Creative Accounting and Earnings Management

Topics: Enron, Kenneth Lay, Jeffrey Skilling Pages: 6 (1623 words) Published: December 2, 2014
Question 1

Explain the meaning “creative accounting” and “earnings management”.

Creative accounting refer to the accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules. It also defined as the exploration of loopholes in financial legislation in order to gain advantage or present figures in a misleading favourable light, the creative accounting’s task is to interpret the figure imaginatively, with the result that a largely fictional picture of events is often presented. They allow investors to compare the financial health of competing companies. However, when firms indulge in creative accounting they often distort the value of the information that their financials provide. Creative accounting can be used to manage earnings and to keep debt off the balance sheet.

Earning management refer to the use of accounting techniques to produce financial reports that may paint an overly positive picture of a company's business activities and financial position. Earnings Management takes advantage of how accounting rules can be applied and are legitimately flexible when companies can incur expenses and recognize revenue.

It can be difficult to differentiate these allowable practices from earnings fraud or manipulation. Earnings management theoretically represents this gray area, but it is often used as a synonym for earnings manipulation or earnings fraud.

Question 2

Parfet(2000) came up with the idea that there are two types of earnings management, “good” and “bad” and it appears that there is a correlation between “bad” earnnings management and the failure of the companies.

i. Describe the “good” and the “bad” sides of earnings management.

The good sides of earnings management are:

1. It help enterprise through a temporary financial crisis.

When the enterprise is in operation difficulty, and needed investment funds, often using profits push measures before. At this time, enterprise in general is in a poor financial situation, net assets yield rate cannot achieve match financing conditions due to high property debt, potential creditors credit support is not willing to provide. If confirmed later ahead of enterprise profit, be like, the straight-line method with accelerated depreciation, reduce the proportion of the loss of bad, delayed provision for impairment of long-term investment. Therefore, the current profits will be improved, so that the net assets yield to match demand. At the same time, these practices can raise the rate of shareholders' equity, enterprise more easily through the debt way to raise money. Such, can help enterprise have financial difficulties, causes the enterprise to have plenty of money to fund the production and business operation activities.

2. To help enterprise to reduce the cost of contract.

The surplus management can reduce the cost of contract. They think that the choice of accounting method with enterprise organization form and contracts the same form, can reduce enterprise the contract between the parties costs, promote the maximization of enterprise value. Considering the contract is incomplete, need to give operators certain accounting selection and treatment of flexibility on, in order to cope with the enterprise environment changes and other unforeseen events. Especially in the peripheral environment changes affect the enterprise contract reference index, the enterprise management can through the proper surplus adjustments affect contract index, thus it can effectively avoid the costs or technical negotiation default cost, realize the maximization of enterprise value. Managers have certain of earnings management ability, to maintain effective contract is necessary. But, this kind of earnings management on managers must not excessive opportunism behavior, not sedulous damage related interest group the interests of the premise. That is, by earnings...
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