Question

Q1.)

You have recently been appointed as a researcher for a firm of share analysts. As one of your first roles you are required to prepare a report for your manager to outline common techniques used to manage or manipulate earnings. From your prior accounting knowledge you would have gained an understanding of techniques you can use to examine entity performance and profitability, including trend analysis. Document what strategies you might use as an analyst to detect earnings management using accounting information

Q2.)

Is earnings management always a bad thing or can it really help provide a better view of the company?

Q3.)

Name and provide an example of three advantages and disadvantages of earnings management

Q4.)

Why, and in what circumstances, would a management team consider engaging in big bath accounting?

Answer 1

The Beneish M-Score

Messod Beneish, an accounting professor at Indiana University’s Kelley School of Business, outlined a quantitative approach to detecting financial statement manipulation in his 1999 paper “The Detection of Earnings Manipulation.”

He based his model on forensic accounting principles, calling it the “probability of manipulation”, “PROBM” model or the Beneish M-Score.

This is how he built the model.

First Prof Beneish collected a sample of known earnings manipulating companies. Then he identified their main characteristics and used those characteristics to create a model for detecting manipulation.

The M-Score model includes variables that are designed to capture either the effects of manipulation or pre-conditions that may incentivise management to start manipulating results.

2)Companies use earnings management to smooth out fluctuations in earnings and present more consistent profits each month, quarter, or year. Large fluctuations in income and expenses may be a normal part of a company's operations, but the changes may alarm investors who prefer to see stability and growth.

3)

The positive role of earnings management is concerned, is help enterprise through a temporary financial crisis. When the enterprise is in operation difficulty, and needed investment funds, often using profits push measures before. At this time, enterprise in general is in a poor financial situation, net assets yield rate can't achieve match financing conditions; High property debt, potential creditors credit support is not willing to provide. If confirmed later ahead of enterprise profit, be like, the straight-line method with accelerated depreciation, reduce the proportion of the loss of bad, delayed provision for impairment of long-term investment, so, the current profits will be improved, so that the net assets yield to match demand. At the same time, these practices can raise the rate of shareholders' equity, enterprise more easily through the debt way to raise money. Such, can help enterprise have financial difficulties, causes the enterprise to have plenty of money to fund the production and business operation activities.

Two is to help enterprise to reduce the cost of contract. The contract view (EfficientContracting Perspective) scholars pointed out that surplus management can reduce the cost of contract. They think that the choice of accounting method with enterprise organization form and contracts the same form, can reduce enterprise the contract between the parties costs, promote the maximization of enterprise value.

Considering the contract is incomplete, need to give operators certain accounting selection and treatment of flexibility on, in order to cope with the enterprise environment changes and other unforeseen events. Especially in the peripheral environment changes affect the enterprise contract reference index, the enterprise management can through the proper surplus adjustments affect contract index, thus it can effectively avoid the costs or technical negotiation default cost, realize the maximization of enterprise value. Managers have certain of earnings management ability, to maintain effective contract is necessary. But, this kind of earnings management on managers must not excessive opportunism behavior, not sedulous damage related interest group the interests of the premise. That is, by earnings management, is benefit to the enterprise development.

Three is help enterprise long-term development. In production and management for the instability of the enterprise, the implementation of the profit smoothing method, can deliver to the outside a production and business operation stability of information, strengthen the confidence of investors for the enterprise, stable prices, and also help to shareholders to wealth maximization goal. Take profits back measures is increasing year by year, make enterprise performance out of "growth" trend is increasing year by year, to set up the business enterprise operating performance of the steady growth of the good image, in order to attract more investors. Enterprise if can seize the opportune time, adjust the production and business operation management, improve market share, turn "virtual growth" for "real growth", be helpful for setting up the enterprise image, the realization enterprise long-term development goals.

4 it is to achieve the goal of tax planning. Modest earnings management can help enterprise reasonable, tax avoidance and tax planning. It can not violate national tax policy, under the premise of not only reduce the tax burden on the enterprise, and at the same time and in conformity with the tax law contains the policy guidance. For enterprise, for example, it is a good choice.

The negative part of earnings management is concerned, although earnings management in the domestic and foreign enterprises are to be used extensively, but, when earnings management more than a reasonable degree, can make the accounting information lost fair sex, reliability and comparability, thus misleading information user, affect the market resources optimization allocation function, undermine social economic development. Excessive the disadvantages of earnings management mainly displays in the following respects.

1, reducing the financial statements the reliability of the information. When earnings management more than reasonable limit, it is easy to change for profit manipulation, making accounting information lose relevance and reliability. And the correlation and reliability is the two fundamental accounting information quality characteristics. Among them, the reliability is a foundation, left the reliability, accounting and lost vitality. Earnings information is the most important accounting information, it is investors, creditors and external information users to evaluate the character of the enterprise is significant. Excessive surplus management make statements of the earnings of information become Numbers game, seriously will reduce the quality of accounting information, the reliability of the information lost financial statements.

2, to enterprise's development has some of the risk. Earnings management to a certain extent though can maintain the interests of the business operators and even enterprise, but also put in bigger risk. In fact, many enterprise surplus management motivation did not give due consideration to the future development of the enterprise, and just as an expedient sight. The company through the earnings management current profit increase, will make the expected goals profits becomes more and more big. If no improving enterprise production and management activities, the next year if not reach the expected goal, in order to maintain enterprise image and company managers interests, and only more forcefully by earnings management, or even making illegal profits manipulation and accounting fraud, will eventually destroy the confidence of investors for the earnings quality, leading to a fall in the value of the enterprise market. The Shanghai securities news for investors a survey, and profit, earnings management in later turned back to will make investors disappointed. Performance of the company is not beautiful, will lead a stock value negative effects such as the downturn.

Three, the local interest to damage the interests of the whole. Due to the economic interests of the enterprise management and investors, creditors and the national interest in consistency, usually, earnings management to improve the management level of enterprises, but can't ignore management authorities in order to maintain their own economic interests and damage the investors, creditors and the country's economic interests of the facts. Excessive use of earnings management, because the local interest will damage the interests of the whole. At present, the U.S. subprime mortgage crisis, the emergence of China's financial market stability, looked up, and each enterprise by earnings management means too also have particular concern. If because every enterprise in order to its own interests, not controlled on earnings management, then, standing in the whole society's point of view, the consequences is unimaginable.

4)A big bath may also be taken when a management team wants to write off assets that have over-inflated or fraudulent values. For example, managers could have created false sales, which require that corresponding accounts receivable also be stated on the books. A big bath can be employed to write off these receivables