PART A

CORPORATE FAILURE
LITERATURE REVIEW
Considering the fragmented literature related to business failure prevention and considering the need for unifying conceptual framework on how and why companies fail, the current paper proposes an integration of multiple similar, complementary or supplementary findings of previous preventive contributions, i.e. the studies focused on the identification of failure factors and failure paths. An in-depth analysis of the existing literature and limitation leads us to the elaboration of the original integrative model on how and why do company fail. It is founded on a resource based view of the firm (Wenerfelt, 1984) and it represents, in deterministic perspective, the different general phases which a failing firm goes through until eventually exists the failure process. Nathalie CRUTZEN and Didier Van CAILLIE (October 2007) We find that for a sample of industrial firms that use the M&A (managerial acquisition) investment technology to pursue aggressive corporate growth strategies, excessive acquisitiveness relative to the median industry counterpart can aggravate firms' failure hazard. After removing the failure risk arising from various industry and aggregate economic disturbances, a one standard deviation increase around the mean of the excessive acquisitiveness measure augments the conditional failure risk by 61% (conditional on other exogenous variables evaluated at the mean). We find that excessively acquisitive firms shrink in market value, sink in operating performance, and dislodge the balance between firms' debt and assets structure by taking on more short term debt with less liquid assets at hand between the periods of their intense M&A activities. This mismatch between debt maturity and asset liquidity also explains why excessive acquisitiveness can pave the way to corporate default: a one standard deviation increase around the mean of the excessive acquisitiveness measure increases the conditional default risk by 34% (conditional on other exogenous variables evaluated at the mean) after controlling for various determinants of financial distress that are widely used in the bankruptcy prediction literature. Using a mediating instrument methodology, we argue that the causality from the excessive use of M&A to the firm- failure is channeled through amplified business risk along with managerial cognitive bias and limited attention span. The mediation process seems to be stronger through the behavioral channel than the risk channel. Finally, we document capital market myopia in disciplining excessively acquisitive managers - although the market, on average, punishes aggressive acquirers at the time of the bid announcement, it does not do so at all quintiles of the conditional distribution of acquirers' cumulative abnormal return from announcement events. However, despite this seeming myopia, the external corporate control market eventually reins in the excessive acquirers by turning them into future targets of takeover. Mohammad M. Rahaman (April 30, 2008)
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INTRODUCTION TO THE TOPIC

Corporate failure can arise for many reasons. In fact there is no single definition of corporate bankruptcy; it may result from a single catastrophic event, or it may be the terminal point of process of decline .Under the third perspective, corporate failure is a process which is rooted in management defects, resulting in poor decisions, leading to financial deterioration and to an inevitable corporate collapse; It can also be viewed financially , if a company owes more than it earns over significant periods of time and can no longer repay its debts.

(I) WHAT ARE THE CAUSES OF CORPORATE FAILURE?

Corporate failure in fact is found to have many parents. Understanding the causes of this extreme outcome is important for at least two reasons; first, in times of economic uncertainties failure becomes on all too common phenomenon incorporate landscape and a familiar debate resurfaces of whether the wave of failure is due to some kinds of market tsunami beyond managerial grasp or rather as a consequence of managerial flawed decision making. Second, extreme corporate outcome such as financial distress, default, bankruptcy and ultimate failure, affect more than one stakeholder of the firm and thus have consequences for various industries and macroeconomic dynamics. According to Whitaker (1999) corporate collapse are caused due to two main causes: 1. Economic distress 2. Financial distress

1. ECONOMIC DISTRESS
There could be downturn in the economy, which causes a fall in the level of activity in the economy, thus sales will fall and the economy many eventually move into a recession; causing corporate failure among firms. Asquith, Gertner and Scharfstein (1994) who argue that economic distress is the most significant cause of corporate collapse in their sample of junk bond issuers Another economic distress could be related to the life cycle of the firms. During the companys early life it is possible for it to grow at a very rapid rate, but this rapid growth is difficult to maintain as the firm ages and increases in size. As Penrose explained, this is because each new investment must contribute an ever-increasing amount to the firm and, eventually, it becomes impossible to find investments that contribute sufficiently to the firm to maintain this growth rate. When this happen the growth curve flattens out and the firm faces two possible options for the future. Either the company is able to find some way to re-vitalize itself, in which case the growth rate will increase again, or the firm will become more sedentary and this may be the start of a decline to financial distress and, ultimately, failure.

2. FINANCIAL DISTRESS
Financial distress is a situation where the company's operating cash flow is not sufficient to cover the needs current liabilities, and will force the owners to do the actions to save the business. Companies can be brought into the condition of financial distress because of economic pressure resulting from a decrease in the occurrence of the industry, or because of poor management (Wruck 1990). The companies that have been managed well but have financial difficulties because of economic declined will be more easily improved their performance
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through management actions. Whiteaker (1999) states that most of companies have financial difficulty as a result of weak management of the company compared with as a result of economic decline. Financial distress could further be causes due to many factors .These factors would either create corporate failure or aggravate the corporate bankruptcy of firm. These causes are: (A) COMPANYS BAD MANAGEMENT Companys management is one of the main causes of financial distress and eventually led to corporate collapse. According to john Baldoni (leadership consultant, coach, and speaker) management failure can be due to: Failure to decide. Managers who cannot make clear, thoughtful decisions cannot lead purposeful teams. Lack of decisiveness and lack of responsiveness manifested through not only hinders efficiency, it erodes morale. No one likes to work with a boss who cannot decide, or worse, decides one thing one day only to reverse it the next day. Example include ENRON company. Absent without responsibility. When things go wrong, bad managers are nowhere to be found. Long years of experience have tuned their antennae to danger and so when things seem tense, they disappear. This leaves underlings to bear the brunt of the failure. Such lack of accountability is not reserved for the middle ranks; we have seen far too many senior executives insist on bonus compensation even as their organizations lost billions. Fraud by management. Companies are virtually all characterized by elements of fraud and unethical behaviour by members of top management of the company. Sometimes failure stems from fraudulent behaviour. Fraud is perpetrated by top management of companies. What CEO really expects from a board of directors is good advice and counsel, both of which will make the company stronger and more successful; support for those investment decisions that serve the interests of the company and its stakeholders .But however many of those managers use their power that has been granted to them to do fraudulent action. This can seriously lead to failure One Man Company. The dominant senior manager/owner directly uses company funds for his own personal gain, sometimes granting himself large bonuses. Given the nature of these cases, there are usually few signs of financial distress until the underlying fraud or unethical behaviour is detected. Besides management, fraud may also be perpetrated by employees. In three cases (Barings, Ferranti, Enron, the initial problems stem from employees within the company rather than a member of top management.) (B) TECHNOLOGICAL CAUSES Technological causes could be another cause for company to collapse. Through latest technology, there is the emergence of substitutes for products. Firms making use of traditional method of production may find their sales decreasing at the expense of firms, which are making use of new technology. As new technologies emerge the growth patterns shifts and new companies appears and prosper. At the same time the olds one become less competitive and lose their real or relative advantage and start witnessing decline in sales patterns. They lose their dynamism and their potential to generate returns on investment.

As they eventually slow down they merged into other companies, are bought out or stop operating as a consequence of corporate bankruptcy. (C) LOW AND FALLING PROFITABILITY Owing to low profits and falling productivity firms often fail. It the profits continue to fall at a point where the company can no more cover its cost of operation, consequently sooner or later the company would find itself in a position of bankruptcy. This condition may be associated to falling profits; falling profits can in turn be caused to bad management, rising competition, frauds among others. Moreover when profit continuously fall for a long period of time and management cannot justify the causes; the shareholders would rather not invest or reinvest in such companies. Consequently firms would be in lack of finance with falling market prices for their products, thus aggravating the situation. (D) BAD VENTURE DESCISION Business ventures hover somewhere between the extremes of the success-failure continuum, which influences the decisions that ventures are faced with, and the potential consequences of failure have significant and interesting impacts on business decisions (Cybinski, 2001) Failures draw attention all the time, whether they occur during start-up or in mature ventures, and it appears that failure is inherently part and parcel of the science of business management. As a matter of fact many companies fail due to bad partnership with other companies. The partners ideas may not match all the times; this may cause certain conflicts thus affecting the business. Moreover there may lack of communication, proper documentation and deed .Thus due to these too often ventures and partnership have failed as a consequence of corporate failure (E) LIQUIDITY CRISIS Companys too often fail because of a liquidity crisis; that is a lack of money. Companies may often face situation where their assets are greater than their liability but they are in lack of financial resources. The companies do not have enough money to cover the day to day operation of the company. Poor liquidity may become apparent through changes in working capital levels as firms find that they have insufficient funds to manage their day to day operations. (Altman 1993). This situation may arise because the company has invested too much in investments or stocks but has not consider paying back the creditors or loans from banks and cover the current obligation the company. This situation of NO MONEY if not resolve will rapidly lead to the failure of the company. (F) POLITICAL AND LEGAL REASON Law is always changing .It adapts itself with changes in the world, new technology, new trend of living, environmental factors among others. Changes of law may affect certain firms sales, productivity of increase their cost. These could contribute to the failure of such companies For instance in the early 70s industrys production were coal based. That is they used coal to manufacture their goods, these activities generated enormous severe air pollution that has seriously damaged the ozone layer. But with the passing of the laws against pollution, those who
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pollute were heavily fined were require to shift production methods. Consequently those who manage to shift continued production, but many firm failed, owing to increasing costs and no alternative. (G) LACK OF RESEARCH AND DEVELOPMENT Research and development is an essential element in the survival businesses. Business need to constantly improve their production process, or product itself, so as to be able to compete with other firms. In order to capture a greater market share, companies should aim to improve the quality of their product and provide the best possible service or product to consumers; this is done through research and development. Thus the survival of the fittest rule applies; whereby only the most competitive firm remain in production while others are forces out of the market due to failure. In some industries, such as the pharmaceuticals, huge expenditures are needed for pure and applied research. Failure to invest in this key factor for success may well be a reason for decline and failure. (H) OVERTRADING In todays economic climate overtrading can also pose the risk of illiquidity and lead to corporate collapse. Overtrading occurs when an organisation attempts to support an increasing recurrent investment in working capital and non-current assets without having sufficient long term funding in place. Overtrading is particularly prevalent in rapidly expanding businesses. Firms may attempt to do too much in too quickly with too little long term capital. It is trying to support too large a volume of trade with the limited capital resources. The business expands rapidly and seeks to increase its turnover too rapidly without an adequate capital base. The organization growths too quickly and cannot finance the growth from working capital. In such situation the sales volume of the company increases rapidly and the input cost also increases; but however due to the fact the more cash is needed than what is obtained from debtors, the companies become over dependent on short term financing to finance operation . As a result sooner or later the companies become over indebted and run in an overdraft limit. Thus the company cannot provide the cash to pay its debts as they fall due.

(II) CORPORATE FAILURE MODELS

Corporate failure models can be broadly divided into two groups: quantitative models, which are based largely on published financial information; and qualitative models, which are based on an internal assessment of the company concerned. Both types attempt to identify characteristics, whether financial or non-financial, which can then be used to distinguish between surviving and failing companies. (A)Quantitative models Quantitative models identify financial ratios with value which differ markedly between surviving and failing companies, and which can subsequently be used to identify companies which exhibit the features of previously failing companies. Commonly-accepted financial indicators of impending failure include: Low profitability related to assets and commitments Low equity returns, both dividend and capital
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Poor liquidity High gearing High variability of income

(B)Qualitative models This category of models rests on the premise that the use of financial measures as sole indicators of organizational performance is limited. For this reason, qualitative models are based on non-accounting or qualitative variables. (A)Quantitative models: 1) ALTMANS Z-SCORE MODEL The Z-Score is the most thoroughly tested and broadly accepted distress prediction model. It was developed by Professor Edward I. Altman of the Stern School of Business at New York State University in 1968. As such it is arguably the most important tool used in turnaround management for diagnosing and evaluating overall financial corporate health, as well as the viability of turnaround or restructuring efforts. As a reliable test of corporate financial health, it is widely used by courts of law, and the banking, credit risk management and turnaround industries in the USA as a benchmark for credit status and corporate health. The Z-Score applies statistical techniques (Multiple Discriminant Analysis) to financial ratios to determine the overall health status of a business: Healthy Zone: Business is in good shape. Danger Zone (zone of ignorance, zone of uncertainty): Warning signals, exercise caution. Failing Zone: High likelihood of bankruptcy within one year. This model is known to be about 90% accurate in forecasting business failure one year into the future, and about 80% accurate in forecasting it two years into the future. It is based on a linear analysis in which five measures are objectively weighted and summed to arrive at an overall score, which then becomes the basis for classification of companies into one of the two apriori groupings (i.e. bankrupt or non-bankrupt). These five indicators were then used to derive a Z score. The prediction model is based on an initial set of 22 financial ratios which each belong to one of five categories (liquidity, profitability, leverage, solvency, and activity). In the final prediction model, Altman included 5 ratios, which he selected not on a theoretical basis, but rather on the basis of their popularity in the literature and Altmans belief about their potential relevance to bankruptcy prediction. The five variables used are: 1. Working Capital/Total Assets (WC/TA) 2. Retained Earnings/Total Assets (RE/TA) 3. Earnings before Interest and Taxes/Total assets (EBIT/TA) 4. Market Value of Equity/Book Value of total Liabilities (MVE/TL) 5. Sales/Total Assets (SL/TA). According to the multiple discriminant analysis, the general model can thus be described in the following form:
Z = 1.2 WC/TA + 1.4 RE/TA + 3.3 EBIT/TA + 0.6 MVE/TL + 1.0 SL/TA A Z-score of less than 1.8 indicates strong potential for failure; between 1.8 and 2.99 is the grey (or warning) zone; above 2.99 is the safe zone. There have been several refinements of the Z-score equation, but all have the same basic idea of combining ratios.

Z-SCORE Less than 1.8 Greater than 1.81 but less than 2.99 Greater than 3.0

PROBABILITY OF FAILURE Very high Not sure unlikely

How we use the Z-Score At CRS Turnaround we apply the Z-Score to determine: The degree of distress of a troubled company i.e. is it in danger or failing. The Z-Score trend i.e. is the company heading towards the Danger Zone or Failing Zone, and how fast. The impact of a turnaround plan - will it be possible to get out of the Danger/Failing Zone, and how soon (see quantitative turnaround viability assessment for a real-life example).

2) BEAVER The pioneer of corporate failure prediction models which used financial ratios was William Beaver (1966). He applied a univariate model in which a classification model was carried out separately for each ratio, and (also for each ratio), an optimal cut-off point was identified where the percentage of misclassifications (failing or non-failing) was minimized. The misclassification could be either classifying a failing firm as non-failing firm (a Type I error), or classifying a non-failing firm as failing firm (a Type II error). Beaver selected a sample of 79 failed firms and 79 non-failing firms and investigated the predictive power of 30 ratios when applied five years prior to failure. Of the ratios examined, he found that the cash flow to total debt ratio was most significant in predicting failure, with a success rate of 78% for five years before bankruptcy. Although the simplicity of the univariate approach is appealing, there are a number of potential problems: o Company classification is based on one ratio at a time, which may give inconsistent and confusing classification results for different ratios used on the same company. o It contradicts reality, in that the financial status of a company is complex and cannot be captured by one single ratio. o The optimal cut-off point is chosen on an ex-post basis, ie, when the actual failure status of each company is known. As a result, the cut-off points may be sample-specific and the classification accuracy may be much lower when applied on a predictive basis.

(B) Qualitative models:

(3) ARGENTI Argentina developed a model that looked at non-accounting variables. He produced a list of possible defects, mistakes, and symptoms of failure with a mark against each. If the defect exists, and then it scores the full mark. If it does not exist then it scores zero. There is a pass mark for each section of the list, and an overall, total, pass mark.

In his classification, Argenti (1976) distinguishes three types of failure named Type 1, Type 2 and Type 3 failures. Type 1 A Type 1 failure characterizes the failure of newly formed, and therefore mainly small, companies. Failure usually occurs within five years of the companys introduction, the health of the company almost never rises above poor, and in many cases the company never generates profits. Type 1 failures are by far the most common of failures and thus most companies that fail do so before they even get off the ground. Type 2 A Type 2 failure is characterized by the presence of a very ambitious, charismatic and active manager with an outstanding personality. These failure types can occur to young organizations, but they usually survive longer than Type 1 companies. As stated, this failure type is usually characterized by a failed, ambitious entrepreneur or manager, who never takes advice because he feels he knows it all (Argenti 1976, p.158). His driving ambitions to grow ultimately bring the company down, and the decline is usually as rapid and sharp as the earlier expansion was. According to Richardson et al. (1994), Type 2 failures have increased in significance over time, as evidenced by the wave of failures in the early 1990s, and of course the most recent business failures, of which some are still impending. Type 3 According to Argenti Type 3 failures only occur to mature companies that have been operating successfully over a fair number of years and that often are of major social and economic importance to the community. Financial performance starts off very strongly, and then falls fairly rapidly before it levels out again at a lower level and then falls again, this time into insolvency. The largest characteristic of Type 3 companies is its insensitivity towards changes in the environment: whereas the world around it is changing, the company is not changing with its environment. Thus; J.Argenti developed a model which is intended to predict the likelihood of company failure. The model is based on calculating scores for a company based on: defects of the company management mistakes symptoms of failure For each of the scores, there is a danger mark. Among the most important factors in the model are the following: Classification and Analysis of Business Failure Defects 1. Autocratic chief executive/ domination by one main executive 2. Passive board/ a non-participating board 3. Lack of accounting procedures/budgetary control 4. Financial distortions in terms of going concern 5. Solvency or cash flow problems Mistakes
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1. Over-ambitious/ Use of company assets for personal ambition 2. Signs of extreme growth or overtrading (expanding faster than cash funding) 3. A high level of gearing or leverage/overdrafts/loans 4. Excessive dependence on big projects which fail jeopardizing the company 5. No adaptation to environment Symptoms 1. Deteriorating ratios 2. Creative accounting- signs of window dressing 3. Declining morale 4. Fraud or unethical behavior 5. Deficient accounting and internal control systems Argenti further indicates that these failures is usually characterized by a lack of sufficient accounting information; an underestimation of cost coupled with overestimation of revenues; and poor financial ratios and negative cash flows, which may induce creative accounting. According to Argenti, this unresponsiveness to major changes in the environment could also lead to overtrading on the part of the company. Moreover, pressure groups from outside the company may impose damaging constraints. In addition, profits are dropping, financial ratios and cash flows deteriorate, and creative accounting may occur, combined with high levels of gearing. Finally, there are generally a number of deficiencies in the management structure management defects, domination by one main executive, a non-participating board, lack of management depth, an unbalanced top team, a weak finance function, and/or a combined chairmanchief executive could all be present. (4) BLACK SCHOLES In their 1973, The Pricing of Options and Corporate Liabilities, Fischer Black and Myron Scholes published an option valuation formula that today is known as the Black Scholes model. It has become the standard method of pricing options. The Black-Scholes formula calculates the price of a call option to be:
C=SN( Where C = price of the call option X = option exercise price T = current time until expiration = [ln (S/X) + (r + /2) T] / Put = call parity requires that Then the price of a put option is , , , S = price of the underlying stock r = risk-free interest rate N () = area under the normal curve , = - ) S N ()X N

:P=CS+X :P=X N (-

Assumptions: The Black-Scholes model assumes that the option can be exercised only at expiration. It requires that both the risk-free rate and the volatility of the underlying stock price remain constant over the period of analysis. The model also assumes that the underlying stock does not

pay dividends; adjustments can be made to correct for such distributions. For example, the present value of estimated dividends can be deducted from the stock price model. Warrant pricing Warrants are call options issued by a corporation. They tend to have longer durations than do exchange-traded call options. Warrants can be valued by the Black-Scholes model, but some modifications must be made to the parameters. When the warrants are exercised, the company typically issues new shares at the exercise price to fill the order. The resulting increase in shares outstanding dilutes the share value. If there were n shares outstanding, and m warrants are exercised, represents the percentage of the value of the firm that is represented by the warrants, where:
= m / (m + n)

When using the Black-Scholes model to value the warrants, it is worthwhile to use total amounts instead of per share amounts in order to better account for the dilution. The current share price S becomes the enterprise value (fewer debts) to be acquired by the warrant holders. The exercise price is the total warrant exercise amount, adjusted for the fact that in paying cash to the firm to exercise the warrants, the warrant holders in effect are paying a portion of the cash, , to themselves. The inputs to the Black-Scholes model for both option pricing and warrant pricing are outlined in the following table:
Black-Scholes Parameters for Pricing Options and Warrants Input Parameter Option Pricing S Current share price X T r Exercise price per share Current time to expiration Interest rate Standard deviation of stock return Warrant Pricing V, where V is enterprise value minus debt Total warrant exercise amount multiplied by (1-) Average T for warrants Interest rate Standard deviation for returns on enterprise value, including warrants

CONCLUSION:
Corporate failure has been existing for several years. It is indeed a problem caused by different factors which have already been discussed. Qualitative and quantitative models have been designed to remedy to this situation, namely: Z-Score model, Beaver model, Ant model, Argenti model, Black Scholes model. Ratio analysis and score analysis are not the only ways of predicting company failure. There are other indicators of financial difficulties namely: (i) (ii) (iii) (iv) (v) (vi) (vii) Very large increase in intangible fixed assets; Worsening of cash and cash equivalent position shown by the cash flow statement; Directors report highlighting any difficulties not yet overcome; Changes in the composition of the board of directors, or directors resignations; Press reports of strikes, redundancies, closures A big rise in interest rates, which might seriously affect a highly geared company A large movement in foreign exchange rates, which might affect a major importing or exporting company seriously
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(viii) Significant disposal of shares by directors; This phenomenon, however, can be avoided by setting clear strategies, proper management, fair accounting and correct use of resources and technological advances.

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BIBLIOGRAPHY Corporate failure BOOKS

1, ACCA BOOK 3.5 (June /July 2008), chapter 12, Corporate failure 2, ALTMAN, E. I. (1968), Financial Ratios, Discriminant Analysis, and the Prediction of Corporate Bankruptcy, Journal of Finance, 23, 589-609 3, ARGENTI.J, (1976), corporate collapse: the causes and symptoms, Holsted press, McGrawHill, London 4, ASQUITH, P., GERTNER, R. AND SCHARFSTEIN, D. (1994), Anatomy of Financial Distress: An Examination of Junk Bond Issuers, Quarterly Journal of Economics, 109, 625-658. 5, CYBINSKI, P, (2001), Description, explanation, prediction: the evaluation of bankruptcy studies? Managerial Finance, 27(4):29-44. 6, ENRON COMPANY (17 April 2002) Corporate Failure, Market Success International Swaps and Derivatives Association, 17th Annual General Meeting, Berlin.

INTERNET
1,'BUSINESS FAILURES AND CORPORATE FRAUD - PERSONAL BANKRUPTCY, CORPORATE FAILURE AND FRAUD', Te Ara - the Encyclopaedia of New Zealand URL: http://www.TeAra.govt.nz/en/business-failures-and-corporate-fraud/1, updated 4-Mar-10 2, SPRINGER LINK, Corporate Failure Prediction Using an Ant Model, http://www.springerlink.com/content/q763h7lxj7701v76/ , Tuesday, March 28, 2006 3, SAGE JOURNAL ONLINE, Australian Journal of management - http://aum.sagepub.com , 2010 3, JOURNAL OF SOCIAL SCIENCES, forecasting corporate failure, http://www.jstor.org/pss/2981666,
last updated 2005

JOURNAL
1, THE JOURNAL OF FINANCE (September 1980) vol xxxv no.4 2, STUDENT ACCOUNTANT (June/July 2008) pg 54 Mathematics in Education and research Vol. 6 No. 4 1997
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PART B

EARNING MANAGEMENT
LITERATURE REVIEW
Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (Healy and Wahlen, 1999, p.365). Healy and Whalens often cited definition sets the tone for several papers on earnings management. While it indicates that there are two motives and two techniques for earnings management, it leaves ample room to refine these goals and modi operandi. Healy and Wahlen came across three different motives for earnings management: capital market expectations and valuations, contracts written in terms of accounting numbers and antitrust or other government regulation. They concluded that research has not been able to assist standard setters in their attempts to restrain earnings management nor to provide evidence on the extent and scope of earnings management practices. Even though Fields et al. (2001) review accounting choice research articles, their classification is also useful for earnings management studies: Although not all accounting choices involve earnings management, and the term earnings management extends beyond accounting choice, the implications of accounting choice to achieve a goal are consistent with the idea of earnings management. They organized the accounting choice literature into three groups based on as many market imperfections: agency costs, information asymmetries and externalities affecting non-contracting parties. Once again, the motives for earnings management were made apparent. Managers want to influence the outcome of contracts (e.g. compensation agreements and debt covenants), stock prices and policies of third parties (e.g. taxes, industry specific regulations). They argued that progress in the field of accounting choice has slowed. They defined three fields for further research: measuring the implications of alternative accounting methods, building analytical models that provide guidance to empiricists, designing more powerful statistical techniques and improving research designs? This last issue is the main subject of the review paper by McNichols (2000). She discussed the characteristics of the three most commonly applied designs in the earnings management literature: aggregate accruals models, specific accruals models and the frequency distribution approach. One of the main arguments against using aggregate accruals models is that we do not have enough knowledge on how these accruals behave in the absence of earnings management. Thats one of the reasons why McNichols argued that progress in earnings management research would come from specific accruals research. The frequency distributions (of different earnings metrics) approach introduced by Burgstahler and Dichev (1997) is another often used method to distinguish between companies who are thought to be managing their earnings and those companies who are probably not. This method, although quite easy to put into practice, is also being criticized.
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INTRODUCTION TO THE TOPIC

In todays capital markets, earnings management has become an issue of critical importance. The fact that large firms mislead investors through the intentional misstatement of financial statements is now a common issue. SEC investigations have uncovered earnings management practices that have pushed the boundaries of GAAP, even to the point of out-right fraud. In some instances, independent auditors were blamed for not catching or correcting accounting irregularities. In others, it is clear that management intended to deceive outside auditors and audit committees. Regardless of fault, when earnings management and fraudulent accounting schemes are uncovered, the monetary losses can be staggering.

(I) WHAT IS EARNINGS MANAGEMENT?

Manifold definitions have been used to define earnings management, the most popular being the one Arthur Levitt used in his speech about Numbers Game where he defines earnings management as practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company. Earnings management has also been described as the intentional misstatement of earnings leading to bottom line numbers that would have been different in the absence of any manipulation. We can, therefore state that earnings management is about manipulating figures that is being disclosed in the financial statements to produce the desired figures that the company management wants. While talking about earnings management, one may think that earnings manipulation is performed only by inflating earnings upwards. But, in practice, that is not the case as there are times where managers prefer to manage earnings downward. These cases occur mainly when the year end or quarterly figures is way above the firms target or analysts figures.

(II)WHY AND HOW COMPANIES MANAGE EARNINGS? Why Do Firms Manage Earnings?
Earnings management has become an issue of critical importance in todays capital markets. Understanding what earnings management constitutes and why it takes place is essential for users of financial statement information. Earning is managed for many reasons. (1) ILLUSION OF LESS RISKY FIRM The popular notion has always been that managers prefer to smooth their Earnings so as to makes their firms appear to be less risky. The main reasons are related to the performance of the firm with respect to some targets. These targets could be the previous periods performance, i.e. the desire for the managers to show an improving trend, or analysts expectations, i.e. the desire to meet or beat present expectations, finally it could also be the desire to remain profitable, or whatever benchmark is specified in a managers compensation contract (the desire to meet a bonus threshold). Missing these targets can prove to be extremely costly because the relationship between stock price and earnings is very non-linear around the benchmarks. A firm that misses an earnings target by a mere cent may see its stock price decline drastically, while a firm that beats a target by a few cents may see a nice boost to its stock price. However, it is more probable that
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firms may miss their target by a cent that firms exceeding their target by a cent .When firms are extremely close to a target, the incentives to take earnings just over the target becoming exceedingly strong. In these cases, the firms will try and use some form of upwards earnings management to raise earnings over the target. However, when firms are way below their targets, they have an incentive to make things look even worse for the following reasons. (2) BIG BATHS To begin with, it is highly unlikely that any amount of earnings management will get them over the target. Secondly, if one is way below the target, the costs of being even worse are minimised. Such earnings management is referred to as big-bath accounting. Typically, firms will take large restructuring charges, increase provisions for bad debts and take other income decreasing accounting decisions. Given the self-adjusting nature of accounting, these will lead to boosts in future income in the form of expenses that will not need to be recognized. (3) Further, any improvements in performance will look even more creditable. Managers will get greater credit for turning around a firm, although a substantial portion of the profit may be an artefact of the accounting. When firms are way above their targets, they may again have an incentive to reduce earnings. Typically, there is little benefit in going way above a benchmark. Consider a firm which expects to report an EPS of $1.30 for a given quarter when expectations hover around $1.00. Such a firm may want to report an EPS of $1.20, still comfortably beating expectations. The 10 cents of EPS reduction may come in handy in future quarters when the firm is slightly below targets. (4) RATCHET EFFECT Moreover, reducing the extent of over-performance prevents the ratchet effect. The ratchet effect is when expectations are adjusted upwards when performance is strong. If firms do too well, expectations for the future are adjusted accordingly making future targets more difficult to attain. Earnings management of this nature is referred to as cookie-jar accounting. By reducing current period income, firms implicitly save some of these excess earnings for the future when they may be more valuable. (5) GIVING A FAVOURABLE VIEW TO STAKEHOLDERS Managers and Shareholders managed earnings so as to give a favourable view of the company to outsiders. This can be useful to attract potential new investors who look at current earnings information when evaluating the firms future prospects. Lenders also make use of information like earnings and cash flow to determine the firms ability to repay loans. Furthermore firms may want to reduce interest rates charge on a loan by demonstrating they have relatively stable current earnings pattern that can be expected to continue in the future. Also, many debts contracts include clauses to protect the lender. For e.g. debt repayment may be accelerated if earnings numbers are not maintained at some agreed upon level. For these reasons, managers have the incentives to put the best possible spin on their current earning number.

HOW DO FIRMS MANAGE EARNINGS?

There exist different ways in which firms can manage earnings. The most common methods involve changing the assumptions for accounting standards, arising as a result of the
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flexibility of Generally Accepted Accounting Practices (GAAP). However, since it is difficult to ascertain whether these changes represent manipulation or the genuine application of managerial discretion, it allows those who do manipulate to get away with it. For example, a manager can adjust depreciable lives periodically, justifying it on the grounds that the change is for the improvement of the companys standards in line with industry standards. An example of this was seen in the case of Southwest Airlines which increased its depreciable life from 20 years to 25 years in 1999 with the aim of maintaining its record of always showing increases in earnings. Other methods that firms use include the capitalization of expenses previously treated as expense, increasing the extent of capitalization, slowing down amortization of previously capitalized expenses and the choice o inventory valuation method. Moreover, since bad debts are deducted from receivables, changes in the amount for bad debts are hardly noticed. This is why bad debts are commonly used as a means of managing earnings. The same applies for provisions. Firms can also reduce income by taking on large one-time charges. These charges can be used for taking big baths in bad times or creating cookie jar reserves. In fact, a big bath strategy involves taking as many write-offs as possible in one period. The period is chosen is usually one with markedly poor performance or one with unusual events such as a management change, a merger or a restructuring. Managing transactions is yet another way through which firms manage income. Managers can accelerate revenue recognition just before the end of the fiscal period. In some cases, these last minute sales are genuine sales whereas in other cases they are merely an attempt to clear inventory from the books and recognize it as revenue, even if the buying firm does not agree to buy additional quantities. Such attempts are known as channel loading. Many of the expenditures made by a business firm are discretionary in nature. Management exercises control over the budget level and timing of expenditures for the repair and maintenance of machinery and equipment, marketing and advertising, research and development, and capital expansion. Each choice regarding these discretionary items has both an immediate and long-term effect on profitability. A company might decide to defer plant and maintenance to boost earnings of the current period; ultimately the effect of such a policy can be detrimental. Treatment of discretionary items has both an immediate and long-term effect on profitability. Examples of such items include research and development and capital expansion. If a company decides to defer the maintenance of plant in order to boost present income, then the effect of such a decision can be harmful Income smoothing represents a way to manage earnings. Income smoothing relies not on falsehoods and distortions but on the wide scope existing in alternatively accepted accounting principles and their interpretations. It is conducted within the structure of GAAP. In effect, it redistributes income statement credits and charges among periods. The prime objective is to moderate income variability over the years by shifting income from good years to bad years. Future income may be shifted to the present year or vice versa. In a similar vein, income variability can be modified by shifting expenses or losses from period to period. An example is reducing a Discretionary Cost (e.g., advertising expense, research and development expense) in

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the current year to improve current period earnings. In the next year, the discretionary cost will be increased.

(III)HOW CAN EARNINGS MANAGEMENT BE DETECTED?

Fraudulent accounting practices involving restructuring charges, reserves, creative acquisition accounting and manipulation of GAAP are very difficult for outsiders to detect. Insiders responsible for earnings management are intent on hiding such activities, particularly when the earnings management practices escalate beyond improper revenue recognition. As the charges in several SEC1 investigations indicate, when managers engage in abusive earnings management practices, they must lie to auditors, analysts, investors and their own co-workers to cover these fraudulent activities. SEC documents indicate that in many cases, once the abusive earnings management practices become firmly entrenched at a company, high-level managers spend a great deal of time devising methods to ensure that the abusive practices continue. Since outsiders cannot observe managements day-to-day activities, investors and auditors should look carefully for warning signs that abusive earnings management present. Fundamentally, two approaches to detect earnings management have been identified. The first qualitative method is based on a detailed analysis of a firms accounting policies. The second analytical method is based on a quantitative analysis of accruals. 1, Accounting Analysis- A Qualitative method of detecting Earning Management In order to identify potential earnings management, a firms accounting should be understood. A particular framework is provided below to carry out accounting analysis. The first step in accounting analysis is to identify the key accounting policies of a given firm and industry. Identifying the key accounting policies allows one to focus on areas where manipulation is most likely to occur. For example, for banking institutions, the issues of credit risk are of utmost importance. The second step is to assess the firms accounting flexibility. Firms require a certain amount of flexibility in choosing their accounting policies. For some of them, this may be very low because GAAP2 accounting may be very restrictive. For others, it may be high, for example, industries issuing credit risk. Managers can choose to adopt either aggressive or conservative accounting. Firms that are currently conservative can potentially boost their earnings through aggressive accounting. On the other hand, firms that currently have aggressive accounting may have a greater propensity to manipulate and may be forced to resort to certain illegal accounting techniques. The third step involves the evaluation of a firms accounting strategy; how it differs from that of its competitors. The past accounting policies and estimates of the firm should be assessed for their genuineness, and if there has been any significant change in the policies, the impact as well should be considered. It is also very important to find out if the managers have any incentives to use accounting opportunistically. If a firm has a track record of clean accounting and realistic assumptions in the past, then any changes in accounting that such a firm implements is more likely to be genuine as opposed to be manipulative.
1 2

SEC: US Securities and Exchange Commission GAAP: Generally Accepted Accounting Principles

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Analyzing the reserves for uncollectible accounts provides clues of earnings management since the estimates can be manipulated by the managers. Receivables growth not also reflected in the allowance could be a sign that managers are aware that revenues were recorded prematurely. It could also be a sign that managers have deliberately understated their reserves for uncollectible accounts or recorded fictitious revenues. Both Lucent and Cendant decreased their reserves for uncollectible accounts at times where revenues and receivables were rising. The fourth step is to evaluate the firms quality of disclosure. In order to assess the firms disclosure quality, the answers to the following questions should be found. Does the firm provide adequate information to assess its strategy and understand the economics of its operations? Are accounting policy choices justified adequately? Is there detailed assessment and analysis of past performance? If accounting is restrictive, does management provide additional disclosure to help better understand financial statements? Is there detailed segment disclosure- geographic as well as business segments? Does the firm provide equally good disclosure for bad news Disclosure quality and accounting quality are inexorably linked. Firms with transparent disclosure practices are potentially far less likely to indulge in earnings management. Companies engaged in improper revenue recognitions will have far less transparency in their disclosure practices. There will be a lack of correlation between cash flow from operations and earnings. If revenue is properly recognized, cash flows should closely follow revenue recognition, that is, the business cycle will be completed and cash will be available for reinvestment when customers discharge their obligations in a timely manner. Cash flow lagging significantly behind revenues could be a sign that companies are inflating revenues by recognizing sales in inappropriate periods, making sales to not credit worthy customers, or recording fictitious sales. Investors should also compare receivables and cash flow from operations with revenues and earnings. Receivables rising more quickly than revenues could be a sign that customers are experiencing financial distress. It could also be a sign that a company is engaging in abusive earnings management by recording fictitious sales or otherwise inflating revenues and accounts receivable. For example, a June 2000 Wall Street Journal article suggested that Lucent Technologies might be engaging in creative accounting practices, noting that Lucents receivables were rising at 49% while revenues were rising at only 20%. The fifth step and most probably the most crucial step in accounting analysis is the identification of red flags. Provided below is a representative list of potential red flags in accounting: Unexplained accounting changes, especially if performance is bad. Unexplained profit boosting transactions- e.g. sale of assets Unusual increase I Accounts Receivable in relations to sales increase- relaxing credit or loading sales channels to boost revenues. Increasing Gap between Net Income and Cash Flow from Operations: Firm might be fiddling around with accruals. Increasing Gap between Net Income for reporting and tax purposes. Unexpected large asset write offs or write downs
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 Large fourth quarter adjustments Qualified audit opinions or change in auditors Large related party transactions It is to be noted that the above are potential red flags. The presence of one or a few of these may not signal anything negative, but if many of these red flags do come up for a firm, further scrutiny is certainly required. The final step is to undo accounting distortions by reversing out the impacts of dubious accounting choices wherever possible. For instance, if a firm has increased depreciable life from 15 years to 20 years in a manner that appears to be manipulative, one should restate the numbers with depreciable life of 15 years. The cleansed financial numbers should instead be used for financial analysis. Practices of companies that consistently and precisely meet analysts expectations; particularly growth expectations should be carefully examined. Although many companies employ legitimate means to meet or exceed analysts expectations, other companies may engage in abusive earnings management practices to cover failures resulting from overly optimistic predictions, economic downturns or business setbacks. For example, Cendant manipulated its financial reports to ensure that revenues and expenses were consistently reported at approximately the same percentages each quarter. While companies strive for smooth earnings, consistencies such as those reported by Cendant should trigger closer analysis of financial reports. 2, Discretionary Accruals: A method to detect Earnings Management Analytically Most methods attempting to find evidence of earnings management rely on the calculation of accounting accruals and their separation in the parts: the normal or expected accruals (referred to as nondiscretionary) and the abnormal or unexpected accruals (referred to as discretionary). Accruals are the differences between earnings and cash flows. Most decisions involve some accruals. For instance, selling on credit leads to the creation of accruals since the sale is recognized along with the receivable, even if cash has not been received as yet. When models are evaluated, results clearly indicate that those models that consider cash flow as an explanatory variable are better than nave models and the popular Jones model. In particular, the Accounting Process (AP) model proves to be the best. The AP model, developed by Garza-Gomez et al in the year 2000, is a new model based on cash flow from operations. Studies report a general improvement over the traditional Jones model but concerns about methodology and comparability still remain. AP model produces better estimates of non discretionary accruals, which yield lower standard errors for discretionary accruals part. Since testing for Earnings Management relies on estimates of standard error, smaller deviations should increase the models ability to correctly identify Earnings Management when it has occurred. The standard error of accruals can be further reduced by increasing the number of industries used to identify matching firms and by separating firms by the market in which they are listed. Two methods can be used to estimate the model: the time-series approach and the crosssectional approach. For the cross-sectional approach, one does not need too much prior information and it gives better estimates than the time-series approach.

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Jones (1991) employs a regression-based expectation model to control for variations in non-discretionary accruals associated with the depreciation charge and changes in economic activity.
E[TAt/At-1] =NDAt= 1( 1/At-1 ) + 1( REVt/At-1 ) + 2( PPEt/At-1 ) Where: TA: Average Total Accruals , A: Total Assets REV: Change in revenue from period t-1 to t PPEt: gross plant property and equipment

According to Jones, REV and PPE are terms to control for the non-discretionary component of total accruals associated with changes in operating activity and the level of depreciation, respectively. The AP model incorporates the natural relation between accruals and cash flow and it is expressed:
E[TAt/At-1] = NDAt = 1+ 1( CFO CFO: Cash Flow from Operations
t/At-1 )

+ 2(TAt-1/At-1 )

Tests of earnings management are straightforward. Once suspect firms are identified, a matching sample for year and industry are obtained. Discretionary accrual model is estimated for the matching firms. Using the parameters for the AP model, discretionary accruals are estimated for the suspect firm. This value is then tested against the average discretionary accruals of the matching firms. If the discretionary accrual of the suspect firm (or average discretionary accrual for the sample of suspect firms) is in the rejection zone (defined using a confidence level), it can be concluded that there was income manipulation. CONCLUSION

What more can be done?

Earnings management is a reality of todays capital markets. The nature of earnings management and the methods to identify means of detecting earnings management have been exposed earlier in the dissertation. This has important implications for different participants in the financial markets- investors, financial analysts, the business press, regulators, auditors, academics and the firms themselves. In spite of the fact that earnings are managed, it would be nave to say that one ought to go back to cash flows. Managed earnings are a reality in a world where managerial discretion can be used manipulatively. That does not negate all of accounting. An insight into how managers can manipulate earnings is essential for capital market participants to extract the most use of financial statements. Knowing what tricks managers have up their sleeve can help market participants unravel the effects of any manipulation and in the long run blunt the effectiveness of earnings management techniques. In some sense, the onus on academics and financial practitioners to focus on the importance of understanding a firms accounting practices. A final point regarding the inherent flexibility in financial statements needs to be made. There have been many suggestions in the financial press that the reasons for accounting scandals are the high level of flexibility that managers have in the application of financial standards. In our opinion, the problem lies not in the inherent flexibility, but in the inability or unwillingness of financial market participants to focus on accounting issues when markets are on an upswing. Focusing on accounting issues will allow regulators to keep accounting standards flexible so that

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firms can use them to best communicate with capital markets as any attempts to manipulate will be ferreted out by market participants with sophisticated forensic accounting skills. The current increased emphasis on financial accounting issues is heartening, but this could be a temporary phenomenon related to the morbid fixation people tend to have with bad news. The challenge will be to keep this momentum going the next time the markets start to ascend, to prevent future large scale occurrences of accounting fraud.

BIBLIOGRAPHY Earning management BOOKS

1, HEALY. P, WAHLEN.J, (1999), a review of the earnings management literature and its implications for standard setting. Accounting Horizons, 365-383 2, FIELDS. T, LYS. T, VINCENT. L, (2001) Empirical Research on Accounting Choice. Journal of Accounting and Economics, 31, 255-307 3, MCNICHOLS. M,(2003) Discussion of Why are Earnings Kinky? An Examination of the Earnings Management Explanation. Review of Accounting Studies, 8 (2-3), 385-391

JOURNAL
1, BURGSTAHLER.D, I.DICHEV (1997), earnings management to avoid earning decrease and loses Journal of accounting economics, 24(1997):101 2, Jones. Jennifer, (1991), Earnings management during import relief investigation. Journal of Accounting Research 29 (2), 193-228 3, Bartov, E. and P. Mohanram (2003), Private Information, Earnings Manipulations, Executive Stock Option Exercises. Working Paper Columbia University/New York University.

INTERNET
1, EARNING MANAGEMENT, p.1. /www.romeassoc.com/inv_lit/archive/earning.htm. Last updated June 12, 2001 2, THE CPA JOURNAL ONLINE, earning management and its implication, http://www.nysscpa.org/cpajournal/2007/807/essentials/p64.htm , last updated 2009 3, INVESTOPEDIA, what is earning management?, http://www.investopedia.com/ask/answers/191.asp , last updated 2010
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