Alternative Earnings Research Articles

Earnings Management via Not-Wholly-Owned Subsidiaries

We investigate an unexplored mechanism of earnings management: income shifting from not-wholly-owned subsidiaries to help the parent company avoid losses at the expense of subsidiaries. Consolidated net income attributable to the parent company (i.e., net income) increases through this mechanism, as the parent company enjoys the full amount of the shifted earnings rather than sharing them with minority investors. We design an empirical model to directly estimate the amount of income shifted from subsidiaries to parent firms. Employing this measure, we find that firms opportunistically decrease earnings of their not-wholly-owned subsidiaries to manage net income upward to avoid losses. The results are stronger for firms with high noncontrolling ownership, firms with large subsidiaries, firms with strong influence over not-wholly-owned subsidiaries, and firms with a high level of related-party transactions. Our results are robust to alternative research designs, including controls for within-firm variations, alternative earnings thresholds, propensity score matching, and entropy balancing techniques. Our mechanism of earnings management is generalizable to other earnings management scenarios, such as share pledging. This paper was accepted by Brian Bushee, accounting. Funding: X. Zhang thanks the National Natural Science Foundation of China [Grant 72102243] for financial support. M. Luo thank the financial support from National Natural Science Foundation of China [Grant 71840011], and the Research Center for Digital Financial Assets at School of Economics and Management of Tsinghua University. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2022.03090 .

Earnings quality and board meeting frequency

We propose that corporate directors are in greater need of soft information about the firm when the quality of hard accounting information is low. We further propose that board meetings constitute a key opportunity for corporate directors to gather soft information about the firm, and empirically investigate the relationship between financial reporting quality and the board's soft information gathering, as revealed by board meeting frequency. Consistent with expectations, we find that boards meet more frequently when accruals quality is low. We further find that the proportion of outside directors, insider ownership, and SOX regulation moderate this relationship. The evidence is reinforced by analysis of management earnings forecasts, financial restatements, and internal control weaknesses and is robust to several alternative earnings quality specifications. Additional empirical tests suggest that our results are incremental to the alternative explanation of increased meeting frequency to address problems in the reporting process per se. We conclude that corporate directors seek more frequent board meetings as an alternative information source to low earnings quality.

Do the educational profile, gender, and professional experience of audit committee financial experts improve financial reporting quality?

Going beyond the mere presence of the audit committee financial experts (ACFEs) within the audit committee, we examine whether the educational profile, gender, and professional experience of ACFEs reduces the extent of earnings management. Using a sample of Chinese listed companies, we find evidence suggesting that ACFEs with postgraduate qualifications and other professional certifications mitigate earnings management. Female ACFEs with postgraduate qualifications are more effective in mitigating earnings management than their male counterparts. Also, the professional experience of ACFEs helps them reduce the extent of earnings management. Results are more pronounced in the case of female ACFEs with more professional experience. In addition, we found that ACFEs working in privately-owned Chinese firms better mitigate earnings management compared to those in state-owned Chinese firms. Overall, our results remain robust after controlling for potential endogeneity problems and using alternative earnings management proxies. Our study provides implications for regulators about necessary policy reforms regarding audit committee composition and recommends that companies appoint female ACFEs in China.

The effect of key audit matters on the association of credit risk and earnings quality

PurposeThe purpose of this study is to examine whether the required disclosure and the high frequency of key audit matters (KAMs) are likely to moderate the effect of higher credit risk on earnings quality.Design/methodology/approachThis study uses 15,106 Taiwanese firm-year observations to explore the relationship between earnings quality and credit risk during the 2011 to 2020 period. We use the two-stage least squares method to test whether the presence of KAM disclosures moderated the association between earnings quality and credit risk and also to examine whether higher KAM frequency moderates the association between earnings quality and credit risk.FindingsOur results provide evidence that the presence of a KAM disclosure requirement moderates the impact of firms with higher credit risk on earnings quality. In addition, there is significant evidence that the higher the frequency of KAM disclosures the greater the moderation impact that is found.Originality/valueThis research investigates whether the disclosure and high frequency of KAMs moderates the effect of credit riskiness on earnings quality. This study improves our understanding of whether more KAMs disclosures would improve earnings quality of firms with higher credit risk. In addition, we also use Beneish M-SCORE, as an alternative earnings quality proxy, to reinforce our empirical results. This markedly differentiates this paper from other studies.

Do powerful CEOs matter for earnings quality? Evidence from Bangladesh.

This study investigates the effects of powerful Chief Executive Officers (CEOs) on earnings quality in a setting where CEOs have strong dominance over other top executives and occasionally attempt to exert their influence over corporate regulatory bodies. Using 10-year longitudinal data for the period from 2010 to 2019 and 1,395 firm-year observations from listed non-financial firms in Bangladesh, we found that CEOs' political power and CEOs with high structural and expert power have a significant detrimental effect on earnings quality. Ownership and prestige power have an insignificant impact on earnings quality. These powerful CEOs use accrual and real activity manipulation techniques together to manage the earnings. This study uses the system-generalized method of moment estimates for estimation purposes, and the results remain robust when alternative earnings quality proxies are used. Taken together, our results suggest that CEOs' political duality (i.e., serving simultaneously as a member of parliament and a CEO) should be restricted and that a CEO's tenure should be limited to a reasonable period. This research adds to the existing body of knowledge by offering empirical support for CEO power dynamics on earnings quality, specifically political and prestige power.

Analysis of the Ivory Trade in Southern Africa: Animal Populations, Economics, and Government

The current nature of the ivory trade and elephant conservation within Southern Africa is unsteady and affected by fluctuating political and economical instability. The goal of this work is to conduct an unbiased investigation of how the ivory trade impacts animal populations, economies, and governments in Southern Africa. The ivory trade stems from a variety of factors, including governmental negligence, high demand for ivory in Asian markets, and the lack of alternative earnings for low-income communities. Besides, this research also considers global legislation to combat the current illicit African ivory trade and the effect of these mandates on animal populations, economies, and governments of African countries. Through such examination, this report aims to propose a concept for new mandates based on general findings, and observe general government influence on the ivory trade in Southern Africa.

VALUATION OF EMBEDDED OPTIONS IN NON-MARKETABLE CALLABLE BONDS: A NEW NUMERICAL APPROACH

The issue of how to price options embedded in callable bonds has attracted a lot of interest over the years. The usual bond valuation methods rely on yield curves, risk premium, and other parameters to estimate interest rates used in discounted cash flow calculations. The option to retire the bond is, however, neglected in the standard pricing models, causing a systematic overvaluation of callable bonds. In the event of a decline in interest rates, investors are exposed to the risk of a lower return on investment than indicated by the yield to maturity. We propose a novel approach to valuing the risk that the issuer will use the right to buy back the bond at a specific call price. While prior models are focused on valuing marketable callable bonds, we deliver a unique approach to valuing bonds with an embedded European option (or a multiple option) that are traded solely through private transactions. These can typically be characterized by the lack of historical records on transaction prices. The modular character of calculation we propose allows us to take into account additional information, such as probable behaviour of the issuer, available opportunities for achieving alternative earnings or different estimates in terms of interest rate development.

Corporate life cycle, family firms, and earnings management: Evidence from Taiwan

Is the corporate life cycle an important factor in management's decisions about real activities management (RAM)? In this study, we empirically investigate firms' RAM activities across the corporate life cycle, given the various costs and constraints associated with the alternative earnings management mechanisms across the life cycle stages. We examine both an aggregate RAM proxy and individual RAM proxies including operating and investing RAM such as sales, expenses, and production cost management, and sales of long-term assets. Employing the Dickinson (2011) proxy of corporate life cycle and Taiwanese data, we document that at the aggregate level, firms in the decline stage are more likely than mature firms to manage earnings upward with RAM. Using the individual RAM proxies, we find that firms in the early life cycle stages prefer sales management to the other RAM mechanisms, especially expenses management. Decline firms employ more sales and production cost management and investing RAM but a similar level of expenses management relative to mature firms. We further find that family firms in the introduction and decline stages engage in more RAM than mature family firms while nonfamily firms do not. Overall, our results indicate that firms prefer different RAM mechanisms across the life cycle stages, that these preferences differ between family and non-family firms, and that these preferences are stronger in family firms. The results are robust after using alternative proxies of operating RAM and additional control variables of corporate governance. Our findings are of interest to investors, auditors, regulators, and academics concerning financial reporting quality and financial statement analysis.

Impact of Nation-Wide Lockdown on Migrant Workers in India

COVID-19 has emerged as a crisis that has impacted all spheres of human life especially, has disproportionately impacted the world's poor population in terms of livelihood and survival. In India, the pandemic also has caused a severe impact on the whole economy, especially, on the life of migrant workers and it will leave long-lasting scars on them. The authorities say the lockdown is key to saving lives, but the lack of planning has hit the country's poorest and most vulnerable citizens hard. This study examines the impact of this pandemic and the related nationwide lockdown on millions of migrant workers in India, who seem to have suffered the most during this period. Here, some of the important issues are also discussed regarding the impact of COVID-19 on the migrant population. These impacts are most troubling for low-income households, which are less well positioned to cope with earnings losses during a recession, have no alternative earnings and have no social security available. Most of these workers earn little more than a subsistence wage and have no other means to protect their incomes if they lose their jobs. In this context, this article focuses on the status of migrant workers in India amidst lockdown and strategies that may help to mitigate the situation. This article also endeavours to study the reasons due to which the lockdown in India couldn't prosper as per the prospect and the adverse impact it had on the migrant population, concretely the inter-state migrants. At the same time, it is trying to summarise some key relief measures announced by the government and directives issued by the Supreme Court for the migrant population about the lockdown. In the end, the study also explores the future course of action that can improve migrant workers’ condition, gives recommendations on how to broaden the support for migrant workers nationwide and suggests pathways for recovery and transformation, including opportunities for rural revival, inclusive welfare, and community response.

Street earnings as a mediator of the effect of intellectual capital disclosure, customer value, and research development activities on firm value

This study is driven by the phenomenon of earnings indicators that can mislead investors due to managers' personal interests. As a result, investors would seek alternative earnings through analysts serving as intermediaries, referred to as street earnings. Street earnings are considered more predictive, informative, and more likely to be used to assess firm value. Furthermore, non-financial information from the corporation can affect street earnings. As a result, this study attempts to determine whether street earnings affect firm value while also determining whether it can mediate the relationship between non-financial information on firms with firm value. This analysis makes use of 392 observations from manufacturing firms between 2015 and 2020. SPSS 25 and the Sobel test are used to conduct data analysis. One of the three hypothesis is proven, namely that research and development activities directly and indirectly affect street earnings and firm value. If street earnings can moderate the relationship between the two variables, this conclusion is also supported by the Sobel test.

THE ASSOCIATION BETWEEN AUDIT QUALITY AND EARNINGS MANAGEMENT USING CLASSIFICATION SHIFTING

Aim: The aim of this paper is to analyze the association between audit quality measured by audit firm size and earnings management by classification shifting. Method: In this paper, we used 896 firm-year observations of the publicly-traded manufacturing firms in Istanbul Stock Exchange for the period of 2009 to 2017. We used least square regression method to analyze the association between audit quality and earnings management by classification shifting. Findings: The findings showed that when the ability of the managers to manage the profit is limited by high quality audit, it is more likely to use the classification shifting by shifting the core expenses to non-operating expenses.Results: The result is important to show that companies can turn to classification shifting as an alternative earnings management tool if their opportunity to manage accruals is limited by independent audit quality.

Stewardship regulation and earnings quality: evidence from Japan

Purpose This paper aims to examine if compliance with the Japanese Stewardship Code by institutional investors is related to the earnings quality of their investee companies. It extends the study by Lu et al. who considered this question for large UK companies with high-quality board governance and a rich information environment. This study provides new insights by exploiting the contrasting Japanese setting. Design/methodology/approach The association between Code-compliant institutional investor shareholding and discretionary accruals is examined for Japanese companies in the Nikkei 225 Index. The study period is from the introduction of the Code in 2015 to 2017. Findings A negative association is found between the level of institutional investor Code-compliant shareholding and discretionary accruals, which is robust to tests that address endogeneity. The findings suggest Code-compliant institutional investor shareholding mitigates opportunistic income-increasing earnings management and promotes conservative accounting. Consistent results are found for benchmark beating and accruals quality as alternative earnings quality measures. Originality/value This study offers new insights regarding the efficacy of the Stewardship Code’s policy approach. The findings suggest the stewardship regulatory model is effective when internal governance is weak and external monitoring by institutional investors is a viable substitute or complement.

Impact of Migration of Labour Force due to Global COVID-19 Pandemic with Reference to India

This article discussed some of the important issues regarding the effect of epidemics like COVID-19 on the migrant population. These impacts are most troubling for low-income households, which are less well positioned to cope with earnings losses during a recession, have no alternative earnings and have no social security available. Most of these workers earn little more than a subsistence wage and have no other means to protect their incomes if they lose their jobs. Migrant workers constitute quite a large proportion of such vulnerable population. Millions of migrant workers are anticipated to be left unemployed in India due to the lockdown and subsequent fear of recession. Many of the migrant workers have returned to their villages, and many more are just waiting for the lockdown to be lifted. The risk is particularly higher for those who are working in unorganised sectors, and those who do not have writer contracts, or those whose contracts are at the verge of completion. The lockdown and the subsequent recession are likely to first hit contract workers across many of the industries. On the one hand, lockdowns and social distancing measures are drying up jobs and incomes, whereas they are likely to disrupt agricultural production, transportation systems, and supply chains on the other. This poses a challenge of ensuring food security and controlling already rampant malnutrition, particularly among children, which is likely to result in increased infant and child mortality. There is a need to relook at the national migration policies, which should accommodate the assistance and protection of migrants arriving from, or faced with the prospect of returning to, areas affected by health crises. Also, there is a need to establish resilient food systems that could reduce food insecurity and the pressure to return to origin among migrants.

Do dividends convey information about future earnings?

Yes. We show that dividend changes contain information about highly persistent changes in future economic income. Three methodological differences lead us to different conclusions from the extant literature: (i) we use an “event window approach” to cleanly delineate earnings after dividend changes from those before, (ii) we use alternative earnings measures to control for endogenous investment and asset write-downs surrounding dividend changes, and (iii) we control for the nonlinear relation between dividend changes and market reactions. Our results suggest dividend announcement returns reflect information about the level of permanent earnings, though the timing of the information content is difficult to reconcile with traditional signaling models.

Do Dividends Convey Information About Future Earnings?

Yes. We show that dividend changes contain information about highly persistent changes in future economic income. Three methodological differences lead us to different conclusions from the extant literature: (i) we use an “event window approach” to cleanly delineate earnings after dividend changes from those before, (ii) we use alternative earnings measures to control for endogenous investment and asset write-downs surrounding dividend changes and (iii) we control for the non-linear relation between dividend changes and market reactions. Our results suggest dividend announcement returns reflect information about the level of permanent earnings, though the timing of the information content is difficult to reconcile with traditional signaling models.

Can Inclusion in Religious Index Membership Mitigate Earnings Management?

This paper investigates whether religious-based index membership is important in mitigating earnings management. Using a large sample of firms domiciled across 12 European countries, our empirical results show that firms included in the Shariah-compliant index, as a proxy for religious index, are more likely to engage in accruals manipulation vis-a-vis non-Shariah-compliant firms. Our results are robust using the Heckman two-stage treatment effect model, weighted least squares model, alternative earnings quality metrics and after controlling for the potential effects of home-country characteristics. Furthermore, our empirical results indicate that corporate governance of Shariah-compliant firms does not constrain managerial opportunistic behaviour in misreporting earnings, and firms that with low scores of board functions, shareholder rights and vision and strategy are more likely to engage in earnings management. Further, Shariah-compliant firms domiciled in Coordinated Market Economies are more likely to manipulate earnings than those in Liberal Market Economies. Taken together, our findings suggest that the Shariah index membership does not indicate good corporate governance that can mitigate earnings management, and it may serve as a legitimacy mechanism to conform to stakeholders’ expectations. Our findings support arguments that the religious-based index membership is plausibly used as a ‘label’ and an impression management tool to attract investment.

"The Relation between Real Activities based and Accrual-based Earnings Management in U.S. Banking Industry"

We examine whether bank managers use real activities manipulation (or transaction-based earnings management) and accrual-based earnings management as substitutes in managing earnings based on U.S. banking industry. We find that bank managers trade off these two earnings management methods based on their relative costs and that managers adjust the level of accrual-based earnings management according to the level of real activities manipulation realized. In addition, banks with higher exposure to fair value accounting rely less on accrual-based earnings management using loan loss provisions as the extent of fair value exposure increases the availability of transaction-based earnings management. Finally, the trade-off relation between accrual-based earnings management and real-activities manipulation is more pronounced after the 2008 financial crisis. In sum, we provide evidence that bank characteristics and the level of alternative earnings management are important determinants of earnings management activities in banking industry. We also contribute to the literature on the effects of financial crisis and fair value accounting on earnings management choices. In particular, the role of fair value accounting in banks’ earnings management practices should be of interest to regulators as they consider ways to increase stability in the banking sector.

The use of earnings and operations management to avoid credit rating downgrades

Firms placed on negative credit watch face the threat of a credit rating downgrade. At the same time, they are given the opportunity to put recovery efforts in place to retain their current credit rating. In this paper, we test to what extent firms use earnings management as a short-term recovery strategy. We find that both accruals-based and real earnings management are associated with firms avoiding credit rating downgrades, and that these alternative earnings management strategies tend to be complements rather than substitutes. However, following the passage of the Sarbanes–Oxley Act, only real earnings management is significantly associated with the credit watch outcome. We find evidence that firms which maintain their rating via earnings management are better able to afford the inevitable earnings reversals, and that in the year following the credit watch period, the credit rating performance of these firms is significantly better than firms which undergo a downgrade, with fewer downgrades and more upgrades in this period. Our results also imply that credit rating agencies are not misled by earnings management but rather allow for some discretion in reporting earnings that facilitates the dissemination of private information about future firm performance.

Female CEOs and Core Earnings Quality: New Evidence on the Ethics Versus Risk-Aversion Puzzle

The question of whether females tend to act more ethically or risk-averse compared to males is an interesting ethical puzzle. Using a large sample of US firms over the 1992–2014 period, we investigate the effect that the gender of a chief executive officer (CEO) has on earnings management using classification shifting. We find that the pre-Sarbanes–Oxley (SOX) Act period was characterized by high levels of classification shifting by both female and male CEOs, but the magnitude of such practices is, surprisingly, significantly higher in firms with female CEOs than in those with male CEOs. By contrast, our results suggest that following the passage of the punitive SOX Act, classification shifting by female CEOs declined significantly, whilst it remained pervasive in firms with male CEOs. This suggests that the observable differences in financial reporting behavior between male and female CEOs seem to be because female CEOs are more risk-averse, but not necessarily more ethically sensitive than their male counterparts are. The central tenets of our findings remain unchanged after several additional checks, including controlling for alternative earnings management techniques, corporate governance mechanisms, CEO and chief financial officer characteristics and propensity score-matching.

Evaluating the information content of earnings forecasts

This study develops a framework to compare the ability of alternative earnings forecast approaches to capture the market expectation of future earnings. Given prior evidence of analysts’ systematic optimistic bias, we decompose earnings surprises into analysts’ earnings surprises and adjustments based on alternative forecasting models. An equal market response to these two components indicates that the associated earnings forecast is a sufficient estimate of the market expectation of future earnings. To apply our framework, we examine four recent regression-based earnings forecasting models, alongside a simple earnings-based random walk model and analysts’ forecasts. Using the earnings forecasts of the model that satisfies our sufficiency condition, we identify a set of stocks for which the market is unduly pessimistic about future earnings. The investment strategy of buying and holding these stocks generates statistically significant abnormal returns. We offer an explanation as to why this and similar strategies might be successful.