YEAR I SEMESTER I ACADEMIC YEAR 2017/2018
MASTER OF BUSINESS ADMINISTRATION
MBS7101: FINANCIAL ACCOUNTING
NAME: MANZI RONALD MARTIN
REGISTRATION NUMBER: 2017/HD06/2690U
STUDENT NUMBER: 210001093
Aggressive earnings management
The threat of aggressive earnings management will always be with us. Those involved in all aspects of corporate reporting must never lose sight of this fact. Sometimes it will be more evident, other times it will be less, but all of those involved in the whole system of regulation, governance, accounts preparation, audit, review and interpretation must be constantly vigilant.
You have been appointed a board member in a multinational commercial bank, and have been asked to prepare a report to be presented in the next board meeting, discussing in detail the particular factors that motivate preparers of financial statements to manage earnings aggressively.
CB Commercial Bank
CBL Central Bank of Uganda
GAAPGenerally accepted accounting principle
IAS International Accounting Standard
IFRS International Financial Reporting Standard
LLP Loan Loss Provision
UAAA Ugandan Accountants and Auditors Association
USM Ugandan Stock Market
The major source of information in assessing the performance of any organisation is a financial statement. The financial report is a formal record of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form easy to understand. According to the Indonesian Institute of Accountants (2009), financial statements are the result of the accounting process that aims to provide information about the financial position, performance, and current companies that benefit the majority of users report in order to make economic decisions and demonstrate accountability (stewardship) management on the use of resources entrusted to them. User information includes financial statements: investors, employees, lenders, suppliers, customers, government, and society in general.
Useful information is relevant and reliable information; being reliable means information is complete, neutral, and free from error. A fundamental responsibility of management is to provide high quality financial reporting (Atik and Ismail, 2011). In other words, in order to be accountable, management has to provide quality information and act ethically, or, in the words of Cotter (2012), to “discharge its responsibilities honestly”. Financial information of quality may also be characterised as information that is useful for the decision-making process.
The information contained in the financial statements is information on profits. Earnings or profits are often used as a basis for decision-making of various stakeholders, such as use as a base to give bonuses to managers, are used as the basis for calculating the taxable income, and also worn as work assessment Criteria Company (Nurdiniah and Herlina, 2015). Therefore, it is often also managers take advantage of opportunities to manipulate earnings figures with engineering accrual to affect the outcome of various decisions such as motivation bonus, considered to perform better or to minimize the burden of income tax to be paid by the company.
Nevertheless, the accrual basis in the financial statements provides an opportunity for managers to modify the financial statements to generate profits (earnings) desired. Generally accepted accounting principle (GAAP) or generally accepted accounting principles also provide flexibility for managers to choose accounting methods that will be used in preparing the financial statements. This is consistent with the positive accounting theory which allows the manager to choose a particular accounting method. Actions that can make financial reports to be good, action is often referred to as the earnings management.
Earnings management performed by the manager arises because of the agency problem is the conflict of interest between owners / shareholders (principals) with manager / management (agent) as a result of not meeting the maximum utility among them because management has more information about the company from the shareholders that occurs asymmetry of information that allows management accounting practices oriented towards profit to achieve a certain performance. Agency conflict that resulted in the management of opportunistic actions that reported earnings is false, will lead the company’s value is reduced in the future.
There are various motivations that supposedly underlies and encourage a manager behave opportunistic. Motivations will affect the pattern of managerial engineering by management organisations like banks. Positive accounting theory has three hypotheses that form the basis of the main motivations that managers perform earnings management bonuses, contract debts and political costs (Nurdiniah and Herlina, 2015). In the bonus motivation stated that the management will get a bonus if certain corporate performance targets. Promise this bonus will motivate managers to manage earnings at a certain level in accordance with the required limit. In this case, the manager will perform earnings management by increasing profits in order to obtain greater compensation from the company. The second motivation is motivation debt contract. Managers will conduct aggressive earnings management to prevent violations of the debt contract. Managers do earnings management by increasing earnings to avoid violating the debt limit. Last motivation is political costs which larger companies will do more policies that will lead to decreased profits for the purpose of reducing the political effects.
This report is indented to answer the following question
What are the perceived motivation factors behind the earnings management practices in Commercial Banks?
Complete financial statements typically include a balance sheet, income statement, statement of changes in equity, statement of changes in financial position (which can be expressed in various ways for example, as a cash flow statement / funds flow statement), notes and other statements and explanatory material that are an integral part of the financial statements.
According to the Indonesian Institute of Accountants (2009), the objective of financial statements is to provide information concerning the financial position, performance and changes in financial position of an enterprise that is useful for a large number of users in making economic decisions.
A Financial report is required by each company to determine the progress and setbacks of its efforts. The financial statements are also used as the basis for determining or assessing the financial position of the company. Through analysis of the financial statements, interested parties can make decisions on whether to invest in the company or not.
Financial reporting represents the means by which managers are able to communicate information about their firm’s performance to the users. In the preparation of financial reports, managers are given some room to exercise their own judgement to determine the amount of some figures e.g. the provision for bad debts (Holland and Ramsay, 2003). Although this flexibility provides managers with the opportunity to make accounting estimates based on their “knowledge of the business” which may increase the financial information’s usefulness, it also opens the door for earnings management (Holland and Ramsay, 2003).
According to Mohanram (2003), earnings management has become a significant issue in today’s stock markets; “hardly a day goes by without mention of a large firm that misled investors through the intentional mis-statement of the financial statements” (p.1). He also added that it is of great importance for investors and other stakeholders to understand what earnings management is, what the consequences are and why it happens (Mohanram, 2003). Nelson et al. (2003) suggest that a better understanding of earnings management could: (a) help regulators and standards setters to identify weak areas that need to be tightened; (b) assist auditors in evaluating and reporting on earnings quality as well as training newly qualified auditors about earnings management; (c) enable CEOs, CFOs, audit committees, and investors to focus on areas of the financial statements where they should be most skeptical; (d) enable managers and audit committees to anticipate areas that investors will put under scrutiny; (e) help educators teach the subject; and (f) encourage researchers to focus on understanding the reasons for and implications of earnings management.
Earnings Management Techniques
Earnings management techniques vary according to earnings management types; accounting earnings management clearly uses different methods from those used by economic earnings management. Ortega and Grant (2003), classified the accounting earnings management techniques that can be used by firms as follows: (a) premature revenue recognition, where management could record revenues early in order to boost current earnings; (b) operating expense timing, where management may delay expenses to the next year if the company is experiencing low performance; and (c) unrealistic assumptions to estimate liabilities, for example if management manipulates their liabilities estimation on current year performance and if current year performance is low, then management may make an unrealistically low estimate, say for the bad debt allowance, and by contrast when economic performance is doing well, management may tend to use high estimates for liabilities allowances. By contrast, economic earnings management uses real operating decisions, where business decisions are taken in the normal course of the business, for example, when sales are below average, management could decrease prices so as to raise sales volume in an attempt to reach the targeted earnings (Ortega and Grant, 2003). Another example of economic earnings management is provided by Bartov (1993) who concludes that managers manipulate reported earnings through selling fixed assets and investments. In their study of more than 400 executives, Graham et al. (2005) concluded that economic or real earnings management is the preferred type by managers, as they point out that “most earnings management is achieved via real actions as opposed to accounting manipulation” (p. 66). However, such a practice could affect the “firm’s long-term interest” and therefore, it might be costly (Man and Wong, 2013, p. 400). Real earnings management, according to, Zhao et al. (2012), “is more likely to entail substantial costs to shareholders” as it implies that the firm sacrifices its “longer-term cash flows” (p. 112).
In general, earnings management may involve a company manager intervening or influencing the information in the financial statements for the purpose of deceiving the stakeholders who want to know the performance and condition of the company. Managers can choose several accounting policies for calculating earnings without violating GAAP (Generally Accepted Accounting Principles).
According Sulistyanto (2008), earnings management is done by playing the components of
accruals in the financial statements, because the accrual component can be a numbers game through the accounting method used in accordance with the wishes of the person doing the recording and preparation of financial statements. Accrual component is one that does not require proof of physical cash so, toying with the size of the accrual component does not have to be accompanied by cash received or issued by the company.
Based on the above understanding, it can be concluded that earnings management is an intervention in the external financial reporting process with a view to personal gain. Earnings management is done with the purpose of manipulating the users of financial statements. This understanding is consistent with agency theory which states that the separation of ownership and management of the company will encourage managers to seek for maximum welfare, although they have to manipulate the data to other parties.
According to Sulistyanto (2008), accrual accounting is divided into two components, namely discretionary accruals and non-discretionary accruals. Discretionary accruals are the accrual component of management engineered by utilizing the freedom and flexibility in the use of estimates and accounting standards.
Non-discretionary accruals are an accrual component obtained naturally from the accrual-basis of accounting standards. An example of non-discretionary accruals is the determination of depreciation and inventory which must follow the methods that are recognized in the accounting principles. Whereas in the more discretionary accruals, freedom is given making it easier to be toyed with the managerial policy. Total accruals consist of a number of discretionary accruals and non-discretionary accruals.
In the bonus plan or managerial compensation, the owner of the company promises that the manager will receive a bonus if the actual performance of the company is above the average.
Managers will use discretionary accruals when maximizing short term bonus compensation. Different managers will observe income before discretionary accruals based on their respective incentives for instance; 1.) When income before discretionary accruals is sufficiently below the lower limit or above the upper limit, managers will make income- decreasing discretionary accruals in anticipation of increasing probability of earning a bonus in the future. 2) When earnings before discretionary accruals fall between the upper and lower limit, a manager will make income – increasing discretionary accruals. (Healy 1995).
Managers have competing incentives to engage in earnings management other than bonus motivation for instance reputation, stock ownership and stock based compensation. In settings where incentives to smooth earnings dominate incentives to engage in bonus maximization behavior, it is more difficult to detect an association between managers’ short term bonuses and their earning management decisions. The benefits from smoothing earnings are greater than those of maximizing profits. (
Motivation Debt Contracts
Based on the hypothesis of a debt contract, the company will conduct an aggressive earnings management to prevent violations of the debt contract (Watts, Zimmerman, 1986). Therefore, the amount of debt the company has will motivate management to manage earnings.
According to Septa Dwi Aryani (2011), debt variables can be measured by leverage. Leverage is the ratio of total liabilities to total capital of the company. The greater the leverage ratio, the higher the value of the company’s debt. This size is strictly related to the presence and absence of a debt agreement. Management will increase the profit (income increasing accruals) to avoid breaching the debt limit. The greater the leverage to be owned by the company, the greater the motivation of managers to manage earnings.
Motivation Political Cost (Size Company)
Firm size is a scale in which large and small companies can be classified. Watts, Zimmerman (1986) in the positive accounting theory states that the size of the company can be used as a baseline for the political costs and political costs will increase with firm size and risk. Firms will want to reflect lower profits by using earnings management so as not to attract the attention of politicians who may make regulation targeting high profit firms. On the other hand, some political legislation may be in favor of large and high profiting firms which may not call for earnings management techniques. Thus, the political cost motivation can influence managers’ decision in managing earnings basing on the political atmosphere of where the firm is located.
Earnings Management in the Banking Industry
Bank managers are much more concerned about earnings stability and growth; therefore it is anticipated that bank managers are engaged in earnings management (Bhat, 1996). Banks generally represent a significant proportion of total listed companies which means that banks have an influential role in the capital market (Kanagaretnam et al. 2010). Shen and Chi (2005) stressed the importance of banks and describe the banks’ share in the capital market as “typically large”. Moreover, banks play a vital role in economic development, with investors and regulators monitoring banks’ performance on a regular basis; the former for monitoring share prices, the latter to assure the robustness of a banking system’s financial soundness. As a result, reported earnings growth remains one of the key pointers that demonstrate a bank’s performance and financial stability which ultimately suggests that bank managers may be inclined to smooth earnings volatility over periods. By earnings management in general and income smoothing in particular, bank managers can help to sustain the appearance of a robust financial position as well as meeting legal requirements (Taktak et al., 2010a). It has been suggested that income smoothing is a continuing practice that is employed by banks (Bhat, 1996). Moreover bank managers are accused of being more likely to indulge in earnings manipulations compared to others (Leventis, 2011).
For instance, Bhat (1996) suggests that bank managers exercise income smoothing for a number of reasons: (a) to enhance the risk perceptions of the bank to its investors and regulators; (b) to support managers’ efforts in maintaining their compensation schemes; (c) to satisfy shareholders where income smoothing will enable managers to afford a constant stream of dividends; and (d) to provide low quality managers with a good chance of delivering an image of high quality management to investors where measuring management’s quality is difficult. Also, bank managers may smooth earnings to reduce tax payments and improve share prices.
Shen and Chi (2005) list three factors that demonstrate the importance of studying earnings management in the banking industry. First, banks at all times fear a potential problem of illiquidity that puts them under the risk of extensive bank runs. Therefore, with the intention of retaining depositors’ confidence, banks resort to earnings management practices in order to avoid negative earnings.
Second, they cite Morgan (2002) who says that: “… uncertainty over the banks stems from their assets, loans and trading assets in particular, the risks of which are hard to observe or easy to change. Banks’ high leverage compounds the uncertainty over their assets; their assets present bankers with ample opportunities’ for risk or asset substitution, and their high leverage inclines them to do so.” Therefore, bank managers have a high incentive to manage earnings to hide asset substitution behaviour.
Third, banks are highly regulated organizations in which a non-performing loan ratio, among other things (i.e. capital adequacy ratio, liquidity ratio, etc.) is firmly regulated. Therefore, earnings management could be adopted in order to avoid regulations’ breach. According to Kanagaretnam et al. (2010) a bank’s LLP is the proper approach to study earnings management in the banking sector for two reasons. First, given the considerable discretion that is allowed by GAAP, bank managers may use this flexibility in using LLP for earnings management. Second, LLPs are considered to be major accrual items in banks accounts that provide bank managers with sufficient leeway in manipulating earnings.
Earnings management continues to be a problematic issue in the financial reporting context (Man and Wong, 2013) and an important topic that concerns a wide range of stakeholders including regulators, investors and managers (Achilles et. al., 2013). Its importance, according to Man and Wong (2013), stems from its negative effects on the financial statements as it “may undermine the credibility of financial statements” (p. 400). It involves deliberate management intervention in the financial reporting process to misstate the reported earnings to achieve certain rewards (Foster and Shastri, 2013). This managerial behavior, according to Aerts et al. (2013) is mainly incurred for “the benefit of insiders” by acting as to “mislead outsiders’ perceptions” about the firm’s financial performance (p. 94). Although earnings management might be used to make information more informative for outsiders, however it is still questionable. Aerts et al. (2013) argued that:
“Management’s motives for earnings management are, however, not transparent from reported numbers, both manipulative opportunistic and communicative informative earnings management are likely to feed ex ante uncertainty of users with regard to earnings management consequences” (p.94).
Earnings management may have an adverse consequence on accountability relationships. Accountability, or being accountable, relies on managers providing useful, unbiased, and reliable information to the firm’s stakeholders. Aers et al. (2013) stated that earnings management could reveal an accountability breach, they indicated:
“Given users’ ex ante uncertainty with regard to management’s earnings management motives, indication of earnings management may be perceived as a significant accountability predicament, and bring management to offer more explanations on performance-related matters in ” (p. 95).
This section has provided a literature review on the earnings management definition and motivations. The next chapter highlights the theoretical framework adopted for this study: accountability.
The current study examined the motivation results however 50% of them had the view that ‘job security’ could mainly be blamed for such a practice by CBs’ managers. However, interview findings provide evidence about other motivations; for example, US1 indicated that earnings management may be practiced to cover corruption as well as for job security reasons.
The results demonstrated views that CBs’ managers could be motivated by a set of motivations: management compensation and job security, regulatory and political reasons, and capital market.
The evidence provided by results regarding the motivations of earnings management refers to a serious problem to accountability. The existence of these motivations, although, they may be unavoidable, put pressure on the accountability process and exposes it to a lack of trust and disrepute which therefore may have an adverse effect on the relationship between CBs’ managers and their stakeholders. CBs’ managers should be free from such motivations in order to produce unbiased and fair accounting information.
It can be explained that the motivation bonus has no significant effect on earnings management. Although, not significant, but the negative sign on the coefficient describing the existence of a negative relationship between motivation in doing earnings management bonuses. The results of this study failed to indicate a bonus plan as motivation for managers in managing earnings. Arguments possible failure hypothesis because its owner determines the bonus is not seen from ROA but based on the amount of the bonus targets that have been set by the company earlier.
From the results it can be explained that the debt levels had no significant effect on earnings management. Positive sign on the coefficients indicate a positive relationship between debt contracts with earnings management. The greater the level of debt coefficient, the higher the manager will act profit management companies.
From the results it can also be explained that the size of the bank does not have a significant effect on earnings management. Positive signs on the coefficients describe the existence of a positive relationship between firm size and earnings management. Although the relationship is not significant but the sign on the coefficient has been able to explain the existence of a positive relationship.
On average, stakeholders perceive that local accounting practices, ineffective external auditing, and poor corporate governance would make it easy for bank managers to exercise earnings management. In addition to the above factors, stakeholders also perceive that, the lack of business knowledge by users and the ineffective monitoring by the different monitoring bodies may also encourage bank managers to easily be engaged in earnings management practices.
Based on the results of the research, it can be concluded that:
Motivation bonuses, partially have a positive impact on earnings management. This indicates that the level of bonuses given to the bank managers may not necessarily lead them to manage earnings. Motivation contract debt (leverage) has a large impact on earnings management. This indicates that the company’s debt level can contribute to managers managing earnings for their companies. Motivation political costs (the size of the company) have a partial positive effect on earnings management. This indicates that the political costs (the size of the company) may not necessarily contribute to the managers engaging in earnings management.
The recent financial crises have reflected the importance of the quality of financial reporting and accountability. Managers should be held accountable not only to shareholders but to a wide range of stakeholders.
In the banking sector the stakeholders list would include, for example, depositors who will arguably suffer the most in the event of collapse when bank managers are not properly held accountable. Therefore, the importance of accountability should be acknowledged, and improved through promoting the quality of financial reporting for the benefit of society as a whole.
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Aerts, W., Cheng, P. ; Tarca, A. (2013). Management’s earnings justification and earnings management under different institutional regimes. Corporate Governance: An International Review, 21, 93-115.
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