8-1 Discussion: Earning Management Techniques
I am providing additional authoritative resources for expanded perspective for the inquisitive among us.
Earnings Management vs Financial Reporting Fraud – Key Features for Distinguishing:
Earnings management: When Does Juggling the Numbers Become Fraud?
Management Fraud and Earnings Management: Fraud versus GAAP as a Means to Increase Reported Income:
Earnings Management and the Abuse of Materiality:
Craig Lumpkins, CPA, CFE
Auditors state in their reports whether or not, in their opinion, financial statements are presented fairly. This is generally interpreted as being free from material misstatement (Mintz & Morris, 2013). According to FASB, the concept of materiality concerns whether or not the information reaches the point to cause or influence the user of financial statement information to change a conclusion about the overall financial statements.
Companies may use earnings management techniques to increase income when management compensation is based on performance, to meet financial analysts’ expectations, or to smooth income over several periods (Mintz & Morris, 2013). A company’s bottom line can be easily managed through abuse of revenue recognition as well as the use of estimates and accruals (Smieliauskas, 2008). This earnings management can be accomplished in a variety of ways:
- Recording revenue before it is earned
- Recording questionable revenue
- Recording fictitious revenue
- Shifting expenses to prior or later periods
- Failing to record liabilities
Small misstatements can rise to the level of material misstatement in the following situations:
- The recorded item could be measured without an estimate
- The technique concealed earnings trends
- The technique is used to meet analysts’ expectations in income
- The technique affects the company’s compliance with regulations
Giroux (2008) found that corporate culture plays a large part in earnings management and could be a significant “red flag.” A complex or constantly changing organizational structure increases the opportunity for fraud (AICPA, 2002). Individual behavior factors leading to possible fraud were personal greed and lack of ethics, and these qualities extended to the larger corporate climate (Giroux, 2008).
Restatements of financial statements were a recurring problem from 2000 to 2006, when there were a record number of restatements. The amount of restatements has decreased since the enactment of SOX (Mintz & Morris, 2013). Restatements occur from corrections to financial statements because of errors or fraud. Exhibit 7.5 in the textbook lists a number of items that require a company to issue restated financial statements.
Auditors realize that although management cannot record all financial information free of errors, management should record the information using ethical judgment and without fraudulent intent. Therefore, auditors should assess the risk of fraud from internal pressures or incentives as well as from external sources.
American Institute of Certified Public Accountants (AICPA). (2002). Consideration of fraud in a financial statement audit: Amendment to AU 316. Statement on Auditing Standards No. 99. New York, NY: AICPA.
Giroux, G. (2008). What went wrong? Accounting fraud and lessons learned from recent scandals. Social Research, 75(4), 1205–1238.
Mintz, S., & Morris, R. (2013). Ethical obligations and decision making in accounting (3rd ed.). New York, NY: McGraw-Hill.
Smieliauskas, W. (2008). A framework for identifying (and avoiding) fraudulent financial reporting. Accounting Perspectives, 7(3), 189–226.