Bank finance articles and tips

Imagine the following situation: you're now a senior level executive, it's time to prove yourself, and the numbers are not in your favour, what do you do? Ethics tell us that the principal-agent relationship is fiduciary- a relationship built on trust. A company's duty to their stakeholders is to properly represent the company, be it in a positive, or negative light, to show the numbers as they are. This, however, is not always the case. Earnings management is a creative accounting technique that, albeit ethically unsound, allows managers to crunch the numbers in their favour to make the company look more profitable to their stakeholders, and mislead them on the actual financial situation of the company. Billionaire Warren Buffet is quoted saying: "Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers" in the book Warren Buffett's Management Secrets - "Five Terrific Business Tools.".

Detecting earnings management is not easy, unless your hands are physically caught in the cookie-jar, it is difficult to detect, and prove. With the complexity of accounting laws, it is very hard to detect accounting scandals before they happen, investors rely on the fiduciary relationships they have with the companies they are in business with. On the Lehman Brothers scandal, the largest bankruptcy in history, to date, United States Secretary of the Treasury, Timothy Geithner, gave the following statement:

Before and during the crisis, weaknesses in these checks and balances were prevalent. Boards of directors failed to exercise critical judgment and address critical weaknesses in risk management. Ratings agencies failed to do an adequate job of assessing the risks in structured credit products and disclosing their ratings methodologies. Auditors failed to identify practices that may have crossed the line from an accounting perspective. And the existing accounting and disclosure regime did not adequately apprise investors of material risks in a timely fashion.

Lehman Brothers' financing came from supplying short-term debt, operated with very high levels of leverage. Their hands were caught, although when the situation was beyond control. But how did auditors fail to identify these practices?

The special Committee of Sponsoring Organizations of the Treadway Commission (COSO), an organization that looks at frameworks and guidelines on enterprise risk management, internal control, and fraud deterrence sponsored a study, "Fraudulent Financial Reporting: 1998-2007" (issued May 2010), and investigated fraudulent financial reporting between Janurary 1998 and December 2007. The following are notable practices used in earnings management as described in the study: improper revenue recognition, followed by the overstatement of existing assets or capitalization of expenses. Revenue frauds accounted for more than 60 percent of the cases, versus 50 percent in 1987-1997. Also notable is the section on Audit Committees, almost all fraud and fraud-free firms have audit committees, but the COSO do not see a meaningful difference in their auditing techniques, stating more research was needed.

What causes management to fudge the numbers? While there are various incentives, it simply comes down to meeting targets, oftentimes management will receive a bonus upon reaching a certain milestone, and money drives people into action. Like the senior level executive, an auditor may receive their own incentive to make a certain financial report look more pleasing to stakeholders. Statement on Auditing Standards (SAS) No. 82, Consideration of Fraud in a Financial Statement Audit, distinguishes fraud from error on the basis of whether the underlying action that results in a misstatement of the financial statements is intentional or unintentional. Anyone can make an error on a financial statement, this fact is what makes catching an earnings management crime more difficult. It is an auditor's duty to report any discrepancies and blow a whistle if they believe a wrong action has occurred.

The topic of earnings management began to receive much attention after the 2002 stock market downturn involving Enron, Worldcom and other firms in the United States, and now the 2008 stock market crash. While accounting may be referred to as a safe industry, fraud has many faces and like most criminals it starts out small and escalates until it is found. With earnings management, it's not a case of "a few bad apples destroy the bunch", but rather, a few bad apples can cost billions of dollars in downturn to the economy. With money like that, it's better to keep this topic in your back pocket and keep a watchful eye the next time you're sifting through those financial statements.

By Nikol Paar