Earning Management and Creative Accounting

CREATIVE ACCOUNTING
DEFINITIONS
INCENTIVES
TECHNIQUES
IMPLICATIONS AND CONSEQUENCES
INTEGRITY AND ETHICS
DEFINITIONS
The exploitation of loopholes in financial legislation in
order to gain advantage or present figures in a
misleading favourable light
(The Oxford Dictionary, 1991)
The flexibility in the accounting process (involving
matters of judgement and of resolving conflicts between
competing approaches) provides opportunities for
manipulation, deceit and misrepresentation which if
practised by the less scrupulous elements of the
accounting professionis known as creative accounting.
INCENTIVES
Twofold purpose of Creative Accounting:
1. To stop shareholders from withdrawing capital
2. A means of reporting favourably on stewardship and
performance when stewardship reporting is seen as
paramount. (after all, overall numbers are the same except
they just come out at different times).
Reasons why companies practice Creative Accounting:
1. Pressure placed upon management to show favourable returns
on their investors money
2. Due to vagueness and flexibility of accounting standards and
legislation
TECHNIQUES
Some of them are:
1.
2.
3.
4.
5.
6.
7.
8.
Extraordinary Items
Income Recognition
Smoothing Expenses
Fixed Assets
New management and the Big Bath
Off-Balance Sheet Finance
Acquisitions
Goodwill and Brands
4
IMPLICATIONS AND CONSEQUENCES
1.
Credibility of the accounting profession

expectation gap
interpretative gap
unreliable accounting standards
2.
It hurts not just the shareholders (exposed to unseen

risks) but also the country as a whole where in the end
the economy suffers (share prices fall) as investors look
elsewhere.
ETHICS
Is creative accounting ethical????

o Exploiting loopholes is not using the legislation
as it was intended and is unethical.
o Gaining advantage or presenting figures in a
misleading manner is also logically unethical,
as it harms users by portraying a view that is
distorted and exaggerated.
6
Alternatively, creative accounting in itself is not necessarily

all bad.it can be viewed in a positive light:
o Large corporations with a monopolistic position need to
smooth income patterns to avoid the attention of
authorities or lobby groups with a political agenda
o Companies in volatile markets may seek to flatten spiky
results that would otherwise spook investors.
o Companies in less comfortable position may seek to
maintain debt finance and the financial support of
creditors to attain attractive debt ratios and high
profitability margins which in the end benefit their
investors.
7
EARNINGS MANAGEMENT (EM)
Good EM
Patterns
of EM
Motivations
for EM
Implications
for accountants
Bad EM
DEFINITION
Earnings management is the choice by a manager
of accounting policies (e.g. revenue recognition
and depreciation policies) or in discretionary
accruals (such as inventory values and timing and
amounts of non-recurring and extraordinary items)
so as to achieve some specific objective .
(However, EM may also be done by means of real
variables such as R&D, maintenance, timing of
disposals of capital assets, etc.)
Too much EM..

EM is made possible by the fact that GAAP do not completely
constrain managers choices of accounting policies and
choices are often motivated by strategic considerations
such as meeting earnings expectations. Nevertheless,
some managers may abuse the communication potential
of GAAP by pushing EM too far. Too much EM:
o reduces the ability of investors to interpret current net
income and may reduce its usefulness as an indicator in
evaluating future firm performance.
o affects the managers motivation to exert effort as they
can use EM opportunistically to smooth their
compensation over time, thereby reducing compensation
risk.
10
From a financial reporting perspective .

o
Managers may..
use EM to meet analysts earnings forecasts, thereby
avoiding the strong negative share price reaction that
quickly follows a failure to meet investor expectation
record excessive write-offs, or emphasize earnings
constructs other than net income, such as pro
forma earnings.
use EM to create a stream of smooth and growing
earnings over time. Thus, EM can be a vehicle for
the communication of managements inside
information to investors.
11
From a contracting perspective

o
EM can be used as a way to protect the firm from the

consequences of unforeseen events when contracts are
rigid and incomplete.
Managerial compensation contracts that allow some EM

can be more efficient than ones that do not due to the
high costs of eliminating EM completely.
12
PATTERNS OF EM
o
o
o
o
Taking a bath (during periods of organisational stress)

Income minimization (political visibility during periods
of high profitability and income tax considerations)
Income maximisation (bonus purposes or close to debt
covenant violations)
Income smoothing (risk-averse managers prefer a less
variable bonus stream so as to receive relatively
constant compensation)
These various EM patterns may be in conflict. Even at a
given point in time, the firm may face conflicting needs
to reduce reported net income for political reasons,
increase it to meet analysts forecast or smooth it for
borrowing purposes.
13
OTHER MOTIVATIONS FOR EM

o
To meet investors earnings expectations

Firms that report earnings greater than expected typically
enjoy a significant share price increase.
Conversely,
those that fail suffer significant price decrease.
Debt contract motivations
Debt contracts typically depend on accounting variables
arising from the moral hazard problem between manager
and lender. EM may be used as a device to reduce the
probability of covenant violation (i.e. against lenders best
interest) in debt contracts.
Initial public offerings (no established market price)
Managers of firm going public may manage earnings
reported in their prospectuses in the hope of receiving a
higher price for their shares.
14
THE GOOD SIDES OF EM

The blocked communication concept of Demski
and Sappington (1987) where EM can be a
device to convey inside information to the
market, enabling share price to better reflect
the firms future prospects i.e EM is used as a
way to communicate blocked inside information
to the market. The market cannot unravel this
EM since it is based on inside information about
sustainable earning power.
However, the
market can use the EM to infer what this inside
information is.
15
THE BAD SIDES OF EM

o
Opportunistic EM from opportunistic manager behavior

when they use EM to e.g. maximise their bonuses.
Do managers accept securities market efficiency?

Managers emphasis on pro-forma earnings suggests
they do not accept market efficiency.
Contracting variables do not completely reconcile
economic consequences and market efficiency i.e.
accounting policies without cash flow effects can matter
to managers simply because they believe that the
market will not see through them.
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IMPLICATIONS FOR ACCOUNTANTS
The accountants tread a fine line between earnings

management and earnings mismanagement. Ultimately,
the location of this line must be determined by effective
corporate governance, reinforced by securities and
managerial labour markets, standard setters, securities
commissions, and the courts.
Accountants need to be aware of the legitimate needs of

management as well as of investors. Actual financial
reporting represents a compromise between the needs
of these two major constituencies.
17
CONCLUSIONS
Whether EM is good or bad depends on how it

is used.
Thus, the possibility that EM can be good
should not be used to rationalize misleading or
fraudulent reporting.
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Earning Management and Creative Accounting

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What are some incentives for companies to practice creative accounting?

What are some incentives for companies to practice creative accounting?

What are some techniques used in creative accounting?

What are some techniques used in creative accounting?

CREATIVE ACCOUNTING

IMPLICATIONS AND CONSEQUENCES

Credibility of the accounting profession

It hurts not just the shareholders (exposed to unseen

Is creative accounting ethical????

Alternatively, creative accounting in itself is not necessarily

EARNINGS MANAGEMENT (EM)

Too much EM..

From a financial reporting perspective .

From a contracting perspective

EM can be used as a way to protect the firm from the

Managerial compensation contracts that allow some EM

Taking a bath (during periods of organisational stress)

OTHER MOTIVATIONS FOR EM

To meet investors earnings expectations

THE GOOD SIDES OF EM

THE BAD SIDES OF EM

Opportunistic EM from opportunistic manager behavior

Do managers accept securities market efficiency?

IMPLICATIONS FOR ACCOUNTANTS

The accountants tread a fine line between earnings

Accountants need to be aware of the legitimate needs of

Whether EM is good or bad depends on how it

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