Earning Management Analysis

Table of Contents
1. Introduction ................................................................................................................................. 2

2. Earning Management: definition ................................................................................................ 2

3. Motivation for Earnings Management ........................................................................................ 3

4. History of earning management .................................................................................................. 3

5. Theoretical framework ................................................................................................................ 6

6. Types of Earning Management ................................................................................................... 8

7. Techniques of Earning Management .......................................................................................... 8

8. Consequences of earning management ....................................................................................... 9

9. Model used for detecting earning management ........................................................................ 10

10. Determinants of earning management .................................................................................... 11

10.1 Firm Characteristics .......................................................................................................... 11

10.2 Corporate Governance ...................................................................................................... 12

10.3 Country-Level Determinants ............................................................................................ 12

11. Earning Management in Bangladesh (Sector Wise) ............................................................... 13

12. Conclusion .............................................................................................................................. 13

References ..................................................................................................................................... 14

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 Earning Management

1. Introduction
The earning management in the last two decades was the subject of significant concern in particular
the accounting literature. It is the innovative method of accounting to generate desired income
which provides an optimistic viewpoint on the financial future of a business. Accounting rules and
standards are not explicitly broken in earning management, which gives the management an ability
to take advantage of accounting rules to distort the company's profits and incomes. The technical
assistance is to regulate the financial statements by means of which management would possibly
symbolize what they would like to have happened somewhere in the duration, rather than what
happened in fact. These strategies are vital for acceptance as an accountant, auditor, financial
consultant, lender, or investor.

Managers are committed to increasing or reducing their recorded profits through income
exploitation. In this method, the presence of various responsibility options and the basic
implementation of economic decisions are used. Managers practice earning management by a
range of different accounting methods or a basic economic decision with respect to these problems.
Many studies related to earnings management, however, is concerned with coercive accrual
earnings, but lately researchers have also applied actual operation management for the regulation
of profits.

For stakeholders, a better understanding how earning management is designed and practically used
is highly necessary. Regulators and norm setters are presented with useful insights, which they can
use to build laws mitigating the harmful influence of earning management. According to the
results, auditors may adjust their method of operation. Financial results should be objectively
reviewed by analysts and other stakeholders. An information structure is important to understand
earning management, including the root of ordinary attempts that will improve the likelihood to
identify this form of behaviour.

2. Earning Management: Definition

Earning Management has been so significant internationally that it is being addressed in a large
set of research. Many definitions of Earning Management in the literature have been published.

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The popular definition given by Healy and Wahlen (1999) about Earning Management is as
presented below:

“Earnings management occurs when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some stakeholders about
the underlying economic performance of the company or to influence contractual outcomes that
depend on reported accounting numbers.”

According to Schipper (1989), earning management is a targeted interference in the financial

reporting process to gain such personal benefit. According to Stolowy and Breton (2003), earning
management is the exploitation and management of accounts to make accounting decisions or to
design transactions to manipulate the transfer of resources among the various players.

3. Motivation for Earnings Management

Earnings Management entails the exploitation of company earnings against a pre-determined
objective. A motivation for more predictable profits, in which management is said to be carrying
out income smoothing, will inspire this goal. Opportunistic Income smoothing will in turn signal
less risk and raise the stock value of a business. The desire to preserve the rate of such accounting
ratios due to loan obligations and the incentive to maintain growing profits and to beat analyst
expectations are other potential reasons for earnings management.

Earnings management involves taking advantage of possibilities to make accounting decisions that
adjust the figure of earnings recorded in the financial statements. In essence, accounting decisions
will affect earnings as they can affect the timing of sales and the figures used in financial
statements.

4. History of earning management

Healy (1985) was the first to implement discretionary earning management, with concepts and
parameters of earning management in incentive agreements. His research analysed management
accounting judgments that postulate that managers with income-based incentives prefer
accounting methods that maximize their pay-outs. The test findings of Healy indicate that the
management's accrual practices apply to income-reporting incentives for compensation contracts

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and improvements in managers' accounting processes to their Bonus Programs. This study
identified earning management as a research line for researchers

Watts and Zimmerman (1986) claim that managers of businesses with income-based pay
agreements will exploit profits by choosing revenue-increasing accounting strategies to increase
award. McNichols and Wilson (1988) found that manipulation of provision for bad debt is another
way to manage earning. In 1988, DeAngelo noticed that administrators had a more flattering view
of their own success of accounting discretion. The administrators' blamed prior managers for
malfunctioning activities.

Schipper (1989) is another research that the writers primarily discuss. It illustrates the information
asymmetry and the impact on coercion between management and shareholders. The world around
earning management is a void between analytical and methodological income management
studies. As an indicator of income management, Jones (1991) uses discretionary accruals and
found that in import relief inquiries, managers make profits decrease accruals.

DeAngelo and Skinner (1996) found the significant negative accruals of heavily leveraged
distressed firms in relation to the renegotiation of their loan contracts. By revenue reductions in
accounting options only where confirmatory proof exists of financial difficulties and sacrifices by
other creditors, management of struggling firms during a crisis may strengthen their role with trade
unions. The irregular accruals of 94 companies reporting debt covenant breaches in annual reports
were investigated by Defond and Jiambalvo (1994). In comparison to other research, debt
arrangements that rely on collateral as a surrogate for the presence and tightness of accounting
agreements are endorsed. They found that models show that the offending businesses had an
abnormal overall accrual and that operating capital is substantially positive in the year previous to
the breach.

According to Dechow, Sloan and Sweene (1995), they test potential models for earnings
management identification. They change the Jones model (1991) and essentially demonstrate the
greatest strength of earnings control detecting. Their results further underline the importance of
financial output monitoring in the management of profits.

McNichols (2000) addresses trade-offs in relation to three typical research designs used in
literature on earnings control: aggregate accruals, accrual and earnings allocation dependent on

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management. They found that aggregate accrual models that do not take into account the growth
of long-term income are potentially deceptive and may cause misleading conclusions on income
management behaviour.

There were many accounting scandals during 2001-10 (Enron, Tyco, Worldcom, Tesco).
Researchers focused on preventing manipulation that time. Eg: Klein (2002) points to the audit
committee's central value. In overseeing the financial reporting process, he reveals that an audit
committee has a significant role to play. Klein finds that the integrity of the audit committee is
adversely tied to earning management. In order to discourage earning management, Xue (2003)
investigate the position of the board of directors, the audit committee and the executive committee.
They indicate that board of directors and auditors with business and financial experience are
aligned with businesses with lower discretion.

In the next two years, an attempt should be made to reflect on the effects and effect of the IFRS
implementation. Callao and Jarne (2010) would also investigate whether the implementation of
IFRS has, by comparing accruals over periods before and immediately after regulatory reform,
strengthened or reduced the reach of discretionary accounting procedures in the European Union.
They point out that earnings management improved after the IAS/IFRS criteria were introduced,
as opposed to previous authors. As for present budgetary accruals, for France, Spain and the UK
they are substantially increased and in other countries no big adjustments (for rise or decrease). As
far as long-term budgetary accruals are concerned, they find that all the adjustments are important,
but the number of companies in which the growth is beyond that of companies in which it is
diminished.

From 2011-2019 researchers investigates different factors and issues regarding earning
management. The association between actual and accrual earning management practices and the
IPO risk loss is studied by Alhadab, Clacher and Keasey (2013). They prove that IPO businesses
exploit profits by using actual and accrual benefit accounting around the IPO. Further, they
observed that the risk of IPO loss and lower survival rates over the following cycles was better
with a higher degree of actual and accrual earnings management over the IPO year. According to
Muktadir-Al-Mukit and Keyamoni (2019), good corporate governance practice can reduce
manipulation of income and reduce earning management.

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The management of earnings is a matter determined by various causes and situations. Various
problems relating to earnings management were seen in accordance with current market
conditions, such as why the managers manage earnings, the variables that affect the managers'
decision to opt for income management, the effectiveness of manipulation calculation and the
meaning of the term. Finally, new literature indicates that the subject remains of concern.
Management of earnings is also a matter of concern.

5. Theoretical framework
The management of earnings relates to management's responsibility, stimuli, intentions and
behaviours. The paradigm is backed by earning management theories, signalling theory, prospect
theories and theory of agency. They are discussed below:

Signalling Theory:

By presenting information in financial reporting companies will signal progress, financial stability,
and future opportunities to various stakeholders. These financial reports provide policy makers
such as owners and borrowers with the primary source of information. Decision makers respond
to these signs, and managers are allowed to exploit reports to make decision makers behave as
managers prefer (Healy and Wahlen, 1999). The company gives a misleading signal to its players
on the company's current financial results and future prospects by reporting of lower profitability
(Iatridis and Blanas, 2011).

Earning management may be efficient or opportunistic. It will improve the accuracy of accounting
information and be effective if managers had the influence and independence of calculating those
products. By using data manager calculations to divulge blocked data to shareholders, the
importance of financial information is improved (Subramanyam, 1996). Administrators are seen
as opportunistic with their own personal gain. If such an Earning management is used, managers
give disappointing details to stakeholders. Incentives for the practice of opportunistic Earning
managements are to earn bonuses based on results, please the Board, maintain jobs and give
optimistic messages on management qualifications to the sector. For customers, earning
management could be optimistic and negative, and the messages from the organization can hardly
be perceived and suitable reactions analysed.

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Agency Theory:

The agent makes decisions based on personal interests in most agency relations and does not make
decisions optimizing the value of the principal if choices conflict with agent preference (Jensen
and Meckling, 1976). maximizers are behaving opportunistically according to the agency principle
head and agent. As suggested, we describe opportunistic earning managements as managers
manage income to their own advantages. There will be a disagreement where the agent and the
principal's priorities vary and the principal needs to control the agent costly (Lambright, 2009).
Many managers have incentives dependent on results, for example promotions. This offers a good
chance to inflate sales and make them more enticing. If management are behaving according to
agency theory (opportunistically), they may provide false details in the financial statements. The
philosophy of the agency defines and discusses the fundamental issue of earning management.

Prospects Theory:

The prospect theory suggests that decision makers derive value rather than total capital from profits
and losses. The authors argue that (1) the value is to be viewed as the starting point and (2) as the
positive or negative change from this point of reference (Kahneman and Tversky, 1979). The
reduction in value by reporting income just under null is higher than the rise in value added by
reporting income just above null. This means that management do not want to announce lower
profits or losses so the valuation of the business will be diminished. Thus, there is a catalyst for
EM. One of the key reasons for managers to practice EM, as stated earlier or achieving a certain
level, is that meeting standards improves the reputation of managers. Managers give an indication
to their clients that their business is economically stable and willing to fulfil their obligations by
achieving or beating earnings expectations.

The prospect theory was assessed by researchers and contradictory findings were found. Any
studies dismiss the hypothesis of prospects after undertaking research. Other scholars have
considered empirically consistent proof hypothesis of the prospect. The philosophy of prospect
provides a perspective to the theory of rational investors and utility theories. The prospect theory
has to do with our research which may understand why minor losses are not published.

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Stewardship theory:

The manager is called a steward rather than an agent in the stewardship principle. The steward
should not behave opportunistically contrary to the principle of stewardship. The steward works
instead analogously and pro-organizationally for the interests of the principal. The steward is
committed to pursuing underlying immaterial targets including growth potential, success, revenue
growth and self-improvement (Lambright, 2009). Not for personal gain as the agency's hypothesis
suggests. The manager may behave in compliance with the best interests of the company. If
managers are behaving properly, earning management is (actually) helpful for stakeholders by
supplying stakeholders or directors with additional details.

6. Types of Earning Management

Basically, there are two types of earnings management.

Accrual Based Earnings Management: Accrual based earnings management is defined

as modifying accounting procedures or estimates within the commonly agreed accounting
standards, the purpose is to hide real economic results.
Real Earnings Management: It is defined as operational management to modify recorded
earnings in a specific direction, which is done by overproduction of inventory to minimize
the cost of goods sold or reduce discretionary spending ( advertising expenditures, research
and development).

7. Techniques of Earning Management

There are many techniques that have been used in earnings management based on firm size and
financial status. However, three techniques are commonly used by the firm-

Cookie Jar Reserve: Cookie jar reserves are savings reported by a corporation as profits in
subsequent periods from prior years to make it seem that its earnings were better than they were.
A company accountant will reach into the cookie jar to inflate the figures when a firm struggles to
achieve its earnings goal.

The Big Bath: If a company faces a bad time due to external conditions, it will harm its earnings,
it must disclose it in its accounts, but the firm will make it much harder by writing off all bad debts,

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overvaluing the depletion of properties, restructuring expenses, reporting more losses and evading
tax in the same year.

Expenses and Revenue Recognition: It can be called "Income Smoothing" as well. This is a false
accounting estimation when the organization reports the costs before revealing the benefit, sales
when received, or not showing the profit. They can also dramatically increase sales and display
excess revenue, or in the next year, they don't consider a bad debt and move it to the next year
since it decreases the benefit this year.

8. Consequences of earning management

In general, income management altered a given firm's financial position, adversely affected the
consistency of the disclosed data and enhanced information asymmetry between managers and
stakeholders. When the result of the business decision is manipulated, an organization falls from
the best business performance (Gunny, Ke and Zhang, 2010). Empirical evidence suggests that
exploitation via real activity management affects cash flow and is likely to increase volatilities
(RoyChowdhury, 2006). Only as consumers become aware of fraud will potential cash flow
previsions built into share values be re-adjusted.

The quality and accuracy of company's reporting challenges are linked to both the quality of
financial statements. The strong impact of the tax laws and the poor compliance structures of a
nation are among the reasons that lead to a low degree of data relevance. In this situation, it will
take time for investors to define earnings management practices through legitimate operations and
to tailor forecasts to the success of the company over this phase. In essence, this fact creates a
deceptive motivation. Managers will compromise potential returns in order to exploit current
results.

In recent times, the detrimental consequences of earning management have been consistently
demonstrated. The Enron bankruptcy in 2001 was simply a result of income administration, for
example, as reported by Nasrun (2019), which also referred to the Xerox and WorldCom
controversies in 2002. A critical concern that must be understood during these controversies is that
the assumed integrity of financial statements has dramatically dropped because of the very serious
impact earnings accounting activities had on corporate operations. It is worth remembering that
the Securities and Exchange Commission of the United States (SEC) has carried out an

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investigation to check the corporate commitment in the case of WorldCom and Enron and thereby
raise a global awareness of the topic of earning management.

Therefore, consequences of earning management has negative impact on shareholder and the
whole economy. People should be careful about this issue.

9. Model used for detecting earning management

Beneish’s M-Score: The mathematical version known as the M-Score from Beneish, Professor
Messod Beneish, utilizes 8 or 5 financial ratios which are weighted by coefficients to assess the
company's income exploitation. In June 1999, in order to diagnose earnings management,
Professor Messod Beneish was publishing a paper titled "Detection of Manipulation of Income."
Beneish expectations that management is encouraged to monitor benefit in order to give a strong
financial viewpoint. Via increased revenue increase, decrease cost of sold products, and cut other
discretionary expenses, they are also likely to manipulate the real benefit.

Beneish’s M-Score (8 index model): The 8 financial ratios are individually weighted according
to the following formula:

M-Score = −4.84 + 0.92 *DSRI + 0.528 * GMI + 0.404 * AQI + 0.892 * SGI + 0.115 * DEPI

−0.172 * SGAI + 4.679 * TATA − 0.327 * LVGI

Where,

1. Days Sales Receivables Index (DSRI)

2. Gross Margin Index (GMI)

3. Asset Quality Index (AQI)

4. Sales Growth Index (SGI)

5. Depreciation Index (DEPI)

6. Sales General & Administrative Expenses Index (SGAI)

7. TATA - Total accruals to total assets (TATA)

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8. Leverage Index (LVGI)

And,

DSRI = [(Net Receivablest1/ Salest)] / [(Net Receivablest-12/ Salest-1)]

GMI = [(Salest-1 - COGSt-1) / Salest-1] / [(Salest - COGSt) / Salest]

AQI = [1 - (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 - ((Current Assetst-1

+ PP&Et-1 + Securitiest-1) / Total Assetst-1)]

SGI = Salest / Salest-1

DEPI = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))

SGAI = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)

LVGI = [(Current Liabilitiest + Total Long Term Debtt) /Total Assetst] / [(Current Liabilitiest-1

+ Total Long Term Debtt-1) / Total Assetst-1]

TATA = (Income from Continuing Operationst - Cash Flows from Operationst) / Total Assetst

All elements for calculating this eight financial ratio are available in the company’s financial
statement.

Beneish’s M-Score conclude that

If Model Score < -2.22, then the company is not likely to be manipulated.

Model Score > -2.22, then the company is probably to be manipulated.

10. Determinants of earning management

The determinants of earnings management are followings:

10.1 Firm Characteristics

Leverage: Leverage is the use of fixed costs to raise the earnings of a company. The leverage ratio
calculates as total debt to total equity of any firm to understand the debt level of the firm. To

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display the extent of risk of unpaid debt, it may also include an overview of the capital structure
held by the company.

Firm Size: Firm size can be seen from the total assets, income, or market capitalization. Firm size
can be measure at log (Total asset). Firm size is considered very sensitive to earnings reporting
behavior as a proxy of political costs. This behavior will in turn affect the practice of profit
manipulation and income smoothing.

Firm performance: Firm performance can be measure as the efficiency of the company and its
market operation.

Firm investment opportunities: Firm investment opportunities help in the prospective growth of
the firm by physical and human capital investment.

10.2 Corporate Governance

Board Size: Number of directors on the board. Board size is an important determinant of earning
management.

Ownership Structure: Many research provides evidence that ownership concentration is

positively associated with accrual earnings management. Therefore, an increase in ownership
concentration increase in earnings management.

Managerial Ownership: It is measure as a percentage of shares owned by the directors. The

earnings management practices of the company sometimes depend on it.

Audit Quality: The audit standard is described as the auditors' integrity and independence, which
defines the quality of the audit as the accounting firm's ability to understand the business of the
client. Audit quality is related to six elements: first, auditor competence; second, auditor
independence; third, the specialization of auditors; fourth, audit of tenure; fifth, peer review; and
sixth, affiliated with the big four.

10.3 Country-Level Determinants

Economic development: Economic development depends on human resources, physical capital,
natural resources and technology.

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Origin of country: Earnings management practice of the country depends on the origin of the
country and its socio-economic structure.

11. Earning Management in Bangladesh (Sector Wise)

The detection of earning management contribute to help to distinguish between likely and non-
likely manipulator manufacturing companies from different industrial sectors. The investors can
make their better investment decision based on earnings management practices on various sector.
However, policymakers or regulators propose or reinforce regulations that increase the consistency
of financial statements and reduce the risk of manipulation.

Parvin (2020) shows the outcome in his paper that non-manipulator companies are greater in
percentage than earning manipulator companies except jute, cement paper & printing Industry. All
out 39 % of manufacturing companies are likely manipulator where industry-wise pharmaceuticals
& chemicals 28 % , food & allied 42%, cement 80%, engineering 42% , ceramics 0% , tannery
33% , textile & clothing 40 % , paper & printing 100%, jute 100% , fuel & power 25 % and
miscellaneous 17% of manufacturing organizations are likely to be manipulator.

12. Conclusion
Earnings Management presents an overly positive view of the company’s financial statement and
business activities using various accounting techniques and methods. It becomes a fraud activity
when a company intentionally misstate its financial statement for personal benefit. Detection of
earnings management in a firm creates a bad reputation in the market by reducing the reliability of
the financial statement. It fraudulently presents the company’s financial health to investors. It is
an unethical accounting practice where managers feel to manage predetermined earnings by
manipulating accounting practices to meet financial expectations.

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