's also difficult to determine whether the company is manipulating its earnings or not. It is because of highly confidential information. Individuals that aware of this used of earnings management is only the individual who adopt it which usually chief executive officer (CEO) and chief financial officer (CFO). As the great investorÂ Warren Buffett once said, "Managers that always promise to "make the numbers" will at someÂ pointÂ be tempted to make up the numbers". The function of auditor are supposedly to detecting such misused in order to protects shareholders interest but based on several previous case of big corporate scandals, its show that how careless the auditor even though some of well establish auditor to detect that misused or purposely not detected that issues. For example in Enron case in 2001, the auditor of Enron is Author Anderson which was one of the most well establish audit firm in the world. The failing of Enron is the main reason of Author Anderson to also close down due to defect in their reputation.
Some examples of earnings management and also the practitioner whose misused this technique that lead them to failure that been stated by Spear and Nasser (2007) are included offensively recording revenues (for example apply by Xerox, Bristol-Myers), recording uncollectible sales (for example practiced by Merck), hiding losses (for example by Allied Irish Banks), hiding expenses (apply by WorldCom), and using special purpose vehicles to blow up income (e.g., Enron).
There are many phrases or words can be describing earnings activities and no standard that universally accepted for the definition of these terms. Some of those terms are income smoothing, accounting hocus - pocus, financial statement management, the numbers game, aggressive accounting, reengineering of income statement, juggling the books, creative accounting, financial statement manipulation, accounting magic, borrowing income from the future, banking income for the future, financial shenanigans, window dressing and accounting alchemy. Some the earnings management is legal which is can be accepted worldwide due to the low level of manipulation and some are illegal due to high level of manipulation and intention to trick the stakeholders. This illegal earnings management is also called cooking the books.
1.2 Reason for Earnings Management
The applications of earnings management are kept in using by all around the worlds even though several corporate scandals which misused of earnings management arise. Spear and Nasser (2007), mention that, reason for using earnings management are due to market incentives, contracting incentives and regulatory incentives.
Market incentives are regarding to meet with analysts' expectations which are important in order to keep the company name at the established position. The reason is to smooth earnings time's series even when it's affected by periodic figure such as seasonal sales. It's not like the company not good when it is not in seasonal period, but then, the sales will definitely boost when it's come to seasonal. If the seasonal period is not even at the right time, therefore, management of earnings is needed in order to smooth the earnings for the company.
Contracting incentive are include as managing earnings of which in order to avoid violating loan agreement that are written in terms of accounting numbers. In order to gain faith from the lender and to archive the optimal credit term, management of earnings is needed. Not all the time the company account might look as good as it's expected and if it is not, doesn't simply mean that the company is in the bad position. Other than that, it's also managing earnings to maximize earnings based management compensation.
Other than that is a regulatory incentive. This incentive are been practice in order to avoid industry regulations such as to reduce the risk of political exposure and also to take advantage of certain governmental benefits such as subsidy.
1.3 Satyam Corporation
Satyam establish by B. Ramallinga Raju (Mr Raju) in Hyderabad, India with less than 20 employees. In Indian language Sanskrit, Satyam means "truth". This company specializes in information technology, business services, computer software, and is a leading outsourcing company in India.
Satyam Corporation successes begin when the company issued initial public offering on the Bombay Stock Exchange in 1991. The company continuously grew quickly during 1990s and 2000s. It's been name as fourth largest outsourcing company in India. At its peak time, Satyam employed around 50,000 employees and operated in 67 countries. Satyam even winning several awards which some of the award are been rewarding by well establish auditors and also, some reward are regarding their good corporate governance application and practices. Few month after the award winnings, the manipulation are been exposes due to several factors. Therefore, the purposes and certification of awards winning are blurred and still in question. Even the company that already certificated by well establish body of accountancy could also done big manipulation over several years that resulting in cheated several stakeholder without being detected. This is how earnings management can become as bad as parasite to the shareholders.
2.0 Literature Review
2.1 Types of Earnings Management
Earnings management is not specifically stated for certain types or techniques only. There are several types of earnings management and techniques that can be used by a company through their operations. One of the very popular techniques of earnings management is called "Cookie Jar". This technique is function such as save some revenue in a good year as a backup for losses that might incurred in the bad years. The example gives by McGregor S., consultant that been hired by a firms to perform some particular activity are reflect the expenses related to which it is incurred, not when the bill is paid or invoice is received. It's all depending on the situation and stability of the company during the years. If the performance of the company is better, therefore the expenses can be recognizes during the year but somehow, if it is not a good year, the expenses can be recognizes next period to ensure the performance of company is goods. The concept is such as cookie jar concept. Used it when needed and fill it back when there was a time.
Other popular techniques is also been called big bath. This technique or strategy is to make bad income statement look even worst. This technique is a technique that used by blame the previous manager that already sign out as to ensure the company performance for next year are booms. This type of technique is used by the new manager which is appointed before the end of the period. The new manager put blame to the previous manager by incurred as many expenses as they can write off to ensure that next year, company can even perform better than this year.
Capitalization practice is also other type of earnings management. This type of earnings management is used to manipulating intangible assets such as research and development. Cost to capitalize research and development are very subjective and only based on judgment. A company might have possibility to allocate more expenses to the research and development project to reduce current operating expenses. Therefore the expenses might only amortize through the life of the assets and it's usually only a small portion.
There are also other types of earnings management that can be applied by all the manager of the company to ensure the safeguard of the company's income. Some earnings management are used in merger and acquisition, some are used in recognition of revenue, materiality concept that been misapplied, reserve that been charge one time and also other earnings management types.
Some earnings management is done for the benefit of all stakeholder and some are done for their personal benefit. The bad side of earnings management can also been called as fraud as the intention is not to manipulate figure for the whole benefit but for their own benefit. The controllers of earnings management are depending on the management party of the company and how they predict and forecast the future of the company to ensure the optimal return is able to archive. Management especially manager have a better knowledge regarding to the company future compare to others. That's the reason of why, earnings management are still allowed even though this benefits are always been misused as the way of cheated stakeholders and most of all, for personal benefit.
2.2 Satyam Scandals
There were several scandals that involve manipulation or earnings management that involve several cases that affected not only that country but also all around the world. The most influence scandals in the history of corporation are the collapsing of Enron in2001. Enron have a very big influence to the corporate world that also evolves the way of how the corporate governance are maintained and implement. The ethical issues of auditor are also in question where still; even Enron was audited by one of the biggest audit firm which called Author Anderson. One of the most important argument that been brought up are the issues of why earnings management are still allowed even if it's been misused by several parties. Even thought, before the scandals exposes, Enron maintain their goodwill by winning several awards regarding their good corporate governance. Other than Enron, WorldCom are also one of the big corporate scandals that lead to their collapsing in 2006 that lead to more study and argument on the use of earnings management as one of company strategy or manipulation.
In year 2009 are the year where the exposed the Indian accounting scandals by Satyam Corporation which also been called "India's Enron" by corporate world. The reason of why it's been called Enron is that the manipulation and the strategy implementing by this company is similar to what Enron previously done which manage its earnings until it is out of control. As for the auditor, the case also similar where the auditor of that company can't even detect the misstatement made or may be didn't detect it on purposes. The answer of this question never been revealed even though there was suspicious payment for the auditors during the year of manipulation been done.
The first cracks of Satyam Corporation revealed in October 2008 where one of the bank names World Bank issued an eight years ban against Satyam due to accusation that Satyam installing spy system in the bank computers and steal some of the bank assets. Based on Winkler D. (2010), the investor still ignore the Satyam issued up to that level even though one of the analyst expressed his concern regarding to the large balance and accuracy of the numbers. This is due to good names of Satyam and the faith by the investors to Satyam's because the company are always maintaining it's good names and good culture of corporation that's lead to the company in winning several awards that been recognize worldwide. In addition, world collapsed during 2008 affected Indian Stock Exchange quite bad. The big losses lead to the withdrawal of investors from the stock market and that where it's triggered to the discovery of several scandals as the perpetrators could no longer hide the true result. Satyam maintain its good record and still reported for increasing in profit even though there was a tough time. That may be the other reason why most of the investor still has faith in Satyam that time.
The trigger of Satyam failure stated in December 2008 where Satyam boards of director have made erroneous decision which to approve the purchasing of two companies which unrelated field and they claim that it will be greater diversification. The decision decrease the confidence of investor to Satyam since Mr. Raju's family members are the largest shareholders in that both companies. Winkler D. (2010) stated that the shareholders of Satyam view that as an attempt to transfer the money to the family members of Mr. Raju. The decision been aborted afterward but it's still give a significant impact to Satyam reputation.
The incident affected Satyam badly where its share dropped and most of its director resigned. Winkler D. (2010) did mention that consultant have been appointed by Satyam in order to increase the value of its shareholders and also the potential for Satyam to mergers with its competitors, but the merger failed due to some material irregularities in Satyam account. The competitors might try to avoid doing merger with Satyam since the risks are too great and also Satyam's financial account including some material misstatement as the competitors might have already detected it. Even though Satyam have a good reputation previously, but still, due to several exposures and finding by their m competitors for merger purposes, public or in other words shareholders loss their confidence to keep their investment in Satyam.
Incident afterward exposes the true color of Satyam where Mr. Raju reveal the letter for Satyam Board of Director regarding to what he had done for Enron's number and profit for the past several years. According to Winkler D. (2010), Mr. Raju disclose that he overstated assets, under reported liabilities and overstated income more than 75%. Mr. Raju not only used same technique but several techniques to commit this manipulation. He also revealed that the income from interest from bank was from non existing bank, thousand fake salary accounts and also created fake customers. Some of the earnings management techniques that Satyam might be using are revenue over recognition, cookie jar reserve, assets overstated and several manipulation of figure. The figure started with only a small figure stated to grow up more for coming period. This is due to the problems that's didn't been manage and overcome properly, that turn to worse and worse over the times. Up until the exposure by Mr. Raju, the problems already turn into a gigantic stone that he unable to hold it anymore. Quoted from Mr. Raju, "It was like riding a tiger, not knowing how to get off without being eaten".
Earnings management are only become useful when the management able to fixed it afterward or only done it if the result are more certain as one way of to ensure the operation and earnings are smooth. This is because only management has the best knowledge regarding company operation. To let them manipulate the earnings are good in other view because the reaction of the investor regarding the value of the company are very sensitive. The problems is how the shareholder can determine whether what done by management are for the benefit of them, not for the management itself, and that the problems of earnings management.
2.3 Impact on Satyam scandals
India's government acted quickly in their effort of trying to save Satyam from bankruptcy such as Enron and WorldCom. When both of this companies file for bankruptcy, its creating large disruption of capital market and immediately increase unemployment as all of the employees who work there loss their jobs. Even though in government trying to help Satyam, at the same times, they limiting the direct participating because they don't want to be seen as cover up the manipulation and fraud done by Satyam (Winkler D. 2010). In other words, India's government want public to know that Satyam recover themselves and not because of the help from them. Immediately new Board of Director appointed by India's Minister for Corporate Affairs P.C. Gupta (Ians from Simple Tought on 15 January 2009) and their mission is to sell the company within 100days. After so many efforts and hard works have been done, the mission accomplishes and one company, Tech Mahindra, bought Satyam in April 2009. This good reputation of this company and further investigation regarding the manipulations leads to stabilize the India stock market afterward most of all Satyam save from bankruptcy.
India government also decide to have amendment on some of their standards and on the other hand, strengthen the commitment in adopting International Financial Reporting Standards (IFRS) which very much different with India's policy currently. Winkler D. (2010), stated that Indian Generally Accepted Accounting Practices and IFRS have a significant different. Therefore, in order to strengthen the application of IFRS, there are needs for the government to incur a lot of cost and efforts to ensure that it is successfully adopted.
The entire responsible parties are arrested; Mr. Raju, his brother, B. Ramu Raju, Satyam's former managing director and other person who seem responsible included their external auditor, officer of Price Waterhouse Cooper. The investigation also caught up several Indian politicians. The arrested of those party are as evidences that India are seriously concern with the frauds activities even though the company might have a good reputation in strengthen the Indian economic condition. India's government is trying to show to the corporate worlds the bad effect if the manipulation or earnings management used for wrong purposes. It's also the way to attract back the investor that already loss their faith in Indian economy. Even though it's not a simple task, but then the Indian government have already achieve the goal as all the decision made by the government are at the right rail. As an evidence, currently, 2010, Indian economic are at the level as one of the good economic growth for developed country with overpopulation. The GDP for Indian increasing compared from previous year.
Arising corporate scandals around the world leads to better review and application of how to derive business more properly and transparently. The biggest case that gives impact on the world's corporate culture such as Enron leads to change in several standards accepted around the world. This cannot be simply recovered but also a lot of work needs to be done. The effect for this scandals are not specifically to stakeholder involve but also all around the world. For example the name and functions of auditor are in doubt of whether it is really effective or just to comply with standard. The professionalism of auditor is in question and its give bad name to auditor all around the worlds.
Satyam or India's Enron are another example of corporate scandals and how stakeholders react to that based on previous experience that gain from previous scandals. As for me, the step taken by the India's government to rescue Satyam from bankruptcy is the excellence step and also, to show that how Indian government learn from the past mistake by another government and what will happen if they just abandon and let Satyam go for bankruptcy. India is one of the biggest countries with an overload population. Even though they have a good economic condition, their peoples have a significant gap between high blue collar and white collar peoples. If Satyam file for bankruptcy, the level of unemployment will increasing from even at already high to higher than before. The economics of India will also badly affect as foreign investor have lost faith through Indian corporate structure. The selected replacements of Satyam Board of Directors are also precise decision made by the Indian's Minister for Corporate Affair, P.C. Gupta Thursday, as the person he choose are from several background and have a lot of experiences regarding to corporate world are able to accomplish the goal that are targeted.
The used of earnings management could be friend or also could be foe for the shareholders. In term of friends, due to all management work are been done by the company themselves, so the prediction and situation of the company are well known by management teams compared to external party such as external auditor. The manipulation might only do because the management wants the shareholder maintain their faith to the company itself. It can be foe if the manipulations are more to the fraud reason.
Standards and regulation are needed in the used of the earnings management techniques as it is used for benefit of all stakeholders, not only for particular stakeholder for their personal purposes. The act such as Sarbanes- Oxley Act 2002 (arise after Enron's cases) are the example of law created to overcome the earnings management problems but still, it is too lax. More strict standards and law are needed to ensure earnings management is done within good deeds.
The ethical of the practitioners also need to be taken into the considerations. All the parties that are used to involve directly in the preparation of figure using earnings management need to have a good basic and capital. The education regarding the ethical in business and corporate governance are need to be imply to all party that might involve in corporate world in future, so that they can differentiate whether it is wrong or right.