Accrual-based Earnings Management Research Articles

Corporate Income Tax Changes in the Context of Earnings Management: a Review of the Literature

The purpose of the article/hypothesis: This paper aims to provide a comprehensive review of the theoretical and empirical literature regarding tax-induced earnings management. In particular, the association between anticipated tax changes and earnings management is of interest to the authors.
 Methodology: This paper uses a systematic literature review to achieve its research objectives.
 Results of the research: The presented research is mostly devoted to tax rate decreases and focuses on accrual-based earnings management methods. In anticipation of a tax rate change, companies shift their income from a high to a low tax rate period. Moreover, the probability of tax-induced earnings management is higher in case of extreme changes in the tax rate, larger prospects for tax savings as well as in case of private firms. This paper identifies several inconsistencies and gaps in the current literature, emphasizing that the connection between firms’ characteristics, the level of book-tax conformity and the practice of earnings management remains unclear.

Do price-earnings multiples for firms with patterns of increasing earnings vary with the quality of the earnings pattern?

ABSTRACT Prior research finds that firms with patterns of consecutive earnings increases are rewarded by market participants with higher Price-Earnings (P/E) multiples, and that some firms manage earnings to sustain the earnings stream. We propose several fast and inexpensive heuristics to classify firms as suspect or non-suspect of maintaining the stream through earnings management and examine whether market rewards differ for suspect and non-suspect firms. We find higher P/E multiples for firms with a pattern of increasing earnings supported by the same pattern of increasing cash flows (non-suspect). This is an important result as it shows that cash flows can be used to assess the quality of earnings in scenarios prone to earnings management, where earnings quality is expected to be low. We also find lower price-earnings multiples for firms suspected of using accrual-based earnings management, sales manipulation, and overproduction to achieve the earnings pattern.

Playing it Ethical or Safe? Exploring Earnings Management by Military Executives

The majority of studies argue that military experience makes executives more ethical and then reduces firms’ misconducts. What remains unclear is whether this is due to higher ethical values of ex-military executives or their preference in “playing it safe”. We propose that executives depend more on risk-aversion preference than their ethical values when making earnings management decisions. This is because the ethicality of earnings management is ambiguous and thus military executives may not perceive it as unethical. By examining a sample of 2,135 listed firms in China, a risk-avoidance culture (2006?2018), our results find military executives reduce higher-risk method (i.e., accrual-based earnings management) but increase lower-risk method (i.e., real earnings management). In a post-hoc test, we find that this risk-aversion characteristic is still significant when the external environment is subject to less litigation or auditing risk, and corporate risk-taking level mediates the effects of military experience on earnings management.

Labor protection, information disclosure and analyst forecasts: Evidence from China’s Labor Contract Law

Labor protection increases employees’ stability and strengthens their monitoring role, improving firms’ information environment and increasing analysts’ earnings forecast accuracy. Using the implementation of China’s Labor Contract Law as a quasi-natural experiment, we find that labor protection significantly improves analyst forecasts. This positive impact is stronger when agency problems are weaker, board independence is greater, corporate reputation is better and industry competition is more intense. Enhanced labor protection significantly reduces firms’ business risk and accrual-based earnings management, decreases stock price synchronicity and increases market pricing efficiency. Our findings of significant impacts of China’s Labor Contract Law on analysts’ forecasting behaviors offer important guidance for promoting the development of the Chinese capital market and policy making in labor protection.

Labor unions and real earnings management

Using firm-level union membership data for the period of 2002–2016, we show that firms with higher union membership are more likely to engage in real earnings management than accrual-based earnings management, with abnormal production as the dominant form of real earnings management. We further show the causal effect of union membership on real earnings management by exploiting two natural experiments-the staggered enactment of state-level right-to-work (RTW) laws and the shock to unemployment insurance benefits (UIB)-as exogenous shocks to union power. Further exploration shows that the positive association between union membership and real earnings management is more pronounced for unionized firms with (1) high managerial incentives to reduce employee hiring and retention costs and (2) operating inflexibility created by labor overinvestment. Our evidence is consistent with managerial incentives for upward earnings management to mitigate employees' perceived job security and the cost of employee management in competitive labor markets.

Predicting earnings management through machine learning ensemble classifiers

AbstractIn this paper, we utilize six novel ensemble classifiers to predict earnings management (EM) in both its forms, accrual‐based earnings management (AEM) and real earnings management (REM), and then compare the EM prediction accuracy of wrapper feature selection (FS) and filtering FS techniques in the context of EM. Specifically, we integrate three well‐known filtering FS techniques (information gain [IG], principal component analysis [PCA], and relief [Re]) and three popular wrapper FS techniques (particle swarm optimization [PSO], genetic algorithm [GA], and artificial bee colony [ABC]) with the support vector machine (SVM) to generate our ensemble classifiers. We then assess the performance of each of the six ensemble classifiers to predict AEM and REM based on three criteria: type Ι error, type ΙΙ error, and average accuracy. The results show that the ABC‐SVM ensemble classifier outperforms the others in predicting both AEM and REM. We also find that, overall, wrapper FS ensemble classifiers outperform filtering FS ensemble classifiers in predicting AEM and REM and that it is more difficult for our ensemble classifiers to predict REM than to predict AEM. This paper contributes to the literature on EM prediction by introducing six new ensemble classifiers. It is also the first work (to the best of our knowledge) in the domain of ensemble classifiers' applications (a) to consider both REM and AEM in one context and to show that REM is more difficult to predict than AEM and (b) to compare the performance of wrapper and filtering FS techniques in the EM prediction setting.

Effect of Capital Structure on Real and Accrual-Based Earnings Management in Sub-Sahara Africa

The study examines the effect of Capital Structure (CS) on real and accrual-based earnings management among listed firms in Sub-Sahara Africa (SSA). Real Earnings Management (REM) and Discretional Accruals (DA) were proxies by Rowchowdhury (2006) and Khothari et al. (2005) models respectively. Secondary data used were obtained from annual reports of 276 non-financial listed firms from six countries for eleven years (2010 to 2020). A Generalized Method of Moments (GMM) estimator was used to analyze the data collected. The findings show that CS among firms in Kenya, Tanzania and Nigeria have positive and significant effects on REM while the negative and significant influence of CS among firms in Zimbabwe, South Africa and Ghana was observed on REM. Also, CS among firms in Kenya, Zimbabwe and Nigeria have negative and significant effects on DA. However, CS among firms in South Africa and Ghana have a positive influence on DA. The study concludes that firms in SSA substitute REM and DA forms of earnings management. Hence, the study recommends that capital providers in the sampled countries should maintain sufficient attention to both REM and DA for sustainable leveraging, and management of opportunistic selections of accounting choices, but increase the use of REM.

Corporate site visits, private information communication, and earnings management: evidence from China

PurposeThis paper aims to provide new evidence that corporate site visits give institutional investors better opportunities to obtain information and exert monitoring powers, which reduce listed firms’ earnings management.Design/methodology/approachThis paper explores how private communications affect firms’ earnings management by using a sample of institutional investors’ visits to the corporate sites of Chinese listed firms between 2010 and 2018. This study uses the performance-matched Jones model (Kothari et al., 2005) to measure accrual-based earnings management and Roychowdhury’s (2006) method to measure real earnings management. The authors also perform several robustness checks including an alternative measure of accounting accruals, a two-stage instrumental regression and the Heckman two-step approach.FindingsUsing a sample of institutional investors’ site visits to Chinese listed firms during the 2010–2018 period, this study finds that institutional investors’ site visits reduce listed firms’ earnings manipulation activities (both accrual-based and real). This association is robust to several checks, including an alternative measure of accounting accruals, a two-stage instrumental regression and the Heckman two-step approach. This study further documents that other private communication approaches such as private in-house meetings and conference calls moderate the effect of site visits.Practical implicationsAs the Shenzhen Stock Exchange is one of the few stock markets to mandate that listed firms record and disclose their private communication information, this study also has implications for researchers and policymakers who work in other stock markets.Originality/valueTo the best of the authors’ knowledge, this study is the first comprehensive study of the impact of private communications on earnings management. This study extends the earnings management literature by examining institutional investors’ information acquisition process and revealing a negative association between their site visits and listed firms’ earnings management. Moreover, this study examines the effects not only on traditional accounting accruals but also on real earnings management. In addition to studies that emphasize the effect of corporate site visits on individuals and market reactions, this study examines the effect of site visits on firms’ financial misbehavior. This study shows that institutional investors’ corporate site visits provide external monitoring that mitigates listed firms’ earnings management behavior.

Substitution between Accrual-Based Earnings Management and Real Activities Manipulation—A Commentary and Guidance for Future Research

ABSTRACTConsidering the voluminous published research confirming and extending the original findings of Cohen, Dey, and Lys (2008), we conclude that Pincus, Wu, and Hwang (2022) make a modest contribution to the earnings management literature. Specifically, their analysis does not incorporate recent advances in the earnings management literature, especially the measurement and estimation of real earnings management activities and the incorporation of the changing information environment. As a result, we conclude that the Pincus et al. (2022) results and conclusions with regards to the substitution between accrual-based and real earnings management activities should be interpreted with caution.JEL Classifications: G10; M4.

Accrual-based and cash-based earnings management in Algeria: substitution or complementary

Abstract Managers are often employed many alternatives for earnings management following their objectives or the financial reporting objectives; the commonly used are the accrual-based and cash-based earnings management. The literature reveals that managers adopt the two strategies in different ways, suggesting a mixed relationship between them. Hence, this study investigates the relationship between the two strategies of earnings management in Algeria, whether it is a substitute or complementary. The study included 30 Algerian companies during 2011-2019, so a total of 270 firm-year observations were employed. Accrual-based earnings management was measured through the modified-Jones model, while cash-based earnings management was measured through the abnormal cash flows model. According to the results, Algerian companies engage more in accrual-based earnings management and employ the two strategies as substitutes, which explains the strong and negative effect of accrual-based on cash-based earnings management. We argue that companies engage first in accrual-based earnings management, and then they shift towards cash-based earnings management due to auditors’ scrutiny. Furthermore, we found a positive and a medium effect of return on equity on cash-based earnings management, which reflects the managers’ desire to adjust operating cash flows consistent with the reported earnings. Finally, the results indicated that company ownership, company listing, and the nature of financial statements do not affect cash-based earnings management.

Dividend policy and earnings management: Do agency problem and financing constraints matter?

The present study aims to examine the relationship between dividend policy and earnings management by explicitly considering the role of the agency problem and financing constraints. The sample comprises 3250 non-financial Chinese listed firms from 2009 to 2018. This study uses fixed- and random effect models as econometric techniques. Dividend policy is measured with dividend yield, payout ratio, large and small dividend payment status. Earnings management is measured with discretionary accruals, which are used as a proxy of accrual-based earnings management. The salient findings of the study are as follows: (1) overall, dividend payments restrict managers' involvement in earnings management practices; (2) compared with small dividend-paying firms, larger dividend-paying firms have less involvement in earnings management practices; (3) the agency problem does not affect the nature of the proposed relationship; (4) the dividend payments of non-financially constrained firms dampen managers’ opportunistic behavior toward earnings management practices and vice versa.

The effect of corruption on the level of real and accrual earnings management in cases of target firms

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.

Related Party Transactions and Earnings Management: The Moderating Effect of ESG Performance

The purpose of this paper is to investigate the effect of ESG performance on the possible association between related party transactions (RPTs) and different types of earnings management (EM). We study a sample of Italian non-financial listed firms over the 2014–2019 period, controlling for the fixed effects of the company’s sector of operation and the year. We investigate the effect of Environmental, Social and Governance (ESG) performance scores on the association between related party transactions and real earnings management (REM), as well as accrual-based earnings management (AEM). We provide evidence that firms might use RPTs in association with downward AEM or as a substitute of REM perpetrated by sales anticipations and discretionary expenses reductions, as well as an autonomous form of earnings manipulation. Our empirical evidence shows a significant moderating effect of ESG performance on earnings management. In particular, social as well as governance performance significantly moderate the association between RPTs and downward AEM; environmental performance moderates the possible use of RPTs in association with cashflow-based REM. This is the first study that analyzes the effect of ESG performance on the possible association between related party transactions and earnings management.

Investigating the nonlinear relationship between debt structure and real and accrual-based earnings management

Earning is one of the most important items of financial statements. Sometimes managers manipulate and distort earning reports to maximize their own benefits, reach a certain profitability level, or achieve a certain corporate objective. Firms with a low level of debt tend to have few or no restrictive clauses in their debt contracts, which allow them to operate with less concern about breaching these contracts and give less incentive to managers to engage in earning management reports through accrual manipulation. However, when firms accumulate large amounts of debt, the relationship between debt and accrual-based earnings management tends to get reversed. In firms with large debts, managers are incentivized to report good earnings as they are under pressure to avoid the penalties of violating the restrictive clauses in their debt contracts. In the absence of scientific and empirical evidence regarding this issue, the present study examined the nonlinear relationship between debt structure and real and accrual-based earnings management. For this purpose, the data pertaining to a sample of 130 firms listed on the Tehran stock exchange from 2014 to 2019 were collected and analyzed. The results of multivariate regression analysis showed a nonlinear relationship between debt structure and accrual-based earnings management. A non-linear relationship was also found between current debt structure and real earnings management. However, the results could not confirm the presence of a non-linear relationship between total debt structure and real earnings management

Investigating the relationship between managers’ loss-aversion characteristics and non-discretionary accruals-based earnings management in companies listed on the Tehran stocks exchange

The present article aimed to investigate the relationship between the managers’ loss-aversion characteristics and non-discretionary accruals-based earnings management in companies listed on the Tehran Stocks Exchange. The Pen Pin Questionnaire (2008) was employed to investigate the managers’ loss-aversion bias, which was introduced to the model as a virtual variable (0, 1). To measure non-discretionary accruals-based earnings management, the adjusted Jones’ model was used. Variables of financial leverage, return on assets, corporate size, institutional ownership and market-to-book value entered the model as effective control variables to explain and examine the effects of the independent variable on the dependent variable. A total of 137 companies listed on the Teran Stocks Exchange (from 2018 to 2019) were selected via systematic elimination method. The research variables were also analyzed by Excel and Eviews software as well as cross-sectional data model. The findings suggested that the variable of managers’ loss-aversion bias is not significantly associated with non-discretionary accruals-based earnings management, which nullifies the research hypothesis.

Impacts of managers’ loss-aversion characteristics on discretionary accruals-based earnings management in companies listed on the Tehran stocks exchange

The present article investigates the impacts of managers’ loss-aversion characteristics on discretionary accruals-based earnings management in the Tehran Stocks Exchange companies. The study falls under applied research, which uses a descriptive-correlational method in terms of goals. The statistical population consists of all companies listed on the Tehran Stocks Exchange, which, in 2019, totaled 435 companies. The screening sampling method (systematic removal method) selects the statistical sample. Thus, the number of 138 companies are selected. To gather data on managers’ loss-aversion bias, the Pen Pin Questionnaire (2008) is employed, which, the loss-aversion bias, was introduced to the model as a virtual variable (0, 1). The adjusted Jones’ model is used to measure discretionary accruals-based earnings management. Variables of financial leverage, return on assets, corporate size, institutional ownership, and the market-to-book value entered the model as effective control variables to explain and examine the effects of the independent variable on the dependent variable. Excel and Eviews software and cross-sectional data model are used to analyze the data. The findings suggest that the variable of managers’ loss-aversion bias is positively and significantly associated with discretionary accruals-based earnings management.

Whether family ownership affects the relationship between CSR and EM: evidence from Chinese listed firms

PurposeThis study explores the relationship between corporate social responsibility (CSR) and earnings management (EM) in China and whether family ownership impacts this relationship.Design/methodology/approachThe research data are the financial reports and CSR disclosure reports of Chinese listed companies from the CSMAR database for the 2010–2020 period. Ordinary least squares (OLS) regression was used to analyze the relationship between various variables in this study.FindingsResults show that CSR significantly and positively affects accrual-based EM (AEM) but does not affect real EM (REM). Moreover, family ownership influences the positive relationship between CSR and AEM. Compared with non-family enterprises, family enterprises tend to disclose less CSR performance but also have lower AEM behavior.Originality/valueThis result is related to the information transparency of listed enterprises and Socioemotional Wealth theory. This study provides reference for domestic and foreign investors and other stakeholders in understanding the impact of family ownership on the relationship between CSR and earnings management to optimize their investment decisions.

Exploring the deep neural network model’s potential to estimate abnormal audit fees

PurposeThe paper aims to estimate abnormal audit fees more precisely than the traditional audit fee model by applying an artificial intelligence (AI) method.Design/methodology/approachThe AI technique employed in this paper is the deep neural network (DNN) model, which has been successfully applied to a wide variety of decision-making tasks. The authors examine the ability of the classic ordinary least squares (OLS) and the DNN models to describe the effects of abnormal audit fees on accounting quality based on recent research that demonstrates a systematic link between accruals-based earnings management and abnormal audit fees. Thus, the authors seek to imply that their new method provides a more precise estimate of abnormal audit fees.FindingsThe findings indicate that abnormal audit fees projected using the DNN model are substantially more accurate than those estimated using the classic OLS model in terms of their association with earnings management. Specifically, when abnormal audit fees predicted using the DNN rather than the OLS are incorporated in the accruals-based earnings management model, the adjusted R2s are larger. Additionally, the DNN-estimated coefficient of abnormal audit fees is more favorably associated to earnings management than the classic OLS-estimated coefficient. Additionally, the authors demonstrate that the DNN outperforms OLS in terms of explanatory power in a negative discretionary accruals subsample and a Big 4 auditor subsample. Finally, abnormal audit fees projected using the DNN method provide a better explanation for audit hours than those estimated using the OLS model.Originality/valueThis is the first approach that utilized a machine learning technology to estimate abnormal audit fees. Because more precise measurement yields more credible research results, the findings of this study imply a significant advancement in calculating unusually higher audit fees.

Relation among corporate environmental disclosure, earnings management and accounting conservatism: evidence from Chinese listed firms

PurposeThis paper aims to examine the relationship among corporate environmental disclosure (CED), earnings management (EM) practices and accounting conservatism in Chinese listed firms and determine how internal corporate governance (CG) mechanisms moderate these relationships.Design/methodology/approachThis study uses two different EM practices, accrual-based EM (AEM) and real EM (REM), to analyze the relationship between CED and EM practices, as well as accounting conservatism. The final sample consisted of 1,619 observations, documented between 2015 and 2019. The panel data method was applied to estimate the relationship among CED, AEM and REM, as well as the moderating effect of CG on this relationship.FindingsThis study finds a negative relationship between CED and EM (both AEM and REM) and a positive relationship between CED and accounting conservatism. Further, CG, measured as the independent director ratio, institutional ownership and state-owned entities, was found to moderate these relationships.Practical implicationsChinese policymakers should reinforce CED because it reduces corporate EM practices and improves accounting conservatism. Further, CED, as a mandatory requirement, may be expanded to all industries, that is, beyond the highly polluting industries listed on China’s stock exchanges.Originality/valueThis study is among the first to examine the relationship between CED and EM practices from both the AEM and REM perspectives and the one between CED and accounting conservatism. It also extends extant analyses by investigating the moderating effect of CG on these relationships in China.

Determinants of the capital structure and accrual-based earnings management

Purpose: The main purpose of the paper is to examine the relationship between the value of discretionary accruals and the legal and economic determinants of capital structure, which are taken into account in static trade-off theory and pecking order theory. Methodology/approach: Discretionary accruals were extracted using the Jones model and the Kang-Sivaramakrishnana model. The empirical research is based on regression analyses, variable distribution statistics, and Spearman's rank correlation coefficient analyses, among others. The study covered 72 public industrial enterprises listed on the Warsaw Stock Ex-change. Findings: In the studied sample, there are statistically significant relationships be-tween discretionary accruals and variables such as effective tax rate, non-debt tax shield, operating risk, enterprise size, and the operating profitability of assets. Research limitations/implications: Due to the limited sample, the research results cannot be generalized to all industrial enterprises. Moreover, the indicators of good-ness-of-fit of the regression models to the empirical data are low, which indicates the need to further explore this field of research. Originality/value: The presented research methodology is innovative in relation to the Polish capital market. Previous empirical research on this issue is limited to showing the relationship between financial leverage and discretionary accruals.