Earnings Management and Executive Compensation

Only available on StudyMode
  • Download(s) : 107
  • Published : November 4, 2010
Open Document
Text Preview
UNIVERSITY OF GHANA BUSINESS SCHOOL

MBA: ACCOUTING THEORY 1 – (ADMN 631)

LECTURE: JAMES KWAME OTIEKU

A PRESENTATION ON

EARNINGS MANAGEMENT AND EXECUTIVE COMPENSATION
BY

EMMANUEL MENSAH
ID NO: 10328957
AND

PETER OPATA NYAKO
ID NO: 10329653

1st October 2009

EARNINGS MANAGEMENT AND EXECUTIVE COMPENSATION

Introduction

Accounting standards define the accounting language that management uses to communicate with the firm’s external stakeholders. By creating a framework that independent auditors and the Securities and Exchange Commission (SEC) can enforce, accounting standards can provide a relatively low-cost and credible means for corporate managers to report information on their firms’ performance to external capital providers and other stakeholders. Ideally, financial reporting therefore helps the best-performing firms in the economy to distinguish themselves from poor performers and facilitates efficient resource allocation and stewardship decisions by stakeholders.

If financial reports are to convey managers’ information on their firms’ performance, standards must permit managers to exercise judgment in financial reporting. Managers can then use their knowledge about the business and its opportunities to select reporting methods, estimates, and disclosures that match the firms’ business economics, potentially increasing the value of accounting as a form of communication. However, because auditing is imperfect, management’s use of judgment also creates opportunities for “earnings management,” in which managers choose reporting methods and estimates that do not accurately reflect their firms’ underlying economics.

What is Earnings Management?

Earnings management has received several interpretations by many authors some of whom allude fraud to its application while others claim it is a legitimate exercise so long as the Generally Accepted Accounting Principles (GAAP) are not breached. The Statement on Auditing Standards (SAS) No. 82, Consideration of Fraud in a Financial Statement Audit, distinguishes fraud from error on the basis of whether the underlying action that results in a misstatement of the financial statements is intentional or unintentional. The SAS notes that, while fraud is a broad legal concept, the auditor’s concern with fraud specifically relates to fraudulent acts that cause a material misstatement of the financial statements. SAS No. 82 not only is a complex and detailed standard, but also calls for the exercise of considerable judgment. Two types of intentional misstatements are relevant to the auditor's consideration of fraud - misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets. Fraudulent financial reporting involves intentional misstatements or omissions of amounts or disclosures in financial statements, perhaps as part of a scheme to “manage earnings.” Thus to the extent that earnings management results in a material misstatement of fact(s) contained in financial statements, it will be regarded as fraudulent. Earnings management that constitutes “fraud” is distinctly different from earnings management that is perceived as reducing the quality of earnings. The term earnings management covers a wide variety of legitimate and illegitimate actions by management that affect an entity’s earnings. It is the acceptability of an accounting policy under GAAP that draws the line on the continuum distinguishing legitimate earnings management from fraud. However, determining whether or when the behaviour in the earnings management continuum crosses the line from legitimacy to fraud in a specific situation is not always easy. Where legitimate earnings management is present, there indeed may be issues and debates about the quality of an entity’s earnings, but not about whether the financial statements are presented fairly, in all material respects, in conformity with GAAP.

According to Healey and Wahlen...
tracking img