Pre-managed Earnings Research Articles

Economic policy uncertainty and incentive to smooth earnings

We examine how economic policy-induced uncertainty influences managers' discretionary accounting choices to achieve a smoother earnings stream. We find that managers offset the partial risk of policy uncertainty on reported earnings by using discretionary accruals. We mainly observe that firms report more negative discretionary accruals when managers are less certain about their prospects. We further show that managers' engagement in income-decreasing earnings management is more significant when firms’ current period pre-managed earnings are higher. To complete the story, we also find that the propensity of reversal of discretionary accruals is positively associated with levels of policy uncertainty. Our results imply that managers opportunistically use discretionary accruals around an uncertain exogenous environment to smooth earnings.

An alternative approach to detect earnings management to meet or beat benchmarks

PurposeThe authors propose an alternative robust technique to test for discontinuities in distributions and provide consistent evidence of discontinuities around zero for both scaled and unscaled earnings levels and changes. The advantage of the proposed test is that it does not rely on arbitrary choice of bin width choices.Design/methodology/approachTo evaluate the power of the test, the authors examine the density function of non-discretionary earnings and detect no evidence of discontinuities around zero in levels and changes of these non-discretionary earnings. As robustness, the authors use pre-managed earnings excluding accrual and real manipulation and find similar evidence.FindingsThe finding using our technique support the Burgstahler and Dichev (1997) interpretation on earnings management, even for smaller sample sizes and reject the theory that discontinuities arise from scaling and sampling methods.Originality/valueThe study provides an overview of those studies that support and those that oppose using “testing for discontinuities” as a way to examine earnings management. The authors advance the literature by providing an alternative methodology supporting the view that the kink in the distribution represents earnings management.

Ownership type and earnings management in U.S. hospitals

We examine variation in accrual-based and real earnings management in U.S. hospitals by ownership type, using a stable comprehensive sample of hospitals from 2011 through 2016. We expect managers' reporting incentives to differ between ownership type (for-profit versus non-profit), resulting in differing uses of accrual and real earnings manipulations. First, we document that non-profit hospitals exhibit lower levels of both income-increasing and income-decreasing earnings manipulations than for-profit hospitals do. Second, we find that compared to non-profit hospitals, for-profit hospital managers use discretionary accruals (in particular) to create larger reserves when pre-managed earnings are high and to increase reported earnings more when pre-managed earnings are low. Together, these findings suggest that, relative to non-profit hospital managers, for-profit hospital managers have incentives to report higher and more consistent earnings.

Determinan Discretionary Loan Loss Provision pada Perbankan Syariah di Indonesia

This study is a quantitative study that aims to examine the effect of pre-managed earnings, capital management, leverage, sharia supervisory board, concentration ownership, and institutional ownership variables on earnings management proxied through discretionary loan loss provision. The research object used in this study were 12 Islamic banks registered with the Financial Services Authority (OJK) for the 2015-2019 period which were selected through purposive sampling technique. The data analysis technique used is panel data regression analysis using the help of the e-views software version 11. The results of this study indicate that pre-managed earnings, concentration ownership, and institutional ownership have no effect on discretionary loan loss provision. The leverage variable has a significant negative effect on the discretionary loan loss provision and the sharia supervisory board has a significant positive effect on the discretionary loan loss provision. While the capital management variable has an effect on the discretionary loan loss provision but has the opposite direction to the hypothesis in this studyKeywords: Discretionary Loan Loss Provision, Pre-managed Earnings, capital management, Leverage, sharia supervisory board, Ownership

Earnings quality determinants in pre-corona crisis: another insight from bank core capital categories

PurposeDiscretionary accruals are earnings quality proxies that illustrate that the greater the value of discretionary accruals, the greater the practice of earnings management and vice versa. High-quality financial reports (especially earnings quality) are expected to help investors and potential investors to make decisions. This study analyses the factors that affect earnings quality, such as pre-managed earnings, liquidity and efficiency. Furthermore, the authors identify the moderating effect of the governance mechanisms proxied by the proportion of independent commissioners in conventional commercial banks listed on the Indonesia Stock Exchange.Design/methodology/approachThis study uses 226 banking data in the pre-corona crisis period 2013 until 2019. The data were analyzed using EViews 10 for hypothesis and MS Excel for a differential test.FindingsThe results show that pre-managed earnings, liquidity and efficiency affect earnings quality. The governance mechanisms can moderate liquidity and efficiency on earnings quality, while pre-managed earnings cannot be moderated. The different bank categories (BUKU) of earnings management mechanisms are shown for each BUKU (BUKU 1, 3 and 4 perform earnings management by increasing earnings, BUKU 2 lowering earnings). Another thing is information on the earnings quality between BUKU 2 with BUKU 3 and BUKU 4 because of differences in capital and bank operating coverage regulations.Research limitations/implicationsFurther research expects to analyze the factors affecting banking earnings quality concerning applying IFRS 9 (PSAK 71) in Indonesia. Future researchers expect to apply mixed methods to verify the financial statement data and provide comprehensive discussion and genuine insight from their study. Future research requires more samples from companies or an international scale (cross country) to obtain maximum results and be generally accepted.Practical implicationsThis study implies that managers should have more control over pre-managed earnings and bank liquidity as manager's incentive to do earnings smoothing. Managers should also pay attention to cost-efficiency and effective implementation of governance mechanisms to maximize earnings quality. This study also implies that policymakers can encourage commercial banks to apply more prudential principles in terms of a reserve for failed loans to minimize earnings management in banking.Originality/valueThe significance of this study revealed in the discussion of the difference test between bank core capital categories (BUKU) and its relation to earnings quality.

Earnings management and the role of MOSAL in co-ops

• Consumer co-ops drive their annual earnings toward zero earnings based on their prior expectations of the level of pre-managed earnings. • Co-ops manipulate sales up, increase COGS, and reduce SG&A discretionary expenses when observed pre-managed earnings fall below zero earnings. • If pre-managed earnings exceed zero and attract regulators’ attention, co-ops reduce sales and COGS, and increase SG&A discretionary expenses. • Co-ops with small losses engage in real activities manipulation to avoid reporting losses and to make small profits. • Real activities manipulation and accrual-based earnings management have decreased following the passage of the 2013 MOSAL regulation. This study provides evidence that consumer co-operative societies (co-ops) drive reported earnings toward zero profit by adjusting sales, discretionary expenses, and costs of goods sold. Evidence also indicates that co-ops with small losses manage earnings up to avoid reporting losses and make small profits. Furthermore, earnings management tends to decrease after the 2013 MOSAL (Ministry of Social Affairs and Labor) regulation. This paper examines a highly significant and currently unresearched segment of the economy using a unique and comprehensive dataset of annual information on Kuwaiti co-ops. It also provides new insights on the role of government regulations in curbing the accounting practices co-ops managers use to misreport financial statements.

Banks’ Discretion Over the Debt Valuation Adjustment for Own Credit Risk

During our 2007 to 2015 sample period, firms recorded unrealized gains and losses on fair-valued liabilities attributable to changes in the firms’ own credit risk, referred to as the debt valuation adjustment (DVA), in earnings. Various parties criticized the inclusion of DVA in earnings as counterintuitive and manipulable. Using a small but comprehensive sample of European banks reporting nonzero DVA during this period, we decompose banks’ DVA into a normal portion explained by economic factors (e.g., changes in bond yield spreads) and an abnormal portion (the residual). Controlling for abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), we find that banks’ abnormal DVA is negatively associated with their premanaged earnings, consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP or RGL or that have histories of using LLP or RGL to smooth earnings are less likely to exercise discretion over DVA. These findings obtain in the financial crisis but not afterward. Collectively, our findings suggest that banks exercised discretion over DVA substitutably with discretion over LLP and RGL during the crisis. With the caveat that our analysis is limited by a small sample and the inherent difficulties of DVA decomposition, our findings have implications for how bank regulators and investors should interpret banks’ reported DVA, particularly in stress periods such as the crisis, and they provide support for the International Accounting Standards Board and Financial Accounting Standards Board’s (FASB) decisions to require firms to record DVA in other comprehensive income starting in 2018.

A Reexamination of Earnings Management through Permanently Reinvested Earnings

ABSTRACT Krull (2004) finds evidence that firms manage earnings through the permanently reinvested earnings (PRE) designation using the backing-out methodology. However, Lim and Lustgarten (2002) demonstrate that studies using the backing-out methodology may be subject to Type I errors. In this study, I demonstrate that the Krull measure of pre-managed earnings is susceptible to Type I errors. I then introduce an alternative measure based on Gupta, Laux, and Lynch (2016), and I find no evidence of earnings management through PRE using the Gupta measure of pre-managed earnings in the cross-section. However, among a sample of firms with the greatest ability to manage earnings through PRE, I find evidence of upward earnings management through PRE using both the Krull and Gupta measures.

The Influence of Ownership Type and the Affordable Care Act on Earnings Management in U.S. Hospitals

Using a comprehensive sample from 2011 through 2016, we examine variation in earnings management in U.S. hospitals by ownership type, and before and after the implementation of the Affordable Care Act (ACA). We expect managers’ reporting incentives to differ between ownership type (for-profit versus non-profit), resulting in differing uses of accrual and real earnings manipulations. First, we document that non-profit hospitals exhibit lower levels of both income-increasing and income-decreasing earnings manipulations than for-profit hospitals do. Second, we find that compared to non-profit hospitals, for-profit hospital managers use discretionary accruals (in particular) to create larger reserves when pre-managed earnings are high and to increase reported earnings more when pre-managed earnings are low. Together, these findings suggest that, relative to non-profit managers, for-profit managers have incentives to report higher and more consistent earnings. Third, we find that post-ACA, both non-profit and for-profit managers use real earnings management to report lower earnings, while only non-profit managers appear to use discretionary accruals to bolster earnings. Our findings also show that for-profit hospital administrators manage their earnings downwards using real earnings manipulations more so than non-profit administrators do. It is plausible that for-profit hospital managers are less willing to disclose any increased margins resulting from the ACA implementation than non-profit managers are.

Consequence of loan loss provisions on earnings management behaviour: A study on the best African commercial banks

This study aimed at analysing the relationship between loan loss provision (LLP) and earnings management in the African commercial banks. The study selected the 11 banks among the 32 best commercial banks as identified by the Global Finance Magazine in 2014. These 11 banks are available online in the Bureau van Dijk Bankscope data and helped observe 10 years (2004-2013, of which 2003 is the base) financial statements, which accounts 34.38% of the 32 best banks. Accounting data derived from 11 years audited financial statements were used; 110 bank-year observations. A two stage panel regression, partial and pairwise correlation, and independent t-test were applied in order to analyse the relationship between the discretionary LLP (DLLP) and earnings management. Accordingly, the study found that loan to deposit (LD), return on asset (ROA), and earnings before tax and provision (EBTP) significantly influence the DLLP. Besides, banks with high premanaged earnings and well-capital more indulge in the DLLP. The study supports empirical findings on income smoothing and external financing hypotheses, but not the capital management hypothesis. Finally, further research on this topic is recommended, among others, by taking relatively large bank-year observations.

Bankss Discretion Over the Debt Valuation Adjustment for Own Credit Risk

Prior to 2018, accounting rules required banks that recognize financial liabilities at fair value to record unrealized gains and losses on the liabilities attributable to changes in the banks’ own credit risk, referred to as the debt valuation adjustment (DVA), in earnings each period. Using a comprehensive sample of publicly traded European banks during 2007–2015, we investigate the economic determinants of DVA and banks’ exercise of discretion over DVA. We find that DVA exhibits the expected associations with economic factors, e.g., is positively associated with the change in banks’ bond yield spread. We decompose DVA into normal and abnormal components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions and realized securities gains and losses, consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger loan loss provisions or realized gains and losses and banks that have histories of using provisions or realized gains and losses to smooth earnings are less likely to exercise discretion over DVA to smooth earnings. These findings generally are consistent with banks using loan loss provisions, realized gains and losses, and DVA substitutably to smooth earnings. Lastly, we provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis but not afterward. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA, and they support the decisions by the IASB and FASB to require firms to record DVA in other comprehensive income starting in 2018.

Allowance for uncollectible accounts as a tool for earnings management

Purpose This study aims to verify the circumstances under which managing the allowance for uncollectible accounts is used as a tool of earnings management. Design/methodology/approach The authors investigate whether bad debt expense, which is an income statement counterpart of allowance for uncollectible accounts, is adjusted downward when pre-managed earnings is slightly above zero earnings, prior year’s earnings or analysts’ forecasts. Findings The findings of this study show that firms manage bad debt expense downward to avoid losses, sustain the prior year’s earnings and meet or beat analysts’ forecasts. The authors also find that the understatement of bad debt expense to meet earnings benchmarks is pronounced for firms with high tax costs. Social implications Standard setters and auditors can gain a better understanding in detail of the practices and methods of managing earnings via the allowance for uncollectible accounts. Originality/value This study is the first to examine earnings management via the allowance for uncollectible accounts in non-financial Korean firms. In addition, the findings provide the evidence that firms prefer to use the allowance for uncollectible accounts as a strategic tool to meet benchmarks, especially when their tax costs are high.

Do Firms Use Tax Reserves to Meet Analysts’ Forecasts? Evidence from the Pre‐ and Post‐FIN 48 Periods

AbstractWe examine whether firms decrease tax reserves to meet analysts’ quarterly earnings forecasts in the period prior to FIN 48, and whether that behavior changed following FIN 48. We use analysts’ forecasts of pretax and after‐tax income to impute premanaged earnings, or earnings before any tax manipulation. Pre‐FIN 48, we observe that firms reduce their tax reserves (i.e., increase income) when premanaged earnings are below analysts’ forecasts. Specifically, 78 percent of firm‐quarters that would have missed the analyst forecast if not for the tax reserve decrease, meet that target when the decrease is included. Furthermore, we find a significant positive association between the decrease in tax reserves and the deviation of premanaged earnings from analysts’ forecasts. In contrast, post‐FIN 48, we find no evidence that firms use changes in tax reserves to manage earnings to meet analysts’ forecasts. Thus, our results suggest that FIN 48 has, at least initially, curtailed firms’ use of tax reserves to manage earnings.

Managing accruals for income smoothing: empirical evidence from Pakistan

Purpose The purpose of this paper is to investigate whether income smoothing helps to reduce volatility in reported earnings and which firms are more inclined to be engaged in income smoothing. Design/methodology/approach The authors used negative correlation between pre-managed earnings of a firm and its discretionary accruals (DAs) as proxy for income smoothing and the firms having more negative correlation coefficient are expected to have lower volatility in their reported earnings. The authors used Kothari et al.’s (2005) version of modified-Jones model to estimate DAs and used least squares estimations to investigate the research questions using six-year (2007-2012) sample of non-financial firms listed over Karachi Stock Exchange, Pakistan. Findings The authors found that firms experiencing more volatility in economic activities and smaller firms are more aggressively involved in income smoothing. Moreover, a predominant majority (72.2 per cent) of firms in the sample are involved in income smoothing through accruals manipulation. Also, the authors found that firms which are more aggressively involved in income smoothing have lesser volatility in reported earnings. Lastly, the level of DAs per se does not have any impact on income smoothing. Research limitations/implications The proxy used for income smoothing, though the authors consider it to be better, is not the only one used in literature and the sample is limited to Pakistan. Originality/value This study adds to earnings management literature by providing evidence on extensive accrual manipulation for income smoothing in Pakistan.

Accounting Implications for Managed Earnings via Pension Expense

Recent earnings management studies provide evidence firms manage reported earnings to achieve certain capital market reporting objectives. This study extends earlier research by focusing directly on pension expense rather than focusing on the effect of individual pension rate assumptions. This study uses a $.10 screening technique in selecting the sample for testing. Based on a proxy for premanaged earnings, firms hypothetically missing their capital market benchmark earnings (i.e. prior year earnings target) are predicted and shown to reduce their actual pension expense to increase actual reported earnings; whereas firms hypothetically beating their capital market benchmark earnings (i.e. prior year earnings target) are predicted and shown to increase their actual pension expense to reduce their actual reported earnings. Results suggest firms use pension expense to actively and predictably manage actual reported earnings.

Does Dividend Policy Drive Earnings Smoothing?

SYNOPSISThis paper examines the earnings-smoothing behavior of dividend-paying firms. We show that dividend-paying firms engage in more earnings smoothing than non-payers through both real activities and accrual choices. More specifically, dividend-paying firms with positive (negative) pre-managed earnings changes engage in more downward (upward) earnings management than non-payers. Additional tests suggest that the results are driven by dividend-related incentives and not the differences in the economic characteristics of dividend-paying firms, are robust to alternative measures of earnings management, and are not due to spurious correlation. We also show that earnings smoothing, in part, explains the higher earnings persistence of dividend-paying firms. These findings are consistent with a firm's dividend policy having an incremental impact on earnings-smoothing behavior.JEL Classifications: M41; G35

A Theory on the Discontinuity in Earnings Distributions

This paper presents a model of financial reporting in which investors infer both pre-managed earnings and the precision of earnings from reported earnings. Over-reporting earnings has two opposing pricing effects: investors infer higher pre-managed earnings from an inflated positive earnings surprise (i.e., positive effect); however, investors also infer a lower earnings precision at the same time, leading to a lower pricing weight placed on the higher surprise (i.e., negative effect). For firms with (relatively) strongly positively autocorrelated earnings, in equilibrium, the trade-off between the two opposing effects creates a pooled report right above the prior mean of the earnings distribution and a no-reporting hole right below the prior mean (i.e., an earnings discontinuity consistent with empirical findings). Further, the model predicts cross-sectional variation in the earnings discontinuity phenomenon yet to be explored. In particular, the model shows and predicts: (1) no earnings discontinuity exists for firms with negatively or (relatively) weakly positively autocorrelated earnings, and (2) the earnings discontinuity is more pronounced for firms with more positively autocorrelated earnings.

Qualitative audit materiality and earnings management

This study investigates auditors’ propensity to rely on quantitative materiality thresholds to the exclusion of qualitative materiality thresholds. Specifically, we examine whether auditors are more likely to allow earnings management that is less than typical quantitative materiality thresholds but that nonetheless is qualitatively material. We use changes in tax expense as a proxy for earnings management. Our results indicate that companies with pre-managed earnings that would have missed the consensus analyst forecast are more likely to decrease their tax expense when the magnitude of the decrease is less than quantitative audit materiality thresholds. The results also indicate that firms are more likely to meet or beat the forecast when the amount of earnings management necessary to meet the analyst forecast is less than quantitative materiality. These results are consistent with auditors relying on quantitative materiality thresholds to the exclusion of qualitative materiality thresholds, i.e., the importance of meeting or beating the analyst forecast. Finally, we find that the ability to use tax expense reduction within quantitative materiality to meet or beat analysts’ consensus forecasts was significantly reduced by the SEC’s guidance on materiality in SAB-99 and by the passage of the Sarbanes–Oxley Act.

An Examination of Whether Firms Alter the Normal Evolution of Fourth Quarter Earnings to Avoid Losses

Our paper provides a comprehensive examination of issues and concerns in the current unresolved debate over the existence of loss avoidance behavior. We rely on a methodology that avoids previous strong assumptions for approximating pre-managed earnings and provide, instead, new earnings management tests. The primary issue that we consider is whether firms alter the normal evolution of earnings around the zero profit line relative to other nearby locations in the earnings distribution. Using generalized logistic regressions, we find that firms starting in adjacent intervals of the cumulative earnings distribution after three quarters generally have the same odds of experiencing a given fourth quarter earnings except when such fourth quarter evolutions result in annual earnings in close proximity to the zero profit line. It is there that the odds of a given magnitude of fourth quarter earnings diverge in favor of firms experiencing smallest annual profits, in comparison to firms experiencing smallest annual losses. Our results are robust to the choice of earnings measure: earnings scaled by size, net income, and earnings-per-share.

Weighing the Evidence on Earnings Management to Meet Dividend Thresholds

Daniel, Denis, and Naveen (2008) report evidence that firms manage earnings upward when premanaged earnings are expected to fall short of dividend payments. However, we find that this evidence is not robust when controlling for firms’ tendency to manage earnings upward to avoid reporting earnings declines. We further report that the decision to cut dividends depends on whether reported earnings fall short of past dividends, but not on earnings management that eliminates a shortfall in pre-managed earnings relative to dividend payments. Overall, our evidence suggests that firms that face dividend constraints are more likely to cut dividends rather than to manage earnings to avoid dividend cuts.