ACCOUNTS INTERPRETATION AND EARNINGS MANAGEMENT Flashcards
EARNINGS MANAGEMENT
Measurement of earnings is a key figure in the interpretation of financial information.
Interpretation of financial information depends on the figures we are presented with.
Figures we see are a result of earnings management.
There is no such thing as a “right” earnings figure, no matter how carefully the income statement is prepared.
Result of decisions being made at different stages of preparation.
AGGRESSIVE EARNINGS MANAGEMENT
Presenting the financial performance of a company in a favourable light which does not necessarily reflect underlying reality.
Management adopt an “accounting strategy”
Question to be asked:
What are the incentives to manage accounting information?
INCENTIVES TO MANAGE ACCOUNTS
1) Incentives driven by the contract with the shareholders.
Management are acting on behalf of the owners (shareholders) and will want to sow they are doing a good job, so will try to:
- Avoid earnings volatility by using income smoothing techniques.
-Will want recurrent and increasing stream of earning
-Try to meet earnings and targets and industry
benchmarks
2) Incentives driven by debt contracts
- Try to avoid violation of debt covenants
- Try to get favourable credit ratings
3) Contracts with regulatory authorities and governments
- Tax biased accounting - minimise taxes
- Avoid regulatory intervention e.g. bankruptcy
4) Contracts with management:
- Try to meet the bonus criteria
- Try to have a favourable share price in the case of stock options.
- Avoid management turnover, perform above the industry-average
- Earnings management around CEO turnover - big bath accounting.
- Big bath accounting - taking a one time loss through a major cleaning up exercise.
5) Other incentives to manage the accounts
- Competitive pressures
- Disclosure levels
- Employees - union negotiations.
- Provide the impression to be a reliable supplier i.e. responsible company.
What are the causes of earnings management
Adverse market reactions when share price results do not meet market expectations.
Directors and management remuneration package being related to results and/or stock options.
Tax reduction incentives
Pressure to meet financial ratios or debt covenants.
Leads to stakeholders and capital markets being misled.
FACTORS CAUSING DIFFERENCES IN ACCOUNTS
1) Choice of accounting method:
-Choice of depreciation method
-Choice of inventory valuation (FIFO or AvCo)
Choice whether or not to capitalise certain expenditures
Measurement method (HC or FV)
2) Choice of accounting estimates: Bad debt allowances Provisions Write down on inventory Impairment of assets Useful life or economic life of a non current asset.
3) Real Transactions:
Defer payments
Structure acquisitions in certain ways
Sale of an asset
Can earnings management be stopped?
IFRS 18 Accounting Policies requires choice of most appropriate accounting policies.
Enhanced disclosure practice.
But accounting standards can also hinder increased judgement which increases subjectivity.
CORPORATE GOVERNANCE
The way in which companies are directed and controlled.
Idea is to help accountability.
Has not prevented accounting scandals.
What do codes of corporate governance encourage?
Directors to act in best interests of stakeholders (different countries prioritise different stakeholder groups).
Shareholders - UK and US
Workers, managers, customers and community - Continental Europe and Japan.
How can directors be encouraged to act in the best interests of the stakeholders?
Legislation
Mandatory Regulation
Voluntary self-regulation
How is good governance to be achieved?
Good behaviour or Rules
Corporate governance legislation in the UK
Company legislation covers directors duties e.g. promote success of the company and exercise independent judgement.
But, difficult to measure and monitor.
Disclosure of directors salaries and other remuneration must be made.
Yet, given constant complaints about the level of directors’
remuneration, is this a useful way to promote good governance?
How does voluntary regulation improve corporate governance?
In terms of corporate governance, there is no mandatory regulation (e.g. equivalent of IFRS) but instead have:
VOLUNTARY SELF REGULATION:
- Corporate governance principles and codes have been developed around the world.
-Stock exchanges may require compliance with these, but otherwise not mandatory.
COMPLY OR EXPLAIN APPROACH
WHAT ARE THE 5 CATEGORIES TO BE CONSIDERED IN CORPORATE GOVERNANCE?
- Board and management structure process.
- Ownership structure and exercise of control.
- Financial transparency and information disclosure.
- Auditing
- Corporate responsibility and compliance.
CORPORATE GOVERNANCE CODES
There are many different codes in place around the world.
In the UK strong emphasis is placed on the use of non executive directors (NEDs)
What are NEDs?
- Directors who are not employed by the company or affiliated with it in any other way.
- NEDs should control audit and make up remuneration committees to try and improve independence.
