Question

Define the earnings management in the accounting regime; based on agency theory and from the efficient contracting approach to the decision usefulness perspective , discuss the motivations of earnings management; patterns of earnings management; and market efficiency in responding to potential earnings management;

Answer 1

Agency is link between two parties. In finance, this agency is manager and the parties are shareholders and management. Shareholders want to maximize their worth and management wants to maximize their wealth. Both objectives are contrary. Shareholders wealth is maximized when the salary distributed to managers are low. Thus, One party's profit is other party's loss. This is agency problem.

This kind of problem is rationally solved by managers to rationalize the returns for both parties. The earnings are managed and manipulated to rationalise the returns of both parties. This management is tearmed as Earnings-management (EM).

EM can be done by following ways:

Bonus schemes: In this method, agent's salary is variable or dependent upon productivity of the project. This will motivate agent to work harder to earn extra profit out of the project which will maximize the principal's returns as well as agent's return.

Accrual reporting: Agents can manipulate the accounts to some extent. If they want to show extra income, they will adopt opportunistic accounting methods for accruals. And if they want to show less income, they will use pessimistic accounting methods.

The motivations of EM can be explained as below:

1) Political motivation: If a firm doest not want to come in the eyes of politics, agents try to report minimum income in the accounts. It results in lesser public pressure and reduced Governement regulations.

2) Taxation motive: In order to manipulate the amount of taxes, the earnings are manipulated. Different EM methods are adopted in order to avoid extra tax burden in certain years.

3) Contractual motivations: There are some contracts which demand higher accounting profits of the firm. Agents may use profit-increasing EM in such cases to lure these contracts. In case of paying back to the debts, firm may want to shoe lesser income. IN such cases, Profit-reducing EM are being used.

Apart from these three motivations, there are some other motivation of EM are also visible. they are:-

• Change is the management: Change in management may result in change in accounting methods as well.

Patterns of EM are discussed as below:

1) Income smoothing: In this pattern, the stress of organisation is covered up by accounting. The average income is shown in the accounts so that managers can get their bonuses and incentives.

2) Income minimization: larger amount of depriciation is charged, greater amount of assets are amortized and other pessimistic accounting is used to minimize the reported earnings. It is used as political motivation or taxation motivation.

3) Income maximization: Lesser amount of depriciation is charged, lesser amount of assets are amortized and other optimistic accounting is used to maximize the reported earnings. It is used as contractual motivation.

Market effeciency is its ability to adopt the available information in the market price of firm's share. Thus, market efficiency is dependent upon the available information. Responsible earnings managemnet discloses the potential earnings capacity of the firm. This information is converted in the price of share. Thus, Market responds to the EM as it reveals the potential earnings of firm. Potential increase in earnings will result in increased market value of firm and vice-versa. Therefore, responsible EM should be ensured by the management.