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GROUP ASSIGNMENT 4
GROUP:
G
PREPARED FOR:
DR. MUHAMMAD SYAHIR BIN ABD. WAHAB
PREPARED BY:
NORSURIYA BINTI MOHAMAD SAAT
HAZRINI BINTI MAZLAN
NURUL FATEHAH BINTI ABD JALAL
SHARIFAH FIKRIYAH BT SYED ABDUL GHANI
221380
221389
221617
221933
DATE OF SUBMISSION:
1
6 DECEMBER 2015
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.
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.
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
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.