Discretionary Current Accruals Research Articles

Tax-Induced Earnings Management in Emerging Markets: Evidence from China

ABSTRACTChina issued the New Enterprise Income Tax Law in 2007, which changed the corporate income tax rate from 33 percent to 25 percent and came into effect in 2008. Using the simulated marginal tax rate as an indicator of firms' earnings management incentives, and discretionary current accruals as a proxy for earnings management, we find significant tax-induced earnings management in 2007. However, the downward earnings management becomes less obvious for firms that have a greater percentage of shares owned by state-owned enterprises, have an audit committee on the board, and disclose certified internal control reports.Data Availability: All data are available from the second author (contact author) upon request.

Can corporate governance discipline opportunistic earnings management during IPO process?

This study investigates whether corporate governance can discipline opportunistic earnings management during IPO process and thus enhance long–run stock returns. Using a sample of IPOs in Taiwan, the study shows that there is a negative relation between pre–IPO discretionary current accruals (DCAs) and post–issue stock performance. These findings suggest that though corporate managers might mislead the market by accrual management during IPO process, such as accelerating the recognition of revenues or deferring expenses, issuers cannot always manipulate accounting discretion to sustain their earnings. Most importantly, the results of the study demonstrate that corporate governance can deter the abuse of accounting discretion during IPO process, and thus reduce potential losses of investors who were temporarily deceived by opportunistic earnings management. Notably, in family–controlled firms, increasing institutional ownership or the presence of venture capitalists will aggravate stock reversal due to earnings management, which is different from the supervising effect on non–family controlled firms.

Accrual quality: The presence of women directors on audit committee boards

This article examines whether the participation of women on audit committee boards enhances audit committee effectiveness to control earnings management practices. While numerous studies have investigated the effects of women audit committee on earnings management, empirical evidence is rather inconsistent. Therefore, it is imperative to investigate the impact of female representation on audit committee effectiveness. In order to address the objective of the study, we use cross-sectional version of the performance-adjusted current discretionary accruals model to detect earnings management (Kothari, Leone and Wasley, 2005). Using a sample of 356 companies for the year ended 2007; we found a significant negative relationship between the presence of women directors on audit committee boards and earning managements. The results suggest that the presence of women directors on audit committee boards reduces earning management practices.

The effects of venture capital syndicate diversity on earnings management and performance of IPOs in the US and UK: An institutional perspective

This study examines the extent to which principal–principal agency conflicts within venture capital (VC) syndicates lead to additional principal–agent conflicts in IPO firms in two institutional contexts. Using a matched sample of 274 VC-backed IPOs in the US and the UK, it shows that the diversity of a VC syndicate increases pre-IPO discretionary current accruals, used as a proxy for earnings management, but the impact of such diversity is higher in the US. There is also evidence of higher underpricing and lower aftermarket performance in firms with higher earnings management and VC diversity, and these negative performance effects are also higher in the US. Our findings indicate that local and informal institutions have a significant effect on multiple agency conflicts in IPO firms and performance outcomes.

Financing Decisions and Discretionary Accruals: Managerial Manipulation or Managerial Overoptimism

We examine whether discretionary accruals of firms obtaining substantial external financing can be explained by managerial manipulation or managerial overoptimism. Insider trading patterns and press releases around equity and debt financing suggest that managers are more optimistic about their firms around debt financing. Consistent with earlier studies, we find that discretionary current accruals peak when firms obtain equity financing. However, we also find that discretionary accruals peak when firms obtain debt financing. Moreover, discretionary accruals are higher for firms that rely on debt rather than on equity financing. The results are robust to controlling for firm characteristics, excluding small and distressed firms, and using alternative measures of discretionary accruals. These findings support the hypothesis that managerial overoptimism distorts financial statements of firms obtaining external financing.

Earnings Management Surrounding Seasoned Bond Offerings: Do Managers Mislead Ratings Agencies and the Bond Market?

AbstractWe study earnings management (EM) efforts surrounding seasoned bond offerings using discretionary current accruals. We find that issuers tend to inflate earnings performance prior to an offering. In order for EM efforts to effectively mislead ratings agencies and the bond market, they must lead to inflated bond ratings and decreased offering yields. Regression results indicate the opposite; aggressive EM efforts are associated with lower initial ratings and higher offering yields. We also find a statistically lower proportion of subsequent downgrades for firms with the most aggressive EM efforts, which is inconsistent with these firms’ inflated initial ratings. While some firms may attempt to mislead ratings agencies and market participants by window-dressing earnings, these efforts appear to be counterproductive.

Behavioral theories and the pricing of IPOs’ discretionary current accruals

The main purpose of this paper is to provide additional evidence about the effect of discretionary current accruals on the pricing of IPOs. This paper seeks to discriminate between two alternative explanations for the prior findings: (1) behavioral biases coupled with limited arbitrage; and (2) the sample- and period-specific nature of the results in the prior literature. The IPOs from 1962 to 1998 were used to obtain the following results. First, there was not a negative association observed between discretionary current accruals and subsequent price performance for the 1926–1971 period. Second, analysis reveals that the pattern of cross-sectional evidence is inconsistent with the predictions made by behavioral theories. Third, in the 1972–1998 period, evidence of predictable negative performance attributable to IPO discretionary current accruals is limited to NASDAQ firms. These findings are difficult to reconcile with the explanation of behavioral biases coupled with limited arbitrage.

The effect of corporate governance on earnings management around UK rights issues

PurposeThis paper aims to investigate the relation between corporate governance and earnings management around UK rights issues.Design/methodology/approachThe paper examines the effect of board structure, ownership structure, adviser structure, and capital structure on discretionary current accruals – a proxy for earnings management – for a sample of size‐controlled rights issuers. Rights issues are chosen as a context in which firms have particular incentives to manage earnings.FindingsThe results suggest that firms with higher debt to equity ratios, with lower proportions of non‐executive directors, or with no large block owner, are more likely to use discretionary current accruals to manipulate earnings around rights issues.Research limitations/implicationsSimilar research can be conducted around other equity issuing methods such as open offers and around other major corporate events such as initial public offerings.Practical implicationsThe paper's evidence contributes to an understanding of corporate governance and has practical implications for stakeholders. It suggests that investors can rely more on the financial disclosures of firms with lower debt to equity ratios, higher proportions of outside directors, and with a large blockholder. Regulators may propose that firms undertaking corporate events such as equity offerings should follow best corporate governance practices to enhance investor confidence.Originality/valueThis study is the first to investigate the corporate governance mechanisms in place to check opportunistic earnings management around specific corporate events for the UK market.

Investor reaction to earnings management

Purpose – The purpose of this paper is to investigate whether earnings management that surpasses a threshold is associated with market mispricing.Design/methodology/approach – The paper examines the level of discretionary current accruals (DCA) as a proxy for earnings quality. Operationally the threshold of earnings management is defined as the mean DCA, and it is assumed that highly managed firms (both income‐decreasing and income‐increasing) produce low‐quality earnings information. It is postulated that such management may lead to mispricing errors by investors who make incorrect adjustments for lower earnings quality.Findings – The evidence suggests that investors possess idiosyncratic perceptions toward earnings management. Investors of income‐decreasing firms tend to under‐adjust for analyst optimism, while investors of income‐increasing firms are inclined to over‐adjust for analyst optimism. In addition, investors of both types of highly managed firms appear to under‐adjust for earnings management....

Market Competition and Earnings Management

We show that product market competition reduces agency problems by curtailing misleading earnings management and improving earnings informativeness. Using the Herfindahl-Hirschman Index from the Census of Manufacturers to proxy for product market competition, we find that firms in more competitive industries are less likely to engage in earnings management as measured by the absolute value of discretionary accruals and they are more likely to engage in earnings smoothing improving earnings informativeness about future cash flows. Earnings smoothing ratios are higher in competitive markets and the positive relation between current discretionary accruals and future changes in operating cash flows is stronger in such markets. Moreover, we find that firms in competitive industries have lower analysts' earnings forecast errors and lower dispersion of earnings forecasts, suggesting lower information asymmetry between managers and the market. Stock-price informativeness is also higher in more competitive markets. Furthermore, forced earnings restatements and security fraud lawsuits are less common in such markets. When firms engage in misleading upward earnings management, in a competitive market they are more harshly punished by the stock market when the market learns about the misleading management. We find that firms engaging in such management experience worse long-term stock performance in competitive markets. In addition, the negative market reaction to the announcements of forced earnings restatements is stronger in competitive markets. Overall, our findings suggest that product market competition is an effective mechanism improving the accuracy of financial reporting and reducing the information asymmetry between managers and the market. Moreover, product market competition achieves more accurate reporting without incurring substantial costs often associated with government regulations of financial reporting or corporate governance.

Earnings management and long-term performance: evidence from reverse stock splits

This study investigates earnings management and long-term stock performance surrounding reverse stock splits. It is designed to provide evidence on the role of managerial pessimism and discretionary current accruals. Discretionary current accruals are used to measure earnings management. These discretionary current accruals are measured in our study using the balance sheet approach as well as the cash flow statement approach. We find consistent evidence of negative discretionary current accruals prior to reverse stock splits. Such negative discretionary accruals are consistent with managerial pessimism prior to a reverse stock split. Such pessimism is warranted by the observed negative market reaction to a reverse split announcement and the negative abnormal returns observed after reverse splits. Negative discretionary current accruals are also consistent with smoothing of earnings during difficult and challenging periods for the firm. Our study might provide an alternative to the opportunism explanation. It also provides additional evidence buttressing the role of managerial optimism and pessimism in explaining earnings management.

Earnings Management and the Long‐Run Underperformance of Firms Following Convertible Bond Offers

Abstract: This paper examines whether the long‐run underperformance of convertible bond issuers can be explained by earnings management, as reflected in discretionary current accruals around the time of the offer. Consistent with the earnings management hypothesis, we find that convertible issuers who adjust their discretionary current accruals to report higher net income in the issue year will generally experience inferior operating and stock return performance over the five‐year post‐issue period. Our findings indicate that there is some temporary overvaluation of convertible issuers by the stock market, but that the resultant disappointed investors will subsequently correct their valuation errors. The similarity of our results to those reported within the prior literature on initial public offers (IPOs) and seasoned equity offers (SEOs) suggests that the earnings management hypothesis is not unique to stock offers, but that it actually extends to convertible bond offers.

Earnings management around UK open offers

We examine the long run operating and stock price performance of UK open offer firms in the context of the earnings management hypothesis. We find that in the pre-offer period offer firms report significant improvements in their operating performance unrelated to cash flow performance. Results on return performance show that offer firms outperform various benchmarks in the pre-offer year but underperform up to four years after the offer. Regression results show that pre-offer discretionary current accruals predict the long-run post-offer return underperformance but do not predict the short-run reaction to SEO announcements. Our findings are more consistent with the earnings management hypothesis than with either the timing hypothesis or the managerial response hypothesis and suggest that investors do not take full account of the information available at the time of open offers.

Datastream returns and UK open offers

We report a fundamental error in Datastream equity data for share prices and return indices relating to a failure to make any capital adjustments for UK open offers before February 2002. We re-examine the findings of Iqbal, Espenlaub, and Strong (2008), correcting for this error. We find that the short-run market reaction to open offers is now significantly positive. However, we confirm that long-run post-offer returns continue to be significantly negative up to a four-year horizon and, most importantly, that pre-issue discretionary current accruals predict the long-run underperformance, in support of the earnings management hypothesis. We continue to find no support for the timing hypothesis or the managerial response hypothesis.

Earnings Management and Performance of Indian Equity Rights Issues

Earnings management occurs when managers use judgment in financial reporting and in structural transactions to alter financial reports to either mislead some stakeholders about the underlying performance of the company, or to influence contractual outcomes that depend on reported financial performance. Many research studies are conducted to investigate the earnings management in developed economies. Due to regulated operating environment of in India until 1992 earnings management was not a fertile topic for research. But, post-1992 companies are given freedom to price their capital issues. This freedom motivates the issuers to manage their earnings prior to capital issues. The objectives of the study are to investigate if firms in India manage earnings prior to launching of equity rights issues (known as seasoned equity offerings in the USA and Europe) and the post issue performance of the firms. We used discretionary current accruals (DCAs) to measure the extent of earnings management. Modified Jones Model is used to estimate DCAs during three years prior to the rights issue (pre-issue period) and three years after the rights issue (post-issue period). DCAs of rights issue firms are adjusted for DCAs of control sample (non-rights issuers).Adjusted mean DCAs of pre-issue period is compared with adjusted mean DCAs of the post-issue period to detect earnings management. The results suggest that there has been earnings management prior to the rights issues. Analysis of pre-and-post issue performance the sample firms corroborate the findings based on DCAs. Study period is 1993-94 to 2003-04. Sample size is 259.

Datastream Returns and UK Open Offers

We report a fundamental error in Datastream equity data for share prices and return indices relating to a failure to make any capital adjustments for UK open offers before February 2002. We re-examine the findings of Iqbal, Espenlaub, and Strong (2008), correcting for this error. We find that the short-run market reaction to open offers is now significantly positive. However, we confirm that long-run post-offer returns continue to be significantly negative up to a four-year horizon and, most importantly, that pre-issue discretionary current accruals predict the long-run underperformance, in support of the earnings management hypothesis. We continue to find no support for the timing hypothesis or the managerial response hypothesis.

On‐market share buybacks, exercisable share options and earnings management

Abstract Chan et al. (2006b) suggest that managers might announce a share buyback to manipulate investors’ perceptions and capitalize on the positive price reaction usually associated with the announcement. The incentive to do so is greater when managers have exercisable options. Prior studies document that managers engage in upwards earnings management for opportunistic reasons related to option holdings (Bergstresser and Philippon, 2006). We examine the association between earnings management and exercisable option holdings for buyback firms to investigate if earnings management in the pre‐buyback period is greater for firms with equity incentives to increase share price. Our results, using 138 buybacks over the period 1996–2003, support our prediction. We find that buyback firms with both exercisable options that are in‐the‐money prior to the buyback announcement as well as options that are exercised in the buyback period have higher discretionary current accruals than buyback firms with no exercisable options, unexercised options or with out‐of‐the‐money options. Overall, our results are consistent with buyback firms with exercisable options using earnings management and buyback announcements to maximize option payoffs, and buyback firms without exercisable options signalling undervaluation.

MANAJEMEN LABA MELALUI AKRUAL DAN AKTIVITAS REAL PADA PENAWARAN PERDANA DAN HUBUNGANNYA DENGAN KINERJA JANGKA PANJANG (STUDI EMPIRIS PADA BEJ)

This study investigates 149 Initial Public Offering (IPO) in Jakarta Stock Exchange (JSX) from 1994 up to 2003. In general, this study is aimed to prove whether firms opportunistically manage earnings in the period o f IPO. Specifically this study examines the effect o f earnings management on firm s’ long term performance and provides explanation as well as comparison o f several measures o f earning management and long-term performance. In this study, earnings management is measured by two accrual variables which are discretionary current accruals and discretionary long term accruals and by two var iables o f discretionary real activities through Cash Flow from Operation (CFO) and Cost o f Goods Sold (COGS). In addition, the underperformance phenomenon is measured by market performance (Cumulative Abnormal Return and Buy and Hold Return method) for periods 1 years after IPO, 2 years after IPO and 3 years after IPO ’s date. The hypothesis testing used in this thesis are t test and multiple regression models. The results show (1) earnings management is conducted through accruals but not through real activities manipulation and (2) earnings management affects stock performance 1 year after IPO. Finally this research finds that there is no difference in stock performance for IPO issuers with aggressive and conservative earnings management.

Legal Systems and Earnings Quality: The Role of Auditor Industry Specialization

This paper extends prior studies in auditor industry specialization to an international setting and examines if the impact of industry specialist auditors on earnings quality is dependent on the legal environments. Using data for 28 countries over 20 industries from 1993 to 2003, we find that clients of industry specialist auditors have lower discretionary current accruals and higher earnings response coefficients than clients of nonspecialist auditors. In addition, we find that the impact of auditor industry specialization on earnings quality increases as the legal environment weakens. Collectively, the results suggest that the benefits from engaging the services of industry specialist auditors increase as a country's legal environment shifts from a strong to a weak environment. Our results are robust to the inclusion of additional control variables.

Firm diversification and earnings management: evidence from seasoned equity offerings

Popular press suggests that diversified firms are more aggressive in managing earnings than non-diversified firms. We examine this claim in the seasoned equity offering (SEO) setting, where firms have been shown to have the incentive to manage earnings upwards. Using the cross-sectional modified Jones [(1991) J Accounting Res 29:193–228] model to measure discretionary current accruals, we find that discretionary current accruals are higher among diversified firms than in non-diversified ones. Our evidence is consistent with the view that the extent of firm diversification is directly related to the degree of earnings management. We further show that diversified issuers with high discretionary accruals underperformed other SEO firms.