Detecting earnings management: a review of the proxies

Abstract

Earnings management research is of interest not only to academics, but also to practitioners and regulators. A major strand of the relevant literature examines the divergent reporting incentives that managers face when reporting for tax and for financial accounting purposes. In case of conforming earnings management, firms that prefer tax aggressiveness also lower their financial accounting income, whereas firms that are aggressive in financial reporting also inflate taxable income. However, there is significant evidence that firms also take advantage of the opportunity provided by the dual reporting system (i.e., preparation of distinct reports) and simultaneously manipulate both accounting and taxable earnings (i.e., non-conforming earnings management). As the extent of earnings manipulation cannot be measured directly, a number of proxies have been developed in the literature relying on publicly available data. For the purposes of the present review, the most commonly used ones are classified into three groups: accrual models, effective tax rates and book-tax differences.