Earnings management practices in India: a study of auditor's perception

Author:Divya Verma Gakhar
Position:University School of Management Studies, Guru Gobind Singh Indraprastha University, Delhi, India
SUMMARY

Purpose – Earnings management are euphemisms referring to accounting practices that may follow the letter of the rules of standard accounting practices, but certainly deviate from the spirit of those rules. Companies across the world follow earning management practices in a way so as to show a favourable position to their stakeholders. Satyam scam in India was a similar type of case. The... (see full summary)

 
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Introduction

Earnings management involves adopting such practices by companies which will help them show a favourable financial position to their stakeholders ( Healy and Wahlen, 1999 ). These practices are very common, but public gets to know the repercussions only when the bubble bursts in the form of a big accounting fraud. Satyam scam in India was a similar type of case. Satyam Computer Services Ltd was formed in 1987 and was the biggest auditing fraud in Indian corporate history. Satyam was plunged into a crisis in January 2009 after its Founder, B. Ramalinga Raju, said that the company's profits had been overstated for several years. According to Raju's statement, about $1 billion (£0.65 billion), or 94 percent of the cash on the company's books, was artificially made up. Raju confessed that Satyam's balance sheet of 30 September 2008 contained inflated (non-existent) cash and bank balances of Rs 5,040 crore (as against Rs 5,361 crore reflected in the books). Raju had been allegedly withdrawing Rs 20 crore every month for paying salaries to 13,000 non-existent employees. Satyam's shares fell to Rs 11.50 on 10 January 2009, their lowest level since March 1998, compared to the highest level of Rs 800. This fraud could happen because auditors did not perform their role independently and were under the owner's influence ( Van Tandeloo and Vanstraelen, 2008 ).

At international level the accounting scandals like WorldCom (WCOM), ENRON from the USA and Parmalat from Europe are popularly quoted examples of such type of practices.

Enron Corporation was an American energy company which filed its bankruptcy in 2001. Major reason of Enron Debacle was the role played by the auditors from a prestigious firm of Arthur Andersen. Enron was estimated to have about $23 billion in liabilities, both debt outstanding and guaranteed loans. Its stock price fell to $0.61 at the end of the day's trading when it filed for bankruptcy. It happened because stock prices and executives' remuneration and wealth were linked. A favourable earnings picture and the avoidance of excessive leverage on Enron's balance sheet were perceived by its management as essential to maintaining the firm's credit rating. It also reflects failure of credit rating agencies who could not predict the fraud.

WCOM was the USA's second largest long distance phone company. Between 1999 to May 2002, the company used fraudulent accounting methods to mask its declining earnings by painting a false picture of financial growth and profitability to manage the price of WCOM's stock. The fraud was accomplished by underreporting “line costs” (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them in profit and loss account. On 21 July 2002, WCOM filed for Chapter 11 bankruptcy protection in USA. In 2002, $3.8 billion of fraud was unearthed.

Parmalat, a food giant (Italy's eighth-largest industrial empire), employed traditional means to falsify its records by doing unashamed forgery, paying no heed to the law and painting a picture of an imaginary company for the eyes of the public.

The popular methods adopted to practice earnings management by companies include premature revenue recognition, fictitious revenue recognition, aggressive capitalization, extended amortization policies and misrepresenting cash flows. It has been found that accrual accounting gives managers a great deal of discretion in determining the actual earnings a firm reports in any given period as compared to cash system. Managers can also, to some extent, alter the timing of recognition of revenues and expenses by advancing recognition of sales revenue through credit sales, or delaying recognition of losses by waiting to establish loss reserves ( Teoh et al., 1998b ). Misreporting assets and liabilities by overvaluation of assets like accounts receivable, inventory, investments, accrued expenses payable, environmental claims, and derivatives-related losses.

The present paper analyses the auditor's perceptions on earnings management practices and has been divided into five sections hereafter which include review of related literature, research objectives and methodology, data analysis, results discussion and conclusion.

Review of related literature

As far as the reasons behind earning management in corporate entities is concerned, the reference to various studies indicate that the primary objective for such practices include favourable impact on market share price, debt rating, performance management, mergers and acquisitions, equity offerings, etc. The significant references in this regard are Trueman and Titman (1988) , DeAngelo (1988) , Kaplan (1994) , Perry and Williams (1994) , Dechow and Sloan (1995) , Wu (1997) , Easterwood (1997) , Teoh et al. (1998a) , Rangan (1998) , Erickson and Wang (1999) , Loomis (1999) , Lundholm (1999) and Hirst et al. (2003) .

It has been seen that companies which are more prone to such fraudulent financial reporting practices are those with weak internal controls, having no or weak audit committees, majorly family owned businesses and board of directors have significant equity ownership ( Bloomfield, 2002 ; Hirshleifer and Teoh, 2003 ). Leuz et al. (2003) found that earnings management is positively associated with the level of private control benefits enjoyed by insiders. Spira (1999) concludes that audit committees are largely ceremonial and are ineffective in improving financial reporting. Erickson and Wang (1999) revealed that firms engaged in stock mergers inflate their...

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