The consequence of earnings management

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However, company’s earnings began to slip in 2000 and market condition became worse due to increased competition and reduced demand. Under this situation, to maintain its E/R ratio and meet Wall Street earning target, the company utilized accounting techniques to manage its earnings. 2. 0 Identification of issues Following issues are identified and analyzed in this report: Issue 1: What factors motivate managers in World to engage in earning management? Issue 2: Whether or not World crossed line from earnings management to fraudulent reporting? Issues: Why were the actions of World managers not detected ever a long time?

Issues: Why Cooper and Venison’s actions are so different in terms of ethical values? 3. 0 Analysis of Issues in World 3. 1 Earning Management Earning management is defined as “the process of taking deliberate actions within the constraints of GAP so as to achieve a desired level of reported earnings” (Cosmonauts, 2005, p. 31). It is closely associated with three factors which are existence of motivation, availability of earning management tactics and weak corporate governance which encourages earning manipulation (Same, 2010). There are different ways for managers to engage earning management.

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For example, accounting judgment can be used by managers to make financial report more informative for users. They also can choose make or defer expenditure and determine how to structure corporate transactions (Healy & Whalen, 1999). Managers manage earnings for different motivations which 1 can be divided into internal and external factors. External factors include pressure of meeting analysts’ forecast, contractual obligations, and avoidance of regulatory intervention and internal factors include pressure for meeting bonus and promotions (Duncan, 2001).

In terms of the consequence of earnings management, it can affect the credibility of financial information for shareholders, which can lead to major financial scandals, such as World (Man, 2013) 3. 2 Two Motivations in World One motivation for World manages to manage earnings is meeting capital market expectation. Managers usually manage earnings upward in order to avoid reporting earnings lower than analysts’ expectations (Burgomaster & Names, 2006).

They also manipulate financial figures to beat analysts’ forecast when these forecasts would not otherwise have been met. Senior managers in World chose to manipulate earning as they focused on achieving No. Stock in Wall Street to meet its expectations and maintain high stock value. Etched (2011) claimed that firms often have unusual strong stock price performance before committing fraud, which further pressure them to involve in fraud to avoid sacrificing high stock price. The other motivation for World managers is compensation and bonus arrangement.

Managers have opportunities to manage their income since they have inside information (Man, 2013). They are more likely to utilize income- increasing discretionary accruals to boost their current or future bonus if bonuses are increasing in earnings (Healy & Whalen, 1999). They can also choose to defer income when the earning objective in their bonus plan will not be achieved. Senior managers in World have generous stock options and overly generous compensation, which actually motivated them to boost their compensations by manipulating earnings. . 3 Methods of Earnings management in World Senior managers in World manage earnings in two ways, which are accrual release and capitalization of line cost. Line costs expense are significant cost for the company. The company released accruals in 1990 and 2000 and capitalize line cost in 2001 when the accruals were used up. More specifically, the company released line cost that had been reversed to cut reported line cost and it did not release excess accruals which have been identified.

To maintain 42% EIRE ratio, senior 2 managers also chose to identify the costs of excess net work capacity as a capital expenditure because they believed excess capacity will bring opportunities in future if demand are increased. Non-revenue-generating line expenses were also capitalized to increase reported income. The line costs are ongoing and operating expenses which should have been immediately recognized according to accounting principles. Instead of expensing the cost, World capitalized it to overstate its pre-tax income. . 4 Pressures leading managers to manage earnings The external pressure came from deteriorating industry condition in 2000 due to increased competition, overcapacity, and reduced demand during recession. Such pressure forced World to its price to match its competitors. However, it adversely affected its EIRE ratio which was viewed as the most important indicator. The internal pressure come from company’s target to meet Wall Street earning target, which makes revenue growth to became the center of company’s session.

The pressure also comes from the fact that the company entered into a long-term lease for network capacity to meet future customer demand, which resulted in increasing line costs. The company had to pay substantial termination fees for neutralized capacity when the demand was not as expected. Due to these pressures, senior managers in World chose to utilize accounting tactics to achieve its objective. 3. 5 The line between earnings management and fraudulent reporting There is a debate among researchers regarding the line between earnings management and fraud.

A prevailing opinion is that fraudulent reporting differs from earnings management because it is outside the scope of the GAP, whereas earnings management is within the scope of GAP as a form of earnings manipulation (Perils & Loge, 2011 Fraudulent reporting was defined as “intentional distortion of financial statements to conceal the misappropriation of assets or otherwise for gain” (Same, 2012, p. 31). It is clear from the definition that fraudulent reporting involves illegal acts against the regulatory framework. However, identifying a clear line is not easy because two terms are sometimes inherently interrelated.

Even if earning management is within the scope of GAP, it still have a positive and close relation with fraudulent reporting (Hosanna, 2008). Therefore, some researchers claimed that the only way to differentiate them is to understand motives behind 3 managers to decide whether the act is deliberate or accidental (Same, 2012). As for World case, there is no doubt that senior managers’ behaviors crossed line from legitimate earning management to fraud. Firstly, managers have deliberate motives to hide poor performance and overstate its revenue in order to meet market expectations.

This is not simply earnings manipulation nice managers behave opportunistically for their own private benefits rather than consider the welfare of stockholders (Same, 2012). In addition, a series of methods used to maintain EIRE ratio, such as improper capitalization of cost and drawn of reserves, are outside the scope of GAP. Such a “creative accounting can eventually turn into fraud if managers fails to achieve desired accounting figures (Jones, 2011). Furthermore, managers deliberately provide misleading reports to external auditors and restrict their access to information in order to hide its fraudulent acts.

All these indicate that managers were not just using the flexibility to manage earnings to achieve predetermined profits and objectives. 3. 6 Key factors relating to the failure to detect managers’ actions The failure to detect senior managers’ actions over a long term can be attributed to a series of factors. Firstly, the corporate culture in World is so weak and its legal function are less influential. For example, creating a code of conduct was not supported by the senior manager in World. Employees did not have an independent outlet to express their concerns about relevant policies and behaviors.

The implication of this failure is that there is no positive culture which encourage or support employee to report their concerns. Secondly, although Cooper as an internal auditor demonstrates his responsibilities, her actions for further detection was restricted by SCOFF Sullivan and encountered substantial resistance from her supervisor when she identified relevant issues. Also, the functioning of internal auditing in World was ineffective as it was understaffed, underpaid and under-qualified (Thornburg, 2004).

In terms of external auditor, Andersen did not exercised any professional skepticism. Although he identified the company as “maximum risk”, he did not hang audit approach and failed to further investigate accounting irregularities. He also failed to inform the audit committee when his access to information was restricted. The implication is that managers could continue to 4 hide fraudulent acts even though some questionable indicators are so obvious to detect. Thirdly, there is a lack of transparency and communication between senior management and the board of director.

Directors in World are not independent and CEO Beers has too much power over the board. Outside directors almost never attend the board’s meeting and never communicate with managers and employees. The implication is that there is no channel for employees to contact outside directors about any concerns even if they raised doubts. Such a failure of the board permits fraudulent acts to grow dramatically. Fourthly, compensation committee approved extraordinarily generous rewards for managers without analyzing the incentives designed.

It also provided enormous loans to Beers without informing the full board and taking actions to protect company. Therefore, managers’ actions to realize their own private benefits were not detected. On the other hand, audit committee showed little diligence for company’s internal financial workings. Its members did not exercise critical judgment on accounting and reporting issues. The implication is that the committee did not detect any irregularity and even was provided with false and misleading information from managers. 3. The comparison of Cooper and Vinson in terms of actions and motivations It is clear in the case that Cooper behaviors are in accordance with accounting standards and ethical values. She as internal auditor asked the company for further explanation of accounting irregularity and also brought the issue to the audit committee. Despite pressure from his boss, she still decided to conduct uncial audit to discover the fraud. In contrast, Vinson as accounting manager did not demonstrate ethical value when requested by her supervisor to make illegal accounting entries.

She initially disagreed but eventually followed her supervisor’s instructions. Such different actions can be attributed to different motivations. Cooper is a strong-willed person. His motivation to disclose the fraud is her adherence to principle and belief, which are doing things in accordance to ethical value and legal framework and her responsibility as an auditor to discover the truth. However, Vinson involved in illegal actions eventually because she was afraid of losing her job and worried about family livelihood. She is loyal to the company and also rely on Coffs reputation when making decision.

She was motivated by the reward and actually received a large bonus and 5 promotion after making illegal entries. 4. 0 Recommendations 4. 1 Processes and systems used for World to detect fraudulent actions The most critical process for World is to establish an effective internal corporate governance mechanism involving the board, audit committee, and compensation committee. Such a mechanism “serves the needs of shareholders by directing ND controlling management behaviors with good business practices, objectives, and integrity’ (Man, 2013, p. 92) More specifically, inclusion of more independent outside directors can help World to detect fraud due to increased communication and transparency. Man (2013) claimed that firms with extensive earning management are more likely to be controlled by insiders, which require more outside directors to reduce the likelihood of fraud. Additionally, audit committee can help World to discover manager’s opportunistic behaviors. This is because it provides independent monitoring for quality and credibility of financial information Man, 2013).

Also, as compensation is one of motivations for managers, the compensation committee could design proper compensation plan to ensuring both fairness and motivation for top managers to control their self-interested behaviors (Man 2013). As corporate culture is a factor in the failure of fraud detection, a positive corporate culture should be developed in World which encourages communication between different levels of management, employees, and the board. This is because each participant in the company has a interrelated role in a shared responsibility to detect fraudulent acts” (Center for Audit Quality, 2010, . 26).

This culture can also enhance collaboration among all stakeholders and encourage continuous efforts to detect financial reporting fraud in World (CA, 2010 An internal whistle blowing system can be developed in World to complement the company’s code of ethics. Lee (2012) claimed that an effective whistle blowing system serves in the timely detection of fraudulent acts and it permits the company to correct mistakes to minimize the risk of fraud. For example, the system in World should encourage anonymous reporting and provide 6 support for every participant, such as Cynthia Cooper who is the whistle-blower n the company. . 2 Alternative courses of actions if I were placed in Venison’s position Firstly, I would consult with other appropriate persons in World for help to obtain resolution. For example, I would consult with those charged with corporate governance, such as the board of directors or the audit committee who may have same concerns. Secondly, I would ask for professional advice from relevant professional bodies and legal advisers to obtain guidance for ethical issues if conflicts still can not be resolved. This could help me get out of the dilemma without breaching confidentiality.

Thirdly, I would search articles or other information on internet for the similar situation in other firms to learn how this dilemma can be dealt with. Last, if ethical conflicts still remain, I would choose to resign immediately after considering the significant consequence of such illegal actions on my future career and life. This is because an accountant should not merely satisfy needs of employers but also comply with legal framework and ethical value which are more important. Reference List 7 Burgomaster, D. , & Names, M. (2006). Management of earnings and analysts’ forecast SST to achieve zero and small positive earnings surprises.

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