Decreasing Earnings Management Research Articles

Choice of auditors and earnings management during the Asian financial crisis

PurposeThis study sets out to examine the effect of the choice of auditors in constraining earnings management within a rule‐based reporting framework during the Asian financial crisis.Design/methodology/approachUsing the iterative seemingly unrelated regression methodology, 383 firm‐observations of service‐oriented listed companies in Singapore are analysed.FindingsThe results show that service‐oriented companies engage in income decreasing earnings management during the crisis period. More importantly, the results indicate that only the Big‐6 firms are able to significantly constrain the earnings management of managers of such companies.Practical implicationsThe ability of Big‐6 firms to constrain earnings management is perceived to add credibility to the quality of reported earnings, and hence contributes to the competitive advantage of the Big‐6 firms in the market for auditing services.Originality/valueThe evidence contributes to the literature on corporate governance and the competitiveness of the market for audit services in the context of an economy‐wide financial crisis from an Asian perspective.

The role of audit committees in decreasing earnings management: Korean evidence

The several accounting scandals that have occurred recently in the USA suggest the importance of well-functioning audit committees. This study examines how the characteristics of audit committees – independence, competency and activity – are related to earnings management. The data used in the analyses are collected from the Korean stock market during the period 2000-2001. The empirical results demonstrate that the independence and competency of the audit committee are associated with the earnings management of a firm. Specifically, the committee members' shareholdings are positively associated with earnings management, while the presence of professors or the employees of financial institutions on the committee is negatively associated with earnings management. However, the activity measure of the committee is not significantly related to earnings management. These results suggest several important implications for regulatory bodies on the composition of audit committees.

Can Stock Recommendations Predict Earnings Management and Analysts’ Earnings Forecast Errors?

In this article we present evidence that a firm's stock price sensitivity to earnings news, as measured by outstanding stock recommendation, affects its incentives to manage earnings and, in turn, affects analysts’ex post forecast errors. In particular, we find a tendency for firms rated a Sell (Buy) to engage more (less) frequently in extreme, income–decreasing earnings management, indicating that they have relatively stronger (weaker) incentives to create accounting reserves especially in the form of earnings baths than other firms. In contrast, firms rated a Buy (Sell) are more (less) likely to engage in earnings management that leaves reported earnings equal to or slightly higher than analysts’ forecasts. Our empirical results provide direct evidence of purported, but heretofore, weakly documented equity market incentives for firms to manage earnings. They are also consistent with a growing body of literature that finds analysts either cannot anticipate or are not motivated to anticipate completely in their forecasts firms’ efforts to manage earnings.

Incentives, Discretion, and Asset Valuation in Closed–End Mutual Funds

This paper studies earnings management using 363 closed–end mutual fund firm–years of data. Closed–end fund assets consist of unrestricted and restricted securities, and realized and unrealized income. While unrestricted securities are not subject to earnings management, restricted security values are largely discretionary. Managerial valuation of restricted securities is modeled as contingent on unrestricted returns relative to a performance benchmark. Four unrestricted performance regions are identified. Known multi–period compensation incentives become the basis for hypothesizing earnings management behaviors in the regions in the form of restricted security valuation. Across several benchmarks, the results are consistent with multi–period maximization rather than simpler single–period compensation maximization or income smoothing. Funds with extreme unrestricted performance show relatively larger income–decreasing earnings management, and funds with slightly–below benchmark returns show relatively larger income–increasing earnings management than those slightly above. These results clarify the relationship between complex earnings management behavior and managerial incentives.

Corporate Governance and Earnings Management

This study investigates whether a firm's corporate governance practices have an effect on the quality of its publicly released financial information. In particular, we examine the relationship between audit committee and board of directors characteristics and the extent of corporate earnings management as measured by the level of positive and negative discretionary accruals. Using two groups of US firms, one with relatively high and one with relatively low levels of discretionary accruals in the year 1996, we find that earnings management is significantly associated with some of the governance practices by audit committees and boards of directors. For audit committees, income increasing earnings management is negatively associated with a larger proportion of outside members who are not managers in other firms, a clear mandate for overseeing both the financial statements and the external audit, and a committee composed only of independent directors that meets more than twice a year. We also find that short-term stocks options held by non-executive committee members are associated with income increasing earnings management. Income decreasing earnings management is negatively associated with the presence of at least a member with financial expertise and a clear mandate for overseeing both the financial statements and the external audit. For the board of directors, we find less income increasing earnings management in firms whose outside board members have experience as board members with the firm and with other firms. We also find that larger board, the importance of the ownership stakes in the firm held by non-executive directors, and experience as board members seems to reduce income decreasing earnings management. Our results provide evidence that effective boards and audit committees constrain earnings management activities. These findings have implications for regulators, such as the Securities and Exchange Commission (SEC), as they attempt to supervise firms whose financial reporting is in the gray area between legitimacy and outright fraud and where earnings statements reflect the desires of management rather than the underlying financial performance of the company, as pointed out by the Blue Ribbon Committee (1999).