Abstract
Prior research has shown that a firm’s tendency to meet or beat earning targets is greater during bad economic times than good times. The paper extends this line of research by investigating which means of earnings management is used in different states of economy. A sample of non-financial companies listed on Korea Securities Market from 2003 to 2011 is used for empirical tests. The findings of this study are summarized as follows. The magnitude of discretionary accruals is negatively related to investment sentiment, indicating that firms tend to use positive discretionary accruals to manipulate reported income upward when the sentiment is pessimistic. However, the real activity based earnings management is not significantly associated with the state of economy. Collectively, this study contributes to behavioral finance and accounting literature by suggesting that managers use discretionary portion of accruals, but do not change their real operating activities, in order to meet or beat earnings targets in economic downturn.
Highlights
There is voluminous accounting research on earnings management, which is defined as “the purposeful intervention in the external financial reporting process with the intent of obtaining some private gain (Schipper, 1989)
This study adds new evidence that managers do not manipulate operating activities to boost reported income in bad times, but they tend to rely on discretionary accruals, indicating that accrual quality is affected by sentiment
Using a sample of public companies on Korea Securities Market from 2003 to 2011, this paper show that firms do not rely on real activity manipulation rather they tend to inflate earnings using discretionary accruals in bad economic times
Summary
There is voluminous accounting research on earnings management, which is defined as “the purposeful intervention in the external financial reporting process with the intent of obtaining some private gain (Schipper, 1989). On the other hand, the real-based earnings management (i.e., operating activities, discretionary R&D expenditures and production activities)is not significantly related to investor sentiment These findings suggest that firms do not depend on real activity manipulation, but rather inflate discretionary accruals to report favorable income in bad economic times. Such conclusion is consistent with Graham et al (2005) arguing that managers are likely to boost earnings in recessions based on their expectation of reversal of intrinsic earnings in economy recovery. This study adds new evidence that managers do not manipulate operating activities to boost reported income in bad times, but they tend to rely on discretionary accruals, indicating that accrual quality is affected by sentiment.
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