Earnings Management and Its Effects on Corporate Performance Report

This report examines the multifaceted impact of earnings management on corporate entities. It begins by defining earnings management and its significance in financial reporting, highlighting how companies may manipulate financial statements to present a more favorable financial position. The report delves into various techniques employed in earnings management, such as cookie jar reserves, big bath accounting, and strategic asset sales, illustrating how these methods can distort financial results. Furthermore, it analyzes the role of auditors in detecting and addressing earnings management practices, discussing the approaches auditors take to mitigate risks and ensure the integrity of financial statements. The report also explores instances where earnings management has contributed to corporate failures, emphasizing the importance of robust accounting standards and ethical conduct. Finally, the report concludes by summarizing the main findings and implications of earnings management, offering insights into its effects on stakeholders and the broader financial market.

Running head: EARNINGS MANAGEMENT EFFECT ON COMPANIES
Earnings Management Effect on Companies
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1EARNINGS MANAGEMENT EFFECT ON COMPANIES
Abstract
The objective of the paper is to analyze the impact of earnings management on companies. The
paper revealed that as the market becomes more competitive, sometimes the companies tent to
eliminate their certain operation which is not performing well by naming it restructuring of the
entity. As per the GAAP, it allows the manager to charge the cost of the change against the
company’s income. It is against the company’s reputation in the market as it can be seen as
uncompetitive but if the same is taken in positive way by the shareholders could also boost its
share prices. It is a simple way of putting the losses occurred during the restricting process in
current fiscal report and save the future reports from such losses and expenses. The paper also
revealed that the main reason of managing the earnings lies with being more predictable in the
future while walloping the volatility.

2EARNINGS MANAGEMENT EFFECT ON COMPANIES
Table of Contents
1. Introduction......................................................................................................................3
2. Issues causing earnings management and associated techniques....................................3
3. Auditors Approach in Dealing with OrganizationFailure with Use of Earnings
Management....................................................................................................................................6
4. Auditors are Accountable for Company Collapse.........................................................10
5. Conclusion.....................................................................................................................12
References..........................................................................................................................13

3EARNINGS MANAGEMENT EFFECT ON COMPANIES
1. Introduction
The profitability or earnings of the company is regarded as the most significant part of
the company’s financial statement. It shows how the company is involved with the with its value
maximization activity. The primary factor which reflects the company’s health is its earnings
which is also positively proportional to its value and also gains confidence of the shareholders.
Therefore, reflecting the financial reports in positive light is the most imperative function of the
management of a certain company (Aris et al., 2015).
The management of a particular company while carrying out the accounting process to
derive the financial reports also calculates the future estimates. Here, the accounting standard
provides various process to record a transaction and the managers can choose one of them.
However, the outcome of the report is totally dependent on the process chosen. However,
sometimes the managers try to present their reports in the most positive way possible by
overstating their earnings; this practice is known as earnings management (Bessis, 2015). This
practice is generally not encouraged across the globe as it is seen to deceive the stakeholders.
Hence, there are techniques of managing ones’ earnings and standards followed to counter the
same, which will be discussed later.
2. Issues causing earnings management and associated techniques
Earning Management is an attempt of reflecting the better side of the company by
overstating the earnings of the company to soothe the future journey of the entity using loopholes
in accounting techniques (Beuselinck&Deloof, 2014). It is generally considered as manipulation
of financial statements but is actually using the deficits of accounting policies. The main reason

4EARNINGS MANAGEMENT EFFECT ON COMPANIES
of managing the earnings lies with being more predictable in the future while walloping the
volatility. There has been a belief that the investors are more interested in the companies which
reflects a steady growth rather than those which reflect volatility as people tend to take low risk.
However, the managers who put a huge effect in overstating their earnings must put the same
effort in planning business strategies for long-term growth. There are several techniques through
which the earning can be managed such as:
 Cookie Jar Reserve- The accounting process require the accountant to record the
transaction in accrual basis in which the payment is shown in the books even before the
payment is done. In this case, the managers find a loophole and records the highest
possible expenses as per their estimation (Beyer, Guttman &Marinovic, 2014). In this
process the highest expenses are recorded in the current fiscal year but leaves the future
fiscal period from such expenses to be recorded later. Hence, it can be said that the
manager through this practice creates the cookie jar for earnings to boost the growth in
years yet to come.
 Big Bath- As the market becomes more competitive, sometimes the companies tent to
eliminate their certain operation which is not performing well by naming it restructuring
of the entity. As per the GAAP, it allows the manager to charge the cost of the change
against the company’s income. It is against the company’s reputation in the market as it
can be seen as uncompetitive but if the same is taken in positive way by the shareholders
could also boost its share prices. It is a simple way of putting the losses occurred during
the restricting process in current fiscal report and save the future reports from such losses
and expenses. Hence, in other words, it refers to the recording of the highest loss so the
future earnings remain safe.

5EARNINGS MANAGEMENT EFFECT ON COMPANIES
 Big Bet on The Future- The term ‘big bet on the future’ is referred when a company
acquires another believing that the acquired company will perform well in the future. It
can be considered as the risk which the acquiring company takes after analysing the
value of acquired entity. As per the accounting standards, such transactions are needed to
be shown as ‘purchase’ (Black et al., 2017). Hence, the acquirer generally write-off the
major portion of the purchase against the current income so as to keep their future
earning free from any debt. Moreover, they also consolidate the earnings from the
acquired company in their own income.
 Flushing the Investment Portfolio- When a company buys less than 20% of the stake in
another company, the rules of accounting forbids the investor from recording the profit
from investee company to be shown in investor’s earnings (Patrick, Paulinus &Nympha,
2015). It is expected to be included in the operating income. But the managers are
observed to manage their earning s by selling the stakes at unrealized gains or losses as
per their requirement at the time.
 Throw Out A Problem Child- It is mainly practiced when the subsidiary of the
company is dragging down its earning and is estimated to do same in the future. It is the
process of eliminating such subsidiary by selling it generally in loss. The loss occurred is
recorded in the income statement but in case the loss is huge, it is distributed amongst the
shareholders which is also termed as spin-off (Braam, Nandy, Weitzel &Lodh, 2015).
However, much more effective method of hiding such loss is creation of special-purpose
entity where the loss is transferred and is also not reflected in the consolidated statement.
 Sale/Leaseback- It is much more complicated techniques where the company
immediately leases back the asset it soldand record the losses (if any) in its books.

6EARNINGS MANAGEMENT EFFECT ON COMPANIES
However, in case of profits, the same is amortised through the earnings during the asset’s
life if the same is under the capital lease and in case of operating lease it is amortised in
proportion to the payment (Liu, 2016).
 Shrink the Ship- The accounting standard does not permit a company to record the
profit/loss it incurred during the share buyback in its income statement. It only allows the
same if the company has transacted with outside party. However, instead of effecting the
earning the company uses it to elevate its earning per share from the stock which
eventually increase the value the company in the market (Nazir &Afza, 2018).
3. Auditors Approach in Dealing with OrganizationFailure with Use of Earnings
Management
It is gathered that the auditors make attempts to deal with the practices regarding earnings
management and it is deemed that many companies collapse within which the earnings
management practices are used. It is evidenced that several huge corporate forms like Enron and
Satyam company dealt with bigger challenges related with toughest policy issues concerned with
any financial failure of companies. It is also observed that this company is dealing with
addressing suchdisclosure concerns (Bratten, Payne & Thomas, 2016). The earnings
management issue has been evidenced in the situation faced by Enron Company over past
yearsdue to their increasing earnings misstatement. In addition, another example related with
collapse of earnings management practices is evidenced that took place due to weak
consolidation rule which is prescribed by enhanced and leveraged “Special Purpose Entities
(SPE)”. These were focused on accomplishing many projects in which the liabilities and assets
were not signified in the organizations balance sheet. Satyam collapsed due to the losses that
took place from many SPEs that were developed (Chen, Cheng, Li & Zhao, 2018). Earnings

7EARNINGS MANAGEMENT EFFECT ON COMPANIES
management practices implementation that includes discretionary accruals, cookie jars, shrink
the ship, big bath, big bet on future, troughing out a problem child, flushing, leaseback and sale
might also have a bad effect on most of the businesses.
It is evidenced that there is a chance of high damage to the companies that are associated
with earnings management and related guidance’s. Earnings management techniques impacts
organizations in a situation they deal with it in order to obtain short term results other than short
term growth and sustainability. There are numerous adverse impacts of ineffective earnings
management quality that is implemented by organizations. This might lead to enhanced cost of
capital because of increased price earnings ratio. In addition, techniques of earnings management
might also result in some harms to organizations those use them for this can result in negative
attitudes of analysts that follow the organization and effects of bid-ask spreads (Dimitras,
Kyriakou&Iatridis, 2015). For such causes, it can be gathered that evaluating an instance of
Enron and Satyam Corporate failure can clarify that earnings management of a material amount
encompass fraudulent financial reporting. Moreover, this must be pressured effectively by
government regulators as well as external auditors.
For addressing the concerns those are associated with earnings management that further
leads to losses within businesses, the, members of audit committee focus on employing some
accounting policies that are elaborated below:
 Recognising every transaction that requires management for developing a better
anticipation of judgement. For example, a company that elaborates its accounting process
for inventory is significant as it has increased its selling products over a period ad is also
considered as fact sales.

8EARNINGS MANAGEMENT EFFECT ON COMPANIES
 Associating the choices that are present with the management in IFRS to be responsible
for transactions of organizations. In addition, the auditors consider the same to be
important to identify the potential that is provided by a particular earnings management
selection (Fisher, Gavious& Martel, 2016).
Rather than these control techniques for earnings management, the auditors take into account
the most efficient way in which earnings can be controlled is by means of setting highlyrigid
accounting standards. In addition, this can also have negative impact as managers consider real
earnings management which encompass suboptimal, abnormal as well as other business practices
in order to change reported earnings (Healy, Serafeim, Srinivasan& Yu, 2014).
In account for the legal system and absence of accounting in capital market infrastructure
within transitional economies earnings management is deemed to be adverse. The emerging
economies are likely to deal with such larger concerns in supervising accounting decisions of
managers. The introduction of the international accounting practices long with standards in the
organizations has ensured this has enhanced decreasedtransactions cost, enhanced market
liquidity as well as increased pricing efficiency. This decreases the level of earnings management
and the auditors ensures that the organizations need to implement international accounting
standards which can further facilitate in earnings smoothening. The auditors also take inti
account that the corporate businesses need to implement international accounting standards
which can further consider revising accounting standards in a better manner (Jacoby, Li & Liu,
2016). This is for the reason that there are decreased loopholes in order to manipulate earnings.
They are increasingly cautious in recognizing earnings manipulation activities of companies
within which their interdependence is made sure. The auditors are also focused on the
consciousness and morality of stakeholders that can convert such malpractice into a better

9EARNINGS MANAGEMENT EFFECT ON COMPANIES
practice. This is in a situation where motivations behind the earnings management does not
involved any unethical intentions.
The auditors are accountable for identifyingfrauds in financial statement audit of
organizations. They are also aware and maintain control fraudulent financial reporting. This
encompass international omissions or misstatements related with disclosure of financial
statements in order to deceive the financial statement users. The auditor monitors accounting
fraudwhich facilitates in controlling earnings management in companies (Saleem, Alifiah&
Tahir, 2016). In addition, the auditors of organization implement two major earnings
management detection along with dealing strategies which can control the fraudulent financial
statements misstatement by organizations. Such processes employed by auditors are elaborated
below:
Approach of AggregateAccrual Method: The auditors use this model by means of using
some suggestions on accruals. These are considered to be anticipated outcomes of the exercising
managerial discussions. This might also happen from some changes in a company’s economic
situation. In order to detectacontrol, the techniques of earnings management regression model are
used relied on such variable. This is due to the fact that overallaccrual as well as independent
variables encompass sales property, plant and equipment. In addition, for decreasing earnings
management chances by referring change in sale and change in the property, pant and equipment
level.
Specific accrual method approach:This model is used by auditors for measuring any
distortion or preconditions in thefinancialstatements. For example, the auditor of banking and
insurance companies use particular accrual earnings management processes for dealing with the
earnings developed by financial institutions (Tabassum, Kaleem & Nazir, 2015). Such

10EARNINGS MANAGEMENT EFFECT ON COMPANIES
approaches persuade the auditors to serve for losses in loan and moreover the insurance
companies also develop reserve against the claim losses. Use of this model by companies also
supports auditors in evaluating that increased values of the financial statements by organizations
has increased chance of manipulation.
4. Auditors are Accountable for Company Collapse
All the corporate organizations auditors are deemed to be the watchdogs but over the
previous few years and they are centered on the organizations services they audited than making
sure effective information flow to its investors. The auditors attain authority which in case after
analyzing the organizationsfinancial reports, incase they do not real any type of materialconcerns
in the financial statementsthat the report is published along with standardized assurance
statements (Capalbo et al., 2017). This can ensure that the auditors consider the
company’sfinancialstatements to be represented fairly in consideration to materiality and in
compliance with GAAP principles. Auditors are basically employed by directors andinvestors of
a specific organization to realsie of the company’s financial situation facilitates n understanding
if its financial situation is maintained following all accounting rules. Responsibility of an auditor
is to offer the stakeholders with the company’s fair value. For this reason, the auditing quality is
of increased importance that facilitates in recognizing error within accounting process and
facilitates in recognizing if certain records are not prepared as per accounting standards (Chu,
Dechow, Hui & Wang, 2016). The auditor’s effort impacts the opportunity that an individual will
identify the existing issue in which independence of the auditor effects the chances of reporting
these issues. Therefore, auditor’sindependence impairment serves asanaspect of earnings
management that is a topic for research. This is exposed to several aspects that includes auditors
fee, importance of consumers, auditing tenure along with other services. It can also be concluded

11EARNINGS MANAGEMENT EFFECT ON COMPANIES
that there is absence of evidence on earnings management-based audit initiatives. A highly
competitive auditor has capability of understandingreports in an efficient manner and arelikely to
recognize anyoverstated earning (De Jong, Mertens, van der Poel & van Dijk, 2014). Conversely,
an auditor’s effort has inverse impact on earnings management. The major cause of this low
availability level of evidence is because of audit hours unavailability.
Auditors put their reputation at stake and their work is deemed to be an unethical conduct
in case their consumer revealed overstated earnings or organizations. However, in a situation
where it is vice-versa no actions are considered for it. In addition, there exist regular
disagreement among the auditorswith their consumers as former deals with asymmetric loss
(Gavious& Martel, 2016). The earnings management might be gauged through anticipating
abnormal accruals along with increased auditor’s effort is needed to decrease the managers
practice regarding earnings overstatement. Conversely, in such scenario if audit hoursare lower
than such abnormal accruals will be casual. Internal auditing is highly complex to realize for this
can be biased. In a situation, the auditor can put increased effort for curbing earnings
management chances through the managers. For this reason, a positive relation among earning
management along with audit hours might be considered (Norden &Stoian, 2014). In addition, if
managers focus on managing their earnings then it might try to encompass the auditors in their
plan for facilitating them in in excreting less effort. In such situation a negative image might be
drawn among the relationship of audit hours along with earnings management. For this reason, it
might be derived that audit effort can decrease earnings management chances.
Taking the instance of Greece, the have generated an accounting body named SEOL, a
self-regulatory audit profession. This accounting body needs all the engaging partner to report
regarding the hours of audit to SOEL (Gounopoulos& Pham, 2017). For tracing ay missing

12EARNINGS MANAGEMENT EFFECT ON COMPANIES
hours, the body matches the organizationsauditor against the database. It also suggests its
partners to report regarding the hours of audit to SEOL. In order to trace any missing hours, the
body matches the organizations auditors against the database. It also suggests its partners to not
retire till the audit data is submitted. It also has techniques to recognize the inaccuracies within
the audit report. Conversely, in case one fails to report or inaccuracies are recognized within data
report than it is deemed to experience penalties.
Based on the responsivity of an auditor, it is their primary responsibility to offer a fair
value of the company to the stakeholders. The investors are highly dependent on the auditors for
the investment along with any negligence from the later might not only result in losses but can
also result in shareholders to lose their confidence withinauditors. Additionally, it relies on the
ethical background related with the auditors to excerpt effort within their audit. Moreover,
implementing the Greek techniques of gauging audit hours can also control any efforts made to
manage earnings and can prove to act as an evidence against the auditor responsible for
assimilating the managers within their unethical plans.
5. Conclusion
The accounting standard provides various process to record a transaction and the
managers can choose one of them. However, the outcome of the report is totally dependent on
the process chosen. It is gathered from the paper that it is generally considered as manipulation
of financial statements but is actually using the deficits of accounting policies. The main reason
of managing the earnings lies with being more predictable in the future while walloping the
volatility. There has been a belief that the investors are more interested in the companies which
reflects a steady growth rather than those which reflect volatility as people tend to take low risk.

13EARNINGS MANAGEMENT EFFECT ON COMPANIES
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Beuselinck, C., &Deloof, M. (2014). Earnings management in business groups: Tax incentives or
expropriation concealment?. The International Journal of Accounting, 49(1), 27-52.
Beyer, A., Guttman, I., &Marinovic, I. (2014). Earnings management and earnings quality:
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Black, E. L., Christensen, T. E., Taylor Joo, T., &Schmardebeck, R. (2017). The Relation
Between Earnings Management and Non‐GAAP Reporting. Contemporary Accounting
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Braam, G., Nandy, M., Weitzel, U., &Lodh, S. (2015). Accrual-based and real earnings
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Bratten, B., Payne, J. L., & Thomas, W. B. (2016). Earnings management: Do firms play “follow
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14EARNINGS MANAGEMENT EFFECT ON COMPANIES
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15EARNINGS MANAGEMENT EFFECT ON COMPANIES
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