Reporting and Regulation

 Advanced Financial Reporting and Regulation
Financial Reporting and Regulation
Question 1:
The reduced sales figures and revenue can vastly affect the image of an organization in market. In current commutative business environment none of the organizations like to see a downfall in their share prices or market reputation. So in order to manage its reputation in market and maintain the market position many organizations take the help of earning management (Schultze, 2005).

This part of the study is going to assess two different techniques that are used by companies to achieve their short term objectives by changing the actual figures. Both these techniques are “Channel Stuffing” and “Cookie Jar Accounting”. For making the in-depth understanding of concepts this report will assess a case of Bristol-Myers Squibb co (BMS). This company was levied with the penalties of USD 150 million in August 2004 for being involved in fraudulent scheme. According to Securities Exchange Commission, company inflated its sales and earnings figures to meet earnings forecasts. This study will provide the reasons behind using these techniques of extreme earning management and a critical evaluation of both these techniques.

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A. Motivation to Earning Management Techniques

Earning management is the choice of accounting policies that are made by managers in order to meet some specific objectives related to reported earnings. It includes both the choice if accounting policy and real actions. The choice of accounting policy includes amortization, revenue reorganization, etc. along with optional accumulation such as warranty costs, credit losses, amounts of extraordinary items and inventory values and timing. Another way to manage earning is real actions; it includes real variables such as research and development, advertising, disposals of capital assets and purchasing timing (Stickney, Paul and James, 2004).

The different patterns of earning management are used according to economic conditions and characteristics. The taking bath pattern of earning management is commonly used when the major reorganization of company is going on. Using this pattern enhances the profitability of future reported profits because of accrual reversal. The pattern of income minimization is used for incentives in form of income tax consideration during the period of high profitability. The income maximization pattern is used for bonus purpose (Howard, 2002). Another pattern is income smoothing that is used for reducing the possibility of reporting low earnings.

Healy’s Bonus Schemes Theory: The bonus that managers will revive is the one of the biggest incentives for earnings management. It was predicted by researcher Healy in their paper “the Effect of Bonus Schemes on Accounting decisions” that the performance of managers is driven by the bonus which is given on the basis of recorded net profit. In order to maximise their bonus they are usually tempted to use any one of the patterns discussed above (Haggard, Baber, and Fairfield, 1999).

According Healy there are three situations, first of them is Bogey, it is the level of net income that is fixed by the company that needs to be reached for bonus. There is no bonus given to the managers if net income is reported below this level. The bonus to managers depends on net income above bogey. Organization also set a point where managers will get the maximum amount of bonus that point is called cap. The same amount of bonus is given to managers even if the income is more than cap.

Reduce the probability of covenant violation in debt contracts: Another motivation for earning management is to stay away from convent infringement in debt agreements of the company. These agreements indicate the limitations of company to function its business. These limitations can be in term of additional borrowing, avoiding excessive dividends, etc (Bartov, 1993).

Meeting Investor’s Expectations: Another most common motivation of earning management is to meet inventor’s earning expectations. If the expected revenue is missed by the company then its share prices goes gown but if company hits it’s expected revenue than demand of shares increases and so as reputation of the company.

According to Iron Law of Accruals Reversal all increases ultimately reverse themselves. This law states that managing the earnings upward for short term will ultimately force the future earnings downward. Thus if the management of the company manages its sales revenue greater than it actually can be for short term objectives, will ultimately result as downwards in future. So if the organization need to future postponed its reporting losses then it will require even more earning management. This law concludes that if the firm’s performance is unfortunate then the day of reckoning cannot be indefinitely postpo