CHAPTER II REVIEW OF RELATED LITERATURE

AND STUDIES

In order to place the research paper in context, the

researcher reviewed literature and studies which will
be used as basis of this research. The researcher
focused on related literature and studies about
earnings management and taxes. All these literature
and studies were reviewed because the researcher
believes that they will have relevance on achieving the
objective of this research.

Earnings Management

Roman (2012) stated that earnings management

occurs when the manager of the firm obtained an
opportunity to make accounting decisions that could
change reported income. The definition is in
conjunction with the definition given by Healy and
Wahlen (1999) as annotated by Ising (2013) who stated
that earnings management appears when the manager
alter financial statements by the use of judgment in Figure 2.1.Accounting and Economic Earnings
financial reporting and in structuring transactions in management
order to mislead stakeholders or to influence future
outcomes. But according to Ronen and Yaari (2012), This research focuses on accounting earnings
this definition has weaknesses and therefore they management because economic earnings
offered an alternative definition of earnings management varies widely depending on industry and
management. Accordingly, they stated that earnings method of business engagement.
management is a collection of managerial decisions
which can hide the true short-term value of earnings. McKee (2015) enumerated twelve widely used
They also added that earnings management could be accounting earnings management, namely:
beneficial, pernicious, or neutral. Earnings
management is beneficial because it signals long-term i. Cookie Jar Reserves techniques. Mechanically,
value. Earnings management is pernicious because it cookie jar reserves happen when a company
conceals short-term and long-term values. Earnings reverses a contra asset account or accrued
management is neutral because it reveals the short- liability account as earnings (Accounting Top
term true performance. 10: Cookie Jar Reserves, Wolfe Research,
2014). McKee (2015) enumerated common
Technically, earnings management is in areas where cookie jar reserves are created.
accordance with GAAP, but most people viewed it as a a. Sales returns and allowances estimates
method of creating fraud. One good proof of this belief b. Bad Debt write-offs estimates
is the case of Enron Corporation who performed a c. Warranty costs estimates
systematic method of accounting to produce financial d. Pension expenses estimates
reports with positive income even though the company e. Terminating pension plans
was actually in near bankruptcy, and these methods f. Long-term contracts completion
were actually fraudulent earnings management estimates
techniques. Contrary to the idea, Omar et al (2014) g. Inventory write-downs estimates
concluded in their research that whether earnings
management is a good, bad, or ugly accounting ii. Big Bath techniques. Big bath techniques is a
practice, it will still depend on the ethical commitment method of reporting present and future losses
of the manager n using appropriate earnings at the same time in order to ensure that there
management techniques without compromising the will be high amount of accounting income in
interest of other stakeholders. This statement was the next period. Some common example of this
proven to be true based on the success of General is operations restructuring, operations disposal,
Electric (GE) to ethically use earnings management in debt restructuring, and impairment of assets.
order to have one hundred consecutive quarters of
earnings increase starting year 2000. iii. Flushing the investment portfolio. This
technique involves the holding intent, timing of
According to Healy and Wahlen (1999) as sales and write-down of impaired investments.
annotated by many recent earnings management This may involve:
researchers, there are two types of earnings
management, either accenting earnings management a) Timing sales of securities that have
or economic earnings management. Accounting higher market value as compared to
earnings management uses managerial judgment in cost.
financial reporting or the use of flexibility allowed in b) Timing sales of securities that have
GAAP to change reported earnings without changing lower market value as compared to
the underlying cash flows. Economic earnings cost.
management is a method of structuring transactions c) Reclassification from equity security to
by changing operating decisions in order to manage trading security and vice versa.
underlying cash flows. The difference of these two d) Write-down of securities with declined
general types of earnings management is shown in fair market value
Figure 2.1.
iv. Big Beth on the Future techniques. It involves
writing-down research and development cost of
company acquired and integrating the earnings
of acquired company into consolidated reports.

v. Throw Out a Problem Child techniques. It

involves the disposal of subsidiary in case the
said subsidiary is not performing well. Some of
the most common techniques are:
 a. Sell the subsidiary
b. Spin-off the subsidiary ix. Operating versus Non-operating income
c. Swap the stock into equity method techniques. It involves managements decision
subsidiary in considering whether an income is operating
income or not.
vi. Change GAAP. It involves the use of new
accounting standards by means of revenue and x. Early retirement od Debt. It involves
expense recognition rules. managements decision whether they will retire
a debt early and determining the right time to
vii. Amortization, Depreciation, and Depletion. It do it.
involves the selection of write-down method,
estimation of salvage value, and estimation of xi. Use of derivatives. It is a method of managing
useful life. earnings by hedging against future business
risk.
viii. Sales or Leaseback and Asset Exchange
techniques. It involves the decision on outright xii. Shrink the Ship techniques. It is a method of
sales of assets to get more profit in certain increasing the firms earnings per share by the
periods or exchanging the asset with similar use of treasury shares. This technique s also
but more productive asset. called as stock buy-back technique.