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GROUP ASSIGNMENT 4
BKAF3083 ACCOUNTING THEORY AND PRACTICE A151
1. Define the meaning of earnings management.
Earnings management usually involves the artificial increase (or decrease) of
revenues, profits, or earnings per share figures through aggressive accounting tactics.
It also happen when the management wish to show earnings at certain level or
following a certain pattern seek loopholes in financial reporting standards that allow
them to adjust the numbers as far as is practicable to achieve their desired aim or to
satisfy projections by financial analysis.
This adjustment amount to fraudulent financial reporting when they fall outside
the bounds of acceptable accounting practice. In addition, aggressive earnings
management become more probable when a company is affected by a downturn in
business. Plus, earnings management is seen as a pressing issue in current accounting
practice. It is relatively easy for an auditor to detect error but earnings management
can involve sophisticated fraud that is converting.

2. Discuss patterns of earnings management.


Taking a bath/ big bath
This strategies will take place during organizational stress or reorganization, when
hiring a new management or CEO or if net income less than bogey. The manager
may take bath by writing off investment in capital assets and setting up provisions
for future costs such as reorganization and layoffs. This will reduce reported net
income but the probability of high net income will increased as the future
amortization charges will be lower and future costs can be charged against the
provisions rather than against net income. Furthermore, if the provision turns out to
be higher than actually needed, the excess amounts can be reversed into future years
operations. Consequently, future years reported earnings will be higher (or losses
lower) than they would otherwise be, and the probability of the manager receiving a
bonus correspondingly increases.
Income minimization
This strategy quite similar with taking a bath but less extreme because it involves
rapid write off of capital assets and intangibles, expensing advertising and R&D and
successfully efforts accounting for oil and gas exploration costs. Basically it use for
politically visible firms during period of high profitability or if net income above the
cap.

Income maximization
Basically, this pattern will be used for bonus purpose and to violate debt covenants.
When the net income is between bogey and cap, they will use the accounting policies
and procedures that can increase an income so that the net income will be increase
exceed the bogey. However, this tactic is unlikely to be used unless pre-bonus
earnings are only slightly below bogey.
Income smoothing
This strategy quite similar with income maximization but try to sustain between
bogey and cap as they reduce volatility of reported net income thus it shows a good
signalling to the whole market in order to maintain the good reputation of
management or CEO.
Cookie jar
This strategy normally use for income smoothing because it seems reasonably
effective as an earnings management device since it can be hard to detect. The firm
has some flexibility about the extent of disclosure of gains and losses from assets
disposals. While cookie jar accounting can be reasonably effective, and has the
potential to be good, its continuing and excessive misuse may lead to its discovery
and subsequent penalties. Some company using this method to smooth reported
earnings.

3. Describe any three motivations to manage earnings.


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Bonus motivation:
Managers have incentives to maximize their bonuses, consistent with the
bonus plan hypothesis of positive accounting theory.
Consequently, they may adopt accounting policies to increase reported net
income if net income between bogey and cap (income maximization), or
to reduce reported net income if it is below the bogey (taking a bath) or
aboive the cap of the bonus plan (income minimization).
Contractual motivation:
Managers may adopt policies to increase reported net income, or other
financial statement variables, to avoid covenant violation or even to
avoid being too close to violation.
It consistent with the debt covenant hypothesis of positive accounting
theory.
Lending aggreements may also induce income-smoothing behaviour
A smooth sequence of reported net income will reduce the propability
of covenant violation.
Also, higher reported profits will reduce the profitability of technical
default on debt covenants

Political motivation:
By reducing its reported net income the firm may reduc givernment
intervention which might emerge if the oublic felt the firm was earning
excersive profits.
According to the political cost hypothesis, the largest/ utilities
companies would be most concerned because big companies are more
in the public eyes and because of their size and economic power, they
tend to attract media and political attention.
Also they may be under greater pressure to behave responsibility than
smaller firms that attract little or no public attention

4. Discuss strategies to detect earnings management.


Qualitative analysis strategy
Qualitative analyses that assess whether the companies strategies, competitive
position in the industry, corporate governance and monitoring structure make sense
or not.
Quantitative analysis strategy
Quantitative financial analyses of the financial statements using models to measure
discretionary accruals and ratios analyses.
Detailed accounting analysis strategy
Detailed examinations towards financial statements, any specific issue raised and
notes to the accounts.

5. Briefly explain the concept of agency theory and its costs.


Agency theory is developed by Jensen and Meckling. It is a theory developed to
explain and predicts the actions of agents (managers) and principals (shareholders).
This theory assume that both the agent and principal are utility maximizes.
Agency theory attempts to describe financial statements and the accounting theories
from which they originate and to explain their development base on the economic
theories of prices, agency, public choice and economic regulation. It offers a
consistent and relatively complete explanation for accounting practices and
standards.
Agency relationship involves costs to the principals. Agency cots arise from the
separation of ownership from control of an entity or an asset. It is dollar equivalent

of the reduction in welfare experienced by the principal due to the divergence of the
principals and the agents interests. The cost divided into:
1. Monitoring costs by the principal
It is expenditure by principal to measure, observe and control the
agents behaviour. Example, fee of external auditor.
2. Bonding costs by agent
Bonding costs are those the manager takes upon himself to
reduce agency conflict. Example, managers may agree to stay
with a company even if the company is acquired. The managers
must forego other potential employment opportunities.
3. Residual loss by the principal
It is the loss incurred by the principal because the agents
decisions do not serve its interests despite adequate monitoring
and bonding of management. Example, the reduction in the
market value of the firm due to poor strategies by management
of the firm.

6. Discuss two economic consequences and relate them with positive accounting
theory.
Economic consequences is a concept that asserts that, despite the implications of
efficient securities market theory, accounting policy choice can affect firm value. If
accounting policies affect firm contracts and political heat, they concern
management. The impact of accounting reports on decision making behaviour of
businesses, government and creditors.
Positive accounting theory is a theory to predict managers accounting policy
choices. Positive accounting theory shows how accounting policies can have
economic consequences:

Even without cash flow effects, accounting policies matter because they affect the
provisions of contracts based on financial statement variables and can affect the
firms political environment.
Thus, accounting policies matter to managers, they have economic consequences.

hypotheses of positive accounting theory:

Bonus Plan Hypothesis - derives from managerial incentive contracts


Debt Covenant Hypothesis - derives from debt contracts
Political Cost Hypothesis - very large firms minimize political heat

7. A companys stock market price is fully informative if all available information


is reflected in the price. Do you think it is happen during a companys
reorganization? Discuss.
This term goes to big bath. Big bath takes place during organizational stress or
reorganization, when hiring a new management/CEO or if net income less than
bogey. It is sometimes termed as clear the deck and if company must report a loss,
report a large one. The manager may take a bath, by writing off investments in capital
assets and setting up provisions for future costs such as reorganization and layoffs.
This will reduce reported net income this year, but the probability of high net income
in future years is increased, since future amortization charges will be lower and future
costs can be charged against the provisions rather than against net income.
Furthermore, if the provisions turn out to be higher than actually needed, the excess
amounts can be reversed into future years operations. Consequently, future years
reported earnings will be higher (or losses lower) than they would otherwise be, and
the probability of the manager receiving a bonus correspondingly increases.