This paper discusses the motives behind earnings management and explains some of the methods used by firms to manage their earnings. Earnings management has been defined differently by a number of scholars. It is important to note that there is a thin line between fraud and earnings management. Hamid, Hashim and Salleh citing the works of Brown, Perols and Lounge and Erickson, Hanlon and Maydew noted the difference in the definitions that are offered by the scholars. According to Perols and Lounge organizations will engage in fraud due to the constraints on earnings management. The research found out that the firms that had engaged in earnings management will be more likely to be involved in cases of fraud. Brown and Erickson et al noted that the difference between earnings management and fraud is that earnings management is usually within the scope of the generally accepted accounting principles (GAAP) while fraud is outside of the boundaries of GAAP.
Earnings management has been defined as the manipulation of the financial statements and reports by the managers so that the firms can earn extra profit. It has also been defined as the action where the management of the organizations apply their own self-assessment in the communication of the financial information and transactions to modify the financial data for two main reasons: 1) influencing contractual businesses that solely rely on the financial information or 2) providing the stakeholders with a wrong impression about the financial position of the firm.
Table of Contents
1. Discuss the motives behind earnings management and explain some of the methods used by firms to manage their earnings
2. Motivations for earnings management
3. Methods of earnings management
4. Mechanisms for constraining earnings
Research Objectives and Themes
This paper examines the underlying motivations driving firms to engage in earnings management and explores the various techniques employed to manipulate financial reports, while simultaneously analyzing effective governance mechanisms to constrain such practices.
- Contractual and financial motivations for earnings management
- Methods and techniques of earnings manipulation
- The impact of debt covenants on financial reporting choices
- Governance mechanisms for constraining earnings management
- The role of board characteristics and external auditors
Excerpt from the Book
Motivations for earnings management
There are a number of motivations for firms to engage in earnings management. The unexpected demise of Arthur Anderson, a Big 5 accounting firm, has brought to the fore the issue of earnings management. The related failures at Baptist Foundation of Arizona and WorldCom and the fiasco at Enron were all symptomatic of an auditing firm that allowed the clients to push too far (Krishnan and Visvanathan 2008, p. 36). Based on the massive effects of the earnings management on the continued operations of an organization, the paper will consider the motivations of firms to engage in earnings management. First, there are contracting motivations. The financial and accounting information is usually applied in regulation and monitoring of the contracts between the firms and their stakeholders. Implicit and explicit management compensation are used to align the management incentives with the incentives of the shareholders. The lending contracts are usually written as a means of limiting the actions of the managers that stand to benefit the shareholders of the firm at the expense of the creditors of the firm. The existence of such contracts create a motivation for earnings management because it is likely to be more costly for the creditors and compensation committees to reverse the earnings management (Marinakis 2011, p. 40).
Summary of Chapters
Discuss the motives behind earnings management and explain some of the methods used by firms to manage their earnings: This introductory section defines earnings management and distinguishes it from fraudulent activities, establishing the scope of financial reporting manipulation.
Motivations for earnings management: This chapter details the primary drivers for manipulating earnings, including contracting motivations, avoidance of debt covenants, and the pressure for job security or bonus rewards.
Methods of earnings management: This section explains specific accounting techniques used for manipulation, such as the "cookie jar" reserve, "big bath" accounting, and the strategic timing of asset sales or acquisitions.
Mechanisms for constraining earnings: This chapter discusses governance-based solutions to mitigate earnings management, highlighting the effectiveness of board independence, board size, CEO duality, and external audits.
Keywords
Earnings Management, Financial Reporting, Fraud, GAAP, Debt Covenants, Cookie Jar Reserve, Big Bath, Corporate Governance, Board Independence, CEO Duality, External Auditors, Financial Analysts, Accounting Manipulation, Stakeholders, Incentives
Frequently Asked Questions
What is the primary focus of this academic work?
The work focuses on understanding why firms engage in earnings management, the methods they utilize to achieve these ends, and the governance mechanisms available to limit such behavior.
What are the central themes discussed in the text?
The central themes include the distinction between earnings management and fraud, the motivations behind financial manipulation, various accounting techniques, and the role of corporate governance in maintaining financial transparency.
What is the core research goal?
The primary goal is to provide a comprehensive overview of the incentives for earnings management and to identify how internal and external control mechanisms can constrain these activities.
Which scientific methods are utilized?
The paper relies on a review of scholarly literature, synthesizing findings from existing studies and empirical evidence regarding accounting practices and corporate governance.
What is covered in the main body of the work?
The main body examines motives like contractual obligations and debt covenants, provides technical explanations of manipulative methods, and analyzes board characteristics and auditor involvement.
Which keywords best describe the paper?
Key terms include earnings management, financial reporting, corporate governance, GAAP, cookie jar reserve, big bath, and board independence.
How does the "cookie jar" technique function according to the text?
It involves overestimating expenses in a profitable period and hiding the excess in a reserve, which can then be used to boost earnings in later, less profitable periods.
What role does "CEO Duality" play in the context of earnings management?
The text suggests that CEO duality—where the CEO also chairs the board—often leads to weaker oversight and a higher likelihood of engagement in earnings management and fraud.
Why are debt covenants considered a motivation for earnings management?
Firms may manipulate earnings to avoid violating restrictive debt covenants, which can trigger costly consequences or penalties imposed by creditors.
What is the significance of the Tesco case study?
The Tesco example illustrates how optimistic self-assessment of commercial income and rebates can lead to the exaggeration of profits, demonstrating the real-world application of earnings management.
- Quote paper
- David Onditi (Author), 2017, Financial Reporting on Earnings Management, Munich, GRIN Verlag, https://www.grin.com/document/499803
