This is an investigatory study on how companies
manipulate their earnings which emphasizes on the importance of ‘Earnings
Management’ which is an area of great interest to current and potential
investors. It is obvious that companies are being hard pressed to deliver
returns or earnings as per market expectations to enjoy the privilege of valuation
premiums and low cost of capital. However, this eventually pushes investors to
resort to shortcuts to manipulate their actual earnings which poses a serious
threat to investor’s confidence.

 

‘Earnings’ which is sometimes referred to as
the ‘Bottom Line’ or ‘Net Income’ is the most important item in the financial
statements. They reveal the extent to which the company is engaged in value
added activities. Also, it is a matter of fact that the calculated value of
company’s shares is nothing but the discounted present value of the future
earnings. An increase in earnings indicates a proportionate increase in the company’s
value. Having said the above, it is critical for any company to understand the
effect of their accounting choices which they can make to effectively manage
their earnings so that they increase investor’s confidence and market
capitalization. However, ‘Earnings Management’ should not be misinterpreted
with illegal activities that are used to manipulate financial statements and
reporting results that do not reflect the reality. These types of manipulations
are known as ‘Cooking the Books’ or ‘Fraudulent Accounting’.

 

‘Earnings Management’ which is also commonly
referred as ‘Window Dressing’ or ‘Accounting Jugglery’ refers to a set of proper
and well-defined practices that are a part of well managed business entity
which can deliver higher value to the shareholders. Earnings Management is
primarily achieved by leveraging Accounting Choices from GAAP or Operating
Decisions. Estimating Bad Loans and Provisions and Inventory Write Downs are
some of the common practices that are used to inflate financial statements
using ‘Accounting Choices whereas ‘Operating Decisions’ are whether to offer a
special discount or incentive to flush out unsold stocks if revenue targets are
not being met.

 

Earnings Management can be done by manipulating
accruals or operational activities of the company. ‘Accrual’ is defined
as an event that has no impact on the cash flows of the company. A credit sale
will result in goods moving out of the company but will not lead to an instant
cash inflow. Also, a change in depreciation method on fixed assets will impact
the bottom line of the company but will have a neutral effect on cash flow
being a cashless expense. These decisions are done at the discretion of the
company’s management and hence they are called ‘Discretionary Accruals’ which
are used as proxy for the earnings that are being managed.

 

It is a matter of fact that Companies continue
to manage their earnings to show high top line growth that increases the
positioning of the company in the eyes of the shareholders and thus inflating
the financial statements. Creating Large Provisions and Cookie Jar Reserves are
some of the techniques companies follow to manage their earnings.

 

This paper throws light on Earnings Management
that happens in Indian Companies across various sectors by altering
discretionary accruals. There are prior researches which have used
discretionary accruals to detect ‘Earnings Management’ manipulation namely Healy
(1985), De Angelo (1986) and Jones (1991).

 

The difference between DeAngelo and Healy model
is that DeAngelo assumes a random process while Healy model assumes that non-discretionary
accruals revert to the previous state. The Jones Model was further extended as
‘Modified Jones Model’. However, it has been proved that the ‘Modified Jones
Model’ was more efficient in uncovering the discretionary accruals as it has
generated the highest R adjusted value compared to other models. Also, it takes
into effect the exogenous effect whereas other models do not take them into
account.

 

It has also been observed that the
coefficient for cash sales is positive with increasing income. Further, the multiple regression
model (Modified Jones) indicate that the coefficient of PPE has a negative
effect on total accruals which implies that decreasing income has a negative
effect on total accruals. Therefore, it indicates that the Modified Jones
modified model is the most appropriate model when analyzing earnings
management, given time series data. Also, Jones model and modified Jones model
reveal that business makes higher average discretionary accrual compared to
DeAngelo and Healy models.

This research study looks at the financials of
50 companies from 5 independent industry sectors between 2012 and 2016. The
study uses the Modified Jones Model to compute
discretionary accruals.

 

The Modified Jones Model calculates the Total
Accruals and Non-Discretionary Accruals and estimates the Discretionary
Accruals as difference between the Total Accruals and Non-Discretionary
Accruals. Discretionary Accruals may be positive or negative. A positive
discretionary accrual means earnings are being overstated than actual numbers and
a negative discretionary accrual means that companies are understating their
earnings which they usually do when they have met their revenue and profit targets
for the year and wanted to make a provision or take a cushion for the next
period.

 The data from the financial statements were
plugged in into the Jones Model and Total Accruals and Non-Discretionary
Accruals were estimated for each company. The Discretionary Accruals were
inferred as the arithmetic difference between Total Accruals and
Non-Discretionary Accruals post which the data was consolidated for each sector
and mean accruals for each year was computed and the findings were reported
based on the assumption that the data from the companies that were taken for
study is representative of the entire sector.

 

It has been proved from our analysis
that among the 5 sectors that were taken, Pharmaceuticals Sector is
showing mean negative discretionary accruals of -15% over the
period of five years. Steel and IT Services Sectors have an average
figure of -0.6% and -0.5% respectively in the same time frame. In the case
of IT Services, revenue recognition depends on the management’s signoff of
project accomplishment and the revenue inflow happens only when the client
releases the funds. Two sectors where the understatement of earnings is evidenced
by a negative number are Real Estate and Automobile Sectors.

It is also evident from the above
analysis that companies are indulged in earnings management through discretionary
accruals. Also, this gives an insight into industry level accruals from the discretionary
accrual numbers of the key players whose identities are not revealed here.

This study is a good indicator for regulatory
bodies like SEBI and an eye opener for potential investors as well. However, it
also puts forward some critical recommendations that SEBI should increase the
surveillance and enhance the intensity of monitoring on the companies or
industry that are showing a high level of discretionary accruals. Also, this is
not only limited to the market regulatory bodies like SEBI. As most of the
earnings management is done by company’s management, a good board of directors
also play a critical role in future valuation of the company which are
dependent on potential cash flows and current earnings. Hence, discretionary
accruals are reflective of the quality of company’s board of director’s and
audit committees. It is imperative that regulatory bodies increase their
surveillance on the effectiveness of these boards and committees. Also,
enforcing stringent investor protection laws and accounting standards to
protect the interest of minority shareholders can reduce the amount of earnings
management.