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CREATIVE ACCOUNTING
II

Earnings Management and
Related Party Transactions

Financial Accounting
Module 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
TA
i,t
/A
it-1
= a
i
[1/A
it-1
] + b
1i
[REV
it
- REC
it
/A
it-1
]
+ b
2i
[PPE
it
/A
it-1
] + [ROAt]

o [Where: TA
i,t
= Total accruals in year t for firm i; Total Accruals = net
income after extraordinary items net cash flow from operations; A
it-1
=
Total assets in year t - 1 for firm i; REV
it
= Revenues in year t less
revenues in year t - 1 for firm i; REC
it
= Net receivables in year t less
net receivables in year t - 1 for firm i; PPE
it
= 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
WC
t
= b
0
+ b
1
CFO
t-1
+ b
2
CFO
t
+ b
3
CFO
t+1
+
b
4
Sales
t
+ b
5
PPE
t
+
t

o [Where in working capital in year t (WC
t
) =

Accounts receivable +
Inventory - Accounts payable - Taxes payable + Other assets (net), this
can also be calculated as (Current Assets Current Liabilities) Cash;
CFO
t-1
represents Cash flows from operations in year t 1; CFO
t
represents
Cash flows from operations in year t and CFO
t+1
represents Cash flows from
operations year in year t + 1; Sales
t
represents Sales in year t Sales in year t
1 and PPE
t
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
arms length
ARMS LENGTH

Elements of transactions are
determined on an open market basis
no more or less favourable than for a
3
rd
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 entitys 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
entitys 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 entitys 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 arms
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 subsidiarys FSs. Transactions
and balances with other group entities to be disclosed in an
entitys FSs.
SUMMARY IAS 24
RELATED PARTY DI SCLOSURES

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.