Earnings Management Tools Research Articles

Fair value hierarchy in financial instrument disclosure. Is there transparency for investors? Evidence from the banking industry

The debate on fair value accounting is still open although the last 20 years have been spent in looking for solutions by academics, practitioners and institutions. After long and continuous discussion both on the basic concepts and the information level contained in fair value measurements and on the different solutions that are possible to adopt in mark to market measurements, IASB and FASB have recently issued new standards on fair value measurements applying some principles not only to financial instruments but also to property and other investments. To verify if the solutions adopted in these Standards really improve the disclosure level and the “usefulness of data for investors”, this paper analyzes the actual level of transparency and the “usefulness” of the “fair value hierarchy” (which from some points of view synthesized the Board’s way of thinking regarding to fair value) which has already been introduced for financial instruments by IFRS 7, Financial Instruments: Disclosure. The paper presents results of an empirical investigation on a sample of domestic and foreign listed banks that adopted fair value hierarchy in line with SFAS 157 and IFRS 7 recommendations. Research questions can be summarized as follows: (i) does fair value hierarchy improve transparency in financial instrument evaluation in bank annual reports, or can it be considered as a tool for earnings management?

Fair Value Accounting, Auditor Specialization, and Earnings Management: Evidence from the Banking Industry

In this study, we examine whether the extent to which banks use the loan loss provision (LLP) and realized gains and losses on sales of investments to manage reported earnings is associated with the extent to which they hold assets that are recorded using fair value accounting. We argue and find that banks with a greater extent (or proportion) of assets reported using fair value accounting substitute LLP-based earnings management with transaction-based earnings management (i.e., earnings management achieved by timing the realization of gains/losses) to a greater extent. In addition, we find that banks engaging industry specialist auditors use less LLP-based and transaction-based earnings management. Our findings suggest that banks with a greater extent of assets reported using fair value accounting have a different and potentially less visible set of earnings management tools with which to achieve desired earnings outcomes. Our results should be informative to regulators, members of the banking industry, and academics interested in the association the use of fair value accounting and bank earnings management behavior.

The Association between Corporate Governance and Earnings Surprises Games

In this paper, I investigate (1) the extent to which corporate governance is associated with managers’ choice of the mix of earnings management and expectations management to avoid negative earnings surprises, and (2) whether the association has changed following the passage of the Sarbanes-Oxley Act (SOX) 2002. Three distinct earnings management tools are considered: real earnings management, accruals management, and classification shifting. I document that higher quality corporate governance is associated with less upward accruals management and classification shifting, but also increases both the likelihood and magnitude of downward expectations management. With respect to real earnings management, the results are less conclusive. While board independence is positively associated with temporarily boosting sales, it is negatively associated with cutting discretionary expenses such as R&D. I also find some evidence that the impact of corporate governance quality on managers’ choice of the four mechanisms to meet or beat analysts’ forecasts has changed in the post-SOX period.

CEO Pay Contracts and IFRS Reconciliations

We examine whether UK managers exploited the discretion provided in the UK GAAP to IFRS reconciliation process to manage earnings and whether this earnings management is associated with the structure of the managers’ compensation contracts. Using a comprehensive dataset, mainly hand-collected from the firms’ annual reports, we provide evidence that, given the existence of an accounting-related vesting target in their pay schemes, CEOs use UK GAAP to IFRS reconciliations as an earnings management tool. We test our hypotheses under a number of different specifications including a propensity score matching analysis. Our study contributes to the literature on the relation between earnings management and contractual incentives by focusing on a setting surrounding a major structural change in accounting policies.

The Market Reward for Achieving Analyst Earnings Expectations: Does Managing Expectations or Earnings Matter?

Abstract: This study explores the market response to achieving analyst earnings expectations, distinguishing between expectations achieved through earnings forecast guidance and earnings management. We consider three earnings management tools: real earnings management, working capital accruals management, and classification shifting. Analysis indicates that UK firms use earnings forecast guidance and classification shifting to achieve analyst expectations. The market does not reward firms that achieve expectations through forecast guidance, and achievers that classification shift receive a lower market reward than genuine achievers. The market response aligns with information on future profitability and rational pricing tests show that there is no overall mispricing of achievers. Evidence of stock price incentives to engage in earnings forecast guidance is found only within more opportunistic downward forecast revisions mainly driven by high market growth expectations.

Related party transactions as a source of earnings management

In this article, we contribute to the earnings management literature by addressing the issue of Related Party Transactions (RPTs) during a firm's Initial Public Offering (IPO) process. We regard RPT-based earnings management as a kind of agency problem in the context of Chinese IPOs, and argue that the conflicts of interests between the controlling shareholders and the minority shareholders are the root of RPT-based earnings management in Chinese IPOs. We provide empirical evidence to demonstrate that RPT-based earnings management in a portfolio of earnings management tools including accruals management, and how it affects the firm's post-IPO long-term performance in China. Using 257 Chinese A and B shares IPOs during 1999 and 2000, our empirical findings suggest that controlling shareholders structure operating RPTs in pre-IPO period and these RPTs are positively associated with firm's operating performance. The decline in operating RPTs after IPO contributes to firm's post-IPO long-term underperformance...

Loan Loss Provisions, Earnings Management and Capital Management under IFRS: The Case of EU Commercial Banks

Prior research has shown that loan loss provisions are primarily used as a tool for earnings management and capital management by listed banks. Effective 2005 all listed companies in the European Union (EU) are required to comply with International Financial Reporting Standards (IFRS). Adherence to IFRS, it is claimed, should enhance transparency of reporting practices relative to local General Accepted Accounting Principles (GAAP). The overall objective of this paper is to examine the impact of the implementation of IFRS on the use of loan loss provisions (LLPs) to manage earnings and capital. We use a sample of 91 EU listed commercial banks covering a period of 10 years (before and after implementation of IFRS). Since early adopters may have different incentives and motivations relative to those who adopt mandatorily, we dichotomize our sample into early and late adopters. Overall, we find that earnings management (using loan loss provisions) for both early and late adopters while significant over the estimation window is significantly reduced after implementation of IFRS. We also find that, for risky banks, earnings management behavior is more pronounced when compared to the less risky banks, but is significantly reduced in the post IFRS period. Capital management behavior by bank managers is not significant in both pre and post IFRS regimes. Overall, we conclude that the implementation of IFRS in the EU appears to have improved earnings quality by mitigating the tendency of bank managers of listed commercial banks to engage in earnings management using loan loss provisions.

Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool?

We examine the information role of accounting disclosures on warranties, utilizing a database that became available due to the requirements of FIN 45. First, because firms use warranty policies as a business strategy to promote their products, a warranty reserve can serve two roles: an information signal regarding product quality as well as a contingent liability. Consistent with this view, we find that the stock market recognizes that: (1) the warranty reserve contains information about firms’ future performance, and (2) the reserve is a liability. Second, because warranty accruals require estimation of future claims, they can be used as a tool of earnings management. Our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet earnings targets. Finally, we find that the stock market recognizes the understatement of warranty liabilities of firms that managed earnings.

Did FIN 48 Limit the Use of Tax Reserves as a Tool for Earnings Management?

We utilize new income tax reserve disclosures required under FIN 48 to examine whether managers use discretion over this accrual to manage earnings to meet the consensus analyst forecast. We find that firms with pre-managed earnings (i.e., earnings before the change in the tax reserve) that are below the consensus analyst forecast are far more likely to reduce their tax reserves and thus report higher net income. In fact, we find that 37 percent of firm-years with pre-managed earnings below the consensus forecast meet the forecast when the change in the tax reserve is included in earnings. In contrast, only 9.8 percent of firm-years with pre-managed earnings above the consensus forecast increased their tax reserves to the extent that it caused them to miss the consensus forecast. This asymmetric result is consistent with managers using their discretion over tax reserves to meet consensus analyst forecasts. Using a proxy for changes in tax reserves developed by Blouin and Tuna (2007), we also document a decline in the use of tax reserves to meet the consensus analyst forecast following the adoption of FIN 48. Nonetheless, our results using both estimated and actual changes in tax reserves clearly suggest that managers continue to use their discretion over this account to meet the consensus analyst forecast, although at a lower rate of recurrence than during the pre-FIN 48 time period.

Fair value accounting and gains from asset securitizations: A convenient earnings management tool with compensation side-benefits

Accounting rules for valuing retained interest from securitizations require management to make assumptions concerning discount rates, default rates, and prepayment rates. These assumptions provide management with discretion to determine the “gain on sale” of the receivables. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. Overall, our results do not suggest that better “monitoring” reduces earnings management or CEO pay-sensitivity to reported securitization gains. Our results suggest that CEOs are rewarded for the gains they report and boards do not intervene.

Pension Actuarial Incentives for Earnings Management

This study investigates whether financially distressed firms exploit the pension actuarial assumptions of the Statement of Financial Accounting Standards No. 87 (Employers’ Accounting for Pension) as a tool for earnings management. For a sample of 587 firm-year observations over the period of 1988-2002, the solution for detecting earnings management is the use of a system of four simultaneous equations. By using three-stage-least-square (3SLS), this study demonstrates that taking account of simultaneity is important for three of the seven modelled incentives, namely, the discount rate, expected rate of return on plan assets, and salary progression rate. All three behave as if they are used to manipulate pension costs, and discretion in each of these incentives depends on the levels of the other two. In contrast, the remaining four incentives are used as control variables in this study, namely: debt covenant, bonus plan, cash flow, and funding status incentives, which appear to be determined independently of the other incentives. The parameter estimates indicate that the discount rate and the expected rate of return on plan assets are used to manage earnings, and salary progression rate is used, perhaps secondarily, to offset the total pension costs. Therefore, managers of financially distressed firms may have smoothed reported earnings by jointly changing the pension rates to change the corresponding pension costs and cash requirements.

The joint decision to manage earnings through discretionary accruals and asset sales around insider trading: Taiwan evidence

This study assesses the joint decision of multiple earnings–management tools around insider trading. The Taiwanese evidence indicates significantly higher magnitudes of both discretionary accruals and asset sales before insider selling. In addition, to investigate the endogenous relationship between discretionary accruals and asset sales, this study develops a set of simultaneous equations and includes the inverse Mill’s ratio as a regressor to account for firms that choose not to use asset sales. The results indicate a marginal complementary correlation between discretionary accruals and asset sales before insider selling. Further tests find this complementary correlation becomes stronger when accompanying abnormal insider selling. The findings support the view that insiders consider both tools jointly and adjust them as complements to meet their directional earnings management objective.

Discussion of “Evidence of differing market responses to beating analysts’ targets through tax expense decreases”

Gleason and Mills (2008, Review of Accounting Studies) extend prior research investigating whether investors detect obvious earnings management. They improve on previous efforts to answer this question by examining firms with a clear motivation to manage earnings and by investigating a specific earnings management tool. They investigate firms that fall short of analysts’ expectations when income tax expense is based on the third quarter effective tax rate but meet expectations by reducing the fourth quarter tax expense below predicted tax expense. Their results suggest that investors are sophisticated enough to identify a transparent earnings management tool and that they discount the fact that firms meet expectations using such an obvious tactic. Specifically, the authors find evidence suggesting that the reward for meeting analysts’ expectations is 86% lower when managers use the tax expense as an earnings management tool to meet expectations. The puzzling feature of their results is that, although it is diminished, investors still reward firms for meeting expectations when they can only do so through an apparently obvious manipulation of tax expense.

Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool?

ABSTRACT: We examine the information role of accounting disclosures on warranties, utilizing a database that became available due to the requirements of FIN 45. First, because firms use warranty policies as a business strategy to promote their products, a warranty reserve can serve two roles: an information signal regarding product quality, as well as a contingent liability. Consistent with this view, we find that the stock market recognizes that: (1) the warranty reserve contains information about firms’ future performance, and (2) the reserve is a liability. Second, because warranty accruals require estimation of future claims, they can be used as a tool of earnings management. Our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet earnings targets. Finally, we find that the stock market recognizes the understatement of warranty liabilities of firms that managed earnings.

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

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

Earnings Momentum and Earnings Management

This paper provides evidence on firms that report long “strings” of consecutive increases in earnings per share (EPS). First, we find 746 firms that report earnings strings of at least twenty quarters since 1962, and show that this frequency is much larger than would be expected by chance. We interpret this as prima facie evidence of earnings management. Next, we document that these firms enjoy abnormal returns that average more than 20 percent per year during the first five years of these strings, and these returns are larger than those of firms reporting at least five years of consecutive increases in annual (but not quarterly) EPS. We argue that these market premia, and the rapidity with which they disappear once the strings end, provide managers with incentives to maintain and extend the strings. Finally, we present several tests that document how managers of these firms use various earnings management tools to help their firms sustain and extend these strings.

Earnings Momentum and Earnings Management

This paper provides evidence on firms that report long of consecutive increases in earnings per share (EPS). First, we find 746 firms that report earnings strings of at least 20 quarters since 1962, and show that this frequency is much larger than would be expected by chance. We interpret this as prima facie evidence of earnings management. Next, we document that these firms enjoy abnormal returns that average over 20 percent per year during the first five years of these strings, and these returns are larger than those of firms reporting at least five years of consecutive increases in annual (but not quarterly) EPS. We argue that these market premia, and the rapidity with which they disappear once the strings end, provide managers with incentives to maintain and extend the strings. Finally, we present several tests that document how managers of these firms use various earnings management tools to help their firms sustain and extend these strings.

Earnings Management and Guidance for Meeting or Beating Analysts' Earnings Forecasts

We examine a comprehensive set of earnings management tools and forecast guidance to gain insights into the tools used by firms to meet or beat analysts' earnings forecast. Among the earnings management tools, in addition to discretionary accruals, we consider classification shifting (McVay 2006) and real activity manipulation: negative abnormal selling, general and administrative expenses (Gunny 2005), positive abnormal production and negative abnormal cash flow from operations (Roychowdhury 2005). We find that the use of downwards forecast guidance, upwards discretionary accruals and upwards classification shifting increases the probability of meeting or beating analysts' earnings forecasts by 9%, 5% and 10%, respectively; negative abnormal selling, general and administrative expense increases the probability of meeting or beating analysts' earnings forecasts by 3%; and positive abnormal production and negative abnormal cash flow from operations decrease the probability of meeting or beating analysts' earnings forecasts by 3% and 6%, respectively. We also find downwards forecast guidance, classification shifting and negative abnormal cash flows decreases the meet or beat premium by about 9% to 18%: investors appear to recognize the tools for achieving the benchmark and appropriately adjust the meet or beat premium.

Deferral of currency variation losses as an earnings management tool

Earnings management has become an important topic in accounting and finance in recent decades. This practice is possible due the existence of alternative accounting criteria for recognition, measurement and/or demonstration of earnings, creating opportunities for managers to choose one of the available options in order to reflect information in the desired form. This can sometimes distort the analysis of the company’s performance. There are various ways to manipulate accounting information. This paper investigates whether there was earnings management in Brazil through deferral of losses due to exchange rate variations in 1999 and 2001, as well as through the respective amortization of these losses in following years. We analyze the companies that carried out such deferral in one or both years, and the respective amortization from 1999 to 2003, utilizing histograms and nonparametric methods, and find strong indications that the companies that chose such deferral did so to manage their earnings, in order to avoid showing decreased earnings or even losses.

Managing Earnings with Intercorporate Investments

Abstract: We explore to what extent firms deliberately manage their financial reports by exploiting the flexibility of generally accepted accounting principles. Using a sample of Oslo Stock Exchange‐listed firms with 20–50% equity holdings in other firms, we find that firms with high financial leverage tend to maximize reported earnings from these investments through their choice between the cost method and the equity method, possibly in an attempt to reduce debt renegotiation costs or to avoid regulatory attention. In contrast, managers do not systematically bias reported earnings to extract private benefits or to signal revised expectations about future cash flows. Firms use different earnings management tools in a consistent way, as the earnings effect of the cost/equity choice is not offset by discretionary accruals.