Evidence from Auditors About Managers’ and Auditors’ Earnings Management Decisions

When analysts question a firm’s earnings quality, it raises concerns regarding under or over aggressive accounting practices that may be allowing the firm to manipulate the earnings. Earnings quality is defined as the strength of the current earnings in being used to predict future earnings and cash flows. Since earning quality is indicative of future performance, analysts are more likely to address issues that have substantial impact on the earnings quality. An issue arises when the nature of the earnings is questioned. While permanent earnings are part of normal operations, any irregular, one time earnings can skew the earnings, making the firm look more profitable than it is. This is due to the inability to recreate similar one-time transactions that will give rise to such numbers. Investors prefer predictable

Understandably, there are a variety of ways in which a company can manage their earnings, and if accomplished successfully, the results can be highly profitable. Not all techniques are fraudulent, as effective earnings management is considered good for business and shareholders. Income smoothing is a specific example of permissible earnings management that involves controlling fluctuations in net income to make earnings less variable over a given period of time (Goel & Thakor, 2003). Smoothing is acceptable as long as it adheres to the restrictions of U.S. GAAP, which maintains that all revenues and expenses are accounted for in a defined fashion. There are a lot of incentives in figuring how to effectively smooth income, as substantial value can be created through the successful arrangement of financial transactions. Management is able to make more intelligent decisions with regards to the future of the firm if the earnings are able to match the forecasts. One instance this is seen is when management is faced with the decision to smooth total income or

Such an intense focus has been placed on quarterly earnings as an indication of a company’s success by everyone from analysts to executives that ethics have for the most part been thrown out the window, sacrificed to the all important number, i.e. earnings per share. This is the theory in Alex Berenson’s book “The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America.” This number has become part of a game to be played, a figure to be manipulated – beat the number and Wall Street all but throws a parade, miss it and a company’s stock may be abandoned. Take into account the incentives that executives have to beat the number and one can find plenty of reasons to manage earnings.

Generally accepted accounting principles (GAAP) allow companies wide latitude in the choice of accounting policies. After a firm chooses a set of accounting policies, current accounting rules permit changes from one alternative policy to another at the discretion of the management. Since reported accounting figures are widely used by a number of external parties, managers of firms have incentives to choose accounting policies in order to influence the behavior of these parties. A variety of managerial motives for

The study of Gowthorpe and Amat (2005) illustrated two different types of behavior of the preparers of financial statements. To demonstrate the manipulative behavior of preparers of financial statement, the researchers used the accounting regulation in the USA and Spanish economy. The research demonstrated the weaknesses of U.S. standards in relation with a preparer lobby. Major corporations challenge regulators by insistent their interests. Consequently, the regulation attempts to mediate and compromising between the regulator and the preparer of financial statements (p. 61). Unfortunately, the interests of financial statement users are not taken into consideration. Moreover, practices of macro- and micromanipulations do not reflect the financial user’ needs. The main goal of financial statements is to deliver the useful information to investors. However, bargained accounting regulation is unable to fulfil the key objective of financial statements (pp. 62-63). It leads to the conclusion that the accounting at macro- and micro levels is ethically questionable. Business ethics should demonstrate a high quality of the individual. Preparers of financial statements exercise the manipulative behavior through the amoral arguments and no obligation for the unethical actions. The financial misrepresentation destroys the shareholders’ income, economic activity in the country, and the public trust.

3. Identify the primary audit objectives for client’s year-end discretionary expense accruals. Is it permissible for companies to overstate period-ending expense accruals to make their financial statements more “conservative”?

Carcello, Hollingsworth and Mastrolia tested whether PCAOB annual inspections result in higher quality financial reporting (Carcello, Mastrolia, & Hollingsworth, 2011). They compare abnormal accruals reported by audit clients before and after initial inspections by PCAOB (Carcello, Mastrolia, & Hollingsworth, 2011). If the inspections result in improved auditing, they expect to see less earnings management after the initial inspection (Carcello, Mastrolia, & Hollingsworth, 2011). For comparison purposes, they make the same observations before and after AICPA peer review inspections made prior to SOX (Carcello, Mastrolia, & Hollingsworth, 2011). They find a significant decrease in income-increasing abnormal accruals in the first and second years

This research paper analyzes the degree of an auditor's liability to clients and third parties under applicable law.

As stated in Exhibit 3, Earnings management is the managerial use of discretion to influence reported earnings. Within the accrual accounting system, managers have significant discretion with their firms’ accounting choices. Management has the ability to make choices that can opportunistically lead to higher or lower reported earnings. Richard 's and Ira Zar’s (CFO) actions would not change if these results were the result of GAAP flexibility because he violated the rules of accounting, the conceptual framework principle of neutrality in numerous ways to report the financial results that CA did under false pretenses. It would be one thing if CA garnered these results through legitimate business decisions versus using accounting tactics like changes in accounting estimates or outright fraud as in the use of the 35 day Month. The purpose of which was solely to allow CA to meet or exceed analysts’ estimates.

One explanation of why firms might choose to put into practice conservative accounting practices lies in efficient contracting theory, for example, conservative accounting can be used as part of a firms strategy to ease the conflicts that arise among the many claimants of a firm’s net assets. This is because conservative accounting methods place restrictions on the distribution of those net assets thereby limiting the scope for self-serving opportunistic behavior. Conservative accounting can also help in bringing into line the interests of managers and shareholders through its impact on accounting earnings measures that are regularly used in management compensation contracts (Iyengar & Zampelli, 2010).

According to ICAEW, auditor independence mainly refers to the independence of the external auditor from parties that have an interest in the financial statements of the business being audited. It requires having both integrity and an objective manner to the auditing process. In order for the concept to be deemed effective the auditor needs to carry out their work freely. One of the main purposes of auditing is to increase credibility of the entity’s’ financial statements, as they have expressed their own professional opinion on the truth and fair view in accordance with the proper accounting standards used. This is only possible if the audit is made with reasonable assurance that it has come from an independent source and has not been influenced by other parties, such as managers, directors or by conflict of interest.

Management accounting change and the continuously changing roles of management accountants have dominated accounting literature for the past few decades and the theme of management accounting change procedures has been a topical issue of many studies such as Baines and Langfield-Smith, 2003; Kapla, 1985 and Granlund and Lukka, 1998, just to name a few.

An important function of the accounting field is to provide external users of financial statements with assurance that the financial information being presented is both reliable and accurate. This basic function of accounting is so important that there is an entire field of experts, called auditors, dedicated to assuring its proper performance. Throughout history there have been many instances in which the basic equilibrium between an institution and current/potential investor has been threatened due to a lack of accountability and trust between the two parties. This issue has been the catalyst for many discussions regarding the proper procedures a firm should follow in order to provide

The Burns and Scapens framework for analyzing managerial accounting change was built on the study of old institutional economics, which sees "economics as a process of social provision, subject to multiple and cumulative causation." This view culminates in a model that argues that the managerial accounting practices at institutions are subject to a process of constant change, influenced by routines and rules. The institutions contribute to these routines and rules, but so do actions on the part of managers within the institutions. By combining multiple influences over time, we arrive at modern managerial accounting practice. In other words, Burns and Scapens tells us that managerial accounting practice changes over time, influenced by a number of factors including rules, routines and actions.

Since reliable financial information is essential for investors and other stakeholders to take adequate decisions, this reliability must be backed by independent review performed by independent and certified auditing firms, which are supposed to verify and certify financial statements issued by a company’s management. If the auditor is not competent and independent from management, the audit of the financial statements loses its credibility (Schelker, 2013, p.295). According to Impastato (2003), because of audit failures, accountants are to blame for investors losing billions of dollars in earnings in addition to market capitalization (as cited in Grubbs & Ethridge 2007).