Income-increasing Earnings Management Research Articles

Asymmetry in Earnings Management Surrounding Targeted Ratings

This study examines earnings management among financial institutions attempting to achieve a target financial strength rating. We find empirical evidence that firms with an actual rating below their target rating use income-increasing earnings management, however we find no evidence that firms above their target rating manage earnings. Our result is consistent with financial institutions facing less pressure from unions and suppliers, but more pressure from regulators, relative to non-financial institutions. Our findings are robust to a variety of alternative definitions of target rating. Notably, we examine a subset of firms with an exogenously determined target rating and find consistent results. We also find evidence that firms can influence ratings agencies, as firms that underestimate their initial claims are more likely to receive a rating upgrade.

Earnings management, corporate governance, and ownership structure of Philippine initial public offerings

Prior studies examined the effect of corporate governance variables on discretionary current accrual, the most widely used measurement of earnings management. The principal-agent conflict implies that the size of the board, the percent of independent directors, CEO duality, and auditor prestige limit discretionary current accruals (DCA). This paper extends past studies by examining the effect of ownership structure on discretionary current accruals. The study determines the level of income-increasing earnings management of initial public offerings (IPOs) in the Philippines and the factors that explain it. Particularly, the paper examines the effect of ownership concentration and largest shareholder ownership on discretionary current accruals. The study uses a final sample of 105 IPO firms in Philippine Stock Exchange (PSE) from 2008 to 2018. Employing the modified Jones’s (1991) model to measure discretionary current accrual and multiple regression analysis, the study finds -4.19% discretionary current accrual on the average. It also reveals that the 2002 Philippine Code of Corporate Governance (PCCG) is ineffective in curbing earnings management. In addition, there is an insignificant relationship between the size of the board, CEO duality, ownership concentration, largest shareholder ownership and auditor prestige, and earnings management. Furthermore, the paper finds a significant relationship between the percent of independent directors, industry sector, return on assets (ROA) and cash flow from operations and earnings management.

Dividends and tax avoidance as drivers of earnings management: Evidence from dividend-paying private SMEs in Finland

ABSTRACT Using a sample covering practically all dividend-paying small and medium-sized private companies in Finland during 2006–2010, we document that earnings management in these companies is driven by two concurrent forces: the willingness to pay (tax-exempt) dividends and avoiding unnecessary company income tax. Moreover, we show that the need for income-increasing earnings management enabling current dividend distribution is mitigated by the amount of retained earnings from prior years. This article adds to the existing literature by providing empirical evidence for dividend and tax-driven earnings management in private SMEs facing neither political pressures nor capital market incentives for earnings disclosures.

Multilevel optimal managerial incentives and audit fees to limit earnings management practices

The main objective of this study is to design an optimal managerial compensation scheme and optimal auditor fees to counter income-increasing earnings management behavior. This study draws on game theory with three players: the shareholders, managers and auditors. It considers the possibility of collusion between the manager and auditor and analyzes the different scenarios that may exist between the three players. The results of our study prove that it is possible to establish an optimal managerial compensation contract and optimal auditor fees which will limit earnings management manipulation and guarantee high audit quality. We found that the optimal managerial compensation scheme depends on the firm situation. Moreover, we illustrated how the auditor is motivated by improving audit effort in all possible scenarios. This paper can be considered a tentative effort to provide systematic evidence for designing optimal contracts that align divergent interests between managers and shareholders.

Surplus Free Cash Flow, Stock Market Segmentations and Earnings Management: The Moderating Role of Independent Audit Committee

Management engages in earnings manipulation for different reasons. This article argues that low-growth firms with high free cash flow will opt for income-increasing earnings management in order to obscure the low profits derived from their investments in negative net present value (NPV) projects. On the other hand, we argue that the listed companies might be interested in being listed in the first market due to its privileges and to preserve the competitiveness, through managing their earnings upwardly, so that they can satisfy the condition of achieving a particular earnings limit. This article should advance the body of earnings management literature in the Jordanian context by examining the effect of the moderating role of an independent audit committee (IAC) in the association between surplus free cash flow (SFCF) and income-increasing discretionary accruals (DAC). Further, this is the initial empirical attempt to investigate the moderation effect of IAC between stock market segmentations (SMS) and positive DAC. The results of this current study offer original and beneficial information for the Jordanian government and other countries with a similar institutional environment because the study promotes the application of applying IAC as an efficient tool to constrain management behaviour towards manipulation of the accruals. On top of that, this research offers information concerning the prevailing situation of earnings management practices and corporate governance in Jordan, in which shareholders, local and international investors, policymakers, regulators and academic researchers are interested. Finally, panel data analyses and various statistical techniques are employed to derive conclusions.

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.

Financial Crisis and Earnings Management Under U.S. GAAP and IFRS

This paper examines the effects of the global financial crisis of 2008 on real and accrual-based earnings management activities of foreign companies listed in the United States as American Depositary Receipts (ADRs). The ADR firms are classified according to whether they report under U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Accrual-based earnings management is measured using the absolute value of performance-matched discretionary accruals. We also use the positive and negative values of performance-matched discretionary accruals to examine income-increasing and income-decreasing earnings management, respectively. Real earnings management proxies are measured using performance-matched measures of the abnormal levels of cash flow from operations, production costs, and discretionary expenses. In summary, our findings indicate no difference in accrual-based earnings management for ADRs reporting under IFRS and U.S. GAAP but suggest that ADRs reporting under IFRS are more likely to manage earnings using income-decreasing discretionary accruals and aggregate real earnings management than ADRs reporting under U.S. GAAP during the financial crisis.

The Impact of Surplus Free Cash Flow and Stock Market Segmentations on Earnings Management in Jordan: Agency - and Institutional - Theory Perspectives

The current research aims at providing evidence concerning the influence of surplus free cash flow (SFCF) and stock market segmentations (SMS) on income-increasing earnings management practices in Jordan. The results, based on a sample of all non-financial companies that were listed on the Amman Stock Exchange (ASE) from 2013 to 2017, confirm the research hypotheses. The Huber-White’s sandwich standard errors for randomeffects regression was used as the primary statistical tool for this study. The findings revealed a significant and positive association between SFCF and income-boosting discretionary accruals (DAC). As well, the results found that SMS was significantly and positively associated with the positive DAC. This research adds value to scholarship by investigating the impact of SMS variable on earnings management. To the best available knowledge, this relationship has not been examined either in Jordan or elsewhere in the world. Further, this is the first empirical attempt to investigate the effect of SFCF on earnings management in Jordan, which provides meaningful information for companies seeking to understand and reduce agency problems within the Jordanian context. KEYWORDS: Earnings management; DAC; surplus free cash flow; SFCF; stock market segmentations; SMS; agency theory; institutional theory; Jordan.

Earnings management prior to private debt issuance

PurposeThe purpose of this paper is to evaluate the extent to which firms manage earnings prior to private debt issuance.Design/methodology/approachThis is an empirical archival research paper using financial statement data and data related to private debt issuance.FindingsThe results indicate that, on average, firms engage in income-increasing earnings management in the period prior to a new private debt issuance. In addition, it was found that this income-increasing earnings management is limited to firms which have engaged in income-increasing earnings management to a greater extent in prior years.Research limitations/implicationsThis paper provides insight into how managers’ balance competing incentives to use income-increasing earnings management to obtain more favorable lending terms, and to use income-decreasing earnings management to reduce the risk of a future debt covenant violation. The results indicate that firms’ incentive to use income-increasing earnings management dominates. However, reputational concerns significantly constrain firms’ earnings management decisions prior to private debt issuance.Originality/valueThe paper fills a notable void in the literature by investigating firms’ earnings management activity prior to private lending agreements, and thereby provides new insights into both the relation between private debt and accounting quality, and the literature investigating the use of earnings management to avoid debt covenant violations.

Equity incentives, earnings management and corporate governance: Empirical evidence using UK panel data

Using a UK panel data set drawn from 1675 Chief Executive Officer (CEO) year observations and 1540 Chief Financial Officer (CFO) year observations, we examine the relationship between CEO and CFO equity incentives and earnings management. In addition, we examine the moderation effect of corporate governance mechanisms on the relationship between executives’ equity incentives and earnings management. We use multivariate regression models to test our hypotheses. We find that CEO equity incentives are related to higher absolute and income increasing earnings management. These results support the managerial power theory argument that CEOs exploit equity-linked compensation to obtain more personal benefits without causing public anger. Contrary to CEO equity incentives, we could not find any significant relationship between CFO equity incentives and any of the earnings management proxies. In addition, we find that corporate governance quality (measured by individual mechanisms and overall index) has no effect on the relationship between executives’ equity incentives and earnings management. This result indicates that whereas some corporate governance mechanisms can reduce earnings management in general, they do not affect wealth driven incentives to manipulate accruals. In total, results question the effectiveness of the corporate governance system in mitigating opportunistic behavior motivated by executives’ compensation structures

Dealing with Ethical Dilemmas: A Look at Financial Reporting by Firms Facing Product Harm Crises

A product harm crisis (PHC) undermines a firm’s reputation as well as its managers’ career outlook. To shake off the stigmatization resulting from the PHC and regain a firm’s legitimacy among stakeholders, managers usually face an ethical dilemma as they choose to be transparent about the crisis’ financial implications or to obfuscate them to neutralize the negative impact of the PHC. We find evidence that managers engage in income-increasing earnings management when their firms experience PHCs. Moreover, while income-increasing earnings management in PHCs reduces the likelihood of customer loss and CEO forced turnover in the short run, such behavior can be deemed opportunistic and unethical as it carries long-run negative consequences in terms of a higher likelihood of accounting restatement and weaker future operating performance. Finally, managers in firms that are subject to stricter external monitoring and managers in firms with proactive ethical policies are less likely to engage in upward earnings management in PHCs.

Pre-merger management in developing markets: The role of earnings glamor

For a broad, 16-year sample of mergers by Chinese listed firms, we document that income-increasing earnings management through both discretionary accruals and real activities in the year immediately preceding mergers significantly increases the probability of deal payment all or partially in stock. Concomitantly, in contrast to Western developed markets, we find these share-for-share bidders outperform pure-cash bidders during times close to deal announcements; while over longer periods of time, similar to Western markets, underperform pure-cash bidders. Our results are consistent with bidder pre-merger earnings management leading to market expectations reflecting an over extrapolation of bidders' past performance. We interpret our results as acquirer firms in the Chinese developing market being able take advantage of informational voids by signaling. In this case, exploiting a known bias toward “glamor” stocks identified for Western markets by consciously establishing earnings glamor. Results should be of great interest to scholars interested in how known aspects of Western financial systems may or may not be similar in environments of greater institutional voids.

Earnings management strategies during financial difficulties: A comparison between listed and unlisted French companies

This paper investigates and compares the earnings management strategies of listed and unlisted firms during situations involving financial difficulties. The evidence from a sample of 6407 French non-financial entities from 2009 to 2016 shows that, in the presence of severe financial problems, both listed and unlisted entities exhibit income-increasing earnings manipulation carried out through real activities rather than discretionary accruals. The findings consistently reveal a more extensive use of income-increasing earnings management behaviours among listed firms compared to unlisted entities, especially in the presence of high levels of indebtedness. Thus, they provide full support for the “opportunistic behaviour” hypothesis about the earnings management behaviours of listed firms, at least in the context where firms are highly dependent on external debt and the institutional setting does not provide strong protection to creditors. Finally, the results indicate that, under such circumstances, entities trade off earnings manipulation strategies and define earnings management behaviours based on the probability of being detected, rather than looking at the cost of such earnings management tools.

Foreign Capital and Earnings Management: International Evidence from Equity Market Openings

When equity markets open to foreign investors, firms in these markets face significant opportunities to attract foreign capital. Using a set of countries that opened their equity markets, we find significant income-increasing earnings management in the year of opening, with substantial heterogeneity across industries and firms. The positive effect is more pronounced in industries that are more dependent on external financing and for financially constrained firms, suggesting that firms’ intrinsic need for equity finance contributes to income-increasing earnings management behaviors. The effect is weaker when the firm is audited by a Big N auditor, consistent with the monitoring effect of relatively more reputable auditors. We find that income-increasing earnings management is less pronounced in countries with stronger legal enforcement. Overall, our results suggest that incentives to attract financing when a country opens its equity market to foreign investors affects firms’ reporting bias.

Earnings management and equity incentives: evidence from the European banking industry

PurposeThis study aims to examine the effect of equity incentives on earnings management that occurs via the use of loan loss provisions by using a sample of 204 bank-year observations over the period 2006-2011.Design/methodology/approachThe authors use the data of 39 European banks to test the main hypothesis. Several valuation models and regressions are used to measure the main proxies for executives’ compensation and the determinant factors of loan loss provisions.FindingsThe empirical results reveal that earnings management that occurs via discretionary loan loss provisions is associated with equity incentives in the banking industry. In particular, European banks’ executives with high equity incentives are found to manage reported earnings upwards by reducing loan loss provisions. The results therefore show that income-increasing earnings management via discretionary loan loss provisions is widely practised by the executives of European banks and that this is partly motivated by executives’ compensation.Practical implicationsThe findings of this paper present important implications for regulators in the European Union, who should take further steps to reform the regulatory environment to monitor and mitigate the earnings management practices that occur via the manipulation of loan loss provisions. Earnings management practices do not just negatively affect subsequent performance but are also found to lead to firms’ failure. Thus, regulators should take the necessary reforms to protect the wealth of stakeholders (investors, creditors, etc.).Originality/valueThis study provides the first evidence on the relationship between equity incentives and earnings management in the European banking industry. The study sheds more light on an issue of great interest to a broad audience that does not receive much attention in the prior research, thus opening new avenues for future research.

Top Management Team Characteristics and Financial Reporting Quality

ABSTRACT The accounting literature often views managers as individuals whose financial reporting decisions are determined by their economic incentives and individual characteristics. However, managers typically work in a team and most decisions have at least some input from other members of the team. This study examines the impacts of two top management team (TMT) characteristics on financial reporting quality. The results indicate that background homogeneity and long-shared working experience are each distinctly related to a higher likelihood of restatements. Additional tests document that team homogeneity and shared experience also are positively associated with discretionary accruals for firms with income-increasing earnings management incentives. Moreover, the impact of TMTs on financial reporting quality varies with the proportion and tenure of independent directors. These findings indicate that top management team characteristics are important determinants of financial reporting quality. JEL Classifications: G34; M14; M41; M54.

When and why do IPO firms manage earnings?

There is significant disagreement about whether, when, and why IPO firms manage earnings. We precisely identify the timing and motives behind earnings management by IPO firms. The period around an IPO is characterized by two events: the IPO itself and the lockup expiration. Both the raising of capital at the IPO and the exit by pre-IPO shareholders at lockup expiration create incentives for firms to manage earnings. To disentangle the effect of these events, we examine quarterly, rather than annual, abnormal accruals. We find no evidence of income-increasing earnings management before the IPO. However, IPO firms exhibit positive abnormal accruals in the quarter before and the quarter of the lockup expiration. Positive abnormal accruals are concentrated in less scrutinized firms and firms with high selling by pre-IPO shareholders. Moreover, we find that these accruals subsequently reverse and that such reversals contribute to long-run IPO underperformance.

How the 2007 global financial crisis changed the financial disclosure behavior

PurposeThe purpose of this paper is to investigate how the 2007 global financial crisis (GFC) changed financial disclosure behavior using a sample of US equity real estate investment trusts (REITs) from 2000 to 2015.Design/methodology/approachThe authors use panel data spanning from 2000 to 2015 to examine the impact of the GFC on REITs’ earnings management (EM) after controlling for other factors (including the market shock in 2007 and 2008). The measurements of EM are estimated by using the models developed from literature such as modified Jones models. The static panel data regression models are used to estimate the impact of GFC on the REITs’ EM.FindingsThe authors find that REITs are more likely to engage in income-increasing EM to embellish their financial reports during the GFC. However, the magnitude of the use of EM to manipulate disclosed financial information decreased following the GFC, indicating an improvement in the quality of financial disclosure as a consequence of the enhancement of the regulatory environment. REITs also changed the manner in which their EM behavior responded to the main factors in the market following the outbreak of GFC.Research limitations/implicationsThis study contributes to the finance and accounting literature by providing the first empirical test results concerning how the financial disclosure behavior and quality of listed portfolios and companies such as REITs have changed corresponding to the enhancement of the regulatory environment and adverse market conditions brought by GFC.Practical implicationsThis study provides references for investors, auditors, and regulators to help them make adjustments for and improve the interpretation of the disclosed financial information.Originality/valueThis is one of the first empirical study testing the impact of the GFC on EM. It is also the first empirical study investigating the impact of GFC on the financial disclosure behavior of REITs.

Overvaluation and earnings management: Does the degree of overvaluation matter?

We examine whether the choice of earnings management strategies employed by managers of overvalued firms depends on the degree of market overvaluation. By distinguishing between substantially overvalued (SOV) and relatively overvalued (ROV) firms, we find that SOV firms significantly inflate earnings using both accruals-based and real earnings management. In contrast, managers of ROV firms do not engage in accruals-based earnings management and their firms’ accounts tend to report higher discretionary expenses. The reported higher discretionary expenses of ROV firms are comparable to the discretionary expenses of firms in the expanding stage of their business life cycle, a pattern consistent with ROV firms increasing discretionary expenses to finance growth and hence justify the high market valuation. Overall, we show that the existing evidence on income-increasing earnings management by overvalued firms is mainly driven by the pressure to sustain the high market valuation of firms that are substantially overvalued.

Is earnings management sensitive to discount rates?

We argue that managers’ choice to manage earnings depends on the trade-off in the present value of expected future net benefits associated with that choice. Specifically, we examine if discount rates are associated with the likelihood that managers engage in earnings management to meet or beat various earnings targets. We find that discount rates are positively associated with income-increasing earnings management. This means that managers increase both accrual-based and real earnings management when discount rates are higher. However, the economic magnitude of this association is relatively moderate.