Assignment Sample on AFE-7-FRE Financial Reporting

Introduction 

Earnings management refers to purposeful intervention in process of reporting of financial information for obtaining private gains. There are two types of earnings managements namely real earning management and accruals management. Earning management refers to manipulation without affecting flow of cash or often actions which affect flow of cash. Increasing allowance for doubtful debts for lowering profit is an example of real earning management. Accrual management refers to obstructing in reflecting economic position by changing accounting methods. Companies selling items on credit are examples of accrual management. The study sheds light on motivation behind earnings management, methods used, and role of government in minimizing it.

Motivation behind earnings management

Earnings management is undertaken by an organization as it has certain advantages. Earning management helps managers in easily achieving targets and increasing financial bonus.   Earning management also helps to increase value of an organization by improving its overall earnings position. According to Strakova (2021), earnings of an organization are often considered to be main parameters chosen by an investor for investing in an organization. For this reason, companies try to manage their earnings to make it attractive in eyes of investors. Some of earning management motives may be listed down as below:

Compensation Contract

Managers from an organisation having earning based compensation adopt increased income accounting for increasing earnings. They try to introduce income-reduced methods of accounting if earnings drop below lower limit or increase above upper limit which was mentioned during plan. According to Strakova (2021), theory of management compensation, also known as bonus plan theory, takes into consideration that managers within an organization are motivated to use earning management for improving compensation. Bonuses offered by management are often linked with earnings of an organization. Tesco also adopted this concept and sold its products at higher rates for increased earnings. As earnings were dropping they increased their earnings by selling at higher prices which in turn helped Tesco in maximising profits.

Debt Covenant

Debt Covenant tries to establish relations based on agreement between an organization and a lender in which financial ratios which are set by creditors play a key role. For instance, return on asset ratio, equity ratio, which is calculated from financial statements, managers try to manage these numbers as these play a vital role in getting motivated for earning management. Organizations in same level of business try to manage their revenue upwards by reducing the amount of debt capital.

Reputation of Managers

Reputation has a strong link with results of performance of managers which gets clearly reflected on financial statements of an organization. According to Strakova (2021), failure in meeting forecasted numbers is often due to poor performance of managers and as a result it directly impacts financial statements. Often failure leads to termination from a job leading to losing their reputation and for this reason they try to manipulate earnings as much as possible.

Providing investors with positive business image

Investors are always seeking information which would be helpful to them for predicting future performance of an organization. According to Strakova (2021), earnings management helps in disclosing inside information of an organization which in turn helps in improving function of financial statements. It is assumed that stable earnings compared to variable earnings helps in supporting need for dividends. Managers try to apply earnings management so that external entities can easily predict about profitable situation of an organization.

Methods used by organisations for earning management 

Earnings management is an accounting technique used by organisations for presenting an overly positive view of financial position. Many accounting policies and principles are used by companies for making judgment of what method should be used for earning management (El Diri et al., 2020). Methods used by organisations for earning management are as under:

Real earning management

It is management operational method that helps in altering reported earnings in a particular direction. It is achieved by overproduction stocks at lower cost of sales or reducing discretionary expenses (Ozili, 2019). For instance, discretionary expenses include marketing, advertising or R&D expenses. Real earning management can take palace by using suitable accounting policies.

Using accounting policy

Accounting policies can be defined as specific policies and principles which are implemented by management of company for developing financial records. An organization can utilize accounting principles for execution of earning management. For instance, using straight-line versus reducing balance method for charging depreciation, delaying asset impairment, charging lower provision for doubtful debts or amending inadequate estimates for depreciation and amortisation can be used by organisation in earning management process.

Accrual earning management

Accrual earning management is used by managers of organisations by using flexible accounting policy for showing certain profit targets in financial statements and misleading shareholders. As per Rachmawati (2019), accrual earning management aims to obscure actual economic performance by changing accounting methods. By evaluating the discretionary element of total accruals, accrual management takes place. Use of “Modified Jones Model” can be used for measuring discretionary accruals. Modified Jones Model is most important method of determining earnings management (Liu et al., 2021). Here, it is assumed that managers can use credit sales for conducting earning management. So, variance of receivable are deducted for determining earning management in business.

Real activity management

Real activity management is kind manipulation that is undertaken with the primary aim of meeting certain earnings thresholds. Such type of management action deviate earnings from normal business practices. For instance, a company can cut prices at the end of the year to accelerate sales from next financial year. Another example of real activity management includes delaying desirable investment, and selling fixed assets for affecting gains & losses.

Big bath write-off

Big bath write off is an earning management practice where one time change is taken by the manager of a company for  reducing cost or asset balance that results in lower expenditure in future. As opined by big bath, writing of methods helps in reducing or removing assets from financial books and helps in showing lower net income at year end. This type of earning management method is used by companies for showing lower earnings that helps in paying lower taxes.

Income smoothing

It is a method of shifting expenses and revenue in different reporting periods for projecting a false impression that the company has steady earnings. Management of a company generally associated with an income smoothing method for increasing earnings of a particular period which is otherwise low. As opined by Peterson and Arun (2018), income smoothing helps in reducing variability in earnings of a particular period. Income smoothing method was used by Tesco Plc in its earnings management practices. In 2014, it was found that biggest retailer of UK Tesco has used earnings management practices for overstating revenue. It has been revealed that Tesco’s profit was overstated by £263m (Theguardian, 2021). Preliminary investigation of the company’s accounts showed that the earnings were stated correctly before 2014, but the company had started resting suppliers as a source of income in books of accounts during 2014.

Role of corporate governance mechanisms in constraining earnings management 

Corporate governance is a set of rules, processes and laws by which operations of a business are regulated and controlled. The factors affecting operation of a business may be both internal and external in nature (Alzoubi, 2018). Government of UK government is imposing certain measures for checking earnings management. They believe that higher quality audits will hinder process of earnings management. Audit quality is a function which helps auditors for detecting any material misstatements or any errors in financial statements. An auditor is one who is committed to reporting any kind of misstatements or errors being reported in financial statements. Government of UK has also introduced concept of International Financial Reporting Standards for bringing in a reduction in earnings management.  IFRS has launched an IASC foundation which focuses on development of global accounting standards which in turn forces companies to provide transparent information in their financial statements (Hsu et al. 2021). IFRS has successfully brought about a change in global accounting standards. Previously UK followed concept of GAAP for preparation of financial statements which had many flaws and introduction of IFRS has helped to a great extent in reduction of earnings management.  Laws have been designed in such a way that companies are bound to follow proper methods for preparation of financial statements. According to Collis et al. (2017), if institutional investors find any problems with financial statements, they now have sufficient power with them to take legal actions. It has also been found that there is often conflict of interest between managers and shareholders and for this reason protection of shareholders rights has become very important.

Conclusion 

Earnings management is process of internationally influencing financial reporting of company. Such action is taken by higher executives and managers of company due to different motives. Some of the motives that influence earning management of a company are compensation, contract, debt covenant, providing investors with positive business image and political costs. There are real and accrual methods of earning management. In 2014, Tesco Plc used earning management practices for overstating profits. Corporate governance mechanisms are policies and guidelines that help in reducing inefficiencies in corporate reporting of a company. Inclusion of a strong board of directors, and internal control is helpful for avoiding earnings management practices from the business.

References

Alzoubi, E.S.S., (2018). Audit quality, debt financing, and earnings management: Evidence from Jordan. Journal of International Accounting, Auditing and Taxation, 30, pp.69-84.

Collis, J., Jarvis, R. and Skerratt, L., (2017). The role and current status of IFRS in the completion of national accounting rules–Evidence from the UK. Accounting in Europe, 14(1-2), pp.235-247.

El Diri, M., Lambrinoudakis, C. and Alhadab, M., (2020). Corporate governance and earnings management in concentrated markets. Journal of Business Research, 10(8), pp.291-306.

Hsu, Y.L. and Reid, G.C., (2021). Stated preferences for the adoption of IFRS and UK GAAP: case study vignettes. Asian Journal of Economics, Business and Accounting, pp.20-30.

Liu, Z., Xie, N. and Li, X., (2021). Analysis of the earnings management methods of China’s electric power companies based on modified Jones model. Indian Journal of Power and River Valley Development, 71(5&6), pp.82-90.

Ozili, P.K., (2019). Bank income smoothing, institutions and corruption. Research in International Business and Finance, 4(9), pp.82-99.

Peterson, O.K. and Arun, T.G., (2018). Income smoothing among European systemic and non-systemic banks. The British Accounting Review, 50(5), pp.539-558.

Rachmawati, S., (2019). Company Size Moderates the Effect of Real Earning Management and Accrual Earning Management on Value Relevance. Ethics: Journal of Economics, 18(1), pp.133-142.

Strakova, L., (2021). Motives and techniques of earnings management used in a global environment. In SHS Web of Conferences (Vol. 92). EDP Sciences.

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