analysis of earnings management
TRANSCRIPT
AA102 Group Report TG14/Team4
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Analysis of Earnings Management
Contents Page
Overview Page
1. Abstract
1.1. Key Definition ------------------------------------------------------- 4
1.2. Identified Company and two Accounts -------------------------- 4
2. Justification for Choice of Company
2.1. Company Background ---------------------------------------------- 5
2.2. Volatility of Property Sector --------------------------------------- 5
2.3. Funding for Projects ------------------------------------------------ 6
2.4. Motivating Employees-Annual Performance Incentives ------- 6
2.5. Motivating Employees-Employee Share Option Scheme ------ 7
3. Justification for Choice of Accounts
3.1. Revenue Recognition ------------------------------------------------ 8
3.1.1. Ambiguity and Significance --------------------------------- 8
3.1.2. Managing earnings through Revenue account ------------ 9
3.2. Impairment of Financial Assets ------------------------------------ 9
3.2.1. Ambiguity and Significance -------------------------------- 9
3.2.2. Relative ease of manipulation ------------------------------ 10
3.2.3. Managing earnings through Impairment account -------- 10
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4. Integrating Corporate Governance Mechanism
4.1. Board of Directors ---------------------------------------------------- 11
4.2. Internal Controls and Audit ----------------------------------------- 13
5. Conclusion/Insights -------------------------------------------------------- 14
6. References ------------------------------------------------------------------- 15
7. Appendix 1 to 6 ------------------------------------------------------------- 17 to 23
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1.1 What is
Earnings
Management?
1.2 Identified
Company and
Accounts
1. Abstract
Earnings management is defined as the active manipulation of the
accounting results for the purpose of creating an altered impression of
business performance. 1
Earnings management, which often reflects the
unethical side of management, has always been viewed negatively.
However, it might be notable that traces of earnings management might
be constructive when a managed earnings number is a better indicator
of expected future earnings and reflects a more realistic index of
financial risk.
Nevertheless, management‟s behavior and self interest still portray the
harmful side of earnings management. For instance, managing earnings
to reach earnings target to earn incentive compensation, or simply
complying with the financial covenant are often the reasons to play the
financial numbers game.
With that, we chose Keppel Land to study the possibilities of managing
earnings through two accounts identified: Revenue Recognition and
Impairment of Financial Assets.
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2.1 Company
Background
2.2 Volatility of
Property sector
2. Justification for Choice of Company
Keppel Land (KepLand), Singapore‟s third-largest listed property
company, conducts key businesses in offshore and marine,
infrastructure and property, having strategic focus on two core
businesses of property development and fund management.
KepLand being part of the property sector is badly hit by the financial
meltdown and the fair value gain on investment properties have also
dropped drastically due to its cyclical as seen below. As such, managers
might potentially recognize more revenue to beef up its KepLand‟s
reported income, possibly to save their reputation and jobs.
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2.3 Funding for
Projects
2.4 Motivating
employees:
Annual
Performance
Incentives
Although KepLand has recently announced rights issue to raise funds, it
is reckoned by analysts that more gearing is expected to fund
KepLand‟s projects and other strategic opportunities.
To further undertake projects, KepLand is likely to increase its financial
resources through borrowings, thereby raising its gearing level. This
presents a “justification” for the management to employ earnings
management to keep financial ratios healthy, so as to secure funding
from banks.
KepLand‟s remuneration mix comprises of annual performance
incentive which is tied to manager‟s performance. Hence, management
benefits maximum emoluments if the company is able to keep earnings
rising smoothly by planning ahead or changing accruals over a period.
Hence, the presence of management incentives in KepLand is likely to
support Healy and Wahlen‟s (1999) study3 that management
compensation is one of the principal factors motivating earnings
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2.5 Motivating
employees:
Employee Share
Option Scheme
(Appendix 1)
management.
Employee incentives such as share options, which are highly correlated
with the firm‟s performance, may increase the risk of earnings
management. In the short run, employees will be encouraged to enhance
the reported earnings of the firm to maximize their rewards. Raising
public‟s confidence in KepLand will lead to an increase in market
capitalization and a higher share price. Thus, employees might be
motivated to manage earnings in an attempt to exercise their share
option scheme when share price increases.
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3.1. Revenue
Recognition
3.1.1 Ambiguity
and Significance
of account
3. Justification for Choice of Accounts
Revenue Recognition was chosen as it is a measure of a company‟s
financial performance. When there is ambiguity over how much
revenue should be recognized, whether and when revenue has been
earned, there is scope for opportunistic manipulation.
The trading of properties in KepLand accounts for 80.20% of the
revenue (Appendix 2). Due to this significant proportion, it presents one
of the greatest opportunities for KepLand to potentially manage
revenue, where an incremental percentage increase could substantially
boost the revenue. Next, it is important to focus how revenues on partly
completed projects are recognized. KepLand in particular uses the
percentage of completion (POC) method (Appendix 3). Although the
revenue account are often under stringent checks by auditors and
governing bodies due to its significance, assumptions are still required
to determine POC which is based on past experience and expertise,
making earnings management possible. In addition, there is no clear
conclusion of whether POC method or completion of construction
(COC) is more appropriate for property developers in FRS 18. Hence,
revenue recognition is still subjected to the company‟s choice of
method.
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3.1.2 Managing
earnings
through
Revenue
account
3.2 Impairment
of Financial
Assets
3.2.1 Ambiguity
and Significance
of account
KepLand might potentially report a higher POC by recognizing a larger
portion of total estimated project costs incurred, hence overstating POC.
For example, the management can inflate revenue by recognizing a
larger portion of total cost incurred in the current Sixth Avenue
Residences project to cushion the weak quarter.
Impairment of Financial Assets (IFA) was chosen because
management may have incentives to understate the estimate for the IFA,
in order to present a higher reported net income. With regards to
KepLand, it is estimated based on historical loss experience and
judgment of the management under FRS 39 which might be another
grey area to determine, providing KepLand with another opportunity to
manage earnings.
Referring to the diagram below, KepLand estimated a relatively large
proportion of IFA, between 13-22% of total receivable from other
debtors, which is a significant amount to impact revenue and hence,
management might choose to manage earnings with this account.
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3.2.2 Relative
ease of
manipulation
3.2.3. Managing
earnings
through
Impairment of
As compared to non-financial assets such as long-lived PPE, the nature
of financial assets is such that its fair value tends to fluctuate more. For
example, the fair value of available-for-sale financial assets is under the
influence of the quoted bid prices which can be volatile. Besides, the
duration of holding on to such assets is relatively shorter, meaning that
the composition is constantly changing. With this, IFA will hence be a
better avenue to manage earnings since there are more opportunities to
do so and detection is also harder given the difficulty of keeping track.
To illustrate fictitiously, KepLand might have estimated a lower
allowance for doubtful debts in 2008 than 2007 by potentially impairing
lesser such that expenses are lower. This results in reported income
which had taken a hit by the financial crisis to be higher.
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Financial Assets
account
4.1 Board of
Directors
4. Integration of Corporate Governance
The Board, acting as “professional referees”, oversees the effectiveness
of management with the utmost consideration for shareholders‟
interests. Eight of the twelve directors are Independent Directors (ID),
positively influencing the group‟s corporate strategies and directions,
risk taking, human resource requirements and overall firm performance
(Higgs, 2003). This is in line with Singapore Code of Corporate
Governance (SCCG), principle 2, guideline 2.1 (P2:G2.1).
This inclusion of IDs acts as a control mechanism as they have no ties
to the firm. This lowers the probability of collusion, thereby minimizing
agency problems. Also, high transparency and disclosure standards are
ensured to minimize earnings management often engaged by managers
who are aligned by incentives linked to earnings. Hence, it helps to
monitor any conflicts of interest and also improves on the quality of
reported information. Each committee has well-defined roles to align
with shareholders‟ interests and this enhances the competency aspect of
how the company is managed.
Board composition is also important to in determining the reported
earnings quality. The current size and diversity of expertise is also
deemed as appropriate and effective to lead KepLand because it allows
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perspectives from different experts while keeping the team nimble.
Regular meetings by the Board also reduce any incoming-increasing
earnings management by frequently reviewing reports and performance
objectively.
The Chairman and CEO are two separate persons to ensure impartiality
in their varied roles. Appropriate balance of power is also provided to
ensure increased accountability and more independent decision-making
for the Board as supported by the Sarbanes-Oxley Act 2002,
corresponding to SCCG, P3:G3.1.
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4.2. Internal
Controls and
Audit
The Audit Committee (AC) consists of three IDs and is guided by
written terms of reference. The AC reviews external auditors‟
independent and objective findings to ensure they are sufficient to
assess the adequacy and effectiveness of internal controls. The AC also
provides internal audit and reviewing of key accounting principles
applied. Furthermore, under the company‟s whistle-blower protection
policy, the AC Chairman will assess and investigate any protected
report raised.
It is also found that independent AC members with financial expertise
are most effective in mitigating earnings management.5
The autonomy
and objectivity of the AC serve as a check such that Keppel Land
complies with the accounting rules and makes proper judgements in the
estimation of financial figures.
The Group Internal Audit (GIA) serves as another control mechanism.
It assists the AC to ensure adequate internal control by frequent reviews
of material control and procedures.
This mechanism addresses the accountability aspect of how the
company is managed. The independent monitoring and inspection
increases level of transparency, leading to the AC and internal controls
being effective in improving quality of reported information which are
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in line with SCCG, P11:G11.1,G11.4, P12:G12.1, P13:G13.1.
5. Conclusion
Our group believes that the issue of earnings management deserves
greater emphasis given that there is an upward trend of such cases in
recent years. Through the appropriate incorporation of corporate
governance mechanisms, reported information can be enhanced but
total eradication of earnings management may still be impossible.
Moreover, an unconscious biasness in the assessment of KepLand‟s
performance may arise due to the close working relationship of the AC
with the company, which can limit the effectiveness of the above
control mechanism (Bazerman 1997)6. What can further be done would
be to instill corporate social responsibility into the workforce and
promote a transparent culture of doing business. With this, it would
allow for a fairer business environment with reliable information in
circulation.
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References
1) C. Mulford and E. Comiskey. (1996). Financial Warnings. John Wiley & Sons, Inc.
2) Aswath Damodaran. (2002). Investment Valuation: Tools and Techniques for
Determining the Value of Any Asset
3) Oliver Marnet. (2008). Behaviour and Rationality in Corporate Governance
4) Proforma Financial Statement Unaudited Results For The Year Ended 31 Dec 2008
5) Joseph V. Carcello, Carl W. Hollingsworth, April Klein, Terry L. Neal. (2006). Audit
Committee Financial Expertise, Competing Corporate Governance Mechanisms, and
Earnings Management
6) Max H. Bazerman. (1998). Judgment in managerial decision making.
7) Charles W. Mulford, Eugene E. Comiskey. (2002). The financial numbers game:
detecting creative accounting practices. John Wiley & Sons, Inc.
8) Keppel Land. (2008). Annual Report. Retrieved September 06 2009, from Keppel
Land Ltd official website: http://www.keppelland.com.sg/AR.asp
9) Lock MunYee. (23 Apr 2009). DBS Group Research: Keppel Land. Equity
10) Lock MunYee. (27 Apr 2009). DBS Group Research: Keppel Land. Equity
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APPENDIX
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Appendix 1
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Appendix 2
Appendix 3
Mechanics of Percentage-of-Completion Accounting
In the simplest sense, a ratio of the percentage of completion is determined and applied to
the expected gross profit on the contract to determine the gross profit and revenue to be
recognized in the financial statements.
Two typical methods of measuring the percentage of completion are:
The cost-ratio method, which uses the ratio of actual contract costs incurred during
the reporting period to total estimated contract costs.
The effort-expended method, which uses the ratio of some measure of the work input
during the reporting period, such as labor hours, machine hours or material
quantities, to the total units of that measure of work required to complete the
contract. This method assumes that profits on the contract are derived from the
contractor's efforts rather than from the acquisition of materials or other tangible
items.
From: http://www.housingzone.com/probuilder/article/CA462657.html
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Appendix 4
Keppel Land Annual Report 2008 Pg162
(y) Critical Accounting Estimates and Judgement
(i) Critical judgement made in applying the Group’s accounting policies
In the process of applying the Group‟s accounting policies, Management is of the opinion that
there is no instance of application of judgement which is expected to have a significant effect
on the amounts recognised in the financial statements, apart from those involving estimations
described below.
Revenue Recognition
The Group recognises revenue from partly completed projects based on the percentage of
completion method. The stage of completion is measured in accordance with the accounting
policy stated in paragraph II (k). Significant assumptions are required in determining the stage
of completion, the total estimated development costs and the estimated total revenue. In
making the assumptions, the Group evaluates them by relying on past experience and the work
of specialists. Revenue from partly completed projects is disclosed in Note 2.
Income Taxes
The Group has exposure to income taxes in numerous jurisdictions. Significant assumption is
required in determining the provision for income taxes. There are certain transactions and
computations for which the ultimate tax determination is uncertain during the ordinary course
of business. The Group recognises liabilities for expected tax issues based on estimates of
whether additional taxes will be due. Where the final tax outcome of these matters is different
from the amounts that were initially recognised, such differences will impact the income tax
and deferred tax provisions in the period in which such determination is made. The carrying
amount of taxation and deferred taxation is disclosed in the balance sheet.
(ii) Key sources of estimation uncertainty
The key assumptions concerning the future and other key sources of estimation uncertainty at
the balance sheet date that have a significant risk of causing a material adjustment to the
carrying amounts of assets and liabilities within the next financial year, are as follows:
Impairment of Non-Financial Assets
Determining whether or not the carrying values of non-financial assets are impaired requires
an estimation of the value in use of the CGU. This requires the Group to estimate the future
cash flows expected from the CGU and an appropriate discount rate in order to calculate the
present value of the future cash flows. The carrying amounts of fixed assets, investment
properties, properties held for development and properties held for sale at the balance sheet
date are disclosed in Notes 15, 16, 17 and 22 respectively.
Impairment of Financial Assets
The Group assesses at each balance sheet date whether there is any objective evidence that a
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financial asset is impaired. To determine whether there is objective evidence of impairment,
the Company considers factors such as the probability of insolvency or significant financial
difficulties of the debtor and default or significant delay in payments.
When there is objective evidence of impairment, the amount and timing of future cash flows
are estimated based on historical loss experience for assets with similar credit risk
characteristics. The carrying amounts of financial assets at the balance sheet date are disclosed
in Notes 18, 21, 24, 25 and 26 to the financial statements.
Appendix 5
2006 2007 2008
Revenue (million) 1155.00 1835.00 950.00
Net Profit (million) 96.00 209.00 157.00
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Appendix 6
Other Debtors 2008 2007
Allowance for doubtful debts(„000) 23,499 19,588
Total other debts („000) 180,839 90,217
Percentage changes (%) 13% 22%