Earning Management and Earning Quality Harvard Case Solution & Analysis

Victims of Earning Management

The aim of using a costly approach for earning management is because it is harder to detect the accounting practices when a costly method is utilized. The financial statement users are the most common victims of the earning management. The most common examples of a financial management users include equity investors, bankers, regulators, supplier, customers, and even competitors involved(Rahman, Moniruzzaman, & Sharif, 2013). While considering the case of a public limited company, the victims involve the investors that have shares in company’s equity. It has been explored through various studies that the companies who are involved in this practice tends to have a poor financial performance in the near future. The investors of the company have to overpay for the amount of their shares if earning management process is applied in an organization(Lo, 2008).

The reason that the investors of the firm cannot anticipate the earning management practices and applies discounted information in its IPO price is because the nature of the IPO is different as it does not operate like the secondary market which results in the higher efficiency of company’s shares(Ewert & Wagenhofer, 2012). In order for the efficiency to occur in the shares,it is necessary to balance the buyers, the sellers and the price. Therefore, in secondary markets the balance has been provided by the shareholders and short sellers in balancing out the number of buyers. However, in the case of IPO market company insiders are generally the sellers, and the investment bank is responsible for setting the IPO price of the company. In this case, it does not provide a need to balance the IPO shares, which makes the process vulnerable to earning management(Ewert & Wagenhofer, 2012).

Motives for Earning Management

It is a global assumption that a crime is not committed for no specific reason, but it always have certain purpose or any kind of financial gain which rewards the performer for the fraud. In a study it has been revealed that carrying out the earning management practices involve many aspects and reasons which might include financial gains, revenge, self-preservation and many other reason which either involves gains or losses. As the earning management activity is performed deliberately by a suspect, the aim of personal gain is highly involved as the risk is even greater to attempt malpractice(Iatridi & Kadorinisb, 2009). The major reason for the inception of earning management is the satisfaction of expectations. The purpose of income smoothing the meeting, the expectations of investors are prime reasons which allow financial users and the capital markets to perform the illegal activity(Rahman, Moniruzzaman, & Sharif, 2013).

The socioeconomic factors involved in the motives which include pleasing the expectations of the investors that varies from one country to another. Many countries have defined the types of earnings which are acceptable and legal and have drawn a fine line with the types of earning management which is illegal(Ewert & Wagenhofer, 2012). However, the motives may remain the same between countries but the extent of the crime shall differentiate according to the cultural differences. The motives of the earning management may also be the result of concealing the private information of companies if it does not want any quick consequences in its stock prices. The growth and the stock signal element can be revealed and manipulated to conceal the private information(Rahman, Moniruzzaman, & Sharif, 2013).

Escaping the governmental regulations and tax laws are also considered as the general motive of the company. Some government regulations may encourage to influence tax collection when a certain amount of profits are achieved by the company. Therefore, in order to avoid paying taxes to the government, the company uses the approach in making changes in the financial reports(Rahman, Moniruzzaman, & Sharif, 2013). While considering the personal incentives involved during the process, the CEO of the company can manipulate the reports in order to keep a seat in the board of directors because of the good performance of the company. These personal incentives can ruin the company in the future run(Iatridi & Kadorinisb, 2009).

Enron Scandal

Enron was an American energy corporation which was filed for its bankruptcy in the year 2001 and was considered as the largest bankruptcy to be filed in the American history. The company developed the accounting loopholes and poor financial reporting due to which the company was able to hide billions of dollars which were in debt which had occurred due to the failure in projects. The Chief Financial Officer and other top executive of the company tempered with the financial reports to mislead the board of directors and also pressurizing the auditing committee. The shareholders of the company filed a lawsuit which declined the stock prices of the company from $90 to $1...............................

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