Finance accounting on earning management - Assignment Example

?Introduction This project examines critical elements and concepts in Financial Reporting and Regulation. It includes the examination of the concept of earning management, an element of creative accounting. It also examines the concept of impairment and how it relates to financial reporting. The paper is written in two parts. The first part of the paper examines the incentives of managers to undertake earning management. It examines the techniques used by managers and the motives for it. The section will also examine the concept of channel stuffing and cookie jar accounting as techniques for earning management. It would examine the effects of these two earning management techniques on a single year's disclosure and on a series of years. The second part of the paper would answer questions relating to impairment of assets. It will involve a critique of the circumstances under which impairment is declared. It will also explain when companies must perform impairment reviews and examine a practical case of impairment my Peugeot-Citroen and Vodafone. Part 1 Question 1: A. Managers' Incentive for Earning Management. “Earning management occurs when managers use judgement 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 reporting accounting numbers” (Rowen and Yaari, 2009: 26). This implies that earning management is centred around the fact that a firm's directors and managers might want to present information in a way and manner that is not true nor accurate. Earning management is sometimes called disclosure management and creative accounting. It includes the use of approaches and systems to disclose accounting information in a way and manner that meets a defined end or objective (Alistair, 2008). Managers often have targets that are predetermined for them by the board of directors. This implies that they would have to work hard and do whatever is legally acceptable and possible to meet those objectives and standards. In the process of attaining the given standards and objectives of financial statements, most managers end up putting together financial statements in a creative manner. In other words, they do everything possible and practicable to balance the accounts so that it reflects the ends or the final figure that is expected of the management of an organization. In most situations, earning management is done to smoothen profits and ensure that the earning of the company in a given period is forged in a way and manner that it is in line with targets. This presents a different reality of the earnings of the period and this defeats the purpose of financial statements and financial reporting of capturing the economic realities in an objective and complete manner. These managers therefore manage their earning and disclosures in a way that favours them and enables them to appear to be meeting the end that they have in mind. In a research conducted by Cheng and Warfield (2005) they identified that the main objective for earning management amongst manager includes three interlinked ideas and concepts. They include: 1. Earning management incentives 2. Future manager trading. 3. Enhancement of organisational position. The first idea is that earning management incentive allows managers to attain the favour of people who set targets for them. This is because in most cases, managers are judged and assessed on the basis of the attainment of results and targets. In reality, manager's worth is identified by how well he meets the financial and economic targets that are set by the people at the top of corporate governance. There is therefore the desire or expectation to use creative techniques to ensure that they attain financial targets. This leads to pressure to use various loopholes and techniques in accounting concepts to present a favourable position. The second idea is that managers often get incentives that are tied to their performance. In other words, most managers get rewarded with shares and other benefits that are linked to the long-term success of the company (Fan, 2007). Hence, a manager would want to maintain a favourable financial disclosure regime in order to entice outsiders and external stakeholders to believe the company is healthy when it is not (Fan, 2007). This would cause the shares of the company to rise and remain high and the manager would benefit from this because higher shares would enhance their stake and their investments in the company. Finally, creative accounting and earning management allows a business to show external stakeholders that they are doing well when the reality might be the opposite (Fan, 2007). This is because when external stakeholders believe that everything is alright, the company would get benefits like the trust of parties like suppliers and shareholders. This would cause the firm to have a healthy and enhanced financial position. A typical example is the Enron case where the firm used techniques of earning management to present to the world very solid earning figures. Within days after the scandal erupted that Enron is using creative accounting and other foul techniques, the shares fell to almost zero. This shows that earning management could be used as a tool to mislead the stock markets and present an unrealistic view of things. Thus, the essence of earning management used by Bristol-Myers Squib (BMS) was to enable them to present a positive view of their operations and activities. The management might have used earning management to smoothen profits because they needed to show a positive position of their financial operations to please the shareholders and directors. They might have also done that to enhance the position of BMS on the New York Stock Exchange and also safeguard their shares in the company. However, when it was discovered, it was against the Securities and Exchange Commission's rules. This issue obviously distorted the concept of comparability, since the accounts were not prepared in good faith. B Effects of Stuffing Channels and Cookie Jar Accounting on a Year's Accounting and Year-by-Year Accounting. Basically, earning management is done through the abuse of the accruals principle of accounting (Bissesur, 2011). The accrual concept requires a business to capture the net income from the net cashflows from operations. This implies that the company must use an objective approach to record income and deduct costs of operation to arrive at profits. This function of accounting is objective and an independent accountant would just record the sales and less cost of production. However, the concept of objectivity in recording transactions is challenged win the idea of recording accruals come to play. Accruals are necessary because they enable a business to record the economic realities of a given period through some conventions. For instance, the profit of a firm in a given period has to reflect the worth of assets used in the period. This cannot be done very objectively or scientifically. Thus, the firm must use depreciation techniques which must be applied at the discretion of management. Other reserves can be created by the decision of management and they are also discretionary. “Stuffing the channels” is an approach where a company would come up with very high sales and transactions at the end of the accounting period (Hamilton, 2009). It is done by convincing distributors and wholesalers to purchase a lot of a firm's products at the end of a reporting period (Hamilton, 2009). This would normally happen when a firm needs to report a given period or level of sales in order to attain a required level of profitability. “Stuffing the channels” can be used to beat the objective element of financial reporting. In other words, it can be used to ensure that profits are higher than normal. This is because when the sales figure is high, it would appear as if the company made a lot of money and this could overstate profits because it would be above the cost of sales by an expected level. This means that profits might be higher for a given year and the effect would be that the firm's profit of a given level at the year in question would be higher than normal. If viewed as a year's profit, there might be no issues with it. However, when viewed on a month-by-month basis, evidence that the channels were stuffed could be ascertained because there would be unusually high transactions at the end of the period and this shows that sales was not conducted evenly (Griffith, 2010). In a series of years, stuffing the channel might show very uneven trends in financial reporting (Guenther, 1994). This is because when there is a high level of sales at the end of a given year, it is apparent that the next first months of the next year would be times where sales would be low. This is because all distributors would have purchased a lot at the year end and may not need to make purchases at the beginning of the year. Thus, it would appear that the firm only makes sales at the end of the year and there is a shortfall at the beginning of the year. That is the judgement tool and technique used by auditors in determining channel stuffing. “Cookie jar” technique of earning management is about the abuse of discretionary reserves for the purposes of promoting an expected profit figure. It is a practice where reserves are created in a good year where profits are high (Dignen, 2009). These reserves are “artificial” and are created to lock up some funds in order to release them into revenue in bad years (Dignen, 2009). This is done by creating a liability through the reserves which are recorded as expenses. This locks up funds and ensures that profits are at a given level that management expects (Kruger, 2010). In a year where trading was not so favourable, these reserves are understated. In a year's report, the profit would appear to be very logical and normal. The reserve would be at a given level and nothing would look suspicious. However, when the figures for different years are examined, a “cookie jar” reserve would vary significantly across the figure. This means that the reserve is manipulated to manage earnings and smoothen profits. Question 2: A When is Impairment loss deemed to have occurred? According to Rittenberg (2009), impairment occurs “where market value of an asset falls below the carrying amount and not expected to recover” (p91). In other words, impairment is about the situation where the value of a given asset recorded in the financial statements is below the market value and it is going to remain so permanently. In order to illustrate this concept, impairment is about a situation where the asset of a company is recorded at a high amount. This is because assets are to be disclosed at their historical costs and depreciated over their useful life. A question arises as to what happens after the value of the asset falls below the price at which it is bought? The argument for this is that if accounts are to record economic realities, a set of financial statements cannot be said to be reflecting the true and fair view if assets are overstated (West, 2011). Thus, IAS 36 seeks to make it mandatory for assets' values to be reviewed over a period of time in order to record the value that reflects the economic realities on the market. IAS 36 provides detailed and critical analyses of the concept of impairment and the key terms of the concept. IAS 36 states that “an asset is impaired if its carrying amount exceeds its recoverable amount”. This is a more technical concept of impairment. This provides a different explanation of the idea. It shows that when the amount of an asset recorded in the financial statements of a company is above what would be attained on the market, then the asset is impaired. An impairment loss is recognised where the carrying amount of an asset falls below market value permanently. Carrying amount of an asset is defined by IAS 36 as the amount that an asset is recognised in the balance sheet after deducting accumulated depreciation and accumulated impairment losses. Thus, if an asset's carrying amount shows that the asset's 'value' is lower than the recoverable amount, then it must be reviewed for impairment. “Recoverable amount” is the higher of the asset's fair value less costs to sell (net selling price) and its value in use (Walton and Aerts, 2011). Fair value is the amount obtainable from the sale of the asset in question whereas value in use is the discounted present value of money from continued use or disposal at the end end of useful life (Walton and Aerts, 2011). An example of an impairment review is the situation where a firm purchases another company and they realize that the assets of the company are below the value that they paid for it. In that situation, the assets would be up for impairment review because the situation suggests that the recoverable amount of the firm is below the carrying amount they recorded after the purchase. In that case, an impairment loss must be recognised. There is a question of which procedure should be used to commence an impairment review. In conducting an impairment review, a class of assets ought to be reviewed as a group and not a single asset (Adadevoh, 2007). This is to avoid “cherry-picking” which is a situation where a firm would selectively and opportunistically choose the assets that must be reviewed for impairment. This can potentially lead to creative accounting where managers might want to select some assets to review where they feel there is the need to smoothen figures in the financial statements. B Effects of Impairment on Financial Position and Performance: PSA Peugeot Citroen and Vodafone Impairment has an effect on the financial position and financial performance. This is because if an impairment loss is recognised, it is obvious that the value of assets would be reviewed downward. This would understate assets and the financial position of a firm would be reduced. On the other hand, there would be an influence on depreciation because the value for depreciation is going to fall due to the fall in the value of assets. Thus, if the method of depreciation remains as it is, the worth of depreciation would fall. Hence, expenses would fall. PSA-Peugeot-Citroen's 2012 results published on 13th February 2013 included an impairment charge on assets of the Automotive Division which was to reflect the impact of the deterioration of the European Markets (Reuters, 2013). The review was in line with the French Securities Regulator's accounting reporting standards. They undertook an analysis of the difference between the value of consolidated equity in the balance sheet and its economic value based on future discounted cash flows. The idea was weigh the assets of the company against the deterioration of the European markets. The impairment review resulted in a write off of asset values in the Automotive Division to the tune of €3,888 million. PSA Peugeot Citroen's impairment is not going to involve any form of cash-out and hence would not affect the group's liquidity and solvency. However, the impairment is to affect the group's net income. In November 2012, Vodafone wrote off ?5.9 on the value of its businesses in Spain and Italy and this led to a loss of ?492 million on the first half of 2012's operations. This culminated to a write off of ?59.1 billion on a range of businesses in the group after 2006. The Chief Financial Officer explained that the write off were due to economic conditions in Vodafone's operations in Spain and Italy which stifled the economic conditions and caused interest rates to fall. This caused the valuation of Vodafone's assets in those countries by a significant percentage. Most of the assets were acquired during the telecoms bubble ten years ago and this led to the need to review the assets after the economic hardships and conditions. The impact was that goodwill, which was recognized as an intangible asset had to be decreased by the value of the impairment loss in the balance sheet. The next thing was compute the impairment loss and amortise it. This led to a reduction in profits which caused the firm to incur a loss in the period. From the two cases it is clear that impairment of assets causes the balance sheet position to be weakened. This is because assets would have to be understated and this goes on to reduce the intangible asset or goodwill position of the firm. The impairment loss is amortised and this leads to a charge to the profit and loss account which reduces profits for the period. References Adadevoh, J. (2007). Financial Reporting. London: FTC Publishing. Alistair, M. (2008). “Comparative Approaches to Earning Management in Multinational Businesses in Europe.” Journal of International Accounting, 23 (2), pp. 231 – 249. Bissesur, S. W. (2011). Earnings Quality and Earnings Management. New York: Rozenberg Publishers. Cheng, Q, Warfield, T. D. (2005). “Equity Incentives and Earning Management.” The Accounting Review, 8 (2) pp. 441 – 476. Dignen, B. (2009). “Cooking Jar Accounting.” Journal of Accounting & Management, 31 (3), pp. 231 – 233. Fan, Q. (2007). “Earning Management and Ownership Retention for International Public offering Firms: Theory & Evidence.” The Accounting Review, 82 (1), pp. 27 – 64. Griffith, G. (2010). “Elements of Creative Accounting Examined.” Financial Reporting Quarterly, 12(2), pp. 558 – 569. Guenther, D. A. (1994). “Earning Management in Response to Corporate Tax Rate Changes: Evidence from the 1986 Tax Reform Act.” The Accounting Review, 69 (1), pp. 230 – 243. Hamilton, D. (2009). “Elements of Creative Accounting in North American Entities.” Journal of Accounting Review, 12 (2), pp. 323 – 342. Kruger, J. (2009). “Taking Away Dell's Cookie Jar.” The Economist, June 23, 2010. Reuters. (2013). “PSA Peugeot Citroen: result of impairment tests on Automotive Division assets for Financial Year 2012.” [Online] Available at: http://www.reuters.com/article/2013/02/07/psa-peugeot-citron-idUSnBwcqshba+80+BSW20130207 Accessed: 13th April, 2013. Rittenberg, L. E. (2009). Auditing: A Business Risk Approach. Mason, OH: Cengage. Rowen, J. and Yaari, V. (2009). Earning Management. London: Springer. Walton, P. J. and Aerts, W. (2011). The Global Financial Accounting and Reporting Principles and Analysis. Mason, OH: Cengage. West, J. B. (2011). Advanced Financial Reporting. Hoboken, NJ: John Wiely and Sons. Read More