Empirical Evidence on Earnings Management Strategies and Their Consequences in Innovative Small and Medium Entities

Abstract

We investigate innovative Small and Medium Entities’ (SMEs) earnings management strategies and their related economic consequences. Uncertainty and complexity surrounding innovative SMEs’ activities lead to high information asymmetries between managers and investors which facilitate earnings management strategies. Yet managers do not want to be penalized by market participants which could impair their innovative capacity and future performance. It is generally argued that real activities-based earnings management are more difficult to detect by outsiders than accrual-based earnings management. We examine SMEs listed on the AIM London stock exchange, an exchange for firms of smaller size, over the 1995-2014 period. We document that innovative SMEs engage less intensively in accrual-based earnings management and more intensively in real activities-based earnings management relative to non-innovative SMEs. Our evidence shows that innovative SMEs undertake earnings management strategies that are more difficult to detect externally. We find that the combination of low accruals earnings management and high real earnings management is done efficiently by focusing resources towards investments in R&D in the future years which lead to higher market value. We further examine the role of external monitoring on accounting quality, comparing innovative SMEs listed on stock exchanges with different regulatory requirements, i.e., the AIM London and the Nasdaq stock exchanges. We document that stricter rules reduce the level of accrual earnings management, while it leads to more use of real earnings management. This paper contributes to the literature on SMEs’ financial reporting quality and on the effect of regulation on financial reporting quality.