Shareholders' conflict at the heart of earnings fraud

ACCOUNTANCY

Earnings management is intentional misstatement of earnings to mislead users of financial statements. The most extreme cases of earnings management amount to outright fraud and are best dealt with by the criminal justice system. More interesting, for accounting students, are situations where the broad framework of accounting allows different figures of earnings to be arrived at and various stakeholders have different opinions regarding which figure is more informative.

Such situations can arise, among other reasons, because management decisions in one reporting period generate costs and revenues which can be allocated over the subsequent periods in different ways and because many of the inputs and outputs of the firm are not traded in active, arms-length markets.

Cases like this demand the development of a corporate governance structure which brings the incentives of management closer to those of the majority of shareholders and the development of capital markets which allocate productive resources more efficiently rather than rewarding short-term profits over long-term investment.

Two kinds of conflict lie at the heart of earnings management""conflicts between different groups of shareholders and conflicts between shareholders and managers. The first kind of conflict, that between different groups of shareholders, may exist for a number of reasons. It may exist because some shareholders are 'insiders' involved in the management of the firm, while other shareholders are 'outsiders' whose only source of information about the firm are public ones like financial statements.

It may be because capital markets themselves have anomalies which allow sophisticated participants to gain at the cost of less sophisticated participants. Or it may be the case that imperfections in capital markets give advantages to large investors which are not available to small investors. In all these cases one group of shareholders would like earnings to be manipulated in ways that allows them to gain at the cost of other shareholders.

Thus, for example, incumbent owners may be motivated to inflate earnings before an IPO so that they can sell their stake in the ownership of the firm for more than it is worth.

If capital markets penalise volatility in earnings, 'insiders' may be motivated to implement a form of self-insurance by 'storing' earnings in good periods and using them in lean times, thereby smoothening the earnings stream. This shunting of earnings between periods can be done by strategic timing of investment, sales, expenditure and financing decisions.

While this also helps the 'outsiders' by keeping share price high, this does not mean that they will necessary be in support of such a scheme. This is because they may loose more in information content than they gain in firm value.

After all, an earnings management scheme can be classified as smoothening only in retrospect. If in a particular period of bad earnings 'insiders' inflate earnings, how are 'outsiders' to know if it is mere smoothening or a covering-up of a permanent decline in the firm's profitability?

Another motivation of earnings management comes from capital market imperfections which emphasise short-term gains over longer-term performance. If the capital market irrationally penalises deviations from short-term (say quarterly) goals declared by management or expected by analysts then there is a strong temptation for earnings management. While an ideal firm is expected to be transparent about its long-term goals and realistic about the short-term expectations that it creates, for many firms the temptation to fudge the figures is too hard to resist.

The other conflict which drives earnings management is that between managers on one hand and shareholders as a whole on the other. When top management's compensation is linked to current year's earnings, managers have strong motivation to manage current year's earnings to increase personal wealth even at the cost of long term performance of the company.

The main argument put forward to link top management compensation to company's earnings is that it aligns managers' interests to those of shareholders. But in practice, this objective is not achieved. Rather, it creates motivation for self-enrichment through accounting fraud. Some experts feel, rightly or wrongly, that corporate governance will significantly improve only if managerial compensation is delinked from the performance of the company.

Before the regime of regulated accounting policies, earnings management often took the blunt form of a choice of accounting policies which targeted profits. However, now companies are not allowed to change accounting policy at will.

Accounting policy can be changed only if the adoption of the new accounting policy is required by the statute; or the adoption of the new policy is required for compliance with an accounting standard; or the change in policy would result in a more appropriate presentation of financial statements. Hence, now it is rare that companies change accounting policy voluntarily.

However, it has not reduced the scope for earnings management. Under accrual accounting, assets and liabilities are carried in the balance sheet at estimated values. In many situations, those estimates depend upon the management's perception about uncertainties that surround the inflow or outflow of economic benefits. For example, the carrying amount of receivables in the balance sheet depends on management's estimate of doubtful debts.

Moreover, concepts of 'allocation' or accrual are at the heart of accrual accounting. It is difficult to set out objective criteria for the selection of the accrual policy. For example, it is difficult to set out the objective criteria to decide the period over which goodwill should be amortised. Users and auditors can seldom question the bases selected by the management for allocations of expenditure over more than one accounting period. Therefore, the accrual accounting system provides enough opportunities for managing earnings.

The most common methods for earnings management are: under or overvaluation of inventory; under or overprovisioning for depreciation; amortisation of expenses over a shorter or longer period; under or over-provisioning for doubtful debts; under or over-provisioning for liabilities; advance recognition of revenue or deferment of revenue recognition; derecognition of liabilities on the strength of dubious transactions, and recognition of assets on the strength of dubious transactions.

Motivations for earnings management will remain. Therefore, regulators, accountants and board of directors have to find ways to minimise the scope for earnings management. Formulation of rule-based accounting standards is no solution. It would be a retrograde step as it is established that rule-based accounting standards provide greater opportunities for earnings management.

The writer is a professor of finance and control at IIM-C