Auditing Theory and Practice: Earning Management and Auditor's Role

This report discusses earning management and the role of auditors in reducing it. It covers the impact of earning management on substantive procedures carried out for auditing financial reports, researches evidence of earning management in Oroton Group, and highlights means through which auditors can reduce earning management.

Running head: AUDITING THEORY AND PRACTICE
Auditing theory and practice
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1AUDITING THEORY AND PRACTICE
Executive summary
Aim of the task is to focus on the concept of earning management and role of the auditors in
context of the same. The report will further state earning management’s impact on substantive
procedures carried out for auditing the financial report. The report will further research on the
evidence in context of earning management of Oroton Group and the way in which the same is
dealt by the auditor along with the report issued by them. Finally, the report will highlight the
means through which the auditor can reduce the earning management.

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Table of Contents
Introduction......................................................................................................................................3
Answer (a).......................................................................................................................................3
Answer (b).......................................................................................................................................4
Answer (c).......................................................................................................................................7
Answer (d).......................................................................................................................................8
Answer (e).....................................................................................................................................10
Conclusion.....................................................................................................................................12
Reference.......................................................................................................................................14

3AUDITING THEORY AND PRACTICE
Introduction
Audit quality is considered as of great importance from the perspective of shareholders,
managers and society. The same has become more relevant in context of financial crisis globally
as the greater quality of the accounting figures help is reducing the asymmetry of information as
well as strengthen the financial stability. Though the exiting theoretical frameworks do not
provide any consensus regarding in context of expected impact of audit on earning management,
empirical finding regarding this is mixed and suggests that the additional research can be useful
for understanding how the audit quality can reduce the earning management (Brad et al., 2014).
The task will focus on earning management and auditor’s role in context of the same. The report
will further highlight the means through which the auditor can reduce the earning management.
Answer (a)
Earning management –
Before focussing on earning management it is necessary to know the meaning of
earnings. Earning that is also known as the net earning or the bottom-line profit is the most
significant item under financial statement. It indicates the level to which the entity is engaged in
the value-added activities. It provides the signal that assists in direct allocation of resources in
the capital market. Considering the importance of earning, it is not surprising that the
management of the entity has vital interest in the way in which the same is reported. Owing to
this fact each executive is required to understand the impact of the accounting approach they
choose which in turn will allow them to make best possible decision for the entity. In other
words, they must learn for managing the earnings (Omar et al., 2014).

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Earning management is defined as the reasonable and legal decision making by the
management as well as reporting that is intended for achieving the expected and stable financial
outcome. The term earning management can be confused with theillegal activities for
manipulating the financial statements and the reporting results that does not provide economic
reality. Generally these acts are known as cooking the books and are involved in misrepresenting
the financial results. Earning management is the approach used by the entity’s management for
interference in the course of financial reporting deliberately with the intention of obtaining the
private gain. To be more specific, report is altered by managers for misleading the shareholders
in context of the performance of the entity (Nikoomaram, Arabahmadi & Arabahmadi,
2016).Generally the managers are under pressure for managing the earnings through
manipulating the accounting practices of the entity for meeting the financial expectations and
keeping up the stock price of the entity. In many entities the executives receives the bonuses on
the basis of the earning performances and they are eligible for the bonuses when the earnings of
the entity goes up. Generally it is expected by the society and stakeholders that the earning
manipulation eventually shall be uncovered by the audit firm carrying out the company’s audit.
Generally the methods used by the management for manipulating the earnings are changing
accounting policy of the entity that will generate higher earning over short term period.Another
approach used by the management is changing the company’s policy so that higher amount of
costs can be capitalized instead of spending immediately (Patrick,Paulinus&Nympha, 2015).
Answer (b)
Auditor’s role in earning management –

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Audit committee is considered as one of the most crucial committees in reducing the
earning management as they can reduce the asymmetry of information among the shareholders
and management. Audit committee’s major function involves monitoring the process of the
entity’s financial reporting, supervising the process of risk management and internal accounting.
Audit committee’s direct impact is reflected in greater quality of the financial reports along with
the accounting figures (Shahzad, 2016). On the other hand, efficiency of audit committee is
limited as they are dependent on the different characteristics. Auditors are most effective while
thy understand approaches and motivations behind the offensiveearning management. Numbers
of incentive systems are there for the management for manipulating the reported earnings
including meeting the contractual requirements or arguing on the performance based
compensation. Whatever be the motivation behind manipulating the earnings, as there are
number of accounting estimates, accruals and judgments there are many avenues for earning
management (Brad et al., 2014). As the additional approaches come into the knowledge, the
parties involved and their reputations may suffer and their report may become meaningless to the
investors. It will further invite additional scrutiny from the regulators along with penalties.
There is a growing concern among the investors and society regarding certain practices of
the earning management will have an adverse impact on the public confidence regarding external
financial reporting as well as obstructing efficient flow of the capital in the financial market.
Hence, the independent auditors shall lead the way in preventing the dishonest accounting
practices as the same not only possess the accounting’s in-depth knowledge for accounting as
well as reporting, they also have the access to audit committee as well as board of directors those
are responsible to scrutinize the decision making process of the entity (Omar et al., 2014).
Further, over the past years ASIC devoted noteworthy effort for empowering the audit

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committees which in turn allows the members to discharge the responsibilities effectively.
Hence, the auditors are in the prime position for curtailing the dishonest earning management
approach and assist is maintaining and improving the public confidence in context of financial
reporting (Rozidi et al., 2015). Though the auditors are expected to inspect the financial
statements that involves the subjective judgements of management, it is unlikely that they will
fully neutralize the pervasive and deliberate efforts of the management for shading the accruals
from one direction to another. Though the auditors are required to develop wide range of
reasonable values for the account however they rarely insist on the exact estimate under the
range. Nonetheless the auditors, regulators and financial executives are required to understand
motivation behind earning management for counteracting efficiently the pervasive and deliberate
efforts of the management for shading the accruals from one direction to another (Al-Matari, Al-
Swidi & Fadzil, 2014).
Apart from that, the society expects that the auditors are responsible for reinforcing trust,
enhancing confidence regarding the financial reporting and strengthening the accountability.
Auditors care further responsible for providing independent check regarding the information
delivered by the entity in the financial reports for the users which in turn will improve the trust
and confidence. It is the general assumption of the society that the directors are likely to issue the
financial statements that will represent the entity’s better performance (Riwayati & Siladjaja,
2016). In the same way the shareholders feel that the financial statement presented to them by
the board of directors are misleading. Major role of the auditors are to serve the proprietor’s
interest that involves shareholders and general public. Apart from that, as the managements are
responsible for preparing the financial statement, the auditors are required to be concerned
regarding whom they can rely on regarding the reliability of financial accounting. Hence, it can

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be stated that reducing earnings management is the role of the auditors (Ashtiani, Oskou &
Takor, 2016).
Answer (c)
Impact of earning management on the substantive procedure performed under audit
Substantive procedure are proposed to generate the evidence assembled by the auditors in
support of assertion that no material misstatement exists there in context of accuracy, validity
and completeness of any entity’s financial records. Hence, the substantive procedure is carried
out by the auditor for detecting the material misstatement, if any exist in the financial report of
the entity. It includes testing the transactions, disclosures and account balances, matching
financial records and associated nites with the underlying records and analysing the material
journal entries as well as other adjustments made while preparing the financial statements (Dibia,
&Onwuchekwa, 2014).Financial crises observed for decades in addition to financial scandals
like Enron have generated revolution in evaluation as well as design of audit quality. Different
reasons lead to earning management involves capital market valuation and expectation, anti-trust
or any other regulation of the government and contract those are written in context of the
accounting numbers. Empirical evidences show that the entities manage earnings for window
dressing the financial statement before offering the same for public securities or for any other
reason like meeting expectation of the investors or financial analysts or forecasting public
earnings by management, to enhance the compensation of corporate managers or for avoiding
violating contracts for lending or to minimise the regulatory costs or maximising regulatory
benefits. Generally the auditors collect information in context of misstatement or in context of
audit differences for individual items and report the same on summary worksheet for the possible

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adjustments of financial statements. Adjusting entry worksheet may deliver details regarding real
earning management. In case the auditor senses the earning management issues, the substantive
procedures expand to wide area coverage for detecting the manipulation (Dibia, & Onwuchekwa,
2014). The auditors are required to gather information required for identifying risks of material
misstatement in context of earning management and analyses the risks after considering the
company’s controls and programs. Auditors are further required to overcome some of the natural
tendencies like overreliances on the representation of the client and biases along with the
approaches of the audit with skeptical attitude and not assuming that the client is honest.
Auditors are required to discuss potential for material misstatement in context of the financial
statement owing to manipulation before as well as during the process of gathering information
(Omar et al., 2014).
In addition, the senses of manipulation will increase the sample size for which the
substantive procedure is to be carried out. However, for making the sample test effective the
sample shall be chosen in unbiased manner where all the units will have equal chance for
selection. Further, the auditor shall use their knowledge, experience and skills for performing the
evidence gathering process with integrity and in the good faith (Farichah, 2017).
Answer (d)
Earning management issues in listed Australian entity
Oroton Group, the ASX listed entity started its business since 1938 in Sydney, Australia.
From the textile design to the must-have fashion accessories, the entity reached best in the
Australian luxury and is committed to provide high quality leather goods as well as accessories
for modern women in Australia. The iconic handbag revealed during November 2017 that 8

9AUDITING THEORY AND PRACTICE
month strategic review that was looking to recapitalise, sell, privatise or refinance business had
failed in context of finding viable option in securing the future (Australian Financial Review,
2017). During 2016-2017 financial years the entity reported losses amounting to $ 14.2 million.
However, the directors were trying different strategic models for strengthening the brand. These
strategies involved manipulating the financial statement to furnish better results to its users,
stating different protective measures have been taken to recover the losses in the press meet and
its general meeting while in reality they knew that the same is not possible. Core Orton brand
lost the market share to the international brand like Kate Spade, Michael Kors, Furla and Coach
who have set up the standalone stores along with grabbing prime shelf space in brands like Myer
and David Jones. In addition, costs blew out when the entity tried plugging hole in the earnings
after losing Polo Ralph Lauren licence through opening the Gap stores. As per the report by
insiders the company’s management was well aware of its perilous situation and still they issued
shares(Australian Financial Review, 2017). For instance, Spheria Asset Management purchased
7% interest in September 2017 and Gazal Corp snapped up 7% stake in July 2017. As per the
sources, Orton Group was near to collapse in June 2107 while the lender Westpac rejected to
extend the credit facility for providing credit support one of the major shareholder Will Vicars
put up $ 3 million. In addition, one of the major reasons for collapse believed to be the expensive
leases of the entity and franchise of loss making brand Gap. It lost $ 14 million in 2017 including
greater than $ 11 million for one-off costs after it pulled the plug for Gap that is scheduled for
close at the end of January (Hatch, 2017).
Audit for the financial year 2017 for Oroton Group’s financial statement was carried out
by Pricewaterhouse Coopers (PwC) and they issued unmodified report to the entity. In
accordance to their report the entity’s financial statements has been organized in accordance with

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Corporations Act 2001 and presents the true and fair view of its financial position and financial
performance. However, they raised concern in context of going concern as the entity incurred
loss after tax amounting to $ 14,258,000 and cash outflows on account of operating activities
were amounted to $ 16,09,000. Auditors issued unmodified opinion considering the forecast of
Oroton’s future cash flow and action planned in context of its going concern issues
(Member.afraccess.com, 2019).
Answer (e)
Means through which earning management can be reduced by auditors
Financial reports are used by the stakeholders including creditors, investors, customers
and others as the mirror for the entity’s performance. However, owing to agency problem
associated with interest conflict among shareholders and management, managements are
motivated for misrepresenting the firm’s performances. Owing to this, high quality audit is
required by most of corporations for eliminating the likelihood of audit failure by auditors that
offers independent judgements as well as financial report’s valuation. Further, high quality audit
isexpected for delivering independent auditing function that will detect the earning manipulation
as well as other misconduct performed by managers or controlling shareholders (Alrabba, 2016).
Hence, likelihood is there that the management will influence the decisions of auditors and will
offer incentive to the switch the auditor with their intention to satisfy their own interests. Means
through which the auditor can reduce the earning management are as follows –
 Strengthening tone at the top – the auditor shall assure that all the employees have
adequate resources and time for resolving management issues. Further, the auditor shall
demonstrate track record in context of consistency based on standard based decisions,

11AUDITING THEORY AND PRACTICE
establish and communicate regularly the formal code of conduct, challenge the unethical
behaviours along with addressing the instances for non-compliances with the code of the
firm through disciplinary action (Octavian, 2017).
 Enhancing client acceptance and the continuance process – auditor shall perform
adequate background check for the client and shall associate with the client those have
highly ethical track record.
 Align or hire experts, consultants and specialists – audit team shall have adequate
technical personnel or must have access to the external experts, consultants and
specialists those can offer the client with appropriate suggestion while facing with
challenging issues (Octavian, 2017).
Apart from above, in accordance with generally accepted auditing principles (GAAP) the
auditors shall follow the below mentioned procedures to reduce the earning management issues –
 Unusual transactions – in accordance with the recent revisions in the GAAP, the auditor
shall examine closely the transactions those are significantly unusual and are outside the
normal business operation of the entity. Once the explanation from the management is
received, engagement team shall corroborate the response of the management with the
other information received during the process of audit.
 Accounting judgements and estimates –accounting judgements and estimates is another
place for committing fraud as the same are subjective and management are able to
influence the accounting estimates for manipulating financial estimates. Auditors shall
look for the fraud in context of accounting estimates in 2 manners – (i) auditors shall
complete the look back process for determining if there is any change in the accounting
estimates as compared to the preceding year. Changes in the accounting estimates may

12AUDITING THEORY AND PRACTICE
signify the likelihood of manipulation. The auditors shall further examine directionality
of overall estimates. For instance, if all the estimates in prior years are nearly were in the
trend of reducing income and in current year all the income in increasing trend, the
auditors shall be concerned that the entity is moving income from one period to the other
(Suryanto&Grima, 2018).
 Testing journal entries –as committing the material manipulation in financial statement
requires the adjustments in the financial records of the entity the auditors shall test the
journal entries of the entity if any sign is there for manipulation. For carrying out the test
the auditors after gaining the understanding in context of the entity’s procedure and
control shall make the selection from the journal entries of the entity. Generally the
auditors shall select the entries those are of large values, those are made by the upper
management, those are posted late in accounting period or those are otherwise of
interests. Once selections are made auditors shall ask for the supporting documents that
will validate the entries.
 Fraud brainstorming session – under GAAP, the team of audit engagement shall hold the
fraud brainstorming session at the initial stage of audit. This session shall be led by the
audit partner-in-charge. And is designed to offer time for the audit team in considering
how the entity may commit fraud. In addition, this is used for setting the tone of
scepticism under audit(Suryanto&Grima, 2018).
Conclusion
From the above discussion it is determined that earning management is the approach used
by the entity’s management for intervention in the process of financial reporting deliberately
with the intention of obtaining the private gain. Entities manage earnings for window dressing

13AUDITING THEORY AND PRACTICE
the financial statement, for avoiding violating contracts for lending or for any other reason like to
enhance the compensation of corporate managers, meeting expectation of the investors or
financial analysts or forecasting public earnings by management or to minimise the regulatory
costs or maximising regulatory benefits. However, it can be stated that reducing earnings
management is the role of the auditors as the managements are responsible for preparing the
financial statement, the auditors are required to be concerned regarding whom they can rely on
regarding the reliability of financial accounting. However, the auditors can reduce the earning
management through strengthening tone at the top, enhancing client acceptance and the
continuance process, aligningor hiring experts, consultants and specialists, carrying out complete
check for unusual transactions, analysing all the accounting judgements and estimates, testing
journal entries on sample basis and taking up fraud brainstorming session.

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