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    Earnings Management and Creative Accounting

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    jaclyn3koh
    The document discusses creative accounting and earnings management. It defines creative accounting as selecting accounting methods to achieve desired results rather than being objective. Managers have incentives like meeting targets to "cook the books" through income smoothing, discretionary accruals, and other methods. While some see it as communicating information, overuse can mislead investors and erode confidence in financial reporting.

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    Earnings Management and Creative Accounting

    Uploaded by

    jaclyn3koh
    149 views13 pages
    The document discusses creative accounting and earnings management. It defines creative accounting as selecting accounting methods to achieve desired results rather than being objective. Managers have incentives like meeting targets to "cook the books" through income smoothing, discretionary accruals, and other methods. While some see it as communicating information, overuse can mislead investors and erode confidence in financial reporting.

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    Earnings Management and Creative Accounting

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    The document discusses creative accounting and earnings management. It defines creative accounting as selecting accounting methods to achieve desired results rather than being objective. Managers have incentives like meeting targets to "cook the books" through income smoothing, discretionary accruals, and other methods. While some see it as communicating information, overuse can mislead investors and erode confidence in financial reporting.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    149 views13 pages

    Earnings Management and Creative Accounting

    Uploaded by

    jaclyn3koh
    The document discusses creative accounting and earnings management. It defines creative accounting as selecting accounting methods to achieve desired results rather than being objective. Managers have incentives like meeting targets to "cook the books" through income smoothing, discretionary accruals, and other methods. While some see it as communicating information, overuse can mislead investors and erode confidence in financial reporting.

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    © All Rights Reserved
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    Download as pptx, pdf, or txt
    of 13

    EARNINGS

    MANAGEMENT AND
    CREATIVE ACCOUNTING
    CREATIVE ACCOUNTING: DEFINITION

    • Where those responsible for preparing accounts select accounting methods not
    objectively but according to the results desired by the preparers.
    • Accounts preparers can be creative, yet at the same time follow financial reporting
    standards.
    • Although they might not be objective, it might be difficult for parties such as auditors,
    with an oversight function, to claim that the financial report preparers are doing anything
    wrong.
    CREATIVE ACCOUNTING: A REVIEW

    • “Every company in the county (the UK) is fiddling its profits. Every set of public accounts
    is based on boods which have been gently cooked or completely roasted. The figures
    which are fed twice a year to the investing public have all been changed in order to
    protect the guilty….it is totally legitimate. It is creative accounting” (Griffiths, 1987).
    • Source: Creative accounting: how to make your profits what you want them
    to be.
    CREATIVE ACCOUNTING: A REVIEW

    • Managers were engaging excessively in premature revenue recognition in


    order to meet the expectations of Wall Street (Speech given by Arthur
    Levitt: “The numbers game”, 1998).
    • This argument was affirmed in 2002 by a series of accounting scandals
    involving companies engaging in premature revenue recognition through
    excessive manipulation of the latitude provided by accounting
    pronouncements. The scandals made the news headlines and eroded
    public confidence in the accounting profession.
    PWC 2016
    Securities
    Litigation
    Study
    THE TERMINOLOGY

    • Many terms can be used to describe the practices of changing the facts in accounting, e.g.
    cooking the books, aggressive accounting, massaging the numbers, window dressing,
    earnings management, etc.
    WHY FIRMS/MANAGERS “COOK THE BOOKS”?

    Firms & managers often have incentives to misstate earnings/balance sheet items:
    – Contracting incentives:
    • Avoid violating contracts
    • Maximize bonus (managers)
    • Avoid regulatory/government/union intervention
    • Avoid detection of managerial shirking
    – Stock market incentives:
    • Meet analysts’ targets
    - Political incentives:
    • Avoid political scrutinization
    WAYS TO DO IT

    • Income smoothing is the deliberate normalization of income in order to reach a desired trend or
    level.
    • Ways to do it:
    • Changing accounting policies
    • expenses. Managing discretionary accruals (Non-discretionary expenses refer to expenses that the business
    is obligated to pay. Both utility bills and wages to be paid to employees count as non-discretionary accrued
    Discretionary accrued expenses are expenses that the business is not obligated to pay but considers to have
    been incurred and not yet paid. Examples of discretionary accrued expenses are rare, but bonuses to be paid to
    management are an excellent example.)
    • Timing of adoption of new accounting standards
    • Changing real variables--R&D, advertising, repairs & maintenance
    • Structured transactions like SPEs e.g. Enron
    • Fraud like Worldcom capitalizing operating expenses
    THE GOOD SIDE

    • Managers may use earnings management or creative accounting as a vehicle for the
    communication of management’s inside information to investors
    • In this case, earnings management or creative accounting is useful from a financial
    reporting perspective
    • ’Good’ earnings management or creative accounting occurs when
    • Management knows that the long-term earnings prospects of the firm are better than the
    current non-managed earnings would imply
    • Management wants to improve the predictability of earnings by reporting a stream of smooth
    and growing earnings over time
    THE BAD SIDE

    Management may use earnings management or creative accounting to avoid:


    • Negative stock price reaction that follows, if investors’ expectations are not met
    • Reputational damage
    • Negative concequences on executive compensation.
    Management can achieve these goals by
    • Avoiding reporting losses
    • Meeting or beating analysts’ earnings forecasts
    • Taking actions that influence the reported earning
    MECHANISTIC OR BEHAVIOURAL EFFECT OF
    ACCOUNTING INFORMATION
    • Leftwich (1970) and Kaplan and Roll (1972) report on mechanistic or behavioural effect of accounting
    information. They provide the following logical explanation on what are mechanistic and behavioural effects:
    • Mechanistic hypothesis:
    • Market reacted mechanistically to changes in accounting numbers, regardless of whether they were cosmetic or
    whether they had cash flow implication.
    • It implies that cosmetic or creative accounting can fool market participants easily.
    • The “no-effect” hypothesis extracted from the EMH:
    • The market ignored accounting changes which had no cash flow consequences.
    • It implies that the creative accounting change was understood by the market participants, and they would not
    be fooled easily by the change.
    • On the other hand, if an accounting policy affected the cash flows, we would expect to see abnormal returns at
    the date of announcement
    CREATIVE ACCOUNTING-THE IMPLICATIONS

    • If overdone, creative accounting brings negative impacts to:


    • The company- Reported a higher profit/ greater wealth at the expense of long run
    sustainability.
    • The capital market- The overnight collapsed of corporate giant like Enron affected the
    investors’ confidence towards the capital market.
    • The financial reporting system- The public began to question the credibility of the financial
    reporting system.
    • The accounting profession- The profession lost its reputation in the public.

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