Discretionary Current Accruals Research Articles

Auditor Independence: Evidence on the Joint Effects of Auditor Tenure and Nonaudit Fees

This study examines whether the impact of nonaudit fees on auditor independence is contingent on auditor tenure. The results, based on a sample of 4,720 U.S. firms for the years 2000 and 2001, show that there is a positive association between nonaudit fees and positive discretionary current accruals, a proxy for auditor independence, for firms with short auditor tenure of not more than three years. These findings suggest that nonaudit fees may impair auditor independence when auditor tenure is short and not when auditor tenure is long. Furthermore, exploratory analyses show that the positive association between nonaudit fees and earnings management for firms with short auditor tenure is significant for small clients but not for large clients. Taken together, these results suggest that the association between nonaudit fees and auditor independence is contingent upon auditor tenure, and that high nonaudit fees have a negative impact on auditor independence when audit tenure is short and client firm size is small.

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.

Overvalued Equity and Discretionary Accruals

This paper provides evidence consistent with the overvaluation hypothesis (Jensen 2005). We categorize firms as overvalued if they are in the top quintile based on beginning of year price-earnings ratio, prior year abnormal return, or a classification technique that uses both the lagged price-earnings ratio and abnormal return. Under the overvaluation hypothesis, overvalued equity provides a strong incentive for managers to present an earnings number that does not disappoint the market. Using annual data from 1990 to 2005, we find that overvalued firms have significantly higher discretionary current accruals in the year following their classification as overvalued. Moreover and again consistent with the overvaluation hypothesis, we find that (a) the negative association between discretionary accruals and operating cash flows is more pronounced for overvalued firms and (b) the positive association between discretionary accruals and an indictor variable that captures whether discretionary accruals were necessary to beat last year's earnings target is also more pronounced for overvalued firms. To reinforce our interpretation of the findings as evidence of reduced earnings quality for overvalued firms, we show that audit quality proxied by whether a firm uses one of the Big N auditors has the effect of diminishing rather than reinforcing the negative (positive) association between discretionary accruals and operating cash flows (earnings target indicator variable).

Earnings Management, Corporate Governance and the Market Performance of Seasoned Equity Offerings in Hong Kong

This paper examines the use of discretionary current accruals by firms that make seasoned equity offers (SEOs). We find evidence suggesting that firms borrow future income to manage earnings in pre-issue years and consequently earnings decrease in post-issue year 2. However, we find no evidence that pre-issue discretionary accruals affect future stock returns. We find evidence that family-owned firms are more likely to use positive discretionary accruals prior to making an SEO, independent directors and outside blockholders constrain earnings management in family-controlled firms and SEO firms that have a larger board size have a higher degree of earnings management around SEOs.

Earnings Management and Stock Performance of Reverse Leveraged Buyouts

AbstractThis study provides further evidence of earnings management around security offerings. We find positive and significant discretionary current accruals coincident with offerings of reverse LBOs. Issuers in the most aggressive quartile of earnings management have a one-year aftermarket return that is between 15% and 25% less than the most conservative quartile. We also find a negative and significant relation between abnormal accruals and post-issue abnormal returns within the first year after the offering. The relation remains after controlling for book-to-market ratio, firm size, offering size, and involvement of buyout specialists or management. Although earnings management has been used to explain post-issue long-term underperformance of IPOs and SEOs, our study shows that earnings management can explain post-offering returns of reverse LBOs, even in the absence of post-offering underperformance.

The impact of tax holidays on earnings management: An empirical study of corporate reporting behavior in a developing-economy framework

This study investigates whether foreign investment enterprises (FIEs) in China alter their corporate reporting behavior in response to a known schedule of tax-rate increases. The context of this investigation is a tax-incentive scheme that allows firms to pay taxes at a reduced rate for a limited period of time, and then at a higher rate when this period expires. If managers attempt to maximize firm value by minimizing tax costs, then the spread of tax rates in the periods surrounding the rate change may provide a substantial incentive for them to accelerate revenue and defer expenses. Consistent with this hypothesis, the empirical results indicate that firms report significantly higher discretionary current accruals for the years before tax-rate increases. The evidence, which indicates that firms manage earnings upward to take advantage of lower tax rates that are available in certain years, has important implications for tax policymakers.

Earnings Management, Corporate Investments, and Stock Returns

In this paper, we investigate the relation between accounting accruals and abnormal corporate investments and if the accrual-based anomaly documented by Sloan (1996) is distinct from the investment-based anomaly documented by Titman, Wei, and Xie (2004). Our results indicate that abnormal capital investments are positively associated with accounting accruals and that the mispricing of abnormal capital investments is distinct from the mispricing of discretionary current accruals. In addition, investors can earn substantially higher size-adjusted returns by exploiting both strategies at the same time than by exploiting each individual strategy alone. Finally, our result suggests that the stock market appears to overvalue both discretionary current accruals and abnormal capital expenditures.

To Swear Early or Not to Swear Early? An Empirical Investigation of Factors Affecting CEOs' Decisions *

On June 27, 2002, the SEC ordered the CEOs and CFOs of public companies with revenues during their last fiscal year of greater than $1.2 billion to file written statements, under oath, regarding the accuracy of their companies' financial statements. The SEC's order required the sworn statements to be filed with each company's next periodic disclosure report to the SEC due on or after August 14, depending on the company's fiscal year-end. The Sarbanes-Oxley Act which requires all public companies to file CEO certification can be seen as a continuation of the June 27, 2002 SEC order. Many companies elected to file sworn statements prior to the specific filing deadlines for their companies in response to the June 27, 2002 SEC order. Given the importance of CEO certification, we examine the characteristics and incentives of companies that certified their financial reports prior to the deadline set by the SEC. Using regression analysis, logit analysis, and the Cox proportional hazards model, we find that larger firms, firms with higher earnings quality (measured as firms with lower current discretionary accruals or total discretionary accruals), and firms with higher levels of institutional holdings filed sworn statements early. These results are consistent with our theoretical predictions and contribute to our understanding of factors affecting firms' responses to regulatory requirements.

Seasoned Capital Offerings: Earnings Management and Long-Run Operating Performance of Indian Firms

The present study examines the behavior of seasoned offering firms surrounding their issue period for the capital issues offered during the period 1995-96 to 1998-99. Analysis of earnings management practices of firms though show apparent differences in terms of discretionary current accruals between issuers and non-issuers as well as between debt issuers and equity issuers, these differences are not statistically significant. This finding is consistent with Korean findings of Yoon and Miller (2002). Perhaps earnings management is all pervasive and is not just confined to seasoned offering firms in emerging markets unlike the markets in developed countries. Analysis of adjusted operating performance of firms show important differences for equity offering and debt offering seasoned firms. Similarly earnings management appears to have negative impact on the immediate post-issue operating performance while in the long-term it appears to have a positive impact for equity issuers. The latter result contradicts the findings of Rangan (1998) and Teoh et, al (1998). Analysis of influence of earnings management on stock market performance of seasoned offerings shows insignificant role of discretionary current accruals in explaining post-issue stock returns. Similarly analysis of determinants of SEO decision shows that run up in adjusted operating performance prior to offer has no impact - thus contradicting the view that seasoned offerings are timed to meet better operating performance - and that information asymmetry has positive influence on the decision to issue seasoned equity.

Do Insiders Manipulate Earnings When They Sell Their Shares in an Initial Public Offering?

ABSTRACTIn this article we examine whether insider share selling in an initial public offering (IPO) influences R&D expenditures. Insiders (managers and venture capitalists) who sell their pre‐offering shareholdings might try to increase the IPO offer price (1) by overinvesting in R&D to signal the firm's prospects (the signaling hypothesis) or (2) by underinvesting in R&D to increase current reported earnings (the earnings fixation hypothesis). We find that, for a sample of 243 IPOs from 1986 to 1990, change in R&D spending in the year of the IPO is negatively related to managerial selling. Because reductions in R&D spending increase current earnings at the expense of future earnings, our evidence suggests that managers believe that investors place more emphasis on current earnings and less emphasis on R&D and therefore spend less on R&D. We also document a positive association between discretionary current accruals in the offering year and managerial selling, suggesting that selling managers manipulate accruals as well.

Audit quality and earnings management by seasoned equity offering firms

We investigate the relationship between audit quality as measured by audit firm size and industry specialisation, and earnings management as measured by discretionary current accruals, for companies making seasoned equity offerings (SEOs). Earnings management in the SEO process is of concern because of the underperformance of seasoned equity offering firms. We find evidence that Big 5 auditors are associated with lower earnings management in the years before, during, and subsequent to the SEO. Industry specialist auditors are associated with lower earnings management only in the year of the SEO. Our study contributes to the literature by demonstrating that audit quality reduces earnings management by SEO companies, and that industry specialisation, as a measure of audit quality, also constrains earnings management.

Insider sales and earnings management

This study examines the relationship between managers’ insider transactions and their strategic behavior on earnings management. Prior literature provides a theoretical basis to empirical studies of insider trading and earnings management ( Elitzur and Yaari, 1995; Trueman, 1990; Bar-Gill and Bebchuk, 2003). We predict that managers adjust discretionary accruals (DAs) to increase current-period earnings before they sell their own firms’ shares in the subsequent period. Our empirical results support that current discretionary accruals are higher for firms whose managers sell their ownership in the subsequent period than for other firms, indicating that managers of insider sales firms would have deliberately increased current-period earnings through DAs. However, the observed positive relationship between DAs and insider sales can also be explained such that managers may have adopted passive and opportunistic strategies by trading their shares after higher earnings are reported regardless of earnings manipulation. To address this causality issue, this study employs simultaneous equations approach. The two-stage least square estimation shows that our test results are insensitive to controlling for the possibility that managers time their transactions after observing unusually high accruals. We also find that, after accruals manipulation and insider sales, stock prices tend to be adjusted downward in the future and that current high discretionary accruals induced by the insider sales have an incremental explanatory power in explaining the post-transaction stock underperformance.

Do Insiders Manipulate Earnings when they Sell their Shares in an Initial Public Offering?

In this article we examine whether insider share selling in an initial public offering (IPO) influences R&D expenditures. Insiders (managers and venture capitalists) who sell their pre-offering shareholdings might try to increase the IPO offer price (1) by overinvesting in R&D to signal the firm`s prospects (the signaling hypothesis) or (2) by underinvesting in R&D to increase current reported earnings (the earnings fixation hypothesis). We find that, for a sample of 243 IPOs from 1986 to 1990, change in R&D spending in the year of the IPO is negatively related to managerial selling. Because reductions in R&D spending increase current earnings at the expense of future earnings, our evidence suggests that managers believe that investors place more emphasis on current earnings and less emphasis on R&D and therefore spend less on R&D. We also document a positive association between discretionary current accruals in the offering year and managerial selling, suggesting that selling managers manipulate accruals as well.

Stock Option Exercise, Earnings Management, and Abnormal Stock Returns

This essay uses a large sample to examine whether stock option plans provide incentives to executives to manage earnings when exercising their options. The evidence presented is consistent with a hypothesis where managers use accruals to shift earnings to increase the stock price prior to and during option exercise periods. However, the results indicate that the magnitude of earnings management related to stock options may be limited. Reported income peaks at the earnings announcement immediately preceding option exercise activity and is followed by both reversals in income and discretionary accruals as well as negative abnormal stock returns during the post-exercise period for up to one year. Current discretionary accruals range from 0.3% to 0.62% of assets, depending upon the accrual model, during the quarterly earnings announcement immediately preceding option exercise activity. Over the two quarters following option exercise, sample firms experience small but statistically significant reversals in discretionary accruals and on average experience negative abnormal returns of approximately -3%. The magnitude of the return reversals is shown to be cross-sectionally positively related to the magnitude of the pre-exercise discretionary accrual proxies, even after adjusting for the Sloan anomaly. I find similar evidence for a sample of firms that experience option expiration but weaker evidence of earnings management for stock sales unrelated to stock option exercise.

Earnings management and initial public offerings: Evidence from the Netherlands

This paper presents one of the first studies of earnings management by initial public offering (IPO) firms in a European country. Using a sample of 64 Dutch IPOs, we investigate the pattern of discretionary current accruals (DCA) over time. We find that managers manage their company's earnings in the first year as a public company but not in the years before the IPO. We also examine the impact of earnings management on the long-run stock price performance of IPOs. We find a negative relation between the size of the DCA in the first year as a public company and long-run stock price performance over the next 3 years. A number of additional tests support these findings.

Earnings Management Around Share Repurchases: A Note

This work examines a subset of the important area of earnings management. Specifically, it seeks to identify the extent of earnings management preceding self‐tender offers for a sample of U.S. firms. Pre‐repurchase total accruals and discretionary current accruals were found to be somewhat lower for a sample of self‐tendering firms compared to a sample of industry‐ and performance‐matched control firms. Weak evidence of post‐buyback accruals reversal is also presented. The evidence is weakly consistent with the notion that share repurchases are employed by managers to exploit shareholders through earnings management.

Earnings Management, Corporate Governance and the Market Performance of Seasoned Equity Offerings

This paper examines whether pre-issue discretionary current accruals predict post-issue earnings performance and returns. We find evidence suggesting that offering firms borrow future income to manage earnings in pre-issue years and consequently earnings decrease in post-issue year 2. The information content of pre-issue discretionary current accruals is reflected in one-year buy and hold abnormal returns for the rights offering firms. Our paper also examines whether the incidence of earnings management around SEOs depends on corporate governance structures. Our results show that SEO firms that have larger board size have a higher degree of earnings management around SEOs. This result is consistent with Jensen's (1993) view that smaller boards provide more of a controlling function than do larger boards.

The Long-Run Underperformance of Post-Listing Stock Returns: The Evidence of Earnings Management

This paper explores the puzzle of underperformance during post-listing period by investigating whether managers manipulate earnings before their stocks switch from the NASDAQ to the NYSE and the AMEX, and from the AMEX to the NYSE during the period 1990-1997. Evidence indicates that managers manipulate earnings during the year prior to having their stocks switch to new trading locations. I find a negative relationship between pre-listing discretionary current accruals and subsequent earnings changes and stock returns. Such negative relationship is specially pronounced for small-and-aggressive firms than large-and-conserve firms. The negative relationship remains even after controlling the potential bias for high-performance firms and is common to all switching firms, especially for those switching to the NYSE.

Do Nonaudit Services Compromise Auditor Independence? Further Evidence

This paper challenges the findings of Frankel et al. (2002) (FJN). The results of our discretionary accruals tests differ from FJN's when we adjust discretionary current accruals for firm performance. In our earnings benchmark tests, in contrast to FJN we find no statistically significant association between firms meeting analyst forecasts and auditor fees. Our market reaction tests also provide different results than those reported by FJN. Overall, our study indicates that FJN's results are sensitive to research design choices, and we find no systematic evidence supporting their claim that auditors violate their independence as a result of clients purchasing relatively more nonaudit services.

Earnings Management and Executive Compensation: A Case of Overdose of Option and Underdose of Salary?

We present and test hypotheses about how the components of compensation influence earnings management behavior. Hypotheses are based, in part, on the observation that discretion over accounting accruals gives managers a potentially valuable timing option that will lead to strategies for maximizing their compensation. Our empirical analysis shows that earnings management intensity, as measured by the absolute value of discretionary current accruals scaled by asset size, is related to managerial compensation contract design. We find the amounts of stock options and bonuses, and the incentive intensity of stock options, are positively related to earnings management intensity, whereas salaries are negatively related. Results do not reliably support either positive or negative effects of long-term incentive plans or restricted stock compensation on earnings management intensity, aside from the incentive intensity effect of restricted stock. We show that magnitudes of the effects of some compensation variables on earnings management intensity are conditional on proximity of premanaged earnings to specified targets. The importance of our findings is the strong evidence they provide that compensation contract design does influence earnings management, and that the influences of the various compensation components appear to be largely predictable on a presumption that (at least some) managers behave opportunistically.