The interaction between accruals management and financial engineering with special purpose entities

Abstract

PurposeIn response to recent financial corporate scandals, this study aims to provide a helpful understanding for investors and accounting regulators on how firms manage their reported earnings. This leads to a better firm valuation by financial intermediaries and more useful accounting standards.Design/methodology/approachEstimating discretionary accruals and opportunistic special purpose entities and using a simultaneous equation approach, the aim is to check how managers trade off between such tools of earnings management. Based on real earnings manipulation and accruals management of earnings, the goal is to understand if such tools are used simultaneously or as substitute by firms.FindingsAfter controlling for each cost determinants of such earnings management tool, firms use discretionary accruals and financial engineering with special purpose entities as substitutes. Additional analyses show that managers use such tools in a sequential process. Indeed, they first use special purpose entities during the course of the year but they manipulate discretionary accruals especially at the end of the year.Research limitations/implicationsDespite sensitivity checks, measurement error in discretionary accruals proxy and opportunistic SPE estimation model remains an alternative explanation for the results. The sample size and the lack of accurate information about the size of special purpose entities may limit the extent of the findings.Practical implicationsIt is a very useful tool for regulators when they plan to disclose new accounting standards. For investors, this study can help them in assessing the firm's value more accurately for investing and financing purposes.Originality/valueProviding a new methodology and new models to detect pervasive earnings management strategies adopted by firms.