Earnings Management Researches Based on Financial Analysis

Earnings Management Researches Based on Financial Analysis
WANG Xinsheng1 LIANG Chao2
1.The Department of Management, ShanDong JiaoTong University, Jinan, China,250023
2. School of Management, University of Jinan, Jinan, China, 250022
[email protected]
Abstract: With its developing and strengthening, securities market takes more and more important
function in China's economic development. As the main part in security market the financial reports
offered by the listed companies have been considered as the most important basis to people related
benefits such as investor, creditor and government making decisions. But in recent years, the
phenomenon of dressing financial reports for earnings management became more and more obvious.
General personnel are difficult to gain the related intra-company information. This paper takes Ke Long
Electrical Holdings Co. Ltd as an example, elaborates how to find the phenomenon of distortion of
financial accounting caused by earnings management as a general personnel according to the financial
reports.
Key words: Earnings Management; Financial Analysis; Listed Company
，
，
1 Introduction
1.1 The summary of pertinent literature overseas
The western scholars started their research of earnings management in the 1980s and the early
earnings management actions mainly concentrate in the view of earnings motivation research. The
earnings management motive is mainly made up of management reward contract, debt contract, political
cost, management position change.
Healy conducts the empirical study to the US 94 Industrial enterprises in The Effect of Bonus
Schemes on Accounting Decisions. Then he indicated: The administrative personals adjust the
maneuverability accrued profit to achieve the goal of dividend maximization. His empirical study has
confirmed the accuracy of management reward contract.
In Debt Covenant Violation and Manipulation of Accruals, Defond and Jiambalvo conduct the
empirical study to 94 companies which violate the debt contract in the 1985-1988 annual financial
report. The enterprise's management regulate the earnings using the abnormal accrued profit and
working capital in the preceding year of breaking a contract. In the violation same year, they analyzed
the 51 companies which didn’t have a qualification audit report and found that they increased the
accountant earnings. Their empirical study has confirmed the accuracy of contract motive.
In the 1990s, the Western scholars shifted the earnings management research to the capital market.
The capital market motive is mainly made up of the stock issue, avoid losing money, and cater to
financial analyst's anticipation.
In Earnings Management and the Post-issue Underperformance of Seasoned Equity Offerings, Teoh
S H, I Welch and T J Wong verified the fact that the administrative personals overestimate the
accountant earnings through non-anticipated accrued items.
，
1.2 The summary of domestic pertinent literature
China started the earnings management's theory and the empirical study relatively late following
the appearance of the accounting information distortion. And the research mainly manifests in the
earnings management existence, motive, method and so on. The representative findings are as follows:
In his article of The Empirical Study of Operation Profit in the Listed Companies, Jiang Yihong
conducted the empirical study to the earnings per share and the net assets returns ratio published by 744
listed companies in the Shanghai and Shenzhen stock market in 1997. Then he indicated that the profit
operation phenomenon exist in the listed companies.
In The Empirical Study of Earnings Management of listed companies which is losing money in
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China, Lu Jianqiao conduct the empirical study to 22 listed companies which is losing money in
Shanghai stock market and finally demonstrated that the 22 listed companies scaled down the earnings
obviously in the first loss year, and increased earnings in the preceding year and the year turning losses
into profit.
2 The case study of earnings management
Sometimes, companies take fairly concealed earnings management. It is very difficult to
distinguish by the public and make the correct decision-making. Take Kelong electric enterprise as an
example, this chapter analyzes its financial report and recognize its earnings management actions.
2.1 The analysis of net assets returns ratio
Net assets returns ratio is the ratio of net profit and the shareholder rights. It reflected the net
income earned by 1 Yuan shareholder capital. It is the core target of entire analysis system which has
good feasibility and comprehensive nature, may weigh the whole profit ability of the enterprise.
net profit
sales income
total assets
(2.1)
net assets income rate =
⋅
⋅
sales income
total assets
shareholde r equity
net assets income rate = sales net profit rate ⋅ total assets turnover rate ⋅ equity multiplier (2.2)
Net profit
Sales revenue
Assets
Owners’ equity
Net assets returns ratio
Grew compared to last
year
Sales net profit rate
Grew compared to last
year
Total assets cycling
rate
Rights and interests
multiplication
Table 2-1 The analysis of net assets returns ratio
1999
2000
2001
2002
643,584,316
-678,418,823
-1,475,892,124
101,276,990
5,597,880,271
3,869,502,617
4,381,616,368 4,878,257,017
7,485,339,144
6,911,367,126
6,509,847,794 7,656,539,329
4,815,210,308
4,134,255,797
2,470,316,183 2,575,000,833
13.37%
-16.41%
-59.75%
3.93%
2003
202,180,248
6,168,109,963
9,432,791,214
2,808,730,941
7.20%
-29.78%
43.34%
63.68%
3.27%
-17.53%
-33.68%
2.08%
3.28%
29.03%
16.15%
35.76%
1.20%
74.78%
55.99%
67.31%
63.71%
65.39%
1.5545
1.6717
2.6352
2.9734
3.3584
11.50%
(Data source: Kelong electric enterprise 1999-2003 annual finance report)
From the table, we can see the annual net assets returns ratio compared to last year in 2000, 2001,
2002, 2003 respectively be - 29.78%,43.34%,63.68% and 3.27%. In 2000 and 2001 the net assets
returns ratio was a negative number, which indicate that the shareholder's investment produce negative
income. Moreover, we may see that the sales net profit rate is consistent to the net assets returns ratio.
The analysis of sale net profit can tell us the net profit reduce suddenly in 2000 and 2001, while it turned
losses into profit in 2002.
2.2 The analysis of revenue, expenses and profit
The analysis of revenue, expenses and profit is mainly concerns the influence of the change of
revenue and profit to the change of net profit. These targets mainly reflected that 1 Yuan revenue takes
how many expense as the premise. We analyze the ratio of revenue to general and administration
expense, selling expense and finance expense respectively, test whether these ratios and the net profit
have the consistent and normal change tendency in recent years. Then discover the abnormal
phenomenon and recognize the earnings management actions.
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Table 2-2 The analysis of revenue, expenses and profit
1999
2000
2001
Main operating
revenue
General
and
administration
expense
Selling expense
Finance expense
General
and
administration
expense
/Revenue
Selling expense
/Revenue
Finance expense
/Revenue
Net profit
2002
2003
5,597,880,271
3,869,502,617
4,381,616,368
4,878,257,017
6,168,109,963
369,713,921
473,930,351
911,607,048
34,899,332
364,897,076
756,702,631
72,260,414
918,195,704
73,030,754
1,126,262,303
86,687,871
791,497,880
75,536,164
1,002,390,964
100,397,258
6.6%
12.25%
20.81%
0.72%
5.92%
13.52%
23.73%
25.7%
16.23%
16.25%
1.29%
1.89%
1.98%
1.55%
1.63%
643,584,316
-678,418,823
-1,475,892,124
101,276,990
202,180,248
(Data source: Kelong electric enterprise 1999-2003 annual finance report)
We can see from the table above, Kelong electric enterprise’s income growth compared last year
are 30.88%, 13.23%, 11.33% and 26.44% in 2000, 2001, 2002 and 2003 respectively. While the
corresponding year's general and administration expense growth compares respectively is 28.19%,
92.35%, -96.17% and 945.57%; the corresponding year’s selling expense growth compares respectively
is 21.34%, 22.66%, -29.72% and 26.64%; the corresponding year’s financial expenses growth ratio is
1.07%, 18.70%, -12.86% and 32.91%. The main operation revenue in 2000 and 2001 lower to 30.88%
and 21.73% separately compared to 1999. But in 2000 the general and administration expense grew
28.19% than 1999; 2001 grow 92.35% than 2000; The corresponding growth ratio of selling expense is
21.34% and 22.66%; the corresponding of financial expenses is 1.07% and 18.70%. See the expense to
income ratio, the general administration expense /revenue increased to 12.25% and 20.81% in 2000 and
2001compared to 6.6% in 1999 and decreased to 0.72% in 2002; The selling expense/revenue ratio
increased to 23.73% and 25.7% in 2000 and 2001 while decreased to 16.23% in 1999. The range of
price goes up and drop up is shocking.
Because of the large scale reduction of revenue and the increase of expenses, Kelong electric
enterprise gain net profit respectively - 678,000,000 and - 1,476,000,000 in 2000 and 2001. While the
net profit in 2002 becomes 101,000,000 profiting from the increased revenues and decreased expenses,
particularly the general administration expenses reached the decreasing amplitude as high as 96.17%.
2.3 The analysis of provision for the decline in value of inventories
The analysis of provision for the decline in value of inventories mainly concerns the ratio of it to
the total inventories. The higher the provision for the decline in value of inventories is, the lower the
inventory cash realizable value is. In the following analysis, we divide three types as raw materials,
goods in process and the finished product to inspect whether the tendency of the provision for the
decline is normal to judge the earnings management actions.
Table 2-3 The analysis of provision for the decline in value of inventories
1999
2000
2001
2002
The provision for the
decline in value of raw
39,651,892
32,264,408
48,500,305
50,997,459
materials
The withdraw ratio
4.88%
7.42%
13.63%
12.16%
The provision for the
decline in value of goods
3,793,708
1,968,783
1,646,597
in process
The withdraw ratio
4.88%
2.84%
2.99%
The provision for the
32,770,400
164,305,420
273,831,903
85,729,527
decline in value of
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2003
38,461,291
5.29%
172,000
0.17%
65,286,425
finished product
The withdraw ratio
4.88%
11.48%
24.05%
11.13%
5.35%
(Data source: Kelong electric enterprise 1999-2003 annual finance report)
Seen from the table above, the ratio of the provision for the decline in value of raw materials to the
raw materials increased to 7.42% and 13.63% in 2000 and 2001 from 4.88% in 1999 while decreased to
12.16% and 5.29% in 2002 and 2003. Kelong returned more than 200,000,000 Yuan and more than 6800
ten thousand Yuan provision for decline separately in 2002 and 2003. We can see it clearly in the two
tables below. In the highly competitive time of domestic electrical profession, while the majority of
electrical appliances reduce prices, Kelong returned more than 200,000,000 Yuan provision for decline
instead, which has no alternative but to be doubtable.
Table 2-4 The change of provision for decline of inventories in 2002
Raw materials
Goods in process
Finished product
Initial balance
48,500,305
1,646,597
273,831,903
The
increase
volume Because of
6,890,235
4,077,457
purchasing
subsidiary company
The
withdraw
13,472,879
9,343,774
volume
The return volume
17,865,960
1,646,597
201,523,607
Closing balance
50,997,459
85,729,527
Table 2-5 The change of provision for decline of inventories in 2003
Raw materials
Goods in process
Finished product
Initial balance
50,997,459
85,729,527
The
withdraw
2,598,000
172,000
32,491,035
volume
The return volume
15,134,168
52,934,137
Closing balance
38,461,291
172,000
65,286,425
Total number
323,978,805
10,967,692
22,816,653
221,036,164
136,726,986
Total number
136,726,986
35,261,035
68,068,305
103,919,716
(Data source: Kelong electric enterprise 1999-2003 annual finance report)
From the above analysis, we may see that there are serious earnings management actions in Kelong
electric appliance enterprise. In a word: (1) The analysis of net assets returns ratio and the revenue,
expenses and profits indicate that Kelong electric appliance enterprise took earnings management
actions by confirming falsely revenue and expenses to adjust profit. (2) The analysis of provision for
decline of inventories tell us Kelong electric appliance enterprise achieve the goal of control profit
finally though adjust the provisions.
3 The related countermeasure to standard the earnings management of listed
companies in China
3.1 From the interior angle
3.1.1 Perfect the structure of stockholder's rights
To perfect the structure of stockholder’s rights, the following steps is necessary: Fully display the
function of board of supervisors, increase the independence of the supervisor’s work; Fully display the
function of audit personals and standard the financial behavior of listed companies; Reduce the inside
director's proportion and maintain the fairness of board of directors; Perfect the suit system of
shareholder represents and protect the minority shareholder's benefit.
3.1.2 Perfect the structure of administer
Firstly, perfect the corporate equity system and form the multi-dimensional owner's property right
structure to strengthen the monitoring ability of shareholder and other finance information need
participates. Then, perfect the internal monitoring mechanism and strengthen the internal monitoring.
Thirdly, perfect company exterior monitoring system, reduce state-owned shares, form the manager
power of attorney competitive system as well as fully display the function of the social outside. Fourthly,
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establish chairman and general manager's separation mechanism and fully display the surveillance of
board of directors. Fifthly, reform the reward mechanism of the manager to reduce their earnings
administrative action.
3.2 From the exterior angle
3.2.1 Strengthen the construction of policy system
The controls parameter is single in the existing negotiable securities control system, and many take
accountant the digit as the standard, it is necessary to carry on the reform to it. For example, listed
companies should consider the influences of other factor such as net cash flow besides net assets returns
ratio when distribute new stock.
3.2.2 Strengthen the construction of accounting system
In the new accounting standards and systems, the construction of accounting policy and accounting
variation should be strengthened so that the listed companies can’t adjust accountant earnings using
accounting policy and accounting variation. For example, stipulate strict conditions when propose the
proportion of bad debt provision avoiding skullduggery.
3.2.3 Improve the supervision environment
The stock market should strengthen the supervision and increase the penalty dynamics to avoid the
earnings adjusting.
3.2.4 Consummate the auditing system of CPA
CPA has upper accounting profession knowledge. They can contact the related finance professionals
of the enterprise and has effectual watch-dog to the earnings management action. Strengthen the
independence of accounting firms and enhance the judgment ability of CPA. Moreover, the listed
companies can’t change accounting firm discretionarily. The accounting firms also can’t collect fees at
will.
3.2.5 Strengthen the reconstruction of good faith and moral
Appeal higher commercial ethic standards in all enterprises in order to strengthen the construction
of accountant occupational ethics.
3.2.6 Improve the quality of market participants
Raise the education lever of investors, improve their quality and strengthen their recognition
abilities to earnings management in order to gain the real financial information from the enterprises. It is
also a good choice to cultivate institutional investors.
4 Conclusion
This article shows the serious earnings management actions of Kelong electric enterprise through
analyzing the finance data and teaches the public how to distinguish the earnings management actions of
listed companies. So long as the actions are taken from the interior and exterior of listed company, the
earnings management behavior of listed companies can be improved effectively , the stock market can
be purified, and the investor can obtain the real financial information as well as the distortion phenomenon
of accounting information can be improved.
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