Earnings Management Practices and Techniques

What are earnings and what is earnings management? Simply stated, earnings are the accounting profits of a company. Stakeholders (current or potential providers of debt and equity capital, employees, suppliers, customers, auditors, analysts, rating agencies, and regulators) use earnings to make important financial decisions. Many investors view earnings as value relevant data that is more informative than cash flow data. Others have suggested that current earnings are better predictors of future cash flows than are current cash flows. In the US, these profits are derived using Generally Accepted Accounting Principles (GAAP) – a system based on the accrual method, which measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur.… Read the rest

Prospect Theory in Behavioral Finance

The Prospect Theory was originally conceived by Kahneman and Tversky (1979) and later resulted in Daniel Kahneman being awarded the Nobel Prize for Economics. The work by the authors is considered as path breaking in behavioral finance. They introduced the concept of prospect theory for the analysis of decision making under risk. This theory is considered to be seminal in the literature of behavioral finance. It was developed as an alternative model for expected utility theory. It throws light on how individual evaluate gain or losses. The prospect theory has three key aspects.

  1. People sometimes exhibit risk aversion and sometimes risk loving behaviors depending on the nature of the prospect.
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An Introduction to Behavioral Finance

Traditionally, economics and finance have focused on models that assume rationality. The behavioral insights have emerged from the application of insights from experimental psychology in finance and economics.

Behavioral finance is relatively a new field which seeks to provide explanation for people’s economic decisions. It is a combination of behavioral and cognitive psychological theory with conventional economics and finance. Inability to maximize the expected utility (EU) of rational investors leads to growth of behavioral finance within the efficient market framework. Behavioral finance is an attempt to resolve inconsistency of Traditional Expected Utility Maximization of rational investors within efficient markets through explanation based on human behavior.… Read the rest

Altman Z-Score Formula – Corporate Bankruptcy Prediction Model

The financial failure of a company can have a devastating effect on the all seven users of financial statements e.g. present and potential investors, customers, creditors, employees, lenders, general public etc. As a result, users of financial statements as indicated previously are interested in predicting not only whether a company will fail, but also when it will fail e.g. to avoid high profile corporate failures at Enron, Arthur Anderson, and WorldCom etc. Business failure is defined as the unfortunate circumstance of a firm’s inability to stay in the business. Business failure occurs when the total liabilities exceeds the total assets of a company, as total assets is consider a measure of productivity of a company assets.  … Read the rest

Creative Accounting – Definition, Techniques and Ethical Considerations

Definition of  Creative Accounting  

Creative accounting is accounting practice that falls outside the regulation and give benefit to certain people. It can be described as a practice with a clear aim to interrupt the financial reporting process which affects reported income to make it looked normal and provides no true economic advantages to relevant parties like shareholders. Concisely, creative accounting is the transformation of financial accounting figures from what they actually are to what users’ desire by taking advantage of the accounting policies which is permitted by accounting standards.

Creative accounting is a practice that potentially being undertaken as a result from some individual care more on their own interest and indirectly causes issues arise in ethical dimension of creative accounting.… Read the rest

Beyond Budgeting Approach

A traditional budget is usually prepared by reviewing past year’s budget and actual expenses, with addition or deduction towards extra business activities or reduced business activities planned and also by effecting changes towards changing factors, such as growth, inflation etc. It is basically to tie managers to predetermined actions in order to achieve the planned budget. It is usually based on organizational hierarchy and centralized leadership. In a business that operates in a very dynamic, rapidly changing, and innovative environment, traditional budgeting is inappropriate to exercise. Budget is a barrier for the business because the vibrant market demands flexibility, fast response, innovation, process improvement, customer focus, and shareholder value.… Read the rest