First and foremost before we discuss what is earnings management we need to have an insight on what earnings in a company refer to. Earnings are profits that a company has made after probably a financial year or half way through the financial year. Earnings of a company are important because they help determine the stock prices of a company. An investor can tell what company he or she is going to invest in just by observing a particular company's earnings. Prospective earnings are those earnings that a company is expecting to make, maybe due to acquiring new market or having a new product to be released in the market in the near future. This can make the share price of a company to improve because the company is expected to make good earnings. Earnings management is a form of strategy used by companies to manipulate the accounting practices so that they can meet the pre-determined targets (Bissessur, 2008). It is also known as income smoothing.
When companies are under pressure to meet certain targets of earnings so as to still maintain the company's good image, they may be forced to 'cook up' some numbers that will not tell the whole truth .especially in big companies, it is very difficult to correctly follow their accounts because of their magnitude and difficulty so one just heads straight to the earnings section only to realize sometime later when the company falls that the earnings were actually faulty. There are three different types of earnings management according to (Giroux, 2003). In a company we can have white earnings management; in this case the company's management takes advantage of the flexibility in the choice of accounting treatment so that they can signal future incomes or earnings. For example a company can recognize future incomes in their current accounts before even the incomes are actually received. This practice is not illegal and it's used by many companies. The other type is gray earnings management, here the management uses accounting practices as an opportunistic means to the managers and those that will help the company look good economically. For example a company that uses the accrual basis can use estimates to exaggerate their earnings. The third type of earnings management is referred to as black. Here the management uses tricks and fraudulent means to misinterpret the financial reports, for instance managers can be forced to 'cook' numbers to achieve certain targets.
There are different modes that are used in earnings management; they include 'cookie jar' reserves method, capitalization practice method and the use of operating activities method. The cookie jar reserves is the action of a company putting in more expenses in times when they know that they have strong earnings and stating less expenses in times of low earnings so that the earnings of a company are neither so high at a time and low at another but the earnings remain leveled. For the capitalization method companies have a tendency of exaggerating the expense on some assets, so that they can increase operating expenses thus lowering their earnings. The common assets that are used in this method are the intangible assets, like research and development. Companies also use operating activities to maneuver their earnings, here the managers can delay the time for recording certain operating activities only to record them much later when targets need to be met. It is important for companies to make reasonable targets for the managers so that they can avoid the use of some of these methods that the managers are forced to use to meet the targets. A famous investor once said that managers that promise to meet certain numbers are at some point forced to 'cook' the numbers so as to meet this targets.
Fair value accounting
Fair value accounting is accounting for items such as assets or liabilities at their market price also known as the fair value. It can also be the price at which an asset or a liability can be transacted at a particular time in the market. fair value differ with market price in that for fairvalue, it has to be fair to the both parties ,but for market price it is not necessarily fair especially in the part of the buyer. In accounting fair value is used in place of historical accounting (Zack, 2009). Many financial instruments are measured at fair value, while the fixed assets are measured in historical value and subjected to depreciation on that value. Financial instruments are measured by companies in fair value so that they can help the company in investment decisions or in case a time comes for the instrument to be sold or paid the right amount has already been established. But an exception is made for those financial instruments that are intended to be sold after maturity, their value can be recorded using the historical value, for instance treasury bonds that a company intends to hold until maturity.
The use of fair value accounting is deemed necessary especially in companies that need to make investing decisions and also those that are mostly involved in risky business ,the use of fair value accounting is very essential to keep the company going. The process of determining the correct fair value for an asset or a liability is very difficult and companies have to be very cautious of the methods they use to determine the fair value (Schmidt, 2005). For most financial instrument the stocks price are used to determine these values. But incase the assets or liabilities do not have a readily available value in the market then valuation methods can be used, although they will be forced to incorporate a lot of factors before they can arrive at the most fair price. This difficulty in determining the fair value is the main reason why most companies do not prefer using this method unless the law requires them to do so. The benefit of the fair value method is that it helps a company compare previously acquired financial instruments with the current ones easily. It also helps investors to understand the financial report easily, from which they can then make useful decision using this fair value. Although the method for attaining the fair value may be difficult, this method is highly recommended especially for financial instruments, companies are advised to use the fair value method in the accounting of the financial instruments.
Measurement in accounting is used to determine the right figures to be used in the financial records of a company. when a company is making its measurement it must consider some business principle that are important this principles include the going concern principle; here the company has to assume that the company is going to be on operation for long and for the subsequent financial periods. The company too has to consider the fiscal period for which the measurement is being conducted. Some companies usually divide their fiscal period half yearly or quarterly so this must be born in mind when taking measurement. In accounting, measurement can be done using different values, there some that are measured using the original cost, others the fair value needs to be used; in other times we use the replacement cost, which is the current price of something in the market (Goldberg, 2005). An example of this measurement is where stock is valued at either the original cost or replaceable value whichever one of the two less is. We can also use the original cost of assets to measure their value, this method is mostly used in measuring of fixed assets such as land and tractors. Measuring methods must put into account certain factors that are essential in accounting.
This include objectivity, the matching concept and revenue recognition concept .in objectivity, this requires that values that are used must be verifiable and must be backed by documents, for instance a value of sales must be verifiable from the invoices and the receipts that were issued during the sale. For the revenue recognition it deals with the measurement of the right value to be recognized in the right financial period, even if the amount has not been physically received. The matching concept is about matching of revenues of a certain financial period to the expenses of that period so that the correct amount of earnings is recognized in a certain financial period. The survival of an organization largely depends on the organization’s adaptation and relationship to its environment, which include its stakeholders. Werther & Chandler (2010) say that this requires an evaluation of the organization’s strategies to identify its sustainable competitive advantage. This evaluation helps the organization determine its internal competence in relation to the demands of the external environment. For peaceful coexistence of entities, individuals and organizations must take responsibilities for their existence. Corporations and business have a corporate social responsibility to their environments. This includes the physical environment, surrounding communities, employees, and consumers. Corporate Social Responsibility (CSR) is a form of a business model integrated in the organization’s plan to support the environment and community as a means of giving back to the community, promoting public interest, encouraging a positive impact on the community, willingly removing harmful practices that may harm its environment. Therefore, it can be defines as the measures and practices taken by corporations to protect their own corporations by getting involved in wellness programs for its stakeholders.
Kotler & Lee (2005) highlights the different forms that this kind of support may be provided by the corporations. They say the corporation may use cash contributions to sponsor initiatives, offer basic needs such as food and homes, promote human rights for communities such as voting rights, animal rights and ant discriminatory campaigns, use promotional sponsorships, grants, offering technical expertise, involving their employees in volunteer activities, publicity, paid advertising, and in-kind donations. In-kind donations include providing products, services and equipments that are most needed by the community such as computers. An organization keen on getting involved in Corporate Social responsibility may do so alone or in partnership with another corporation. CSR has numerous benefits to the Corporation. Basically, it helps organizations adopt a sustainable mission and guide its moral standing in the community. The relevance of CSR to a corporation’s success is received with mixed feelings. Those who argue in its favor say that getting involved in CSR helps companies manage risks. In comparisons to those who are not involved, Companies undertaking CSR face lesser risks associated with law suits, litigations, investigations, legislations and prosecution. Similarly, during crises, such as economic damages, companies not undertaking CSR may face worse problems such as consumer boycotts and poor corporate reputations.
In addition to this, Kotler & Lee (2005), say that CSR enhances the company’s social image. A positive image is beneficial in many ways to the company. It may increase sales and ensure continuity through community support when the company is facing problems. To increase their competitive advantage, companies usually get involved in CSR, to build a reputation that sets them apart from competitors. A good reputation increases the chances of the company getting the best employees, as the employment competition is high for such companies. With competent employees, a company is well placed at achieving its goals. Similarly, employees stay longer in such companies. This reduces the training and recruitment costs as well as work disruptions. It also motivates employees to work harder and achieve their targets as it creates the feeling of importance and recognition. Getting involved in CSR ensures that the company complies with regulatory requirements.
Though this is not a guarantee, the recognition it places on the company ensures the company upholds its moral standards. Companies that are actively involved in their local communities activities tend to generate positive press coverage as compared to non-contributors. This encourages investors and other stakeholders to maintain interest in the company and finally, CSR helps companies understand the wider impact of their products or services. This encourages growth through development of newer products and services to enhance this impact. In conclusion, CSR is a strategy that helps companies maintains their positive social standing in their environment. Through giving for the common good, companies take care of their environments while increasing their sales and developing effective management strategies.
These are reports that are used to show the performance of a company or a project. They are also used to measure key elements of a company for instance, customer satisfaction, sales level and even the goodwill of the company. These reports are common in the government because they are always the ones conducting projects that may have been funded by other organization and there is need to keep updating them on the progress. But this does not mean that companies do not this performance reports, in fact they should have regular performance report s so that they can ascertain whether the company is headed in the right direction or not. Performance reports are important because, they can help in decision making on the part of the managers, like if some new policy in the company is not working or some sale strategy is not bringing in more earnings, then a decision about improving the situation can be made (Barker, 2004).
Performance reports also provide information to the external user too, for example an investor may be interested in knowing how the company they have invested in is performing in other matters apart from the financial matters. Performance reporting should not be conducted as financial reporting is done. It should be different and it should indicate comparisons. These comparisons can be done by comparing the last year performance or to last week performance with the current performance. The performance reports must also clearly show the difference by use performance indicators like graphs, charts and even tables. It should also as much as possible try to link the non-financial matters to the financial issues and their implication should also be shown clearly.