Magnitude Of Earnings Management Research Articles

Do family-controlled and financially healthy firms manage their reported earnings? Evidence from Indonesia

This paper examines whether family-controlled and financially healthy firms practice earnings management. The data collection focuses on non-financial firms listed on the Indonesia Stock Exchange for the fiscal year 2017–2019. Family and financially healthy firms are key predictor variables for predicting earnings management behavior. Jones’s (1991) modified cross-sectional model measures discretionary accruals (the earnings management indicator). This study reveals a negative relationship between family entities and earnings management practices, suggesting that family-controlled firms are more likely to report a higher quality of earnings. This study also documents that family entities with financial difficulties have more incentive to practice earnings management. Additionally, the study indicates that the involvement of a family member in executive positions leads to lower financial reporting quality. Finally, this study reports a nonlinearity association between family share ownership and the magnitude of earnings management. The study’s findings may assist policymakers in considering the costs and benefits associated with various levels of ownership concentration, especially in the hands of family members.

Philanthropy, audit firms culture and auditor independence.

In this study, we examine how the prosocial ethical culture in audit firms, measured as their philanthropic contributions over gross revenues, influences auditor independence. Using 5,246 audits in the Chinese market between 2010 and 2012, we find that the level of ethical culture in audit firms is significantly negatively associated with the magnitude of earnings management and the frequencies of financial restatements of their client firms. We also find this association is even stronger when auditors provide services to clients that are economically important or when signing auditors bear school ties with at least one top executive of the client. Further evidence show that the ethical culture can both act as a mechanism that attract auditors with a compatible internal norm, and great a group norm in audit firms that directly shape auditor behavior. Collectively, our study suggests that ethical culture of audit firms can significantly improve auditor independence.

The tone from above: Does tunnelling by ultimate owners impinge on the relations between managerial compensation and earnings management?

AbstractThis study aims to explore the impact of tunnelling by ultimate owners on the relation between managerial compensation and earnings management. Using a sample of the Chinese listed firms from 2009 to 2019, we find that tunnelling by ultimate owners leads to adjustments in pay‐performance sensitivity and impinges on the magnitude of earnings management. In private‐dominated firms, tunnelling by ultimate owners reduces pay‐performance sensitivity, and the decreased pay‐performance incentives do not motivate managers to inflate corporate profits by manipulating earnings information. Moreover, owing to managers' resistances, tunnelling does not generate more severe problems in the quality of earnings information. In state‐dominated firms, due to government regulation, tunnelling by ultimate owners does not induce significant adjustments in pay‐performance sensitivity. However, due to the strong motivation of managers delighting their superiors in the administrative hierarchy by adjusting financial reporting, the quality of earnings information of state‐dominated firms may be worse. Our results suggest that in firms with concentrated ownership structures‐irrespective of the nature of ownership, both the formulation and implementation of managerial compensation incentive programmes, and the magnitude of earnings management, are equilibrium results of a dynamic game between ultimate owners and managers.

The context of earnings management and its ability to predict future stock returns

This paper constructs a signal-based composite index, namely ESCORE, which captures the context of earnings management. Specifically, ESCORE aggregates 15 individual signals related to both accrual and real earnings management based on prior relevant literature. After establishing that ESCORE is capable of capturing the context in which earnings management is more likely to occur, the study finds that low ESCORE firms outperform those with high ESCORE by an average of 1.37% per month after controlling for risk loadings on the market, size, book-to-market and momentum factors up to one year after portfolio formation in the UK. This finding implies that investors tend to ignore the observable context of earnings management. In addition, with ESCORE model, investors do not need to estimate the magnitude of earnings management, rather it is sufficient to look at the surrounding context to differentiate between low and high earnings management firms. Finally, when tested using the US data, most of the main results of the study appear to hold.

Share repurchases and market signaling: Evidence from earnings management

AbstractFirms may repurchase shares to send true or false signals to the market. Since the mindset of managers is invisible, we measure it with earnings management. Discretionary accruals are used to proxy for earnings management. We show that earnings management is negatively related to the probability and frequency of share repurchase announcements. We also show that earnings management is negatively related to postannouncement 2‐year operating performance and stock returns. Our findings support the prediction that the magnitude of earnings management can serve as a reliable indicator of managers' mindsets with regard to the valuation of firms.

Natural Disaster Impedes the Corporate Earnings Management in the U.S.

We examine the timing and magnitude of earnings management following natural disasters to provide new insights into how and when firms manage earnings. Using difference-in-difference regressions and a sample of U.S. publicly listed firms from 1980 to 2017, we find that natural disasters reduce the magnitude of corporate earnings management by 19.5% in the two-year, post-disaster period. Natural disasters attract the attention of investors and intensify external monitoring, which results in reduced levels of corporate earnings management. In addition, we find increased information disclosure quality following disasters. Our findings of reduced earnings management following negative, external shocks contradict the predictions of big bath accounting practices.

The relationship of board of directors, audit committee and earnings management: Analysis of Russian public companies

Using the sample of Russian public companies, this paper analyzes the relationship between the level of earnings management and several characteristics of the board of directors, the key element of the firm’s corporate governance. A particular attention is devoted to the audit committee — its structure and the characteristics of its members. The object of the study are 184 Russian public companies for 2014-2018. The analysis demonstrates the inverse relationship between the magnitude of earnings management and several attributes of the board of directors — its size, presence of the audit committee, the proportion of independent directors on Board. A similar type of relationship is revealed at the level of the audit committee for the proportion of independent directors in the committee and the presence of financial experts in the committee. At the same time, there is a positive relationship between the number of directorships positions of the audit committee members and the magnitude of earnings management. The results indicate that several characteristics of corporate governance might have a potential for restraining earnings management in Russian public companies.

대손충당금 분류조정을 이용한 상호저축은행의 이익관리; 특별대손충당금을 중심으로 (Earnings Management of Savings Banks Using Loan Assets Classification: Focusing on Special Loan Loss Provision)

Korean Abstract: 본 연구는 상호저축은행이 특별대손충당금의 분류조정을 이용하여 이익을 조정하는지를 살펴보았다. 상호저축은행은 일반(상업)은행과 달리 고정여신에 대한 충당금을 일부 자본으로 인정받는다. 상호저축은행이 위 규정을 이용하여, 특별대손충당금의 분류조정을 통해 이익관리 및 자본관리를 수행하는지 살펴보았다. 이를 검증하기 위하여 대손충당금 전입액을 일반대손충당금과 특별대손충당금으로 구분하고 대손충당금과 대손충당금 전입 및 법인세 전 이익과의 관련성을 살펴보았다. 실증분석결과 저축은행은 이익을 유연화하기 위하여 대출자산 항목의 분류조정을 이용하는 것으로 나타났다. 구체적으로, 상호저축은행은 고정이하여신 내 분류조정을 이용하여 특별대손충당금 전입액을 조정하여 이익을 유연화하고 있다. 재무건전성이 취약한(BIS 7% 미만) 저축은행의 경우에는 특별대손충당금 전입액을 이용한 이익조정을 더 많이 하는 것으로 나타났다. 이러한 결과는 저축은행의 고정여신의 충당금을 자본으로 인정하는 현행 제도의 수정보완이 필요함을 시사한다. English Abstract: This study examines earnings management method of savings banks which serve as representative financing institution for people with poor credit. Because regulatory and supervisory regulations of savings banks are different to those of commercial banks, managers of savings banks may reflect these characteristics in earnings management method. Especially, managers of the savings bank are expected to choose the earnings management method considering resulting costs and benefits such as effects on BIS ratio, discretion of loan assets classification, and the magnitude of earnings management. Empirical evidence indicates that savings bank discretionarily exploit classification of loans assets to smooth earnings. Specifically, managers discretionarily classify loan assets items upwards or downwards within non-performing assets. In addition, savings banks with BIS ratio lower than 7% tend to manage earnings upwards by classifying loan assets items upwards within non-performing assets to increase both net income and BIS ratio. The results of study imply that limitation of present regulatory and supervisory rules on savings banks incurs unintended negative effects on agency problem

Voting with hands, earnings management and corporate governance

PurposeMotivated by managers’ intentions to pursue private interests by engaging in earnings management, this paper aims to investigate whether voting with hands (shareholders cast votes on shareholder proposals) by shareholders acts as an external disciplining mechanism over earnings management relative to corporate governance. Also, as corporate governance can scrutinize managers’ behavior, this study also examines whether there is a substitutive relation between shareholder proposals and corporate governance mechanism.Design/methodology/approachFirst, this paper uses ordinary least squares (OLS) regressions of discrepancy accruals on the percentage of “For” votes for shareholder proposals to test the incremental effect of shareholder proposals on earnings management. Second, firms receiving shareholder proposals are matched with those not receiving proposals by propensity scores, and the levels of earnings management and corporate governance between these two groups are compared by univariate analysis and OLS regressions. In addition, six portfolios are created based on whether firms receive shareholder proposals, as well as on the levels of corporate governance, to assess whether external control from shareholder proposals can substitute internal control for corporate governance in disciplining earnings management. Regressions of earnings management on corporate governance (shareholder proposals) are conducted in the sub-samples formed on shareholder proposals (corporate governance) to further explore the above substitution effects.FindingsBased on a sample of 2,041 firm-year observations from 2001 to 2010, this paper finds that the “For” votes received from the shareholder proposals have a significant negative relationship with the practice of earnings management, even when corporate governance is controlled. The negative relationship between shareholder proposal and magnitude of earnings management is also found to be stronger when firms have weak corporate governance. The overall evidence suggests that the external control from “voting-with-hand” shareholders has a significant impact on earnings management. In addition, shareholder proposals can substitute the monitoring mechanism for corporate governance in constraining managers’ myopic behavior.Originality/valueThis paper contributes to the extant literature by using the percentage of “For” votes for shareholder proposals as a proxy for shareholder pressure and concerns. This study contributes to the earnings management literature by showing the disciplinary effect of outside shareholders on managers’ reporting behavior. Also, it contributes to the corporate governance research by presenting that shareholder proposals can substitute for the internal control of corporate governance in decreasing earnings management. This paper should be of interest to investors and standard setters.

Banks' funding structure and earnings quality

Using a sample of U.S. public and private banks, we examine the implications of banks' funding strategies for banks' earnings quality. We find that the ratio of core deposits to total liabilities (CDL), our proxy for bank reliance on retail deposits over wholesale funds, is negatively and significantly associated with the magnitude of earnings management through discretionary loan loss provisions (DLLP). This finding is consistent with the arguments that retail deposits are relatively more stable and information-insensitive, reflect a more conservative business model, and attract more intensive monitoring from the Federal Deposit Insurance Corporation (FDIC) than wholesale funds. We find that the inverse relationship between retail funding and earnings management holds for both income-increasing and income-decreasing DLLP. Besides, reliance on retail funding decreases the likelihood of meeting-or-beating earnings benchmark, and the extent of income smoothing through loan loss provisions (LLP). In an additional analysis, we find that banks with higher CDL are exposed to lower asset deterioration risk, proxied by large non-performing loans and loan charge-offs during the financial crisis period 2007–2009. Collectively, our results indicate that the banks' funding strategy that relies more on retail deposits as opposed to wholesale funds increases banks' earnings quality.

An exploratory analysis of earnings management practices in Australia and New Zealand

PurposeThis study aims to explore corporate earnings management practices in Australia and New Zealand before and after the regulatory changes and corporate governance reforms. The study argues that the effectiveness of regulatory reforms has to be reflected in constraining earnings management in post-reform period as compared to pre-reform period.Design/methodology/approachUsing a sample of 3,966 firm-year observations, including all ASX and NZX listed firms for the period 2001-2006, the study examines earnings management practices in both countries in pre- and post-reform periods with appropriate statistical methods.FindingsThe results indicate some interesting phenomenon: the magnitude of earnings management did not decline after the governance reform as a positive time trend is observed in the entire sample as well as in Australian and New Zealand sub-samples, suggesting that earnings management has been growing over time. Additional test indicates no structural change has occurred before and after the new regulations. The shifting from decreasing earnings management to increasing earnings management can be interpreted as an evidence that earnings become more ‘informative’ in a more transparent disclosure regime to capture short-run benefits from regulator reforms.Research limitations/implicationsThe shifting of earnings management behaviour from decreasing to increasing income can be interpreted as the outcome of more “informative”, rather than “deliberate”, earnings management in a more transparent disclosure regime to capture short-run benefits of regulatory reforms, which is worth further investigation. The findings of the study can lead regulatory authorities taking appropriate measures to promote earnings quality in corporate financial reporting from a long-run decision usefulness context. Any future reforms should be directed to protecting the interest of stakeholders as well as ensuring benefits outweighing costs for them.Practical implicationsThe findings of the study can lead regulatory authorities in taking appropriate measures to promote earnings quality in corporate financial reporting from a long-run decision usefulness context.Originality/valueThe study adds value to the existing earnings management literature as well as effectiveness of regulations for the benefit of wider stakeholder groups.

The influence of CEO and CFO power on accruals and real earnings management

In this study, we examine the effect of CEO and CFO power on both accruals and real earnings management (AEM and REM, respectively), and the extent to which CEO and CFO power mitigate the effect of one another on AEM and REM. We further examine whether the passage of the Sarbanes-Oxley Act (SOX) altered these effects. In the pre-SOX period, we find that AEM (REM) is greater when the CEO (CFO) is powerful relative to the CFO (CEO). In the post-SOX period, however, we find that the effect of relative CEO power on AEM subsides, whereas the effect of relative CFO power on REM persists. Additionally, we find evidence to suggest that powerful CFOs inhibit the AEM preferences of powerful CEOs in both the pre- and post-SOX periods. Finally, we find evidence to suggest that powerful CEOs inhibit the REM preferences of powerful CEOs in the pre-SOX period, but not in the post-SOX period. Collectively, our results suggest that the power of the CEO relative to the CFO is an important factor in the both the type and magnitude of earnings management.

Earnings Management and Financial Sustainability in Greek Municipalities

This study investigates whether Greek municipalities engage in earnings management practices through the manipulation of accruals and if this behaviour is related to indications of financial sustainability. In order to test our hypotheses, we use the annual financial data of Greek municipalities for the period 2011-2015. The final sample corresponds to an unbalanced panel data sample that includes 1,119 yearly observations. Total accruals and discretionary accruals modelling is based on the aggregate Jones (1991) model. Our findings provide evidence that Greek municipalities undertake earnings management practices through the manipulation of accruals in order to report financial results around the value of zero. Moreover, we find corroborative evidence that financial sustainability indicators relate to the magnitude of earnings management.

Non-GAAP Reporting and Accounting Restatement

In this study, I examine whether disclosing Non-GAAP earnings is a signal of experiencing accounting restatement. I propose a scenario in which earnings are managed within the constraints of GAAP guidelines, as long as there is sufficient leeway to permit income-increasing accounting choices. Managers usually avoid issuing Non-GAAP earnings because of severe penalties. If this becomes no longer possible within GAAP earning management, managers have incentives to cross the line into Non-GAAP territory. At this point, disclosing Non-GAAP earnings is positively associated with accounting restatement because of the great magnitude of earnings management. I find that firms with restatements experience a significant increase in the relative use of disclosing Non-GAAP earnings with positive other exclusions. Firms with the positive other exclusions excluded from Non-GAAP earnings may exhibit increased likelihood of fraud or core-earnings restatement. Finally, firms disclosing Non-GAAP earnings and having high accounting complexity are more likely to restate than those disclosing Non-GAAP earnings and having low accounting complexity.

Impact of financial crisis and family control on earning management of Portuguese listed firms

Accounting information is used to evaluate the firm's financial performance. Although, firms may have incentives to engage in earnings management, misleading all stakeholders. This study aims to analyse earnings management behaviours of Portuguese listed firms. Both accrual-based and real activities of earnings management are analysed to draw an overall picture of earnings management’ strategies. Most studies focused only in discretionary accruals as a proxy for earnings management, since cash flow-based earnings management is more difficult to detect. Although both strategies can be complementary instead of substituting. Moreover, the impact of financial crisis, family control, and firm characteristics is taken into account. Previous literature found that 2008 crisis had impact on earnings management as firms want to meet debt covenants and investors’ expectations. Moreover, family firms also impact the magnitude of earnings management. While some researchers found a negative relationship since managers are highly controlled, others found the opposite relationship because the family may want to maximize their own wealth. Analysing 51 listed firms, from 2003 till 2015, results show that firms engage more in earnings management during crisis, when the firm's financial situation is less stable. In addition, accrual-based earnings management is higher in family firms than in non-family ones, suggesting less quality of information in the first group. Due to less control of family firms, the family may expropriate minority investors’ wealth to increase personal benefits. Finally, the impact of firms’ characteristics on earnings management depends on the proxy of earning management analysed, suggesting that firms use accrual or real-activities earnings management depending on its purposes.

An Exploratory Analysis of Earnings Management Before and after the Governance and Disclosure Regulatory Changes in Australia and New Zealand

This study examines the effect of regulatory changes and corporate governance reforms on firms’ earnings management practices in Australia and New Zealand. Using a sample of 3,966 firm-year observations including all ASX and NZX listed firms from the period 2001 to 2006, we find that the magnitude of earnings management did not decline after the introduction of new regulations to reform corporate governance. In fact, we observe a positive time trend suggesting that earnings management has been growing over time. We also perform Chow test and the results indicate a structural change has occurred in earnings management practice before and after the new regulation was introduced in Australia. The results reveal that managers tend to reduce earnings before the introduction of corporate law and economic reform program, companies with high reported earnings may be targeted by the regulators and attracted more public inquiry during the reform movement and therefore managers would have incentive to engage in downward earnings management to reduce such political exposure. We also find that subsequently following the reform action, managers are more likely to show a smooth and growing earnings string to prove that firm performance has benefited from the reform. As such, upward earning management severs a role of information signalling in the period after the introduction of corporate law and economic reform program to convince investors the better shaped and improved financial performance after the regulatory change. These findings taken together can lead regulatory authorities considering appropriate measures to promote earnings quality in corporate financial reporting from a long-run decision usefulness context.

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.

The Influence of Corporate Social Responsibility and Board Characteristics on Earnings Management

This paper examines whether firms that act socially responsible and have favourable board characteristics engage in a more transparent financial reporting. In particular, the first question is whether firms with high corporate social responsibility (CSR) engagement exhibit less earnings management than their socially less responsible counterparts. Simultaneously, the second question deals with the level of support of favourable Corporate Governance (CG), leading to a superior transparent financial reporting. The study therefore examines whether firms with high engagement in CSR and high independence in board and selected committees engage in even lower earnings management. The results show that CSR firms engage in lower (1) accrual-based earnings management and (2) real activities based earnings management. Additionally, these firms exhibit lower earnings management, when (1) nomination committee and (2) overall board have higher degrees of independent members. These coherences are non-linear. Most important, there is a interaction level effect between the favourable board independence characteristics and CSR, leading to a superior transparency in financial reporting. However, high-incentive situations are detected in which the magnitude of earnings management is high for all firms. The results are robust to (1) using various models and estimators to compute accrual-based and real activities earnings management, (2) using mean-centered or standardised proxies, (3) using alternative measures for CSR performance respectively grouping and (4) applying additional performance control.

Independent director cash compensation and earnings management

This study examines the impact of independent directors’ cash compensation on firms’ financial reporting quality using a sample of Chinese listed companies from 2002 to 2008. Unlike in the U.S. where most listed firms provide stock-related compensations to outside directors, Chinese listed companies compensate independent directors with cash only. This context offers a cleaner setting for examining the effects of independent director cash pay on earnings management. Our study documents a positive association between independent director cash compensation and the magnitude of earnings management. This suggests that compensating independent directors with higher cash pay compromises their independence and reduces their effectiveness in financial reporting oversight. Our results are robust to an array of sensitivity checks. These findings have important implications for both investors and policy makers by showing that independent directors’ cash compensation is also a significant determinant of financial reporting quality.

How should we think about earnings quality? A discussion of “Earnings quality: Evidence from the field”

Dichev, Graham, Harvey and Rajgopal (DGHR, in this issue) survey chief financial officers (CFOs) to elicit their views on earnings quality, broader trends in financial reporting, and the prevalence of earnings management. They provide some interesting insights on these issues. We discuss how CFOs' incentives in the financial reporting process are likely to affect what we can learn from them about earnings quality. We also discuss how DGHR's methodological choices regarding survey sample and question design affect their inferences, including what we can infer about the prevalence and magnitude of earnings management.