Cubbies Cable - Earnings Management and the Quality of Financial Reporting - Case Study Example

Earnings Management and the Quality of Financial Reporting" [Enter the date of submission] prepared by [Enter your name] Executive Summary Earning management involve falsification of financial transactions to ensure that the company reports a good earnings. The analysis is done on Cubbies Cable which is a limited company dealing in the sale of cables. The company expenses all the cost of cables which is not complying with the recommendations of the auditor requiring capitalization of these costs. It is ethical to practice earning management as it complies with GAAP but the only problem is that the management can collude with clients to defraud the company. It also ensures that the CPAs professionals to abuse their code of practice of integrity and transparency where they do not report true state of company’s affairs. Table of Contents Introduction People with little knowledge about finance take earning management as a very simple thing and look like a very interesting topic (De Jong and van Dijk, 2012). In this report the discussion is on earning management which has been mistaken as a good thing. In real sense, earning management is where the accounting information of a given company books of accounts are manipulated to window dress the public that the business is doing well (Christensen and Şabac, 2005). All the techniques which are used in this act are not enforceable by law although they conform to accounting principles and policies. The only problem it has is that it infringes the spirit of accounting principles and policies. The purpose of earning management is to attract investors and make them perceive the company as profitable (Dechow and Schrand 2010). The mostly used technique is income smoothing which involves changing earnings from one period to the next to have steady profits. This report is based on Cubbies Cable which is a limited company dealing in the sale of cables (Armstrong and Riedl 2008). This company has it’s headquarter in Chicago and had a problem on how to account for installation costs for its clients in 2013 financial year. There was a contradiction where the client wants the cost to be expensed while the audit manager request for capitalization. Question a There are different types of earning managements. All these categories involve manipulation of accounting figures to reflect that the company is profitable (Dechow, 2000). This action is illegal but not violates the accounting principles although; it fails to reflect the accounting professional code of ethics of accountability, transparency and integrity. "Cookie-jar" Reserves This type of earning management requires the accrued expenses to show the date of their occurrence (Dechow and Schrand 2010). It should not be shown to reflect the period at which it was paid. When there are high earnings, the company creates another accrued expense to reduce the company liabilities so that it can be used to produce future earnings when it is low. "Big bath" one-time charges The company can use non recurring charges to solve confusion problems when using aggressive accounting practices (De Jong and van Dijk, 2012). It is likely for the financial analysts to assume non recurring charges since they do not form part of regular activities. The company that uses earning management removes future period economic earnings. When there is unsustainable earning growth, the company can use a given event that has one time event character to overload the expenses attributable to the same event (Christensen and Şabac, 2005). It is possible for the auditors not to account for one time event as not one of the operating activities. Operating activities The organization management has the capability to change timing of events to ensure that the accountants only account for such activities that id convenient for them (Dechow and Schrand 2010). They lack the capacity to change long term economic value of operations which cannot have a short term effects on the financial statements. Purchase accounting and goodwill When the purchase price used to acquire the asset is more than fair value in the purchasing accounting method of acquisition, the difference is treated as goodwill for intangible assets and it is amortized over a long period of time (De Jong and van Dijk, 2012). The formation of goodwill is able to create an expense which has negative effects on the reported earnings. This method is therefore able to inflate the loss or claim reserves to portray the company as profitable. Revenue Recognition The time for reporting revenues is also a very important area to manipulate the management earnings. The management is able to employ aggressive steps to increase annual revenues within a given period by way of providing incentives. The management can also use aggressive accounting steps like the sale of securities to recognize gains. Immaterial misapplication of accounting principles It is also possible to misuse materiality concept to report high profits. It gives the auditors to overlook errors and misstatement if they are not falling within materiality (De Jong and van Dijk, 2012). This gives the company an opportunity to misstate the earnings which is below materiality threshold to prevent scrutiny. The persistent of the same practice may make the balance sheet to have a very significant misstatement. Question b The motivation for Cubbies Cable for taking the position to expense all the cable costs was to ensure that the company does not report high profits which are not easy to maintain in future (Dechow and Schrand 2010). This will ensure that the company maintains reasonable profits which are sustainable for a long time. Capitalization of all the cost of cables could have increased the operating profit which it may be difficult to maintain in the future. Expensing all the cost of cables is also able to reduce the liabilities of the company. This could have shown the company to the public as one with optimal liquidity and as a result is not keeping excess idle cash which could be reinvested in other long term investments to increase revenues. This will not reflect the company as one which is not practicing overtrading and overcapitalization (Dechow and Schrand 2010). To expense all the cost of cables is also reduces cost of sales which reflect the efficiency of the company. It will show to the general public that this company is very efficient as it has a short inventory holding period which shows that the company is able to convert its finished products into sales within a short time. This is a serious attempt to manage earnings since it reduces the value of reported profit and ensure that the company only reports sustainable profit which it will be able to maintain in future (Leuz and Wysocki, 2003). The action is characterized as an attempt to manage earnings as it amounts to a reduction in annual profit and also increase company liquidity position (De Jong and van Dijk, 2012). It also reflects the as a very efficient company as it reduces average inventory period. This has a reflection in the profit earned at the end of the year (Dechow and Schrand 2010). This action amounts to manipulation of the earnings of this company since it reduces annual profits as it increases annual expenses. It is also because this company created additional expenses to reduce the liabilities in order to produce future earnings to ensure the company show positive profits in future. Question c Stakeholders are people who have interest in the company (Barth and Lang, 2008). They include customers, management, Government, creditors, suppliers, Local Community, investors and employees (Hribar and Collins, 2002). The action of this company affects all the stakeholders in one way or the other. It affects the Government by ensuring that the company pays less tax revenue due to low reported earnings. It also affects potential investors since they may perceive the company as less profitable but very profitable. This will influence their decision making process (De Jong and van Dijk, 2012). Management is also very important stakeholders; they participate in the preparation of the financial statement to ensure that it reflects rue and fair view of the company states of affairs. The creditors are also affected by this action taken by the management of this company. They are not able to make correct decision since there is no integrity and transparency when the books of accounts were being prepared by the management. The major ethical issue which should be of concerned to Binks is to support the position of the auditor who recommended the capitalization of the cost of the cables. The capitalization of the cost of the cable will ensure that there is integrity and transparencies which will allow not the company to window dress its stakeholders (Dechow and Schrand 2010). To expense the cost of cable will reduce the earnings of the company but it will also show that the company is not profitable and will also reflect true states of affairs this company. The only effect of the use of client position is that it will reflect the company to have high liquidity position which is not a reality but the manipulation is meant to meet some illegal objective (De Jong and van Dijk, 2012). The action taken by the client is also not complying with the accounting standards and therefore it is not an accepted accounting practice. The use of the client is only ethical for management purposes since it ensure that the company only reports sustainable earnings to shareholders. The chances which the management has for manipulating financial information may also lead to misappropriation of funds in the name of managing company earnings (Goel and Thakor, 2003). The use of auditor’s recommendation is able to increase accountability, transparency and other ethical principles which are able to limit frauds, errors and misappropriation. Question d It is unethical for CPAs to horse trade when negotiating with client about proper GAAP to apply in a particular situation. This is because CPAs has proper professional code of practice to use when preparing financial statements (Christensen & Şabac, 2013). They also have accounting standards which has been approved by the accounting boards such as IASB. The board has established accounting frameworks which set out rules and procedure on how to account for any particular business transaction. The negotiation with the client on the GAAP to apply may lead to manipulation of financial statement which is likely to significantly amount to errors and material financial misstatement. Such negotiation is relates to accepted auditing standards of the AICPA and PCAOB by having the same accounting procedures (Aussenegg and Schneider, 2008). They are also complying with accounting auditing principle. Such negotiations follow materiality concept which allow the management to manipulate transactions which possibly lead to misappropriation which does not meet the materiality threshold. This negotiation is unethical since the management may abuse their discretion to mislead the stakeholders regarding the performance of the business organization or have the capacity to influence the contractual results to maximize their personal benefits from the company (Christensen and Şabac, 2005). It is therefore effective for the business organization to follow guidance of GAAP to use the flexibility of accounting treatment as to eliminate the risk that can infringe GAAP. It is unethical to negotiate with client when adopting GAAP to use since the client can influence the management to manipulate accounting profits that only benefits them (Dechow and Schrand 2010). The use of earning management by the organization is related to the accepted auditing standards of the AICPA and PCAOB by following auditing principles but only affect the accounting professional code of practice of accountability, transparency and integrity. The transactions may be recorded according with the law but it may lead to abuse of materiality concept. Conclusion People with little knowledge about finance take earning management as a very simple thing and look like a very interesting topic. In this report the discussion is on earning management which has been mistaken as a good thing. In real sense, earning management is where the accounting information of a given company books of accounts are manipulated to window dress the public that the business is doing well. There are different types or categories of earning management and they include "Cookie-jar" Reserves and Operating activities etc. The motivation that the company gets from practicing earning management is to ensure that it reports sustainable financial profit which it can maintain in future. There are also stakeholders who are affected when the company practices earning management and they include creditors, The Government and potential investors. 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