Earning Management, Corporate Collapses, and Auditor Responsibility

This essay explores the concept of earning management, its driving issues, and prevalent techniques such as cookie-jar reserves, discretionary accruals, and big bath accounting. It highlights the critical role of auditors in identifying and mitigating these practices, referencing corporate collapses like Enron and Waste Management to underscore the consequences of unchecked earning management. The essay concludes by emphasizing the need for auditor accountability in preventing corporate failures stemming from the misuse of earning management techniques, advocating for diligent auditing practices and ethical considerations in financial reporting. Desklib provides students with access to a wealth of resources, including solved assignments and past papers, to further their understanding of auditing principles and corporate governance.

AUDITING PRINCIPLES AND PRACTICE

ABSTRACT
This essay is in relation to the concept of earning management and its popular techniques.
The concept of earning management is a burning topic nowadays and is grabbing every
corporate’s attention. The first section shall provide with the basic introduction to earning
management followed by the issues that lead to the same. The major techniques involved
shall be discussed. Carrying on the series, the auditor’s role in overcoming these practices
shall be highlighted with examples of well-known corporate collapses. In the final section,
comments would be made on the need of auditor’s accountability in the company’s failures
on following the techniques of earning management. This essay shows all the key details and
required audit practices which will showcase the possible issues and mitigating business risk
program in determined approach.

Table of Contents
ABSTRACT..........................................................................................................................................1
INTRODUCTION.................................................................................................................................1
ISSUES LEADING TO EARNING MANAGEMENT.........................................................................1
POPULAR TECHNIQUES OF EARNING MANAGEMENT.............................................................2
1. COOKIE JARS RESERVES.....................................................................................................2
2. DISCRETIONARY ACCRUALS.............................................................................................3
3. BIG BATH................................................................................................................................3
4. BIG BET ON FUTURE.............................................................................................................3
5. SHRINK THE SHIP..................................................................................................................3
6. “THROWING OUT” THE PROBLEM CHILD........................................................................4
7. SALE AND LEASE BACK......................................................................................................4
ROLE OF AUDITORS.........................................................................................................................4
Some popular corporate collapses:....................................................................................................5
AUDITOR AND COMPANY’S FAILURE..........................................................................................7
Conclusion.............................................................................................................................................8
References.............................................................................................................................................9

INTRODUCTION
Every company that carries on an economic activity runs with an ultimate goal to make
money. Apart from making profits throughout the accounting year, the accountants and
management want to present the company’s profile to the public in an attractive manner to
lure the investors for investment and public so that shares can be sold. If this doesn’t happen
naturally, the management thrives on manipulating the accounts. They try to even out the
earnings by window dressing the timing of revenues, payments, incomes, expenses, losses
and gains. It’s like creating a perfect looking book of accounts by using several techniques
and original set of books. Although this technique is legal, it may damage the performance
and even lead to collapse and crash if done improperly (Lowe, McKENNA, & Tibbits, 2011).
ISSUES LEADING TO EARNING MANAGEMENT
If the management has chosen to imaginatively manipulate the accounts, then there should
stand some reasons for that. Various issues re-identified, some major being:
 The company might have projected a goal or an aim for certain near or time frame. On being
unable to achieve that target, it may feel the requirement to transfer the revenues or expenses
of one accounting period to another. By doing this is using the accounting policies and
procedures in a unique way to show the accounts in the way they were expected as per the
targets.
 Unlike the goals said aloud to the public in the previous paragraph, sometimes there may be a
situation where a company, sets its internal targets for every department or process on which
the whole budget lies. The respective department or process that cannot achieve the targeted
result would look ulterior and harm the whole budget. In order to avoid that, the accounts
related to that particular part are customised (Lowe, McKENNA, & Tibbits, 2011).
As market movements are bound to affect every entity, be it directly or indirectly, the growth
and income patterns of a company show severe ups and downs. It creates a reluctance in the
mind of investors and creditors to extend finance. To smoothen out the earning patterns, the
company goes on adopting earning management (Rose, 2017).

 Leave aside the existing stakeholders, every organisation wants to grow and in order to do
that, they want to attract as many potential investors and shareholders as possible. In the
process of doing this, the company starts to window dress the existing profits by bringing
stability in their time frame of achievement.
POPULAR TECHNIQUES OF EARNING MANAGEMENT
1. COOKIE JARS RESERVES
In this technique, the company tries to bring evenness in the income generating pattern. This
technique can be helpful if the company recognises the expense for a certain transaction on
estimate basis in an accounting year, but the actual payment for the same is made in another
accounting period and that too less than what was estimated. As a result, there lies a reserve
of the expense that was over than actual. The company may use this extra expense in the
accounting period in which its earnings go more than normal to show evenness and avoid
recognising the loss in the year which goes either in loss or turn to be less income generator
(Rose, 2017).
2. DISCRETIONARY ACCRUALS
Discretionary accrual stands abnormal accruals. The term discretionary stands for open or at
the option of. The management is on the footing to estimate certain accruals regarding an
accounting period. This is different from normal/non-discretionary accruals because normal
accruals aren’t manipulated and aren’t affected by management’s judgement. The
discretionary accruals allow the management to understate or overstate the financial position
by manipulating the whole accounts by adding accruals into it (Rose, 2017).
3. BIG BATH
Big bath tends towards the technique wherein the loss estimates like impairment,
restructuring etc. are done on a large scale than approximately estimated. This is based on the
mindset that if something bad is going to happen, it should be reported at a single time. If the

actual loss turns out to be lesser than the expectation, then the actual position would look
better than targeted. It acts like bliss in future because if the estimated loss would have been
shown lesser than approximate than the targeted position would have appeared deteriorated
(Graham, 2014).
4. BIG BET ON FUTURE
Big bet on future comes into play when a company is acquired by the organisation. By using
big bet, the company writes off the complete expense incurred on the research and
development of the company acquired in the year of acquisition only rather than writing off
over a period of time. As a result, the future earnings get a boost and are more than they
actually would. Its other way includes merging the current earnings of the acquired entity into
the overall earnings of the acquiring company which balances out the writing off charges and
shows a boost in growth because of acquisition.
5. SHRINK THE SHIP
In this technique, the company generally repurchases its own shares, in order to minimise the
no of shareholders. This in a way doesn’t change the earning of the concern because
according to current accounting standard the profit or loss on repurchase of own shares isn’t
reflected in accounts. But it affects the company’s position otherwise by improving the
earning per share; this helps in removing stagnancy and provides the company to highlight
the targeted earning per share with requisite growth (Graham, 2014).
6. “THROWING OUT” THE PROBLEM CHILD
When an entity works as a conglomerate and has other subsidiaries working as a group with
it, there may lay certain subsidiary(s) which may be performing lower than the expected and
negatively affecting the overall earnings. As a result, the company may decide to sell or spin
off the subsidiary. It may even create a special purpose entity for the financial assets of the

underperforming subsidiary. As a result, the assets and liabilities of the concerned subsidiary
will be removed from the consolidated balanced and be deemed as sold (Graham, 2014).
7. SALE AND LEASEBACK
By using this technique, the management can mould its unusual profits or losses of a
particular accounting period. The management can sale an asset and lease it back and
recognise the gain/loss on the sale of the books of account.
There can be either outright sale of an asset or a transaction wherein the company sells an
asset and immediately leases it back. Both ways it gives the company a chance to make losses
or gains as required (Rose, 2017).
ROLE OF AUDITORS
There is always an ever-going debate about whether earning management is legal or not. But
many scholars believe it to be a legal practice. However, where the auditors are concerned,
they stand in a position to give an opinion about the truthfulness and fairness of the
information stated in the books of accounts (Tricker, & Tricker, 2015). Any technique of
earning management contributes in manipulating the actual state of the accounts and is
intentional. As it’s well versed that any intentional fraud is hard to capture by the auditor than
the unintentional ones, same becomes the case of earning management. In order to add to the
beauty of financial statements management usually resorts to some level of manipulation and
that becomes difficult for the auditor to catch. Although earning management is not a fraud
but it would have created a difference in the auditor’s opinion if it was known to him that
accounts have been window-dressed (O’Callaghan, & Graetz, 2017). The auditor is required
to know the difference between frauds and earning management to provide his opinion on a
better front. The auditors need to find the reason behind every finding they observe; as it’s
the only way they can spot whether an intentional manipulation is fraud or earning
management (Davies, 2016).
Even if earning management is counted as an ethical practice and within the boundary of
accepted accounting principles, there may stand a chance wherein due to this practice the

corporates have faced detrimental repercussions (Lowe, McKENNA, & Tibbits, 2011). Various
famous scandals are there that witness that many times earning management eventually takes
the shape of fraud. This brings another responsibility on the shoulders of the external auditor
to even report the cases of any manipulations noticed in the books of accounts even if they
seem to bring no harm, as later they might bring trouble to the concern. Though, the auditor is
not responsible for anything if he has done his work with due diligence and has gathered
sufficient and appropriate audit evidence before framing an opinion. As his responsibility is
to give reasonable assurance based on what he has observed, provided he did it with vigilance
and due diligence. He is not responsible for the preparation of the books of accounts that lies
with the organisation itself. However, if during the course of the audit, auditor finds some
discrepancy in the accounts or he is personally interested anyhow in the company, it calls for
an irregularity in the conduct of audit by him (Argenii, 2015).
Some popular corporate collapses:
1. Enron scandal: Enron is a Houston based company dealt with energy services. Its CEOs Jeff
Skilling and Ken Ley were the main conspirators behind the earning management technique
and turned it into a fraud. They framed special purpose entities and creatively used the
financial reporting techniques to keep billion dollars’ debt that arose from unsuccessful
contracts and projects out of the balance sheet. Its auditor Arthur Andersen was even found to
have not performed audit diligently and properly (Murphy, 2009). Because of these thousands
of employees lost their jobs and retirement accounts and the shareholders lost around $74
billion. According to research, an employee Sherron Watkins, whistle blown the whole
malpractice and got them red-handed in front of everyone (Masuch, 2015). Adding to the fire,
the sudden rise in share price added to the scepticism. As a consequence, both the key fraud
makers were sentenced for 24 years and the auditor was held guilty for helping in
manipulating the accounts. The company got filed for bankruptcy (Liu, & Wilson, 2012).
2. Waste management scandal (1998): it is also a Houston based company which is traded
publicly. It’s a waste management and environmental services company. It made the fake
reporting of around $1.7 billion of earnings. In order to restate the earnings, the company’s
founder, as well as CEO and chairman, Dean L. Buntrock and other top-level administrators,
tried to show higher earnings by falsely ascending the depreciable life of their balance sheet’s
plant, property and equipment. When the company got under the safe hands of new
management and CEO, their scrutiny and analysis of the false accounts revealed the

restatement done by the former team with the help of auditor Arthur Andersen. Penalties hit
both the auditor and the company being $7 million fine by SEC and settlement of $457
million being shareholder class action suit respectively (Iraya, Mwangi, & Muchoki, 2015).
3. WorldCom scandal (2002): WorldCom used to be one of the well-celebrated
telecommunication companies with more than $30 billion in annual revenue. It used the
practice of earning management in a fraudulent manner by making fake accounting entries to
underreport line cost by capitalising them instead of treating them as an expense and at the
same time hitting revenues high. Company’s CEO Bernie Ebbers was held guilty for the huge
misstatement and was penalised by 25 years of imprisonment. He even was pleaded for filing
false documents. Along with penalising him, the company was also filed for bankruptcy
(Barlow, & Clarke, 2017).
4. HealthSouth scandal (2003): HealthSouth being a sound publicly traded U.S. Company,
famous for providing health care services was taken on the verge of destruction by CEO
Richard Scrushy. As one of the issues leading to earning management seen in the earlier
sections, CEO in a pressure to meet the shareholders’ expectations made a fake inflation in
the earnings by $1.4 billion. He even used this fraud done by him for his further personal
benefit by selling the shares he held one day before the company posted a deep loss resulting
in falling share prices. This act raised a suspicion and he got caught. The CEO even was
found to have bribed the then Governor of Alabama. All his wrongdoings got him imprisoned
for seven years,
All these well-known corporate scandals led the reality of poor governance and poor
practices shout loud. After the shameful collapse of Enron and other corporates, U.S.
Congress passed an act called Sarbanes-Oxley Act (Argenti, 2016). This act demands
corporates to improve their governance and completely disclose all the financial matters and
requisites in an improved manner. It brought a responsibility on the management and external
auditors to report whether the company’s internal controls are adequate or not. Hence, in any
case, the auditor, is aware of the circumstances involving earning management that can lead
to fraud or are done with intent to commit fraud, must report them. Any failure on the part of
the auditor to comply with this requirement may cause him to be legally dealt with (Ooghe,&
De Prijcker, 2008).
Increased costing of their business- The failure to comply with the applicable rules by these
companies was also the major reason for the collapse. For instance, Penalties hit both the

auditor and the company being $7 million fine by SEC and settlement of $457 million being
shareholder class action suit respectively in the Waste management scandal (1998).
These are several collapses which have drastically affected the economic and industry at
large. However, after analysing all these companies, it is inferred that these companies were
lacking with the proper nexus between the organizational growth and economic development
at large. If these companies could have implemented the proper strategic plans and effective
business decisions then it would have increased its return on capital employed. The Auditors
compliance program and their internal control system were also the weak which divulges the
biggest reason for the failure of this business organization (Perry, 2011).
AUDITOR AND COMPANY’S FAILURE
Earning management stands to be an internal step taken by the top-level management to make
manipulations within the books with intent to make the financial statements look appealing.
Along with the external auditor, the company needs to have an audit committee and an
internal audit function. The internal auditor is under the duty to check whether the company’s
controls are adequate or not. This ensures the safeguarding of assets, compliance with rules
and regulations, meeting targets set and continuance of operations with effectiveness and
efficiency. The internal auditors are much into the organisation and are in a better position to
look for any conspirator of frauds in the veil of earning management. If the proper audit
program and effective work functions are undertaken then it will not only increase the overall
output of the company but also assist management of companies to mitigate the possible
business risk (John, 2016).
However, the external auditor is not expected to directly rely on the observations and work of
internal auditor unless they have the reasons for same. The external auditor is an independent
party and must make an unbiased report (Sharma, & Mahajan, 2012). If he indulges in any
kind of conflict of interest, he may be pleaded as being guilty. That means until and unless he
is a party to fraud he cannot be held liable for any collapse happening for either reason, be it
fraud or fraud disguised as earning management (Laitinen, 2012). These external auditors
evaluate the business process and financial reporting framework as independent auditors.
They help the company to evaluate all the possible problems and financial reporting issues

which company might face due to non-effective accounting policies and internal and financial
recording standards in their books of account (Kiviluoto, & Bergius, 2012)
There are seen corporate collapses where the auditors are rarely found guilty. One of the
obvious reason being, the auditors have performed as per the expectations and with
applications of all auditing principles including integrity, accountability, confidentiality,
rigour, professional scepticism (Weir, & Laing, 2011). They have considered all the auditing
standards that are applicable to the respective client’s case. If there had been no biases or
unethical practice on part of the auditor, they he cannot be held accountable for company’s
failure. So, in a brief sense, it’s appropriate to keep the accountability on management’s head
if the auditors aren’t involved as a party to fraud. These corporate collapses have shown
several hidden possible actions which could have been taken by these companies to stop their
collapse. If the proper audit program and transparent reporting frameworks were used by
these companies then it would have saved a high amount of capital from the possible losses
(Kangari, Farid, & Elgharib, 2012).
Conclusion
With the changes in the reporting frameworks and adoption of the international
accounting frameworks accountant and auditors should use equal parameters to record and
reporting of the books of account of companies. It is observed that auditors have needs to
follow several intents in his recording frameworks with a view to increasing the effectiveness
of the audit program such as principles including integrity, accountability, confidentiality,
rigour, professional scepticism. Now, in the end, it could be inferred that this corporate
collapse could be restrained by the company by using the effective recording and reporting
frameworks.

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