According to Chipper’s definition in 1989, earnings management is defined as the “purposeful intervention by management in the earnings determination process, usually to satisfy selfish objectives”. Managers may use their discretion in accounting to manipulate or window dress financial statements. Window dressing and big bath are two common techniques of earnings management. Window dressing is a cosmetic earnings management, purposeful intervention by management to show higher profits for the current year. For example, managers change from LIFO to FIFO method of inventory valuation.
In the other hand, big bath strategy involves taking as many write-offs as possible in one period. The period chosen is usually one with markedly poor performance in a recession because most other companies also report poor earnings. This enables a company to more easily manage income upwards in future period. There are several reasons for managing earnings. One reason is contracting incentives. Managerial compensation contracts often conclude bonuses based on earnings. Typical bonus contracts have a lower and upper bound.
It means that managers are not given a bonus if earnings fall below the lower bound and cannot ran any additional bonus when earnings exceed the upper bound. This means managers have incentives to adjust earnings based on the unmanaged earnings level in relation to the upper and lower bounds. Another incentive for earnings management is the potential impact on stock price. Managers may increase earnings to temporarily boost company stock price for events such as a forthcoming merger or security offering, Some managers lower market expectations through pessimistic disclosures and then manage earnings upwards to beat market expectations.
Earnings management causes distortions in accounting income and can reduce the economic content of financial statements. As a result, it will reduce confidence in the business reporting process. Analysts should do accounting analysis in view of possible earnings managements. The analysis includes evaluating earnings quality and adjusting financial statements generally. Evaluating earnings quality involves the following steps. First, identify and assess key accounting policies. Second, evaluate extent of accounting flexibility. Third, determine the reporting strategy.
Fourth, identify and access red flags which are items that alert analysts to potentially more serious problems, such as too much debt. For fictitious sales, sales account and ratio of the asset utilization are particularly reviewed in order to identify the accounting distortion. The ratio includes turnovers of cash, accounts receivable, working capital, average PEEP (property, plant and equipment) and average total asset. These ratios are related to the sales amount. If there are fictitious sales, the ratios will be larger than the normal ones when other factors keep unchanged. Ratio analysis can be applied to assist the investigation.
Ratios are interpreted in comparison with its prior ratios, predetermined standards Corporation’s ratio. Besides, applying index-number trend analysis, fictitious sales lead to great divergence between the trends of revenues and operating expenses. Return inwards account is concerned when the company fails to timely record returned credit card purchases. As no return inwards is recorded, net sales amount is overstated. However, cash and equivalents cannot be gained under this tactics. Therefore, cash turnover should be specifically reviewed because the ratio is abnormally bigger using this tactic.
As the average accounts receivable is unchanged, the collection period is shorter in the condition of overstated sales. Analysts can also review the collection period of the company. The collection period is shorter normally compared with its competitors by using ratio analysis. Discounts allowed account is affected by this tactic. The expenses for PIP members can attract more sales. At the same time, the company may reduce the amortization amount on purpose and improperly capitalize the related expenses. These actions can inflate the earnings. It turns out to be an attractive operating performance.
Compared with the competitors, better net profit margin and operating profit margin are obtained by the Capital Star Corporation. In conclusion, five analysis tools can be applied to assist the investigation of those three tactics generally. They are comparative financial statement analysis and ratio analysis, which are discussed above. Other three tools are common-size financial statement analysis, cash flow analysis and valuation. For the common-size financial statement analysis, it is common to express total assets or sales as 100%. Then, the remaining items or accounts are expressed as a percentage of their respective total or sales.
Cash flow analysis is primarily used as a tool to evaluate the sources and sees of funds while valuation normally refers to estimating the intrinsic value of a company or its stock. Instead of detecting accounting irregularities, an auditor is responsible to express an opinion, which is a true and fair view, on the financial statements based on the audit. The auditor is required to obtain reasonable assurance about whether the financial statements are free from material misstatement. It is also responsible for the auditor to obtain the sufficient and appropriate audit evidence to provide a basis for the auditor’s opinion.