Manipulating Budgets For Earnings Management: Internal Factors And Motives

Importance of Budgeting

Discuss about the Budgeting and Its Impact on Financial Reporting.

The purpose of this paper is to find out how manipulating budgets can assist in earnings management. The report will include a discussion on the budgeting process, the person/s involved, why is it done and how it is done to identify the internal factors and/or motives behind the manipulation of budgets and how it assists in earnings management. The importance of knowing how budgets are manipulated will help deter fraud and other unethical behaviors, aid in creating better and effective budgeting alternative, therefore minimizing if not preventing earnings management.

This paper utilizes secondary research to answer the question of how manipulating budgets can assist in earnings management by analyzing previous research and studies and by comparing differing viewpoints. The main sources of information for this research are Academic Journals, Trade magazines, and research studies and articles from credible sources both from NAIT library database and the Internet. This report could help managers and/or business owners identify the reasons or motives on why manipulation of budgets happens and how it assists in earnings management. By knowing this, managers and/or business owners can then find alternatives and ways to improve the budgeting process and create a plan to deter this unethical business practice from occurring again. Since earnings management is a broad topic on its own, discussions in this paper is limited to earnings managements in relation to budget manipulation and emphases on internal factors that cause it.

Budget is an essential tool to translate general plans into specific, action-oriented goals and objectives (Walther, n.d.). It provides guidance to insiders in an organization such as managers and/or business owners to help achieve organizational goal. The purpose of budgeting is to give those goals and plans financial values, making the progress easily measurable and to transform the strategic ideas into understandable operative actions (Hanninen, 2013). Budgets are useful for allocating the resources of an organization to different areas and departments within it and for controlling and monitoring how such resources are spent. Insiders often have access to a wide range of financial and non-financial information in addition to the budgets when carrying out their internal operations. Therefore, organizations uses budgets to forecast income and expenditure, as means for making important decisions and monitor business performances. Business owners and managers need to be able to predict if the business is profitable or not, therefore budget forecast is very important because it models how the business should perform financially and how plans should be carried out to achieve profitability targets. Also, budgeting provides financial framework for the decision-making process to make sure that a certain course of action is something planned or not. Lastly, budgeting enables actual business performance to be measured against the forecast business performance. (Isaac, n.d.).

Budgeting Process and Those Involved

A good budgeting process engages those who are responsible for adhering to the budget and implementing the organization’s objectives (Foley, n.d.). Budgets are typically used to hold managers accountable for their areas of responsibility in the organization; actual results are compared against budgeted goals and timetables, and variances are highlighted.  Managers don’t mind taking credit for favorable variances, when actual comes in better than budget. However, beating the budget for the period doesn’t always indicate outstanding performance. A favorable variance could be the result of manipulating the budget so that the budgeted benchmarks can be easily achieved. Budgeting decisions are driven both by mission priorities and fiscal accountability and although budget is made to serve as guide for managers to make financial decisions for the company, it can be altered and use for personal advantage instead.

Since budget is simply a tool that can help management plan and control resources, any tool can be misused. The budget processes too often serve as opportunities for self-aggrandizement and enrichment by undeserving and unscrupulous manager. Many will manipulate numbers in their budget reports to inflate results and artificially achieve short-term targets and others will spend money wastefully so as not to see a reduction in next year's budget allocation (Merchant, 2013). Issues arise due to conflicting interest of various people in an organization whether they are directly involved in the budgeting process or not. Most common conflict is between managers and shareholders, and managers and lower level employees.

According to Walker K. B. and Fleischman G. M., organizations that link accounting measures to pay, frequently deal with a variety of undesirable, and often unethical behaviors. Presently, the business press is replete with stories about how employees engaged in ethically questionable and illegal behaviors to make themselves look better on performance evaluations and obtain bonuses. Generally, these behaviors occur in two related contexts: (1) biasing information or otherwise coordinating activities to “game" the realization of budgets or (2) timing reported or actual economic events to shift income between periods, also known as earnings management.

Earnings manipulation or commonly known as Earnings Management is an  accounting technique used by management in many companies to influence earnings to achieve the desired end. This is done to produce financial reports that may portray an overly positive picture of a company’s business activities and financial position. Earnings being the most important information in financial reporting is used by different parties in their decisions to determine the firms’ economic value and the allocation of its resources which is done through budgeting (Nurul Fitri Mohd Noor et al., 2015). Organizations then compare the financial results of their actual operations against their budgets to find out the reasons and sources for the difference. These differences could arise because either the actual operations strayed away from the budget, or the budgets were unrealistic to start with and thus had no chance of being met from the very beginning. Many financial reporting frauds have their origin in overly optimistic budgets and forecasts that subsequently lead to an environment of “cooking the books” to reach unrealistic goals (Gartenstein, n.d.). This means that a deliberate distortion or falsification of the financial statements is present which gives a misleading picture of a firms’ financial performance or position. These issues are all components of Earnings Management and as mentioned earlier, these behaviors occur in two related contexts; gaming the budget and income smoothing.

Ethical Issues and Unethical Behaviors

Budget gaming is a technique of manipulating budget through biasing information or otherwise coordinating activities to “game" the realization of budgets. Budget-based performance contracts is considered as one of the most common causes of unethical behavior in organizations. Although the goal of budget-based performance is to motivate people to perform well, this approach has tempted them to engaged in behaviors that include lying, cheating, and shirking. These systems fail to create enduring commitment; instead, they increase dependency rather than empowerment among employees, which leads to management cultures based on fears, all of which may lead to unethical and fraudulent behaviors by both employees and managers. Whether budgetary gaming is an accepted practice or not, organizations behavioral norms are sometimes an explicit factor in determining the ethicality of budgetary manipulation. These behaviors arise in response to management pressure: Generally, higher levels of management are accepting this practice and are concerned more with controlling slack instead of eliminating it. Although there have been good and bad outcomes, the Securities & Exchange Commission (SEC) and the court find these activities unethical. They agree that lying about the occurrence of business transactions, falsifying accounting records, and defrauding customers are illegal actions. (Walker K. B. & Fleischman G. M, 2013)

Meanwhile, income smoothing is a technique used in manipulating earnings through timing reported or actual economic events to shift income between periods, also known as earnings management. This is just one of the few patterns or technique in earnings management. In this technique, firms’ use earnings targets which is frequently rooted in the budget to determine compensation pay. As a result, managers have the incentives to manipulate earnings, the budget, or both to maximize their monetary benefits such as salary, commissions, or bonuses, while at the same time, avoiding actions that might cause subsequent year’s performance standards difficult to achieve. An example given by Walker K. B. & Fleischman G. M is that, managers may choose various inventory and bad debt  accounting methods, or they may manipulate revenues and expenses as the circumstance dictate. 

1. Analysis and Recommendation
2. Evaluating and overhauling the budget process
3. Setting realistic goals not over-optimistic budgets.
4. Rewarding employees for accomplishments and not just for achieving targets.

Who are involved in budgeting and financial reporting?

This is process which to identify the future expenses and income which company will receive. This budgeting will idea or estimation about the future expenses and income which company will have in future. There are following persons involved while preparing budgeting and financial reporting such as management department, financial manager, accounting department and business planner of organization.

Earnings Management and Budget Manipulation

Budgeting of the organization is prepared by using capital budgeting tools and financial reporting frameworks.  However, all stakeholders are involved in preparing budgeting and financial reporting of organization. Therefore, all the key stakeholders who are working at the management team are the person involved in budgeting and financial reporting.

Why is it done?

Budgeting and financial reporting is prepared to deter fraud and other unethical behaviors. In addition to this, it will also aid in creating better and effective budgeting alternative for making effective financial planning of organization.

In simple words, budgeting is prepared to provide guidance to insiders in an organization such as managers and/or business owners to achieve certain financial goals and objective in determined approach. The purpose of budgeting is to give those goals and plans financial values, making the progress easily measurable and to transform the strategic ideas into understandable operative actions.

How is it done?

This budgeting is prepared by using budgeting tools and using capital budgeting methods such as Net present value method, preparing cash flow by using direct and indirect method and drafting various budgets such as operational and financial budget.

This will help company to evaluate the future expenses and income of company to prepare financial planning. This prepared budget will help owners to make effective strategic decision for the betterment of organization and creating effective business functioning.

How to prevent it?

This report has reflected various limitation and problems which company will face due to its non-efficient budget. However, in order to curb these problems, organization should follow proper trend analysis while preparing budget.

This trend analysis will identify all the ups and down of the organization which will identify all the associated factors and problems in budget.  This budgeting issues and problems are very common. However, proactive budgeting plans and using project escalation amount is used to help organization from the unforeseen factors and challenges arise due to sluggish market conditions.

Conclusion

In evaluating the budget process, it is important to remember that a budget is simply a written estimate or a plan of how an entity will perform financially. Thus, a budget should not be prepared on the imaginary data but should be made of primary and secondary data. Now in the end, it would be inferred that budgeting is the most important tool to estimate the future expense and amount of income which company will receive in future. This could be concluded that if company could use proper budgeting tools then it will surely result to effective preparation of budget.

References

Foley, E. H. (2010). The Budgeting Process. Retrieved October 10, 2017, from https://www.nonprofitaccountingbasics.org/reporting-operations/budgeting-process

Gartenstein D. (n.d.). Budgeting Ethics. Retrieved October 11, 2017, from https://smallbusiness.chron.com/budgeting-ethics-47002.html

Hanninen, V., (2013). Budgeting at a crossroads – the viability of traditional budgeting – a case study. Master’s thesis, Aalto University School of Business.

Isaac, L. (n.d.). Purpose of a Budget. Retrieved November 1, 2017, from https://www.leoisaac.com/budget/bud031.htm

Merchant, K. A. (2013, July 21). Companies get Budgets All Wrong. Retrieved October 9, 2017, from https://www.wsj.com/articles/SB10001424127887323873904578571810482331202

Noor, M. N., Sansui, Z. Mm, Heang, L. T., Iskandar, T. M., & Isa, M. Y. (2015). Fraud Motives and Opportunities Factors on Earnings Manipulations, Procedia Economics and Finance, 28 126 – 135. Retrieved November 15, 2017 from https://www.sciencedirect.com/science/article/pii/S2212567115010916

Walker, K. B. & Fleischman G. M., (2013). Toeing the Line: The Ethics of Manipulating Earning and Budgets. Management and Accounting Quarterly Spring, 14(3): 18-24.

Walther, L. (n.d.). Importance of Budgets. Retrieved October 10, 2017, from https://www.principlesofaccounting.com/chapter-21/budgets/