Accrual Choices Research Articles

Earnings Management and Acquiring Firms Preceding Acquisitions in Malaysia

ABSTRACT The primary objective of the current study is to investigate whether there is any manipulation of accounting earnings through discretionary accrual choices by acquiring firms in the period preceding the announcement and completion of acquisitions. The current study hypothesised that the process of acquisition may provide incentives for managers to make accounting choices that increase the earnings of the firm. By doing so, managers may increase the share price of the firm. The higher the price of the acquisition firm’s share on the agreement date, the fewer the number of shares that must be issued to purchase the target firms. 125 sample of share acquiring firms and 158 cash acquiring firms were analysed over the period 1991-2000. In addition, 125 industry and size-matched control companies are also selected from the population of non-acquiring firms in that particular year. The control group is used to provide information on how comparable firms, not involved in acquisition from the sample share-acquiring firms. The results in the current study provide evidence that in the year prior to the acquisition, acquiring firms in share for share acquisitions manage earnings upward. The result indicates that acquiring firms in Malaysia use accounting procedures in an attempt to increase their share price prior to share for share acquisition.

Earnings Management Response to Debt Covenant Violations and Debt Restructuring

The study investigates whether the choice of income-increasing or income-decreasing discretionary accruals is related to the severity of financial distress and whether this choice is also influenced by the creditors' waivers of debt covenant violations. Financially distressed firms experiencing debt covenant violations and/or debt restructuring during the 1989–96 period are used to evaluate the management's choice of discretionary accruals. Discretionary accruals are calculated based on four different accrual models. The results show that managers of financial distressed firms use income-increasing discretionary accruals if they are able to obtain waivers for debt covenant violations, and use income-decreasing discretionary accruals if debt restructuring takes place or debts are renegotiated because waivers are denied. These findings thus provide support to the expectation that the choice of income-increasing or -decreasing discretionary accruals is influenced by the severity of financial distress. They also provide an explanation for divergence in the results of earlier studies on the use of income-increasing or -decreasing discretionary accruals by financially distressed firms.

Empirical tests of budget ratcheting and its effect on managers’ discretionary accrual choices

In this paper, we investigate whether budgets ratchet. Using business-unit data from a large multinational corporation, we find evidence consistent with ratcheting where favorable budget variances result in performance budget increases that are larger than decreases associated with unfavorable variances of the same magnitude. We argue that under ratcheting, the cost of reporting positive transitory earnings surprises outweigh the short-term benefits of the current-period bonus. Consequently, we hypothesize that managers make income-decreasing discretionary accruals to offset transitory earnings surprises beyond the level expected under fixed budgets. Using a proxy for transitory earnings surprise, we find evidence consistent with this hypothesis.

Empirical Tests of Budget Ratcheting and its Effect on Managers' Discretionary Accrual Choices

In this paper, we consider the maintained assumption in previous earnings-management research that budgets are static through time (fixed-target assumption) versus the common belief in practice that budgets ratchet. Using business-unit data from a large multinational corporation, we find evidence consistent with ratcheting, where favorable budget variances result in performance budget increases that are larger than decreases associated with unfavorable variances of the same magnitude. We then demonstrate that managerse bonus-maximizing discretionary accrual decisions differ when they perceive that budgets ratchet rather than remain fixed. On average, bonus-maximizing discretionary accruals are lower assuming ratcheting budgets. Finally, we find that proxies for discretionary accruals are better explained by bonus-maximizing behavior conditioned on ratcheting budgets than by bonus-maximizing behavior conditioned on fixed budgets. Collectively, these results suggest that including the dynamic nature of budgets in models of bonus maximization is likely to improve the power of tests of the relation between earnings-based bonus compensation and earnings management.

The Impact of Ownership Structure on Earnings Usefulness: Japanese Evidence

Using a large sample of Japanese firms, this paper examines the impact of the ownership structure on managerial incentives for income smoothing through discretionary accrual choices. Our results show that like US managers, Japanese managers engage in income smoothing in consideration of both current earnings and expected future earnings. More importantly, we find that managers' ability to smooth income through discretionary accrual choices is constrained by external monitoring by financial institutions, while it is enhanced by managerial entrenchment arising from cross-corporate shareholdings.

Analysis of the Impact of Accounting Accruals on Earnings Uncertainty and Response Coefficients

This paper uses the residual income valuation model in Feltham and Ohlson (1996) as the basis for developing a model in which management has private information and their choice of accruals influences the information received by investors. The noisiness of accruals relative to management's private value relevant information is exogenous. The analysis examines how the characteristics of the management's private information and their accrual choice process influences the variance of unexpected earnings and the earnings response coefficient. The variance of unexpected earnings is shown to be an increasing function of the noise in managed accruals, but information enhancing earnings management does not necessarily decrease the variance of unexpected earnings. It depends on the nature of the information. The earnings response coefficient is shown to depend on both the persistence of earnings as well as the informativeness of reported earnings.

The Interaction between Accrual Management and Hedging: Evidence from Oil and Gas Firms

This research investigates whether oil and gas producing firms use abnormal accruals and hedging with derivatives as substitutes to manage earnings volatility. Firms engaged in oil exploration and drilling are exposed to two kinds of risks that can cause earnings volatility: oil price risk and exploration risk. Firms can use abnormal accrual choices and/or derivatives to reduce earnings volatility caused by oil price risk, but cannot directly hedge the operational risk of unsuccessful drilling. Because hedging and using abnormal accruals are costly activities, and because prior research suggests managers do not eliminate all volatility (Haushalter 2000; Barton 2001), we expect that, at the margin, managers will use these smoothing mechanisms as substitutes to manage earnings volatility. Our results suggest a sequential process whereby managers of oil and gas producing firms first determine the extent to which they will use derivatives to hedge oil price risk, and then, especially in the fourth quarter, manage residual earnings volatility by trading off abnormal accruals and hedging with derivatives to smooth income.

The Interaction between Accrual Management and Hedging: Evidence from Oil and Gas Firms

This research investigates whether discretionary accrual decisions and use of derivative instruments areindependent of each other. We examine firms primarily engaged in oil exploration and drilling since we can identify two kinds of risks to which these firms are exposed that can cause earnings volatility. These are oil price risk and exploration risk. While firms can hedge oil price risk with derivative instruments, markets do not exist in which firms can hedge the operational risk of unsuccessful drilling. Discretionary accrual choices can be used to reduce variability in earnings induced by the exploration risks and both discretionary accruals and hedging can reduce earnings variability associated with oil price fluctuations. We find that firms in our sample do not hedge all oil price risk they face, but instead appear to want to achieve some benchmark level of earnings volatility. In our primary analysis, we separate the decision to hedge oil price risk from the extent of hedging, and simultaneously consider the extent of hedging and the extent of smoothing with discretionary accruals. The results indicate that firms are more likely to hedge the higher the level of exploration risk they face. Moreover, after controlling for other determinants of hedging and discretionary accrual smoothing, we find that the extent of hedging and the extent of discretionary accrual smoothing are substitutes.

Earnings management in Japanese companies

This study examines choices of accounting accruals using a large sample of Japanese companies, which operate in an environment that is generally regarded as being rather different from the United States. We find that debt-to-equity and asset hypotheses hold in the Japanese environment only for the years after the market crash of 1990. Prior to the crash, the number of employees seems to capture the political (or economic) pressure. Similar to their U.S. counterparts, managers of Japanese companies chose income-increasing accounting accruals to increase their bonus and increase the amount of outside funding. The ownership effect was also observed on the choice of accounting accruals. Those companies that have higher degrees of ownerships by trust companies and stock brokers have incentives to choose income-increasing accruals to provide a more positive picture of the firm. Since this incentive does not exist for ownership by financial institutions, the opposite effect was observed. The effect of ownership by individual investors, management, or corporations on the choice of income-increasing accruals was opposite to that hypothesized in 1989. These opposite-to-expected effects were not present after the Japanese market crash. The stock market crash of 1990 appears to have had a profound effect on the choices of accounting accruals.

What motivates managers' choice of discretionary accruals?

The papers by Subramanyam (1996) and Kasanen, Kinnunen, and Niskanen (KKN, 1996) both consider why managers manipulate accounting accruals. Subramanyam finds that discretionary accruals are associated with several performance measures, and concludes that managers' accrual choices increase the informativeness of accounting earnings. However, a strong competing alternative is that the ‘Jones model’ systematically mismeasures discretionary accruals, so that they contain a significant non-discretionary component. Unlike many US studies, KKN find strong evidence of earnings management in Finland, where Finnish managers set earnings to satisfy the demand for dividends by keiretsu-like institutional investors.