Earnings Management and Financial Reporting Fraud: Can External Auditors Spot the Difference?

The aim of this paper is to increase external auditors’ knowledge about earnings management and help them spot the difference between earnings management and financial reporting fraud.Athorough literature reviewwas undertaken to achieve the paper’s aim.The secondary data used in this paper was obtained from different databases like Ebscohost, Business Search Premier, Academic Search Premier, Emerlad, Sciencedirect, and Jstor.The current paper suggests a new approach and way of thinking for external auditors that might help them in spotting the difference between earnings management and fraud. This new approach calls for the importance of considering management’s motives which is the main driverfor all fraudulent activities.Aset of recommendations forexternal auditors, researchers, and standards’ setters are provided in this paper. External auditors have to view external auditing in terms of the audit of motivations. Standards’ setters should provide external auditors with more guidelines regarding the audit of management’s motives. More research is still needed in management’s motives and integrity.Keywords: financial reporting fraud;earnings management;fraud detection;occupational fraudIntroductionThere is a debate in the audit literature on what should be considered as fraud or in other words, is earnings management another form of fraud. Reviewing the literature showed mixed results regarding whether earnings management isan ethical act. Some researchers (Subramanyam, 1996; Watts &Zimmerman, 1986; Holthausen, 1990; Demski, 1998; Glover &Sunder, 2003 as cited in Jiraporn, et al., 2007; Peasnell, et al., 2001, as cited in Abdul Rahman &Ali, 2006; Davis-Friday and Frecka, 2002; Diana &Madalina, 2007; Jiraporn, et al., 2007) argue that there is nothing wrong with earnings management because it is within the boundaries of GAAP, while others (Healy &Wahlen, 1999; Public Oversight Board, 2000; Rosner, 2003;Abdul Rahman &Ali, 2006; Jones, 2011;Hasnan, et al., 2008;Jiraporn, et al., 2007; Kamel &Elbanna,2010; Perols &Lougee, 2010;Beneish, 2001; Higson, 2003;Chia, et al., 2007;Jones, 2011)believe earnings management is not just an unethical act but another form of financial reporting fraud. By and large the debate on earnings management and fraud will continue unless there is a proper way to help auditors identify the difference between them.*Email: rasha.kassem@bue.edu.eg This paper proposes a new approach and way of thinking that might help external auditors spot the difference between earnings management and financial reporting fraud. This new approach calls for the importance of auditing management’s motives and viewing auditing as the audit of motivations.Literature ReviewDefining Fraud and Earnings ManagementThere are various definitions of fraud in the audit literaturehowever they all have common facts about fraud. For instance, Wells (2009) mentioned that four elements must exist in any fraud case: A material false statement, intent to deceive, reliance on the false statement by the victim, and damages as a result. Lord added that differentcountries define fraud by using a common set of three elements: ‘Material false statement with the intent to deceive, a proof that the victim depended on the false statement, and damages occurred as a result of victim’s reliance onthose false statements’ (2010, p.5). In fact, in each country, the definition of fraud will be slightly different; but all definitions will involve that fraud is breaking the law or violating the regulatory framework (Jones, 2011). Fraud can generally be defined as an intentional and illegal act carried out by the perpetrator to steal or misuse the victim