Earnings Management and Auditors

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There are three ways of managing reported earnings and the reasons behind each way may be different. (1) Report lower earnings. Managers intend to report lower earnings for mainly three reasons. Firstly, they want to hide profit for future use. In some years, the company presents a strong performance and has earned huge profit; however the manager may worry that the company’s future performance would not be as strong as current year, which gives them the incentive to save the profit by reporting a managed lower earning, so that in the future they can use the hidden profit to powder the company’s financial report. Secondly, managers are trying to avoid taxation by reporting a lower profit. Usually they will report more expenses and costs than real, so there will be less tax to pay. Lastly, the company may have a plan of issuing options to managers, and they may try to decrease the share price by reporting a lower earning so that they can set the exercise price lower as well. By manipulating the reported earnings, the managers can gain more when they exercise the options.

(2) Report higher earnings. There are also three reasons for managers to report higher earnings. Firstly, the remuneration of management may depend on the company’s performance. In order to get more payment, managers often have strong incentives to report higher earnings. Secondly, if the company is going to issue new shares, managers may try to report a higher earning, showing that the company has a strong performance or potential. Then as the share price goes up, they can raise more capital in the new share issuing Lastly, managers will report higher profit to prevent the company from being delisted (suspension) or make the company achieve the listing standard. In China, if a company’s earnings are negative in 3 consecutive years, it will be suspended; a company can only go to IPO? when it has positive earnings in the resent 3 consecutive years.

(3) Combination of the former two....
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