Earnings management occurs when managers use judgment in financial reporting and structuring transactions to alter financial...

 

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"Earnings management occurs when managers use judgment in financial reporting and structuring transactions to alter financial report to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers." Healy and Wahlen (1998). There are two methods that could be used for earnings management. First, one could use the flexibility allowed in generally accepted accounting principles (GAAP) to change reported earnings- without changing the underlying (past) cash flows, which Healy and Wahlen describe as usage of managerial judgment in financial reporting. This is called accounting earnings management. Second, a manager may change operating decisions, such as delivery schedule or maintenance, in order to manage the underlying cash flows that will affect the reported income reports, which is being described as structuring of t transactions by Healy and Wahlen. This kind of management is usually referred to as economic earnings management. According to Roman (2009), "Earnings management occurs when firm management has the opportunity to make accounting decisions that change reported income and exploit those opportunities". He also stated that accounting for business operations requires judgment and estimates. For example, one can't measure revenue without estimating when customers will pay, how many will not pay, how many will return goods for refund and costs to the seller for fulfillment of warranty or maintenance promises. Many writers restrict the term "earnings management" to the selection of estimates that achieve an earnings target and would not use the term to refer to timing of transactions. According to Roman (2009), earnings can be also be managed by timing of transaction. For example, management can decide to paint the office in December. All other things being equal, management will report lower earnings in that office painting period than in other periods. Management can choose when to paint and thereby, manage the earnings. In addition, management of a company that uses a LIFO cost flow assumption for inventories has an opportunity to manage earnings by timing end of year purchases. In times of rising prices, management can buy during this period which will increase the cost of goods sold and reducing income or delay purchases until the next period that will decrease this period's cost of goods sold and increasing income. Management can choose when to buy and manage earnings. Management has the ability to choose a number from a reasonable price range and be confident no one can say some other number is better gives them the opportunity to manage earnings. When management's number choice is made with an eye to its effect on net or comprehensive income, it is engaging in "earnings management". (Techniques, Motives and Controls of Earnings Management Md. Musfiqur Rahman Mohammad Moniruzzaman Md. Jamil Sharif 29th March 2013. Vol.11 No.l 2012 JITBM & ARF.) Required: a) Identify the factors that motivate earning management. How earning management has a negative effect on the quality of earnings for predicting future cash flows. (5 marks) b) Critically evaluate earning management within conventional GAAP flexibility? How does it differs from behavior that goes well beyond GAAP boundaries and into the dark realm of fraudulent financial reporting? (5 marks) c) Critically discuss whether a company should manage its earnings. Why a company managing earnings by using LIFO and FIFO inventory methods? (5 marks) "Earnings management occurs when managers use judgment in financial reporting and structuring transactions to alter financial report to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers." Healy and Wahlen (1998). There are two methods that could be used for earnings management. First, one could use the flexibility allowed in generally accepted accounting principles (GAAP) to change reported earnings- without changing the underlying (past) cash flows, which Healy and Wahlen describe as usage of managerial judgment in financial reporting. This is called accounting earnings management. Second, a manager may change operating decisions, such as delivery schedule or maintenance, in order to manage the underlying cash flows that will affect the reported income reports, which is being described as structuring of t transactions by Healy and Wahlen. This kind of management is usually referred to as economic earnings management. According to Roman (2009), "Earnings management occurs when firm management has the opportunity to make accounting decisions that change reported income and exploit those opportunities". He also stated that accounting for business operations requires judgment and estimates. For example, one can't measure revenue without estimating when customers will pay, how many will not pay, how many will return goods for refund and costs to the seller for fulfillment of warranty or maintenance promises. Many writers restrict the term "earnings management" to the selection of estimates that achieve an earnings target and would not use the term to refer to timing of transactions. According to Roman (2009), earnings can be also be managed by timing of transaction. For example, management can decide to paint the office in December. All other things being equal, management will report lower earnings in that office painting period than in other periods. Management can choose when to paint and thereby, manage the earnings. In addition, management of a company that uses a LIFO cost flow assumption for inventories has an opportunity to manage earnings by timing end of year purchases. In times of rising prices, management can buy during this period which will increase the cost of goods sold and reducing income or delay purchases until the next period that will decrease this period's cost of goods sold and increasing income. Management can choose when to buy and manage earnings. Management has the ability to choose a number from a reasonable price range and be confident no one can say some other number is better gives them the opportunity to manage earnings. When management's number choice is made with an eye to its effect on net or comprehensive income, it is engaging in "earnings management". (Techniques, Motives and Controls of Earnings Management Md. Musfiqur Rahman Mohammad Moniruzzaman Md. Jamil Sharif 29th March 2013. Vol.11 No.l 2012 JITBM & ARF.) Required: a) Identify the factors that motivate earning management. How earning management has a negative effect on the quality of earnings for predicting future cash flows. (5 marks) b) Critically evaluate earning management within conventional GAAP flexibility? How does it differs from behavior that goes well beyond GAAP boundaries and into the dark realm of fraudulent financial reporting? (5 marks) c) Critically discuss whether a company should manage its earnings. Why a company managing earnings by using LIFO and FIFO inventory methods? (5 marks)

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a Factors that motivate earnings management include executive compensation linked to reported earnin... View the full answer