Question

Members of the financial community often allege that corporate managers “manage” their company’s reported accounting results. To accomplish this, they commonly use “discretionary accounting accruals.” Discuss the possible motivations behind this behavior. Could you envision a situation where a manager might manage a company’s earnings downward? If so, why?

When a company’s management or its independent auditors discover misstatements in financial statements, they are required to evaluate the nature and materiality of misstatements, and make decisions to issue financial restatements. What are the negative implications associated with financial restatements?

Answer 1

In accounting, the term "accrual" refers to a journal entry where a revenue or expense item is recorded in the absence of an actual cash transaction. Discretionary expenses that take place to promote or enhance the company's standing with its employees, often it is called as "Earning management".

There can be a strong motivational factor to managers to play with earning figures since bonuses are often based on the bottom line. Managers may be tempted to increase earnings figure since their bnuses may be direct figure of this amount. On the other hand managers may be "take a bath" in a year where net income is expected to be low since they will not reach the earnings figure required to receive a bonus. There is the minimum net income figure required for the managers to receive a bonous; the cap is the maximum net income figure for which a bonus will paid out. Therefore, managers realizing that they will not be able to reach the targeted minimum net income figure may be enticed to "take a bath". Likewise, if income were considerably higher than the cap, the manager would be willing to absorb additional losses since the amount of their bonus will not be affected. Ultimately managers, who take losses in the current year to reduce net income below the cap will place the firm in a better position to perform well in future.

Many contractual agreement within the corporation revolve around the debt convenant hypothesis. This hypothesis implies that lenders to the corporation may include requirements in the debt contracts that net income, the current ratio, the debt equity ratio,and dividend policies must not change or fall below a certain level. Since the cost violating a debt convenant can be extremely high, a managers interests lie in keeping the corporation at a level that does not jeoparadize the contractual agreement.

The third reason is stems from political motivation. Many industries in the economy operate under a monopoly or a oligopoly. Firms in this industries may be tempted to use earning management to decrease net income because profits that are too high may prompt a public outcry for the government intervention in the industry. Minimizing net income allows the industry to continue operation without government interferance.

Fourth reason is to take advantages of taxation policies.

The managers can be make a situation where he migt manage company's earning downward. This situation can be remember for the factor motivating this by the word WISE.

1. Window dressing
2. Internal target
3. Income smoothing
4. External expectation

There is a internal factor also The internal reason is to meet targets. The targets may be there for a number of reason. Some may just be budgeted numbers, which if they are not met will look unfavorable on the person, deparment, or company that "blew the budget".

The external factor is that the company may have previously projected numbers that external parties are now expecting the company to meet or exceeds. Extarnal analyst may have made their own predictions public, which the company would now like to achieve.

Investors and potential investors, like to see continual upward income growth. It looks really positive and looks as if the company is doing well in the charts found in annual reports.

finally, if a company is looking for new financing, they will have an easier time obtaining it if they have good looking financial factor listed. Therefore window dressing is the final factor listed.

The need to restate financial figures can result from accounting errors, noncompliance with generally accepted accounting principal (GAAP), fraud representation, or a simple clerical error. A negative restatement often shakes investors confidence and causes stok's price to decline.

Investors rely on financial statement for forecasting firms' future profitability and for firm valuation. Research has been statetd that firm has been depended on the report for future assesment and firm's relliability. Unlike the estimations of earnings component or analyst pperception of earning quality, restatements clearly signals that the prior financial statements were not credible and were of relatively lower quaity.

The effect of restatement on information asymmetries in the stock market and on the investors reliance on the firms future financial.

It also affect the temporary changes in the perceived information asymmetry in the stock market. Due to the asymmetry in the market firm's stock price may be declined because of uncertainty surrounding the finacial result of the company.

For the error in prior financial statements may reduce the perceived reliability of future financial statements, information assymetry may remain higher even after the restated financial statement.

Restatement also affect the future coefficient of firms earning releases. And it is expected that investors will rely less on earning report after error on finacial statements.