Earnings Management Essay

1. When a fixed asset is purchased or leased by a company, it is expected the asset will produce future revenue over more than one accounting period. Todd (2000) explains how the accruals concept "helps when matching the cost of using the asset with the revenue it helps to generate". Todd continues to say that if it is expected that the asset will give an irregular amount of revenue every year then the depreciation charged to the asset can be greater when the revenue is greater and less when revenue is lower.

Another view is portrayed by Dechow (1994, p.4), that the matching concept was introduced in order to reflect, more closely, a company's performance and overcome any difficulties in measuring it. This, Dechow, says is due to realised cash flows having "timing and matching problems", meaning that the matching concept allows a less uneven view of earnings. By showing revenue and its associated costs in the same accounting period, whether they occurred in the same accounting period or not, allow users of the accounts to see what costs relate to what revenue and that costs are being allocated appropriately.

2. The accruals principal only provides the concept of allocating a certain amount of revenue to costs when applied over more than one period, therefore it is up to management to decide exactly how much and when (Todd, 2000). Xiong (2006) discusses the use of judgement whilst using the matching concept, noting that managers must decide when to recognise the costs and sales by deciding which costs relate to which sales in a particular period; this concept offers much flexibility as there are several stages in which revenue can be recognised. The matching concept does not have to recognise revenue when cash has exchanged hands, but at other possible times previous.

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This judgement offers opportunities for earnings management by allowing managers to "bring revenue into the year of need and postpone expenses", thus giving the accounts a smoother look (Stolowy and Breton, 2003, p.6). Jinghong Liang (2001, p.4) states that when applying the matching concept, it is important to see that it is used along side the revenue recognition concept and that both principals contribute to the accounting of earnings.

3. While a company can reap the benefits from creative accounting, it can also be beneficial to its shareholders by "manipulating key ratios used in market analysis", smoothing earnings and can therefore affect the share price (McBarnet and Whelan, 1999), and this is supported by Blake et al. (2000). However, McBarnet and Whelan (1999) also consider how this "manipulation" badly affects other stakeholders.

4. It is generally perceived that primarily the social cost of earnings management is a lack of trust in the capital market and business executives (see, for example, Lev (2003); O'Brien, (2005); Schipper (1989); Warren (2000)). Lev (2003, p.43) talks of how the social cost stretches throughout the whole of society, with manipulation possibly effecting "pension funds, university endowments and insurance companies" which the majority of society are concerned with.

5. As mentioned by Lev (2003, p.45) creative accounting is blamed on the flexibility of the accounting concepts. To a certain point this can be seen, however as Lev discusses, the shock is how these manipulations are legal. Therefore, perhaps a tightening of the rules should be made increasingly "specific and uniform".

References

Phil Todd (2000), Understanding the fundamental concepts, Association of Chartered Certified Accountants, [online], Retrieved on 10 February 2006 from: http://www.accaglobal.com/publications/diplomanewsletter/15563

Arya, A., Glover, J. C. and Sunder, S. (2003), Are unmanaged earnings always better for shareholders?, Accounting Horizons 17, pp.111-116.

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