Question

MASTERING CORPORATE GOVERNANCE: WHEN EARNINGS MANAGEMENT BECOMES COOKING THE BOOKS There is often a blurred line between appropriate and inappropriate accounting techniques, but the audit committee must attempt to clearly distinguish which is which. The guiding principle of the audit committee is shifting from a focus on technical accounting procedures to determining whether disclosures in the financial reports present a true and fair view of the entity’s affairs. Companies often face a great deal of pressure to meet the earnings forecasts they present to investors and analysts, or the estimates these analysts make. Executives of companies in this situation often resort to using a range of ‘earnings ­management’ techniques to help them ‘make the numbers’. These techniques will often exploit loopholes in generally accepted accounting principles (GAAP) to manipulate the company’s income. It is up to the audit committee members to identify whether earnings management, accounting -estimates and other judgements are legitimate or are designed to blur the true financial position of the company. Source: Adapted from Ira Millstein, ‘When earnings management becomes cooking the books’, The Financial Times.83

QUESTIONS

1. What earnings management techniques are outlined in the above article?

2. What role can the audit committee play in detecting and/or limiting earnings management?

3. What relationship does the audit committee have with the external auditors in ensuring earnings management is within acceptable limits?

4. Evidence shows that earnings management has often been a practiced for a considerable period of time. Motivation for this practice is driven by management wishing to achieve outcomes that are favourable to them and or favourable to the entity. Outline the five methods that entities can use to manage earnings. Discuss the circumstances in which entities are likely to use each method. For each method provide a relevant example.

(Rankin, 7/2017, p. 280) Rankin, M., Ferlauto, K., McGowan, S., Stanton, P. (7/2017). Contemporary issues in accounting 2nd edition, 2nd Edition [VitalSource Bookshelf version]. Retrieved from vbk://9780730343530

Answer 1

Answers:

1|• The article provides a glimpse of how the audit committee has shown a paradigm shift from technical accounting procedures to ensuring whether the financial statements gives a true and fair view of the affairs of the company.

Following are the earnings management techniques outlined:-

• Exploitation of loopholes in the GAAP to falsely represent higher profit.

• Understatement of accounting estimates/provisions.

• Overstated Assets.

• Unrecorded liabilities.

• Misrepresentation of contingent liabilities as lower chances to materialize.

• Biasness in Financial forecast to reflect stronger liquidity and solvency.

2|• An Audit committee functions as a representative of the Board of Directors of a company and plays a significant role in corporate governance mechanism and are trusted with critical responsibilities.

Following are the roles of audit committee in detecting and/or limiting earnings management:

• Review the functions of the management, Internal and external auditors so as to ensure fair functioning of the financial system within the company and safeguard the stakeholders Interest.

• To provide accurate, complete and reliable informations to the stakeholders so as to establish transparency.

• Review of accounting policies, principles and practices followed by the company in preparation and presentation of financial statements.

• Monitoring the financial reporting process, involving review of quarterly statements to detect misrepresentation of facts and figures and other manipulations.

• Perform all other functions to enhance the credibility and trustworthiness of the financial reporting.

3|• Management resort to Earnings management and false representation when they fail to meet the investors expectations.

In this situation the Audit Committee should ensure that such earnings management report to by the management are within the limits of statute, accounting standards and policies.

The audit committee should work very closely with the external auditors and establish an effective coordination between the management, Internal auditors and the external auditors.

This should be followed by providing information and explanations, supporting documentary evidences, allow and assist the external auditors in physical verification of Assets and discuss the deficiencies identified by the internal auditors and corrective actions taken.