There have been numerous corporate accounting scandals in the past that have compelled regulators to be stricter on firms that do not adhere to ethical and professional codes of conduct. For instance, it can be recalled how Enron and Worldcom caused outcries after going through major financial scandals. The accounting errors displayed by these two firms were the main reason behind the formation of the 2002 Sarbanes-Oxley (Sox) Act (Call et al 963). The main rationale for implanting the new law was to boost internal control mechanisms and improve accountability as well as transparency of financial documents. There was need to avoid a repeat of such scandals in future.
Based on the goals of Sox, a lot was achieved in the accounting field. However, the benefits of the Sox Act were never realized at the beginning. Its success elements were noted far much later after the gross decline of Sox’s Accrual-Based Earnings Management. Real manipulation of activities continued to damage many firms even when the regulator tightened scrutiny measures. In the end, negative results were realized (Doukakis 71). Examples of manipulations that went on for some time included postponing investments and in some cases reducing investment portfolios altogether. This type of entrepreneurial concept is referred to as Real Earnings Management (REM).
Latest accounting discoveries have pointed out that two manipulation strategies are often used. They are usually interchanged with each other depending on which one is more favorable than the other. For instance, if the application costs of accrual-based earnings management are lower than the cost of applying real earnings management, then the accrual earnings management is used. The same scenario applies when the application cost for real earnings management is lower than that of the accrual earnings management. Financial distress, institutional ownership, marginal tax and industry competition are some of the costs that constrain real earnings management (Doukakis 53). On the other hand, regulators’ scrutiny, auditors’ scrutiny and accounting flexibility are among the costs that hamper the application of accrual-based earnings management.
Investors are directly implicated whenever real and accrual-based earnings management systems are used by firms. From a societal point of view, it is vital to mention that both concepts are instrumental in either limiting or boosting trade gains and relations. It is upon investors to understand that businesses which go through stiff market competition and financial distress are highly likely to use real and accrual-based earnings management systems in order to attain short-term goals. This entrepreneurial trend is the very reason why investors should have some reservations on the trading activities of firms especially before injecting their capital investments. One of the key requirements for investors before making investment decisions is to critically analyze financial statements of firms. Similarly, auditors are advised to be cautious when perusing the accounts of firms facing industry competition and also in bad financial shape because such firms may already be applying real and accrual-bases earnings management to deceive investors and the public at large. In addition, it is highly recommended for regulators to increase their scrutiny so that firms that intend to use real and accrual earnings management are kept at bay.
Literature Review and Hypothesis
Maximizing shareholders’ value is the core objective of business enterprises. The latter goal is achieved by optimizing the use of assets obtained by debt or equity. Nonetheless, raising capital is usually a major challenge for most firms, and that is why incentives are offered to investors so that they can put in sizeable amounts of capital as part and parcel of their investment portfolio. Before they can agree to raise significant capital, investors ought to be assured that the firm they are investing in will perform well in future and so they will reap back good returns. Lack of such an assurance may lead to inadequate capital for investment. Therefore, firms will often gear their performances towards positive reporting of financial results after the end of a given trading or fiscal period. Firms will also strive to meet the forecasts portrayed by analysts and record positive earnings growth so that they can obtain surplus capital for investment (Call et al 969). Nevertheless, a firm may quite often fail to live up to these expectations or meet such trading objectives. Even at times when firms suffer decreases in stock prices, they often find themselves unwilling to produce negative reports to shareholders. Consequently, some firms may decide to manage earnings so as to quench the economic desires of shareholders as well as hold equity. It is not uncommon to see firms engage in earnings management (Doukakis 65).
Accruals and cash-flow from operations are the main sources of earnings for firms. These leave business enterprises with only two alternatives to manage earnings. To begin with, businesses that find themselves in such challenging situations may decide to change their normal course of conducting business. Such a move aims to disrupt cashflow from operations. Whenever a firm deviates from its usual trading activities with the aim of manipulating revenue, it creates a scenario known as Real Earnings Management (REM). Alternatively, a business entity may change the quantity of accruals so as to get the anticipated level of earnings. There are instances when financial reporting is carried out using judgment. Such type of manipulation is known as Accrual-based Earnings Management (AEM). The earnings level is affected in various dimensions when any of these manipulation strategies are used by managers in firms.
Real Earnings Management (REM)
As much as a business enterprise may choose to deviate from the actual business activities for the sake of impressing shareholders, the posterity of a firm may be seriously affected. In other words, it is highly likely for a firm to suffer negative implications in future whenever it manages its earnings at the present time.
The concept of managing earnings is not new or a mere speculation in the business world. Numerous past studies have unanimously agreed that deviation from usual trading operations is a common gimmick applied by firms that face financial hurdles.
In this regard, deviation may take two distinct forms namely:
- Deviating from financing operations and
- Deviating from injecting additional capital and day-today operations
A business entity may deviate from operations and capital investment by making sure that the quantity of discretionary expenditure is changed considerably. The latter expenses include administrative expenditures, general expenditures, selling expenditures as well as expenses for research and development. At the exact timeframe when research and advertising expenses are realized, they are deliberately recorded. The reported revenue is instantly affected when the latter costs are reduced.
When it comes to costs incurred from development, the whole adjustment is handled quite differently owing to the risk of uncertainty. Instead of being capitalized, they are expensed after being incurred. When a product or service is being developed, it bears a lot of uncertainty risk and that is why it cannot be capitalized. Rather, it is treated as expenditure (Doukakis 69). Hence, earnings can be increased by delaying the start of development projects.
In addition, building up inventory, offering price reductions and overproduction can create a major deviation from the investment and operational activities of a firm. The unit cost of goods sold is bound to go down owing to surplus production. Besides, fixed assets can be sold by firms in order to be in a position to manage earnings. The latter is quite often possible if the items are sold at a profit. Restructuring may also facilitate deviation from the usual mode of operation in a firm. For instance, business acquisitions and mergers usually lead to low or reduced cost of production. So long as the operating expenses have been lowered, a business enterprise can comfortably increase reported income (Wongsunwai 298).
As already pointed out, deviating from financial operations is another way firms can interfere with earnings. For example, if actual earnings are slightly lower than the projected earnings, stock options can be readily granted. However, cash transactions are not involved in stock options. Once the option has been granted, it is treated as a compensation plan. Nonetheless, earnings per share are reduced due to the option. Since such a scenario is not favorable for a firm facing industry competition and tough economic times, the stocks are repurchased. Thereafter, their earnings per share increase in value.
Businesses can also shield themselves against earnings decrease by acquiring a number of financial instruments. Better still; an increase in reported income can be implemented by debt-to-equity swaps. Perhaps, it is prudent to point out that myriads of possibilities exist to change the degree of earnings via affecting the movement of cash during business activities.
Accrual-based Earnings Management (AEM)
The true performance of a business entity can only be demonstrated through accruals. Factually, the core goal of accruals is to display the authentic performance of an enterprise by keeping records of income and expenses within the timeframe when they took place instead of outlining just the cashflows. A case in point is the deferred income. Immediately a cashflow is obtained from sales, this type of income is reported (Alhadab, Clacher, and Keasey 55). Realistically, the process takes place before recording sales.
As much as the primary aim of accruals is to reflect the true performance of a firm at any given time, managers can still use the tool for manipulative purposes. In other words, accruals can be used to give unrealistic performance of a firm. If accruals are booked for activities that demand discretion in accounting, it is possible to manipulate reported income.
Long term assets that have been salvaged, asset impairments and losses incurred from unpaid debts are some of the business activities that can trigger booking of accruals. If these approximations are biased and not a true reflection on the ground, accrual-based earnings management will have been applied. Hence, REM and AEM are the two broad options that managers can use to manage earnings in a firm. Relative cost of the approach applied is the main determinant of the earnings management method to use (Ge and Kim 641).
In accounting principles, it implies that the real earnings management is more commonly used by managers than the accrual-based earnings management if AEM costs surpass REM costs. The opposite is true when REM costs higher than AEM.
Limitations on Real Earnings Management (REM)
If the economic effects of diverging from the usual optimal business activities is roughly equal to the application cost of REM, the value of a business entity can be affected (Wongsunwai 296). Nevertheless, different firms experience these economic impacts in a unique way. For instance, it might be quite expensive to deviate from the usual business activities for corporations that encounter industry competition. If a firm attempts to go against such a tide, it can easily lose its competitive advantage. However, the industry counterparts may only suffer minimal economic injuries due to less rigorous competition. From this outset, it is evident that the use of real earnings management is constrained by industry competition. Moreover, REM application is also reduced by institutional ownerships that fall within the higher levels since monitoring is strict.
Taxable income also tends to go up when REM is used in the process of book-keeping. Accrual-based earnings management hardly affects tax increases. Hence, REM can be best used by firms when the marginal tax rates are higher. The latter boosts net earnings. This is a major limitation for firms that may desire to use AEM. It is also vital to point out that REM may be readily applied by firms that go through distressful economic times because managers think that it us a costly application (Wongsunwai 299).
Limitations on accrual-based earnings Management
Managers may use their own discretion when reporting financial records. Nonetheless, several aspects may constrain this discretion. To begin with, auditors’ scrutiny may constrain managers’ discretion to manipulate earnings. Well established audit firms tend to carry out their functions cautiously because they stand the risk of spoiling their reputation. Therefore, they tread carefully when auditing books of accounts just to avoid any accounting errors. Besides, large audit organizations are well experienced with their job. They also tend to inject surplus capital in audit resources in order to perform their work well. Since they do not want to suffer reputational risk, such audit firms would strive to make sure that their works stand out. Hence, large audit firms are in a position to detect accrual-based earnings management compared to young upcoming firms.
The accounting flexibility of a firm is also a major constraint in the application of accrual-based earnings management. The manner in which past applications of accruals have been implemented usually affects the ability of an organization to interfere with earnings. In any case, it is cumbersome to reverse some past accruals. In addition, a long operating cycle may significantly delay the reversal process of accruals.
Regulators’ scrutiny also lowers the likelihood of discretional earnings management by managers. It is agreeable that since the adoption of Sox, the frequency of applying accrual-based earnings management has considerably reduced. Organizations that are open to keen examination by the regulating authorities are less likely to manipulate AEM for fear of being blacklisted. Primarily the Sox regulation was meant to protect external investors who may be naïve on the actual operations and performance of firms.
From the above proposition, it can be affirmed that the ability to use AEM is limited by investor protection policy. This implies that the application of accrual-based earnings management and investor protection have a negative correlation. As a matter of fact, private control by insiders is quite cumbersome when investors are duly protected by the regulator. Hiding the true economic performance of a business organization is often motivated by the hidden trade de benefits that insiders enjoy. Private control of firms can be economically harmful to external investors who are out to invest impartially.
The development of Hypothesis
Accrual-based earnings management can be hindered by accounting flexibility. In most instances, applying AEM to conceal the actual performance of a firm can be detected more easily than using REM as a manipulative tool. The first hypothesis that can be developed from this study is that relative cost is the main determinant of earnings management method to use. The second hypothesis is that real earnings management is higher among business units that have lower degrees of accounting flexibility. The two hypotheses have been studied and proved in a number of past accounting research studies.
Through the agency theory, it is known that people seek to achieve their own interests and that, despite the existence of agreements between parties; they cannot cover all possible opportunistic attitudes. An agent may prove to be the main detriment of wealth because there is information asymmetry between an agent and the principal.
Thus, the higher the quality of information, the smaller the asymmetry information and reduces user uncertainty and causes more efficient economic decisions (Ge and Kim 646). However, when you have limited and dubious information, the main agent may feel some greater insecurity or in a risky position due to lack of information. In this sense, the accounting officials can assist users in decision making. They can also reduce information asymmetry, minimize conflicts of interests and contribute to the allocation of adequate resources.
In business organizations, individuals have unique needs and different incentives. Some may use their influence to achieve unique interests (Wongsunwai 300). The possibility of exercising discretion allows administrators the freedom to measure the results of a firm or Earnings Management (EM). At this point, research studies have found out that certain choices are made to mislead users on the true financial performance of a firm through EM.
EM is possible because there is freedom in the accounting rule that allows a manager to exercise discretion when executing accounting procedures. When an administrator chooses “what”, “how” or “when” to disclose any information, it may impact a company’s results and reduce the quality of transparency of that information. Nevertheless, there are schools of thought for managing results.
Earnings Management (EM) can be a good way for a company to disclose its financial and economic reality rather than simply adopting the same accounting choices for similar events. EM can also be an opportunistic act whereby agent acts to achieve his interests at the expense of wealth creation for a firm. There may also be some motivation to meet the contractual restrictions imposed by loans for the purpose of facilitating or improving conditions of future loans. Hence, a company faced with numerous debts can be motivated to manage its financial performance results to get better costs (Wongsunwai 296). On the other hand, if EM is perceived by financiers as a way to deceive them about financial performance of a firm, they can raise the risk premium charged on the amount given out (the higher the risk, the higher the required return ) (Ge and Kim 642). Therefore, it leads to higher funding costs for companies.
The fact is that while accounting provides information to the market, it plays an important role in the management of conflicts of interest and reduction of information asymmetry. After all, accounting more accurate information reduces investor risk, and improves the relationship between the quality of information and the return required by providers of funds to a business organization.
Within the process of accounting information, result is one of the most important information to users because it contains valuable information on the continuity and viability of a firm. Performance results to users can be a parameter for gauging investment policy because it affects decision-making process of investors and creditors.
Profit made by a business entity is used to predict the future path and it is also a performance measure that guides all future management decisions such as predicting future profits, assessing investment risks and accessing external funds. Given the importance of accounting results, the perception of profit calculated correctly usually reduces the risk of lenders and investors. However, this perception is related to the evidence that results are determined independently among different groups.
The accounting accrual makes use of appropriations, deferral and allocation procedures in order to relate revenues, expenses, gains and losses within given fiscal periods. These measures reflect the performance of a business enterprise rather than simply listing payments and receipts from cash inflows and outflows.
However, accounting standards have flexibility because they allow managers to choose how and when some economic events can be identified and reported. In this case, managers can choose to practice accounting principles consistent with the set standards or present information the way that interests them. This results into an opportunistic behavior.
Relationship between Seasoned Equity Offerings and Earnings Management (AEM & REM)
There is massive evidence that business organizations often employ several real earnings management so that they can be in tandem with the financial reporting needs of a firm (Alhadab, Clacher, and Keasey 60). By far and large, reporting annual losses is a practice that most accounting managers try to avoid as much as possible. In order to boost sales, price discounts are given by some managers. Moreover, the desire to lower discretionary expenses is also desired by financial managers. By so doing, they are in a position to improve reported margins. The value of goods sold is also manipulated through surplus production. As expected, REM is preferred by most managers.
Nevertheless, Seasoned Equity Offering (SEO) also comes in handy in the study of earnings management by firms. Are reported earnings managed by business organizations when SEO in going on. Do such activities have any relationship with the stock market and accounting practices?
Apart from the ordinary accruals prevalent in firms, there are some reported earnings that are upwardly managed. They are also referred to as the positive abnormal accruals. The interesting fact is that such abnormal accruals are evident among SEO firms. It is also vital to mention that poor stock performance and earnings reversal can also be predicted by these types of accruals.
At a time when SEOs are running, firms have the tendency to manage their earnings. On the other hand, the upwardly managed earnings easily mislead the stock market (Call et al 966). Although the latter is a temporary process, the issuing firms are over-valued. Their predictable earnings are not anything to excite investors.
Other studies have demonstrated marginal differences between SEOs and accrual-based earnings management. For instance, upwardly managed earnings do not remarkably affect the stock market. In fact, any effects created by such markets are undone by investors. As can be seen, this argument shows a slight variation from other studies discussed in this paper. The effect is referred to as abnormal stock returns and can be used to verify whether there are any misspecifications. As a matter of fact, the purpose of earnings management is never close to fooling investors (Wongsunwai 296).
Financial positioning measure is one of the most important parameters used to estimate or valuate the costs of real and accrual-based earnings management (Call et al 960). This implies that the financial position of a firm can be aptly measured using two elements namely the total debts and cash-flow. The ratio obtained by the two elements is crucial in measuring the cost of either real earnings or accrual-based earnings. Moreover, the financial distress of a firm can be measured by this ratio even if other measurement factors come into play. However, the Z-score is not used in this case even though it is the most common application for gauging a firm’s level of financial distress. It is vital to note that the Z-score is not applicable in this case because earnings management may be intertwined with ratios that make up the Z-score. Firms that experience less financial distress usually display higher ratios.
Second, the investor protection measure is a fundamental tool for comparing the costs of real and accrual-based earnings. Investor protection is also affected by a number of factors (Alhadab, Clacher, and Keasey 59). They include disclosure level, equity market, ownership concentration, legal enforcement and outsider investor rights. In addition, the level of investor protection can be determined using summary measures alongside the existing level of enforcement as well as a country’s legal tradition. Civil-law nations perform below the par compared to common law nations when it comes to investor protection. The latter scenario takes place even if enforcement levels in both nations are the same. Some scholars argue that the strongest investor protection laws are provided by the British common-law nations. On the other hand, the French-civil law nations tend to offer the poorest investor protection.
Both real and accrual-based earnings management have distinct control variables. The cost of real earnings management can be increased by other variables. Two main variables that can be controlled here are effective tax rate and lagged market share. The cost of accrual-based earnings management can also be affected by other variables that are controllable as well (Doukakis 59).
The ethics of Real and Accrual-based earnings Management
First, information asymmetry is a dominant factor to consider as far as the ethics of earnings management is concerned. People may lack the same platform of information in most cases. Sometimes, vital information might be held by the management. Stakeholders and other investors might require the same information. This implies that information asymmetry might lead to ethical concerns bearing in mind that financial reporting is done with a hidden agenda. Therefore, management and separation of ownership should be treated with a lot of caution in order to enhance corporate transparency (Enomoto, Kimura, and Yamaguchi 83).
Ethical conduct among managers in business organizations goes beyond just regular financial reporting. This explains why organizations should adhere to strict codes of conduct fuelled by corporate governance framework. For example, disclosure should be made in a timely and accurate manner. Such financial disclosure should be done thoroughly and exclusively on all matters regarding a firm. Some of the areas that require disclosure include governance of the firm, ownership, performance, and most importantly, the financial situation.
On the other hand, corporate secrecy may be legally applicable in some cases. For instance, unreasonable cost should not be placed on a firm when there is need to maintain some corporate secrecy. Better still, shareholders and other investors to a firm should not be economically jeopardized as a result of earnings management. The competitive position of a firm should not be endangered by exposing sensitive information (Alhadab, Clacher, and Keasey 57). Even when it comes to the manipulation of real and accrual-based earnings management, disclosure of financial information should be done cautiously for the sake of informing investment decision. When the latter is done appropriately, investors will not be misled.
In recap, real and accrual–based earnings management are used by managers to manipulate financial reporting on the performance of firms. It is prudent to underscore the fact that managers should exercise their own discretion when disclosing financial performance of firms. However, such disclosures should be in tandem with the best accounting practices.
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