Earnings Management: Techniques and Role of Auditors in Curbing the Practice

This essay discusses the concept of earnings management and its techniques such as discretionary accruals, cookie jars, shrink the ship, big bath, big bet on future, throwing out the problem child, sale and leaseback, and flushing. The role of auditors in curbing this practice is also discussed. Examples of various corporate collapses are quoted to explain the role of auditors. Subject: Auditing Theory and Practice

Running head: Auditing Theory and Practice
Auditing Theory and Practice

Auditing Theory and Practice 1
Abstract
Earnings Management can be explained as the utilization of various techniques of accounting to
generate the required results which depict the positive view of the trade related activities and the
financial position of the organization. It takes undue advantage of the loopholes of the
accounting processes which influence the different items of the balance sheet such as assets,
liabilities and earnings.
With the help of this concept, the companies embellish the differences in their income and show
exaggerated profits in their monthly or yearly financial statements. Though the differences in
revenue and expenditure may be a normal occurrence in the routine business life of the company
but it may alarm the investors who want to see its progress and growth. It also has an influence
on the share prices of the company as they vary according to the sentiments of the investors.
So, in this essay, the technique of earnings management would be assessed along with its
different procedures. Additionally, the examples of various corporate collapses will be quoted to
explain the role of auditors to curb this practice. The role of auditors in the failure of the
company due to earnings management will also be assessed in this project.

Auditing Theory and Practice 2
Earnings Management can be described as the deliberate impact on the preparation and
projection of financial documents so that the selfish needs of the managerial personnel can be
satisfied within the organization. It consists of the alteration of the financial position of the
company so that the shareholders can be misguided about its growth policies. It also influences
the contractual obligation of the company as it is affected by its growth and developmental
strategies (Yang, 2017).
There are certain factors which lead to earnings management. Some of them may be internal
factors such as the management pressurizing the accounts and finance departments to meet the
annual or monthly targets. Another might be the budgeted figures which if not achieved may
adversely influence the performance of the personnel and the company as a whole. The external
factors could be the anticipations of the stakeholders to optimize the profits of the company so
that they receive maximum returns on their investments. Lastly, the external analysts who
forecast the returns of the company before the announcement of the financial results add the
burden on the shoulders of the management which it has to accomplish (Wajnsztajn and
Heintz,2016).
The management manipulates the figures by using the below mentioned techniques of earnings
management:
1. Discretionary Accruals: These are used by the organizations to decrease the variations in
the income. They occur due to the differences in the timings of the realization of cash inflows.
Since the technique is less traceable by the shareholders, it is widely used to manipulate the
statistics by the personnel. Additionally, it is difficult to discover and match it with the
differences occurring in the commercial transactions or the accounting procedures of the
company. Thus, the horizon of earnings management becomes broader through discretionary
accruals (Thi, 2015).
2. Cookie Jars: Through this, the earnings are influenced by selecting the timings of the
items of expenditure and income. These are used to manipulate the variable costs which are
based on estimates. With the help of this technique, the organization can enlarge some of the
reserves in the current year so that it can under estimate them in the forthcoming year. Thus the

Auditing Theory and Practice 3
company can regulate its future income on the basis of its expenses in the existing year (Dutzi
and Rausch, 2016).
3. Shrink the Ship: With the help of this technique, the company buy backs its own shares
without revealing the gains or losses in the fiscal statements. It is done to increase the earnings
per share. However, in some parts of the world, buy back of own shares is banned by the
government.
It is used by the management to increase the earnings and for fulfilling the aspirations of the
external analysts with reference to EPS. It is implemented by the management to survive in the
industry and to protect the goodwill of the company in the capital market. It is applied to increase
the prices of the stock so that more investors can be attracted and growth can be shown in the
financial ratios. The ratios related to price –to- earnings ratio (P/E) and earnings per shares (EPS)
can be increased for temporary duration with the help of buy back of shares (Hamza, 2015).
Furthermore, it enhances the return on equity (ROE) and return on assets (ROA) by the
organization as less assets and low outstanding equity shares remain post buy back at the
disposal of the organization. As a result, the financial statistics can be misguide the shareholders
if the organization uses ‘shrink the ship’ for manipulating the revenue.
4. Big Bath: It is a part of embellishment of income. It exaggerates the current cash
outflows and losses of a loss making company so that its financial progress and development in
the future seems to be better thereby creating an illusion for the shareholders. Some of the
examples of ‘Big Bath’ technique are recognizing losses on assets having a fair market value
below their current market value and financial rearrangement of the company which had not
been done.
5. Big Bet on Future: Through this another company is acquired by the company and is said
to make a big bet on the future. It can be a guarantee for enhanced earnings in the purchased
company. The techniques comprise of the following:
(a) Reducing the development and in –process research expenses for the purchased
company. This technique directs the management to set off the major part of the purchase price
against the current earnings in the year of purchase so that the future income of the company can
be protected and boosted superficially.

Auditing Theory and Practice 4
(b) Merging the income of the acquired company into the collective earnings: The income of
the acquired company can be merged with the income of the parent company thereby resulting in
an increase in the income if the purchased company is acquired on favorable terms (Ghazali,
Shafie and Sanusi, 2015).
So the Big Bet Technique helps the purchasing company to increase the future and present
earnings in a definite manner.
6. Throwing out the problem child: When due to the underperformance of one of the
subsidiaries of the company , its earnings are decreased and if they are predicted to increase in
the future, the company can adopt the strategy of ‘throwing out of the problem child’ to
eliminate the problem. The techniques are spin off the subsidiary, selling the subsidiary, creation
of a special purpose entity (SPE) and exchange the stock in an equity method subsidiary for
financial assets.
7. Sale and Leaseback: It is used for selling the assets to the purchaser by the company and
procuring them back from him immediately. The company wants to obtain cash from these
dealings. Some of these transactions are financing activities through which the seller lessee
obtains monetary benefits without declaring it as a liability in the balance sheet (Uwuigbe, Peter
and Oyeniyi, 2014).
For example, if a company sells an asset with a book value of $2000 Million to another company
and it immediately leases it back for 6 years. According to the agreement, it has to pay $400
Million annually for 6 years. The seller lessee has to pay $2400 Million in cash for the lifetime
of the asset. In this way, it is a financing arrangement as the motive is to interchange the cash
rather than the sale of the aircraft.
8. Flushing: The managers can gain earnings by investing in the stocks of the other
companies. With the application of this tool, the managers can monitor the flow of their earnings
by regulating the sale of the securities which can impact their loss or profits. For example, if the
company needs more earnings, it can sell the stock with unrealized profits. On the other hand, if
it wants to show low earnings in its financial statements, it can trade in those securities with
unrealized losses. Thus, in both the cases, the gains and losses resulting from dealing in the

Auditing Theory and Practice 5
securities can be depicted in the cash inflows and outflows in both the scenarios (Kacharava,
2016).
The auditors monitor and regulate the capital markets through assuring the shareholders who are
interested in knowing the financial position of the company. They play a crucial role in lessening
the impact of earnings management. They reduce the variations pertaining to the accounting
information by validating the authenticity of the financial statements. They are accountable to
diminish the manipulation of cash inflows and increase the dependability of auditing (Mussalo,
2015).
The auditors track the doubtful accounting practices and raise objections on their application by
stating their qualified opinions in the audit report. With the help of auditing, the auditors regulate
the self-serving choice of the managerial personnel in the depiction of the financial documents.
Thus improved auditing may lead to better quality of reported gains. Thus, the auditors act as a
precautionary measure to protect the goodwill of the management and the value of the company
(Wanyama , 2017).
The auditors improve the validity of the financial documents which are provided by the
management through their independent certification of those documents. They implement
consistent methods of audit, pursue the views of the second partners and execute training
programs for regulating the earnings management. The auditors apply efficient internal control
methods to eliminate earnings management (Ibrahim et al., 2015). The auditors protect the
interest of the shareholders and decrease their data risk by providing a factual and rational view
of the financial statements of the business.
According to Rani, Hussain and Chand (2013) several corporate scandals can be stated where the
earnings management technique was used. The current corporate collapses such as HIH
Insurance and the demise of Arthur Anderson have questioned the reliability of the financial
statements. The collapse of HIH Insurance Group had led to a deficit of around AS$ 5.3Billion
thereby making it Australia’s largest corporate collapse. On March 1, 2001 the Australian
Prudential Regulatory Authority (APRA) had served notice on HIH to state the reasons for not
appointing an inspector under section 52 of the Insurance Act 1973. On March 15, HIH applied
to the court for registering itself into provisional liquidation.

Auditing Theory and Practice 6
Upon the investigation it was discovered that HIH had recorded a shortfall of assets over
liabilities amounting to AS$5 Billion out of the total of AS$ 7 Billion in the Balance Sheet. The
company had accounted for less than 0.5% of the total assets of the various financial
establishments. It was the second biggest non-life insurance company in Australia and the fraud
was amongst the largest corporate scams which occurred till date. It had a great impact on the
Australian economy and as a result, the Royal Commission was appointed by the Australian
Government to investigate this corporate collapse. As a result, the performance of the auditor of
HIH, Arthur Andersen and APRA were in question. The verification of these events lasted for
more than 18 months and Justice concluded by saying that the deficit of billion dollars had arisen
as the claims from the insured events were more than the company really provided for. The
factors contributing for the disaster of HIH were under provisioning, poor corporate governance,
insufficient valuations of the assets and lack of proper information provided by the auditors and
the board to the regulator. It also questioned the failure of APRA in exercising its powers and
responsibilities under the Insurance Act (Lane, 2016).
As per the opinion of Dodo (2017) another company which suffered with the corporate collapse
was Parmalat. It is one of the cases which lacked sufficient corporate governance structure. The
company had also appointed the audit committee but sadly it accepted the accounting procedures
which were improper. Furthermore the complexity of the structure of the group added on to the
misery. The problem was that the controlling shareholders used to exploit the organization rather
than administrating its activities. The company adopted an opaque and arrogant attitude towards
its investors and there were several incidences of fraud committed by the management such as
lots of cash was recorded in the books but the management continued to borrow money on
interests. It puzzled the investors of the company thereby provoking them to withdraw their
investments from the company.
The rating agencies reduced the ratings of the company to its lowest prior to the breaking up of
the scandal. It increased the worries of the investors as there was no connection between the debt
level of the company and the cash stated in its balance sheet. Additionally, the shareholders of
the company who also owned it were engaged in handling other projects such as tourism
business and soccer team rather than focusing on the management of the core activities which
resulted in large debts (Kang, 2015).

Auditing Theory and Practice 7
Besides this, the company additionally created a wholly owned special purpose entity to adjust
the fictitious cash amounting to €4 billion. All the events led to the downfall of the company.
The audit committee was also engaged in this scam as they approved the unfair practices
performed by the shareholders and the managerial personnel (Wiyadi, Veno and
Sasongko,2015).
The case of Royal Ahold, a grocery market chain with its stores located worldwide is a case of
poor corporate governance and mismanagement. The company had become successful through
its acquiring strategies and expanding itself in U.S, Europe, Asia and Latin America. But in
February 2002, its share prices decreased by 7 %. The company denied these numbers and
revealed its statistics of growth and manipulated them by decreeing the transparency. In its
annual report of 2001, it confirmed its financial crises and negotiated an emergency loan of €3.1
Billion to compensate with its immediate cash requirements. As a result, it had begun the
proceedings for disinvestment of its assets in Poland, Portugal and Slovakia (Dowd, 2016).
The key issue with the management of the company was its consistent expansion without
introducing any corporate governance changes. The instant success of the company looked
attractive to its shareholders but it reduced the opportunities for the auditors and the directors to
track the cause of the problems. It was the fault of audit committee who overlooked the
manipulations in the numbers.
The audit committee should have been investigated into the affairs of the company including the
policies relating to whistle blowing and internal controls. Additionally, the audit committee
should have enforced the tough policy regarding the attendance of the members appearing in the
meetings of the committee. The members of the audit committee should have been professional.
They had to execute the tasks of the board in a serious manner ( Loukianova, Nikulin and
Zinchenko,2017).
The case of filing of bankruptcy of Lehman Brothers Holdings with $639 Billion in assets and
$619 Billion in debt was the biggest in history as it assets exceeded the previous bankruptcy
giants such as Enron and World Com. It was the fourth largest investment bank of U.S. at the
time of the filling of its bankruptcy with 25000 employees all over the world.

Auditing Theory and Practice 8
The history of Lehman Brothers originated back from 1850 and it progressed with 209 registered
subsidiaries operating in 21 countries. Between 2003-2004, the company acquired five mortgage
lenders along with BNC Mortgage and Aurora Loan Services which targeted on ALT-A loans
which did not require complete documentation by the lenders to the borrowers during the period
of housing boom in U.S. As a result, the income from the real estate business of the company
allowed it to invest in the capital markets with the rate of 56% between 2004-2006. The firm
recorded enormous increase in its revenue amounting to $19.3 Billion and net income amounting
to $4.2 Billion (Chadha, 2016).
But on 15th September, 2008 Lehman Brothers filed for Chapter 11 insolvency processes. It was
the largest bankruptcy case in the history of U.S. with the creditors amounting to $613 Billion. It
had a great impact on the Dow Jones Industrial Average which recorded a downfall of 500 Points
immediately. As a result, within two hours, securities valuing around US$550 Billion were
exchanged and an amount of US$105 Billion was withdrawn from the U.S. Treasury. It led to the
closure of the electronic money markets when no response had occurred concerning the same.
Some of the causes for the failure of Lehman Brothers were negligent lending practices and
extreme dependence on the credit ratings by the investors. It also figures out the accountabilities
of the auditing committees for reducing the rate of corporate scandals and increases the
effectiveness of the procedures of corporate governance (Clarke and Dean, 2014).
The responsibility of the auditors is to identify and evaluate the possible threats related to
material frauds occurring in the financial statements of the company. It is the duty of the auditors
to apply professional skepticism and respond to the probable frauds and report them to the upper
management of the company. They should also mention the qualified and adverse opinions
regarding the matters in the auditing reports (Consoni, Colauto and Lima, 2016).
In my opinion, it is not appropriate that the auditors should rarely be held responsible for the
failure of the company. They form the basis of the risk management framework and the
corporate governance structure. The audit committee manages and regulates the internal control
system of the company .It is liable to report the frauds arising from misappropriation of the
assets and processes and should offer appropriate solutions to be implemented to prevent the
errors in the future in the auditing report (Uwuigbe, Ranti and Bernard,2015).

Auditing Theory and Practice 9
According to ASA 240, the auditors are held responsible for recognizing the possibility of
material frauds in the statement of affairs of the company. The auditors are liable to verify the
inaccuracies pertaining to the responses of the management and the corporate governance
committee. They are accountable for analyzing any possible risks related to the evaluation of
revenue in the financial documents of the company. Mostly, the companies create fake revenues
by increasing the sales falsely thereby recording the accounting transactions in the books of
accounts to increase the amount of assets and cash. With the help of cross verification from the
third party to validate the status of these accounts, the assessors would be able to verify if the
revenues are fake or genuine (Auditing and Assurance Standards Board, 2015).
Hence the auditors must involve in direct discussions with the stakeholders to examine the
dealings of the company and maintain proper control measures to strengthen the risk
management framework within the company. They should apply certain steps for reducing the
substantial fraud from the financial documents of the company. Thus with the help of
independent opinion of the auditors, a true and fair view of the statement of affairs of the
company can be provided to the stakeholders (Alabede, 2012).
Thus, to conclude, it can be said that the earnings management adversely impact the revenue
generation and may weaken the reliability of the financial statements. It is a strategy applied by
the management to affect the revenue generation so the figures can be complemented against an
objective. The auditors play an important role in eliminating the risk of earnings management
and erroneous reporting of the fiscal statements by the organization. They shall form and apply
the auditing processes which help in analyze the risk of material mismanagement.

Auditing Theory and Practice 10
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Auditing Theory and Practice 11
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