ADVANCED AUDITING

Lecturer:
Topic: Earning Management
Student Name: Gaurav Sikri
Student Number: 12970975

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 TABLE OF CONTENT

ABSTRACT.....................................................................................................................................................2
INTRODUCTION..........................................................................................................................................3
CORPORATE COLLAPSES........................................................................................................................4
AUDITOR FUNCTION – CRITICISM.......................................................................................................4
CRITICISM AGAINST AUDIT FUNCTION............................................................................................5
CRITICISM IN FAVOR OF AUDIT FUNCTION - JUSTIFICATION....................................................6
CHANGE IN AUDIT FUNCTION – RESULT OF CRITICISM.....................................................................7
‘SUFFICIENT APPROPRIATE EVIDENCE’ .........................................................................................9
AUDIT PROCEDURE TO DETECT EARNING MANAGEMENT.......................................................10
EARNING MANAGEMENT – AUDITORS DUTY.................................................................................11
‘FORENSIC TYPE FIELDWORK PHASE’............................................................................................11
AUDIT PLANNING..............................................................................................................................12
AUDIT PROCEDURE...................................................................................................................................12
EARNING MANAGEMENT – POSSIBLE SOLUTIONS .....................................................................13
A REVIEW OF ACCOUNTING STANDARDS: ............................................................................................................13
A REVIEW OF ACCOUNTING EDUCATION OF ETHICS AND CONSEQUENCES OF BEING
UNETHICAL:.......................................................................................................................................14
A REVIEW OF THE ROLE OF AUDITOR: ..........................................................................................14
INCREASED AUDIT REGULATION: LOWER AUDIT QUALITY...................................................15
EARNING MANAGEMENT – INTENTION...........................................................................................16
CONCLUSION.............................................................................................................................................18
BIBLIOGRAPHY.........................................................................................................................................19

Abstract

The report is based on the impact of the corporate collapse such as Enron in United States
and HIH in Australia on the Auditors. It critically evaluates the auditors’ functions and
the changes that occurred in the role of auditor as a result of the collapses.

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To decrease the possibility of such collapses in the future, efforts have been made to
reduce earning management. Further in the report the implications arising from proposed
changes have been discussed along with the good and the bad side of earning
management.

INTRODUCTION

The business community is more than familiar with the financial corporate collapses of
companies like HIH insurance of Australia and Enron in the United States. As a result of
the failure of such big corporations, fingers have been raised on the professional bodies
such as accountants and auditors. The question that arose is if the accountants and
auditors knowingly made the wrong decisions.

Efforts have been made to restore the confidence that the financial report viewers lost in
the auditors and audited financial report since these collapses. This has resulted in
changes in the standards, review of audit functions and audit firms separating the auditor
role from that of a consultant.

In this report we critically evaluate one of the main causes ‘earning management’ that
was common among both of these collapses and the effect of this on the Auditors. Based
on the research we analyze the good side and the bad side of earning management and
the procedure auditor should follow to discover earning management, gather sufficient
appropriate evidence and report it.
Report further puts some light on the introduction of ‘forensic type fieldwork phase’
introduced by the panel of auditing standard to help auditors plan the audit in such a way
that most of the grey areas with possibility of fraud are covered when auditing the
reports.

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Later in the report we examine the change in the Auditors role and we assess the best
possible way to conduct an Audit to detect earning management and some proposed
solutions to reduce earning management.

CORPORATE COLLAPSES

Enron and HIH failed due to financial mismanagement, poor decisions and a lack of
oversight (Jennings).

Enron, the energy giant in United States went into liquidation in October, 2001. Enron’s
Bankruptcy has focused evident attention on Anderson, one of the big five accounting
firms, which audited Enron until bankruptcy.

HIH Insurance Company in Australia collapsed in March 2001 for its inability to pay
debts as they fell due. Along with the shareholders, many other bodies were affected by
the collapse and the auditors were not left out.

AUDITOR FUNCTION – CRITICISM

Enron and HIH were both undoubtedly engaged in managing earnings. The main reason
for earning management is to maintain numbers and performance. As a result of these
collapses Accountants and Auditors functions were highly criticized. Anderson (the
auditor firm) was common between both these corporations. The issue of the
independence of the Auditors has been raised along with the auditors performing non
audit work.

Investors, regulators and other interested parties of the financial report increasingly doubt
the audited report to be true and fair. Some even suggests that accounting and auditing
are in the ‘state of crisis’ (Dean, 2002).

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So many reform proposals have been made and they are not something new as they have
been happening for years now. They are likely to have minimum effect on the unexpected
collapses of the big companies as according to M.M.Jennings, companies collapse
ethically long before suffering financial demise and board members play a big part in that
as they are the ones engaged in earning management and are committing the fraud.
Auditors are just one hand of the cycle, all the business analysts, investor’s minds and the
financial press failed as well in discovering the fraud in these collapsed companies. But
that does not stop interested parties from criticizing the role of Auditors. (Jennings)

Some of the issues raise against and in favor of the audit function have been discussed
below to evaluate if audit function is sufficient or not.

CRITICISM AGAINST AUDIT FUNCTION

Anderson was the Auditing firm for Enron in U.S. and HIH in Australia. Anderson’s
participation in hiding weaknesses of Enron has put the spot light on the auditing function
as never before. As a result of Enron’s collapse, PKF chairman called for a thorough
review of the role of Auditor and their relationship with the listed companies (PKF).

In the case of Enron as mentioned by Professor M.M. Jennings, the employees were not
sure who worked for Enron and who worked for Anderson, employees sharing a very
close relationship with the auditors. Due to the close relationship with the clients,
auditors’ independence was questioned.

Later, the liquidator of HIH sued Anderson (HIH’s auditor) for producing misleading or
deceptive reports and breaching the contract. In total from 1997 to 2001, Anderson paid
almost $400 Million to settle claims related to audit failure excluding Enron claims
according to industry newsletter Public Accounting Report (Pg 90, David Ward and

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Loren Steffy). Arthur Anderson was legally held for destroying Enron’s Documents and
was found guilty in June 2002.

In 1999, Anderson introduced a new methodology for collecting Audit evidence called
business Audit process. The sole aim of this new process was to make the Audit function
faster and earn more profits for Anderson and was less likely to detect fraud. So Auditors
in this case were diverting the attention from discovering fraud to making money. (book,
pg 77). According to Arthur Louis, When auditors discover something wrong with the
accounts and if they can’t get management to make changes, their normal practice is
resign the account without making it a big deal. (The Enron Collapse).

CRITICISM IN FAVOR OF AUDIT FUNCTION - JUSTIFICATION

Clarke suggests that auditors are on ‘a mission impossible’. (Clarke, 1997). This
statement has been supported by the article ‘Why auditors were not likely to blow the
whistle’, which suggest that ‘if a company is intent on deceiving the investing public,
there is little the auditor can do to discover and prevent it’.

Auditors role is to make sure that companies financial statements fairly reflects the
condition of the company but the truth is even the biggest auditor do not have the time or
resources to go through each and every receipt or memorandum related with the financial
report in a large corporation. Auditing is based on the laws of probability as mentioned
by Reuven Lehavy, professor of accounting at the Haas School of Business at the
University of California at Berkley. (The Enron collapse)

Enron paid US$25 million in audit fees and $ 27 million in non audit services performed
by Anderson. Critics have said that the $ 27 million in non audit services results in a
compromise in the quality of audit, as a result the audit firms in US are no longer allowed
to provide non audit services to the same companies they perform audit for. Perhaps, $25

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million is not a small amount for auditors not to forget about their ethics and Anderson
compromising the Auditors independence.

Accounting rules limits the auditors’ ability to perform an independent audit and give an
independent opinion on financial statements. Most of the accounting standards have
optional treatment to be chosen by the companies. Following these standards can result in
making the financial reports meaningless, like Australia’s GAAP virtually ensures that
the income statement will not show its genuine financial position in any significant way.

HIH’s published financial reports had various capitalized expenses all in accordance with
the accounting standards, but those figures were highly applicable in regards with the
solvency of the firm. So these accounting treatments make auditors highly dependent on
the preparers of the financial position. This makes it clear that compliance with
accounting standards is a main cause of misleading, creative accounting data.(Clarke).

Additionally, in past no evidence has been provided to confirm the effect of non audit
services with the quality of audit report.

Above discussion makes it clear that auditors have been trying to justify the actions but
criticism never stops. As a result, changes have been made to keep audit function up to
date. In my viewpoint, auditors follow the judgment criteria and the only way to solve the
issue is by reminding them time and again about their ethics.

Where auditors are dishonest and are not being professional, they deserve to be punished.
On the other hand, auditors can be as honest as possible and not detect any error in the
financial reports by following the accounting rules in framing their judgment.

CHANGE IN AUDIT FUNCTION – RESULT OF CRITICISM

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As a result of the collapses in United States, Sarbanes Oxley act was launched resulting
in a total ban on auditors providing other services to their clients, creation of an
independent oversight body for auditors and mandatory audit committees.

In Australia they launched the Corporate Law Economic reform Proposal 9. CLERP 9 did
not put a ban on auditors providing other services to audit clients, (Accountancy reform:
sound of one hand clerping). CLERP 9 gave extensive protection to auditors from civil
liability and a system was in place in which all professionals will have to pay
compensation on the proportion of damage they caused. (Civil Protection for Auditors,
but no cap).

The 200 page Ramsay report includes proposals to mandate the rotation of Audit partners
every 5 years and make auditors attend company annual general meeting to answer the
investors. (Corporate shake-up hits accountants). It is based on the ethical issue of the
auditor-client relationship.

In 2000, new rules to increase the duties of auditor committees and independent auditors
were adopted by the Securities and Exchange Commission (SEC) and major national
security exchanges. They gave a list of things to be done in reviewing the quality of
independent auditors and the auditor independence. Further they (Client advisory).

In September 2002, the federal parliament’s public accounts committee called for a major
overhaul of regulations on company auditing, financial reporting and governance. It was
followed by a six month long enquiry on whether auditors have been sufficiently
independent of the companies they scrutinize. Recommendations were made like auditing
firms to lodge an annual report with the Australian Securities and Investment
commissions showing how they ensure their independence from the companies they
audit. (Self regulation called into question).

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In April 2003, Commissioner Justice Neville Owen delivered a total of 61 policy
recommendations in the report on findings on royal commission into the collapse of HIH.
( Post HIH).

Chairman of AuASB Bill edge said that the increased oversight of auditing was
understandable given public criticism of auditing after recent collapses. (Auditing council
gets oversight job).

The reliability on audit function has diminished over time, but changes have been made
to keep them up to date with the changes in business function. As discussed above, even
the best auditor can not sometimes detect earning management. So in my viewpoint to
regain the confidence of the interested parties, internal auditors and external auditors
should gain some more knowledge on why earning management occurs and try and
inform the board members about the later effects of engaging in earning management.
They should try and make the company culture more ethical. Auditors should be given
some flexibility to have independence of mind rather than just independence in making
the judgment.

Some of the change that has been made in the auditing standards has been interpreted
below to help auditors regain the trust of society.

‘SUFFICIENT APPROPRIATE EVIDENCE’

AUS 502.02 requires auditors to obtain sufficient, appropriate evidence.

‘Sufficient’ is the amount or quality of evidence. It is a matter of judgment by the auditor,

but should take into account the risk and materiality factors before considering the
evidence sufficient. ‘Appropriateness’ refers to the relevance, timeliness, competence and
consistency of the available evidence. (www.canberra.edu.au..........). Evidence includes
all the information collected as an assurance to any fraud detected.
(http://aaahq.org/audit/midyear/03midyear/papers/cfnew.html)

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According to P.M.Clikeman, “Earning management is the practice of choosing accrual
estimate or timing operating decisions to move short term earning in a desired direction”.
It is not about violation of accounting principles but finding a way around them to hide
some information from the users of the financial statements.

AUDIT PROCEDURE TO DETECT EARNING MANAGEMENT

Firstly, auditor should plan the audit efficiently taking into account the risk and
materiality factors to meet the audit objective. Auditors must conduct the audit
effectively and must not forget to gather more persuasive evidence. Many suggestions
have been made till date and some of the important ones are listed below. Auditors
should try and do the following efficiently. (www.canberra............

Significant transactions near the end and the beginning of financial year must be
reviewed to detect earning management. Terms of sale transactions and side agreements
must be reviewed.

Suspicious transactions terms should be compared with other similar transactions and the
effect of such terms should be considered by the auditor. It can be for a genuine business
purpose or can be to affect the timing of the earnings.

Accrual estimated is another field of usual error. When they are overly estimated or are
too low, auditors should document the method, so the audit committee can check if the
amounts recorded are reasonably correct or not. (Clikeman).

Significant estimates must be reviewed such as asset reserve account and accrued liability
to make sure that they follow the company procedures and are not overstated or
understated to manipulate the financial reports.

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Higher restructuring costs reserve in one period and reversal of such costs in another is a
common way to show higher profits. Auditor must make sure that the reserve is being
used for restructuring only.

EARNING MANAGEMENT – AUDITORS DUTY

Earnings are one of the most important figures that are looked at by the interested parties
of the financial report. The quality of earnings is compromised when companies engage
in managing earning with the help of the generally accepted accounting principles
(GAAP). http://aaahq.org/audit/midyear/03midyear/papers/cfnew.html

Earning management is not obvious violation of accounting standards as mentioned by

Levitt, it is difficult to prove. The auditor must document the evidence carefully and
should report the evidence of earning management to the audit committee. Audit panel
has introduced the ‘Forensic type fieldwork phase’ to increase the effectiveness of audit
to detect earning management and is elaborated below.

‘FORENSIC TYPE FIELDWORK PHASE’

Audits should be planned and performed to provide reasonable assurance that financial
statements being reported on are free of material misstatement or “fairly presented in
accordance with generally accepted accounting principles”.

The Panel implicitly recognized the importance of an investigative mentality through its
recommendation that standards create a “forensic-type fieldwork phase” on all audits
(Panel 2000, 5). http://aaahq.org/audit/midyear/03midyear/papers/cfnew.html

This phase focuses on the potential for dishonesty, earning management practices and
fraud. (Pg 38, book)

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AUDIT PLANNING

A “forensic-type fieldwork phase” plays an interim role in the planning phase of the
audit. It should be carefully planned on how and when it should be carried out. Forensic
type fieldwork phase does not change the audit type to “fraud audit” but just increases the
degree of skepticism towards the financial reports.

While planning the Audit, the auditor should assume higher possibility of dishonesty at
various levels and plan the audit accordingly to put more stress on the falsification of
documents.

AUDIT PROCEDURE

Auditor should perform substantive tests towards the accounts with the possibility of
fraud. Tests should be based on the high risk accounts in which the probability and the
opportunity of fraud is higher than others. Some of the balance sheet and the income
statement accounts would fall in this criterion that are affected by revenue recognition
policies, deferred costs and the asset addition as a result of a business combination and
any reserves that are related to the estimates of the management. They should also keep
an eye out for unexpected revenue and profit margins between periods. (Book, 38).

Material balance sheet accounts such as accounts receivables, inventory, payables etc
should be audited in an unpredictable manner. Spot counts of inventory should be done
without notice, formal and informal interview should be done of company personnel’s at
different locations.

Further it is suggested that external auditor should not rely on the internal auditors work
in detecting fraud, but should have him performing similar procedures to verify external
auditors work.

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At the end of this phase, the external auditor must re- review the high risk areas and the
findings of the audits to identify if certain areas require more attention. Few suggestions
have been put forward by different professionals to detect earning management and must
be taken into consideration by the auditors.
http://www.pobauditpanel.org/downloads/chapter3.pdf#search='Forensic%20type
%20fieldwork%20phasefinancial%20audit%20planning'

EARNING MANAGEMENT – POSSIBLE SOLUTIONS

In the past efforts have been made to solve the problem of earning management. But all
of them have been inefficient to detect companies engaged in earning management which
was clear in the collapse of Enron, HIH and other big corporations in the past few years.
The controversial issue to improve auditor functions to detect earning management has
resulted in many suggestions to improve the quality of audit and to reduce earning
management. http://aaahq.org/audit/midyear/03midyear/papers/cfnew.html

Some of the main potential solutions that have been addressed as a result of these
collapses include increase emphasis on the accounting standards, a review of accounting
education of ethics, a review of the role of auditor, and better understanding of the
consequences of engaging in earning management. (Clikeman, 2003).

A review of accounting standards:

Evidence has been given by Clarke that compliance with accounting regulation is the
main cause of misleading, creative account of data. (Clarke, 1997). Auditors are usually
caught in the accounting trap “GAAP”. It is quite impossible for an auditor to form an
independent mental attitude when forming an opinion on the financial statement.
(Sydney).

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Parfet (2000,p 488) suggests that ‘accounting rules in and by themselves can not be a
guard against every kind of possible abuse’. In other words, the options available in the
accounting standards is the main wall behind which managers engage in earning
management and increasing them is like increasing the size of the wall between auditors
and detecting earning management.

Financial reporting council (FRC) decided in July 2002 that international accounting
standards will apply in Australia from 2005. This change in accounting standards as a
result of the scandals would have the benefit of reduced cost of capital and the closure of
big gaps in the Australian standards. . (2003 hawaii international conference on Business)

A REVIEW OF ACCOUNTING EDUCATION OF ETHICS AND

CONSEQUENCES OF BEING UNETHICAL:

According to Clikeman, ‘An organisation that manages its earnings sends a message to its
employees that bending the truth is an acceptable practice’. Organisations need to be well
informed about the results of such behaviour and should be reminded that managing
earning is regarded as an unethical practice. “Prevention is better than cure”, internal
auditors should create an ethical climate and should educate employees and executives, to
make sure that company is ethically sound and the financial statements are true and fair
and the company is not engaged in earning management. (clikeman and Jacson and
pitman, 2001, p 44).

A REVIEW OF THE ROLE OF AUDITOR:

Auditors have been questioned in regards with the corporate failures. Once again,
auditors’ role has been doubted as a result of the failure of the auditors to act as the
watchdogs and for not detecting or preventing earning management in these fallen
companies. (http://www.fei.org/magazine/articles/3-4-2002_accounting.cfm). Paul
Sweeny). Requests have been made to stop audit firms to perform joint provisions of

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audit and non audit services, to mandate audit committee and audit rotation. (university
of Sydney).

Preventing auditors from providing joint audit and not audit services may be a solution
for the issue of the auditor – client close relationship. Auditors usually earn more money
in the non audit services and have been questioned about loosing their independence
because of such a big amount they earn in non audit services. This issue mainly came up
after Enron as Enron’s auditor was paid 25 million audit fee and $27 million non audit
fee. But the argument raised against that was that $ 25 million is a big enough amount for
auditors to keep their silence.

As mentioned even before in the report, these reforms are likely to have minimal effect
on discovering earning management and these collapses, as this is not the first time
companies have collapsed, neither is it the first time for reforms to take place. (Sydney).

According to Anil Arya, Eliminating earning management is an unattainable nirvana used

only by politicians and it might be more useful to develop measures that increase the
value of managed accruals. (Arya).

INCREASED AUDIT REGULATION: LOWER AUDIT

QUALITY

According to Antony Young, there are two main problems for auditors’ role comprising
the ‘expectation gap’. One reason is performance gap where auditor is not doing the job
to the professional standard and the second one is the standards gap, where auditing
standards are not of sufficient quality to meet the expectations. ( A fix for audit reports).

The institute of Chartered accountants stays against the increase in the regulations and
against making audit standards legally enforceable. According to the chairman of AASB
Bill Edge “Auditing standards are principles – based and rely on the auditor’s skill and

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competence, rather than being procedural or prescriptive, and this approach would be lost
if standards are rewritten to become subordinate legislation.”

By increasing the regulations of audit functions, auditors are bound to loose their
independence of mind in making judgements as they will have to follow the list of rules
and just tag along the ticking off approach. (2003 hawaii). In other words a compliance
mentality will be adopted, which surely is necessary but is not enough to perform an
audit. http://aaahq.org/audit/midyear/03midyear/papers/cfnew.html

EARNING MANAGEMENT – INTENTION

Earning management has been used by companies for many years now. It is a common
practice as a result of the options available in the accounting standards to be chosen by
the companies.

According to Healy and Wahlen, “Earning management occurs when managers use
judgment in financial reporting and in structuring transactions to alter financial reports to
either mislead some stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on the reported accounting
numbers.” (Book Pg 32).

Levitt defines earning management as practice by which “earnings reports reflects the
desires of management rather than the underlying financial performance of the
company.” Various methods are used by companies to manage the earnings like “big
bath” charges, “cookie jar” reserves, “Premature revenue recognition” principles and a
few others. Usage of these practices result in less reliable financial statements. According
to Levitt, the availability of choice in accounting standards allows it to keep pace with
business innovations and it can still result in bad earning management or good earning
management depending on the intention and the judgment of the managers. (
www.nysscpa.org/...........)

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Different definitions are available of earning management and can be interpreted
differently but they all have one thing in common i.e. deliberate actions by management.
To decide if earning management is always intended to mislead or not, we need to look at
the situations that result in companies engaging themselves in earning management.

Different situations can lead companies to engage in earning management. Some of them
as mentioned by Clikeman and by James and Duncan are:

 MARKET EXPECTATION: In the past few years, variation in the actual earning
as compared to the analyst forecast has resulted in many companies suffering
huge stock price fall. As a result, companies now get under a lot of pressure due
to the market expectation to meet numbers which usually results in a bad
intentional earning management. In some cases, companies try and convey inside
information to the market, enabling share price to better reflect the firm’s future
prospects. According to W.R Scott management has the best inside information
about the company and if they manage the earnings to inform the market,
managed earning can be more informative rather than misleading.
 INCOME SMOOTHING: When organizations face some decline in earning or
some losses, they tend to smoothen the earning by realizing higher profits from
last year reserves. When the companies make huge profits, they tend to put some
earnings away for reserve such as for future warranty. In the later years when the
company does not do well, they use the reserve to show that the company’s
earnings are steadily increasing. This helps managers maximize their company’s
stock prices.
 CONTRACTUAL MOTIVES: In most of the companies, managers are motivated
to increase sales and profits by giving them a bonus on achieving the target. The
bonus can be some percentage of the profit or any other incentive. As a result,
managers try and boost up short term earnings to maximize their income. The
intention here is to mislead stakeholders. On the other hand, if the contracting is
efficient and is not related to any bonuses or sales target it can give managers

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 some ability to manage earnings in the face of rigid and incomplete contracts.
(Page 385, William r Scott).
 REGULATORY MOTIVES: Government policies of giving some kind of
incentive to low earning companies motivate them to show deflated earnings. For
example companies engaged in importing goods deflate earnings to win import
relief. In this scenario intention is to mislead government.

The reasons discussed above are some of the main reasons that result in earning
management. Based on the reasoning above earning management is not always bad and
can have good intentions as well. It can be more informative at times and intention to
mislead is not an inherent part of earning management.

CONCLUSION

Earning Management is a practice companies are engaged in due to the changing needs of
businesses and it can have good and bad impact on the stakeholders. Companies engaged
highly in managing their earnings have resulted in big corporate collapses in the past few
years and as a result of that reviewing auditors’ role has been on the top of the list. Above
discussion made it clear that earning management can not be stopped but companies and
auditors should make effort to prevent it and reduce.

Several reforms have been made in the auditing function which would help the auditors
detect earning management. But as mentioned in the report earlier that even the best
auditor can not sometimes detect earning management. Regarding the changes in
standards auditors should be given some independence of mind to make the best
judgment when auditing.

The best method in my viewpoint is to educate the auditors, company directors and the
people engaged in earning management of the consequences of earning management and
to remind them time and again about being ethical.

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BIBLIOGRAPHY

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