Concept

1.What is earnings management?

Earnings is net income (net income after tax); sometimes called the “bottom line” because it is found
at the bottom of the line after Income and expenses in the income statement. It is used as a measure
of the entity’s performance.

2. Illustrate how earnings management are done using the following:

a) Depreciation method

. is the method of allocating costs to the appropriate period. A few different methods of depreciation
such as straight line method, declining method, sum of the year digit methods and unit of production

b) Inventory valuations

. Choice between FIFO method of valuation, LIFO method of valuation, or Weighted Average method
of valuation.

c) Revenue recognition

. One way to increase earnings for the period is to recognise earnings prematurely..

d) Price discounts

.to increase the sale to push the earning

3. Explain how accrual accounting can be manipulated to do earnings management?

Managers prefer to have consistent revenues and earnings growth. Investors prefer to invest in
companies that exhibits consistent growth patterns, and not those that have erratic earnings. For this
reason, managers use accrual accounting techniques to manage earnings so that it shows a more
consistent pattern over time.

4. What is income smoothing?

. “smoothing moderates year-to-year fluctuations in income by shifting earnings from pek years to less
successful periods”.

5. Describe any three (3) ways in which Real Activities Management can affect the earnings of a company.

Earnings management can also be done by managing the real activities that are going on in business
operations. Some examples: Accelerating sales, Offering price discounts, Reducing discretionary
expenditures, Altering shipment schedules, Delaying research & development and Delaying
maintenance expenditures

Real activities management can have an effect on cash flows and in some cases accruals. One negative
outcome of real activities management could be a reduction in entity value because actions taken in
current accounting period to increase earnings can have a negative effect on cash flows in later periods.

6. Explain why managers manage earnings.

If he can produce much earnings for the company, he would get much bonuses and share option.

7. Outline the ways by which earnings management may benefit a company.

Stock market incentives - Investors often rely on the views and forecasts of stock market analysts to put
together a portfolio of potentially successful firms. Meeting the analyst’s expectations is important
because firms that meet or beat expectations enjoy higher returns, even when it is likely that this is
achieved through earnings management. Missing an earnings benchmark has negative implications for
stock returns as well as CEO compensation.

Maximise share price & company valuation - Net income or earnings is commonly used to determine an
entity’s value. There are a number of different methods commonly used to determine the value of a
company. The current value of a company is measured by forecasting the future value of one of the
following measures book value of the company, operating cash flow and net income.

Signalling or concealing private information- Managers manage earnings to present some private
information, or personal knowledge to shareholders about the entity’s operations.

Avoid violating debt covenants-Debt covenant is a condition that must be upheld by the borrower
throughout the tenure of the borrowing. Usually, under a loan agreement, to protect itself against risks
of loan defaults, the lender would set certain conditions as part of the debt covenants for which the
borrower must abide with.

Maintain Earnings Quality-Earnings quality relates to how closely current earnings are aligned with
future earnings. The better the quality of earnings, the more consistently should the company be able
to deliver solid results

8. Outline the ways by which earnings management may benefit the manager.

Basic salary-This is the basic salary that is offered to the manager for the top job. It is usually fixed.

Cash bonus-This is usually tied to the level of earnings performance. Some measure or formula are used.

Share Options-Shares are awarded for certain performance achievement. Conceptually, share
ownership will influence the manager to strive harder in working for the company as he is a shareholder
and owner.

Various Perquisites-these are other benefits such as motor vehicle, overseas travel, accommodation,
entertainment and so on.

9. Explain how earnings management are done under the following techniques:
a) Cookie Jar Reserve

. This technique employ methods that will create reserves during periods when earnings are good. This
reserve will be used to boost earnings position in future periods when the business faces poor earnings.

b) Big Bath

. A big bath is a very large one-time write-off taken by a company which will result in a very big loss for
that period. The idea is to take a large hit (loss) in the current period so that future performance will
look more profitable.

c) New Accounting standard

. Every now and then, MASB would issue new accountings standards. Upon the introduction of a new
accounting standard, it would take 2 or 3 years for compulsory implementation. Companies may adopt
the standard earlier on a voluntary basis.

Companies can take advantage of early adoption of the standard to change their methods or
measurement. In the process, this may involve big increase in expense or revenue. This would affect
the earnings of the period.

d) Sale and lease back

. A company purchases an asset aircraft for its business use. But the carrying costs would bear down
heavily on the expenses of the company. So it sells it off to another company. Then it leases the asset
back for its operations.

This arrangement removes the asset and the attendant costs of maintaining the asset from the records
of the company. This improves its earnings.

e) Use derivatives

. Derivatives are used to mitigate various business risks; namely interest rate change, commodity price
change, foreign exchange change, etc. When to enter into a derivative contract is at the discretion of
the manager. He can choose a time to do it when he sees it as an opportunity to use it for managing
the business earnings.

10. Illustrate, using an example, on how you would use the following techniques to manage earnings.

a) Revenue recognition

One way to increase earnings for the period is to recognise earnings prematurely.

Eg. Issue an invoice for an order in the current period, but deliver the goods only in the next period.

b) Expenses recognition
To increase earnings, recognition of expenses for the period can be delayed to the next period.

Eg. Accruals are not provided for expenses which are due for payment.

11. Explain the concept of agency theory.

Agency theory is a principle that is used to understand the relationships between principals and agents.
In the business context, principals are the shareholders of the company and agents are the company’s
management team.

12. What is agency problem?

The principal-agent problem is a conflict in priorities between the principal and the agent. An agent has
a legal and fiduciary duty to act in the best interest of the principal. But based on the principle that both
parties are utility maximisers means that the agent will not always act in the best interest of the
principal. The agent might undertake actions that are detrimental to the principal. This poses a risk
termed as a “moral hazard”.

13. List out the three (3) types of agency costs and explain each type.

Monitoring Costs - Monitoring costs are incurred by the principal to measure, observe and control the
agent’s behaviour. These might include costs to audit the financial reports, putting in place operating
rules, and costs to set up a management compensation plans.

Bonding costs - Bonding costs are costs that are incurred on incentives provided to the agent in order
to bind him to work for the best interest of the principal. If he feels that the compensation package is
satisfying enough, then he would can focus more on serving his principal as his own needs has been
fulfilled.

Residual loss - Despite the controls, it is too costly to guarantee that an agent will make decisions which
are optimal to the principal at all times and in all circumstances. It would cost more to monitor agents
that the expected benefits from that monitoring. Eg. It would be too costly to monitor a manager travel
expenses to ensure that they are only business purposes and not for personal use. These divergency
which are left out are called residual loss.

14. What is creative accounting?

Creative Accounting refers to imaginative ways to present account. These may deviate from the spirit
of accounting laws. However, the practice is not illegal. It is just an exploitation of loopholes in financial
regulations (accounting standards, rules, concepts, etc.) in order to gain advantage or present figures
in a misleadingly favourable light. It consists of accounting practices that follow required laws and
regulations, including accounting concepts and principles, but the effect is they deviate from the
intentions which those regulations and principles wish to accomplish.

15. List out any five (5) methods of creative accounting and describe each method.
Overstating Revenue - One of the most techniques used to boost income artificially is to recognise the
revenue prematurely. This amounts to open exploitation of accounting procedure.

Delaying expenses - Deferring the recording of period expenses such as payments to suppliers or paying
rent to the subsequent period makes the current period earnings look better

Masking Contingent Liabilities - Failure to record, or to ignore potential liabilities that are likely to occur
and/or to underestimate their likely financial effect can boost net income or shareholders’ equity.

Undervaluing Pension Liabilities - Pension obligations can easily be manipulated because the liabilities
occur in the future and the company-generated estimates need to be used to account for them.

Property valuation - Property are recorded initially at its cost. Subsequently, its value can be distorted
by revaluing it and putting an ‘over-optimistic’ value on it. This has the effect of increasing the value of
the assets and owners’ equity.

Application

Discuss the effects of the financial results of 31/12/2019 on:

(i) The share price of the company

The share prices change because of supply and demand. If more people want to buy a stock (demand)
than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than
buy it, there would be greater supply than demand, and the price would fall.

ii)The value of the company

The value of the company can deliver maximum shareholder wealth when the company's stock price
to rise. The higher the stock price, the higher the wealth of shareholders. To achieve the company's
value generally investors hand over its management to the professionals.

(iii) The stewardship of the company

The Stewardship refers to the responsibility that companies have to understand and manage their
impacts on the environment in any number of ways. Practicing stewardship can help a business find
sustainable practices, improve its reputation among consumers and even save money.

(iv) The performance-based remuneration to the manager

Performance-based compensation is an incentive-based form of compensation that can be paid to

portfolio managers. Regulated mutual funds with performance-based compensation may add
approximately 0.20% to their management fees for performance-based incentives

What can the manager do to avoid the negative effects of the 2019 earnings?
(i) Describe the action he can take.

If earning are below the forecast, managers use income-increasing earning to bring up earnings.

(ii) Explain the techniques that he can use

Cookie jar reserve

This technique employ methods that will create reserves during periods when earnings are good. This
reserve will be used to boost earnings position in future periods when the business faces poor earnings.

c) In your opinion, is earnings management wrong?

(i) Explain your reasons from a legal perspective.

will affect the likelihood of accounting-related shareholder litigation. Firms can manipulate earnings
upward by accelerating revenue recognition, understating expenses, and overstating gains associated
with special items. Firms can manipulate earnings downward by delaying revenue recognition,
overstating expenses, and overstating losses associated with special items.

(ii) Explain your reasons from an ethical perspective

If While managers generally view earnings management as unethical, managers who have worked at
companies with cultures characterized by fraudulent financial reporting believe earnings
management is more morally right and culturally acceptable than managers who haven't worked in
such an environment.