AIA

Week 12
Earnings Management and
Accounting Frauds & Manipulation:

Chapter 9: Rankin et al (2012)

Earning Management
What is a company’s number 1 goal ?

What is Earnings Management ?

 “Purposeful intervention in the financial reporting

process so as to obtain some private gain” (Schipper, 1989).

 “ It occurs when managers use judgement in financial reporting and

in structuring accounting transactions to alter results of Financial reports to either mislead
some stakeholders about underlying financial performance or to influence contractual
outcomes that depends on financial numbers. (Healy and Wahlen, 1999).

 Earnings management is the creative use of accounting techniques/policies

to produce financial reports that present an overly positive view of a company's business
activities and financial position (Investopedia, 2017)

“A Conservative View:
 ‘Legal management decision making, and reporting intended to achieve consistent and
predictable financial results (Makee, 2005).

In practice, common terminology used to define this is:

“Cook the book” or ‘Creative Accounting’

Why do entities manage earnings ?
‘WISE’ where W=Windrow Dressing (Dress up F/S with floppy dresses
for investors and creditor),
I= Internal Targets
S= Income Smoothing E= Expectations
 To make financial statement look better.
 For the short term, to maximise managerial
remuneration and bonuses.

 To make financial statement look better

 To meet analyst shareholders expectations and prediction,
 To maximise share price
 To avoid violating debt (loan) covenants/contracts (with financiers).
 To maximise company valuation
 Different patters of earning management based on entities
objectives (Source, Rankin et al, 2012, p.258)
Conservative Moderate Aggressive Fraud

Accounts Conservative Liberal credit Liberal use of credit Creating Fictitious

Receivable credit terms and terms and use of policies to expand receivable to support
use of bad debt bad debt sales. existent sales
provisions provisions Understate bad debts
provision or reduce
bad debts ignoring
likely defaults

Depreciation Conservative Liberal useful Restate useful life and Changes useful life
useful life and life and residual residual value and residual value to
residual value value upwards meet earnings
targets

Inventory LCM (Lower of Delay to write- Obsolete inventory is Overstate inventory

costs or market down slow still recorded as an when non-existence
price) is moving asset inventory is
consistently inventory recognised
applied
 Different patters of earning management based on entities objectives
(Source, Rankin et al, 2012, p.258)
Conservative Moderate Aggressive Fraud
Advertising Expenses as Expenses based Costs are Costs are
, marketing incurred on formula; capitalised and capitalised and
costs perhaps sales manipulated. manipulated to
based. meet earnings
targets

Conservative Moderate Aggressive Fraud

Service Services are Services are Services are Fraudulent

Revenues prepaid but prepaid but agreed but not scheme for
performed in partially yet performed performing
full performed services
Techniques of Earnings Management
Several tools used:
 Accounting policy choice and Accrual Accounting
 Lead to different timing and amounts of expenses and Assets valuation
 Changing Accounting policies by providing cases for changes to Auditors’
 Income Smoothing
 Big bath write-offs
 Real activities management
Techniques of Earnings Management:
continued
Several tools used:
 1. Accounting policy choice and Accrual Accounting
 Simple example:
Company A Company B

EPS $1 $1
Proportion of Cash earnings 90:10 70;30
and Accrual earnings (in
percentage)

Which firms would you invest and why ?

Hints: Which firms EPS reflects better earnings quality ?
Can you think ?
 Remember: Quality of Earnings can affect a company’s share price.
 Earnings Quality are commonly used to forecast firms’ future earnings and growth
Techniques of Earnings Management: …..Continued

 2. Income Smoothing
Managers prefer make consistent revenues and consistent earnings growth patterns
to attract shareholders.
 Smoothing moderates year to year fluctuations of income by shifting earnings
from peak years to less successful periods (Using accrual basis of accounting)
 Examples: Early recognition of sales revenues, Variations of
provision for bad debts or Warranty provisions, changing assets useful life or depreciation
rate without any justifications/reasons; Delaying assets impairment.

Circumstances when firms use Income Smoothing

 When firms have IPO (initial public offering) in the market, they manage earnings
upward so that share performance look better after IPO.
 To reach specific performance goals/target and receive exit bonus by departing CEO.
 If management predicts that future performance may fluctuate, and they want to hide the
true fluctuations.
 When managers have bonus targets based on earnings, they want to achieve their bonus.
Techniques of Earnings management:… continued

 3. Big Bath Write-offs

As part of restructure of organisations, selling off subsidiaries or
operational Units. Restructuring of operations, fixed assets sale off,

 Also promote the news that major restructure and operational

change will create new jobs opportunities and positive impact
in the long term.

Circumstances when firms use big Bath Write-offs

 This is used when there is a change in the management team,
 With the need of sale of fixed assets or sale of operational unit
to blame on the outgoing managers/CEOs ‘poor management
of Resources’.
 To avoid breaching debt contracts.
Techniques of Earnings Management: ……Continued

 4. Real activities management:

Not just accounting policies or accruals, but by managing

operational decision, management can also manage earnings. These
include
 Reducing discretionary expenditure (e.g., staff development
costs; Advertising costs, graduate programs, CSR budget)
 Delaying R & D expenditure and maintenance expenditure
 Accelerating sales by offering massive price discounts.

Circumstances when firms use real activities management

 If firms want to avoid auditor's attention and questions.
 To show different activities by new CEO in his/her tenure
compared with previous CEOs.
 When an entity involves in managing earnings ?

 If Managerial compensation (Salary, bonus, share

Options and vehicles and travel facilities) is directly linked with earnings (ROA,
ROE, sales, BSC indicators,
net income)
 At the time of CEO change
- Departing CEO use earning management to musk poor Performance and to
receive his/her exist-package.

 Research studies have evidenced that incoming CEO will take Big Bath
technique and then following year earnings will increase (Strong and
Meyer, 1987).
 In a Australian study, it was evidenced that in the year of CEO change,
earnings are managed downwards, and earnings are managed upwards after
a CEO change.
 This works better when CEO was asked to leave than taking retirement
Godfrey et al, (2003).
Illustrations of earnings management: A finance Manager prepared the
following Income statement(Source: Made by Dr Habib Khan)
$ $ Amount
Amount’0 000
00
Revenues
Sales Revenue 3400
Less: Cost of goods sold 1900
Gross profit 1500
Less: Operating Expenses:
Depreciation (using Straight Line Method) 500
Impairment loss- Equipment 300
Wages and Salaries Expenses 300
Staff development costs 200
Interest Expenses 250
Other operating expenses (Graduate programs, 200
charities and CSR and staff retreats)
Total operating Expenses 1750
Net Loss (250)
Net Cash flows from operation (extracted from (110)
cash flow statement)
 When the results were presented by the finance director, CFO and CEO (joined just one year
ago) was briefed about this actual result, they commented as follows:

 We have consistent profit over last 3 years, how would our investors react to that ?
 This result must be revised as next year first quarter we have important meeting with our lenders, to
review and renew our debt contract.
 If bottom line is down, we all will personally also be worsening. We get bonus,….. everybody enjoy
good lifestyle. CEO added…. We have board meeting just two weeks after.
 CEO delegates responsibility to CFO to investigate it and brief him in the next meeting.
 3 days after the meeting, CEO called CFO in his office and talked with the draft results. CFO gives ideas of
reducing operating costs particularly discretionary costs. CFO also shares that firm's poor performance can
be better-off if restricts budgets on staffs' developments by 3/4 of current years and prosponed CSR
budgets and graduate programs temporarily. (hint: real activities management)
 Other tips CFO suggested by using other creative accounting knowledge and expertise. CFO rest assured
CEO to rely on him. CFO explained to change depreciation methods and could defer and delay
impairment practices of fixed assets and intangible assets. Depreciation under reducing balance method
would be $400 (Hint: Income smoothing).
 CFO also shared CEO to start redundancy programs for employees and sale one of the business unit
which incurred huge costs in the past and will be in near future. Called it as better management of
resources, CEO appreciates CFO and shared that he likes CFO ideas but will talk to Chief of People and
Diversity about first issue and he will raise this ideas in next BOD meeting (hint: big-bath write-off).

Before going to the next slide, do you get different smell of earnings management techniques from
above discussions ?
 Revised Income Statement (Cook the book)
$ ’000 $ Amount
000
Sales Revenue 3400
Less: Cost of goods sold 1900
Gross profit 1500
Less: Operating Expenses:
 Depreciation (using reducing balance method and 400
other methods and changing Dep rates and useful life
of asserts)

 Impairment loss for Equipment (Defer until next 000

notice)

 Wages and Salaries (will be reduced if redundancy 300

plans are executed in future)
 Staff development costs (Reduced by ¾) 50

 Interest Expenses 250

 Other operating expenses (Graduate programs, 000

charities and CSR and staff retreats) Stopped fully until
further decision.

Total operating Expenses 1000

Net Profit 500
 Consequence of Earnings Management

 Overvaluing share price temporarily by managing

earnings during IPO (Initial Public Offerings).
 Disappoint investors as earnings decline, in the
following years.
 Market reacts negatively to the disclosure that there has
been fraudulent and manipulation.
 Corporate collapse and market failure
Is Earnings Management bad or good ? What types of firms involve in Earnings
Management Practices ?

 Not bad (No problem) unless it turns into frauds and

manipulations.
 What types of firms involved in EM ?
 All types of firms even Charitable Organisations. You want
evidence ? Please read the following article published in
Australian Accounting Review (
https://onlinelibrary.wiley.com/doi/epdf/10.1111/auar.12242)

 Read the above article and share with your tutor about your
feelings.
 How to stop Earning Management ? The role of
Corporate Governance elements
 Independent Directors on the board
 Research studies found that greater level of earning management take
place when independent directors on the board is low.

 Independence of the Audit Committee (Corporation Act 2001).

 Independent role of Auditors (at least normative stance !)

 Overall structure of the board (compositions of the board, numbers of
board members, educations and professional qualifications of board
members)
 Board members expertise and skills and corporate governance
mechanism.
 God will punish !
Corporate Failure and Accounting Manipulations

Reading: Rankin et al. (2012).Contemporary Issues in

Accounting, NSW, John Wiley & Son Australia.
Chapter 13

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 What is Corporate failure?
 Also named as business failure, it means a company filing for bankruptcy because they fail to
meet financial obligations.

 Indications of corporate failure

 Appointment of external administrations/liquidators or seek external advice from
professionals.
 Sale of fixed assets.
 Lost the ability to operate as going concern as firms is making continuously loss.
 Poor cash flows;
 Defaults on loans and interest payment to lenders.
 Difficulties in obtaining financing.
 Loss of key personnel.
 Inability to pay creditors and other liabilities

Is Accounting Equation A= L+O/E work at the time of

corporate failure ? No, it does not.

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 Reasons for Corporate failure

1. Poor Strategic Decision: (Failure to scan external environment and drivers
for business growth )
 2. Greed and Desire for powers.
 3. Dominant CEOs and inadequate monitoring by the board
members;
 4. Failure of internal control: poor risk management system identify and
.
manage operational risks

 5. Ineffective board of directors- board members do not give

independent view as they are financially obliged to management .

 6. Accounting frauds
7. Poor Audit quality
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Costs and consequence of Corporate failure
 For the firm:
 Expenses to hire lawyers, accountants and restructuring
advisors;
 Reputations
Loss of key employees, managers and customers:
For the economy:
 More unemployment, slow economic growth, social
unrest and unrest.
 More reliance on social security

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 How to avoid Corporate failure ?
 1. Effective and good Corporate Governance (CG):
 Features of effective CG
 Board members are active in setting and approving the strategic directions of
companies.
 Understanding the importance of risk assessment and management
 Board members are overseeing the appropriate level of risk for the entity.
 Strong performance management system in place
This would ensure that CEO and other managers are working to achieve goals and
target.
 Board independence:
 Stock ownership
 Quality of Directors and board activism (board members should meet regularly
without management presence).
 2. Positive Mindsets of CEOS and others about integrity and fraud detections
(Corporate culture).
 3. Establishing Frauds prevention programs in the organisation.
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Regulations and political response after Corporate
failure
 Sarbanes Oxley Act in USA during 2002.
 It tightens the external auditor's independence.

Australia
 Examples of Corporate Failure HIH Insurance, OneTel

 Changes in Corporation Act 2004,The Corporate Law Economic Reform Program

(CLERP 9) from July 2004.
It strengthen financial reporting disclosures,
executive remuneration disclosures, and audit independence
 Establishment of ASX Corporate governance Council and publishing best practice
of CG guidelines.

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 Corporate Failure: Some practical cases:
HIH Insurance company in Australia
 With $ 8 billion assets, it was one of the biggest insurance companies in
Australia.
 Founded by Ray Williams during 1968. During 2001, the company becomes
insolvent to meet its obligations.
 Largest corporate failure in Australia the estimated loss when company
collapse was 5.3 billion.
 Reasons for failures:
 Ambitions of rapid expansion,
 Unsupervised delegation of authority,
 Extensive and complex reinsurance arrangements, under pricing,
 Reserve problems, manipulation of stock market information, reckless
management style ,
 Incompetence, fraud, greed of key executives
 False financial reports and newspapers information (Monem,2011).

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Corporate Failure: Consequence of HIH
Prime minister John Howard appointed a royal
commission to investigate the issue.
Directors and CEO of HIH were sentenced to jail for 4 and
half years.
See (Westfield, M., 2003) and Kehl (2001).
Was auditors and accountants responsible for that ?
Please read the following article
https://bigbadbookeeper.wordpress.com/whatreallyhappene
dtohihinsurance/

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 Corporate Failure: OneTel in Australia
 One.Tel, the country's fourth largest telecommunications company (telco), ceased
trading on the Australian stock market on May 28 appointed an administrator and after
an investigation of the company's financial situation showed it to be insolvent.
 Founded during 1995, Under an agreement with Optus, One.Tel received SIM cards,
customer call details, and network service from Optus. One.Tel had to pay Optus for the
call charges and a monthly access fee for each of its subscribers.
 OneTel’s gross profit was the excess of the amount billed to its customers over the
amount paid to Optus. The company hoped to attract customers by offering cheap mobile
calling rates, and selling profitable, long distance and international call service (Monem,
2011).

 But in August 2000, the company announced a record operating loss of $291 million for
the 1999–2000 fiscal year despite the doubling of sales revenue from the previous year to
$654 million.
 In October 2000, the merchant bank Merrill Lynch warned that One.Tel was in danger of
running out of cash.
 In February 2001, One.Tel reported a further loss of $132 million for July–December
2000.
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 Key reasons for OneTel’s collapse
 One.Tel’s earnings were of low quality. First, One.Tel had a higher accrual component in its
earnings.
 Second, One.Tel made two major accounting policy changes (one mandatory and one voluntary)
over a period of two years.
 One.Tel’s management emphasised earnings before interest, depreciation, taxes and amortisation
(EBIDTA) instead of the earnings reported under GAAP.
 Third, The audit quality for OneTel was low. The auditor issued unqualified audit opinions for
all these years (1997-2000). Subsequently, the Institute of Chartered Accountants in Australia
(ICAA) examined the OneTel financial reports and identified 48 items of objections
(Monem,2011).
 Fourth, OneTel management was able to paint a ‘rosy’ picture of the firm due to weak corporate
governance.
 Fifth, the management did not make full disclosure to the board about the performance and
solvency of the firm.
 Sixth, The link between executive pay and performance was weak in OneTel. The management
received larger performance bonuses in times of poor firm performance.
 Lastly, the non-executive directors/ independent directors failed to scrutinise management
activities effectively (Monem,2011).

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Collapse of Dick Smith in Australia
 During 2013, popular retailer Dick Smith net assets worth was $520 million.
In January 2016, its 301 stores in Australia and 62 outlets in New Zealand have
now closed. But why ?
 Losing focus with customers;
 Unable to managing the value of inventory.
 Lack of proper business planning and strategic thinking
 Leadership sets the tone.

 Read the following article in detail:

https://www.efax.com.au/blog/the-things-small-businesses-can-learn-from-the-
collapse-of-dick-smith

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 Accounting Frauds: Fraudulent Financial statements
(Rezaee, 2005)
 Financial statement frauds may involve the following schemes
 (1) Falsification, alteration of material financial records, supporting documents, or
business transactions;
 (2) Material intentional misstatements, omissions, or misrepresentations of events,
transactions, accounts or other significant information from which financial statements
are prepared;
 (3) Deliberate misapplication, intentional misinterpretation, and wrongful
application of accounting standards, principles, policies and methods used to measure,
recognize, and report economic events and business transactions;
 (4) Intentional omissions and disclosures or presentation of inadequate disclosures
regarding accounting standards, principles, practices, and related financial information;
 (5) The use of aggressive accounting techniques through illegitimate earnings
management; and
 (6) Manipulation of accounting practices under the existing rules-based accounting
standards which have become too detailed and too easy to avoid and contain loopholes
that allow companies to hide the economic substance of their performance.

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 Accounting frauds in Olympus and Toshiba in Japan (DUTTA AND
LAWSON, 2018)
 Frauds in Olympus in Japan

 After 1990s, Declining export sales led to a decline in the company’s income.
Olympus management decided to increase the earnings shortfall by engaging in
speculative investments.
 But Olympus incurred significant losses on its investment portfolio. Still the company
does not withdraw its investment portfolio and did not report the losses to investors.
 Olympus reported the investments at cost and further investing in even riskier
financial instruments. This high-risk strategy failed grossly. By 1995, the number of
unrealized losses had grown to tens of billions of yen.
 Overall the principles of honesty, fairness, objectivity and responsibility are violated
by Olympus when preparing financial statement. Interestingly, all key people such as
CEO, Chairmen, board members all knew about this frauds. The whole things got
revealed after 10 years.

 Frauds in Toshiba
 Toshiba secured multiyear, multibillion-dollar contracts to build power plants all
over the world. Revenue from these long-term contracts was recognized using the
percentage-of-completion method.
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Accounting frauds in Olympus and Toshiba in
Japan (DUTTA AND LAWSON, 2018)

 Beginning in 2008 and continuing 7 years, the fraud inflated Toshiba’s cumulative net income
by ¥150 billion using the percentage-of-completion method and unusual transaction known as
price masking.
 For price masking, please read page 46 of article written by (DUTTA AND LAWSON, 2018).
Reasons for failure:
Failure of poor Corporate Governance. Ineffective internal audit functions, poor internal control
systems (no job rotations of key finance positions).
 Please read article by (DUTTA AND LAWSON, 2018) uploaded in canvas for details.
Penalty: Toshiba
 Japanese regulator imposed ¥7.37 billion ($60 million) fines to Toshiba
(Source https://www.wsj.com/articles/toshiba-accounting-scandal-draws-record-fine-from-regulat
ors-1449472485
)

 Olympus
 Three former executives of Olympus have been given suspended jail terms for their roles
in an accounting scandal.
Olympus was ordered to pay 700m yen ($7m; £4.6m) in fines. (BBC 2013) (Source
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https://www.bbc.com/news/business-23156879)
Accounting frauds in Lehman Brothers in
USA and GFC
 It was global financial service firm (investment bank) located in US. Lehman Brothers was
operational for 158 years from its founding in 1850 until 2008. They file bankruptcy during 2008,
having over 26,000 employees.

 Key reasons for failure:

(1) Cosmetic Financial reporting and hiding true pictures of business financial status by
doing B/S manipulations.
(2) Sign off as good Audit report when companies actual position was poor.
(3) Excessive risks undertaken by Lehman Brothers.
(See following link https://en.wikipedia.org/wiki/Lehman_Brothers for details).
 Please see following videos
 (1) https://www.youtube.com/watch?v=O_ahwOIt3xI
 (2) https://www.youtube.com/watch?v=01xYpDhYwGg

 As a result of Lehman Brothers collapse, global financial crisis starts in 2008. In USA,
10 million American family lost their house.
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Accounting frauds and scandals: Any Role of
external auditors?
 In society, What we expect from Auditors ? Audit class teach you what to expect
from Auditors. (Normative Theory of Accounting)
 Auditors will work as watchdog for society for stopping corporate manipulations and
corporate collapse.
 By dint of statutory power, they will work to protect public interest.
 Based on their assurance report, they will tell ‘the true and fair view’ of the of the
business operations. They will maintain both independence in minds and
independence in appearance in their audit functions.

 What we get from them in reality ? (Positive Theory of Accounting)

 Auditors are watchdog for capitalism (capital providers only) and forgets their role
of social watchdog/ guardian.
 Audit Profession is multi billion $ industry with social status.
 They know that if capitalism collapse, they will be unaffected as they have money
and strong networks. It will once again be the millions who lose their jobs and their
livelihoods
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 Accounting frauds and Scandals: What role
external auditors perform ?
 Limited Liability of auditors for corporate collapse:
The historical bean counters now had more commercial priorities and – with limited
liability of their own – less fear for the consequences of failure.
 Compromise their independence for lucrative consulting jobs.
After the fall of Lehman Brothers in USA in 2008, it was apparent that Ernst & Young’s
audits of that bank had been all but worthless. Similar failures on the other side of the
Atlantic proved that balance sheets everywhere were full of rubbishes signed off as gold
(The Guardian, 2018).
 Monopoly of Big four Audit firms:
Big four global firms – Deloitte, PricewaterhouseCoopers (PwC), Ernst & Young
(EY) and KPMG – audit 97% of US public companies and all the UK’s top 100
corporations There are no serious rivals to undercut them. since audits are a legal
requirement almost everywhere, this is a state-guaranteed cartel.
 Busy for lucrative consulting business:
 They are free to make profit without fearing serious consequences of their abuses,
whether it is the exploitation of tax laws, slanted consultancy advice or overlooking
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financial crime. (The Guardian, 2018).
Topic to read before coming next week tutorial:

Read articles on Earning management uploaded at

the Canvas and discuss with your tutor how
earnings were managed in different situation.
Reference
 Westfield, Mark (2003). HIH: The Inside Story of Australia's Biggest Corporate Collapse. John Wiley & Sons Australia. ISBN
1-74031-064-0.

Kehl, D (2001) HIH Insurance Group Collapse. Parliamentary Library (Parliament of Australia)
Cook, T (2001), Collapse of Australia's fourth largest telco adds to growing list of corporate failures
https://www.wsws.org/en/articles/2001/06/onte-j08.html

 Monem, R. (2011), ‘Lessons for Corporate Governance’, Australian Accounting Review, 21 (59): 340–351.

 Rezaee, (2005) Causes, consequences, and deterrence of financial statement fraud, Critical Perspectives on Accounting 16, 277–29

 DUTTA, S. K AND LAWSON, R.(2018) ACCOUNTING FRAUD AT JAPANESE COMPANIES, STRATEGIC FINANCE /
November 2018, pp. 41-47

 Rankin et al ( 2012). Contemporary Issues in Accounting, Earning Management, Chapter 9, John Wiley, and Sons Australia. Pp.
256-274

 Earnings Management https: //www.investopedia.com/terms/e/earnings-management/

 asp#ixzz58wriQLZz
 Monem, R. (2011), ‘Lessons for Corporate Governance’, Australian Accounting Review, 21 (59): 340–351.
 Rezaee, (2005) Causes, consequences, and deterrence of financial statement fraud, Critical Perspectives on Accounting 16, 277–29

 DUTTA, S. K AND LAWSON, R.(2018) ACCOUNTING FRAUD AT JAPANESE COMPANIES, STRATEGIC FINANCE /
November 2018, pp. 41-47

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