The Nature of the Beast – Part 2

Introduction

In Part 1 of the article, the characteristics of accounting measurement and the flexibility in accounting regulation were discussed. In this part, the features and consequences of the resulting latitude in accounting measurement are outlined.

Management Latitude

Management latitude exists in two aspects – the operations of the entity and the accounting used. Entity operations, like advertising, building and equipment maintenance, contributions, employee training, quality control and research and development, can be curtailed or even rescinded to improve the portrayal of entity performance in the short term. Obviously, such activities cannot be postponed or eliminated for the long-term if actual management performance is not to be adversely affected. The list of such management operation choices is large and it is therefore too difficult to treat them here.

The focus in this article is on management leeway in accounting choices which leads to the management of the earnings to be reported to the users of accounting information. Ronen and Yaari (2008) define earnings management as

“a collection of managerial decisions that result in not reporting the true short-term, value- maximising earnings as known to management.”

The use of such latitude is divided into opportunistic earnings management and good earnings management. Research studies show that both are used in practice.

Good Earnings Management

The purpose of this type of earnings management is to improve the information about entity performance that is reported to the users of financial information. According to Scott (2012), an argument in favour of good earnings management is based on the ‘blocked communication’ concept of Demski and Sappington (1987a; 1990b). Current financial information is regularly used as an indication of future entity performance. Frequently, however, management has additional, quite relevant information about future performance, including new firm strategies, changes in firm characteristics, or changes in market conditions, which is sufficiently complex that its direct communication to outsiders is blocked. Earnings can be managed to reduce this blockage. Instead of disclosing this complex and costly information, discretionary provisions and reserves could be used to adjust current performance indications to reflect better future entity performance.

Opportunistic Earnings Management

This type of earnings management attempts to mislead accounting information users about the state of the entity. According to Scott (2012), standard setters and the market appear to adopt this view of earnings management with accounting standards trying to constrain as much as possible the extent of opportunistic behaviour.

Different names have been given to the opportunistic use of accounting flexibility. Examples are income smoothing, the numbers game, aggressive accounting, creative accounting, window dressing and juggling the books, with earnings management being perhaps the most widely used. A number of these are used in this paper. Manipulation in accounting has been a problem for centuries, but it became particularly problematic in the 20th century, when it contributed to a number of financial scandals.

Opportunistic earnings management has a negative effect on both its perpetrators and the reporting entity. Its consequences include increased top management turnover and poorer employment prospects of displaced managers (Desai et al, 2006), a fall in stock prices, less liquid markets for securities and a higher cost of capital (Dechow et al, 1994), and lesser likeliness of external financing and more reliance on private debt financing (Chen et al, 2009). Another consequence of financial statement fraud is increased regulatory control (Zabihollah, 2005). In fact, the Sarbanes-Oxley Act of 2002 was enacted in the U.S.A. to improve corporate governance, quality of financial reports and the credibility of audit functions.

One way to determine the extent of aggressive accounting is to compare reported earnings with a ‘true’ concept of income which, many believe, is represented by the Hicksian concept referred to in Part 1. Quoting Schipper and Vincent (2003), Mckee (2005) however claims that since ‘true ‘ earnings exist only as a theoretical concept, the extent of aggressive earnings management cannot be reasonably quantified.

Tim Keefe (Investopedia, accessed 5/12/2015) lists current and long-term accounts receivable, and property, plant and equipment as having a high degree of flexibility, contrary to accounts payable, long-term debt and investments in marketable securities. Schilit (2002) lists seven practices of earnings management. These include recording revenue too soon or of questionable quality, shifting revenue and current expenses between periods, and failing to record (or improperly decreasing) liabilities. All of these belong to the operating section of the income statement. Recent accounting standards issued by the IASB have dealt with the requirements related to these areas but the possibility of manipulation has not been totally eliminated. In its assessment of IFRS 15 ‘Revenue from contracts with customers’, issued in May 2014 to consolidate and simplify the requirements on revenue recognition, PricewaterhouseCoopers (PwC) stated that ‘Applying the new five-step model requires more judgement and estimates than today’ (PwC, 2014).

Manipulation in accounting measurement occurs, irrespective of whether historic costs or fair values are used. Historic cost accounting shenanigans have a long history, with many books and scholarly papers addressing the issues involved. Maneuvering with fair values has also occurred particularly with Level 3 valuations, where fair value is based on an estimate, very often using company specific methods which, no matter how scientific, involve high or low levels of judgement. Benston (2006) claims that Enron’s early and continuing use of Level 3 fair-value accounting was one of the causes of, and played an important role in, its demise. He concludes that, although historical cost accounting was certainly used by opportunistic and dishonest managers, ‘fair value numbers derived from company created present-value models and other necessarily not readily verified elements provide such people with additional opportunities to misinform and mislead investors and other users of financial statements.’

Earnings management is not limited to the large listed companies. Siming and Skerrat (2014) found that, on average, in the U.K., where each type of company follows different financial reporting rules, the earnings quality of listed companies is superior to that of medium sized companies, perhaps because the latter have a lower demand for their public information and a higher cost of supplying it. The earnings quality of small companies was found to be similar to that of listed companies, probably reflecting their lack of incentives to manage earnings.

The Accounting Continuum

It was stated above that it is very difficult to quantify the extent of earnings management. The conventional practice is to adopt the accounting choices that fall within the framework of GAAP. However, there is no ‘bright line’ in GAAP to tell managers what is and what is not acceptable in the measurement of entity performance. Management is simply expected to make choices that appropriately reflect a company’s economic performance. Dechow and Skinner (2000) placed the accounting choices available to management in an accounting continuum distinguishing those that violate GAAP from those that do not. McKee (2005) broadens the Dechow and Skinner (2000) model by introducing the further stage of ‘overly aggressive accounting’. Figure I gives a brief explanation of the stages highlighted in the two models.

Accounting Continuum Explanation GAAP
1 Conservative Accounting The term conservatism is generally used to mean that accountants should report the lowest of several possible values for assets and revenues and the highest of several possible values for liabilities and expenses. It also implies that expenses should be recognised sooner rather than later and that revenues should be recognised later rather than sooner. Therefore, net assets are more likely to be valued below current exchange prices than above them, and the computation of income is likely to result in the lowest of several alternative amounts. Thus, pessimism is assumed to be better than optimism in financial reporting (Hendriksen and Van Breda, 1992). Within GAAP
2 Neutral Accounting Neutrality refers to the absence of bias in the presentation of accounting reports or information. Thus, neutral information is free from bias toward attaining some desired result or inducing a particular mode of behaviour. This is not to imply that the preparers of information do not have a purpose in mind when preparing the reports; it only means that the purpose should not influence a predetermined result (Belkaoui, 1992).
3 Aggressive Accounting A business practice in which certain misstatements are made on balance sheets and in financial disclosures with the goal of making a company appear economically stable (Wisegeek, accessed 31/10/2015)
4 Overly Aggressive Accounting This is the same practice as in (3) but the level of aggressiveness is inordinate. Violate GAAP
5 Fraudulent Accounting Financial fraud has been defined as ‘the intentional, deliberate misstatement or omission of material facts, or accounting data which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision. (National Association of Certified Fraud Examiners, 1999)

Prudence’ is the guideline in the adoption of accounting policies especially if these are not backed by facts. However, a grey area lies between (3) and (4) above. Where the distinguishing line is drawn depends on the circumstances of each case. What is (3) in one case can be considered (4) in another.

Factors Giving Rise to Earnings Management

  • Agency Relationships and Information Asymmetry

    An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to them. The primary agency relationships in business are those between shareholders and managers and between debt holders and shareholders. A possible situation in agency relationships is the existence of asymmetrical information between the agent and the principal, where the agent has more or better information than the principal. This creates an imbalance in power and sometimes causes the transaction to fail as when the agent uses his superior position to ‘cook’ the information given to his principal.

  • Quality of the Audit Process

    Auditing can serve as a monitoring device that will reduce managers’ incentives to manipulate reported earnings. If the auditing is deficient, however, reporting methods that do not adequately reflect the true state of the reporting entity can be used.

  • Flexibility in Accounting Rules

    This has already been dealt with in the first part of the article and is perhaps a predicament that cannot be avoided. Healy and Wahlen (1999) stressed that

    “accounting standards must ensure an adequate reconciliation of rigidity and flexibility requirements.”

    They argue that the adoption of excessively rigid accounting rules could lead to applications that are poorly adaptable to the variety of possible cases. On the other hand, excessive flexibility, loosens ‘the mesh of accounting options and possible treatments’, through greater subjectivity in accounting estimates.

Incentives to Engage in Earnings Management

Management engages in earnings management because there are incentives for doing so. In the absence of such incentives, management would make the accounting choices and decisions that fairly report operating performance. The following three types of incentives are listed by Jacksonh and Pitman (2001):

  • Contractual Incentives

    These arise when contracts between a company and other parties are based on the results as shown by accounting numbers. A major contractual situation that could stimulate management earnings is a debt covenant, especially where the firm is required to maintain pre-established interest coverage and liquidity ratios. Other contractual situations arise where there are management compensation agreements, job security factors and union negotiations.

  • Market Incentives

    These gain importance when management becomes aware that the reported accounting numbers will have an adverse effect on the entity’s rating. Situations that can give rise to such incentives are initial and seasoned public offerings, management buyouts, the perceived non-achievement of earnings forecasts or the missing of analysts’ earnings expectations.

  • Regulatory Incentives

    The management of earnings can influence political scrutiny and the effects of regulation. Banking regulations, for example, use accounting numbers to determine compliance with capital adequacy ratios. Banks that are close to regulatory minimums have an incentive to manage their earnings to try to avoid non-compliance and the costs of increased regulation.

    Earnings management can also be used to influence such factors as the amount of tax to be paid, and the possibility of new business competition.

Reducing the Incidence of Aggressive Earnings Management

Different suggestions have been made to reduce the existence of and scope for earnings management. These deal mainly with the three important accounting aspects of the regulatory process, an appropriate and effective audit procedure and valid and efficient corporate governance. The findings of research on these three aspects have generally given conflicting results.

As regards the regulatory process, basing their research on IFRS first-time adopters in Australia, the UK (both Common Law countries with an important equity market) and France (Code-law country), Jeanjean and Stolowy (2008) found that the pervasiveness of earnings management did not decline after the introduction of IFRS and, in fact, increased in France, making them conclude that management incentives and national institutional factors play a more important role. Regarding the rigidity in accounting standards, Tan and Jamal (2006) found that strict accounting standards relating to discretionary accruals may reduce earnings management but could increase real activity earnings management.

In the case of the audit procedure, Kim et al. (2003) found that Big 5 auditors were more effective in restricting earnings management but Yasar (2013) found that, in Turkey, there is no difference in audit quality between Big-Four and Non-Big-Four audit firms.

When it comes to corporate governance, research showed that board and audit committee activity and their members’ financial sophistication may be important factors (Xie et al, 2003) while, within the Latin American context, the role of external directors is limited and that greater frequency of board meetings and a lower concentration of ownership reduce the incidence of manipulative practices (Gonzalez and Garcia-Meca, 2014).

It has to be stated that the above three aspects complement each other and better results would be achieved through a combination of all three methods.

An aspect that directly impinges on the question of aggressive accounting, but which has not been given its due importance in the accounting literature, is the personal behaviour of the accountants and other preparers of accounting information. It has to be accepted that accounting rules and regulations are only inanimate guidelines. They are given life by the person(s) who has (have) to apply them and that the personal character of the individual is crucial. Ethics and ethical behaviour have assumed an important role in accounting practice and accounting education, although few authors have taken into consideration the character of the accountant when it comes to ethics and decision-making (Mele, 2005). Such a dimension needs to be studied further in the future.

Conclusion

Aggressive accounting is the result of the characteristics accounting and the flexibility in accounting rules. The question is often asked whether financial accounting regulators and standard setters could ever outsmart and control the actions of the financial engineers. According to Glover (2013), the short answer is ‘no’ if the process is approached as a design fight between the standard setter and financial engineers. This is to be expected if managements can benefit from the managing of earnings. Earnings management should, however, be kept under examination since it could mean the wasteful use or inappropriate allocation of society’s resources. This makes investors and other stakeholders spend more of their resources searching for better information or resort to private investigation.

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