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“Earnings Management, in exchange listed companies, is not fraud but a case of caveat emptor for
investors”

This paper will be discussing the arguments, for and against the use of Earnings Management and
whether Earnings Management constitutes as fraud or a case of “Let the buyer be aware”. Firstly
Earnings Management is a strategy used by executives, which involves using judgment to try and
manipulate the earnings of a company to create a false impression of success, generally to match
pre-determined targets. This can sometimes mean covering up underlying debts and other earnings
woes which may discourage investors from investing. Essentially, earnings management is used to
mislead some stakeholders about the businesses performance, or to influence contractual outcome
that depend on reported accounting numbers. It is seen as a problem by investors as it portrays a
false image about a company, this can lead to investors making ill-informed investment decisions.
This is occurs generally when there is information asymmetry between the managers and any
external information users. Earnings management also reduces the quality in any financial
reporting’s, it can also interfere with the resource allocation within the economy. In recent years
there have been many cases of financial reporting manipulation which has led to the collapse of
several major corporations such as Enron, Parmalat and Worldcom.

The term “Caveat Emptor” refers to the Latin phrase “let the buyer beware”, it is a legal doctrine
which states that sellers of real property are not required to disclose any defects except those
inherently dangerous and not discoverable by the purchaser. This means that the buyer alone is
responsible for analysing the quality and viability before a transaction is made. For example when
buying a house, the buyer should do some research into the house they are buying, the area and
things which may have adverse or favourable effects on the house.

The use of auditors can also increase shareholder confidence as the function of an auditor is to be
able to detect when earnings are being manipulated. However they may not always be successful as
shown in recent scandals such as World Com, a company which manipulated its earnings by hiding
its expenses, allowing their losses to build up, ultimately leading to fraud and the companies CEO
resigning.

In 1992 in the UK, the Financial Reporting Council (FRC ) issued the Cadbury’s report, derived from
Sir Adrian Cadbury. The Cadbury report concerned three key areas; The Board of directors, Auditors
& Shareholders. The report contained guidance to company’s on how to maintain their governance,
the report was not compulsory but if a companies didn’t want to follow a certain aspect of the code
then a statement of compliance must be issued with their annual reports. This is known as comply &
explain. In 2003, post Enron scandal, The Smith report 2003 was commissioned with its main focus
on the role of audit committees. It called for there to be an improvement to how audit committees
are run within the board as Enron’s problems derived from the failure of their audit committee. The
main points from the smith report were for the audit committee to monitor the integrity of the
financial statements of the company, to review internal financial control systems as well as
monitoring and reviewing the effectiveness of the company’s internal audit function. The FRC has
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also issued several codes of accounting standards, and guidance to auditors. On accounting standard
the UK has the International Financial Reporting Standards (IRFS), which contains rules to be
followed by accountants when producing and of year statements.

Whilst in the US the FASB (Financial Accounting Standards Board) issued the FASB Accounting
standards codification, which comprises of around 90 accounting topics and guidelines for
companies to follow. However the Securities and Exchange Commission is determined to abandon
GAAP for the IFRS.

In conclusion, earnings management, when used responsibly can be very beneficial to a company, in
helping to defer accruals or profits to the next period in order to achieve targets, providing that it
can settle the balance in the following period. I also do feel that the legitimate use of earnings
management is not fraud and just a case of Caveat Emptor for investors because if they had any
suspicions on the integrity of a company’s financial statements then attainment and analysis of
company information should be undertaken. This forces Investors to be more aware, which is likely
to lead to better investment decisions.

Bibliography
Arya, A. J. (2003). Are Unmanaged Earnins Always Better for Shareholders. Accouting Horizons, 111-
116.

Awidat marai, V. P. (2013). Earnings MAnagement vs Financial Reporting Fraud- Key features for
distinguishing. Economics and Orginization , 39-47.

Chapman, C. J. (2009). An Investigation of Earnings Management through Marketing Actions.

Charles W. Mulford, E. E. (2002). The finanacial Numbers Game: Detecting Creative Accounting
Practices. Danver: John Wiley & Sons.

Daniel Bergstresser, T. P. (2004). CEO incentives and earnings management .

Gunny, K. (2005). What are the consequences of real earnings management .

Ronen, J. Y. (2008, 01). Emerging Insights in Theory, Practice and Research. Boston, MA, United
States of America.

Soon, K. W. (2008). Earnings Management: Is IT Good or BAD. Malaysia : Management and science
University.

The Financial Reporting Council. (2012). Corporate governance, financial crime, ethics & controls.
London: Financial reporting council.
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