Question

Answer the following questions: (i) In your own words, define "earnings management" (ii) Provide two example of a behavioural incentive for earnings management (iii) Provide two example of a market-based incentive for earnings management

Answer 1

(1) Earnings management is the use of accounting techniques to produce financial statements that present an overly positive view of a company's business activities and financial position. Many accounting rules and principles require that a company's management make judgments in following these principles. Earnings management takes advantage of how accounting rules are applied and creates financial statements that inflate or "smooth" earnings.

• In accounting, earnings management is a method of manipulating financial records to improve the appearance of the company's financial position.
• Companies use earnings management to present the appearance of consistent profits and to smooth earnings' fluctuations.
• One of the most popular ways to manipulate financial records is to use an accounting policy that generates higher short-term earnings.

(2)

In contrast with other theories that suggest we are pushed into action by internal drives (such as the drive-reduction theory of motivation, arousal theory, and instinct theory), incentive theory instead suggests that we are pulled into action by outside incentives.

You can liken incentive theory to operant conditioning, where behaviors are performed in order to either gain reinforcement or avoid punishment. Incentive theory states that your actions are directed toward gaining rewards.

What type of rewards? Good grades are a type of incentive that can motivate you to study hard and do well in school. Gaining esteem and accolades from teachers and parents might be another incentive.

Money is also an excellent example of an external reward that motivates behavior. In many cases, these external rewards can motivate you to do things that you might otherwise avoid, such as chores, work, and other tasks you find unpleasant.

(3)

The use of market-based incentives (MBIs) as mechanism for influencing pollution abatement has increased greatly in recent years. This trend reflects the realization that the integration of economic and environmental decision-making will induce the private sector to take steps to reduce their pollution emissions levels. Market-based incentive instruments may be broadly classified to include environmental taxes, investment tax incentives, tradeable permits, user charges and deposit refund systems. Until now, policy- makers world wide have continued to place greater emphasis on the use of investment tax incentives since they seem to more effectively balance environmental considerations with concerns about industrial competitiveness. It is becoming increasingly apparent, however, that other MBIs may be more effective mechanisms for influencing pollution abatement in certain circumstances. This report reviews the theoretical foundations for idealized pollution control MBIs. It then focuses in particular on the way in which environmental taxes, deposit refund system and tadeable pollution permits may be more suitable instruments for inducing pollution abatement behaviour. A number of international examples of the implementation of such policies are reviewed.