ENCUESTA REALIZADA A LOS MAESTRO

The management relies on different ways of practicing earnings management, through which they planned to increase or decrease their disclosed earnings. This study addresses the most important forms of earnings management practices. Overall, EM techniques can be classified into three groups: Income- smoothing, big bath and accounting choice (see figure 2.2).

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Figure 2. 2 EM Techniques

Source: the researcher's development

2.4.1 Income Smoothing

The income smoothing technique is considered to be the most important earnings management method. It is a type of EM technique used by the company through the formation of reserves to reduce profits in good years, especially when the profits are high, so as to use them to increase profits in the bad years when profits are low (Vinten et al., 2005). The idea of income smoothing relies on the basis of achieving stability in the income figures by reducing volatility in the figures between different accounting periods. The management will reduce saved profits in a good period “in which profits rise significantly", and increase it during the bad period. The management indulges in income smoothing because investors are willing to pay a premium for shares with stable predicted earnings (Arya et al., 1998, Demski, 1998). Hejazi et al., (2011) have identified income smoothing as a set of methods used by management to reduce the volatility of income, by managing real or artificial earnings in order to reach the required level of income. Martinez and Castro (2011) identified income smoothing as a deliberate control of income in order to achieve certain results, such as to reduce or increase the published earrings to reach a certain level as desired by the management. The management engage in income smoothing due to the belief

EM Techniques

Income- smoothing

techniques Big Bath

Accounting Choice Techniques

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that earnings volatility is one of the elements by which its performance is assessed, and to ensure that financial analysts and investors will not concentrate on a variation in income figures as a measure of the risk posed to the company.

There are two basic types of income smoothing; the first one is called normal accrual. It is caused by the nature of the entity's production and operations. It is estimated by using the statistical model based on the company's assets, property, plant, and equipment, and change in sales. The second type is abnormal accruals, which is a result of the accounting manipulation undertaken by management in order to reduce income fluctuations, and it is the residual amount between the actual and the predicted accruals. In line with EM literature, this study will argue that income smoothing is a method used by the management to reduce or increase income, in order to maintain a certain level of profits from one year to another.

Lobo and Yang (2001) and Pinho and Martins (2009) have demonstrated that bank managers with high variability will have more powerful incentives to smooth earnings by manipulating loan loss provisions (LLPs). Similarly, Kwak et al., (2009) stated that bank managers could shift earnings from one period to another through LLPs to smooth earnings over time.

2.4.2 Big Bath Accounting

The way the Big Bath technique works is that when a firm is suffering badly and definitely will incur and disclose losses, it may overstate the losses to the greatest extent possible. This technique is used to inflate the losses and reported bad news linked with poor earnings into the current financial year, which will allow the boosting of earnings in the coming financial years (McKee, 2005). Big bath accounting is defined by Mulford and Comiskey (2002, p. 15) as “A wholesale write-

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down of assets and accrual of liabilities in an effort to make the balance sheet particularly conservative so that there will be fewer expenses to serve as a drag on earnings in future years”.

Covering up all losses in bad years or in periods where the company suffered a significant drop in profits may be considered by the management. Thus, the company will resort to increase in the value of losses in the current period, in which it can achieve earnings in subsequent periods (Jordan and Clark, 2011). The management might use exaggerated estimates for doubtful debts or postpone some of the revenue to a future date instead of showing it in the current period. Sometimes, the management resorts to using this method when the company changes the executive administration and then appoints a new one in order to place the blame on the previous administration.

Kirschenheiter and Melumad, (2002) indicated that managers are more likely to engage in income- decreasing (EM) so as to use the savings in the coming year, if the firm is unable to meet its target and current earnings are below expectation. Furthermore, McNichols and Wilson, (1988) documented that managers may engage in EM practices through recognising future expenses in a given period when they know that the current earnings are inappropriate to meet earnings forecasts. Moore (1973) and Pourciau (1993) investigated the association between discretionary accrual choices and CEO change. Their results indicated that new CEOs would have more motivation to decrease earnings in the current year to enhance reported earnings in the coming years, comparing them unfavourably with former CEOs’ results. This gives the new CEOs the opportunity to blame the former CEOs for the previous bad year.

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2.4.3 Accounting Choice Technique

Company managers may abuse or exploit the flexibility available in accounting standards by choosing appropriate methods, such as depreciating expenses, revenue recognition, investments and leases or changing from First- in-first-out (FIFO) to Last- in-first-out (LIFO) in inventories to estimate accruals and then manipulate earnings to affect financial events (Aljifri, 2007; Healy & Wahlen, 1999). Managers usually use depreciation techniques to manage earnings, for instance double-declining balance, straight-line and sum-of-the-year’s digits. The reason behind using the depreciation techniques in managing earnings is that the straight-line method provides the same amount of annual depreciation expense every year. In comparison, sum-of- the-year’s digits and the double-declining balance methods increase the first year’s depreciation expense over the assets’ useful life (low income) and, in the final year, offers the least amount of depreciation (higher income). Similarly, using a sample of 44 Singaporean public firms, Poitras et al., (2002) found that firms exploited the flexibility available in GAAP and used the assets depreciation method and sales revenue in order to manipulate earnings. In addition, Bergstresser and Philippon (2006) have proven that managers could manage earnings through assuming a lower or higher rate of depreciation, which influences cash flow figures and reported earnings.