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ACC30010 Auditing Earnings management

Question:

This assignment assesses the following unit learning outcomes:

1. Research, assess and report on a critical and current topics in auditing.

2. Work collaboratively in a team environment, to achieve set goals related to the building of knowledge of auditing.

 

Answer:

Professional scepticism

Professional scepticism is an attitude that is required by the auditor to be maintained during the entire course of the professional engagement. It requires the auditor to remain alert to all such conditions that indicates the possibility of misstatement as a result of error or fraud on or due to management of the entity (Hurtt, 2010). As a part of fulfilling the professional engagements in the auditing engagement auditor must have a questioning mind to anything that is unusual or unreasonable that he comes across while performing the audit procedures.  The application of professional scepticism enhances the ability of auditor to identify the risks of material misstatements and also to respond adequately to all the identified risks. The concept of professional scepticism is in close relation with basic ethical


considerations of principles of objectivity and independence. An audit engagement which is performed without the use of concept of professional scepticism will not result in achieving the high quality standards of auditing practice. Maintenance of professional scepticism in auditing practices helps in ensuring that auditor do not ignore the unusual situations or oversimplify the outcomes of audit procedures or make use of inappropriate assumptions while determining the response to the risks that are identified during the performance of auditing obligation. The auditor must apply professional scepticism to all the phases of auditing engagement such as acceptance of client, risk assessment procedures are performance, obtaining and evaluating the audit evidences and so on (Nelson, 2009). The detection risk in audit is ultimately reduced with the use of professional scepticism because the said attitude will improve the audit procedure’s effectiveness and thereby minimises the possibility of reaching at the inappropriate conclusion or opinion while evaluating the findings of audit procedures.  The adoption and application of a sceptical mind-set is the ultimate responsibility of every auditor to safeguard the overall audit quality and to raise audit opinion’s credibility (Hurtt, et. al., 2013).  

 

Earnings management

The term earnings reflect the net income of the business in a particular period of time. It is the most important element of financial statement of an entity as it helps the readers to assess the financial performance as well as the financial position of the business of the reporting entity. The stakeholders and potential investors of the company base its earnings as an important criteria for their decision making process in relation to the matters in which they are associated with the company.  Given the significance of earnings for the business and the users of financial statements, it can be said that the management of the entity has a great interest in how these earnings are reported. Earnings management literally means reasonable as well as legal decision making in relation to financial reporting so as to achieve stable financial results. Earnings management is often confused with the illegal activities in the areas of manipulation of financial statements so as to achieve the results that do not reflect the true economic performance of the business. However, the concept of earnings management typically involves selection of those generally accepted accounting procedures that have the capacity to achieve the specific objectives of the managers of the entity (Roychowdhury, 2006).  As long as GAAPs are used to account for the earnings of the entity, earnings management cannot be regarded as a fraudulent or illegal practice. There are generally two motives of earnings management: either to mislead the stakeholders of the company by showing them falsified results about the underlying financial performance of the business or to influence the contractual outcomes which are dependent on the accounting numbers. Not all types of earnings management are deceptive in nature. However, it is usually observed that the managers that tends to manage the earnings of their firm in order to mislead the stakeholders appoint a low quality auditor who could not uncover their unethical and unprofessional accounting practices to the investors and other stakeholders (Leuz, Nanda & Wysocki, 2003).

Discretionary Accruals

Discretionary accruals are the non-mandatory expenses or assets that are recorded in the system of accounting but have not yet realised. The term accrual means the recording of a transaction on its occurrence even when no cash has moved in or out of the business. As per GAAP, the future expenses or liability must be recognised as a liability in the books of accounts when the timing of its occurrence and amount of such expense or liability is known today. In discretionary accruals the entity chooses its own discretion in deciding whether an item must be recorded on accrual basis or not. Discretionary expenses are those expenses that are not essential for the business but are generally incurred to promote the business in front of customers and to enhance the standing of the company in front of employees. A typical example of discretionary approvals is management bonus or a holiday party organised by a company for its employees. Discretionary accruals is generally considered as the most common method of manipulation of financial statements as it is relatively less expensive and also it cannot be traced out easily by the users of financial statements. Moreover, since in discretionary accruals, high degree of subjectivity is involved as it is based on the judgements of the accountant, these areas become more complex to be audited (Krishnan, 2003).  Managers of the entities could engage themselves in aggressively reporting about the accruals that have the capacity to severely undermine the decision-usefulness of the reported earnings. Since external parties that are interested in knowing the firm’s financial position cannot directly observe the true earnings of the company, they place reliance on the independent bodies called auditing professionals to report on the true financial position (Cohen, Dey & Lys, 2008). Hence, the high accrual firms are found to pay high agency cost than the low accrual firms. Auditing serves as an important tool to reduce the agency cost by restricting the opportunistic accrual management (Chen, Lin and Lin, 2008).

 

References:

Chen, C.Y., Lin, C.J. and Lin, Y.C., 2008. Audit partner tenure, audit firm tenure, and discretionary accruals: Does long auditor tenure impair earnings quality?. Contemporary accounting research, 25(2), pp.415-445.

Cohen, D.A., Dey, A. and Lys, T.Z., 2008. Real and accrual-based earnings management in the pre-and post-Sarbanes-Oxley periods. The accounting review, 83(3), pp.757-787.

Hurtt, R. K. (2010). Development of a scale to measure professional skepticism. Auditing: A Journal of Practice & Theory, 29(1), 149-171.

Hurtt, R. K., Brown-Liburd, H., Earley, C. E., & Krishnamoorthy, G. (2013). Research on auditor professional skepticism: Literature synthesis and opportunities for future research. Auditing: A Journal of Practice & Theory, 32(sp1), 45-97.

Krishnan, G.V., 2003. Audit quality and the pricing of discretionary accruals. Auditing: A Journal of Practice & Theory, 22(1), pp.109-126.

Leuz, C., Nanda, D. and Wysocki, P.D., 2003. Earnings management and investor protection: an international comparison. Journal of financial economics, 69(3), pp.505-527.

Nelson, M.W., 2009. A model and literature review of professional skepticism in auditing. Auditing: A Journal of Practice & Theory, 28(2), pp.1-34.

Roychowdhury, S., 2006. Earnings management through real activities manipulation. Journal of accounting and economics, 42(3), pp.335-370.

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