Non-conforming tax avoidance and real earnings management

Research Questions: Does the hierarchy of earnings thresholds differ between accounting systems? Does a temporal shift occur in the hierarchy of the earnings thresholds associated with earnings management? Motivation: A number of studies looked into the hierarchy of earnings thresholds based on the earnings distribution, capital market valuation, survey views, and discretionary accruals. Our study seeks to fill this gap by investigating the hierarchy of earnings thresholds based on real earnings management and by investigating if the hierarchy of earnings thresholds differs between accounting systems. Idea: This paper aims to examine the hierarchy of achieving certain earnings thresholds based on the magnitude of discretionary accruals and real earnings management under two different accounting models. Tools: Large samples of US and French firms for the period ranging from 2008 to 2018 are used. The relative extent of both discretionary accruals and real earnings management used to achieve three earnings thresholds is examined by regression analyses. Findings: Two hierarchies emerge from the US and French contexts. On the one hand, we find (1) avoiding earnings losses, (2) avoiding earnings decreases, and (3) avoiding negative earnings surprises in the US context. On the other hand, we find out (1) avoiding earnings losses, (2) avoiding negative earnings surprises, and (3) avoiding earnings decreases in the French context. An analysis of the real earnings management behavior of these firms indicates that they have used the significant real earnings management for the purpose of avoiding earnings decreases in both contexts. These hierarchies are reorganized over time. Contribution: Our paper contributes to the existing literature in several ways. First, the majorities of studies on earnings management examine and validate opportunistic incentives, whereas our results validate incentives with reference to the signaling theory. Second, our findings are of interest to investors, auditors, regulators and academics with respect to the financial statement analysis, accounting earnings quality, and financial reporting. Research limitations: This study is subject to measurement error which is a common limitation in the earnings management literature.

The paper examines the existence of real earnings management (REM) and accrual earnings management (AEM) around seasoned equity offerings (SEOs) undertaken by Australian firms. We also investigate the subsequent operating earnings performance of the SEO firms that engaged in earnings manipulation and undertake SEOs. Prior studies document the presence of earnings management using univariate tests; however, we provide the first evidence employing both univariate and multivariate tests of the existence and consequences of REM and AEM around the SEOs. We find that managers of Australian SEO firms tend to engage in REM and AEM in the SEO-years, and earnings management activity is greater in these years relative to non-SEO firms and in comparison to the non-issuing years of SEO firms. In addition, consistent with prior evidence, we find that SEO firms performs substantially negatively in the post-SEO period, and SEO firms that engaged in REM and/or AEM underperform significantly those that don’t in the post-offering period. However, we document a non-linear earnings management effect, with SEO firms that engaged in greater levels of REM and undertake SEOs having significantly higher subsequent operating performance.

Financial statements are supposed to convey comprehensive information about firms' financial position, performance and changes in financial positions to assist a wide range of users in making economic decisions. Audited financial statements provide independent assurance that the information presented by management about the company's financial performance and positions are true and fair. However, even with audited financial statements, there is no guarantee of zero risk of financial statements manipulation. The art of manipulating the reported earnings to achieve pre-set objectives is termed as earnings management and it can be categorized into real or accrual earnings manipulations. This study extends existing research on the real earnings management by examining the effects of corporate tax avoidance and free cash flow on real earnings management in Nigeria. The analyses involve a sample of 72 non-financial firms with 360 firm-year observations for a five-year period (2014-2018). Data was obtained from the annual reports of these companies as well as from Thompson Reuters and Bloomberg databases. Multiple regression technique was used to test the model studied. The results show that both corporate tax avoidance and free cash flow increase management's real earnings manipulation activities. The study can benefit policymakers, shareholders, and regulators on the importance of effective internal control mechanisms to help curtail real earnings manipulations and improve the quality of reported financial statements.

PurposeThis paper attempts to investigate the effect of corruption on the real and accrual earnings management of target firms in the process of mergers and acquisitions.Design/methodology/approachThe sample includes target firms from the European area that participate in mergers or acquisitions announced during 2010–2020. The preliminary empirical part estimates the level of earnings management during the period two years before the deal's announcement to identify whether the sample follows the manipulation behavior that the literature suggests for target firms. The primary empirical analysis focuses on the impact of corruption on real and accrual-based earnings management proxies, employing regression models and two alternative proxies for corruption. The existing literature points out that the combination of low levels of corruption and an integrated legal system reduces earnings manipulation.FindingsThe findings provide strong evidence for systematic downwards accounting manipulation practices, whereas the findings for real earnings management are not significant. The findings of the main empirical part show that corruption is positively associated with accrual-based manipulation and negatively related to real earnings management. In essence, in economies with a high level of transparency, managers adopt the manipulation of operating activities as a less detectable practice of earnings management instead of engaging in accounting procedures.Originality/valueThis study contributes to the literature highlighting the diversification of these firms' manipulation strategies according to the national level's corruption status.

This paper examines real and accrual-based earnings management to achieve industry-average profitability in Japanese firms. I focus on three types of real earnings management: sales manipulation, the reduction of discretionary expenditures, and overproduction. The results indicate that Japanese firms engage in income-increasing real and accrual-based earnings management to achieve industry-average profitability. Specifically, I find evidence of income-increasing real and accrual-based earnings management in firms that just meet or slightly beat industry-average profitability. The results also indicate that firms in more competitive industries engage in greater income-increasing earnings management to achieve industry-average profitability. The evidence in this paper is important because it suggests that managers engage in both real and accrual-based earnings management with an awareness of the profitability of competing firms in the same industry. Further, this paper shows the complementary relationship between two types of real (sales manipulation and overproduction) and accrual-based earnings management to achieve industry-average profitability. It also provides evidence of real and accrual-based earnings management to achieve industry-median profitability and industry-average forecast profitability.

Nigerian banking industry has in recent times suffered different degrees of financial malfeasances which rendered many banks distress and bankrupt. This is in spite of the regulatory mechanisms put in place to monitor and control the operations of the banks. Investigations by regulators and researchers to determine the possible causes of the problem are still going on. One of the factors identified is managerial unethical practices which affect the quality of corporate reporting adversely. However, despite an extensive studies on accrual-based earnings management in the banking industry, there has been none or limited research examining whether the audit quality and corporate governance mechanisms constraint real earnings management of banks in Nigeria. This paper examined the effect of audit quality and corporate governance on real earnings management of banks in Nigeria. The paper examined two real earnings management activities; revenue manipulation to alter cash flows from operations and manipulation of discretionary expenses to smooth earnings. Correlation research design was adopted using a cross-section of 15 banks for a period of 10 years (2004-2013). Generalized Least Squares (GLS) technique of analysis was used and the study found an insignificant negative relationship between Big4 auditor and real earnings management (revenue and discretionary expenses manipulation); and positive relationship between joint audit and real earnings management. The results show that governance mechanisms (board independence and board size) have significant positive effect on cash flows manipulation, while audit committee (size, independence and financial knowledge) has a significant negative effect on cash flows manipulations during the period. Overall, the results indicate a significant relationship between aggregate real earnings management and the audit quality measures and governance mechanisms. The study recommends among others that regulators and policy makers in the Nigerian banking industry should consider real and accrual earnings management when making policy to mitigate unethical practices.

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.

This study investigates whether and how institutional shareholders affect the relation between unconditional conservatism and earnings management. We analyze the relation between unconditional conservatism and accrual-based earnings management and the relation between unconditional conservatism and real earnings management, focusing on the role of the institutional shareholders variable in these two relations. First, we find evidence of positive (negative) relations between unconditional conservatism and accrual-based (real) earnings management. Second, we demonstrate that the presence of institutional shareholders has a mitigating (amplifying) impact on the relation between unconditional conservatism and accrual-based (real) earnings management. This study contributes to enrich the previous literature in two ways. First, it extends the strand of research on the relation between accounting conservatism and earnings management (Garcìa Lara, García Osma, & Penalva, 2020; Chen, Hemmer, & Zhang, 2007; Gao, 2013), focusing on unconditional conservatism since it is less prevalent than conditional conservatism in previous literature (Ruch & Taylor, 2015). Second, it extends the strand of research on the impact of institutional ownership on accounting practices (Farooq & El Jai, 2012; Sakaki, Jackson, & Jory, 2017), highlighting the role of the institutional shareholders in the relation between unconditional conservatism and earnings management

This study examines whether management of public companies in Indonesia engage real earnings management to meet earnings benchmarks. This paper documents evidence consistent with firms committing real earnings management around earnings threshold for poor performing firms. Manager opportunistically utilize price discounts to temporarily increase sales, overproduction to report lower cost of goods sold, and reduction of discretionary expenditures to improve reported margins. Consistent with the conjecture of Roychowdhury (2006) and Cohen & Zarowin (2010) auditors find it more difficult to detect real earnings management than accrual-based earnings management. The results of this study indicate that drawing inferences about earnings management by analyzing only accrual manipulation is inappropriate. This study contributes to the accounting literature by presenting evidence on the real earnings management, which has received relatively little attention to date.

Real earnings management and ESG disclosure in emerging markets: The moderating effect of managerial ownership from a social norm perspective

PurposeThe purpose of this paper is to investigate whether audit quality is associated with real earnings management in the UK.Design/methodology/approachThe authors apply the panel fixed effects method that controls for heterogeneity across firms to investigate whether audit quality is related to real earnings management for a large sample of UK manufacturing companies for the period 2010–2013. The authors utilized three proxies to measure real earnings management and two proxies to measure audit quality.FindingsThe results provide evidence that audit fees are negatively related to abnormal operating cash flows. Conversely, audit fees are positively related to abnormal discretionary expenses. Besides, audit quality proxies show insignificant relationship with abnormal production costs and real earnings management index. Overall, the study finds partial evidence of significant relationship between audit quality and real earnings management.Research limitations/implicationsThese results are important subject to the adequacy of the indicators of real earnings management and audit quality. Like previous research works that mostly focus on upward earnings management, the authors do not address the question of whether and how firms take real actions to manage earnings downwards in certain contexts.Practical implicationsThe findings inform monitoring bodies that the imposition of higher levels of audit quality may result in unintended consequences. Therefore, monitoring bodies, such as audit committees, should consider the implication of imposing higher quality auditing, which may drive firms to potentially value-decreasing real earnings management practices. Managers should curtail real earnings management practices, especially abnormal operating cash flow, because attempt to use higher-quality auditors to mitigate such practice may destroy firm value. Also, managers’ employment may be threatened due to the potential deterioration of firm value caused by using higher-quality auditors to mitigate managers’ real earnings management practices. Moreover, shareholders are informed of the potential detrimental effects of imposing higher levels of audit quality which may lower the value of their investments.Originality/valueThe paper extends previous research on earnings management in several ways. First, while earlier studies usually use accruals methods to measure earnings management, the authors use the real earnings management approach as managers can switch from accruals to real earnings management when facing more scrutiny from auditors and/or more constrained regulations or standards that may limit their capability to use discretionary accruals. Second, this study reports new findings, as the authors find partial evidence of a significant relationship between audit quality and real earnings management. Third, it is one of the few studies to use a real earnings management index to measure earnings management and its link to audit quality.

Previous studies argue that religious firms are more ethical and thus engage less in accrual earnings management. At odds with the ethical view, we use a sample of Chinese listed firms and show that firms in religious regions use more real earnings management. We postulate that besides ethics, religion also proxies for risk aversion, which motivates firms to substitute accrual earnings management with real earnings management. Consistent with this view, we show that the positive (negative) association between religiosity and real (accrual) earnings management is more pronounced for firms with lower litigation risk and for firms with less reputable auditors. In addition, we use a mediation model introduced by Baron and Kenny (J Pers Soc Psychol 51(6):1173–1182, 1986) to show that religiosity affects earnings management through the channel of risk aversion. We conclude that firms choose real earnings management over accrual-based earnings management because of risk aversion, rather than ethical reasons.

The main purpose of the research is to evaluate the effects of corporate governance on earnings management. The study is mainly based on secondary data, which was collected from the annual reports of non-financial organizations of Bangladesh from 2011-2021. The dependent variable of the study is earnings management, which was calculated based on accrual and real earnings management. The independent variable is the corporate governance index. The study uses the OLS regression technique to get empirical evidence. Empirical research demonstrates that corporate governance mechanisms have a substantial adverse effect on earnings management. The board-diversity index has a positive impact on accrual earnings management, whereas the audit committee index has a negative impact on it. The influence of the corporate governance index is more on discretionary accruals than real earnings manipulation. This study provides novel perspectives to the current body of knowledge on corporate governance and earnings management research.

PurposeThis paper aims to examine the relationship between abnormal audit fees and accrual-based and real-based earnings management by using a sample of 1,055 UK firm-year observations from 2006 to 2015.Design/methodology/approachLinear regression was used to test the hypothetical relation between abnormal audit fees and accrual and real earnings management. Following prior research, several proxies have been used to measure abnormal audit fees, accrual earnings management and real earnings management.FindingsAbnormal audit fees were negatively associated with real earnings management. A higher level of abnormal audit fees was the major driver of enhanced audit quality, in turn reducing managers’ flexibility to use real earnings management and to manipulate reported earnings. Abnormal audit fees were found to be negatively associated with abnormal discretionary expenses, abnormal production costs and the aggregated measure of real earnings management.Practical implicationsThis paper outlines the importance of considering any abnormal audit fees paid to audit firms. It is expected that the abnormal audit fees might compromise auditor independence and lead to a higher level of earnings management. However, the findings of this paper provide a new insight to many interested parties, e.g. regulators, audit firms, investors and creditors, that abnormal audit fees are associated with higher audit quality and higher financial reporting quality in the UK. Regulators in the meanwhile should reform the audit market by, e.g. revising the types of non-audit services that are provided for the same client, setting a cap on the maximum fees that can charged by auditors and monitoring earnings management practices. Audit firms should take into consideration that any charged abnormal level of audit fees may have a direct impact on audit quality.Originality/valueThis is the first study to examine the impact of abnormal audit fees on accruals and real earnings management after major regulatory changes that took place in the UK. These major changes are the adoption of the International Financial Reporting Standards in 2005 and the new legislation concerning the ethical standards issued by the UK Audit Practice Board in 2004. These two major changes are expected to have a direct impact on both earnings management and audit fees, notably for the largest public listed firms. This study also focuses on one of the very developed and attractive stock markets in the world, the UK FTSE 350 stock index, that incorporates that largest 350 public firms.

Purpose Combining the expectations of agency theory and earnings management theoretical models, we investigate whether publicly held companies engage in real earnings management (REM) as a result of peer effects. Design/methodology/approach We employ a sample of US listed firms over the period 1991–2018, where firm-specific and time-varying peers are identified based on product market similarities. We rely on a two-stage least squares instrumental variable approach (2SLS-IV), where the average idiosyncratic equity shock returns of peers in the previous year serve as an instrument for peers’ REM. Findings We find a statistically and economically significant association between firms’ use of REM and peers’ REM, consistent with both capital market and product market mechanisms. Our analysis also shows that the peer effect on these activities is mitigated when managers’ expected costs, proxied by the likelihood that specialised auditors and institutional investors would question their actions, are higher. Research limitations/implications Our analysis is focused on public firms. Future research may verify if our findings extend to private firms, as they have different reporting incentives. Practical implications Our findings may inform policies aimed at strengthening external monitoring to mitigate peer effects in REM. Originality/value We contribute to the literature on corporate peer effects by documenting that peer influence extends to firm activities that are potentially harmful in the long term, such as real earnings management. Further, we highlight that firms do not completely ignore the costs associated with emulating suboptimal actions, though these costs reduce but do not eliminate imitation.