Earnings Management: Techniques, Issues, and Auditors' Role

Auditing Theory and Practice
Running head: Auditing Theory and Practice

Auditing Theory and Practice 1
Abstract
Earnings management can be defined as the use of accounting procedures to produce the
required results which state the positive view of the commercial activities of the company and its
fiscal position. This technique takes the undue advantage of the practices of accounting and thus
the financial statements are generated which manipulate the various items of the balance sheet
such as earnings, total assets and revenue. Although variations in revenue and expenditure may
be normal phenomenon of the commercial activities of the company but the fluctuations may
alarm the shareholders who wish to see firmness and progress in the company. It also influences
the stock prices of the company as they fluctuate depending upon the fulfillment of the
expectations of the shareholders.
The purpose of this essay is to discuss the various aspects of earnings management along with its
various techniques. The aim of this essay is to illustrate the various corporate collapses in which
earnings management was used. Furthermore, it suggests certain methods to the auditors to
overcome this practice. Additionally, the responsibility of auditors in the company’s failure in
the context of earnings management is also evaluated in this essay.

Auditing Theory and Practice 2
Earnings Management can be explained as intentional influence on the process of financial
reporting for selfish motive of some individuals within the company. It also has an impact on the
contracts of the company which depend upon the statistics of its financial growth. It comprises of
the modification of the financial reports of the company so that the stakeholders can be
misguided about the progress of the company (Xue and Hong, 2016).
Certain issues result in Earnings Management. There are various internal factors such as meeting
the targets by the accounts department of the company. The other may be budgeted statistics
which if not accomplished may have an adverse impact on the personnel, division or company
amongst its stakeholders. The external factors may amount to the expectations of the
stakeholders for the company to maximize its profits and hence their returns (Forbes, 2015). The
burden of hope is added on by the external analysts who predict the performance of the company
prior to the declaration of its financial results which it would like to achieve. Thus the factors
leading to earnings management are WISE viz. Window Dressing, Internal targets, Smoothing of
Income and External Expectations (Huguet and Gandía, 2016).
Window Dressing can be explained as the decision of the management to manipulate the
financial statements to attract the investors and creditors. Here the main aim is to seek the
attention of the new shareholders with the help of presentation of profitable financial statements
so that it seems that the company is performing well.
Internal targets refer to meeting the internal goals of the company with the help of earnings
management technique.
With the help of Smoothing of Income, the company manipulates the financial statements and it
appears that it has a smooth income generating pattern.
External expectations mean shifting the income from one accounting period to another so that the
company can meet the predictable goals. It takes advantage of the various methods of accounting
which are implemented in financial reporting.

Auditing Theory and Practice 3
There are various techniques of Earnings Managements. Some of them are:
1. Cookie Jars: In this method earnings are manipulated by choosing the time period for which
the items of revenue and expenses are taken. It is done for the overheads which are based on
approximations. The company can over accrue some reserves in the present year so that it can
underscore some of them in the future. In this way the company can adjust the next year’s
income on the basis of current year’s expenses (Bešlić et al., 2015).
2. Discretionary Accruals: The companies use accruals to diminish the inconsistencies in the
income. These can be justified on the basis of variations in the timings of the realization of
income. As this technique is less traceable by the stakeholders, it is practiced to a larger extent in
the companies. It is hard to detect and contrast it with variations in the actual transactions taking
place or the accounting policies implemented. Hence, the scope of earning management is
widened through discretionary accruals (Shahzad, 2016).
3. Big Bath: This technique is a portion of income smoothing. It increases the outlays and losses
of the current financial year of the company which is a loss making unit so that its financial
performance in the future deems to be smoother and better. The examples are financial
restructuring of the company which otherwise could not be done and recognizing losses on assets
having a fair market value below their current book value (Patrick, Paulinus and Nympha,2015).
4. Shrink the Ship: This technique comprises of repurchasing its own stocks by the company
without disclosing the profits and losses in its financial documents. The aim behind this non-
disclosure is to increase the earnings per share by the company (Omar et al., 2014). In some
countries the repurchase of own share by the company is prohibited. The management often uses
this technique to improve the earnings per share of the company. The organizations use this tool
for meeting the expectations of the forecast analysts in the context of EPS.
The organizations use this strategy to sustain in the industry and to safeguard their goodwill in
the capital market. They implement it to enhance their stock prices so that they could attract
more investors so that their financial ratios can be improved. The ratios associated with earnings
per share (EPS) and price – to- earnings ratio (P/E) can be inflated for a shorter period of time