Accounting Principles: Earnings Management, Audit and Reduction

This report delves into the concept of earnings management, where companies manipulate financial figures to present a more favorable picture of their performance. It explores various techniques used, such as manipulating revenue and expense recognition, and the role of auditors in detecting and preventing such practices. The report highlights the importance of auditors in ensuring accurate financial reporting and discusses methods to reduce earnings management, emphasizing the negative impacts on stakeholders and the need for ethical financial practices. The report covers topics such as the motivations behind earnings management, the effects on audit procedures, and the means of reducing it, culminating in a discussion of the impact on the financial markets and the need for transparency and integrity in financial reporting.

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ACCOUNTING PRINCIPLES AND PRACTISES

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Executive summary:
This report aims at discussing the earnings management, the role of the auditors in it and the
way the same could be reduced. The concept of earnings management is an old one in which
the company manipulates the sales revenue figures or the profit figures or the expense figures
in order to report profitability of the business operations. This is done by the management so
that bonus could be received by them in line with the increased profit.

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Contents
Introduction:...............................................................................................................................4
Meaning:....................................................................................................................................4
Auditor’s role:............................................................................................................................6
Effect on audit procedures:........................................................................................................7
Means of reducing earnings management:.................................................................................8
Evidence of earnings management:...........................................................................................9
Conclusion:................................................................................................................................9
References:..............................................................................................................................11

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Introduction:
Earnings management is the way through which the company is able to depict a better picture
of the company as compared to what exactly it is. This is done by deferring the expenses to
the next period, recording the revenue of the next period in current period etc. activities like
these are not legal (Management, 2019).
The manipulation of the earnings is something which is illegal today. Though the
management does manipulate the facts and the figures contained in the books of accounts but
it affects the people or the stakeholders that rely on those facts and the figures contained in
the financials for the purposes of making the decisions. These decisions include make or buy
decisions which are connected with the making or the buying of the products or whether to
make an investment into another company or not or to buy the machinery or plant etc or to
make any other capital investment. If the facts are wrong, then that may lead to bankruptcy of
the company (Xotels, 2019)
Meaning:
Due to an intense competition today, the companies are striving hard for the purposes of
reporting the cooked results instead of the actual results that would show the fair and the
accurate picture of the company. Hence the companies are now using earnings management
in which the selection of the GAAP methods would include the ones that would help in
depicting a good picture instead of the fair picture of the company. This includes the subtle
techniques such as the change in the reported earnings through the process of performance
timing. The management would want to reduce the expenses in the current period that may go
on to defer the scheduled routine equipment maintenance to the next month since the current
period has earned a lesser amount of profit and hence, if the company reports this expense in
the statement of profit and loss, then this amount would be lead to a more reduction in the

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amount of the net income. Also, the companies may go for the timing of performance
reporting. The recording of the inventory obsolescence is something which is required under
GAAP. An example of this includes the choosing of the record obsolescence which is open to
judgments. An example of this is that a part of the inventory has gone bad, then the
management of the company may go for the reporting of the loss to the next period since the
current period profit would be affected, if the same has been earned less ("What is earnings
management?", 2019).
The term earnings is just another way of expressing profit, which simply means the amount
derived at when expenses are subtracted from the amount of the revenue. Hence, the simplest
way of managing the earnings is by the way of changing dates of the revenues and the
expenses in the books of accounts. In order to increase the revenue in the current period, the
company could easily recognise the revenue that is expected to be earned in the future in the
current period. Or the expenses that would otherwise would have been reported in the current
period would be reported in the next period. In other words, if the company wants to defer the
profits to the next period, then it will have to recognise the revenue earned in the next period
or report the expenses in the current period.
The following are the techniques of manipulation of revenue:
 Cookie jar accounting. As per the rules of accounting, the company is required to
report the revenues that have been earned in the current period along with the
expenses that have been incurred during the same period. Hence, when the company
sells any asset with warranty, then the costs pertaining to the warranty shall be
recognised at the time when the sales are made. Also, when the company sells its
products on credit to the customers, then the value of the bill of the customer who has
not paid off the amount shall be reported as a bad debt expense. In case, the company
does not over estimate such of the expenses in the current period, then it will not be

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duty bound to report an increased expense in the future as well. Hence, the shift in the
amounts of the earnings from the current period to the future would take place. This
technique of revenue manipulation is termed as the “cookie jar accounting”. The
example in this include estimation of the pension costs and plans station of the
warranty expense etc ("Techniques in Earnings Management", 2019).
 Change in the accounting methods. In the majority of the book keeping practises of
the company, they are allowed to choose between the different reporting methods that
would serve them the best. The examples of such includes the system wherein the
company could use the method valuing inventory or chose the schedule to depreciate
the assets that the company. Over the long term period of time, the company could
sue different methods for doing the same thing time and again, but this is only
possible when the use of the different accounting policy would lead to better
representation of the financials or better picture of the company. The change in the
method of accounting leads to a major change in the earnings that have been earned.
If the company choses one method over the other, then that would mean that this has
affected the earnings of the company.
 One time charges. There are instances when the company has to charge a huge
amount to the project. This may be related with the writing off of the project of the
company that has failed. If these expenses are charged to the statement of income,
then that would mean a big hit for the revenue of the company and hence, the
company would always try to report such an expanse when the earnings of the
company are high. This way, it would be able to take a big one time charge to the
statement of profit and loss which could go on to use the opportunity to accelerate all
sort of the expenses that are required to be charged too. This is also termed as the “big
bath”. This is because the company is going to take a bath in the sense that it could

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suffer big losses. Therefore, it may take a big bath as get the future expenses out of
the way of the earnings possible. The examples in this include the disposal of
operations, restructuring of the operations and the restructuring of the troubled debt
("Management earning techniques", 2019).
The 2 types of revenue manipulation are the accrual earnings management in which there is a
segregation between the discretionary and the non-discretionary accruals. And the second is
the real earnings management which is the proxy variable for discretionary cash flow.
The role of the company affects the revenue manipulation to a great deal. This is because of
the fact that if the size of the company is big, then the goals of the company shall differ.
Hence, the smaller companies may be more inclined towards the use of the earnings
management so as to avoid reporting a loss in the given period of time. Whereas, the large
and the mid-sized companies would be more interested in keeping their earnings more steady.
Hence, the companies usually set their targets and they always strive to meet those
expectations and the targets. They do not want to exceed these expectations since that could
mean an increased future targets ("Types of Earnings Management in Accounting", 2019).
Auditor’s role:
Many studies have been undertaken for the purposes of understanding the role of the auditors
when it comes to the management of the earnings. There is a major relationship which exists
between the auditors and the earnings manipulation. There have been studies that have
indicated otherwise as well, in which it was found that is no relationship between the auditors
that affects the discretionary accruals of the company. Also, it was found in a recent case
study that there was a higher earnings manipulation when the companies changed its auditors
or switched them (Ismail, 2015).

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There is a certain part which is played by the auditors of the company which is in fact that if
the auditors carry on their duties and fulfil their tasks with the utmost responsibility and if
they apply their past experiences and the judgements in the most appropriate when it comes
to the conduct of the duties with regard to the auditing function in the company. These in fact
form the very basis or the foundation of the auditing function or as the base of the audit
function. If they carry out their role in the most apt manner, then they would be able to
discover the manipulation of the earnings and the various incorrect statements given in by the
management of the company to the auditor.
The former chairman of SEC, Arthur Levitt spoke openly about the negative impact of the
revenue manipulation of the companies. He was of the view that the companies include in
such of the kinds of practises when it wants to report a good amount of earnings for itself
when in reality, the performance of the company is very bad. The SEC has addressed this
problem through many accounting bulletins and hence, has provided guidance in order to
prevent the same. The auditors are in existence within the company and hence, they are the
ones that are best equipped with the skills and the knowledge that could prevent the revenue
manipulation being done by the company (""Auditors and Earnings Management" by
Jacksonh, Scott B.; Pitman, Marshall K. - The CPA Journal, Vol. 71, Issue 7, July 2001 |
Online Research Library: Questia", 2019).
The auditors are able to understand the revenue manipulation only when the motivations and
the method behind the abusive management of the revenue. The professionals are then able to
know if the company has done revenue manipulation or not. There could be many motives
behind the revenue manipulation of the company by the managers. The examples could
include the meeting of some to the contractual requirements or the augmentation of the
compensation based upon their performances. Whatsoever is the motivations, there are many
of the avenues to the management of the earnings, judgments, estimates and accruals.

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Additional abuses in the revenue manipulation could hamper the reputation of the companies
and they would become not worth investing money into themselves. There are some growing
concern with regard to the earnings management since they lead to loss of the public
confidence when it comes to the external financial reporting and it also affects the flow of
capital in the financial markets. The critics have stated that the manager usually abuse the
generally accepted accounting principles and also, distort the facts and the figures that have
been contained in the financial statements. The chairman had expressed his concern over the
negative impact on the quality of the earnings and on the financial reporting when the
company resorts to the earnings management (Tsipouridou, 2019).
The independent auditors are the only people that could help these companies in stopping the
revenue manipulation since they are in the possession of a great deal of knowledge of the
various accounting and reporting matters. They also have a direct access to the audit
committee of the company and to the board of directors that are entrusted with the
responsibility of scrutinising the decisions made by the management of the company. Even
more, the past decade has witnessed an increase in the effort to empower the audit committee
so that the members are able to discharge their functions of oversight responsibilities. The
auditors are the people or the professionals that are in the position to stop these abuses and
they could help in maintaining and in enhancing the public confidence in the financial
reporting ("Do auditors care about real earnings management in their audit fee decisions?",
2019).
Effect on audit procedures:
It is due to the earnings manipulations that the reputations of the auditors are at risk and their
reputation is affected. This is in light of the fact that there is as such no penalty for the

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manipulation of the earnings but the confidence on the auditors are affected when they are
unable to detect the stated fact (Elliot & Nelson, 2010) The auditors many times face of
dilemma since the clients consider a transaction as an income increasing one whereas the
auditors consider the same as an income decreasing one which results in the judgment of the
earnings downwards.
Means of reducing earnings management:
One of the ways to control the earnings management is the setting of more rigorous standard
on accounting to be followed by each company. This is due to the reason that the
management of the company will not be able to manipulate the earnings when there are
specific rules to be followed for each transaction. Considering the legal system to be weak
and in the absence of the accounting and the capital market infrastructure in the economies
today, the companies that are functioning in the emerging economies face these dilemmas
when it comes to the monitoring of the accounting decisions of the management. If the
accounting standards are introduced, then there would be an increase in the market liquidity
which would in turn improve the pricing efficiency of these companies ("Techniques,
Motives and Controls of Earnings Management", 2019).
But it is a topic of debate as to if the increased disclosures would go on to reduce the earnings
manipulation. It has been found that the companies that have adopted the IAS are more likely
to smooth out their earnings compared to the ones that have not adopted the IAS. The
economies all across the globe are working to apply the same set of standards to be applicable
on all of the companies today. More than 100 countries have already adopted the IFRS’s
today. The US Securities Exchange stated that it would allow the foreign companies to have
an access to the US market if these companies report under IFRS. In the European countries,
they have to prepare their consolidated accounts in line with the IFRS as on the date of the
balance sheet.

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The second way through which the earnings management could be reduced is the fact of the
corporate governance which signals the earnings management. The company should set up an
audit committee which is able to oversee the business practises that are being followed for the
purposes of the business. The board of directors will have to set an overall pricing and
provide an oversight of the business activities. If the financial records are not in line with the
accounting standards, then the management should be questioned and the responsible
employee should be penalised. Also, the auditors should be very vigilant when it comes to
performing their business functions. They should be wise when it comes to increasing the
quality of the reported earnings. This could be done by questioning the management about
the relevant accounting choices of the transactions (Caramanis & Lenox, 2017).
Evidence of earnings management:
The company chosen for the purpose of this assignment is HIH Insurance Limited.
The company was placed under liquidation as on March 15, 2001. The corporate and the
policies of the company include the professional indemnity, directors and the officers etc.
As per the press reports, the actuarial adviser had warned the company that it would face
some of the major consequences if it continues to indulge in the revenue manipulation. The
management of the company was being indulged in the complex reinsurance, under-pricing,
and reserve issues etc. The company was not in the condition to repay its future claims.
Instead of this, the company chose to lay off the risk by the way of buying reinsurance from
the other insurance companies.
The director of the company was charged with the following charges:
 Stock market manipulation in which the another company had purchased the shares of
HIH in 3 different instalments. The director of HIH of the other company to
misappropriate funds to another company.

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 The directors of the company persuaded the investors that the company’s shares were
undervalued and presented an opportunity for a quick amount of profit, but again this
information was false.
 He acted dishonestly in the sense that related party transactions took place and the
director did not disclose his financial interest in the other business ("HIH Insurance
Group collapse – Parliament of Australia", 2019).
Conclusion:
Hence, in the nutshell, there is an increased need to control the earnings management practise
which is being followed today. This could be done by the way of ensuring a better corporate
governance practise by the companies and also by the way of ensuring that the auditors
follow the stringent rules and regulations with regard to their ways through which they make
the judgments and estimates assumptions. If the auditors are able to determine the link
between the accounting principles adopted by the company and the transactions undertaken
by the company, then it is able to understand the fact of being involved in the earnings
management. It is imperative to control and reduce the earnings management since this leads
to the losing of control of the investors in the companies since the companies in order to
depict a better financial position of the company manipulates the earnings when in reality, the
same is not true. The manipulation of the earnings would lead to manipulation of the financial
records of the company. These are the records on which the investors base their decision of
making an investment or not, so when these are manipulated, the decision made would also
be incorrect or bad ("Earnings Management", 2019).

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The term earnings management has been defined in two different ways. The first being the
purposeful intervention in the process of external reporting with an intention of obtaining
some private gain and the second is the use of the judgement in the financial reporting and
also in the structuring of the transactions in order to alter the financial reports to mislead the
stakeholders of the company about the true financial position of the company and also, about
the underlying economic performance of the company and also to influence the contractual
outcomes that could depend upon the reported accounting judgments. In the majority of the
cases, the accounting of the accruals and the estimates and the adjustments help in calculating
the operating ash flows when it comes to the calculation of the net income which is the way
through which the desired earnings are calculated. The accruals include estimations, requires
the use of subjective judgments and are very tough when it comes to the verification of them
being their realisation. The auditors do carry on their procedures for the purposes of
understanding the basis on which the judgments and the estimations have been done by the
management but still there is a scope of an error. They still develop a reasonable range of
values for any account but many a times, they do no insist upon the exact estimate within that
range.

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References:
Caramanis, C., & Lenox, C. (2017). Audit effort and earnings management. Retrieved 5
October 2019, from https://www.marshall.usc.edu/sites/default/files/clennox/intellcont/
JAE08-1.pdf
elliot, J., & Nelson, M. (2010). Evidence from auditors with regard to earnings management.
Retrieved 5 October 2019, from https://www.jstor.org/stable/3203332?
seq=1#page_scan_tab_contents
Ismail, A. (2015). Auditors Roles Towards the Practice of Earnings Manipulation among the
Malaysian Public Firms. Retrieved 5 October 2019, from
https://www.sciencedirect.com/science/article/pii/S221256711501093X
Management, E. (2019). Earnings Management. Retrieved 5 October 2019, from
https://www.fraud-magazine.com/article.aspx?id=4294968448
What is earnings management?. (2019). Retrieved 5 October 2019, from
http://www.swlearning.com/pdfs/chapter/0324223250_1.PDF
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Management
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Xotels, P. (2019). What is the Definition Revenue Management?. Retrieved 10 October 2019,
from https://www.xotels.com/en/revenue-management/revenue-management-definition

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"Auditors and Earnings Management" by Jacksonh, Scott B.; Pitman, Marshall K. - The CPA
Journal, Vol. 71, Issue 7, July 2001 | Online Research Library: Questia. (2019).
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