In the accounting world, earnings management is increasing becoming an area of interest o many people including government regulators, SEC and stakeholders. Earnings management is defined as the use of accounting techniques to produce financial reports that may paint an overly positive picture of a company’s financial position (“Earnings Management” 1 Ethics and integrity are key aspects of earnings management and people believe that professionals that use earnings management to manipulate their company’s financial standings are not being ethical nor do they have integrity.
Much research has been done to understand what drives companies to use earnings management and the methods that are used. Even though impasses believe that using earning management will help them shine in the eyes of their stockholders, using it may bring many negative consequences. Training our future accountants and teaching them how to make ethical decisions regarding earnings management Is key and should be Integrated Into their education. This Is very important because at the end, using earnings management affects the quality of earnings being reported and manipulates many groups of people.
As defined before, earnings management occurs when managers use Judgment In financial reporting and In structuring transactions to alter financial reports to either aisled some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers (Healy and Whalen 6). Key to this definition Is the Judgment part because managers must make several crucial decisions using good Judgment. Many times, though, managers become blindsided and do not use good judgment when creating their financial reports.
First and foremost it is important to research and understand the reasons and incentives of why companies use earnings management. This Is not very easy task for researchers because to find whether companies are inappropriately using earnings management, they must first try to estimate the earnings before earnings management was used. One reason why managers use earnings management Is because of investors and financial analysts (Healy and Whalen 10). Researchers have found that companies usually overstate their earnings before equity offers, initial public offers, and stock-financed acquisitions (Healy and Whalen 11).
This is not surprising since companies want to portray to the public that they are in good financial standings so that they will invest in them. Companies also want to meet analysts’ forecasts so they manage their earnings to do so. Managers also have a strong stock market Incentive to use earnings management. FIFO motivations. To make a qualified and adequate contract, earnings of a company are key to designing these contracts. Companies have many contracts both with external agents and also internally within the company with employees.
Lending contracts are made to make sure that managers do not take actions or make decisions that benefit the company’s stockholders at the expense of its creditors. Lenders favor that impasses pay them the principal first before they pay out dividends to shareholders (Ironer and Yard 11). The use of earning management causes misleading financial reporting which are then shown to debt investors and to investors’ representatives on the board of directors. Using earnings management decreases the probability of violating lending contracts.
When companies are on the brink of the amount that they should have for earnings as defined in their contracts with lenders, it is most likely that earnings management will be used to avoid violating the contract (Ironer and Yard 12). Compensation and bonus awards received by managers are also a huge incentive for the use of earning management. Manager’s priorities are his or her compensation, bonuses, Job security, tenure, and reputation. Studies have found a positive correlation between managers using earnings management and increased bonuses and compensation.
It is found that firms with bonus awards are the ones that are most likely to report accruals that defer income. This in the eyes of the public and their bosses make them seem that they are on top of their game and are improving the company’s financial standings. Managers also seem to use earnings management more when their Job is at stake or is being threatened. By improving the companies reported earnings by using earnings management, they are increasing their chances of keeping their Job and even better, increasing their compensation (Healy and Whalen 21).
Resent scandals have created the need for tighter and stronger regulation. In 2002, the government passed the Serbians-Solely Act. This act established a public accounting regulatory board and the requirement that management certify financial reports. This act also requires accounting firms to have strong internal controls Ironer and Yard 46). Regulation is a very important motivation for companies to use earnings management. Healy and Whalen state that there are three reasons that regulation causes the need to use earning management.
These are to find a way around industry regulations, to bring down the risk of investigation and intervention by the SEC, and for tax purposes (Healy and Whalen 23). All industries in the United States are regulated, some industries more than others. These regulations increase the incentive for companies to use earnings management to manage their financial statements to the satisfaction of regulators. Managers want to prevent having the company investigated or fined for not following certain regulations so they find using earnings management to be cost effective for the company.
A problem companies also see with these regulations is that studies have found that companies are wasting millions of dollars trying to meet them (Ironer and Yard 48). These regulations were created to try to create more control over companies and their use of earnings management but much work still has to be done to improve these regulations. Failure of a company is the case of Lehman Brothers. In 2007, it was becoming apparent that there were cracks in the U. S housing market because of all the supreme mortgages that were being distributed.
One day after stocks fell because of concerns that these rising defaults would affect Lineman’s profitability, Lehman reported a record revenue and profit. This was a lie, though, to mislead investors. Lehman chose to use many unacceptable accounting practices to manipulate their financial statements so that they could keep attracting investment (“The case against Lehman” 1). One type of practice was called Reps 105. This is a type of repurchase agreement that temporarily removed securities from Lineman’s balance sheet. This Reps 105 deal would be characterized by Lehman as an outright sale of securities.
This created a misleading picture of Lineman’s financial condition in late 2007 and 2008 (Trustful 1). Lehman Brothers carried out this practice by getting government bonds from another bank using one of its units in the United States and then Just before the predetermined dates for settlement or the end of the quarter, they would then transfer these bonds to Lehman Brothers International in London. Their London affiliate then transferred the bonds to another bank for cash with a pledge to buy it back at a higher rate. This cash was then transferred to the Lehman Brothers in the U.
S to pay off large amounts of liabilities and this in turn reduced the firm’s liabilities and showed a healthier quarterly report which raised investor’s confidence. After showing investors and the general public their report, the money would reappear in the books and clearly show the unhealthy financial situation Lehman Brothers was in (“The case against Lehman” 1). They were able to trick many individuals, but at the ND Lehman Brothers still failed. Earning management brings about positive and negative consequences to companies.
The benefits brought about by earnings management are mostly short term. Managers keep their stakeholders happy and can attract in more investors because they become more credible. By showing shareholders that they can meet their earnings target, shareholders build more trust with the company and believe they will continue to fulfill their earnings objectives. These benefits come with long term cost though. Research has found that companies that use large accrual monuments report negative future stock returns (Healy and Whalen 17).
If a company is discovered to have over used their earnings management methods, large fines and punishments can be brought upon them. Investors will lose confidences in the company and pull out and the company may go through a financial shock. Statistics have shown that companies who were accused of using earnings management which led to many mislead investors, suffered a drop in stock prices of nine percent (Healy and Whalen 16). Earnings management can also cause the misapplication of resources (Healy and Whalen 19).
Concerns about earnings management has many people demanding more regulation so that they can have more confidence in the quality of earnings that companies are reporting. This uncertainty comes because of the recent scandals that have occurred their financial stability. The SEC wants to ensure that these cases do not keep occurring in the future and want to educate the current and upcoming accounting professionals about using earnings management. The major problem that is occurring is that many individuals do not see earnings management as being unethical or scandalous.
Research has shown that many public accounting organizations are not communicating issues of managing earnings neither through training nor through continuing education. The CPA societies and the CPA offer continuing education courses of which only eight courses touches upon the topic of earnings management. It is disturbing to see that a survey which asked the top 100 accounting firms about whether they communicate or educate their employees about the topics of earnings management showed that most of them do not. In fact only seventeen responded and only three of these firms state they have training courses n earnings management.
This brings uncertainty to many people because earnings management has caused many companies to fail and accounting firms are not doing anything about it. Accounting educators, state societies, and public accounting firms must strive to address to their accounting professionals the consequences of using earnings management. They must teach them to wisely use their Judgment and think not Just of the short term objectives but of the long term objectives of the company. Just recently universities have started to offer courses on fraud examination.
It is important for universities to address these issues of earnings management early on in the education of accounting professionals so that they can have a strong and ethical foundation when they start their accounting careers (Akers, Cinnamon, and Bellary 1). Earnings management is not necessarily done in malice towards the shareholders and investors of a company. Irregular falling and rising of revenues and expenses is normal in the accounting part of a business. Changes in operations may cause variations in the accounting numbers which may sometimes scare investors.
This persuades managers to use earnings management so these variations can appear smoothed out in the financial statements presented to their investors and also to keep stock prices up (earnings Management” 1). It is important for researchers to keep digging in and studying the use of earnings management. Major company scandals are shocking our nation and we need to create a more confident business environment for our shareholders and investors. It is key that we train and educate current and upcoming accounting professionals of the use of earnings management.
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