Increase In Earnings Management Research Articles

Linking earnings management practices and corporate governance system with the firms’ financial performance

PurposeIn the shadow of global financial crisis, practice of earnings management can be hazardous for the growth and development of an economy, especially for a developing economy like India. This empirical study is performed to analyse the presence of earnings management practices in Indian public and private commercial banking industry. This study also aims at developing a framework for the three-way relationship existing between the variables of corporate governance, earnings management practices and firm performance.Design/methodology/approachData have been collected for a period of 11 financial years (2003-2013) from Prowess (Centre for Monitoring Indian Economy) 4.14 database. A bank-based accrual model has been used for calculating earnings management practices. OLS regression has been used for analysing degree of interdependence among variables of corporate governance, earnings management practices and financial performance.FindingsThe analysis supports the fact that there is the existence of income increasing earnings management practices in Indian commercial banks. It is also observed that corporate government practices (viz. board characteristics, audit practices and performance-based remuneration) basically work as restricting variables for earnings management practices. It is evident from the analysis that market-based firm performance variables (viz. PE ratio, yield and profit after tax) are significantly related to earnings management and corporate governance system.Practical implicationsThe finding of this study will help in monitoring and controlling fraudulent earnings management practices existing in Indian commercial banks.Originality/valueThis study is the initial research about the presence of earnings management practices in Indian commercial banks.

DETEKSI MANAJEMEN LABA MELALUI DISCRETIONARY REVENUE DAN AKTIFITAS RIIL: IMPLIKASI PENERAPAN GOOD CORPORATE GOVERNANCE

The application of good corporate governance (GCG) is expected to increase the transparency and accountability of companies that are expected to detect earnings management is happening in the company. This study aimed to analyze the effect of good corporate governance, to earnings management by discretionary revenue and real activity estimation models. Samples are 62 companies listed in the Indonesia Stock Exchange (BEI) during the period 2011-2014. Data analysis was performed using linear regression.Our research found that good corporate governance positively affect earnings management through real activity earning management. However, the GCG index had no effect on earnings management is done through descretionary revenue models. However, the results of this study are consistent with the Zang (2011) that the post-SOX, GCG implementation will increase earnings management through real activities

Earnings management through accruals: A diagnostic analysis of indian corporate sector

Earnings management has caught the attention of regulators, policy makers and corporate stakeholders due to soaring accounting frauds. This has caused erosion of investors’ wealth and loss of public confidence in financial reports. In such an alarming situation, the need of the hour is to shield the stakeholders from illusive earnings management practices and accounting frauds. Taking a step ahead in this direction, the present paper makes an attempt to examine the magnitude of earnings management in BSE 500 companies across various industries and sectors of the Indian economy over a period of three years commencing from 2013 to 2015. This study further explores the relation between earnings management varies with the size of the business. Modified Jones Model (1995) has been used to estimate the discretionary accruals which act as a proxy for earnings management. The results of the study demonstrate that average discretionary accruals are 1.789 per cent of total assets of the firm. Further, it is found that manufacturing of food product industry is contributing the highest percentage discretionary accruals in industrial classification. Service sector firms are dominated by income decreasing earnings management whereas non service sectors and small firms have been found to be exercising income increasing earnings management.

Bank Loan Loss Accounting: Research Implications for the Post-Crisis Debate

The IASB and the FASB have recently re-evaluated the current model underlying loan loss accounting (the ‘incurred loss’). Taking into consideration the G20‘s advice on using more forward-looking information, they introduce a new approach (the ‘expected loss’ model). This paper reviews the academic literature to shed some light on the new expected loss models when applied to the financial industry. The accounting literature discussed in this study outlines both general theoretical findings and empirical evidence that help to infer the potential impact of the new models. Given the link between loan loss impairment and accounting conservatism as well as earnings management, we explore these concepts from both a theoretical and empirical perspective. Indeed, the discretion envisaged in the new models may provide a potential tool for increased earnings management than at present under the current guidelines. Both models are more conservative than the current approach, but given the differences in the type of conservatism that the two new models entail, conditional and unconditional, we argue that the two proposals will provide different types of information and in this way lead to distinct economic consequences. Additionally, institutional factors and firm characteristics will also have a major impact on the way the models are used. Moreover, we also suggest new avenues for further research in conservatism and earnings management in an industry, the financial sector, where additional stakeholders show significant concerns regarding the economic impact of accounting information.

Management Science Online Appendix Tables: Hiring Cheerleaders: Board Appointments of 'Independent' Directors

We use a unique, hand-collected database of independent directors to provide evidence that firms appoint independent directors who are overly sympathetic to management, while still technically independent according to regulatory definitions. We explore a subset of independent directors for whom we have detailed, micro-level data on their views regarding the firm prior to being appointed to the board: sell-side analysts who are subsequently appointed to the board of companies they previously covered. We find evidence that boards appoint overly optimistic analysts who are also poor relative performers. The magnitude of the optimistic bias is large: 82.0% of appointed recommendations are strong-buy/buy recommendations, compared to 56.9% for all other analyst recommendations. We find that appointed analysts' optimism is stronger at precisely those times when firms' benefits are larger, and that appointing firms increase earnings management, and perform poorly, following these board appointments.The paper "Hiring Cheerleaders: Board Appointments of 'Independent' Directors" may be found at http://ssrn.com/abstract=1343176.

Relative Peer Quality and Firm Performance

This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by a board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

Relative Peer Quality and Firm Performance

​This study examines the performance impact of the relative quality of a CEO’s compensation peers (peers selected to determine a CEO’s overall compensation) and bonus peers (peers selected to determine a CEO’s relative-performance-based bonus). We use the fraction of peers with greater managerial ability scores (Demerjian, Lev, and McVay, 2012) than the reporting firm to measure this CEO’s relative peer quality (RPQ). We find that firms with higher RPQ tend to earn superior risk-adjusted stock returns and experience higher profitability growth compared with firms that have lower RPQ. These results cannot be fully explained by a CEO’s power, compensation level, intrinsic talent, nor by the board’s possible motivation to use peers to signal a firm’s prospect. Learning among peers and the increased incentive to work harder induced by the peer-based tournament, however, might contribute to RPQ’s positive performance effect. Preliminary evidence also shows that high RPQ is not associated with increased earnings management or increased risk-taking behaviors.

Corporate governance mechanisms, sensitive factors and earnings management in Nigerian oil and gas industry

Oil and gas industry is considered as the sector that contributes a big share to the Nigeria economy. This study investigated the effects of corporate governance mechanisms, sensitive factors on earnings management of quoted oil and gas firms in Nigeria using the sample of nine (9) listed oil and gas firms for the period of ten years (2004-2013). Discretionary current accruals was used as the proxy for earnings management. Corporate governance mechanisms (boards size, chief executive officer (CEO) duality, directors’ ownership, audit committee size, audit committee independence), sensitive factors (corporate tax, corporate profit, corporate social responsibility) served as independent variables. The study concludes that corporate governance mechanisms curves earnings management while sensitive factors increase earnings management. The study recommends that corporate governance regulations should be strengthened to reflect present challenges.

When and Why Do IPO Firms Manage Earnings?

We provide new evidence on the timing and motives behind earnings management by IPO firms. The period around IPOs is characterized by two distinct events: the IPO itself and the lockup expiration. Both the raising of capital at the time of the IPO and the large-scale exit by pre-IPO shareholders at lockup expiration approximately 180 days later create incentives for firms to engage in earnings management. To disentangle the effect of these two events, we examine quarterly, rather than annual, abnormal accruals. We find no evidence of income- increasing earnings management in anticipation of the IPO. However, IPO firms exhibit positive abnormal accruals in the quarter before and the quarter of the lockup expiration. We demonstrate that positive abnormal accruals are concentrated in firms for which we predict intense selling by pre-IPO shareholders at lockup expiration. We also confirm the findings of Teoh, Welch and Wong (1998) that positive abnormal accruals are associated with long-run IPO underperformance.

Financial crisis, GDP variation and earnings management in Europe

The purpose of this study is to examine the consequences of the financial crisis on the European companies’ in conjunction with earnings management practice. It focuses on financially distressed companies that audited by a big 4 auditor during recession years. The study makes use of discretionary accruals as a proxy for earnings management and studies the influence of big 4 auditor, in order to shed more light on possible causes for shifting earnings. The findings of the study provide evidence that financially distressed companies that audited by a big 4 auditor exhibit lower discretionary accruals. The results reveal that Greek and Spanish companies reduce earnings management manipulation during recession. In contrast, Portuguese, Irish and Italian companies show mixed results. They tend to reduce earnings management practices, but there are reasons that influence managers’ behavior to increase earnings management. The findings of this study can be useful for both investors and standard setting authorities.

Diversification Strategy and Earnings Management: An Empirical Investigation of Firms in Manufacturing Sector

The present study examines the link between diversification strategies and earnings management for firms operating in manufacturing sector. Diversification strategies include expansion across market (international diversification) and product segments (product diversification). The sample derived for the period 2004 to 2013 includes business groups affiliated firms and standalone firms. Several firm-specific factors are included in the model. Agency cost and business risk variables are included to understand the applicability of information asymmetry hypothesis and earnings volatility hypothesis. Both univariate analysis (mean comparison) and multivariate analysis (panel data regression) is employed. The empirical analysis shows that for the overall sample product diversification enhances the practice of earnings management. Similar finding is found for international firms within business group. This shows that international diversification as such does not increases earnings management however diversification across product segment provide favorable condition for managing earnings thus reducing the quality of reported earnings. Sub sample analysis reveals that agency cost is having a significant negative relationship with earnings management indicating that higher informational asymmetry is not conductive to the practice of earnings management.

Asset revaluations and earnings management: Evidence from Australian companies

This paper examines the association between asset revaluations and discretionary accruals (a proxy for earnings management) using a sample of the largest 300 Australian companies. The results from this study indicate that the revaluation of non-current assets is positively associated with discretionary accruals. This finding is consistent with the argument that revaluation of assets reflects higher agency problems in the form of increased earnings management. Additional findings are that discretionary accruals are higher for firms reporting their non-current assets at fair values appraised by directors, than those of firms that use external appraisers. As well, the choice of auditors and the strength of corporate governance can constrain the opportunistic behaviour of managers in the accounting choice to revalue non-current assets.

Misvaluation and Insider Trading Incentives for Accrual‐based and Real Earnings Management

AbstractWe investigate the incentives that misvaluation creates for: (1) insider trading; and (2) concurrent earnings management through both accruals and real activities. Managers of overvalued firms have an incentive to sustain overvaluation through income increasing earnings management and, at the same time, to sell their shares (Jensen,). Managers of undervalued firms benefit from buying their firm's shares, however the negative effects of downward earnings management may offset incentives to enhance trading advantages. The results indicate that managers ofbothover‐ and under‐valued firms act opportunistically, managing earnings upward (downward) with accruals while selling (buying) shares. The Sarbanes‐Oxley Act of 2002 (SOX) has been largely ineffective in eliminating trading motivated earnings management. Finally, we do not find evidence of a relationship between managerial trading and real earnings management.

Book Reviews

Book Reviews

Does Industry Regulation Matter? New Evidence on Audit Committees and Earnings Management

This paper investigates the moderating role of industry regulation on the effectiveness of audit committees in restricting earnings management. Using comprehensive panel data of S&P 1500 firms between 2003 and 2007, we find that the proportion of CEO directors on an audit committee is positively associated with earnings management in unregulated industries, while this association is significantly weaker in regulated industries. Further, the proportion of financial experts on an audit committee is negatively associated with earnings management. Our results also indicate that the average board tenure of audit committee members is negatively related to earnings management in regulated industries, but positively affects earnings management in unregulated industries. Finally, audit committee members’ average directorship increases earnings management in regulated industries, but reduces earnings management in unregulated industries. Overall, our results suggest that the effectiveness of audit committees in reducing earnings management and improving financial reporting quality is influenced by industry regulation.

DID IFRS REPORTING BY UK FIRMS REDUCE EARNINGS MANAGEMENT?

This paper investigates the effect of reporting under International Financial Reporting Standards (hereafter IFRS) versus reporting under UK GAAP on earnings management in the UK. Prior studies find mixed evidence regarding the effect of voluntary and mandatory adoption of IFRS on earnings quality. I test whether the effect of reporting under IFRS on earnings management is sufficient to overcome earnings management incentives. Furthermore, I test whether the effect of IFRS reporting is conditional on audit quality surrogated by audit firm size. I build the analysis on measures of discretionary accruals and earnings benchmark tests. I find evidence that reporting under IFRS generally reduces levels of earnings management and furthermore, the mitigating effect of IFRS is stronger for income decreasing than for income increasing earnings management. In addition, I find that audit quality plays a key role in IFRS reporting, with only firms audited by big four auditors having a significant IFRS reporting effect.

The Ability of Analysts' Recommendations to Predict Optimistic and Pessimistic Forecasts

Previous researches show that buy (growth) companies conduct income increasing earnings management in order to meet forecasts and generate positive forecast Errors (FEs). This behavior however, is not inherent in sell (non-growth) companies. Using the aforementioned background, this research hypothesizes that since sell companies are pressured to avoid income increasing earnings management, they are capable, and in fact more inclined, to pursue income decreasing Forecast Management (FM) with the purpose of generating positive FEs. Using a sample of 6553 firm-years of companies that are listed in the NYSE between the years 2005–2010, the study determines that sell companies conduct income decreasing FM to generate positive FEs. However, the frequency of positive FEs of sell companies does not exceed that of buy companies. Using the efficiency perspective, the study suggests that even though buy and sell companies have immense motivation in avoiding negative FEs, they exploit different but efficient strategies, respectively, in order to meet forecasts. Furthermore, the findings illuminated the complexities behind informative and opportunistic forecasts that falls under the efficiency versus opportunistic theories in literature.

The Effects of Earnings Management on Enforcement Releases and Their Recognition in Audit Fees

In 2004 German legislation established the Financial Reporting Enforcement Panel. In 147 cases since then, the panel has ordered the announcement of errors in previously disclosed and audited financial statements of German firms. We use this unique dataset to evaluate the consequences of increasing earnings management over time on enforcement releases and their recognition in audit fees. Ettredge et al. (2010) provide evidence on a phenomenon called ‘balance sheet bloat’ that is due to income increasing earnings management and later influences the disclosure of misstated financial statements. Thus, the evidence of earnings management recognition in audit fees (Abbott et al. 2006) and the hypothesis of future information content in fees by Stanley (2011) leads us to hypothesize that auditors recognize increasing audit risk in audit fees before the enforcement process starts. We extend related earnings management and audit fee literature by modeling the development of earnings management within the misstatement firms and systematically link it to auditor reactions. We find significant predictive power of different commonly used accrual measures for enforcement releases in the period prior and up to the misstatement period. In this period of time, we also observe an audit fee increase, e.g. the recognition of increased audit risk. We investigate an audit fee effect after the misstatement period but find no significant relation.

How do accounting standards and insiders' incentives affect earnings management? Evidence from China

Chinese listed companies recently experienced two important institutional changes: split share structure reform (SSSR) and the mandatory adoption of IFRS-convergent new accounting standards (NAS). We find that the introduction of NAS significantly increased earnings management. Although we do not find evidence that SSSR directly decreased earnings management of the average firm, the increase in earnings management surrounding the introduction of NAS is negatively related to the reduction in non-tradable shares. These results suggest that accounting standards are the more important factor associated with the level of earnings management. Insiders' incentives affect earnings management given a specific set of accounting standards.

Firm location and earnings management: Korean evidence

Using 7245 firm-year observations from Korean listed companies over 2000–2004, we find that firms located in Seoul (the capital city of Korea) or its surrounding metropolitan area (i.e. urban areas) are more likely to manage earnings than firms located in other areas (i.e. rural areas). Discretionary accruals are larger for urban firms than rural firms after controlling for variables that affect the level of accruals. Our findings suggest that due to greater attention from large numbers of investors and other market participants, urban firms face greater pressure to manipulate earnings to satisfy market expectations. However, we fail to find evidence of an association between firm location and increased earnings management for firms audited by Big 4 auditors or firms followed by analysts, which are likely to be more closely monitored by investors and other market participants. These findings are robust in various sensitivity analyses.