Professional Scheme
Relevant to Paper 3.1

Earnings management is a particularly relevant discussion topic in corporate governance. It is topical in that it encompasses a wide range of scenarios. These range from innocent acts leading to little manipulation of financial statements - to an extreme criminal act, aimed at deceiving users of financial statements.

The topic is so important that it is a large part of the IAASB's Proposed Revised Exposure Draft (ED) 240, The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements. In 2001, the then Auditing Practices Board (APB) issued a Discussion Paper on Aggressive Earnings Management. This article deals with this topic as a current issue for students of Paper 3.1, Audit and Assurance Services.

What is Earnings management?
Earnings management is principally when companies artificially inflate (or deflate) their revenues or profits, or earnings per share figures. They do this by using aggressive accounting tactics (estimates/policies etc). In other words, it is when companies use creative accounting to create reported figures that show the position (balance sheet) and performance (income statement/profit and loss account) that management want to show.

There may be drivers or pressures that cause management to want to show earnings at a certain level or following a certain pattern. These pressures drive management into seeking loopholes in financial reporting standards which allow them to 'flex' the numbers as far as is practicable to achieve management's desired aim or satisfy projections/forecasts by analysts. This flexing is 'outside the bounds of acceptable accounting practice'. These actions then become unacceptable under the applicable financial reporting framework, and result in fraudulent financial reporting. Examples of pressures include market expectations, personal realisation of a bonus, and maintenance of position within a group of companies (eg having highest profit margin in the industry). The personal integrity of the people involved plays a significant role in these circumstances.

The present situation
There is currently an IAASB Exposure Draft on Proposed Revised International Standard on Auditing (ISA) 240, The Auditor's Responsibility to Consider Fraud in an Audit of Financial Statements. At the time of writing, 36 responses had been received by the IAASB (comprising 23 member bodies, five firms and eight others). Notwithstanding the specific content and nature of each response, there is general recognition that there is a problem with earnings management in the corporate world. It is clear from its title that the ED deals with fraud and starts by distinguishing fraud from error and describing the two types of fraud that are relevant to the auditor.

In the United Kingdom and Republic of Ireland, the APB issued a Discussion Paper on Aggressive Earnings Management in 2001. The paper was timely in that it contributed to the international debate on this subject of global significance. The consultation paper was issued to:

• alert executive directors, non-executive directors, auditors, regulators, and users of financial statements to the potential threat that increasing commercial and economic pressures may cause 'aggressive earnings management'
• seek views on the steps that auditors should take to identify and respond to it.

To put aggressive earnings management into context, the APB paper:

• explained why, even in a properly prepared profit and loss account, there is no such thing as a single 'right' earnings figure
• demonstrated, by use of an example, how legitimate business practices can develop into unacceptable financial reporting
• explored some of the steps auditors might take to identify and respond to aggressive earnings management.

The APB received some responses to this consultation paper but it is not clear as to the subsequent steps to be taken by the APB.

The APB has responded to the ED on ISA 240 and the response indicates that the APB is generally supportive of the revised ISA but has significant concerns in relation to:

• the consideration of reasonable assurance
• the overlap and interaction with the Audit Risk ISAs (especially ISA 315)
• the proposed requirements relating to management representations.

In relation to reasonable assurance, the concerns appear to centre on the difference between fraud and error, and the reality that it is easier for the auditor to detect error than it is for the auditor to detect sophisticated fraud. Therefore, the auditor cannot possibly convey the same level of assurance with regard to the absence of both types of misstatements. Concerning the overlap with the Audit Risk ISAs, the APB's concern is that the ED does not position the consideration of fraud within the framework provided by the Audit Risk ISAs. The APB states that revised ISA 240 should be 'speaking the same language' with the Audit Risk ISAs in relation to fraud risks, significant risks, and documentation. In relation to Management Representations, the APB's concerns arise from the rigidity of the requirements in the ED. This is important considering that representations from management provide little assurance in relation to the risk of management fraud.

In addition to these major reservations, the APB comments on two other significant aspects of the proposed ISA 240 -management and those charged with governance, and communications to regulatory and enforcement authorities. In relation to management and those charged with governance, the APB is concerned that there is very little guidance in the ED in the case of small entities where management and those charged with governance are the same people. The APB is also concerned that there is little recognition in the ED that those charged with governance may themselves be involved in the perpetration of fraud.

In relation to communications to regulatory and enforcement authorities, the APB believes that the revised ISA 240 should state that the auditor should consider whether - when aware of a suspected or actual instance of fraud - the matter should be reported to a regulatory or enforcement authority in accordance with relevant laws and regulations. If such a legal or regulatory responsibility does not exist, the matter should be reported to a proper authority in the public interest where the law does not prohibit this. Determination of where the public interest lies requires careful consideration and needs to be balanced with the duty of confidentiality.

The responses to ED 240 seem to indicate the latest APB thinking on these matters and may be considered as an 'update' to the thinking in the Aggressive Earnings Consultation Paper issued in 2001 by the then APB.1

The ability to distinguish fraud from error lies in the skill of identifying whether or not there has been an intention to create a misstatement. The presence of intention indicates fraud. The absence of intention generally signifies error. However, the auditor must approach each situation with professional scepticism.2

The ED describes two types of relevant fraud - misstatements resulting from misappropriation of assets, and misstatements resulting from fraudulent financial reporting. The misappropriation of assets is fraudulent and resulting misstatements in the financial statements are likely to be fraudulent too. Misstatements in financial reporting may or may not be fraudulent. They may be innocent mistakes (errors) arising from, for example, mistakes in the application of accounting principles relating to measurement, recognition, classification, presentation, or disclosure. However, they may instead result from deliberate (intentional) misapplications of such rules. Here is where the concept of earnings management comes in.

Remember that for audit purposes, materiality is always relevant. Briefly, anything not material is not worth worrying about. Materiality is influenced by many quantitative as well as qualitative factors, and no amounts or percentages can be prescribed or predetermined to result in an approach that is incontrovertibly acceptable. As a result, determining what is material is a matter of judgement having regard to both the amount involved and to the circumstances in each situation. Traditionally, auditors have regarded differences between their view and those of directors as not material, even if the amounts involved would change the profit or loss by 5%. Indeed, there may be some circumstances in which auditors would consider differences approaching 10% as not material. It is worth noting here that there are numerous circumstances in which misstatements below 5% could be material. The auditor must deal with each set of circumstances considering the facts at hand.

Example 1
Consider a company whose profits and earnings per share figures have been rising in line with rising analysts' forecasts for a few years. When a downturn occurs, management - in an attempt to ensure that the analysts' forecasts are met - do everything in their legitimate power to increase sales. Management are successful - forecasts are met. This encourages the analysts to raise their forecasts for the following year. Unfortunately, the downturn continues and the pressure on management is now even greater. Management do everything in their power to increase recorded sales. Management also begin to look for ways of reducing recorded costs - understating provisions, but still within the rules. No disclosures are made in the financial statements in connection with these actions. In the following year, the position has escalated out of control and clearly illegitimate activities are being employed in order to stimulate sales, keep down recorded costs and hide the fact from the readers including the auditors. Clearly, an unsustainable state of affairs and at some point the thing goes 'belly up', the police are called in, and the inevitable newspaper headlines follow:

It is clear in this scenario that management was trying to meet expectations placed on it by the analysts. Management was too involved in the escalating situation to see that the best thing to do would have been to put a stop to the rising expectations. Competent independent auditors should have addressed the issues a lot earlier. Out of the ordinary? Maybe, but think of Enron, WorldCom, Parmalat and other such horrors.

Auditors need sufficient resolve when dealing with clients who wish to employ aggressive earnings management. Auditors need a 'backbone'. A robust ethical framework, which promotes objectivity, strengthens this backbone. The conditions which give rise to aggressive earnings management are, I believe, cyclical: a downturn in the economic cycle or within an industry sector makes aggressive earnings management more likely. Members of audit teams may not have sufficient experience of conditions which occur over an extended period of years and need to be made aware of such factors. This responsibility lies with the training programmes provided by auditing firms.

What are the audit and assurance services implications of earnings management?
Several audit and assurance services implications arise from a regime of aggressive earnings management. Firstly, auditors have to approach their work with a heightened sense of professional scepticism. This means that auditors have to recognise the possible existence of circumstances that may cause financial statements to be materially misstated. It means that auditors have to undertake more questioning of information obtained from, and explanations provided by, the organisation. Even a small suspicion should lead the auditor to ask further questions and seek extra evidence for an item, remembering all the time that records and documents should be accepted at face value. Any information/document/evidence that implies that management and those charged with governance of the corporation may be less than honest should be pursued to its conclusion.

ISA 580, Management Representations, deals with obtaining assurances from management and those charged with governance on certain matters. If those same people (either management or those charged with governance or indeed both) are involved in manipulating the accounting information in order to deceive the readers of the financial statements, these management representations become useless to the auditor. What further evidence the auditor seeks will be dictated by whether professional scepticism leads the auditor to believe that management may be 'up to no good'. If this is the case then the auditor may seek assurances from those charged with governance (assuming that they are separate from management), that they have reviewed the presence and effectiveness of internal controls to provide reasonable assurance with regard to the reliability of financial reporting. It is important that the representations obtained are tailored to the specific circumstances. If management refuses to provide a representation that the auditor considers necessary, this constitutes a scope limitation and the auditor should express a qualified opinion or a disclaimer of opinion. It is important that the auditor is aware of the circumstances that may be indicative of earnings management. The auditor must be particularly aware of positions or judgements that may create intentional material misstatements in the financial statements.

Earnings management presents particular difficulties to the auditor. These include knowing when:

• earnings management is within generally accepted accounting principles (GAAP) (and so innocent) and when it is so aggressive it is outside GAAP (and therefore fraudulent)
• choices within a flexible accounting framework are innocent normal choices, and when they are part of a deliberate aggressive earnings management regime for the purpose of deceiving readers of the financial statements
• internal controls, which appear to be operating effectively, have actually been overridden by management (it is in these cases that management representations become useless - they cannot and should not be relied upon)
• year-end adjustments (for example accruals) are at an appropriate level for the client, and when they are part of an aggressive earnings management deception
• reserves are being created for legitimate purposes at an appropriate level, and when they are part of a fraudulent scheme of aggressive earnings management - this one is particularly difficult to deal with since it is counter-intuitive to an auditor (the 'fraud' here is that the corporation is creating reserves in good times to release in bad times - the result is that the financial reporting is less than honest and so readers may be misled by it).

At the end of the day, the sole purpose of earnings management is to deceive readers of financial statements by influencing their perception about the entity's performance. At its most aggressive, it constitutes fraudulent financial reporting. There are four categories that the auditor has to look out for:

1. unsuitable revenue recognition
2. improper accruals and estimates of liabilities
3. 'big bath' provisions and generous reserve accounting
4. intentional breaches of financial reporting requirements which are, in isolation, immaterial - as in aggregate they may be material.

Key to implementing the spirit of the proposed revised ISA 240 is:

• consciously thinking about how fraud might be perpetrated within the entity
• challenging pre-conceptions
• using the collective knowledge of the team to 'connect apparently isolated occurrences'
• exploring anomalies rather than rationalising them.

Effective education and training are vital in instilling these attitudes and skills.

Conclusion
So why worry about earnings management? It may lead to a set of financial statements that are more a work of fiction than a true and fair representation of the commercial activities of the entity being reported on. It is important to realise that the transition from legitimate earnings management to aggressive earnings management (ie fraudulent financial reporting) may not be so obvious. The auditor needs to be aware of the possibility and so approach each audit engagement with professional scepticism. The auditor should be clear in his mind as to the appropriate audit response to accounting practices that fall short of clear misstatements. Professional scepticism dictates that if in doubt the auditor should seek further clarification.

The proposed revised ISA 240 provides a sound basis for addressing fraud in a financial statement audit. Its focus on professional scepticism and more thorough and thoughtful risk assessments as a platform for designing appropriate responses to identified and assessed risks is spot on. It is important that the auditing profession the world over should continue to engage in dialogue with the various players in the corporate reporting chain to ensure that, collectively, all players are dedicated to working together to combat fraud and deceptive earnings management, and to strengthen the reliability of corporate financial reporting.

Notes

1. The 'new' APB is constituted as a company limited by guarantee and owned by The Accountancy Foundation and is in replacement of the 'then' APB which was a committee of the accountancy bodies. The new APB can, therefore, be considered as an independent regulator of the accountancy profession.
2. The IAASB ED spelling is 'skepticism'.

Namasiku Liandu is assessor for Paper 3.1