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Q1 a) The earnings (net income) are considered as the most critical financial figure in the financial statements as it indicates the profitability of the company. All benefits for shareholders including both the capital gains and dividends are closely related with the earnings. In other words, the performance of the company and the management can be largely evaluated by the earnings figure. Due to the importance of earnings, it is not surprising the management is keen to improve the figure via all possible ways including legal and illegal approaches. The earnings management can be defined as using reasonable and legal means to achieve stable and optimised financing results (Burgstahler & Dichev 1997).

It should be noticed the earnings management is legal activities rather than the illegal accounting fraud. Due to the availability of difference legal choices, the management can choose the most suitable choice which can generate more close earnings number to desired target. For example, the test on the intangibles impairment requires professional judgement and the management may choose to record large impairment in years with good performance to smoothing the earnings.

It is argued several incentives attributing to the earnings management. Firstly, if the bonus compensation is directly related to earnings number or stock price, the management is prone to maximize the earnings to receive higher compensation. This reason can be also explained by the agent theory. From the perspective of shareholders, it is more important to know the true economic performance of the company but for the management higher earnings can bring them more benefit. Given this situation, the agent (management) will not act in the best interests of the principle (shareholders)(Garen 1994). Secondly, a higher cost of debt will be trigged given the violation of the debt covenants. For

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