1. Explain the meaning of “creative accounting” and “earnings management”.

Earnings management defines as the choice by a manager of accounting policies or real actions that affecting earnings, in order to achieve some specific reported earnings objective. Earnings management includes both accounting policy choice and real actions. There are two categories of accounting policies which are the choice of accounting policies per se and the discretionary accruals. One is the choice of accounting policies per se such as straight line versus declining balance amortization or policies for revenue recognition. Meanwhile, the other category is discretionary accruals such as provisions for credit losses, warranty costs, inventory values and timing and amounts of non-recurring and extraordinary items such as write offs and provisions for reorganization. There is an “iron law” surrounding accruals based earnings management which will be familiar from introductory accounting.

Creative accounting refers to the use of accounting knowledge to influence the reported figures, while remaining within the jurisdiction of accounting rules and law, so that instead of showing the actual performance or position of the company, they reflect what the management wants to tell the stakeholders.

2. i) Describe the “good” and the “bad” sides of earnings management.
Good sides of earnings management relates to efficient contracting. When a contract imposes strict or incomplete terms on a manger, earnings management can provide an option of flexibility, so long as it exclude a manager’ s opportunistic motivations. Earning management can serve as a way to unblocked communication to outsiders. Blocked communications exists when it is very difficult and costly to translate a manger’s skilful expertise about a firm to the board of directors and investors. By using the financial