Abstract
The current study examines the relationship between Historical Cost Accounting (HCA) and real earnings management. Accounting literature argues that HCA provides a chance for manipulation. HCA creates large unrealized capital gains/losses that are recognized in income statements only when managers decide to sell such assets. This may induce managers to manipulate earnings. Moreover, managers are able to decide which assets to sell and during which period. Therefore, managers can exploit HCA in real earnings management by interfering in the structuring of asset sale transactions. The current study aims to contribute to the ongoing debate over dropping HCA and replacing it with Fair Value Accounting (FVA). Using a sample of the 71 most actively traded non-financial firms listed on the Egyptian Stock Exchange during 20042010, multiple regression analysis is employed to test two main hypotheses: the income-smoothing hypothesis and the debt/equity hypothesis. The results provide evidence that managers in the Egyptian business environment exploit HCA in real earnings management to some extent. Managers with negative earnings changes tend to use HCA to smooth earnings, while managers with earnings changes do not. Moreover, there is no evidence for managers use of HCA to avoid violating debt contract terms based on accounting numbers.
Highlights
A ccounting aims to provide relevant, accurate, and reliable information on a timely basis to present and potential users of financial reports
Accounting literature has extensively investigated the financial crises of the last decade
There is strong pressure on accounting standard setters to consider the harmful effects of earnings management
Summary
A ccounting aims to provide relevant, accurate, and reliable information on a timely basis to present and potential users of financial reports To achieve this aim, the Generally Accepted Accounting Principles (GAAP) should be flexible enough to enable managers to convey the real performance of firms. Asset sale strategy is examined as a real activity that managers may use to manage earnings since assets recorded at historical cost hold large unrealized gains/losses that may induce managers to manipulate earnings using asset sales. Income from asset sales contains a discretionary component where managers can determine the timing of asset sales and select assets with large unrealized capital gains in order to benefit opportunistically from the gap between historical cost and market value (Brown, 1999). Sections of this paper provide background for earnings management, discussing how managers exploit HCA in earnings management, as well as the related literature; discuss hypothesis development, variable specification and measurement, as well as the study model; include the study sample, study period, and data collection methods; demonstrate the methods used in the data analysis and the results of using such methods; and comprise study conclusions
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