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Incentives for Managers

Discuss about the Revenue Recognition and Earnings Management.

Revenue is defined as the Income which is earned by every company or an organization during the period. It exhibits the operating income which the company generates from its core business activities. Revenue plays very important role in the financial statements of an entity and provides relevant information to the users of financial statements through which they takes and effective and efficient decision. The main aim of this report is to analyze the importance of revenue and to provide the ways by which the earnings can be manipulated. It has also described the strategies for manipulation of the earnings. All the references in the report have been made from the view of the managers and have laid down the ways which have been adopted by the managers for managing the earnings of the company. The report has been divided into four sections and has been ended up with the conclusion.

Over the past two decades there has been collapses in corporate sector affecting various companies including Enron, HIH Insurance and National Bank of Fiji. Due to these collapses, the need for proper management of the earning or revenue generated by the company has become the very significant part as main objective of every company (Rani, 2013). Along with this objective, managers of the organization have different incentives to manage the earning of the company. Management of earnings means structuring the financial transactions and statements in the manner so as to have maximum benefit. It tries to mislead the users of the financial statements by presenting the earnings as budgeted or thought by the management instead of presenting the actual performance made by the company during the period.

The different incentives are – increased managerial remuneration, management buyout and managing the regulatory concerns imposed by different authorities.

Managerial Remuneration – Every employee wants to have good returns in lieu of the work done and efforts devoted by them in the achievement of organizational objectives. Managers at the time of their employment in the business organizations signed employment contract wherein targets have been mentioned for each level of managers working at various functions of the organization. There is a very common phenomenon where Sales Managers are given target to achieve certain increased percentage of sales as compared to the previous year through which they will receive the monetary benefits in the form of incentives and cash bonuses. These targets motivate the managers to increase the earnings by manipulating the sales figure (Oberholzer and Wulf, 2012 and Beneish, 2001).

Types Of Earning Manipulation Strategies

Management buyout – In this form of incentive, managers are always encouraged to reduce the reported earnings in the financial statement. Managers in this situation play diplomatic role and hold fiduciary relationship wherein Managers on the one hand gives assurance to the shareholders for getting the best price for the firm and on the other hand wants not to pay higher price for the firm as the buyer. Therefore, managers will always have an incentive to reduce the earnings to be reported in the financial statements before the buyout. Some companies in New York have faced downward earning trends in the period prior to the buyout. (Singh, 2008). Similarly 175 management buyouts have gone through the decreasing the trends in the earnings reported before the buyout. (Cheng and Warfield, 2005)

Regulatory Concerns – Sometimes the restrictions imposed by some government authorities led the manager to manipulate the earnings. This incentive is mainly faced by the organizations that are prone to any form of investigations like those firms which have availed different forms of subsidy. Generally authorities providing subsidy poses some covenant under which the firm has to function and perform and in case it diverts then the subsidy may either not be granted or will have to refunded.

Every company wants to increase the wealth of the shareholders and other investors so as to induce the shareholder to invest in our company. To achieve this purpose, the company wants to have higher earnings being reported in the financial statements and higher profits so as to provide higher earnings mainly attributable to the shareholders of the company. But sometimes the situation occurs when the earnings goes below the expectations which in turn loses the faith of the shareholders in the performance of the company and gap arises between the earnings forecasted by the company and earnings actually earned by the company. To bridge this gap, the manager manages the earnings by adopting different strategies. There are mainly two types of earning manipulation strategies:

Real Activities Manipulation Strategy – Real earning management is the technique adopted by the manager wherein they manipulate the earnings earned by the company through the way of deviating the business operations from the normal course of operations. In this the income reported to the users of the financial statements are manipulated through deviating from the normal business operations. There are various methods to deviate the business operations. Major business activities which are diverted are Operating Activities, Investing Activities and Financing Activities (Joosten, 2012).

Difference And Trade Off Decision Between Strategies

Operating and Investing Activities – Operating activities can be deviated by reducing the expenditures. For example, as per the principles of International Financial Reporting Standard (IFRS), research and development are charged to the Statement of Income in the year in which it was incurred. Thus, by reducing the amount of Research and Development expense, the reported earnings will be increased accordingly. Also, the manipulation can be done by reducing the cost of goods sold by reducing the sales price and increasing the closing stock. Another way is by adopting any kind of restructuring program. Therefore, proceeding for mergers and acquisitions will create synergies and give rise in reported income (Cohen and Lys, 2008).

Financing Activities – Financing activities includes how the business is being financed and through which sources. These sources may include share capital, secured and unsecured loans, etc. For example, granting of stock options will reduce the earnings per share of the company. In order to increase the earning per share the company generally repurchases the stock options and thus increases the increases. In order to safeguard the earning position in the future, companies also undertake hedge instruments which hedge the company for any loss of earnings in the near future. Similarly currency swaps and other derivative instruments are used to manipulate the earnings (Hribar and Johnson, 2006).

Accrual based Earnings Management – Accrue means the presence of the right to book the revenue although it has not been received. Accrual base accounting has been made mandatory in almost all the sectors of the economy and it is being applied consistently by all the organizations. Accrual based accounting gives true and fair view of the figures reported in the financial statements. It details all the revenues and expenses that have been earned and incurred during the period under consideration. However, it has also been regarded as the earning manipulation technique. These accruals are generally used when the booking of revenue or expenditure depends upon the discretion of the managers keeping in consideration the provisions of the relevant accounting standards. For example bad debts, impairment loss or resale value of an asset, etc.

Although the two strategies – Real earning management and Accrual based earning management proceed for the same motive of manipulating the earnings of the company but there are differences between the two.

  • First strategy focuses on deviation of the business operations of the company and that too in the form of its basic three activities namely – operating, investing and financing whereas second strategy focuses on the fulfillment of legal requirements of the Accounting standards by following the accrual based of accounting.
  • First strategy is possible without the managers discretion in particular decision like decreasing the sales price and increasing the level of inventory and thus decreasing the cost of goods sold whereas in the second strategy option for manipulation of earning is possible only when the accounting standard and principles provides the discretion to the managers. For example in impairment of an assets, the discretion is given to the managers as to check whether the asset is likely to be impaired and if yes necessary provision for loss shall be made. In order to increase the earnings, the managers may declare that the impairment test has been failed and cannot be applied.
  • First strategy is widely used in almost all the organizations operating in various sectors whereas second strategy is least applied by the organizations as it operates within the legal framework and managers generally does not violates the provisions of the law. With the introduction of Sarbanes Oxley Act the chance of having managers violating any of the principles is least and therefore first strategy is more common. 

Trade off implies the method whereby the balance is achieved among the two things which cannot be easily matched. In the given case, tradeoff between the two strategies is very difficult task but managers to manipulate the earnings by both the strategies simultaneously have been able to achieve this. For example in the matter of regulatory concerns, where the company has taken subsidy and the authority governing that has imposed stipulation to have the more revenue so as to ensure that the company can repay the loans. Therefore in order to have more revenue, the manager will first divert its operating activities as per real earning management technique and then increase the revenue by following the accrual based earning strategy. Thus, in this way the manager can have tradeoff between the two strategies.

Yes, I completely agree with the statement. The phenomenon of earning management is very common and widespread. No company can say that it is not involved or indulged in the management of its earnings. It is because of one main reason which is to sustain or survive in the market. In the current scenario every investor conducts the market searches and is ready to invest in that company which will provide the better returns to him from the amount invested by him. Better returns will be provided by that company which will have higher profits and earnings. Therefore, in order to attract more and more investors companies prevailing in the market manage their earnings in such a way so as to increase the revenues and net earnings of the company. They adopt various strategies and techniques.

Secondly, I also completely agree with the second line of the statement that the manipulation generally occurs in every ending quarter and that too in huge amounts. The need of manipulating the earnings at regular intervals arises only because of the covenant or restrictions imposed by the various government authorities. For example, every listed company is required to file their quarterly financial statements within the due period at the relevant stock exchange and if not done then huge penalty may be levied. Non filing of quarterly financial statements may hamper the reputation of the company in the market. This induces the managers of the company to manipulate the earnings on quarterly basis so as to meet the expectations of not only shareholders of the company but also the other stakeholders like financial institutions, banks, employees and Income tax authorities. For example, if the company wants to have finance from the banks and banks requires the good ratios along with the analysis of credit worthiness of the company , then the company will definitely manipulate the earnings so as to give best ratios with good credibility of the company.

Conclusion

Earning management is a technique with which the managers are able to manipulate the earnings of the company so as to attract more and more investors and also meeting the expectations of the government agencies. Managers usually adopted two strategies. One is real activities manipulation and second is accrual based manipulation. First one denotes the manipulation done through deviation of the operations of the company whereas second one denotes the manipulation done through the method of accruing the revenue or expenditure. Both the strategies are executed in totally different manner and the managers usually maintain the tradeoff between the two strategies. The concept of earning management is very common and is geographically spread and is used by the all the companies. Thus, earning management plays very significant role in successful running of operations of the company.

References

Rani P, (2013), “Managerial Incentives for Earnings Management among Listed firms : Evidence from Fiji”, Global Journal of Business Research, Vol.7 (1).

Beneish, M.(2001), “Earning Management: a perspective”, Managerial Finance, Vol. 27 (12).

Singh A, (2008), “Analyses of Earning Management Practices”, University of South Pacific, Fiji.

Oberholzer F and Wulf J, (2012), “Earnings management from the bottom up: Analysis of the Managerial Incentives below the CEO”, Harvard Business School, Vol 12.

Cheng Q and Warfield T, (2005), “Equity Incentives and Earnings Management”, Accounting Review available at https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=1828&context=soa_research  accessed on 20/01/2017.

Joosten C, (2012), “Real Earnings Management and Accrual based earnings Management as substitutes”, available at https://arno.uvt.nl/show.cgi?fid=127248   accessed on 20/01/2017.

Cohen D and Lys T, (2008), “Real and Accrual based earnings management in pre and post Sarbanes Oxley period”, The Accounting Review, Vol 83.

Hribar B and Johnson WB, (2006), “ Stock repurchases as an earnings management divide”, Journal of Accounting and Economics”, Vol. 41.  

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