Discuss the motives behind earnings management and explain 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 (2012, p. 240) citing the works of Brown (1999), Perols and Lounge (2011) and Erickson, Hanlon and Maydew (2006) noted the difference in the definitions that are offered by the scholars. According to Perols and Lounge (2011), 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 (1999) and Erickson et al (2006) 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 (Hamid, Hashim and Salleh, 2012, p. 240). 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 (Hamid, Hashim and Salleh 2012, p. 240). 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 (Hamid, Hashim and Salleh 2012, p. 240).
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). O’Mahony (2014, para 1-2) noted that Tesco was being investigated by the UK’s Serious Frauds Office (SFO) for accounting practices that led to the exaggeration of the profits by £263 million (€337 million). There were irregularities in the commercial income movements according to the Financial Times (Barrett, Agnew and Felsted, 2014, para 1). The problem at Tesco arose as result of the rebates which are the incentives paid by the multi-national companies to Tesco for carrying their brands (Barrett, Agnew and Felsted, 2014, para 5). The multi-national companies such as Coca Cola would pay the rebates to Tesco when a certain amount of sales were hit. The Sales volumes for Tesco were dropping due to its loss of the market share to the competitors thus presenting a problem of not earning the rebates if the sales levels were not reached. Barrett, Agnew and Felsted (2014, para 7-9) noted that Tesco may have booked the rebates based on the historical data and not the current sales volumes. The self-assessment that was used by managers in making the judgment for the sales would be optimistic. This was indicated in Tesco’s annual report by PwC in 2014 when they noted that “Commercial income (promotional monies, discounts and rebates receivable from suppliers) recognised during the year is material to the income statement and amounts accrued at the end of the year are judgmental” (Barrett, Agnew and Felsted, 2014, para 17).
The other motivation are avoidance of debt covenants which are used by the lenders to regulate the financial activities of firms for instance requiring certain objectives to be met or even limiting the financial and investment activities. Debt contracts impacts the financial reporting in two main ways. First the economic consequences when changes to accounting principles are made that have no impacts on the cash flows. Secondly, managers discretion and accounting choice that have an impact on the net income. The debt covenants act as a motivation to engage in earnings management either to avoid the costs associated with the covenant violations or reduce the restrictiveness of debt agreements constraints that are accounting based. Companies usually have few options when it comes to debt-equity ratios ad interest coverage restrictions (Latridis and Kadorinis (2009, p. 168). Research indicates that the firms would accelerate the earnings one year before the violation of the debt covenant. Other companies also make accounting changes that are income increasing (Marinakis 2011, p. 42).
Remuneration and job security are also some of the motivations for earnings management. This can be characterized as speculative motivation. Contribution or production manipulations are used by managers to achieve the financial goals of the companies thus assuring them of bonus rewards and security of their jobs (Aljifri 2007, p. 75). The managers also smoothen the firm’s performance towards the financial goals so that they can get the bonus payments.