Earning Management Essay

Earning Management refers to those news report practices that may follow the letter of the rules of fundamental rules of chronicle practices save unethically misrepresented to the users of accounting information. For the personal interest managers often try to show outstanding performance of the business and use the strategic way to sidestep Income, Assets or Liabilities. Earning Management as generally understood refers to systematic misrepresentation of the true income and assets of corporations or other organizations. Creative accounting is at the root of a number of accounting s terminatedals, and many proposals for accounting reform usually centering on an updated analysis of capital and factors of production that would correctly reflect how value is added. reference of accounting information is one of the Fundamental Concepts of Accounting Framework. Where its mentioned that, accounting information essential be Relevant, Reliable, Comparable, and Consistent & Comparable ( Intermediate Accounting by Keiso, Weygandt, Warfield, twelfth edition). Unless having these qualities a report cannot be treated as qualified. Managers that always promise to stag the come exit at some point be tempted to dupe up the numbers. Warren BuffetDefinition of Earning Management * Managing net income is the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about a desired level of reported simoleons. (Davidson, Stickney and Weil (1987), cited in Schipper (1989) p. 92) * Managing mesh is a purposeful intervention in the external financial coverage process, with the intent of obtaining some private gain (as opposed to say, merely facilitating the neutral operation of the process). A minor extension of this definition would encompass real earnings solicitude, accomplished by timing investment or financing decisions to alter reported earnings or some subset of it. (Schipper (1989) p. 92). * gelt management occurs when managers use supposition in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the troupe or to influence contractual outcomes that depend on reported accounting numbers. (Healy and Wahlen, 1999, p. 368) Motivators Earning Management* Meet financial analysts estimates of earnings that leads to performance-based compensation * Raise the stock charge thereby enhancing the value of stock options * Smooth net income making it appear that the earnings atomic number 18 increasing at a steady rate * base it look as though forthcoming earnings argon amplyer than they really are by establishing cookie jar reserves (inflated expenses) in the contemporary year that can be drawn on in future years. (Dr. Steven Mintz, Professor and Area Chair, Cal Poly, San Luis Obispo) Conceptual Framework for Financial ReportingFrom this figure weve indicated that in the level 2, wh ere bridge between 1&3 creates should be the concerning point of maintaining the qualities of Accounting Information. Qualities are not only admirer to detect falsification, plainly as well helps users to take decisions.Primary Qualities * Relevance It helps users to predict the ultimate outcome of past, present, and future events. It also helps users to predict that, how much loss/profit federation can made. * Timeline ad hoc timeline of accounting period helps users to trace out the business performance over the years. * Reliability To assure that the information is verifiable, faithful and understandingably free of error and bias. subsidiary Qualities * Comparability The reported information should be measured such a way that it can be compared with other phoners reports. * Consistency treatment of similar events from period to period must be utilise by same accounting standards. Standards cannot be changed suddenly, unless its proved that new method is part than p revious. Perspective of Earning ManagementThere are two perspectives on earnings management. (1) the Opportunistic perspective, states that managers seek to mislead investors by showing attractive & predetermined accounting information, (2) the Information perspective, first enunciated by Holthausen and Leftwich (1983), under which managerial carefulness is a means for managers to reveal to investors their private expectations about the firms future exchange flows. (Earnings Management A Perspective by Messod D. Beneish) Accrual vs. Earning ManagementPlenty of research report shows managers try to use Accrual in financial engineering. Accruals are the difference between net income and cash flows. For example, when companies sell items to others on credit during a growth period, the sale creates an accrual of revenue. When companies engage in earnings management, they can increase or decrease income by creating accruals these are often referred to as non discretionary (flexible) ac cruals. Reasons behind using accrual as the engineering tool are * Accruals are the principle product of GAAP, so its easy to do falsification with camouflage. * Accruals resolve some problems related with the effects choosing various accounting methods. * It will be hard for investors to see effect of unobservable components of accrual. Types of earnings managementTheoretically there are two types of earnings management. They are income increasing and income change magnitude earnings management (Messod, 2001). a) Income Increasing earnings management As the name suggests, income increasing earnings management is the process to boost up net income of the troupe intentionally (to hide the poor performance) so that investors get some wrong signal about the firms financial position and performance and make the decision of investing in to company (Messod, 2001). Management are motivated towards increasing earnings management because of getting more debt and equity Financing. b) Income decreasing earnings Management This process of earnings management is done by decreasing the amount of net earnings. Management is more involved in income decreasing earnings management is to get future compensation like reducing this months earnings by increasing expenses, they ensure the profit from the next month. as well tax avoidance, import tariff relief, union negotiations etc. are other reasons for managers motivation towards income decreasing earnings management (Messod, 2001).In incorporated world these are the types of earning management mostly done by the management a) Revenue and Expense Recognition Under standard accounting rules, a company must record revenue in its books when it earns that revenue not when it actually receives payment. Similarly, it must record expenses when it incurs them not when it actually pays money. These rules leave room for companies to manipulate their numbers for earnings management (www.budgeting.thenest.com). For example, say a compa ny signs a deal on December 1 to buy $1 one thousand million worth ad time on TV over the next two months. The company could recognize the entire expense in December, recognize the whole thing in January or split the difference. If it records it all in December, then that years profit will be lower by $1 million but the company will get a head start on the next years profit by not having any advertize expenses in January. Profits have been shifted from one year to the next with an accounting trick. b) Cookie Jar ReservesCompanies shift earnings around by creating overly large reserve accounts in good years, then drawing them down in bad years. For example, when a company sells a product with a warranty, it must recognize the estimated expense of honoring that warranty at the same time it books the revenue (www.budgeting.thenest.com). A company might conclude that it incurs warranty costs of $10,000 for any $1 million in sales. If its having a particularly profitable year, it mi ght decide to take a $30,000 warranty expense per $1 million in sales. That builds up a big warranty reserve now so that the company doesnt have to record warranty expenses in the future, thence shifting profits from one period to the other. This tactic goes by the name cookie jar accounting, because it essentially stashes excess profits away to be used when needed. c) The Big BathThere will be times when a company simply cant avoid a bad year. No matter what it does, its going to post a loss because of a sour economy, unfavorable market conditions, and legal trouble, whatever. Some companies, though, deliberately make a bad year even worse by shifting all kinds of expenses, one-time charges and write-offs into that year and shifting revenue out of it. This allows it to inflate profits in future years (www.budgeting.thenest.com). The reasoning behind this strategy is that if the company is going to take a bath, it might as well take a big bath. The companys stock price was going to suffer anyway, the thinking goes, and the damage probably wont be that much worse if the company inflates the loss. Indicators of Earnings ManagementWe have find out five factors which can be important indicators of earnings managementa) Political connection and earnings management Firms with semipolitical connection (large number of stockholder, or CEO or board of directors of the company is a parliament member) are more involved in earnings management (Paul, Mara and David, 2010). Mainly the reasons are- political leaders help the particular firm involved in earnings management to avoid penalization by southward and also political leaders use these companies financial performance and position to increase their public image.b) Internal Audit and earnings management This one is other major indicator of earnings management. If the quality of internal quality is low there are some possibilities of earnings management. According to the research, if a company is having high quality internal audit, they might be less motivated towards earnings management (Douglas, Jason and David, 2008). Main reasons are these internal auditors are more professional, responsible towards their chew over and they barely miss the experts expectations.c) Financial transparency and earnings management Many studies have shown that financial transparency and earnings management are related. If a particular financial report is more transparent then the manager are less interested toward earnings management (James, Robert and Cheri, 2004) The main reason behind this situation is detail information about the accounts including change in depreciation methods, details about each and every account will help investors to find out any manipulation done by the manager.