Table of Contents
Title: the practice of Earnings Management
The Journal by Graham, Harvey and Rajgopal
The Journal by Paul M. Healy
Title: Climate-related Risks, Corporate Governance and Financial Reporting
AASB Practice Statement 2
Climate related risks and its implications
Title: The Privatization of Prisons in Australia
Judge a society by how it treats its citizens
1. Graham, Harvey and Rajgopal (2005) and Healy (1985) both address the practice of Earnings Management.
To understand the concept of earnings management, one must have a solid understanding about the true or actual meaning of the term earnings. The term earnings are referred to as the profits generated by a company through selling its products or services (revenues) and meeting all its expenses (Andrew 2007). Analysts and investors studies the earnings of a business to evaluate the attractiveness of a specific stock. A business with poor earnings prospects are likely to have lower prices of share as compared to those with good earnings prospects. The ability of a company to generate earnings in future is a very important factor in determining the price of a stock.
Now, earnings management is a methodology utilized by the management of an organization, where they indulge in manipulation of the earnings of the entity (deliberately), in order to match the figures in the financial statements to be presented with the pre-determined target figures. Such practices are carried-out under income-smoothing activities. With earnings management, the companies become able to present figures which are relatively stable, rather than presenting exceptionally bad or good earnings in different financial periods (Boyce 2008).
Graham et al. (2005) targeted the economic implications of corporate financial reporting. They said a large herd of managers and company executives are more interested in taking such economic actions that can result in negative long-term consequences for the company but they will not sacrifice any opportunity to manage (or smooth) earnings. The research in this paper was conducted before the global financial crisis (GFC) of 2008 after which the cash becomes the king, but in this paper, it was found that the executives were of the opinion that investors considers earnings to be the key financial metric, rather than the cash flows, and it could be an accurate judgment for that era.
Now, the paper states that earnings are highly vulnerable to earnings management, because market is unlikely to tolerate if it witnesses even small divergences from the targeted earnings. Therefore, the managers and executives indulge in activities to smoothen the earnings in the “benefit of the company”. There are various motivations behind earnings management like avoidance of regulatory breaching, political scrutiny, violation of debt covenants but the researchers were of the opinion that managers are more interested in influencing their stock’s prices (Brennan and McGrath 2007).
The researchers also make discussions as when the management if earnings become an issue, they said that the financial statements should be aimed at presenting a fair picture of the financial health of the company and must follow the accounting standards (the GAAP), but when managers cross the prescribed limits, then fraud takes place of the management, this is what happened with the case of GFC 2018, where executives at banks did not perform proper due diligence before distributing mortgaged loans, the investment banks created MBS derivative securities backed by bogus original loans, the credit rating agencies were selling false ratings to these fraud fully structure securities and the result was the fall of the overall US economy and it was a systemic disaster that spread around the whole world.
Healy (1985), primary pointed out similar discoveries as Graham et al. (2005) did in their research (as discussed above), but the agenda of the research was different. Healy was aimed at finding the effects of earnings-bonus schemes on accounting decisions. The researcher tests the association between the decisions taken by managers for accounting and accrual procedures and their possible incentives through manipulations income-reporting or through earnings management.
Healy draws her findings by making bonus plan hypothesis – (management compensation hypothesis) as basis. The hypothesis assumes that every individual act in a self-interested manner, considering the statement, the managers will also make attempts to maximize their personal remunerations, commissions and “perqs” by presenting false reports. The attempts include the utilization of accounting methods to artificially escalate or increase the actual or reported earnings in the prevailing financial period. They typically shift the future period’s income to current period and defer current period expenses to future periods and thus increase the net earnings for the current period (Chua 1986).
The journal of Healy might have some discrepancies as the research was conducted decades ago, but her findings that managers tends to use the discretionary accruals to make artificially modifications in the profit figures, still holds strong grounds in the modern financial management. The use of discretionary accruals to enhance earnings and thus earn higher bonuses is nothing but the earnings management or smoothening of earnings. The key discretionary accruals that the managers has control over includes depreciation and amortization, R&D and advertising, etc. The case of Barings Bank is a classic example of the findings of Healy (1985), where Nick Leeson , the rogue trader continuously indulge in illegitimate and unauthorized trades, he hides the losses and presented falsified profit reports, the aim was to earn higher performance bonus from the employer. The negligence of Barings Bank resulted in its collapse in 1995(Clarke and Dean 2009).
2. Islam and Deegan (2010) propose that in producing sustainability reports, organizations are seeking to demonstrate their broader responsibilities and thus their legitimacy in the eyes of the community. They also suggest that this is a strategic desire to ensure success rather than “embrace morally appropriate behaviors” (p133).
The current global structure has lots of emerging risks which can substantially affect the company’s financials and governance. The majorly these risks includes cyber-security and data breach risks, trade wars and conventional wars risks, regulatory and technological risks. Such risks are the most significant part of the investor’s analysis and decision making process. But during recent years it has been observed that investors have started identifying climate-related risks before making investments in a particular entity.
Thus, a demand for specific information about climate related risk has been highly raised by such investors and other stake holders including governmental agencies to present disclosures covering Climate-related risks in the financial statements of the companies (Clarke and Dean 2009).
As per AASB, the Climate risks are not considered material and thus are not obligated to add in the financial statements; the companies can include such risk on a voluntary basis. However as per the AASB Practice Statement 2 Making Materiality Judgments (APS 2), some external factors like the sector of operations and expectations of investor can make these risks material and thus require disclosures in the financial report (ASX 2019).
Both AASB and AUASB require considering APS 2 and make disclosures for climate related risk under ASA 315. If materiality is established than the assumptions that are incorporated in calculations of the fair value of an asset and also the auditing estimates under ASA 540 needs to be made (ASX 2014).
The standards also forms guidelines for the independent auditor to respond fairly and accurately towards the risks related to material misstatement under ASA 330, an auditor is required to respond, if any assessed risk of material misstatement is identified in the financial statements.
The companies can also make disclosures based on the voluntary disclosure recommendations as presented by the Task Force on Climate-related Financial Disclosures (TCFD). Such recommendations were drafted by the Financial Stability Board (FSB) in order to represent financial risks to the economy caused by the climate related risk which has not been identified by the entities (Australian Accounting Standards Board 2019).
During December 2017, International Accounting Standards Board’s (IASB) Practice Statement 2 Making Materiality Judgements as an Australian Practice Statement has been approved by the Australian Accounting Standards Board (AASB). It has been referred as the AASB Practice Statement 2 (or APS 2). APS 2 is a guideline for all the stakeholders of the company including management, investors and auditors about making conclusions about what can be considered material to the financial statements.
But APS 2 is not mandatory. Thus only few entities consider such disclosures or perform such disclosures as part of their Corporate Social Responsibility (CSR). Also the frequency sometimes is too low to 3 to 5 year.
Climate risks are the natural disasters or the changes in the climatic patterns that can cause substantial damage to assets and properties (Climate Council 2019). Broadly, climate-related financial risk can be divided into two categories: physical and transitional risks. Damages to infrastructure, crops, etc. create risks like resource shortages, migration, supply chain disruption, political disruptions and more.
The United Nation’s (UN) COP Paris agreement of December 2015 identified and propagated the issue of climate change. After that discussion about financial consequences of climate risk have started globally and as per estimation by the London School of Economics, the approximate amount of financial assets at risk globally due to climate related risks is around US $ 2.5 trillion. While the annual GDP (gross domestic product) of Australia is around US $ 1.38 trillion and GDP of Japan (the world’s third largest economy) is around US $ 4.87 trillion.
Such huge losses resulted in an eye opener for the global investor’s club and also raised awareness about climate related risks. Now various stakeholders including governments, businesses and investors around the world are increasingly focusing on the financial impacts of climate change.
Governments across the world, realizing requirement for an immediate action have started implementing promoting and funding low-carbon technologies to compete the traditional technologies. These creates conditions of leverage as businesses generate superior returns with exposure to low-carbon technologies but at the same time they have to face additional regulatory requirements as well as risks of price rise and availability of commodities (Battiston et al. 2017).
Climate risks can have substantial effects on companies include in the investors’ portfolio. While some companies can get negatively affected like companies engaged in the business related to agriculture have adverse effects in case of droughts or floods. Other companies like which are engaged in the business of renewable energy provides investment opportunities.
The increasing awareness and governments actions have built substantial concerns amongst the shareholders and the investors. Companies usually provide information about climate risks in their annual reports under CSR activities or in sustainability reports where majority of the disclosures does not provide detailed information (Godfrey et al. 2010).
3. Andrew (2007) explores the consequences of the privatization of prisons in Australia, with a particular focus on the dysfunctional effects of assessing accountability in terms of numerical indicators.
Andrew (2007), has raised a very important point of debate related to the privatization of the correctional system, the prisons in Australia, he argued that these correctional systems must be a central feature for all the prison system in the country. The author argues that accountability in the policies formulated for prisons has an indisputable moral and ethical component and required to be addressed in public domain. In Australia, the term accountability with privatization of prisons is referred to the performance measures, the contractual monitoring and compliance. There is a fast emergence of modern private prisons in the country that raise fresh questions related to accountability. To determine the potential impacts of privatization of Australian prison system, the author has drawn the work of Chomsky on neoliberalism.
The author cited the words of Dostoevsky, who said that “a society should be judged not by how it treats its outstanding citizens, but by how it treats its criminals”. In Australia, the matters that must be handled by the State itself including law, crime and prison system are being transferred in the hands of profit greedy for profit business organizations and the irony is that there is negligible accountability.
There is an acute rise of private prison in Australia over the past few decades. However, history says that businesses have remained a crucial part of administrative system of punishment (Morris and Rothman, 1995). But now there is an altogether prison industry has established that is capable of providing diversified services, which includes food services, medical care, court escort services, employment training, and prisons for juveniles, security, and people on remand, adult offenders and illegal immigrants. However, in most of the countries the prison management is still a State-directive; the governments in countries like USA transferred their prison responsibilities to the private sector around 2 decades ago. A similar trend can be witnessed in Australia and Britain. Australia holds about 17.8 per cent of its incarcerated people in privately owned prisons.
Now the concept of a private prison industry is to have more prisons that means there must be expansion of the prison industry, so that the prison operators and their investors can largely benefited. However, it counters the basis purpose of the legal, punishment and prison system, where a person committed a crime is imprisoned for deterrence and rehabilitation.
Deterrence: is aimed at preventing crimes in future. The people are imprisoned by hoping that it will warn the guilty to think about their committed crimes, and that any future possibilities of going to jail are going to discourage the criminals from breaking the law.
Rehabilitation: is aimed at conducting activities that are specifically designed to transform the criminals into law abiding citizens. It includes facilities of proper educational courses in the prison premises, offering counseling with a social worker or psychologist and teaching job skills.
These are the areas where accountability requires in the prevailing system, where the prison industry indulges in strengthening their accounts. Talking about the theory of neoliberalism, economist John L. Campbell of Dartmouth College states that privatization of the prison system on one hand punishes the lower class, that helps in populating the prisons and on the other hand, it benefits the upper class, who are the owners of the prisons. There is also a third hand, the middle class that is being employed to run the prisons. Apart from that, the prison system becomes a source of cheap labor (or slaves), the prison owner acts as a source of low-wage labor to various corporations. Through such outsourcing and privatization, the penal-state reflects neoliberalism (Andrew 2007).
Accountability must be defined at proper levels, for example, the private prison owners should be accountable to the government and their agencies just like companies or businesses are accountable under accounting and auditing standards. Also the governments should be held accountable and answerable to its citizens.
Accountability can be defined as the duty to:
Undertake the required actions or refrain from taking actions as per the expectations of a group of stakeholders; and
Provide an account or reckoning of those actions to the stakeholders.
Andrew A. 2007, “Prisons, the profit motive and other challenges to accountability”, Critical Perspectives on Accounting, Vol 18, pp877-904.
ASX. 2014 “Corporate Governance Principles and Recommendations”, 3rd Edition, available online at: http://www.asx.com.au/documents/asx-compliance/cgcprinciples-and-recommendations-3rd-edn.pdf , accessed 18/3/16.
Boyce, G. 2008, “The social relevance of ethics education in a globalising era: From individual dilemmas to systemic crisis”, Critical Perspectives on Accounting, vol 19, pp255-290
Brennan, N. M. and McGrath, M. 2007 “Financial statement fraud: Some lessons from US and European case studies”, Australian Accounting Review, Vol. 17, No. 2, pp49-61.
Chua, W.F. 1986, “Radical Developments in Accounting Thought”, The Accounting Review, Vol LXI, No 4, pp601-631 Deegan, C. 2014, “Financial Accounting Theory”, 4rd Edition,
Clarke, F. and Dean, G. 2009 “Taking a bath can be financially indecent”, Australian Financial Review, 22 September, p63.
Deegan, C 2018, ‘Financial Accounting Theory,’ Edition 4, McGraw Hill Irwin, Australia
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Gray, R. 2006, “Does sustainability reporting improve corporate behaviour? Wrong question? Right time?” Accounting and Business Research, International Policy Forum, Vol. 36, Special Issue, pp65-88
Hopper, T. and Powell, A. 1985, “Making sense of research into the organizational and social aspects of management accounting: A review of its underlying assumptions ,” Journal of Management, Vol 25, No 5, pp429-405
Jones, S and Riahi-Belkaoui, A. R. 2010, “Financial Accounting Theory”, Third Edition, Cengage Learning, Melbourne
Lodh and Gaffikin, 1997, “Critical studies in accounting. Research, rationality and Habermas: a methodological reflection” Critical Perspectives on Accounting, vol 8, pp433-474
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