1. Earnings Management Paper

2. The single most important item on a company‟s financial statement is their earnings.
Sometimes referred to as a company‟s net income or “bottom line”, earnings are the one
indicator as to how a company performed throughout the period and added value to its overall
well-being. Earnings are revenue minus with all the expenses the companies occur during the
current period. Earnings are also described as the gain archive by the company for the current
period. Outsiders especially investors and analysts look to company‟s earnings to determine the
attractiveness of a particular stock of a company.
Companies with poor earnings prediction will typically have lower share prices compare
to those with better prediction. The price of the stock are positively correlated with demand of
the stock. More demand will lead to higher stock price and the higher stock price of the
company, the better the company are. The combination of both, earnings and management give
means of profit manipulation that can only been done by people who have power to control and
managing the company.
Given the importance of a company‟s earnings, it is not surprising that the manner in
which a company‟s management is always very interested in how their earnings are reported.
Company executives are in a position to make decisions with how accounting choices are made
and how earnings are managed. Earnings management is not a new issue. It‟s been using by the
corporation since the old time before the technology such as computer even created yet. There
was many type of how earnings are manage or in other word, being manipulate in order to get
the right earnings at the right times (Chapman, 2009).
Managing a company‟s earnings is not an illegal activity and can be used as one of the
company‟s strategy to archive better future but there is a lot of pressure on company executives

3. to manage earnings in order to reach their full potential. In the case of earnings management, it‟s
been used as a strategy by the management of a company to intentionally manipulate the
company's earnings so that the figures match with what they want. For example, in order to gain
trust from the bank to obtain a loan, the management manipulate the company‟s earning to look
good even if the company are not. However, if it is for the purpose of tax, the earnings are
manage to look bad in order to reduce the amount of tax expenses that need to be paid for the
current year. Simply put, the practice of earnings management is carried out for the purpose of
income smoothing (Chapman, 2009). Therefore, rather than having years of exceptionally good
or bad earnings, companies will try to keep the figures relatively stable by adding and removing
cash from reserve accounts. It is one of the techniques of earnings management.
On the other side, earnings management is not favorable by all of the financial reporting
users except the management since they are the people who orchestrate it. For sure, being
cheated regarding the information that should be obtain are not the favorable things that by all
people. In other words, earnings management is also misleading all the users regarding the
company‟s earnings. Regarding the complexity of the preparation of accounting report, the
practices of earnings management are continuously being reviewed and implemented. It‟s also
difficult to determine whether the company is manipulating its earnings or not (Chapman, 2009).
This is because of highly confidential information of how a company compiles its financial
reports. Individuals that are typically aware of the methods used in earnings management are
only the individual who adopted the method, which is usually the chief executive officer or CEO
and chief financial officer or CFO.

4. As stated by the investor Warren Buffett, "Managers that always promise to "make the
numbers" will at some point is tempted to make up the numbers” (Chapman, 2009). The function
of auditor are supposedly to detecting such misused in order to protects shareholders interest but
based on several previous case of big corporate scandals, its show that how careless the auditor
even though some of well establish auditor to detect that misused or purposely not detected that
issues. Some examples of earnings management and also the practitioner whose misused this
technique that lead them to failure that been stated by Agrawal and Chadha (2005) are included
offensively recording revenues as done by Xerox, Bristol-Myers, recording uncollectible sales as
was done by Merck, not to mention the practice of hiding expenses as was done by WorldCom
and using special purpose vehicles to overly inflate income that Enron participated in.
There are many phrases or words can be describing earnings activities and no standard
that universally accepted for the definition of these terms. Some of those terms are income
smoothing, accounting hocus – pocus, financial statement management, the numbers game,
aggressive accounting, reengineering of income statement, juggling the books, creative
accounting, financial statement manipulation, accounting magic, borrowing income from the
future, banking income for the future, financial shenanigans, window dressing. Some the
earnings management is legal which is can be accepted worldwide due to the low level of
manipulation and some are illegal due to high level of manipulation and intention to trick the
stakeholders (Agrawal, Chadha, 2005). This form of earnings management is also called cooking
the books and is illegal.
The applications of earnings management are kept in using by all around the worlds even
though several corporate scandals which misused of earnings management arise. Agrawal and

5. Chadha (2005), mention that, reason for using earnings management are due to market
incentives, contracting incentives and regulatory incentives.
Market incentives are regarding to meet with analysts‟ expectations which are important
in order to keep the company name at the established position. The reason is to smooth earnings
time‟s series even when it‟s affected by periodic figure such as seasonal sales. It‟s not like the
company not good when it is not in seasonal period, but then, the sales will definitely boost when
it‟s come to seasonal. If the seasonal period is not even at the right time, therefore, management
of earnings is needed in order to smooth the earnings for the company.
Contracting incentive are include as managing earnings of which in order to avoid
violating loan agreement that are written in terms of accounting numbers. In order to gain faith
from the lender and to archive the optimal credit term, management of earnings is needed. Not
all the time the company account might look as good as it‟s expected and if it is not, doesn‟t
simply mean that the company is in the bad position. Other than that, it‟s also managing earnings
to maximize earnings based management compensation (Vadiei Nowghabi & Anbarani, 2012)..
Regulatory incentiveshave been in practice in order to avoid industry regulations such as
to reduce the risk of political exposure and also to take advantage of certain governmental
benefits such as subsidy.Earnings management is not specifically stated for certain types or
techniques only. There are several types of earnings management and techniques that can be
used by a company through their operations. One of the very popular techniques of earnings
management is called “Cookie Jar”. This technique is function such as save some revenue in a
good year as a backup for losses that might incurred in the bad years. It‟s all depending on the
situation and stability of the company during the years. If the performance of the company is

6. better, therefore the expenses can be recognizes during the year but somehow, if it is not a good
year, the expenses can be recognizes next period to ensure the performance of company is goods.
Other popular techniques is also been called big bath. This technique or strategy is to
make bad income statement look even worst. This technique is a technique that used by blame
the previous manager that already sign out as to ensure the company performance for next year
are booms. This type of technique is used by the new manager which is appointed before the end
of the period. The new manager put blame to the previous manager by incurred as many
expenses as they can write off to ensure that next year, company can even perform better than
this year.
Capitalization practice is also other type of earnings management. This type of earnings
management is used to manipulating intangible assets such as research and development. Cost to
capitalize research and development are very subjective and only based on judgment. A company
might have possibility to allocate more expenses to the research and development project to
reduce current operating expenses. Therefore the expenses might only amortize through the life
of the assets and it‟s usually only a small portion.
There are also other types of earnings management that can be applied by all the manager
of the company to ensure the safeguard of the company‟s income. Some earnings management
are used in merger and acquisition, some are used in recognition of revenue, materiality concept
that been misapplied, reserve that been charge one time and also other earnings management
types(Vadiei Nowghabi & Anbarani, 2012)..

7. Some earnings management is done for the benefit of all stakeholder and some are done
for their personal benefit. The bad side of earnings management can also been called as fraud as
the intention is not to manipulate figure for the whole benefit but for their own benefit. The
controllers of earnings management are depending on the management party of the company and
how they predict and forecast the future of the company to ensure the optimal return is able to
archive. Management especially manager have a better knowledge regarding to the company
future compare to others. That‟s the reason of why, earnings management are still allowed even
though this benefits are always been misused as the way of cheated stakeholders and most of all,
for personal benefit (Vadiei Nowghabi & Anbarani, 2012).
There were several scandals that involve manipulation or earnings management that
involve several cases that affected not only that country but also all around the world. The most
influence scandals in the history of corporation are the collapsing of Enron in2001. Enron have a
very big influence to the corporate world that also evolves the way of how the corporate
governance are maintained and implement. The ethical issues of auditor are also in question were
still; even Enron was audited by one of the biggest audit firm which called Arthur Anderson.
One of the most important argument that been brought up are the issues of why earnings
management are still allowed even if it‟s been misused by several parties. Even thought, before
the scandals exposes, Enron maintain their goodwill by winning several awards regarding their
good corporate governance.
Enron Corporation was born in the middle of a recession in 1985, when Kenneth Lay,
CEO of Houston Gas Company, engineered a merger with Internorth Inc. The new company,
which reported a first year loss of $14 million, consisted of $12.1 billion in assets, 15,000

8. employees, the nation‟s second-largest pipeline network, and a towering mountain of debt. Enron
was a typical natural gas firm with all the traditional trappings of a highly leveraged, “old
economy” firm competing in the regulated energy economy. Teetering on the verge of
bankruptcy in its early years, Enron had to fight off a hostile takeover attempt. It also incurred
embarrassing losses on oil futures, which its traders in New York covered up in their reports to
the Houston headquarters. Its old economy strategy did not excite the stock market. This would
change dramatically, however, during the 1990s, when Jeffrey Skilling replaced Richard Kinder
as the CEO (Kadlec, 2001).
With the appointment of Skilling as CEO, Enron‟s culture would begin a radical
transformation. By 2000 it had become “the star of the New Economy,” emerging as a paragon
of the intellectual capital company with an enviable array of intangible resources, including
political connections, a sophisticated organizational structure, a highly skilled workforce of
sophisticated financial instrument traders, a state-of-the-art information system and expert
accounting knowledge. In 1999, Enron was named by Fortune as “America‟s Most Innovative
Company,” with business people and academics referring to Skilling – “The #1 CEO in the
USA” – proselytized at technology and leadership conferences across the United States about
how Enron was not only embracing innovative theories of business but also making a lot of
money doing so (Morley, 2009).
How fraud occurs within organizations can be understood by examining the elements that
comprise such actions. At an individual level, SAS No. 99 (Consideration of Fraud in a Financial
Statement Audit) issued by the Auditing Standards Board indicates that the occupational fraud
triangle comprises three conditions that are generally present when a fraud occurs. These

9. conditions include an incentive or pressure that provides a reason to commit fraud (personal
financial problems or unrealistic performance goals), an opportunity for fraud to be perpetrated
(weaknesses in the internal controls), and an attitude that enables the individual to rationalize the
fraud (AICPA, 2002). While the fraud triangle focuses on individual-level constructs of fraud,
such as localized instances of cash or other asset appropriation by employees, the Enron example
highlights fraud at the organizational level as well as systemic organization-wide fraud and
corruption (Kadlec, 2001).
Management controls refer to the tools that seek to elicit behavior that achieves the
strategic objectives of an organization, such as budgets, performance measures, standard
operating procedures and performance-based remuneration and incentives. While Enron‟s
demise has been portrayed as resulting from a few unscrupulous rogues or „bad apples” (the
phrase used by President Bush) acting in the absence of formal management controls, Enron
featured all of the trappings of proper management control, including a formal code of ethics, an
elaborate performance review and bonus regime, a Risk Assessment and Control group (RAC), a
Big-5 auditor, and conventional powers of boards and related committees. This control
infrastructure was widely lauded right up until the demise of the company (Morley, 2009).The
three core pillars of Enron‟s management control system were the risk assessment and control
group, Enron‟s performance review system and its code of ethics.
Risk Assessment and Control Group: An integral part of Enron‟s management control
system was the Risk Assessment and Control group or RAC. RAC was responsible for approving
all trading deals and managing Enron‟s overall risk. Every deal put together by a business unit
had to be described in a Deal Approval Sheet, which was independently assessed by RAC

10. analysts. Deals required various levels of approval from numerous departments, including
approval from the most senior levels, even from the board of directors (Morley, 2009).
Enron‟s Performance Review System: Another vital link in Enron‟s management controls
was the Peer Review Committee or PRC system. The intention of the PRC system was to align
employee action with the company‟s strategic objectives, retaining and rewarding superior
performers on a fair and consistent basis. Under the PRC system, every six months each
employee received a formal performance review, based on formal feedback categories including
revenue generation, and was assigned a final mark from one to five. Feedback came from various
sources including the employee‟s boss, as well as from five co-workers, superiors or
subordinates that the employee selected. The bottom 15 percent, no matter how good they were,
received a “5” which automatically meant redeployment to “Siberia,” a special area where they
had two weeks to try to find another job at Enron. If they did not – and most did not – it was “out
the door.” (Morley, 2009)
Code of Ethics: Enron‟s code served as a behavioral control intended to prohibit a range
of unethical behaviors. The code stressed the following four key principles: communication,
respect, integrity and excellence, and included phrases such as “we treat others as we would like
to be treated ourselves”, “we do not tolerate abusive or disrespectful treatment” and “we work
with customers and prospects openly, honestly and sincerely”(Kadlec, 2001).
What Enron clearly demonstrates is that once employees align themselves with a
particular corporate culture – and invest heavy commitment in organizational routines and the
wisdom of leaders – they are liable to lose their original sense of identity, and tolerate and
rationalize ethical lapses that they would have previously deplored. Once a new and possibly

11. corrosive value system emerges, employees are rendered vulnerable to manipulation by
organizational leaders to whom they have entrusted many of their vital interests. The Enron
demise, then, points to numerous risks associated with degenerate cultures: the risk that a culture
motivating and rewarding creative entrepreneurial deal making may provide strong incentives to
take additional risks, thereby pushing legal and ethical boundaries; resistance to bad news creates
an important pressure point of culture; and internal competition for bonuses and promotion can
lead to private information and gambles to bolster short-term performance. At Enron, these risks
ultimately subverted the company‟s elaborate web of controls (Kadlec, 2001).
Enron offers a number of important insights for managers. Firstly, it underlines the vital
role of top management leadership in fostering organizational culture. Secondly, within
organizations, the impact of culture and leadership on even most the sophisticated management
control system must not be overlooked or minimized. It is often too easy to consider cultural and
management control systems separately, with cultural being a soft issue and management
controls a hard one.
Lastly, the Enron scandal stresses the importance for management to not abandoning
professional integrity. Perhaps, the most important lesson for managers to take away is to use
personal cultural capital to find a working environment that matches one‟s personal values and
principles. Enron should serve as a wake-up call for managers in all organizations.Other than
Enron, WorldCom are also one of the big corporate scandals that lead to their collapsing that
lead to more study and argument on the use of earnings management as one of company strategy
or manipulation.

12. WorldCom, the number two long-distance telephone provider, announced $3.8 billion in
improperly booked expenses for 2001 and 2002. And in August 2002, the company disclosed an
additional $3.3 billion in accounting errors. As a result, the company will be forced to restate
earnings for 2000 as well (Simons, 2002).
The fraud perpetrated at WorldCom did not take place at the lower levels of the organization.
When invoices were paid, they were properly coded to an operating expense account. The
Arthur Andersen staff auditor tracing an invoice through the accounts payable system would not
find this fraud. Instead, huge amounts were reclassified by upper management as capital
expenditures. For example, $500 million in undocumented computer expenses were logged as a
capital expenditure. In addition, line costs were not expensed as required by Generally Accepted
Accounting Principles (GAAP).
Audit authorities say that WorldCom‟s fraud was so basic it should have been obvious to
the firm‟s external auditors, Arthur Andersen. Expenses disguised as capital expenditures are
one of the first things an auditor would examine. Evidence was produced in the court case
against the public accounting firm that Andersen did not verify WorldCom‟s treatment of line
costs. Rather, it relied on management‟s representations. The U.S. District Court held that
Andersen would have uncovered the fraud if it had conducted the required review before issuing
its audit opinion. The Court held that the Andersen audit opinions included in WorldCom‟s
year-end financial statements materially misrepresented the company‟s financial condition
(Simons, 2002).
It would take three internal auditors to uncover the fraud. The team of internal auditors
soon stumbled onto the issue of capital expenditures. They discovered that $2 billion that the

13. company said in public disclosures had been spent on capital expenditures during the first three
quarters of 2001 had never been authorized for capital spending. Concerned that CFO Sullivan
might try to cover up the fraud, Ms. Cooper and Mr. Smith met with Mr. Bobbitt, the head of
WorldCom‟s audit committee. The audit committee then took steps to remove both Sullivan and
Myers. Mr. Sullivan was fired and Mr. Myers resigned. And the next evening, WorldCom
announced that it had inflated profits by $3.8 billion over the previous five quarters. WorldCom
has since filed for bankruptcy. With $107 billion in assets, WorldCom‟s bankruptcy is the
largest in U.S. history, larger than even that of Enron Corporation (Simons, 2002).
The nonprofit industry is not immune to earnings management or nor does it have any
shortage in pressure to perform. Nonprofit colleges and universities have increasingly changed to
using performance-based compensation that encourages enrollment and admissions offices to
entice enrollees in an effort to increase enrollment numbers. Marty Mickey, V.P. for Financial
Services at National-Louis University has noted that he has seen a marked increase in the amount
of incentives offered to the enrollment representatives of nonprofit universitiesin order to remain
competitive which in turn results in them acting more like the enrollment offices of for-profit
universities. Lori Sundberg, the Controller and Associate Vice President of Budget and Planning
for Lake Forest College notes that earnings management in non-profit, higher education can
happen but is rare. She states that the field of higher education prides itself on transparency and
noted how she will collaborate with colleagues at other colleges about the results of their audits
and how other schools handle similar issues. Ms. Sundberg‟s comments were echoed by Doris
Dumas, Associated Controller and Director of Payroll at Lake Forest College. Doris stated that
when faced with a reporting issue, she will often turn to her counterpart at another school for
guidance.

14. Earnings management are only become useful when the management able to fixed it
afterward or only done it if the result are more certain as one way of to ensure the operation and
earnings are smooth. This is because only the management has the best knowledge regarding
company operation. To let them manipulate the earnings are good in other view because the
reaction of the investor regarding the value of the company are very sensitive. Corporate
scandals around the world leads to better review and application of how to derive business more
properly and transparently. The biggest case that gives impact on the world‟s corporate culture
such as Enron leads to change in several standards accepted around the world.

15. References
Agrawal, A., & Chadha, S. (2005). Corporate governance and accounting scandals. Journal of
Law and Economics, XLVIII, 371-406. Retrieved from
https://www.bama.ua.edu/~aagrawal/restate.pdf
AICPA. (2002, December). Summary of sasno. 99. Retrieved from
http://www.aicpa.org/InterestAreas/ForensicAndValuation/Resources/FraudPreventionDe
tectionResponse/Pages/Summary of SAS No.aspx
Caro, M.E, Santora, J. C., & Sarros, J. C. (2007, Autumn). Succession in nonprofit organizations;
an insider/outsider perspective. SAM Advanced Management Journal, 72(4), 26+
Retreived from http://www.uiu.edu:2319/ps/i.do?id=GALE%
Chapman, C. (2009). The effects of real earnings management on the firm: Its competitors and
subsequent reporting periods. (Doctoral dissertation, Northwestern University)Retrieved
from www.kellogg.northwestern.edu/accounting/papers/Chapman.pdf
Kadlec, D. (2001). Power failure. Time Magazine, Retrieved from
http://www.time.com/time/magazine/article/0,9171,1101011210-
186639,00.html#ixzz0updclQaT
Morley, M. (2009). The enron fraud: Why didn't anyone see it?. Retrieved from
http://www.thegaap.net/articles/The_Enron_Fraud.html
Simons, D. (2002, July 08). Worldcom's convincing lies.Forbes, Retrieved from
http://www.forbes.com/2002/07/08/0708simons.html

16. Vadiei Nowghabi, M. & Anbarani, S. (2012, June). Survey some of the factors influencing
ethical judgments of the earning management. International Journal of Accounting and
Financial Reporting, 2(1), 203+, Retrieved from
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