Discretionary Accruals Model

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

This research paper is being submitted on March 10, 2013, for Tiffany Krogman, A340/ACG3085 Section 03, Advanced Auditing Concepts & Standards.

Bline, D. M., Fischer, M. L., and Skekel, T. D. (2004) Advanced Accounting. Hoboken, NJ: Wiley.

One of the most important factors is reliability of financial statements. Reliability is further ensured by audit of financial statements. At last but not least, financial statements should be made in a comparable format either with previous periods or with the competitors.

We find no difference in audit quality between these two samples. Second, we compare the mandatory rotation sample with itself one year earlier (2003) (the mandatory rotation sample in the prior year). We find that the audit quality of companies in the mandatory rotation sample under new audit partners is lower than the audit quality of these same companies one year earlier under old audit partners. Third, we compare our mandatory rotation sample with companies in years before 2003 whose audit partners were voluntarily rotated within the same audit firm (the voluntary rotation sample). We again find no difference in audit quality between these two samples. In sum, we find no support for the belief that mandatory audit partner rotation enhances audit quality. Our findings are robust to various sensitivity checks. Next, we examine the effect of mandatory audit partner rotation on investor perceptions of audit quality, using the earnings response coefficient (ERC) as a proxy for perceived audit quality (Teoh and Wong 1993; Ghosh and Moon 2005), After controlling for common determinants of the ERC, we find that the ERC of the mandatory rotation sample is not significantly different from that of the nonrotation sample or that of the mandatory rotation sample in the prior year, but is significantly larger than the ERC of the voluntary rotation sample. Overall, we find no consistent support for the belief that mandatory

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2012). Accounting Principles (10th ed.). Hoboken, NJ: John Wiley & sons.

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”?

Libby, R., Libby, P., & Short, D. (2009). Financial accounting; 6th Ed. New York, NY: McGraw Hill Retreived from: http://highered.mcgraw-hill.com/sites/0073324833/student_view0/chapter1/information.html.

Evaluate whether the selection and application of accounting policies by the entity, particularly those related to subjective measurements and complex transactions, may be indicative of fraudulent financial reporting resulting from management’s effort to manage earnings

Accrual accounting enables management to exercise its unique understanding of their business to convey important information about its economic welfare (relevance) and allows management some discretion to manipulate important information about the company’s economic welfare (reliability). Accounting analysis evaluates management's judgment on how it chooses to use accruals.

Background: Auditors have historically been more concerned with overstatements than understatements of earnings. However, recent SEC rulings suggest that auditors need to also be concerned about understatements of earnings, particularly when they are used to manipulate earnings in future periods. Actors: Oak Industries CEO, CFO, and controller (Group 4 – Trine Juliussen, Sang Uk Jung, Laura Platler)

The presence of an external auditor allows creditors, investors or bankers to use financial statements that have been prepared with confidence. Although it does not guarantee the accuracy of a financial statement, it provides users with some reassurance that a company’s financial statements give a true and fair view of its financial position and its business operations. It also provides credibility, where in business, is a major asset. With credibility, the willingness of investors, bankers and others to relate and undertake business projects with a company increases. Credibility is also important to build positive reputations.

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

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).

A company prepares financial statement to provide information about its financial position and performance. This information is in turn used by a wide range of stakeholders (such as investors, banks, customers, suppliers etc) in making economic decisions with respect to respective economic interest in the company. Typically, in terms of ownership by investment in shares of the company, shareholders though own the company but do not manage it. Therefore, the shareholder and other such stakeholders to get comfort in taking sound decision need independent assurance from the auditors that the financial statements reflect true and fair view of the company affairs in all material respects. Hence, in order to enhance the level of