Academic journal article E - Journal of Social & Behavioural Research in Business

Manipulation of Earnings through Correction of Prior Period Errors (AASB108): An Empirical Test

Academic journal article E - Journal of Social & Behavioural Research in Business

Manipulation of Earnings through Correction of Prior Period Errors (AASB108): An Empirical Test

Article excerpt


One of the principles that dominated pre-harmonisation of Australian GAAP was that once financial statements had been completed and signed they could not be altered again (Institute of Chartered Accountants in Australia, 2009). The exception was if Auditing Standard AUS 706 applied to a material subsequent event requiring re-issuance of the financial reports (Auditing Standards Board, 1995). Otherwise, if an error from that period was found at some time after the reports had been finalised, it had to be dealt with in the period of its discovery, and then disclosed in the notes.

International Financial Reporting Standard IAS 8, and its Australian equivalent, AASB 108, now requires prior period errors to be amended retrospectively by restating the comparatives as if the error had never occurred (Australian Accounting Standards Board, 2007; International Accounting Standards Board, 2009). Hence, the impact of any prior period errors is shown through retained earnings rather than being included in the current period's profit or loss.

In the United States, where retrospective restatement has been an accepted treatment, there is a well-documented evidence of an increase in restatement activity since the late 1990's. A large body of research has grown out of concern over the causes underlying these restatements, and the persistent trend of increase in their number. A significant stream of this research relates restatements to earnings management.

The introduction of AASB 108 in Australia creates an opportunity for research to examine how Australian firms are applying the standard. This research is likely to be of interest to standard setters. In his address to the International Accounting Standard Setters Board World Standard Setters conference, Chairman of the Australian Securities and Investments Commission David Knott referred to the GAO database companies as "deficient reporting" (Knott, 2002, p. 2). Restatements due to errors and irregularities are considered to indicate poor earnings quality, and to pose a threat to investor confidence, particularly if they occur in high numbers (Ahmed & Goodwin, 2007). This study uses data available for the first time, on Australian companies disclosing corrections of prior period errors under AASB 108, which is the Australian equivalent of IAS 8.

It is therefore possible that the introduction of AASB 108 has presented a temptation for managers of Australian companies to engage in similar opportunistic reporting practices. The standard requires a treatment for prior period errors that could be misused by aggressive managers, as a method for manipulating current period earnings. Alternatively, the need to apply the standard and restate a prior period's earnings may reveal previous earnings management activity within the firm, as has been hypothesised in some studies emanating from the US research. Either way, it is possible that a relationship exists between the disclosure of an earnings correction under AASB 108 and the presence of earnings management within Australian Securities Exchange Limited (ASX) listed companies.

Through its treatment of prior period errors, AASB 108 creates a variety of possible techniques for manipulating the prime targets of earnings management identified by Stlowy and Breton in their comprehensive review (2004), the earnings per share (EPS) and the debt/equity ratio. The more obvious approaches involve recognition of revenues and expenses, but the standard makes it possible to misclassify liabilities, for example as non-current rather than current, or even simply miscalculate the EPS. Under AASB 108, the prior period error can then be amended the following year, with no lingering constraining effects on the balance sheet as a result of the manipulation.

One fundamental and unavoidable difference stems from considerations about the availability and comparability of data as well as those features mentioned above. …

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