Motives behind Earning Management - Essay Example

Contents Page Introduction 1 Earnings Management Definition 2. Earnings Management Measurement Methods 2.1Aggregate Accruals Method 2.2 Measuring Total Accruals 2.3 The Specific Accrual Method 2.4 The Distribution Method 3. Motives behind Earning Management 3.1 Stock Market Motivations 3.2 Management Compensation Contracts Motivations 3.3 Debt Contracts Incentives 3.4 Political and Regulatory Requirements Motivations 4. Conclusion 5. References 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 Earning management is known these days as the creative accounting practices. Companies indulge in creative accounting practices, which can be ethically questioned for not adhering to ethical standards, as motivations behind reported earnings can be compromising to the interests of various stakeholders. Earning management, according to Kothari et al. (2005) should be evaluated through the control in discretionary accruals as appraised by the performance matched accruals model. An analysis of the earning management literature shows a shortage of scholarship on earning management. Only limited research is available on the U. K. Companies. Past researches have used obsolete data and are deficient in approaches like employing undesirable earnings management methods and ignoring some basic control variables, including performance and growth. A complete analysis is required that studies the deficiencies of past studies to update the earnings management study. It is very critical, therefore, to define earning management. 1.1 Earnings Management Definition There is no unanimity over an agreed common definition of the term “earnings management” in literature. One of the most employed definitions is ‘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” (Healy and Wahlen, 1999, p.365). Another accepted definition is made by Schipper (1989, p.92), who remarks that “By earnings management I really mean “disclosure management” in the sense of a purposeful intervention in the external financial reporting process, with a view to obtaining private gain for shareholders or managers”. The literature on this kind of earnings management primarily starts with Healy (1985) who states that managers use income to corner away bonus income. Loss is diverted to the stockholders through managed earnings against the manipulated profit for managers. This could be transferred to managers by increasing their rewards (Healy, 1985). Out of the various definitions, Schipper’s (1989) definition is comprehensive enough as it stresses that earnings management is a planned action. It may include any type of influence that can negatively impress accounting statements either via earnings figures or any other accounting items. It can be either legal as Generally Accepted Accounting Principles (GAAP) or illegal (accounting cheats). This management influence can be exerted to fulfil management aims or shareholders’ aims. 2. Earnings Management Measurement Methods Strategies over earning management are either aimed at increasing current period earnings or reducing them or for reducing volatility by smoothing earnings. There are three most prevalent measurement methods in the earnings management literature: aggregate accruals, specific accruals and the distribution of earnings. 2.1 Aggregate Accruals Method This is the most prevalent method in earlier researches to approximate earnings management. Accounting accruals are divided into discretionary accruals, to be decided by the management, and non-discretionary accruals, which are based on economic parameters. Discretionary accruals permit managers to use their will over accounting choices and measures, and it is an agreed method of practicing earnings management. As there is a division between discretionary and non-discretionary accruals, the managers use the discretionary accruals as a proxy to control their income. This method has one leading flaw, as it is not easy to zero-in and separate total income into controlled and not-controlled divisions. There are various models in aggregate accrual from simple in which the shift in total income is employed as a proxy for discretionary income to the comparatively modern approach, wherein accruals are distinguished through regression analysis. (Habbash, 2010). 2.2 Measuring Total Accruals First, total income is calculated to approximate discretionary accruals. Out of the two methods, the usage of old balance sheet method is common in earlier researches. The second method, the cash-flow approach is latest. The balance sheet approach is relatively famous for providing balance sheet statement data relatively to cash flow statement data. The difference between both the approaches is that while the balance sheet approach deletes non-current incomes other than depreciation and amortisation, the cash flow approach includes both current and non-current incomes. Deleted non-current incomes get shifted from current earnings to future earnings and are not accounted in the balance sheet method (Habbash, 2010). Comparison of both the approaches for measuring earning method made by Collins and Hribar (2002) through four distinct sample traits provides statistical proof that balance sheet design is less effective relatively to the cash flow design in the case of mergers and acquisitions (M&A). Such M&A functions can reduce the connection between shifts in balance sheet working capital accounts and earned incomes and expenses on the income statement. Approximation of total accruals through balance sheet method may include critical estimating mistakes relatively to total accruals as estimated straight by employing the cash flow statement method. 2.3 The Specific Accrual Method Earnings management study depends largely on total accruals to specific accruals to discern the occurrence of earnings management. Healy and Wahlen (1999) counter that there is no proof of earning management employing specific accruals. Study of specific accruals can be helpful for benchmarking the lacunas in standards. Matching with the aggregate accruals researches, this alternative method designs the behaviour of each specific accrual to find out its discretionary and non-discretionary parts. Examples of specific accruals for evaluating earning management include bad debt provisions, depreciation and deferred tax. Philipps et al. (2003) propose considering deferred tax expense accruals to prove earnings management, besides discretionary accruals. It is proved that this expense is increasingly employed, farther from total accruals and discretionary accruals taken from two Jones-kind designs, in locating earnings management, the purpose of which is to keep off a meagre loss or an earnings reduction. Some of the disadvantages of specific accruals method include: If the item being evaluated is managed, it proves earning management occurred. In case, it is not detected, it provides misguiding results of no earnings management. Otherwise too, it is generally difficult to locate the specific accrual employed to manage earnings. If at all, it is proved that a specific accrual has been managed, it may not carry empirically critical value. Reasoning guides that managers might be using many accruals at a time to manage earnings (Habbash, 2010). Overall, total accruals method is relatively more efficient than specific accruals method in finding proof of earning management. Besides, construct strength is on the reducing for the specific accrual method relatively to the total accrual method, as a specific accrual can be easily impacted by other variables, such as credit policy or a shift in normal economic environment. So, the specific accruals method does not work to find a relation between earnings management and other hypothesised elements, as it needs a different design for each accrual to be possibly effected by the hypothesised factors (Habbash, 2010). 2.4 The Distribution Method Managers’ incentives are central in distributional method to attain a level of positive profits or deflecting losses. The distribution of stated earnings nearer to the thresholds of profits or losses can be helpful in locating whether the representation of figures up and down the thresholds is distributed normally or they are showing variations due to earnings management. Burgstahler and Dichev (1997)) evaluate the distribution of earnings shifts and recorded earnings. The outcome indicates an increased frequency of companies with very little positive earnings than companies with very little negative earnings. The frequency in distributional method does not recognise any difference between discretionary and non-discretionary accruals. It fails in approximating management’s incentives to control earnings. This approach points out which group of companies will manage earnings in stead of pointing out a better method of discretionary accruals (Habbash, 2010). It can be derived that the aggregate accruals method has relative increased application than other methods, both theoretically and statistically. Vast research evidence states that aggregate accruals method is used in practice as a complete proxy for earnings management, using the cash flow approach. Specific accruals method and distribution methods are used scarcely because of lacking in providing statistical value to the managers and for the stated limitations of not recognising the discretionary and non-discretionary accruals (Habbash, 2010). 3. Motives behind Earning Management It is very difficult to record motives irrespective of the belief that earning management is occurring, as Healy and Wahlen (1999) counteract. An analysis of the conditions is important behind managers’ robust motivations before examining designs of sudden accruals appearing relevant with the given motives. There are three leading motives recognised in literature, which are: Stock market motivations, managers’ compensation contracts motivations and political and regulatory requirements related motivations. 3.1 Stock Market Motivations The connection between stated earnings and stock prices can actually lead managers towards the practice of earnings management. It is noticed that discretionary accruals are higher in public firms than the private ones by relatively 1.2% of lagged total assets, as stated by Kim and Yi (2006)). Past research on capital market incentives tackles four leading problems: (a) motivations for managers to reach the high expectations’ level of stock market participants; (b) motivations to leverage earnings before going public or equity offerings; (c) to verify if investors are being cheated; and (d) proof over the capital market outcomes of earnings management. Generally, managers choose to control reported earnings for a particular time or bring down analysts’ estimations with the aim of failing them in stead of showing dissatisfied earnings (Soffer et al., 2000). 3.2 Management Compensation Contracts Motivations Managers indulge in this opportunistic practice to impress the behaviour of stock prices. The possibility increases due to implicit financial advantages from the desired financial reporting. It is countered that managers practice earning management to minimise company costs by linking shareholders’ interests with their aims, thus, entering into monitoring and bonding contracts for the common interests of each other. For example, under the management compensation plan, a share of managers rewards is given for its reported income. Accounting figures are manipulated to set up the covenant terms of compensation contracts and to check the adherence to these conditions. Watts and Zimmerman (1986) propose that managers with earnings-based compensation contracts are motivated to state earnings outcomes that optimise the value of their bonus income. Research was conducted by Healy (1985) to find the effect of executive compensation plans on accrual discretions and accounting methods’ selection. It was noticed that managers were economically motivated to report income to increase their cash reward. It was derived from his research that a robust link was maintained between accruals and managers earning-reporting rewards under the bonus plan of the management. Another trend seen is offering bulk rewards to managers for showing a distinct kind of opportunistic behaviour, which could be seen in the income of the companies. All kinds of motivations, whether reward, stock option, bonus and other linked payments were related to earnings, presenting a motivation to managers to benefit from earnings. Managers would create an issue of information imbalances by projecting false and irrelevant income statements. Such projections heighten company costs and promote opportunistic behaviour through earnings management. 3.3 Debt Contracts Incentives Other than likely issues of interests between shareholders and managers, issues can also arise between the interests of shareholders and debt holders. Management decisions over shareholders’ interests, for instance, noticeable dividend payments, may be against the debt holders’ interests. As a result, company costs of debt will be impacted. Such costs can be compensated through managers or shareholders in case they are not minimised through checking and bonding contracts. According to Jensen and Meckling (1976), managers are motivated to be a part of the bonding contracts to save costs of debt. Writing protective covenants in debt agreements is an example of such costs. In this regard, figures are normally manipulated to set up the covenant terms of debt contracts and to check if these terms are revoked. This means that accounting policies are formulated for creating monetary procedures. Thus, any change in accounting policies can impact managers’ income. 3.4 Political and Regulatory Requirements Motivations Other stakeholders such as banking and governmental regulations and tax laws are likely motivating elements of earnings management. Regulatory norms create pressure on companies, thus, encouraging earnings management. For instance, Haw et al (2005) examine income-increasing earnings management in China as a reaction against governmental regulations asking a minimum of 10% return on equity (ROE) for such companies keen to offer shares or release bonds. It arouses a robust motivation for indulging in earnings management. Thus, getting government subsidies or support could be a motivation. Sometimes, trade union pressures, clearing the ground for an increase in future income and reduction in tax liabilities can motivate managers also. A report on 35 large Spanish public companies was published by Amat et al in 2003, which indicated the behaviour of those companies was comparatively transparent and within the near about legal parameters. Certain parameters were found viable concerning the reported practices, pointing out that the companies used creative accounting ways of reporting earnings, such as: -Auditor report reservations for showing the effect of qualifications to be later explained in the auditor report. -Taking special permission from controlling agencies to adopt non-standard policy. -Modifications in accounting policy from the previous year with prior permission of the government, with the outcomes explained later in the auditor’s report. The research on theses firms’ accounting methods for reported income measured three consecutive years’ statements from 1999 to 2001 time period. The overall impact on income from creative accounting practices was 20% of the total stated income. Table 1 below presents a summarised view of the selected companies manipulating income when reported income did not match with the adjusted income through creative accounting practices (Amat & Gowthorpe, 2004). Table 1. Number of Spanish larger listed companies (out of 35) that managed earnings during the period 1999-2001. 1999 2000 2001 % of companies that managed earnings 40% 45.7% 25.7% Number of companies 14 16 9 Reported earnings > Adjusted earnings 5 11 7 Reported earnings < Adjusted earnings 9 5 2 Source: Amat et al (2003)) It is worth pointing out that in 1999, when the overall economic conditions were positive comparatively, the reported income of 9 companies was below the managed income. Nevertheless, in 2000 and 2001 when the economic downturn started affecting the Spanish economy, the tables got turned. Most of the firms under analysis in both years, 2000 and 2001stated reported income on the increase than adjusted income. The outcomes of the research across a three year period indicate that the accounting motivations could be linked to general economic environment (Amat & Gowthorpe, 2004). 4. Conclusion Manipulative or cosmetic accounting methods give a feeling of cheating and wrong accounting practices. Some steps taken by the International Accounting Standards (IASs) need to be implemented to limit the horizon of accounting unethical practices. Regulatory bodies can control the motivational accounting practices variously: 1. By limiting the selection of accounting approaches, the regulatory bodies can control by not allowing multiple ways of accounting or allowing only specific accounting procedures as based on explained or specified circumstances for using an accounting method. It should be made mandatory to a company that it can not change its accounting method even if it faces the possibility of relatively undesired outcome. 2. Misuse of judgement can be controlled in two ways. Either rule can be made to reduce the possibility of making judgements or the company should be ordained to be regularly using an accounting policy that befits the company for forthcoming years also although it may not be preferable to do so in the management interests. . The habitual usage of ‘extra-ordinary item’ by the management needs to be discarded as essential with the profit and loss account for items, the management wanted to postpone including in the functional profit. As per the current rules of the International Accounting Standards, the section of ‘extra-ordinary item’ has been almost erased from practice. Auditors can also play a constructive role in recognising fraud measures. 3. Not-genuine dealings can be controlled by raising the notion of substance over form, wherein the economic suitability in stead of the legal kind of dealing decides their accounting income. This way, connected dealings would be considered as one. 4. The time element needs to be paid attention in the case of real dealings by using discretion on the part of the management. Nevertheless, the propensity to use management discretion can be controlled through incessant reappraisals of items in the accounts to identify profits or losses on shifting value each year as they happen, in stead of only becoming visible once a year when a disposal happens. The approach of the International Accounting Standards Board is shifting in this regard towards valuation at just value in stead of deciding on historical factors, as done in many latest accounting standards and analysis papers (Amat & Gowthorpe, 2004). But other than shifts in accounting controls, ethical parameters and regulatory adherence must be rightly implemented in the corporate accounts. Any control without total and comprehensive implementation means could prove inefficient in holding people from using confusing reporting practices. References Amat, O., & Gowthorpe, C., 2004. 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