Question

As a result of the modernisation efforts of Lee & Razak Bhd (“the Company”), the directors are of the view that the Company requires a further significant injection of working capital since the Company has committed itself to producing and fulfilling future orders for goods of an international quality.

The current lending policies of the Company’s banker requires borrowers to demonstrate a good stream of projected future cash flows, as well as a level of profitability which would indicate that repayments would be made in a timely manner. However, the current projected future cash flows of the Company would not satisfy the bank’s criteria for lending. Meanwhile, the directors of the Company informed the bank:

“Our company is in an excellent financial position. Our latest cash flow projections and financial results will meet your criteria for lending. Our chief accountant, Mr. Anwar will forward the necessary relevant reports to show you our current position.”

Mr. Anwar, the Chief Accountant joined the Company recently and has stated openly that he cannot afford to lose his job due to existing high personal commitments. Meanwhile, the directors are actively involved in managing the level of profits of the Company as they have vested interests to do so. Furthermore, they feel strongly that such efforts on their part would not pose any conflict of interest with the public interest and accounting ethics. They are of the view that ethical behaviour and codes of ethics are irrelevant and not important in managing the Company as compared to managing their profits.

You are required to write a report which include the following:

• Critically evaluate whether a practice like the nature and incentives for ‘management of earnings’ can be deemed ethically acceptable.

(350-400) words

Answer 1

The accounting literature defines earnings management as “distorting the application of generally accepted accounting principles.” Many in the financial community (including the SEC) assume that GAAP deters earnings management. ... It is well known that financial report issuers prefer to report the highest income possible.

Earnings management might be rationalized from an ends justifies the means approach to ethical reasoning. However, the analysis misses the point that the means are not accomplishing what is in the best interest of the shareholders (principals); instead it emphasizes the interest of management (agents).

Earnings management may weaken the credibility of financial reporting. ... Despite its pervasiveness, the complexity of accounting rules can make earnings management difficult for individual investors to detect.

Regulators take a conservative approach by cautioning against inherently “unethical” earnings management, arguing that it distorts a company’s true earnings and misleads the investing public.

Two types of misstatements are relevant to the auditor's consideration of fraud—misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets.

• Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles (GAAP).⁵ Fraudulent financial reporting may be accomplished by the following:
  • Manipulation, falsification, or alteration of accounting records or supporting documents from which financial statements are prepared
  • Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information
  • Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure

  Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may be that management representatives rationalize the appropriateness of a material misstatement, for example, as an aggressive rather than indefensible interpretation of complex accounting rules, or as a temporary misstatement of financial statements, including interim statements, expected to be corrected later when operational results improve.

• Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation) involve the theft of an entity's assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP. Misappropriation of assets can be accomplished in various ways, including embezzling receipts, stealing assets, or causing an entity to pay for goods or services that have not been received. Misappropriation of assets may be accompanied by false or misleading records or documents, possibly created by circumventing controls. The scope of this section includes only those misappropriations of assets for which the effect of the misappropriation causes the financial statements not to be fairly presented, in all material respects, in conformity with GAAP.

Three conditions generally are present when fraud occurs. First, management or other employees have an incentive or are under pressure, which provides a reason to commit fraud. Second, circumstances exist—for example, the absence of controls, ineffective controls, or the ability of management to override controls—that provide an opportunity for a fraud to be perpetrated. Third, those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. However, even otherwise honest individuals can commit fraud in an environment that imposes sufficient pressure on them. The greater the incentive or pressure, the more likely an individual will be able to rationalize the acceptability of committing fraud.

The managers who have worked in a less ethical company culture (i.e., a company where fraud has occurred) perceive earnings management to be more morally right and more culturally acceptable than managers who haven’t worked in such an environment. These findings suggest that tone at the top and corporate culture influence how individual managers perceive the appropriateness of engaging in aggressive accounting practices such as earnings management.

The corporate scandals of the early 2000s brought much greater public attention to the legitimacy of financial is likely to be especially sensitive to behaviors or earnings trends that appear to be unethical or overly aggressive.information reported in company financial statements. That concern has continued in the years since, and the public

Although managers may want to report increasing earnings and meet analysts’ expectations, those engaged in earnings management must also be aware of how such behavior might appear to the public. If managers believe that the public can detect earnings management, they are likely to be concerned about how that behavior is viewed. This concern has the potential to impact not only managers’ perceptions of the ethicality of earnings management but also how likely they are to engage in it.

Today, several resources are available to the general public for assessing the aggressiveness of a company’s accounting practices. With new online investment tools, interested stakeholders can acquire information about the nature of a company’s accounting choices and compare these choices to those of other companies within the same industry.

The Accounting Quality & Risk Matrix developed by Audit Analytics, for example, is an online investment tool that monitors companies for “indicators of potential earnings management and other accounting quality issues.” There’s also the Accounting and Governance Risk (AGR) Metric, offered by MSCI Inc. It assigns a score ranging from 1 (representing a “very aggressive” company) to 100 (representing a “conservative” company) that acts as a composite measure reflecting the risk associated with a company’s financial reporting and corporate governance practices.

In addition to these composite risk scores, stakeholders can also rely on “watch lists” that identify companies with the most aggressive accounting practices, such as the Forbes Corporate Risk List, as well as lists of the most conservative and trustworthy companies, such as the Forbes “100 Most Trustworthy Companies in America” list.

Regulators have also started using analytical tools to identify companies employing aggressive accounting in their financial reporting. For example, the U.S. Securities & Exchange Commission (SEC) uses the Accounting Quality Model (nicknamed “Robocop”) to identify companies most likely to be engaged in earnings management by screening for large discretionary accruals and accounting practices that differ from industry standards. The SEC intends to use Robocop to identify high-risk firms for further investigation.