You are on page 1of 10

a) It is highlighted in the article that earning management practices can be

designed to assist managers in fulfilling their obligations to stakeholders. This is


resulted from the contract that the management has with their stakeholders.
Describe the relationship between the following contracts with earning
management :
i

Lending
- lending contract or lending covenants have relationship with earning
management where firm close to their dividend covenant changed accounting
method, accounting estimates, or accruals to avoid cutting dividend or making
costly restructuring decision. Firms in financial difficulty tend to emphasis on
managing cash flow by reducing dividend payments and restructuring their
-

operation
There are some specific accruals that being used by managers to do earning
management such as bank loan loss provision and claim loss reserve property
and deferred tax valuation expenses. Company will do this in order to meet
bank and insurance regulatory requirements.

ii

Management compensation
- Management compensation are contract to identify management earning
management incentive and this contracts are viewed as tools to reduce the
conflict of interest between managers and shareholders and also to maximise a
firm's value. However these compensation contracts may induce earnings
management simply because managers' compensation is either tied to
-

accounting earnings (for example, bonus) or stock prices.


There is a possibility that rewarding managers on the basis of reported
earnings or stock performance may induce them to manipulate earnings
figures

to

improve

their

apparent

performance

and

their

related

compensations.
iii

Regulatory
- There are 3 form of regulatory motivation for earning management which is
industry regulation, anti trust regulator to reduce risk of investigation and
-

intervention and lastly for tax planning purpose.


Some industries like banking, insurance and utility industries are monitored
for compliance with regulations linked to accounting figures and ratios. Banks
and insurance firms especially are often subject to requirements that they have
1

enough capital or assets to meet their liabilities. This kind of regulations may
-

give managers incentives to use earnings management.


Other form of regulator can also provide incentive to manage earning. For
example, manager for the firm vulnerable to anti trust investigation or political
involvement have advantages to manipulate earning to appear less profitable.
Not only that, this kind incentive also apply to manager seeking government
subsidy or protection.

b) Describe the reasons behind the authors claim that earning management can
also be a good business practice.

Many accountants, analysts and investors believe that good business practice
requires managers to manage earnings. The reasons behind the authors claim that
earning management can also be a good business practice is companies have long
used earnings management techniques to smooth earnings, a process that is
typically rewarded in the stock market, for example, the many ways in which
Genereal Electric smoothed earnings including the careful timing of capital gain and
the use of restructuring charges and reserves. Managers engage in income smoothing
activities because they know that volatile earnings streams typically lead to lower
market valuations. Many successful management teams believe that the strategic
timing of investments, sales, expenditures, and financing decisions is an important
and necessary strategy for managers committed to maximizing shareholder value.
Good business practices also include use of conferencing technology to reduce travel
costs and postponement of repair and maintenance activities when faced with
unexpected cash flow declines.

c) Explain, using accounting examples, each of the accounting hocus focus listed in
articles.

From the listed in article, there are five popular examples of accounting hocus focus that
could be used to create illusionary earning which is:
i
ii
iii
iv
v

Big bath restructuring charges


Creative acquisition accounting
Cookie jar reserves
Immaterial misapplications of accosting principles
The premature recognition of revenue

First, big bath restructuring charges which are companies remain competitive by regularly
assessing the efficiency and profitability of their operation. However, the problem when see
the large charges associated with companies restructuring. This charge help companies clean
up their balance sheet and its called big bath. When a company decides to restructure,
management and employees, investors and creditors, customers and suppliers all want to
understand the expected effects. They are to ensure that financial reporting provides this
information. But this should not lead to flushing all the associated costs and maybe a little
extra through the financial statements. In this article, companies have long used earning
management techniques to smooth earning a process that is typically rewarded in the stock
market.
Second, creative acquisition accounting meaning that whole industries have been remade
through consolidations, acquisitions and spin-offs. Some acquirers, particularly those using
stock as an acquisition currency, have used this environment as an opportunity to engage in
another form of "creative" accounting. Some companies have no choice but to use purchase
accounting -- which can result in lower future earnings. But that's a result some companies
are unwilling to tolerate. In this case, investor and auditor should carefully review the
circumstance surrounding acquisition.
Third, cookie jar reserve is an accounting practice of creating excessive accounting reserves
in one year and using them to improve earnings in another one. Cookie jar accounting is
related to quality of earnings. Quality of earnings is an indication of where companys
earnings are coming from. Cookie jar accounting is a company attempt to manage their
earnings by using accounting reserves, and it may not result in the good quality of earnings.
Escalating abusive earning management practice often provides incentive for company to
seek business combinations that can be used to strengthen their cookie jar. If there is no

apparent business purpose for a business combination, investors and auditors should carefully
analyze the transaction.
Forth, immaterial misapplications of accosting principles mean materiality is another way
they build flexibility into financial reporting. Using the logic of diminishing returns, some
items may be so insignificant that they are not worth measuring and reporting with exact
precision. But some companies misuse the concept of materiality. They intentionally record
errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the
effect on the bottom line is too small to matter. SEC, clarified the issues by indicating that
misapplication of GAAP and stretching the rules to achieve desired target are fraudulent
accounting practices that would be targeted by the SEC.
Lastly, the premature recognition of revenue which is companies try to boost earnings by
manipulating the recognition of revenue. But some companies are doing this with their
revenue recognizing it before a sale is complete, before the product is delivered to a
customer, or at a time when the customer still has options to terminate, void or delay the sale.
In many cases, managers attempt to meet quarterly expectations by prematurely or
improperly recognizing revenue for sales that do not meet criteria for recognition under
GAAP but would be legitimately recognized in future period. Such premature revenue
recognition can go unnoticed if company manager do not consistently engage in such
practices or if the company continues to grow.

d) it is highlighted in the article that pressure to meet revenue expectations is the


primary catalyst in leading managers to engage in earnings management
5

practices that result in questionable or fraudulent revenue recognition practices.


The violation outlined involve techniques to boost revenue, including:
i.
improper sales cut-off
ii.
consignment sales recorded as revenue
iii.
parking, bill and hold and channel stuffing
iv. back-to-back swaps
v. fictitious sales
Describe each of the techniques and explain whether they would be in breach of existing
Malaysian accounting standards. In your answer, refer to the recognition criteria of IAS
18/MFRS 118 Revenue.

MFRS 118 stated that revenue from sales of goods shall be recognised when all the following
conditions have been satisfied:
a) The entity has transferred to the buyer the significant risks and rewards of
ownership of the goods
b) The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold
c) The amount of revenue can be measured reliably
d) It is probable that the economic benefits associated with the transaction will flow
to the entity; and
e) The costs incurred or to be incurred in respect of the transaction can be measured
reliably.

The first technique to boost revenue is improper sales cut-off. In this technique the
books were held open past the end of the accounting period to accumulate more sales and as a
result, sales were recognised prematurely, or during a prior period to the one dictated by the
GAAP. In the case, SEC investigation revealed that premature revenue recognition practices
were such an integral part of operations at one manufacturing company that MIS personnel
wrote a program to automatically freeze the computer date while the quarter was held open.
This technique has breach MFRS 118. It is because the revenue shall be recognised when all
the conditions above are satisfied but in these case it is been recognised prematurely and does
not meet the condition required by MFRS 118.

For consignment sales recorded as revenue, the revenues are recorded for
consignment shipments or shipments of goods for customer to consider on trial basis. This
technique does not breach MFRS 118. It is because revenue is recognised only when it is
probable that the economic benefit associated with the transaction will flow to the entity. In
some cases, this may not be probable until the consideration is received or until an
uncertainty is removed.
Parking, bill and hold and channel stuffing are premature recognition by negotiating
sales with customer who do not need or cannot take delivery of goods in the period. The
goods are held with an intermediary (parking), left in seller inventory (bill and hold), or
shipped to the buyer (channel stuffing). Deferred payment terms are included in the
agreement. The guidance MFRS 118 requires that risks and rewards of ownership to be
transferred to the buyer. In the cases described above, ownership of the seller remains with
seller. The risk and rewards of ownership have not passed, irrespective of the location of the
goods. Therefore a sale should not be recorded.
Back-to-back swap for example firm A sells assets to firm B at gain, an in turn it
agrees to buy assets from firm B in the same or subsequent period, also at gain. This
transaction may appear to be within the revenue recognition guidelines in MFRS 118. In the
standards states that sales and repurchase agreements need to be analysed to determine
whether there is an in substance transfer of the risks and rewards of the ownership. If not,
despite the fact of legal transfer of title, a sale should not be recorded.
Fictitious sales, company goods may be ordered but not shipped, shipped but not
ordered or never ordered not shipped. The company may fabricate purchase orders or
shipping records (fictitious customer), or not produce any records. These transactions cannot
be recorded as revenue because it is not probable that economic benefits associated with the
transaction will flow to the entity.

Advise the investors on ways to detect earning management through the


accounting numbers.

There are a few ways that investors should consider as early warning signs of abusive
earning management which is:

Cash flows that are not correlated with earnings

Receivables that are not correlated with revenues

Allowances for uncollectible accounts that are not correlated with receivables

Reserves that are not correlated with balance sheet items

Acquisitions with no apparent business purpose

Earnings that consistently and precisely meet analysts expectations

Cash flow. One of the most obvious warning signs that companies are engaging in
improper revenue recognition is a lack of correlation between cash flow from operation and
earnings. If revenue is properly recognized, cash flow should closely follow revenue
recognition; that is, the business cycle will be completed and cash will be available for
reinvestment when customers discharge their obligations in timely manner.
Receivables. Investor should compare receivables and cash flow from operation with
revenue and earnings. Receivables rising more quickly than revenues could be a sign that
customers are experiencing financial distress. It could also be a sign that a company is
engaging in abusive earning management by recording fictitious sales or otherwise inflating
revenues and accounts receivables.
Acquisition reserves, Investor should carefully review the circumstances surrounding
acquisitions. Escalating abusive earning management practices often provide incentives for
companies to seek business combinations that can be used to strengthen their cookies jar. If
there is no apparent business purpose for a business combination, investor should carefully
analyze the transaction. If restructuring charge or reserves set aside for disposals are created,
investor should question the legitimacy of the business combination and acquisition.
Consistent earnings. Investor should carefully examine the accounting practices of
companies that consistently and precisely meet analysts expectations, particularly growth
expectations. Analysts expectations are based in part on information obtained from company
8

management; therefore, companies strive to meet analysts expectations to protect their


reputation as well as the market value of their stock.

With the term creative accounting being associated with accounting profession,
do you believe there should be no room for creativity in accounting and that
accountant need to always go by the book? Justify your answer.

The answer is both because we believe there is room for accountants to be creative in
the right setting. Obviously certain roles, organizations, and situation will alow for more
creativity than other, regardless, knowing when and how to utilize creativity will help
separate us from the pack. On the one hand, acountants must follow the rules. On the
other hand, accountants should creativily think about presenting information in ways that
they are most useful and clear to users. For example, accountants in leadership roles can
use creativity to help their company or client in achieving specific results. This may relate
to business development, investment opportunities and other forms of business planning.
An accountant knows the numbers and often has the power to oversee valuable
information unknown or not well understood by management. Carrying this information
over in a creative and effective manner may help in achieving an organizations objectives
or avoid an organization from making a costly mistake. On the other side, an accountant
should not be creative because accountants are trusted by those that rely on their
information to work within an environment of legal and ethical guidelines. Accountants
should always stand by these ethical guidelines. Furthermore, when it comes to the
International Financial Reporting Standards, Generally Accepted Accounting Principle
and Generally Accepted Auditing Standards an accountant should never compromise.

10