Earnings Management & Accounting Fraud

28/07/2022 0 By indiafreenotes

Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company’s business activities and financial position. Many accounting rules and principles require that a company’s management make judgments in following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate or “smooth” earnings.

Earnings management has a negative effect on earnings quality, and may weaken the credibility of financial reporting. Furthermore, in a 1998 speech Securities and Exchange Commission chairman Arthur Levitt called earnings management “widespread”. Despite its pervasiveness, the complexity of accounting rules can make earnings management difficult for individual investors to detect.

Accounting fraud is the intentional manipulation of financial statements to create a false appearance of corporate financial health. Furthermore, it involves an employee, accountant, or the organization itself misleading investors and shareholders. A company can falsify its financial statements by overstating its revenue, not recording expenses, and misstating assets and liabilities.

Motivations and methods

Earnings management involves the manipulation of company earnings towards a pre-determined target. This target can be motivated by a preference for more stable earnings, in which case management is said to be carrying out income smoothing.[6] Opportunistic income smoothing can in turn signal lower risk and increase a firm’s market value. Other possible motivations for earnings management include the need to maintain the levels of certain accounting ratios due to debt covenants, and the pressure to maintain increasing earnings and to beat analyst targets.

Earnings management may involve exploiting opportunities to make accounting decisions that change the earnings figure reported on the financial statements. Accounting decisions can in turn affect earnings because they can influence the timing of transactions and the estimates used in financial reporting. For example, a comparatively small change in the estimates for uncollectible accounts can have a significant effect on net income, and a company using last-in, first-out accounting for inventories can increase net income in times of rising prices by delaying purchases to future periods.

Detecting earnings management

Earnings management may be difficult for individual investors to detect due to the complexity of accounting rules, although accounting researchers have proposed several methods. For example, research has shown that firms with large accruals and weak governance structures are more likely to be engaging in earnings management. More recent research suggested that linguistics-based methods can detect financial manipulation, for example studies in 2012 found that whether a subsequent irregularity or deceptive restatement occurred is related to the linguistics used by top management in earnings conference calls.

Earnings Management Approaches

Companies use several strategies used for earnings management. The most commonly used strategies are as follows:

Biased accounting judgments

Accrual accounting presents opportunities for earnings management; however, a company’s management needs to exercise some difficult judgments when accrual accounting is applied.

There are formal policies, accounting manuals, and processes followed at well-performing companies to ensure that the judgments are bias-free. Earnings management happens when the management team distorts judgments and mends policies to meet expectations.

Earnings-focused decisions

Decisions taken by the management are solely focused on meeting earnings estimates. The easiest way for earnings management is to control the company’s expenses. Companies look to cut any optional expenses to meet earnings estimates.

Certain activities: such as research, advertising, or staff training can be suspended temporarily. Companies suspend such activities for a short time, assuming that the business will perform better in the upcoming periods, and the suspended activities can be resumed thereafter.

However, for companies that are performing well, the management focuses on the long-term success of the business and does not usually resort to artificially enhancing the earnings.

Altering accounting principles

The management of well-run companies chooses the accounting rule that best reflects the implicit economic factors. Earnings management happens when a company’s management selects an alternative of a certain accounting standard, which will cause the earnings number to meet the expectations.

Techniques of Accounting fraud:

Overstating Revenue

A company can commit accounting fraud if it overstates its revenue. Suppose company ABC is actually operating at a loss and not generating enough revenue. To cover up this situation, the firm might claim to be producing more income on financial statements than it does in reality. On its statements, the company’s profits would be inflated. If the company overstates its revenues, it would drive up the firm’s share price and create a false image of financial health.

Unrecorded Expenses

Another type of accounting fraud takes place when a company does not record its expenses. The company’s net income is overstated, and its costs are understated on the income statement. This type of accounting fraud creates a false impression of how much net income a company is receiving. In reality, it may be losing money.

Misstating Assets and Liabilities

Another form of accounting fraud occurs when a company overstates its assets or understates its liabilities. For example, a company might overstate its current assets and understate its current liabilities. This type of fraud misrepresents a company’s short-term liquidity.