Earnings management

practices in India: a study

of auditors perception
Divya Verma Gakhar
University School of Management Studies,
Guru Gobind Singh Indraprastha University, Delhi, India

Abstract
Purpose Earnings management are euphemisms referring to accounting
practices that may follow the letter of the rules of standard accounting practices,
but certainly deviate from the spirit of those rules. Companies across the world
follow earning management practices in a way so as to show a favourable
position to their stakeholders. Satyam scam in India was a similar type of case.
The present study has been carried out with the aim of examining the perception
of auditors on earnings
management in Indian perspective.

Design/methodology/approach A questionnaire was administered on 65

auditors and was
analysed using descriptive statistics and factor analysis methods.

Findings The analysis shows that most of the firms indulge into such practices
even in the presence of regulatory framework available to keep a check on these
practices. The management tries to interpret and modify the law provisions as
per their will and do manipulations in the financial results.

Practical implications The research findings would guide regulators and

management to curb such malpractices. The auditors, top management and
government have to become more aware, socially responsible, have ethical
behaviour, become more transparent to protect the interests of stakeholders
associated with the organizations.

Originality/value The paper provides an insight into auditors perception on

earnings management during a time when financial scams like Satyam in India
have taken place and
auditors integrity is questioned.

Keywords Earnings management, Auditors, Creative accounting practices,

Enron, Financial scam,

Paper type Research paper

Introduction
Earnings management involves adopting such practices by companies which will
help them show a favourable financial position to their stakeholders (Healy and Wahlen,
1999). These practices are very common, but public gets to know the repercussions only
when the bubble bursts in the form of a big accounting fraud. Satyam scam in India was
a similar type of case. Satyam Computer Services Ltd was formed in 1987 and was the
biggest auditing fraud in Indian corporate history. Satyam was plunged into a crisis in
January 2009 after its Founder, B. Ramalinga Raju, said that the companys profits had
been overstated for several years. According to Rajus statement, about $1 billion (0.65
billion), or 94 percent of the cash on the companys books, was artificially made up. Raju
confessed that Satyams balance sheet of 30 September 2008 contained inflated (non-
existent) cash and bank balances of Rs 5,040 crore (as against Rs 5,361 crore reflected in
the books). Raju had been allegedly withdrawing Rs 20 crore every month for paying
salaries to 13,000 non-existent employees. Satyams shares fell to Rs 11.50 on 10
January 2009, their lowest level since March 1998, compared to the highest level of Rs
800. This fraud could happen because auditors did not perform their role independently
and were under the owners influence (Van Tandeloo and Vanstraelen, 2008).
At international level the accounting scandals like WorldCom (WCOM), ENRON
from the USA and Parmalat from Europe are popularly quoted examples of such type of
practices.
Enron Corporation was an American energy company which filed its bankruptcy
in 2001. Major reason of Enron Debacle was the role played by the auditors from a
prestigious firm of Arthur Andersen. Enron was estimated to have about $23 billion in
liabilities, both debt outstanding and guaranteed loans. Its stock price fell to $0.61 at the
end of the days trading when it filed for bankruptcy. It happened because stock prices
and executives remuneration and wealth were linked. A favourable earnings picture and
the avoidance of excessive leverage on Enrons balance sheet were perceived by its
management as essential to maintaining the firms credit rating. It also reflects failure of
credit rating agencies who could not predict the fraud.
WCOM was the USAs second largest long distance phone company. Between
1999 to May 2002, the company used fraudulent accounting methods to mask its
declining earnings by painting a false picture of financial growth and profitability to
manage the price of WCOMs stock. The fraud was accomplished by underreporting
line costs (interconnection expenses with other telecommunication companies) by
capitalizing these costs on the balance sheet rather than properly expensing them in profit
and loss account. On 21 July 2002, WCOM filed for Chapter 11 bankruptcy protection in
USA. In 2002, $3.8 billion of fraud was unearthed.
Parmalat, a food giant (Italys eighth-largest industrial empire), employed
traditional means to falsify its records by doing unashamed forgery, paying no heed to
the law and painting a picture of an imaginary company for the eyes of the public.
The popular methods adopted to practice earnings management by companies
include premature revenue recognition, fictitious revenue recognition, aggressive
capitalization, extended amortization policies and misrepresenting cash flows. It has been
found that accrual accounting gives managers a great deal of discretion in determining
the actual earnings a firm reports in any given period as compared to cash system.
Managers can also, to some extent, alter the timing of recognition of revenues and
expenses by advancing recognition of sales revenue through credit sales, or delaying
recognition of losses by waiting to establish loss reserves (Teoh et al., 1998b).
Misreporting assets and liabilities by overvaluation of assets like accounts receivable,
inventory, investments, accrued expenses payable, environmental claims, and
derivatives-related losses.
The present paper analyses the auditors perceptions on earnings management
practices and has been divided into five sections hereafter which include review of
related literature, research objectives and methodology, data analysis, results discussion
and conclusion.

Review Of Related Literature

As far as the reasons behind earning management in corporate entities is
concerned, the reference to various studies indicate that the primary objective for such
practices include favourable impact on market share price, debt rating, performance
management, mergers and acquisitions, equity offerings, etc. The significant references
in this regard are Trueman and Titman (1988), DeAngelo (1988), Kaplan (1994), Perry
and Williams (1994), Dechow and Sloan (1995), Wu (1997), Easterwood (1997), Teoh et
al. (1998a), Rangan (1998), Erickson and Wang (1999), Loomis (1999), Lundholm
(1999) and Hirst et al. (2003).
It has been seen that companies which are more prone to such fraudulent
financial reporting practices are those with weak internal controls, having no or weak
audit committees, majorly family owned businesses and board of directors have
significant equity ownership (Bloomfield, 2002; Hirshleifer and Teoh, 2003). Leuz et al.
(2003) found that earnings management is positively associated with the level of private
control benefits enjoyed by insiders. Spira (1999) concludes that audit committees are
largely ceremonial and are ineffective in improving financial reporting. Erickson and
Wang (1999) revealed that firms engaged in stock mergers inflate their earnings prior to
the merger in order to inflate their stock price and thereby reduce the cost of the merger.
Jouber and Hamadi (2011) analysed contextual features affect differently earnings
management behaviour in France and Canada, and to reveal which factors are the most
prominent incentives of management discretion. Evidence shows that CEO stock
ownership, independent monitoring and institutional investors property are strong
earnings management determinants in both the French and Canadian frameworks. French
firms show specific earnings management incentives which are related to high ownership
concentration, low equity widespread and high contractual debt costs.
Kamel and Elbanna (2012) investigated the phenomenon of earnings
management in Egypt, with reference to the pricing of IPOs. It also discussed
respondents perceptions of the factors that are likely to weaken the effectiveness of
internal corporate governance mechanisms in preventing the engagement in earnings
management practices. The results suggest that the amount of equity retained by issuers
and the size of IPOs have a very significant impact on determining offering prices in the
Egyptian stock market.
Niskanen et al. (2011) analysed auditor genders impact on the magnitude of
corporate earnings management in SMEs private Finnish firms. It was found that female
auditors allow for more discretion in income reporting. And female auditors are more
conservative in terms of income increasing and income decreasing discretionary accruals
(DACC).
Abody and Kasznik (2000) found that CEOs receive stock option grants near to
the release of favourable news of the company. Bartov and Mohanram (2004) found that
abnormally high discretionary accruals underlie the observed abnormally positive
earnings performance during the pre-exercise period.
 CEO/chair duality can also be associated with greater use of managerial
discretion (Cornett et al., 2008). Ho and Wong (2001) and Eng and Mack (2003) provide
evidence that firms in which the CEO also serves as chairman showed over-statement
fraud and such firms are subject to enforcement actions. Uzun et al. (2004) conclude that
boards of directors of fraud companies are more likely to have a CEO who serves as a
chairman. Cheng and Warfield (2005) provide evidence that board dependence is
associated with the incidence of fraud. Bartov and Mohanram (2004) conclude that the
less the board is independent, the higher the possibility of earning management is.
Ball and Shivakumar (2008) report that large boards are more likely associated
with high earnings management upward in UK context. All these discussions on review
lead us to different dimensions of earnings management which have been considered
while formulating the research decision for analysis in Indian context.

Research objectives and methodology

The present study has been carried out with the objective of examining the
perception of auditors on earnings management in Indian perspective. For this purpose
the primary data has been collected by administering structured questionnaire with
chartered accountants who are practicing as auditors in NCR region. The responses from
65 auditors were collected and analysed using descriptive statistics and factor analysis
methods.

Results and discussion

The views of 65 chartered accountants who are practicising auditors have been
analysed on earnings management practices in Indian companies. About 46 percent of
the auditors have work experience more than three years in their profession and 48
percent of them have a good understanding of earnings management. Further, 52 percent
of the auditors have very often come across earnings management and most of these
auditors have fair understanding of Satyam scam. They believe that the promoters, top
level management, chief financial officer and the auditors were involved in giving shape
to the things in Satyam scam.
Indian auditors have enumerated various reasons for which companies
manipulate their financial performance. Auditors have a viewpoint, if CEO and top
management compensations are linked with performance of a company, then
management is motivated to window dress their books of accounts. Another important
reason which leads to adopting earnings management practices is, meeting the
expectations of capital market so that share prices show a favourable trend. Higher credit
ratings which lead to lowering borrowing costs for the firm also serves as another reason
for adoption of such practices.Those companies which are planning to make a public
issue two to three years down the line also start manipulating their books of accounts to
get favourable response of prospective investors (Aharony et al., 2000; DuCharme et al.,
2001).
Internal environment of the organization has a very important role to play in
deciding how ethically firm would manage its system. It is also realized that companies
which have absence of powerful audit committees with weak internal control systems
(Jensen and Meckling, 1976) or where majority shareholding is concentrated in few
hands and have family relationships among directors and officers of the company tend to
indulge more, in such activities as compared to firms where such an environment does
not exist (Claessens et al., 2000). As per clause 49 of the listing agreement, every listed
company should have an audit committee so as to keep a check on companys accounting
and financial practices. 40 percent of the auditors also express conformity with the clause
49 as according to them the absence of audit committee support earnings management
(Klein, 2002; Agrawal and Chadha, 2004). 54 percent of the auditors agree that
individuals with majority shareholding have a dominating role to play and support these
practices (Table I).
Auditors confirm the fact that companies do window dress their financial
statements and for these they adopt different ways of doing it. The analysis reveals that
the most popular method adopted by Indian companies is creating excessive Earnings
management practices 103 Downloaded by HERIOT WATT UNIVERSITY At 07:51 30
December 2014 (PT) provisions and reserves. Booking fictitious sales and inflating
operating revenues are also commonly used ways of cooking up books of accounts.
Disbursement of loans to related parties, booking advance revenues, shifting expenses
from current accounting year period are also very commonly used practices of
manipulating earnings by Indian corporates.
To analyse the perceptions of auditors on various aspects of earnings
management in Indian corporate sector, a factor analytic model has been used. The
auditors as respondents were inquired about their perception regarding earnings
management and the Satyam scam through 14 statements. A high degree of positive
correlation has been found in those statements. The result of KMO test (0.522) and
Bartletts test of sphericity have been summarized in Table II, which are significant at
0.001 level of significance. So, the data is considered fit for factor analysis.
The principal component analysis has been used for extracting the factors. The
results of varimax rotated matrix are presented in Table III. Six factors were extracted
which accounted for 68.932 percent of the variances. It shows that 68.932 percent of the
total variances are explained by information contained in the factor matrix. Higher values
of communalities (Table III) indicate that a large amount of variance in a variable has
been extracted by the factors solution.
The factor analysis helped extract six factors, which have been shown in Table
IV:
F1: measures to curb earnings management. This is the first principal component
which accounts for maximum percentage of variance of 19.06. The variables
included in this factor are: separation of role of chairman and CEO, independent
directors in the audit committee, peer review of the audited accounts and reducing
the limit for directorship. Non-prevalence of some of these measures in Satyam
has ultimately resulted in such a big scam. These measures would bring in more
accountability, objectivity, transparency and would pave way for good
governance in the system. It would certainly affect Indias position as an
investment destination on the world diaspora.

Conclusion
The foregoing analysis shows that most of the firms indulge into such practices
even in the presence of existing regulatory framework. The managements try to interpret
and modify the provisions as per their will and do manipulations in the financial results.
The auditors, top management and government need to become more aware, socially
responsible, have ethical behaviour, become more transparent to protect the interests of
stakeholders associated with the organizations.
Strong internal control, powerful audit committee, rotation of statutory auditors
after every two or three years, peer review of the audited accounts, reducing the number
of committees in which a director can be a member can help curb such practices. There
should be more communication between auditor and the other parties such as banks,
suppliers, etc. while verifying the books of accounts. Stringent measures should be
undertaken to ensure regulatory compliance and the companies which do not follow
corporate governance practices should be penalized. Auditors should consider
incorporating a surprise or unpredictability element in their tests like
recounting of inventory items, unannounced visits to locations, interviewing financial
and non-financial company personnels, information technology personnels for
identifying possible overrides of computer-related controls.
There must be continuous vigilance over widely held companies, where public is
substantially interested. There must be clear and identifiable authorities,which should be
made accountable in case of failure and should take speedy and strict actions. There must
be speedy disposal of disputes, investigation, prosecution and adjudication process.
Whistle blowers must be protected and promoted. Family based businesses should be
made more transparent, accountable and subject to higher surveillance. Corporate
governance principles need to be followed in letter and spirit. Considering the regulatory
framework, India may be described as over-regulated and under-enforced nation. Our
laws and regulations suffice, but we need to give teeth to the regulators to enforce them
with speed and decisiveness. Such steps would lead to improved corporate governance in
Indian context.