Corporate companies with high profiles collapses of the past decade have undermined the integrity of financial reporting. Earnings management has been of growing concern to many academics, practitioners and regulators. Despite an enormous amount of regulation and standards governing the financial reporting process, earnings management practices are accelerating at an alarming rate in organizations today. Fiji, like many other developed countries, has had instances of financial reporting failures. One does not need to look further than the multimillion-dollar saga involving the state owned Bank, the National Bank of Fiji, which was the largest known financial scandal in the history of Fiji and the Pacific Islands. Another example of fraudulent activity is in the case of Fiji Water, where the organization in 2008 had been involved in earnings management through transfer pricing in order to avoid taxes for extracting of mineral water. We will be focusing on the Fiji Water case. Also, this submission explores the nature and the reason why people keep using creative accounting and earnings management.
Corporates collapses such as Enron, WorldCom, HIH Insurance and the demise of Arthur
Anderson has undermined the integrity of financial reporting. Earnings management also known as creative accounting, income/earnings smoothing, financial engineering and cosmetic accounting has been a growing concern for academics, practitioners and regulators for quite some time. It is an orchestrated scheme where entities capitalizing on loopholes in accounting standards in order to manipulate facts and figures for the benefit of the company. This process consists of various accounting practices that are not illegal, rather, careful tactics of manipulations that are incongruously legal. Creative Accounting stirs a major impact on small and large organizations and piggy bags on loopholes on accounting standards so that a rosy picture of the company is portrayed.
In the past, there have been instances of financial reporting failures in Fiji. It has been revealed that accounting standards in Fiji do not have a legal backing and has a weak regulatory environment that permits high levels of manipulation. Companies are able to manipulate the financial statements through various types of creative accounting techniques. It attracts more and more attention in the whole financial market and its presence distorts the true and fair view of the financial position of companies, and may cause serious corporate failure. Fiji Water, where the organization in 2008 had been involved in earnings management through transfer pricing in order to avoid taxes for extracting of mineral water. The failure of this magnitude resulted from improper accounting practices, corruption and mismanagement despite regulations and monitoring. This emphasizes the need for more policies that require adherence to good accounting practices and financial disclosures and sound corporate governance.
The findings reveals common driver for earnings management. It should also assist users or whoever reads it to be mindful when at a time given the task to review annual reports to be cautious if the firm concerned displays characteristics that are aligned with the most prevalent incentives for earnings management. Moreover, auditors to be more vigilant in the auditing process if their clients have policies and practices that would allow such incentives to take effect.
From the viewpoint of a business journalist, Griffiths (1986), argues : Every company in the country is fidgeting with its profits. Every set of furnished accounts is based on books which have been gently looked or completely roasted. The figures which are disclosed twice a year to the investing public have all been tampered with in order to protect the culpable. It is the biggest con trick since the Trojan horse…. In fact this deception, commonly called creative accounting is completely legitimate and in good taste”.
According to Jameson(1985), “The accounting process consists of dealing with numerous matters of judgement and of resolving clashes between competing methodologies of presentation of the results of financial events and transactions. This resilience presents scope for manipulation, deceit and misrepresentation. These activities practiced by the less scrupulous elements of the accounting profession have come to be known as creative accounting”.
An as investment analyst, Smith (1992) argues: “We experienced that much of the visible growth in profiles which had occurred in the 1980’s was the outcome of accounting stratagem of hand rather than genuine economic growth, and we set out to unmark the main tools and techniques involved and to provide live examples of companies making use of those techniques”.
Naser (1993) suggest that creative accounting is the art of metamorphosing financial figures from what they really are to what developers desire by exploiting the existing rules and/or ignoring some or all of them”.
Some common arguments run through popular works: Creative accounting involves ‘fiddling’ and figures which have been changed (Griffiths) to achieve misrepresentation by sleight of land (Smith) to transform figures from what they actually are.
Categorically in Naser and tactically in other three versions, is suggested that Creative accounting deviates from and marks some underlying truth in financial figures.
Creative accounting is evidenced to be fast spreading in Pacific Island Countries, including Fiji and is believed that because of freedom of choice countries are prone to such manipulation. Companies and organisations are literally taking full advantage of accounting policies and rules to manipulate their financial statements to give a healthy and attractive picture of the performance and business.
In the context of the accounting problem in UK, Waller (1990) suggests moving to a mere prescriptive, legal continental tradition. Finally, as perceived, creative accounting is seen as a disreputable practice, using terms such as fidgeting, deceit and taking advantage.
The Fiji Water Saga – Case Analyses
Transfer pricing is one of the most important issues in international tax. It happens whenever two companies that is part of the same multinational group trade with each other: Example, when an overseas based subsidiary company buys something from another overseas subsidiary. When the parties establish a price for the transaction, this is transfer pricing. It is not, in itself, illegal or necessarily abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing. (Transfer mispricing is a form of a more general phenomenon known as trade mispricing, which includes trade between unrelated or apparently unrelated parties – an example is reinvoicing.)
Estimates vary as to how much tax revenue is lost by governments due to transfer mispricing. To give an illustration, the Fijian subsidiary of Fiji Water sells a 12 litre carton of water for $4 US dollars to its parent company based in the United States, which then sells the water to distributors for $13 US dollars. The carton retails in the United States for anywhere from $20-$28 US dollars. This arrangement ensures that the Fijian subsidiary generates low profits and largely avoids Fiji’s 28 percent corporate tax rate. Both the parent company and its subsidiary are registered in tax havens.
Fiji Water was granted 13 year tax holiday between 1995 and 2008.It was found that the company has underpriced its export for water bottles just to save the company from taxes and then sell the products on higher prices in other countries. The remaining local competitors of the company were exporting at much higher prices; thus, they paying more taxes than Fiji Water. The Fiji government imposed a mineral water extraction tax of FJD$0.20 per liter of water in 2008. The tax dropped to FJD$0.15 per liter in 2010 after threats of closure by the company. Fiji Water did not agree with the tax hike and in retaliation constituted to conduct transfer pricing as an earnings management tactic.
Also, in early 2008, the Fiji Islands Revenue and Customs Authority (FIRCA) had blocked exports of FIJI Water for two weeks on the grounds that it was avoiding tax payments using transfer pricing. The government believed the company had engaged in the practice of selling its product at lower prices to incur lower corporate taxes. A press release by FIRCA in January 2008 “noted that FIJI Water had received advice from international law firm Baker & McKenzie, which under took an economic study on transfer pricing and advised that what the company was doing in FIJI was fair.”. The Prime Minister of Fiji disagreed with the comments and rejected the claim by publicly saying that FIJI Water had paid less than $1 million dollars in taxes since 1995. This is less than a tenth of the $11.7 million (US) FIJI Water was expected to pay to Fiji government in tax in 2011.
Management & Compensation Incentives
Why People keep using Creative Accounting and Earnings Management?
• This is usually used to motivate the employer to increase annual profit
• The employee will get paid when they able to achieve targeted profit
• Employee tends to creative accounting when the targeted profit cannot be achieved.
Share & Share Option
• Employee gets the option to ow/ned the shares and becomes the owner
• Employee became loyal and motivated to increase the company profit
• Employee tends to use creative accounting when the company is in a big crisis or collapsing.
Employees can be offered company shares and more money of he/she is able to follow orders from the BOSS. This can lead the employee to ask his/her subordinates to use creative accounting to beautify report.
Management compensation is the most common incentive for earnings management in listed companies in Fiji. In order to enhance performance, listed companies have in place performance-based contracts for senior managers. Members of the management team are entitled to other incentives apart from normal salary, for instance, bonuses, annual salary increments, share options etc. These additional incentives are based on certain performance evaluation criteria. Generally, Human Resources Department (HR), Board of Directors (BOD), senior executives or remuneration/compensation committee, set the criteria for rewards or remuneration. BOD and other senior executives set the KPI’s for the management and with some, HR sets the criteria for rewards. In most cases performance evaluation criteria for rewards are present in the management contracts. Sales, gross profit, cost, share price and customer listing are the basis on which management receives additional rewards. The achievement of this is significantly important to managers. Profit and sales was the most common benchmark for rewards in the management compensation policies amongst all listed companies. Therefore, if management remuneration is dependent upon entity profit or sales for the period, managers may manipulate firm earnings so they can reach their sales/profit targets and get additional rewards.
Further, respective supervisors monitor management performance on a monthly basis. Criterion such as comparative data, non-financial measures and variance analysis are used when monitoring management performance. If managers fail to perform, they face severe consequences, such as lay-off, non-renewal of contract and demotion. For some firms, there are no severe consequences, except that they will not receive any additional benefits.
Most Corporate collapses have indicated that earnings management is a pervasive phenomenon. Fiji’s weak regulatory environment makes it subject to high level of earnings manipulation therefore it becomes important to study earnings management practices in emerging economies like Fiji. The paper reveals some points of examining provisions in management policies and practices that drive earnings management. Our analysis revealed that common incentives for earnings management in Fiji are management compensation incentive, borrowing cost incentive, incentive to meet/beat targets/expectations and increase (decrease) regulatory benefits (costs and avoid taxes). Management compensation is the most prevalent incentive for earnings management in Fiji. We may have not thoroughly identified the strong incentives that drive earnings management in this Fiji Water research; however we have made assumptions on the most possibilities that lead to the issue. Government must be strict with policies on tax imposed on foreign companies who are extracting minerals from our shore. Thorough search must be done on these companies on the nature of their business who their trade partners are. A good monitoring system must be in place to detect those that tries to avoid taxation as in the case of Fiji Water. .