Evaluate the practice of Earnings Management from the prospective of Corporate Governance and Business Ethics
Definitions of Earnings Management
Traditionally earnings management is viewed as a distortion of economic events that is misleading to certain user of financial statements. Below are two widely quoted definition carrying this point of view:
Schipper (1989, 92): “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)...."
Healy and Wahlen (1999, 368): "Earnings management occurs when managers use judgment in financial reporting and in ...view middle of the document...
Fraud or extreme earnings management, on the other hand, is not acceptable as it involves intention misstatement or omission of material financial information which misled the financial statement users to make wrong decisions and affect economic resource allocation.
Most earnings management practices are within the boundary of accounting regulations, while extreme ones are frauds, which clearly violates accounting regulations. According to Dechow and Skinner (2002, 239): “there is a clear conceptual distinction between fraudulent accounting practices (that clearly demonstrate intent to deceive) and those judgments and estimates that fall within GAAP and which may comprise earnings management depending on managerial intent.”
Fraud or Extreme Earnings Management that violates accounting regulations
Extreme earnings management practice which violates accounting regulations or even involve fraud, is clearly unethical and should be prevented by effective corporate governance mechanisms and controls.
There is numerous famous accounting scandals resulted from fraud or extreme earnings management practices where the benefits of principal stakeholders - shareholders, management, and the board of directors, as well as other stakeholders include employees, customers, creditors, suppliers, regulators, etc are adversely affected by these fraudulent and unethical extreme earnings management practice.
I will use the some international and local cases to illustrate the problem of fraud and extreme earnings management as a result of an ineffective corporate governance.
Background: The debts of Enron were hidden and profits were inflated by more than $1 billion, indicating major problems with Special Purpose Entities. In its last 5 years, Enron reported 20 straight quarters of increasing income.
Consequence: Enron’s collapse in 2001 from a company worth $63.4 billion and it also led to the dissolution of Arthur Anderson. Over 15,000 employees of the corporate had lost most of their savings in stock, which fell from $83.01 in early 2001 to $0.01 in October 2001.
Background: Recorded improper expenses by misclassifying expenses as capital expenditure rather than operating expenses.
Consequence: In 2002, when Worldcom filed for bankruptcy under Chapter 11, it was USA’s largest corporate failure. The accounting scandal covered $11 billion. In 2004, it emerged from the bankruptcy proceedings with $5.7 billion in debt and $ 6 billion in cash.
This scandal drove the White House to back the accounting reforms that finally became the Sarbanes-Oxley Act of 2002.
Satyam Computer Services (2009)
Background: Inflated bank figures, understated liabilities and over 10,000 non-existent employees were among the many fraudulent practices being indulged.
Consequence: The former chairman and nine accomplices skimmed some $2.5 billion from the company, according to the country's Central Bureau of Investigation on Nov...