Question

‘Most directors believe in efficient stock markets yet most also engage in earnings management.’ Discuss the role of financial reporting within an efficient market and the reasons why firms engage in earnings management.

Answer 1

Discuss the role of financial reporting within an efficient market

Financial reporting is the way companies show their performance to outside world. The objective behind financial statement analysis is to use the company’s financial statements & other relevant information to make economic decisions. Such an analysis is used to evaluate a company’s past performance & current financial position and project company’s ability to earn profits and future cash flows so that economic decisions like whether to invest in the company's securities or whether to extend bank credit to the company can be taken.

There are two types of users of these financial statements: internal (working inside the company) and external (outside of company). Please refer to the table below: Sl. No. Stakeholder Objectives / Needs A. INTERNAL USERS 1. Management Financial Performance assessment Preparation of budgets, forecasts etc. Take Business Decisions 2. Employees Financial performance assessment to evaluate the impact on wages/salaries (variable compensation) Negotiate for wages and salaries B. EXTERNAL USERS 1. Shareholders / Prospective Investors Investment Decisions – ROI Risk vs Return 2. Financial Institutions / Lenders Credit worthiness 3. Suppliers Liquidity Position - Credit Terms 4. Customers Sustainability of operations 5. Capital markets / Regulators Corporate Governance Check conformance to regulations 6. Competitors Cross Sectional Analysis Strategies to improve competitiveness 7. Government Correctness of tax declaration Economic development Employment generation 8. General Public Impact on economy, environment & local community, Employment generation 9. Financial advisors and analysts To analyse and assist investors with recommendations

And the reasons why firms engage in earnings management.

• Firms / Directors are under pressure from the board of the directors and shareholders to shown growth, positive results, profits and increasing trend in profits period after period. This may result into earnings management.
• Some of the directors' variable compensation (bonuses, stock options etc) is linked to the performance of the firm. The linkage may be to topline (revenues), bottom line (profits / earnings), ROI, residual income, cash flow etc. Directors may therefore not be able to resist the temptation to involve in earnings management to show superior performance so that they can get the variable compensation.
• Firms tend to operate under competitive environment. At times, competitive landscape in the industry and the environment forces the Directors to showcase a better result and earning. This may lead to the practice of earning management.