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Earnings Management and Cost Investigation Case Study

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Introduction

It becomes a common practice for the managers to intend to smooth the earnings of their companies by means restructuring the information in the financial reports. One of the most important aspects in defining how exactly the earnings can be managed is to analyze the specific accruals.

Motivation

According to McNichols and Wilson (1988), the investigation of the theoretical background of the earnings management in its broad framework allows defining the reasons behind the earnings smoothing practiced by the executives and the incentives of the modern business and accounting environment that lead to the phenomenon of earnings management. However, in a more precise perspective of investigating the specific details of the accounting accruals that have been managed, it is possible to analyze the particular instances and define the empirical measures (McNichols and Wilson 15).

In many ways, earnings management depends on the motivation behind the managers’ actions. The three main domains that encourage the practice of earnings management are the aims to achieve positive profits, to meet the expectations of the market analysts, and to ensure the managers’ personal benefits.

For example, Marquardt and Wiedman (2004) claim that the motivation of the equity offering management as a specific accrual lies in the aim of increasing stock prices (Marquardt and Wiedman 465).

The performance of the managers is partially evaluated on the basis of the positive profit of the company and the smoothness of the earnings. Therefore, out of consideration for job security and personal benefits, it is tempting for the managers to discrete some information in the financial reports presented to the external audience. On the one hand, when the anticipations about the company’s performance are too optimistic, the managers might be tempted to be able to meet the expectations.

Thus, when it is not possible by means of real economic actions, the other option is to smooth the income by using discretionary actions. On the other hand, when the business is not expected to be successful in the upcoming fiscal year, the managers are concerned that they could be dismissed, which also creates an incentive for income smoothing.

Therefore, the management of certain accruals is motivated by specific benefits. Those benefits can be non-material, but the motivation is always different depending on the correlation between the cost of the specific type of earnings management and the income statement items. Therefore, Marquardt and Wiedman (2004) analyze three aspects that motivate the earnings management amongst the executives, which are the costs of detected earnings management, the costs of undetected earnings management, and the benefits of managing specific accruals (Marquardt and Wiedman 466).

Hypothesis development

For Marquardt and Wiedman (2004), the first stage of hypothesis development is the assumption that different types of earnings management relate to different aims (Marquardt and Wiedman 466). According to these criteria, the types of earnings management are:

  • Upward earnings managing in order to boost the equity offerings;
  • Downward earnings managing (discretionary actions);
  • Upward earnings managing to create an impression of a positive profit.

Source: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

In defining the objectives of the theoretical and empirical investigation of earnings management, the main goal is to find out whether the incentives exist and how they function in specific accruals.

Downward management usually refers to discretionary manipulations with the earnings. Discretion of some parts of information that results in smoothing the earnings pursues three main targets. Firstly, it allows the managers to manipulate the impression on the audience to whom the financial reports are presented because the positive profits and smooth earnings are perceived as the indicator of the successful company’s performance. Secondly, it enables the managers to meet the expectations for the future year because the judgment that they and the analysts use can be overly optimistic. However, thirdly, the smooth income also correlates with the benefits for the executives themselves.

Costs of managing specific accruals

In order to be specific, the investigation of the costs of the earnings management should be carried out in two different domains.

The first one is the costs of the “detected” earnings management that refer to the cases when the practice of earnings management and income smoothing became undisclosed.

The second domain of investigation was the undetected managing of the earnings when the practice was not publicly exposed.

There are a number of various means of applying earnings management. The most common methods to manage earnings include choosing the type of treating and dealing with the financial reports, according to the GAAP, deciding whether to adopt any new standards, defining the items in the financial report as those that are above or below the line of operating earnings. The methods of the narrower spectrum include structuring the financial transacting for concluding new contracts and lease agreements and timing the recognized revenues. Finally, there are methods for managing the transparency and the informative potential of the financial reports, such as disregarding or subtracting minor expenses.

Costs of detected earnings management

According to Dechow, Sloan, and Sweeney (1996), the detected earnings management is widely associated with the decrease in stock prices. Thus, some cases of earnings management can be detected when we find the correlation between the governmental restrictions (including SEC regulations), expectations of the analysts, and the company’s actual performance (Dechow, Sloan, and Sweeney 10).

The earnings management can vary in its compliance with the set standards of accounting. According to this criterion, it can be white, gray, and black. The purpose of white earnings management is to make the financial reports more clear, comprehensive, and informative by means of restructuring the information in a more convenient order. The gray earnings management is more opportunistic than the white one; it is in pursuit of the economic efficiency and gain for the company that provides the report. However, despite the dubious intentions, it exists within the boundaries of compliance with the standards. Therefore, it is risky but opportunistically efficient. Meanwhile, black earnings management deals with creating an intermediately misleading impression about the company’s finances.

Earnings restatements

According to Palmrose and Scholz (2004), the earnings restatements can be directly linked to the substantial negative stock returns (Palmrose and Scholz 155).

The earnings restatements usually refer to misrepresenting the information in the financial reports. It involves either documenting the expected future earnings as the current ones or postponing the current earnings for the future.

Source: Palmrose, Zoe‐Vonna, and Susan Scholz. “The Circumstances and Legal Consequences of Non‐GAAP Reporting: Evidence from Restatements.”Contemporary Accounting Research 21.1 (2004): 139-180. Print.

There are distinctive correlations between the earnings restatements, the current performance of the company, and the expected performance in the future. Firstly, the companies with the current poor level of financial performance and anticipation for the increase in it in the future are more likely to be involved in the income smoothing practices. Thus, in those cases, the managers borrow the profits from the expected cash flow in the future or report the expected profits as they already received ones. However, there is an opposite option, in which companies with the successful performance in the present and the anticipation for it to worsen try to postpone reporting their current earning to the future to make the overall situation to look more consistent.

Shareholder litigation

Palmrose and Scholz (2004) point out that any involvement of the company in the litigations initiated with a lawsuit by a shareholder contains a potential incentive for the earnings management (Palmrose and Scholz 158).

The main motivations, in this case, would be to avoid worsening of the analysts’ forecasts concerning the company and not to let the stock share prices decrease.

Source: Palmrose, Zoe‐Vonna, and Susan Scholz. “The Circumstances and Legal Consequences of Non‐GAAP Reporting: Evidence from Restatements.”Contemporary Accounting Research 21.1 (2004): 139-180. Print.

The intermediate means to manage earnings include documenting contingent sales as the self-explanatory ones, restructuring transacting in a “channel stuffing” way, virtual “bill-and-hold” transaction, and violating the regulation of the quarter cutoffs, the recognition of the revenues before the payment or goods were received, or the transaction was finished.

Qualified audit reports

According to Bartov, Gul, and Tsui (2000), the qualification standards of the financial reporting show a positive correlation with the level of involvement of the earnings management in the abnormal accruals. There is also a correlation with the number of accruals the company requires for the successful operation (Bartov, Gul, and Tsui 425). However, it was not yet recognized whether the types of earnings management depend on the standards of qualification of the audit reports.

Source: Bartov, Eli, Ferdinand A. Gul, and Judy SL Tsui. “Discretionary-accruals models and audit qualifications.” Journal of accounting and Economics 30.3 (2000): 421-452. Print.

Whereas GAAP earnings are classified as the earnings in cash that need to be documented, one means of earnings management is to report them as so-called pro forma earnings. The pro forma earnings are a commonly non-cash and one-time, non-recurrent type of earnings. Therefore, they may be disclosed by the company for the purposes of presenting their financial performance in a different way. Usually, such ways of earnings management refer to misrepresent the stock-compensation charges, gains, and losses, the costs of merging between two or more companies, etc.

Given the fact that is documenting the GAAP earnings as pro forma non-cash earnings lead to creating the misrepresenting impression about the company’s performance and misleading the stakeholders and partners, it is classified as a type of black pernicious earnings management, and such practice is condemned by the standards setters and accounting regulators

Negative coverage in the business press

According to Marquardt and Wiedman (2004), criticism and generally negative coverage of the company’s performance in the press can result in changes to the forecasts of the company’s future performance (Marquardt and Wiedman 465). Therefore, the negative forecasts can stimulate downward earnings management when the executives perform discretionary actions to meet the expectations of the other agents of the accounting arena, including the business press.

Source: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

The accounting arena includes many agents that play their role in the business environment. Apart from the company itself, there are users of the reports, including investors, employees, lenders, consumers, competitors of the company, government regulators, etc. Also, there are independent gatekeepers, such as analysts, investment bankers, media, and other agents that can influence the financial situation on the accounting scene. Alongside all those agents, there are different regulations and constraints that define the financial environment.

Costs of undetected earnings management

Undetected earnings management refers to the cases where the manipulations with the earnings represented in the financial reports were not recognized as such.

According to Marquardt and Wiedman (2004), the important aspects that need to be analyzed for the improvement in the detection of the costs of undetected earnings management are:

  • reversals of accruals
  • constrains on the future reporting flexibility
  • audit costs
  • perceived earnings quality
  • probability of detection (Marquardt and Wiedman, 470).

Source: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

The benefits of managing specific accruals

The most complicated aspect hindering the detection and recognition of earnings management is the fact that the benefits of earnings management are always situational. Despite the fact that there are some generally developed patterns that define the common incentives, the main problem is still the fact that the benefits for the company and the executives can vary depending on a very specific situational context. Furthermore, the same context often influences the decision of the managers about which accruals are manipulated in the process of financial reporting.

Hypothesis I

Marquardt and Wiedman (2004) introduced the hypothesis concerning the earnings managements and the companies issuing equity. According to it, since the main motivation for equity is to boost the revenues, and the companies that offer equity receive better forecasts about their performance, they are more likely to defer the detection of their expenses in order to enhance the profits and the cash flow.

Source: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

The second hypothesis concerns the management buyouts. Marquardt and Wiedman (2004) suggest that “unexpected account receivable will be significantly lower for firms engaging in management buyouts than for other firms” (Marquardt and Wiedman 472).

Meanwhile, Perry and Williams (1994) that management buyouts, in general practice, refer to the downward earning management when executives try to make their income seem smaller (Perry and Williams 164).

Sources: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

Perry, Susan E., and Thomas H. Williams. “Earnings management preceding management buyout offers.” Journal of Accounting and Economics 18.2 (1994): 157-179. Print.

In their third hypothesis, Marquardt and Wiedman (2004) suggest that “special items will be significantly more positive for firms avoiding the earnings decrease than for other firms” (Marquardt and Wiedman 472).

That statement mostly concerns the fact that the non-detected cases of earnings management are commonly linked to the situation where it is less obvious from managing, which accruals the company will obtain more benefits.

Source: Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

The total accruals are defined as the change in the current assets minus all the other figures. With such a model, the researchers can estimate the unmanaged accruals. Furthermore, the discretionary accruals are distinguished as the difference between those unmanaged total accruals and the value of the profits and cash flow in the reports that have undergone the discretionary procedure.

Research design

The main objective of the research performed by Marquardt and Wiedman (2004) is to improve the understanding of earnings management by describing the context of managing certain accruals in certain situations.

Therefore, the measures that were examined, in this context, included accounts receivable, special items, accounts payable, liabilities, and other accounting accruals both from the category of cash flows and from the domain of pro forma earnings and non-cash income statement items (Marquardt and Wiedman 473).

Results: Performance matching and equity offerings

Performance matching is confirmed to be one of the most important criteria for identifying large-scale earnings management. If we assume that the forecasts about the future performance are accurate, then it would mean that the discretionary accruals can be defined on the basis of the difference between the sample firm’s measures and the predicted inventory (Marquardt and Wiedman 479). Equity offerings that exceed the expected measures should also be regarded as one of the signs for the additional search of the evidence of the earnings management. Therefore, hypothesis I is confirmed.

Results: Earnings-decrease avoidance and management buyouts

Hypothesis II is confirmed in the research conducted by Marquardt and Wiedman (2004). The results of the test showed that the managers are more likely to be engaged in downward earnings management before the buyouts. The most beneficial type of accruals for earnings management, in such cases, are the accounts receivable accruals. It means that the managers postpone the revenues of the company to be reported in the future financial documents. The same practice is confirmed to be applied in earnings-decrease avoidance. By postponing the revenues, the managers stabilized the profits since the decrease in current revenues and saved up revenues for the future fiscal period create an impression of stable performance with positive profits.

Conclusions

In conclusion, the unexpected accounts receivable are the financial accruals that are most likely to be managed. The benefits and costs of earnings management differ depending on the context of the situation. However, there are areas that are proved to be most related to earnings management. They are equity offerings, management buyouts, and earnings decrease avoidance. They all, coincidently, have to do with the unexpected accounts receivable, but the mechanisms of the income management, including downward or upward management, still depend on the benefits in each particular situation.

Works Cited

Bartov, Eli, Ferdinand A. Gul, and Judy SL Tsui. “Discretionary-accruals models and audit qualifications.” Journal of accounting and Economics 30.3 (2000): 421-452. Print.

Dechow, Patricia M., Richard G. Sloan, and Amy P. Sweeney. “Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the sec.” Contemporary accounting research 13.1 (1996): 1-36. Print.

Marquardt, Carol A., and Christine I. Wiedman. “How are earnings managed? An examination of specific accruals.” Contemporary Accounting Research 21.2 (2004): 461-491. Print.

McNichols, Maureen, and G. Peter Wilson. “Evidence of earnings management from the provision for bad debts.” Journal of accounting research 1.1 (1988): 1-31. Print.

Palmrose, Zoe‐Vonna, and Susan Scholz. “The Circumstances and Legal Consequences of Non‐GAAP Reporting: Evidence from Restatements.”Contemporary Accounting Research 21.1 (2004): 139-180. Print.

Perry, Susan E., and Thomas H. Williams. “Earnings management preceding management buyout offers.” Journal of Accounting and Economics 18.2 (1994): 157-179. Print.

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