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Review questions

One of the most cited definitions of earnings management is by Healy and Whalen in 1999:

”Earnings management occurs when managers intentionally use judgement in financial reporting and in structuring transactions to alter financial reports to mislead some stakeholders about the underlying economic performance of the firm or to influence contractual outcomes that depend on reported accounting numbers.”

Accounting fraud does not have a precise definition, but may be identified as earnings management that is so material that is clearly outside the law and subject to criminal prosecution.

The motives could be structured in two groups (Giroux, 2004):

  1. Earnings management to maximize value for the owners
  2. Earnings management to maximize personal gains for management

Pressure, opportunity and rationalization are three circumstances that usually are present in some degree when earnings management and potentially fraud occurs.

In addition to the general motives for earnings management and the ‘environment’ for earnings management, analysts should be aware of some event specific factors where earnings management is more frequent:

  1. Financial distress
  2. Capital market events
  3. Change of management
  4. Change of auditors
  5. Changes in rules and regulations
  6. Implementation of incentives for managements

See pages 562–572 Example 15.4–15.14, which include firms like Enron, WorldCom, Parmalat, Olympus, Toshiba, ABB (Sweden), Kraft & Kultur (Sweden), Finance Credit (Norway), Sponsor Service (Norway), IT Factory (Denmark) and OW Bunker (Denmark).

Revenue growth is an important input factor in valuation. Recognising too much revenue often results in material numbers and normally has a 100% profit impact. The accounting standards (up till now) have been somewhat vague and with options, allowing for flexibility.

Key mechanisms introduced after 2001 have been to tighten regulations:

  1. More detailed accounting rules, and the discussion of ‘true and fair’ view
  2. Improved enforcement and oversight boards
  3. Stricter regulation of auditors
  4. Increased requirements for corporate governance, some hard law and others soft law