Methods and Techniques Used by Firms to Manage Earnings and the Motives behind Earnings Management - Coursework Example

Critically discuss, giving examples, the main methods/techniques used by firms to manage earnings and the motives behind earnings management. Cite academic literature to support your answer. Critically discuss, giving examples, the main methods/techniques used by firms to manage earnings and the motives behind earnings management. Cite academic literature to support your answer. 1. Introduction Managing earnings is a critical activity for managers in all organizations. However, the credibility and the motives of the particular activity have been often negatively criticized especially since the rules and the processes involved are not always clear or aligned with the rules regulating financial reporting. The techniques available in the context of management of earnings are presented in this paper. At the same time, earnings management, as an organizational process, is analytically presented. The literature related to the particular issue has shown that earnings management is a common activity in firms of different sizes. The value of this activity in large firms seems to be quite high at the level that firms of this size need to publish their reports regularly so that the public is informed on their performance. For this reason, the alteration of figures including in a firm’s financial reports has become a common practice, being related to the efforts for keeping the organizational performance standardized. Still, in the literature a different view seems to be the most popular: the motives behind earning management cannot be easily accepted. Indeed, quite often earnings management is used for giving a different impression to the public in regard the performance of a particular organization. The motives related to earnings management are also presented in this paper, offering important explanations on the following question: could earnings management become popular in all countries worldwide or not? It is proved that earnings management is not related to geographical criteria; rather, it seems that the position of a firm’s in its industry and the targets set by the managers are used as criteria for deciding the introduction of earnings management in a particular organization. 2. Earnings Management – Presentation and analysis of methods and techniques Earning management can be characterized as one of the most important organizational processes. A series of factors has been related to the expansion of earnings management across organizations of different characteristics. In practice, the particular process is often used for promoting personal interests rather than the interests of the organization. The above view is verified through the definition of earning management, as included in the study of Ronen & Yaari (2007). According to the above definition, ‘earning management occurs when managers exercise their discretion over the accounting numbers with or without restrictions… such discretion can be either firm value maximizing or opportunistic’ (Fields, Lys and Vincent 2001, p.260, cited in Ronen & Yaari 2007, p.31). In other words, managers in modern organizations are not obliged to use earning management, as a tool for supporting their firm’s strategies. Also, the actual motives of earning management are not always related to organizational growth. Another definition of earnings management is incorporated in the study of Bhattacharyya (2006). In the context of this definition, earnings management is characterized as the ‘activity of managing earnings through accounting manipulation’ (Bhattacharyya 2006, p.618). The above definition highlights an important aspect of earnings management: accounting principles and rules intervene, either more or less, in the earnings management process (Bhattacharyya 2006). Still, the above fact cannot secure the credibility of the particular activity, as analytically described below. The methods used for the management of earnings are not standardized. Managers can choose among a series of techniques, according to their skills/ background and their motives. The potential methods for managing earnings are described by Ronen & Yaari (2007). It is noted that when having to manage earnings managers can choose: a) to use one of the techniques ‘accepted under GAAP’ (Ronen & Yaari 2007, p.31); reference can be made, as examples, to depreciation or revenue recognition policy (Ronen & Yaari 2007, p.31), b) to proceed to the alteration of their firm’s existing standards (Ronen & Yaari 2007, p.31); c) to proceed to ‘a judgement call’ (Ronen & Yaari 2007, p.31); the above initiative is taken only in the case that estimates are considered as necessary, according to a relevant rule of GAAP (Ronen & Yaari 2007); d) the creation of two categories of earnings: earnings that tend to appear on a continuous basis and earnings that are just temporary (Ronen & Yaari 2007). Separating earnings can offer the following benefit: even if the relevant figures are included in a firm’s financial reports it is possible that stakeholders will not identify any potential drawback, in regard to the firm’s profitability (Ronen & Yaari 2007). Indeed, in case that the figure related to permanent ethics is low but the figure related to temporary ethics is significantly high, the following issue phenomenon will appear: many of the firm’s supporters will not understand the actual financial status of the organization (Ronen & Yaari 2007), but they would think that the organization’s profitability is at high levels; e) presenting the firm’s earnings in such way that the readers of the relevant document or the viewers of the presentation will not focus on earnings (Ronen & Yaari 2007). For example, if the firm’s earnings are low, the firm’s manager who has to develop and present the firm’s relevant financial report can put earnings ‘in the footnotes’ (Ronen & Yaari 2007, p.33). In this way, the viewers will not be able to identify the actual figures related to organizational performance (Ronen & Yaari 2007); f) changing the organization’s practice in regard to the presentation of earnings as of the following point: the earnings of the organization can be presented in a section of the annual report different from those used commonly (Ronen & Yaari 2007). The above practice can be also used in regard to the firm’s interim reports. The specific practice has been highly criticized. The above method has an important advantage: it does not require the alteration of figures related to the firm’s financial results. This means, practically, that no claim could appear for supporting the opposition of this activity to existing law. A high range of standards has been introduced for regulating the financial management of modern firms. The standards used within each organization are depended on the targets set by managers for a particular period. The specific fact is explained by Belkaoui (2004). According to the above researcher, in organizations where emphasis is given on the reliability of financial reports, earnings smoothing is preferred at the level that it can reflects the actual potentials of the organization in terms of profits (Belkaoui 2004). Earnings smoothing is based on the alteration of a firm’s financial results so that excessive or too low profits are avoided in the firm’s financial reports (Belkaoui 2004). This means that in periods of high profitability the figures reflecting the firm’s profits are alternated so that profits seem as being at average level (Belkaoui 2004). On the other hand, in periods with extremely low profits, the relevant figures are increased, showing the firm as being capable to keep its profits within the level set by its managers (Belkaoui 2004). In this way, the position of the firm in its industry is secured, at the level that the firm gives the impression to its stakeholders that it has achieved all its targets (Belkaoui 2004). According to Norton, Diamond & Pagach (2006) the management of earnings is related to two, critical, challenges: a) not all profits are permanent (Norton, Diamond & Pagach 2006); in this context, concerns would be developed in regard to the potential incorporation of these earnings in a firm’s financial reports. Since these earnings are not standardized would it be appropriate to use the above earnings for evaluating the performance of the organization involved? The answer should be negative. However, in this case, the following issue would appear: Is the existence of events that are not controllable a threat for the achievement of the target set? A negative answer would be more appropriate if taking into consideration the potential long term effects on the firm’s financial performance; b) a series of techniques that can help a firm’s managers ‘to artificially increase earnings’ (Norton, Diamond & Pagach 2006, p.126). In any case, managers of each organization are free to choose the accounting technique they consider as more appropriate for managing earnings (Norton, Diamond & Pagach 2006). Allowing managers to be fully independent when having to decide on the technique used for managing earnings leads an organization to severe failures (Norton, Diamond & Pagach 2006). In fact, such independency can severely harm ‘the quality of earnings’ (Norton, Diamond & Pagach 2006), as the particular failure could be reflected in the organization’s financial statements. 3. Motives behind earnings management The development of earning management techniques within each organization can be explained using different approaches. For example, in the study of Albrecht, Stice & Stice (2010) earnings management is considered as related to a series of conditions: a) pressures can be made on managers so that ‘the internal profits of the organization are increased’ (Albrecht, Stice & Stice 2010, p.193); the techniques used for the achievement of this target are not considered as important at the level that internal profits reach a higher level, as set by the organization’s strategic team, b) pressures are made on managers ‘to meet market expectations’ (Albrecht, Stice & Stice 2000, p.193). It is assumed that earnings can be periodically increased, meaning earnings as a figure incorporated in the firm’s financial statements; c) for keeping the income of the organization at an average level, meaning the smoothing of earnings, so that the market position of the firm is not threatened during periods of low profits (Albrecht, Stice & Stice 2000); d) it is possible that an application of a loan is under evaluation or it is to be submitted (Albrecht, Stice & Stice 2000); in the above case the earnings of the organization have to seem as higher, so that the relevant initiative is successful. For Damodaran (2012) the involvement of managers in earnings management is explained as follows: managers can use earnings management techniques so that they are able to increase the average income of the organization, a fact that would result to their rewarding. In other words, earnings management can be related only to the personal interests of the managers developing the particular activity. Schroeder, Clark & Cathey (2011) promotes a similar view. According to the above researchers, earnings management can be promoted in modern organizations for achieving a high rewarding or for ensuring that authorities will not check the financial statements of the organization involved (Schroeder, Clark & Cathey 2011). It is noted though that the existence of other motives, such as ‘keeping the price of the firm’s shares high’ (Schroeder, Clark & Cathey 2011, p.156) cannot be rejected. At this point, reference should be made to the study of McNichols & Stubben (2008). In the above study, the following issue is highlighted: earnings management is not only developed for affecting a firm’s external environment. As explained earlier, the key motives of earnings management are related to the organization’s external environment, at the level that through earnings management effort is made for influencing the decisions of investors, the customers or, even, the state. However, earnings management can be also developed for influencing a firm’s internal environment (McNichols & Stubben 2008); the case of the use of earnings management by managers so that their compensation is increased reflects the interaction between earnings management and the internal environment of modern organizations. Baker & Anderson (2010) note that the willingness of managers to show to their superiors that they are able to achieve the targets they set is the key reason for the use of earnings management within a particular organization. The above view is similar to that promoted through the study of Madura (2012). The above researcher refers to the case of Enron as an example that shows the relationship between the manipulation of earnings and the need for showing the shares of the firm as of high value (Madura 2012). From a different point of view, Chandra (2008) explains that earnings management can be used so that the public is persuaded that ‘the company involved is of low risk’ (Chandra 2008, p.55). Through this view, earnings management is described as a method for attracting investors. The potential use of earnings management for enhancing the capabilities of the management team is also possible (Chandra 2008). Kieso, Weygrandt & Warfield (2011) highlight the following fact: firms that are well positioned in the market can promote earnings management so that the potential political costs from these firms’ low performance are avoided (Kieso, Weygrandt & Warfield 2011, p.1389). The above view is based on the fact that certain organizations are so developed that they can influence their political and social environment. Indeed, the empirical research developed by Nikoomaram, Banimahd & Shokri (2012) revealed that large firms are more likely to incorporate earnings management as a strategic tool, compared to firms of small and medium size. Of course, the potential use of earnings management in small and medium size has not been rejected. Just a trend for a higher involvement of large firms in earnings management has been revealed. Sun & Rath (2009) developed an empirical study in order to identify the key factors for the use of earnings management. About 4,844 firms of different sizes operating in Australia were observed (Sun & Rath 2009). It should be noted that these firms were chosen among nine industries across Australia so that sample is as credible as possible (Sun & Rath 2009). It was revealed that ‘the size and the return of assets’ (Sun & Rath 2009, p.1069) are decisive factors for the use of earnings of management in modern organizations. 4. Conclusion Managers in organizations tend to use earnings management for protecting the market position of their organization. Earnings management has been proved to be a complex process. Apart from the fact that many techniques are available to managers in regard to earnings management, it is not guaranteed whether the particular activity is based on ethical motives. Reference can be made, as for example, to earnings smoothing, a common technique for managing earnings. The specific technique, as explained above, is quite popular in all markets at the level that it can help to secure the market position of organizations of all sizes. The review of the literature focusing on this issue has revealed that earnings smoothing is against the market ethics but also against the laws regulating financial reporting, at the level that law does not accept any alteration on a firm’s financial statements. Protecting organizational profitability and existence cannot be used as reasons for justifying the expansion of earnings management in all markets worldwide. In practice, avoiding earnings management as a tool for enhancing organizational growth can be quite difficult, even if the credibility of the specific tool can be highly doubted. References Albrecht, S., Stice, E. & Stice, J. (2010). Financial Accounting. 11th ed. Cengage Learning. Baker, K. & Anderson, R. (2010). Corporate Governance: A Synthesis of Theory, Research, and Practice. Hoboken: John Wiley & Sons. Belkaoui, A. (2004). Accounting Theory. 5th ed. Belmont: Cengage Learning. Bhattacharyya, A. (2006). Financial Accounting For Business Managers. 3rd ed. Belmont: PHI Learning Pvt. Ltd. Chandra, P. (2008). Financial Management. 7th ed. New Delhi: Tata McGraw-Hill Education. Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of any Asset. 3rd ed. Belmont: John Wiley & Sons. Kieso, D., Weygandt, J. & Warfield, T. (2011). Intermediate Accounting. 14th ed. Hoboken: John Wiley & Sons. Madura, J. (2012). Financial Markets and Institutions. 10th ed. Belmont: Cengage Learning. McNichols, M. & Stubben, S. (2008). Does Earnings Management Affect Firms’ Investment Decisions? THE ACCOUNTING REVIEW, 83(6), 1571–1603 Nikoomaram, H., Banimahd, B. & Shokri, A. (2012). An Empirical Analysis of Earnings Management Motives in Firms Listed on Tehran Stock Exchange. Journal of Basic and Applied Scientific Research, 2(10), 9990-9993. Norton, C., Diamond, M. & Pagach, D. (2006). Intermediate Accounting: Financial Reporting and Analysis. 2n ed. Belmont: Cengage Learning. Ronen, J. & Yaari, V. (2007). Earnings Management: Emerging Insights in Theory, Practice, and Research. New York: Springer. Schroeder, R., Clark, M. & Cathey, J. (2011). Financial Accounting Theory and Analysis: Text and Cases. 10th ed. Hoboken: John Wiley and Sons. Sun, L. & Rath, S. (2009). An Empirical Analysis of Earnings Management in Australia. International Journal of Human and Social Sciences, 4(14), 1069-1085 Read More