QUESTION 2 (b&c)

b) Describe THREE (3) examples of financial fraud techniques common features of

earnings management and provide any FOUR (4) examples of financial fraud techniques.

1) Purposeful and deliberate actions taken by management with the ultimate goal to alter
reported earnings. Thus, earnings management is different from unintentional errors,
such as an accountant mistakenly entering incorrect numbers.

2) Accounting-based earnings management. The reported earnings are artificially impacted

by estimates or judgments that are permitted by accounting regulations, such as losses
from bad debt and asset impairments, obligations for pension benefits and other
post-employment benefits, deferred taxes, and expected lives and salvaging values of
long-term assets. switching from one accepted accounting system to another, such as
changing from LIFO to FIFO or using the weighted-average approach for inventory
valuation.

3) Real earnings management aims to control cash flows, which in turn affects how much
money is brought in and spent on running the business. This entails modifying actual
transactions to change reported earnings by structuring them so that the desired
outcome can be realised. Reduced prices, altered production, discretionary spending,
such as R&D and SGA (Selling, General and Administrative expenses), and debt-equity
swaps are a few examples of these strategies.

EXAMPLES OF FINANCIAL FRAUD TECHNIQUE

1) Improper revenue recognition (recording fictitious revenues or recording revenues

prematurely)
2) Overstatement of assets (excluding accounts receivable)
3) Understatement of expenses/liabilities
4) Disguised use of related party transactions

c. Stated in the above case, “not all earnings management practices involve
overstatements”, describe any other circumstances that manager will practice for
understatement of earnings.

GOOD SIDE OF EARNINGS MANAGEMENT

1. Managers can use earnings management or creative accounting as a medium for the
communication of management’s internal information to investors

2. Based on this case, earnings management or creative accounting is useful from a financial
reporting perspective. ’Good’ earnings management or creative accounting occurs when
management knows that the long-term earnings prospects of the firm are better than the
current non-managed earnings would imply. Management wants to improve the
predictability of earnings by reporting a stream of smooth and growing earnings over time.

3. Creative accounting also helps to smoothen up income patterns of large

corporations to avoid scrutiny and attention from authorities and lobby groups with
political agenda.

BAD SIDE OF EARNINGS MANAGEMENT

1. Management may use earnings management or creative accounting to avoid:
● Negative stock price reaction that follows, if investors’ expectations are not met
● Reputational damage
● Negative consequences on executive compensation.
2. Management can achieve these goals by:
● Avoiding reporting losses
● Meeting or beating analysts’ earnings forecasts
● Taking actions that influence the reported earning