Earnings managment

Difference between real earnings management and accrual-based earnings management.

Real earnings management means when managers hide potential economic performance of cash flow generated assets in the current year for boosting the reported earnings to meet and beat the bench mark report of analyst. In other words, it is called forfeited of future cash flows of the firms. This is otherwise called operating related activities. This may be investment related, finance related or operation related. Reducing any of the activities is hiding of underlying economic performance of firm in future. This activities possible due to time gap and structuring of transactions. A manager does these activities to a large extent for boosting profit. Because he has another tool in his hand in the end of the accounting year to adjust the transaction. Decrease (increase) of real earnings management is adjusted through accrual based earnings management (Zang, 2012).

Why managers do this type of activities- To meet and beat the earnings bench mark of analyst prediction. Mangers want to keep share price in increasing trend. And also to attract investors to invest money to their companies signaling the market that their firms is well performing in the market. If the investors invest money, they will get benefit in terms share price, dividend, and wealth of their investment. These activities cannot be judged by the auditors and outsiders merely watching financial reports of the companies. This type of activities is done when there is target of earnings benchmark, extracting capital through equity issue etc.

What are methods in which real earnings management take place-?

(1)   Providing impulsive discount in the year end to customers for boosting sales to achieve the target revenue of that financial year. Providing lenient credit terms to sell the goods in impulsive manner for generating revenue. The cash inflow should be more than cost of the goods sold (Roychowdhury, 2006)

(2)   Reducing discretionary expenditure which are really having potential power of generating future cash flows in future like R& D expenditure, S&AG expenditure, postpone the project etc. In particular, when managers have tight period, target profit etc. reduce the expenditure for boosting the profit. (Roychowdhury, 2006)

(3)   Producing overproduction for cutting the overall cost of goods sold per unit. Managers keep themselves in over production for increasing finished goods. These finished goods are treated as revenue of that year. This production is done up to adjust of fixed cost. More production means sharing of fixed cost of total units, in turn less expenses will be shown in the financial statement. This ultimately will boost profit. (Gunney  2010). Over production means finished goods more.

(4)   Timing of fixed assets sales for boosting reported income. That means managers do this when there is target of earnings bench mark. In that time they sale the fixed assets for boosting profit (Bartove 1993).

Accrual-based earnings management means when there is timing gap between earnings and cash flow of the firm. Accrual- EBIT- CFO. By definition when there is gap in between earnings and cash flow accrual arises. Accrual helps the firm to show the actual performance of the firm of any fiscal year. To maintain the accrual transactions, there are guidelines of the accounting standard to record the accrual truncations. Managers use as per his discretion to record the transaction in the financial statement. There are three ways that accruals can be reported (1) Conservative accounting (2) Aggressive accounting (3) neutral accounting.

Conservative accounting means where manager overstates the liabilities and under states the assets in recording the transaction. For example overstates the expenses like R&D expenditure, changing of the deprecation policy, and write off the fictitious assets; treat the loss item in the profit and loss account. In this way managers show the profit in conservative way to get the benefit in future.

Aggressive accounting means where manager under states the liabilities and overstate the assets in recording the transaction. For example aggressive revenue recognition, capitalize the expenditure, changing of the depreciation policy; maintain the low provision for bad debt etc. Manager does these types of activities to get the short-term benefit. In future, accruals reverse, actual performance comes into picture. In this way a firm gets penalized by the regulators. It is relatively less costly than real earnings management (Zang, 2012). In this case firm’s underlying economic performance does get hampered. But it is subject to difficult to inflate earnings due to scrutiny by the auditors, regulators etc.  After SOX act, 2002, accounting flexibility has been reduced. There is less flexibility in the hands of manager to inflate earnings using accrual as a tool. However real earnings management has been increased in the hands of managers (Zarowin, 2008).

Neutral accounting means when managers show actual performance what happened during the business course of action. There is no chance of aggressive accounting or conservative accounting.

Other than  three accounting there is another accounting called fraud- where transaction are maintained outside of generalized accepted accounting principles (GAAP). For example Satyam computer (2008), Lehman brother (2009).  These transactions are called fraud transaction.

 For measuring the earnings management two types of proxies are taken (1) Discretionary accrual (2) Real earnings management. The following two proxies are discussed as follow.

Discretionary accrual is not directly detectable from the financial statement. It can be derived with the help of the existing accrual model developed by many accounting researched. For deriving discretionary accrual (otherwise accounting based earnings management) Jones (1991) developed   a comprehensive model. This model was used for detecting earnings management of firms those had identified by the government USA for granting relief due to natural calamity. The basic assumption of this model is underlying accrual is generated by the normal course of business operation. Total accrual is the function of underlying normal course of action. If any deviation arise is called discretionary accruals. In this way more than 10 accrual models have developed to identify the discretionary accruals from financial statement. Derivation of this accrual is possible by the way of industry wise matching firm. For deriving this accrual, cross- sectional, time series and panel regression data are used in industry wise.

Beside the discretionary accrual, other two proxies are used in the research to measure the accrual quality in the financial statement (1) Ratio of cash flow to total accrual (2) residual of accruals. Here the basic assumption is it should match with total assets growth. If the cash flow position is too less or too high there is an indication of earnings management (that may be conservative accounting or aggressive accounting). Other way it can be measure that was developed by the Heal (1985) during the bonus event. Here mean of the ratio of total accrual to total assets within 5 years should be 0. If there is any deviation is called discretionary accruals. It can be determined within industry.