Earnings sometimes called the bottom line are the most important element in the life ofbeing earned by an organization. The essence of the earnings is that they indicate the degree that the company has engaged in valued aIDed activities. Earnings are a good element for the company; however, they lead to uncontrollable ambition, which may lead to fraud. The term fraud can be defined as a criminal activity that exploits one’s position, bogus representation or taking someone else’s rights for personal financial or status gain. In essence, fraud is an act of trickery where a person or a company cheats another person or company in order to obtain an individual gain. The concept of earnings give rise to another phrase termed earnings management, which, in essence, implies the control of finances in such a way as to show a good position of a company. Indeed, it is it is a sensible and legal management reporting and decision-making anticipated to attain steady and feasible financial outcomes. Earnings management is a huge term that leads to other phrases such as “caveat emptor” that implies that a customer is responsible for any financial loss on his or her part. This only happens when the buyer has been informed of the situation of the stuff he or she is buying. In this regard, this essay will delve into earnings management particularly in exchange-listed companies. It will also assess whether it is an illegality or an instance of caveat emptor for an investor in such situations.
Earnings Management Literature Review
According to Weil (2009), earnings quality and quality of earnings have no particular meaning. However, they are utilized in accounting issues, reviewing earnings management, and in analyzing business issues such as timing of transactions. This implies that the two concepts are crucial in understanding the concept of earning management and its implications. Weil (2009) also dictates that the concept of earning management is not a complex phrase rather it is a simple and a vital term in accounting and finance. This concept occurs in two situations namely 1) during a situation when a firm has a chance of making accounting decisions and 2) when a firm takes advantage of these chances.
Bishop states that earnings are a pointer aiding the direction of resource allocation in capital markets (Bishop 2001). Indeed, the hypothetical value of a firm’s earnings is represented by the current state of its earnings. According to Bishop (2001), earnings become a crucial aspect of the firm especially when it comes to firms listed on the securities exchange. This is because the state of the earnings influences the decision of an investor. Indeed, a firm with better-looking earnings is sure to attract more investors than a company with a poor state of earnings. Bishop states that the importance given to earnings in every firm has lead to the phenomenon “earnings management.” h a huge importance, earnings management is sure to lead to several illegalities as the companies try to present a good image in the stock exchange. investor puts his or her money into a wrongly rated investment (Bishop 2001). Bishop states that several listed companies in the US and the UK fix their accounts due to a host of reasons, including the deferment of accruals and increase investor confidence.
Healy & Wahlen (1999) state that earnings management is very crucial for a company that wishes to get more investors, especially in the securities exchange. They assert that obtaining resources is a very crucial aspect in a firm and that it is very important for a firm to design ways that enable it to access these resources easily. However, they state that the existence of independent auditors and the government intervention implies that firms have limited allowance to fix their earnings to their liking. Indeed, several governments require that all financial reports reflect the real state of the company and not a fictional value. Healy & Wahlen (1999) assert that it is through these financial reports the government and hence the investors, assess the financial situation of the company. In truth, the existence of financial reporting standards implies that companies should provide correct reports in a timely manner unlike what is required in earnings management.
Healy & Wahlen (1999) state that the aspect of earnings management can only be legal if the investor is well informed of the financial situation of the company. This implies that an investor can make an informed decision on the viability and the feasibility of his or her investment. Only then, they argue, is the concept of earnings management legal and practical. In another instance, they state that earnings management for companies in the stock exchange is illegal in that the stock exchange depends on the valuation of the companies to value its shares. A wrong evaluation of a company’s earnings implies that the shares in the stock exchange will be valued wrongly too. This implies that the investors will put their money 1) into wrong investments and 2) bogus projects.
Burgsahler et al. (2004) state that the pressures and the requirements of the capital markets forced firms to operate in certain ways. They state that although the morality of earnings management is low, the firms often do it for the sake of financial gains. Several markets in the capital market strive to provide a healthy picture of its fina is different from the reality. Bugrsahler et al. (2004), however, state that the existence of financial reports implies that the investors have a better chance of investing in stocks of real value. This is because the government provides stipulations requiring the firms to provide true information in the financial reports according to financial reporting standards.
Nonetheless, Burgsahler et al. (2004) state that these standards give a considerable flexibility to companies. The reporting is often founded on private information. AIDitionally, the standards are based on personal judgments. In this way, the firms may decide to use this discretion afforded to them to satisfy their interests or provide a true picture of the finances of the firm. This implies that reporting incentives play an integral role in determining the truth of the financial reports projected. For this reason, the investors are likely to be dubbed in the process of investing in such businesses.
Hail et al. (2009) summarizes the argument by stating that there are positive and negative sides to earnings management. However, they state that the benefits accrued fall to the firms rather than the investors. Nonetheless, the investors can benefit from the deal but only if the company begins to profit after the investor has entered into the company. They, however, state that the concept is illegal considering the amount of information hiIDen from the investor.
Synthesis of the Literature
It is evident that most people regard the act of fixing accounts as illegal due to the amount of information given. The rules that govern business dealings stipulate that all the parties to the deal be informed of all the circumstances surrounding the deal. However, earnings management tends to hide these items implying that there is no fairness in the deal. The literature disagrees with the notion that the concept is legal and that it is an instance of caveat emptor in case an investor is caught in such a situation.
The US and UK Regulatory Framework
The US has several measures and regulations that govern financial reporting apart from IFRS. For instance, the United States Commission on Fraudulent Financial Reporting of 1987 describes counterfeit reporting as a deliberate or careless act of omission of information resulting in deceptive financial statements. This implies that earnings management is considered a fraud according to this commission. However, according to GAAP, these activities cannot be considered as fraud but management’s discretion.
In the UK, the Cadbury report and the Accounting Standards Board assert the need for transparency in any accounting reporting. The frameworks were designed to govern the companies from fixing their earnings. However, as it is in the US, the stipulations provided by the IFRS and GAAP influence the definition of fraud in this regard.
Several countries, inclusive of the US and the UK allow earnings management to a certain degree. However, the aggressive aspect of the concept is deemed illegal as the firms use it to obtain finances illegally. However, the importance of the concept comes when the company needs to push accruals to a later date. This, however, does not imply that the process is wholesomely legal. The fact that the investor is left with the responsibility of assessing the company does not also mean that the concept is legal. This is because these investors depend on these financial reports, which have been fixed, to make decisions.
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