FAR 740

EARNINGS MANAGEMENT AND

RELATED PARTY TRANSACTIONS

PREPARED BY : AZEIRA BINTI AHMAD

MATRIX NO : 2014892918

GROUP : AC700F2A

PREPARED FOR : ASSOC. PROF. DR. NOR ASHIKIN

HJ ISMAIL

DEFINITION OF EARNINGS MANAGEMENT (EM)

•Giroux (2003) defined as the use of operating and discretionary accounting methods to adjust earnings to get desired outcome

•Su, Z. and Y. Chen (2014) defined earnings management as the action in which enterprise mgmt. authority makes the reported earnings reach to the expected standards in order to obtain certain private interest.

RELATED-PARTY TRANSACTIONS (RPTs)

• IAS 24 defined related party transactions (RPTs) as a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged (Pozzoli, M. and M. Venuti ,2014).

•A business deal or arrangement between two parties who are joined by a special relationship prior to the deal. For example, a business transaction between a major shareholder and the corporation.

•Rpts include items such as sales and purchases of product and materials, borrowing and lending, interests, rents, purchase and sales commissions, and exchange of fixed assets.

RELATED-PARTY TRANSACTIONS (RPTs)

• RPTs can have a dual nature :

Transactions may be considered sound business exchanges, fulfilling the economic needs of the company. They represent internal dealings able to reduce transaction costs and increase efficiency through the creation of an internal market within the corporate group

Propping

On the other hand, RPTs may be considered a mechanism to exploit company resources as a consequence of existing conflictual interests

Tunnelling

Related Party Transactions and Financial Performance: Is There a Correlation? Empirical Evidence from Italian Listed

Companie. Pozzoli, M. and M. Venuti (2014).

HOW EM VIA RPT ARE DONE?

• MAIN OPERATION METHODS FOR EARNINGS MANAGEMENT VIA RELATED PARTY TRANSACTIONS IN CHINA LISTED COMPANIES:

EM through merchandise trading and

labour service

EM through management

on a commission

basis or trustee mgmt.

EM through transferring

expense burden

EM through fund flow

EM through asset and debt restructuring

Study on Related Issue of Earnings Management for Listed Companies in China, Zhihao Su & Yajuan Chen (2014)

MOTIVATIONS OF EARNINGS MANAGEMENT VIA RELATED PARTY TRANSACTIOS

Study Motivations

1) Related Party Transactions and Earnings Management.Kuan, L., et al. (2010).

Agency theory - The existence of related party transactions represent potential conflict of interest which may results in earnings management and appropriation by controlling shareholder to minority shareholders.

Companies with high level of RPTs might use the RPTs as a means to manipulate earnings for outright appropriation or to report uninformative earnings to avoid detection of theirexpropriation activities

MOTIVATIONS OF EARNINGS MANAGEMENT VIA RELATED PARTY TRANSACTIOS

Study Motivations

2) Can Corporate Governance Deter Management from Manipulating Earnings? Evidence from Related-Party Sales Transactions in China.Lo, A. W. Y. L., et al. (2010).

Transfer pricing as one of the main channels for companies to avoid paying tax. Many firms go beyond the legal boundariesand manipulate the prices of intercompany transactions.

Management may have a strong financial reporting incentive to shift income inward to maximize their performance-linkedbonuses or to avoid losses This can be accomplished by earnings management, and by manipulating transfer prices.

MOTIVATIONS OF EARNINGS MANAGEMENT VIA RELATED PARTY TRANSACTIOS

Study Motivations

3) Family Ownership, Related-Party Transactions and earnings qualityMunir, S. a., et al. (2013).

The use of certain types of related-party transactions might help controlling families to transfer the wealth of firms to themselves and expropriate minority shareholders

4) Effect of Disclosure Regulation on Earnings Management Trough Related Party Transactions: Evidence from Taiwanese Firms Operating in China. Hwang, N.-C. R., et al. (2013).

Since Taiwan’s Ent may invest and conduct business transactions with Chinese entities without official approvals, the Taiwan govt. has imposed investment ceilings. Because net income, as part of s/holder’s equity, ultimately counts towards these investment ceiling, affected firms has strong incentives to manage earnings through related parties to avoid violating the ceilings.

EFFECTS OF EARNINGS MANAGEMENT VIA RELATED PARTY TRANSACTIONS

• Transfer pricing manipulation can have far reaching implications for the economies in which the companies operate. in particular, outward income shifting by companies adversely affects government plans and policies with respect to tax revenue collection, foreign exchange, and market development.

• The outward income shifting through transfer pricing by a company results in a decreased profit attributable to shareholders and this will harm the shareholders' interests, especially those of the minority shareholders. (lo, a. w. y. l., et al. ,2010).

CONCLUSIONS• Earnings management via related party transactions not entirely through accrual based, but it

can also be by cash based (jian, m. and t. j. wong,2010).

• To decrease the negative effects of earnings, the governments needs to enforce the disclosure regulations particularly on related party transactions to improve reporting transparency as the financial reporting become more transparent, the magnitude of earnings management should decrease. this is evidence with the study made by hwang, n.-c. r., et al. (2013).

• Besides that, a good corporate governance also can help to deter management from manipulating earnings. This is evidence with the study done by lo, a. w. y. l., et al. (2010), firms with a board firms with a board that has a higher percentage of independent directors or a lower percentage of “parent” directors (i.e., directors who are representatives of the parent companies of the listed firms), or have different people occupying the chair and CEO positions, or have financial experts on their audit committees, are less likely to engage in transfer pricing manipulations.

REFERENCES• LO, A. W. Y. L., ET AL. (2010). "CAN CORPORATE GOVERNANCE DETER MANAGEMENT FROM MANIPULATING

EARNINGS? EVIDENCE FROM RELATED-PARTY SALES TRANSACTIONS IN CHINA." CORPORATE FINANCE 16: 225-235.

• HWANG, N.-C. R., ET AL. (2013). "EFFECT OF DISCLOSURE REGULATION ON EARNINGS MANAGEMENT TROUGH RELATED PARTY TRANSACTIONS: EVIDENCE FROM TAIWANESE FIRMS OPERATING IN CHINA." ACCOUNT PUBLIC POLICY 32: 292-313.

• MUNIR, S. A., ET AL. (2013). "FAMILY OWNERSHIP, RELATED-PARTY TRANSACTIONS AND EARNINGS QUALITY." JOURNAL OF ACCOUNTING AND FINANCE 9: 129-153.

• JIAN, M. AND T. J. WONG (2010). "PROPPING THROUGH RELATED PARTY TRANSACTIONS." REV ACCOUNT STUD 15: 70-105.

• KUAN, L., ET AL. (2010). "RELATED PARTY TRANSACTIONS AND EARNINGS MANAGEMENT." JAAI 14: 115-137.

• CHEN, J. J., ET AL. (2011). "RELATED PARTY TRANSACTIONS AS A SOURCE OF EARNINGS MANAGEMENT." APPLIED FINANCIAL ECONOMICS 21: 165-181.

• POZZOLI, M. AND M. VENUTI (2014). "RELATED PARTY TRANSACTIONS AND FINANCIAL PERFORMANCE: IS THERE A CORRELATION? EMPIRICAL EVIDENCE FROM ITALIAN LISTED COMPANIES." OPEN JOURNAL OF ACCOUNTING 3: 28-37.

• SU, Z. AND Y. CHEN (2014). "STUDY ON RELATED ISSUES OF EARNINGS MANAGEMENT FOR LISTED COMPANIES IN CHINA." 341-344.