Companies often try to keep accounting earnings growing at a relatively steady pace in an effort to avoid large swings in earnings from period to period. They also try to manage earnings targets. Reflect on these practices and discuss the following in your discussion post.
Are these practices ethical?
According to Ortega & Grant (2003), “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company to influence contractual outcomes” (p. 51). Because these practices are used to alter the financials of a firm from actuality, then, no, these practices are not ethical, however there are common practice and, in some circumstances, acceptable.
What are two tactics that a financial manager can use to manage earnings?
Financial managers at times will use certain tactics to manage earnings. Two tactics that financial managers use to manage earnings are the Big Bath technique and the cookie jar reserve. The big-bath technique consists of taking a one-time, large write-offs or restructuring charges against income in order to reduce assets to further lower future expenses (Hope & Wang, 2018). The use of the big bath method can affect a firms’ competitiveness as it is essentially reporting a loss, which can have negative results on stock prices. The other method is the cookie jar reserve occurs when a company saves money from successful years and draws from that money and applies it to bad years in order to bolster earnings reports (CPA Journal, 1999). The method is used as way to smooth income and appear financially better when in actuality the company is having a bad year.
What are the implications for cash flow and shareholder wealth?
Ultimately, financial manager’s job is to maximize profit, because of this conflict of interest may occur. According to Chalak & Mohammadnezhad (2012), “with respect to increase shareholder wealth, free cash flows are of importance because allow managers to seek growth opportunities which increase share value” (p. 430). Therefore, the use of the techniques in the regards to implications for cash flow and shareholder wealth can be detrimental due to unreliable and inaccurate information, which occurs from managers intentionally influencing actual financials.
Using the financial balance sheet as displayed in the text, provide an example of how purchasing an asset or issuing stocks or bonds could potentially impact earnings targets.
When purchasing an asset or issuing stocks earnings targets are impacted due the changes in cash flow. For instance, when purchasing assets, the cash accounts will decrease the purchase amount, while issuing stocks or bonds increases by the amount received for the purchased stocks. These actions can a company to miss or exceed its earnings targets by the amounts of cash flow coming in or going out.
Chalak, S.L., & Mohammadnezhad, S. (2012). Investigation of the Relationship Between Earnings Management and Free Cash Flows in Firms with High Free Cash Flows and Low Growth Listed in Tehran Securities Exchange. World Applied Sciences Journal, 20(3), 429-437. Doi:10.5829/idosi.wasj.2012.20.03.2372
Hope, O.-K., & Wang, J. (2018). Management deception, big-bath accounting, and information asymmetry: Evidence from linguistic analysis. Accounting, Organizations and Society, 70, 33–51. https://doi-org.proxy-library.ashford.edu/10.1016/j.aos.2018.02.004
Ortega, W. R., & Grant, G. H. (2003). Maynard manufacturing: An analysis of GAAP-based and operational earnings management techniques. Strategic Finance, 85(1), 50. Retrieved from https://search-proquest-com.proxy-library.ashford.edu/docview/229862181?accountid=32521
Signs of Backlash Against SEC’s Attack on Cookie Jar Reserves and Income Smoothing. (1999). CPA Journal, 69(8), 10. Retrieved from http://search.ebscohost.com.proxy-library.ashford.edu/login.aspx?direct=true&db=bsh&AN=2190694&site=eds-live&scope=site
The process of managing or manipulating corporate profits to achieve consistency over a quarter is referred to as earnings smoothing (Eckles, Halek, Enya, Sommer, & Zhang, 2011). Corporate stock valuations are dependent upon a company’s future earnings interest. Many recent research, among them the Eckles et.al. The research has started to directly link quarterly earnings smoothing operations to executive compensation. Heavily compensated managers based on stock value are often found to be heavy manipulators of quarterly earnings results (Eckles et al., 2011).
If quarterly smoothing operations are ethical or not involves a distinction in the justification for the smoothing. As we addressed in the Week 1 forum, there are normal cycles in which businesses receive excess returns in one period, which can or should be allocated or invested in future periods for the assets needed. I’ve banked several customers who would take over profits in one quarter and buy critical inventory that they’d store for future quarters. In effect they would spend cash in preparation for quarters that showed lower cash flow levels to increase the inventory levels. Instead, during quarters where work in progress and completed employment resulted in receivable accounts rather than cash the businesses would draw from the keep inventory created during more cash-rich periods. Yes, they smoothed the company’s service.
Nevertheless, other administrators use strategies such as manipulating tax-reported liabilities, estimating contingency balances and legal cost estimates to smooth quarterly results by understating the actual operating costs. The Reuters News Service dealt with new claims that Bank of America intentionally underestimated and therefore reserved the ongoing legal costs of its mortgage banking activity. The consequence of the underestimate was a sequence of quarters where the operating expenses were under-reported and thus the reported earnings per share were not accurate. The organization now faces higher compliance expenses and the net per-share profits are being impacted.
In my view, when executives use accounting gimmicks and off-balance sheet operations to help earnings for a quarter they have switched from controlling earnings to manipulating earnings and this is an ethical violation. There is also an ethical issue with companies that decide to throw in a single quarter all potential or previously hidden bad news.
A kitchen sink quarter is called the technique of dumping loads of bad news or cost overruns into a single quarter (Rosenbush, 2017). Within this concept, any and all costs should be picked up by a corporation and put into a single quarter. The idea is to pre-load costs into a bad quarter, already. In doing so, the theory is that future quarters will show better than average return rates, as several of the costs were pre-recorded during the quarter of the kitchen sink. It I found often during my career in mergers and acquisitions. The acquiring company will charge off all future expected layoffs, plant closures and synergies upon acquisition of a product. With these costs rolled into a single quarter of the deal, the company was free to charge actual expenses against already reported expense reserves. This has made the cost efficiencies of the merger emerge sooner in the process than would usually have occurred.
The corporate balance sheet reflects the investors’ contribution and distribution of capital by business management (Byrd, Hickman, & McPherson 2013). If the creditors are compensated by financial gains through dividend payments or equity growth value in the stock. Organizations planning to overestimate a quarter’s earnings can either choose to invest in assets or fail to recognize ongoing operating costs. For example, a firm may use factories or machinery to generate revenue but may not realize the loss or use extended periods of depreciation. This activity results in short-term profits that are higher than expected, which leaves the company and the investors vulnerable to future costs of replacement.
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