Earnings Management Activities Research Articles

The Effect of Institutional and Cultural Factors on the Perceptions of Earnings Management

ABSTRACT: In this study we examine the effect of stakeholder orientation versus shareholder orientation, and the level of cultural secrecy on individuals’ perceptions of earnings management practices. Examining perceptions from 1,260 participants from 13 countries indicates that individuals from stakeholder-oriented institutional backgrounds were less accepting of earnings management, including both accounting earnings management and operating earnings management activities, than participants from shareholder-oriented institutional backgrounds, and that individuals from secretive cultures were more accepting of both types of earnings management activities. Our findings provide evidence of the anticipated perceptual differences across countries with respect to earnings management and suggest the need for further research linking perceptions to reported earnings management measures.

Forced Audit Firm Change, Continued Partner-Client Relationship, and Financial Reporting Quality

SUMMARY: This study extends Blouin et al. ([BGR] 2007) by providing partner-level evidence regarding the effect of continued auditor-client relationships on financial reporting quality over a three-year post-switch period. Using a sample of forced audit firm changes in China where the identities of leading audit partners are available, we find that, consistent with BGR (2007), clients with greater earnings management activities are more likely to follow their former audit partners to a new audit firm, and aggressive follower clients who are audited by former partners are less likely to report abnormally high earnings management items in the first post-switch year. Moreover, we find that the financial reporting of aggressive follower clients who continue to be audited by former partners becomes significantly more aggressive in the next two post-switch years; while aggressive follower clients who are audited by non-former partners do not exhibit a similar pattern in the three post-switch years. Our findings indicate that the former partner conservatism as suggested by BGR (2007) may be temporary in nature, and former partners may adopt a strategic approach to auditing follower clients to realize the opportunistic benefits of maintaining a close partner-client relationship.

The “Numbers Game” in the Pre- and Post-Sarbanes-Oxley Eras

We address two research questions in this study. First, is there a change in the prevalence of expectations management to meet or beat analysts' earnings expectations in the aftermath of the 2001–2002 accounting scandals and the passage of the 2002 Sarbanes-Oxley Act (SOX)? Second, did the mix among the three mechanisms used for meeting or beating analysts' earnings expectations: accrual-based earnings management, real earnings management, and expectations management change in the Post-SOX period? We hypothesize and provide empirical evidence that the observed drop in the frequency of just meeting or beating analysts' earnings expectations is associated with both (1) a decline in the use of downward expectations management and upward accrual-based earnings management in the Post-SOX period relative to the preceding seven-year period and (2) an increase in upward real earnings management activities.

An Empirical Analysis of Earnings Management in Australia

This is a comprehensive large-sample study of Australian earnings management. Using a sample of 4,844 firm-year observations across nine Australia industries from 2000 to 2006, we find substantial corporate earnings management activity across several Australian industries. We document strong evidence of size and return on assets being primary determinants of earnings management in Australia. The effects of size and return on assets are also found to be dominant in both income-increasing and income-decreasing earnings manipulation. We also document that that periphery sector firms are more likely to involve larger magnitude of earnings management than firms in the core sector.

Earnings management and firm financial motives: A financial investigation of UK listed firms

This study focuses on the investigation of motives for and characteristics of UK firms that engage in earnings management activities. It concentrates particularly on the provision of voluntary accounting disclosures, the violation of debt covenants, management compensation, and on the equity and debt capital needs of firms and their relation with the use of earnings management. The study examines also the earnings management inclination of firms that seek to meet or exceed financial analysts' forecasts. The findings generally indicate that firms with low profitability and high leverage measures are likely to use earnings management. Also, firms that are in equity and debt capital need and are close to debt covenant violation also appear to be inclined to employ earnings management practices. Likewise, firms tend to use earnings management to improve their financial numbers and subsequently reinforce their compensation and meet and/or exceed financial analysts' earnings forecasts. In contrast, the study shows that firms that provide voluntary accounting disclosures appear to be less inclined to make use of earnings management.

Pengaruh Rasio Camel terhadap Praktik Manajemen laba di Bank Syariah

The purpose of this study is to investigate earnings management in shariah banks and the effect of CAMEL ratios on earnings management. Our samples consist of 21 shariah banks, consist of Shariah Bank (Bank Umum Syariah/BUS) dan 18 Shariah Business Unit (Unit Usaha Syariah/UUS) at years 2004-2006. Our results show that on average, there is no significant earnings management practice (measured using discretionary accruals) in shariah banks, and CAMEL ratios do not have significant effect on earnings management, except NPM which has positive and significant effect. This indicates that although in average there is no earnings management in shariah banks, bank’s profitability encourage management to involve in earnings management activity. This study finds evidence that earnings management in BUS is significantly higher than that UUS.

Insider trading by directors and seniors officers before seasoned equity offerings

An important aspect of corporate governance is how directors discharge their duty to shareholders as monitors of management’s opportunistic behavior. The insider trading by officers and directors before seasoned equity offerings (SEO) provide an opportunity to examine this issue, because insiders’ sales of the firm’s stock are incongruent with the objective of the firm to maximize the proceeds of the SEO. Since the market is aware that firms attempt to inflate their proceeds by managing earnings upwards, these trades may signal that the stock is overvalued. In this study, we compare the earnings management activity and the corresponding market response to earnings management and sales by senior officers and directors. We study a sample of 233 firms that conducted SEOs in the 1987-2004 period and either their directors and/or their senior officers traded in the firm’s shares. We find that 15% have insider trading by directors only, and 85% by both directors and senior officers. The market discounts the insider trading at the issuance date (the discount increases in the volume of insiders sales), but it treats insider trading by directors as a favorable signal that reduces the discount. Our study then identifies two ways directors monitor opportunistic insider trading before SEO. One is to ban it, as evident by the fact that under our selection criteria, 791 firms conducted SEOs in the 1987-2004 period. The other is to trade too as a positive signal to the market.

Auditor reporting and earnings management: some additional evidence

AbstractThis paper investigates the reasons that lead to modification of auditors’ opinions. We revisit the conclusions of prior US‐based research on whether a modification highlights likely earnings management activities. Extending this research, we consider an alternate explanation that managers adjust accruals to report earnings that better predict future firm performance, which has the side‐effect of placing them in conflict with their auditors. Our study sample comprises all firms listed on the Australian Stock Exchange over the period 1999–2003. Consistent with prior research, there is no evidence of earnings management leading to an audit opinion modification. However, we do show that firms receiving inherent uncertainty modifications (other than going concern) have greater persistence of earnings (accruals) relative to other firms. This is consistent with the proposition that managers have made policy choices in reporting current earnings, with which their auditors disagree, that will likely result in a greater ability to forecast the firm's future earnings.

Managerial Discretion and Bias in Annual Forecast Errors

Abarbanell and Lehavy (2003a) empirically link abnormal accruals to two asymmetries in the forecast error distribution (i.e., a high incidence of extreme negative forecast errors and a high incidence of small positive errors) and identify two alternative explanations: (1) that analyst bias is differentially exacerbated by abnormal accruals, or (2) managerial discretion introduces a bias in reported earnings that analysts are unable or unwilling to incorporate in their forecasts. For the lower tail asymmetry, we test these competing hypotheses using forward and reverse regressions that relate contemporaneous forecasts and reported earnings conditional on various earnings components (i.e., cash flow, normal and abnormal accruals). We fail to find that analyst forecast bias is exacerbated by large abnormal accruals. However, our evidence is consistent with analysts being unable or unwilling to forecast managerial discretion in reported earnings, particularly non-current abnormal accruals, which contributes to the frequency of large negative forecast errors. Alternatively, applying the methodology in Abarbanell and Lehavy (2003a) to the middle asymmetry issue, we show that abnormal accruals do not uniquely contribute to firms just beating analysts' forecasts. Further, using an alternative methodology, we fail to find that abnormal accruals contribute to the middle asymmetry. Rather, we find evidence that both income-increasing real earnings management activities and analyst inefficiencies are likely contributors to the middle asymmetry phenomenon.

Book-Tax Differences, Uncertainty about Fundamentals and Information Quality, and Cost of Capital

Prior research suggests that differences between book and taxable incomes reflect firms' underlying economic fundamentals and their earnings management activities. We investigate the extent to which book-tax differences (BTDs) explain differences in cost of equity capital across firms. Our analysis spans the 1982-2006 period. The results indicate that variability in BTDs estimated over five or six years is positively and significantly related to cost of equity capital (estimated in various ways), whereas other BTD variables generally are not. These findings are consistent with variability in BTDs over time capturing information regarding uncertainty about firms' economic fundamentals and uncertainty about the quality of their earnings. If we assume that only a relatively short time-series of data is available, then we find that the absolute value of BTDs is positive and significantly related to cost of capital.

Substitution, availability and preferences in earnings management: empirical evidence from China

Our study analyzes financial reporting data on earnings management from a rapidly changing economy—the PRC. Some Chinese regulatory reforms allow for an easy identification of incentives to engage in both accounting and real earnings management activities. In addition, straightforward economic reasoning suggests that firms incur different costs for pursuing these strategies, which leads to the possibility of a hierarchy or ranking of different earnings management practices. Our results show that accounting and real earnings management activities were significantly higher for firms in danger of missing a regulation imposed performance threshold. After controlling for the availability of the different instruments, our results provide weak evidence for a ranking of different earnings management activities.

Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods

We document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual-based to real earnings management methods after the passage of SOX. We also document that the accrual-based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we find that firms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar firms before SOX. In addition, our analysis provides evidence that the increases in accrual-based earnings management in the period preceding SOX were concurrent with increases in equity-based compensation. Our results suggest that stock-option components provide a differential set of incentives with regard to accrual-based earnings management. We document that while new options granted during the current period are negatively associated with income-increasing accrual-based earnings management, unexercised options are positively associated with income-increasing accrual-based earnings management.

The Role of Disaggregated Accounting Data in Detecting and Suppressing Earnings Management

Though ample empirical evidence alludes to the importance of disaggregated accounting data in the context of earnings management, extant accounting theory considers biases in reporting earnings mostly at the aggregated level of the reported earnings. By analyzing reporting manipulations at the disaggregated level of the earnings report, this study highlights the essential role that disaggregated accounting information plays in detecting and suppressing earnings management activities. Disaggregated accounting information is shown to be especially effective in this role when it consists of components that are tightly interrelated by their fundamental economic nature and highly diverse in their sensitivity to reporting manipulations.

Accrual-Based and Real Earnings Management Activities Around Seasoned Equity Offerings

We examine earnings management behavior around SEOs, focusing on both real activities and accrual-based manipulation. Although research has addressed the issues of earnings management around SEOs and earnings management via real activities manipulation, ours is the first paper to put these two issues together. We make three contributions to the literature. First, we document that firms use real, as well as accrual-based, earnings management tools around SEOs. Second, we show how the tendency for firms to tradeoff real versus accrual-based earnings management activities around SEOs varies cross-sectionally. We find that firms choices vary predictably as a function of the firms ability to use accrual management and the costs of doing so. Our model is a first step in examining how firms tradeoff between real versus accrual methods of earnings management. Third, we compare the economic costs of accrual versus real earnings management around SEOs, by examining the effect of each type of earnings management on the firms future performance. We provide the first evidence on this important issue by showing that the costs of real earnings management are likely greater than the costs of accrual earnings management, at least in the SEO context.

Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk: To Conform or Not to Conform?

Prior research has separately examined pretax earnings management activities that have current taxable income consequences (book-tax 'conforming earnings management') and those that do not have current taxable income consequences (book-tax 'nonconforming earnings management'). Our study documents the prevalence of, and then investigates the firm-specific characteristics that impact the choice between, these earnings management strategies. We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed earnings upward. We find that nonconforming earnings management is more prevalent and that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management. In particular, firms having NOL carryforwards, using a high quality auditor, or engaging in the most egregious misstatements rely less on nonconforming earnings management strategies. We also find that book-tax differences are useful in predicting restatements.

Managerial Opportunism, Cost of Debt Financing and Regulation Changes: Evidence from the Sarbanes-Oxley Act Adoption

This paper investigates the impact of managers’ opportunism on the cost of debt financing. Using managerial entrenchment and earnings management activities to proxy for managers’ opportunism, we find that firms with less entrenched managers enjoy lower corporate bond costs and higher credit ratings. In addition, our results suggest that bondholders generally require higher bond costs, while rating agencies assign lower credit ratings to firms that inflate their earnings (i.e. income-increasing earnings management). We further investigate the role of the Sarbanes-Oxley Act adoption on the perceptions of these two debt market actors. We find strong evidence that the dramatic changes required by this Act have enhanced the “monitoring” role of the debt market since we document that the above results are generally observed only for the post-SOX period.

External Auditors, Audit Committees and Earnings Management in France

ABSTRACT We investigate the effect of various audit quality dimensions (i.e. auditor reputation and tenure, audit committee existence and independence) on earnings management in France. We thus contribute to the empirical audit quality literature in a Continental European environment that markedly differs from the USA in terms of auditing and corporate governance. The main findings are that: (1) the presence of an audit committee (but not the committee's independence) curbs upward earnings management; and (2) the presence of a Big Five auditor makes no difference regarding earnings management activities. Implications of these findings are discussed with regard to the specificities of the French auditing and governance settings. In particular, although the audit committee acts as a device to control the more egregious (i.e. income-increasing) forms of earnings management, the monitoring incentive of outside directors may be hampered by the collective board responsibility for financial reporting quality. Second, the lack of differentiation among Big Five auditors in terms of accounting conservatism is consistent with the lower litigation risk offered by the French Civil Code (vs. the US Common Law system), which is likely to eliminate the deep pockets incentive for investors.

Profits versus Losses: Does Reporting an Accounting Loss Act as a Heuristic Trigger to Exercise the Abandonment Option and Divest Employees?

The binary classification of firms into profits or losses represents a powerful heuristic. The literature that has examined the impact on the firm of this earnings heuristic has focused on the earnings management actions of small profit firms. The impact of this earnings heuristic on the actions of firms reporting accounting losses and the decision-making effects the heuristic may have other than earnings management have not been examined. In this study we hypothesize that reporting an accounting loss acts as a heuristic trigger for firms to exercise the abandonment option and discard unproductive investments. The results are consistent with the hypothesis. We find that there is a sharp and economically significant discontinuity around zero in the level of investment in labor between small profit and small loss firms. The discontinuity is due to loss firms having a lower-than-expected level of investment in labor, given their economic fundamentals. Further tests show that this discontinuity is due to the exercise of the abandonment option. We find that firms switching from a profit to a loss cut labor to a greater extent than other firms with similar changes in earnings that do not pass the loss threshold. Taken together the results are consistent with the accounting loss heuristic acting as a major disciplinary or incentive altering event that resolves agency problems.

Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk: To Conform or Not to Conform?

ABSTRACT: Prior research has separately examined pretax earnings management activities that have current taxable income consequences (book-tax “conforming earnings management”) and those that do not have current taxable income consequences (book-tax “nonconforming earnings management”). Our study documents the prevalence of, and then investigates the firm-specific characteristics that impact the choice between, these earnings management strategies. We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed earnings upward. We find that nonconforming earnings management is more prevalent and that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management. In particular, firms having NOL carryforwards, using a high-quality auditor, or engaging in the most egregious misstatements rely less on nonconforming earnings management strategies. We also find that book-tax differences are useful in predicting restatements.

Earnings management and board activity: an additional evidence

PurposeThe purpose of this paper is to examine the relation between earnings management behavior and the activity of both the board and audit committee.Design/methodology/approach – Different models to isolate abnormal accruals as a proxy for earnings management are applied to a sample of manufacturing companies.FindingsEarnings management is negatively related to both board and audit committee independence. Such negative relation is stronger when the audit committee is more active. However, this result is not valid for the board activity.Research limitations/implicationsResults are limited by the accuracy of the models applied to isolate abnormal accruals.Practical implicationsResults may have implications for corporate governance regulations such as board composition, audit committee composition, and their activity.Originality/valueResults of earnings management research are sensitive to the different models suggested in literature to isolate the abnormal accruals.