www.bradford.ac.uk/management

CREATIVE ACCOUNTING II

Earnings Management and Related Party Transactions

Financial AccountingModule code: MAN2907L

EARNINGS MANAGEMENT

WHY EARNINGS ARE SO IMPORTANT?

• Fundamental measure of performance• Indicate the extent to which an entity has

engaged in activities that add value to the entity

• Help assess managers performance and predict future cash flows

WHY DO ENTITIES MANAGE EARNINGS

• Since the worth of a company is directly related to its reported earnings figures, top management view earnings management as a device to meet earnings expectations for their companies

• Earnings are managed to meet short term goals which lead to maximising managerial remuneration and bonuses

EARNINGS MANAGEMENT?

• Schipper (1989, p 368) defines earnings management as ‘a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain’.

• Mulford and Comiskey (1996, p 360) note that ‘earnings management is the active manipulation of accounting results for the purpose of creating an altered impression of business performance’.

• The SEC (1999, p 3) saying it is: ‘the practice of distorting the true financial performance of (a) company.

METHODS OF EARNINGS MANAGEMENT

• Accounting Policy Choices– Choosing between the available accounting policies is

one of the most commonly used form of earnings management

• Accrual Accounting– Accrual accounting techniques have generally no direct

cash flow consequences and can include– under provisioning for bad debt expenses, delaying

asset impairments and amending depreciation estimates

METHODS OF EARNINGS MANAGEMENT

• Income Smoothing– Rather than reporting erratic changes in revenues,

managers prefer to generate consistent revenues and growth.

– Investors prefer to invest in an entity that shows consistent growth patterns and for that reason managers use accrual accounting techniques to promote smooth earnings

• Big Bath write-offs– It occurs when large losses are reported against income

as a result of a significant restructure of operations

STATISTICAL MODELS TO CAPTURE EM

• Kothari et al., 2005– TAi,t/Ait-1 = ai[1/Ait-1] + b1i[ΔREVit - ΔRECit /Ait-1] +

b2i[PPEit/Ait-1] + [ROAt]

o [Where: TAi,t = Total accruals in year t for firm i; Total Accruals = net income after extraordinary items – net cash flow from operations; Ait-1 = Total assets in year t - 1 for firm i; ΔREVit = Revenues in year t less revenues in year t - 1 for firm i; ΔRECit = Net receivables in year t less net receivables in year t - 1 for firm i; PPEit = Gross property, plant and equipment in year t for firm i; ROA = Return on assets in year t.]

STATISTICAL MODELS TO CAPTURE EM

• McNichols 2002 and Francis et al., 2006 – ΔWCt = b0 + b1CFOt-1 + b2CFOt + b3CFOt+1 +

b4ΔSalest + b5PPEt + εt

o [Where Δ in working capital in year t (ΔWCt) = ΔAccounts receivable + ΔInventory - ΔAccounts payable - ΔTaxes payable + ΔOther assets (net), this can also be calculated as (ΔCurrent Assets – ΔCurrent Liabilities) – ΔCash; CFOt-1 represents ‘Cash flows from operations in year t – 1’; CFOt represents ‘Cash flows from operations in year t’ and CFOt+1 represents ‘Cash flows from operations year in year t + 1’; ΔSalest represents ‘Sales in year t – Sales in year t – 1’ and PPEt represents ‘Gross property, plant and equipment in year t’. All variables shown above are scaled by total assets.]

MECHANISMS TO DETECT AND CONTROL EM

• Statistical Models to Capture Accruals Based Earnings Management

• Corporate Governance and Earnings management

RELATED PARTY TRANSACTIONS

• What are they?

• Why are they important?

• How do we account for and

report on them to avoid abuse?

RELATED PARTY TRANSACTIONS

• What are they?

Granting of, or transfer of, a

benefit or obligation….

• Between ‘related parties’

• Irrespective of…– Disclosure

– Consideration

RELATED PARTY TRANSACTIONS

The ‘a priori’ assumption is

that…

……transactions between

related parties may not be at

‘arm’s length’

ARM’S LENGTH

Elements of transactions are

determined on an ‘open market’ basis

no more or less favourable than for a

3rd party

• Control• Influence

RELATED PARTY TRANSACTIONS

• What are they?

• Why are they important?

WHY IMPORTANT?

• Competition & increasing complexity– Conglomerates carry on their various business / investment

activities through subsidiaries or associates and acquire interests in other enterprises, resulting into multiple legal vehicles, overlapping activities, and complex business needs and structures

• Market prices/valuations• Engineered results – ‘creative accounting’

– Tax– Off -balance sheet– If left unchecked, could foster opportunism!

– Illicit related party transactions limit the availability of external finance and leads to financial under-development.

RELATED PARTY TRANSACTIONS

• What are they?

• Why are they important?

How do we account for and report on them to avoid abuse?

SOLUTIONS?• Restate

• Disclose, but..– Identification (can be difficult)

• Parties

• Transactions– Measurement– What to show?– Mandatory?

• Corporate Governance for curbing abusive related party transactions

– E.g. board approval, fiduciary duties, shareholder voting.

Objective of FRS 8 & IAS 24

To ensure that an entity’s financial statements

contain the disclosures necessary to

draw attention to the possibility that its financial position and profit or loss may have been affected by the existence of related parties and by transactions and outstanding balances, including commitments, with such parties.

WHO IS RELATED?

A B

C

C

A B

Interest & influence

Interest & influence

Who is related to whom?

Two or more parties are related when at any time during the financial period:

one party has direct or indirect control of the other party; or

the parties are subject to common control; or

one party has such influence over the financial and operating policies of the other party that the other party might be inhibited from pursuing its own separate interests; or

the parties entering into a transaction are subject to such influence from the same source that one party has subordinated its own separate interests.

Related Parties as Defined by FRS 8

What is a related party? – IAS 24

• The party directly or indirectly

– Controls, is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries).

– Has an interest in the entity that gives it significant influence over the entity

– Has joint control over the entity

What is a related party? – IAS 24

• The party is:

– An associate or joint venture of the entity

– A member of key management of the entity or its parent

– A close family member of an individual related to an entity

– An entity that is controlled, jointly controlled or significantly influenced by a member of key management or a close family member of a related party.

– A post-employment benefit plan for the benefit of the entity’s employees, or of any entity that is a related party of the entity

The following are not necessarily related parties:

• Two entities simply because they have a director or key manager in common – However consider extent of his interest

• Two venturers simply because they share joint control over a joint venture.

• Providers of finance, trade unions, public utilities, and government bodies, simply by virtue of their normal dealings with the entity.

• A customer, supplier, franchisor, distributor or general agent with whom an entity transacts a significant volume of business, merely by virtue of the resulting economic dependence.

IAS 24 – Not Deemed to be Related Parties

Overall, related party transactions involve transactions between a parent company and subsidiary; employees; an enterprise and its principal owners, management or members of their immediate families; and affiliates.

• Simple transaction (purchase of equipment) between two entities (‘Buyer’ and ‘Seller’) controlled by the same shareholder (Mrs Jones), who is one the board members of both firms

• Key problem:– The proposed transaction may have a business purpose

• E.g., purchasing the equipment may lead to expanded sales.

– Jones is on both sides of the transaction and may benefit if Buyer acquires overpriced equipment from seller.

Mrs Jones

Seller Co.Buyer Co.

Typical Related Party Transaction

RELATED PARTY TRANSACTIONS?A related party transaction is the transfer of

resources, services or obligations between related parties, regardless of whether a price is charged.

Examples• Purchase/sale of goods or assets• Providing/receiving services• Management services• Agencies• Leasing• Technology /R&D transfer• Licence agreements• Provision of guarantees/collateral• Financial transactions

– E.g. inter-company lending and borrowing

DISCLOSURE? (FRS 8)

• Name• Relationship• Extent of ownership• Nature of transaction• Amount involved % or £• Amount o/s• Basis of “pricing”

• Any other information!!

Related Party Disclosures – IAS 24– Control: relationship btw parent & its subsidiaries be disclosed

irrespective of whether there have been transactions between them• Parent• Ultimate controlling party• Intermediate parent that produces FSs available for public use, if

neither the entity’s parent nor the ultimate controlling party does so.

– Aggregate of key management compensation split into specified categories

– Transactions• Nature of relationship• Types of transactions• Amount and outstanding balances• Provisions for bad and doubtful debts• Any other info. to understand effect on FSs.

– Disclosure that transactions were made on arm’s length terms can only be made if such terms are capable of substantiation.

– Should be made separately for different categories of related parties.

– Aggregation is permitted for items of a similar nature, unless separate disclosure is necessary for an understanding of the effects of the transactions on the financial statements.

Related Party Disclosures – IAS 24

EXEMPTIONS – IAS 24

• In consolidations – anything ‘eliminated’

– No disclosure of transactions in consolidated FSs in respect of intra-group transactions, that are eliminated on consolidation.

• In holding company – if consolidation simultaneous

– There is no exemption for the parent's own FSs.

• In subsidiaries – about group transactions if ultimate parent company named– There is no exemption for a subsidiary’s FSs. Transactions

and balances with other group entities to be disclosed in an entity’s FSs.

SUMMARY – IAS 24 RELATED PARTY DISCLOSURES

• All related party transactions – even if ‘normal’

• No need to disclose when ‘economic dependence’ is only badge of relationship

• Group relationship only exempt when same company and then all inclusive

• No name and % - only nature of transaction

Related Party Disclosures – Issues• Related parties (RP) & related party transactions (RPT) not always

easily identifiable

• Tendency not to be effected on same terms & conditions as btw. unrelated parties

• May expose a reporting entity to risks (or provide opportunities)

• Potential for distorted or misleading FSs in the absence of adequate disclosure

• Instances of fraudulent financial reporting and misappropriation of assets facilitated by RPTs.

• Undisclosed RP becomes a powerful tool in the hands of unscrupulous person.

Mechanisms to Detect Fraud and Illicit Related Party Transactions

• Detection is just a matter of time.

• Uncovered by: internal audit, whistle blowers, external audit, parties on other side of transaction; security analysts; plaintiffs bar press. Seldom uncovered by regulators.

• Strong regulatory framework, active watchdogs and effective enforcement are key success factors.

• Rule based procedures no substitute for honesty and integrity.

• Board responsibility – establish effective detection system.

• Check and balance.