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Earnings Management to Avoid Earnings Decreases and Losses

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Abstract

This paper provides a review of the empirical earnings management literature. In particular, it presents a review of the factors that induce and constrain earnings management through accounting decisions. The consequences of actual or assumed earnings management are also discussed. The far majority of the literature focuses on the Anglo-Saxon context. However, major differences exist between Anglo-Saxon and continental European countries. This may result in differences in the importance of various incentives of and constraints on earnings management. In particular, we argue that explicit contracts and a firm's relations with capital markets may be less important sources of earnings management in continental Europe. Implicit contracts and the political and regulatory process may however be of major importance. We question further whether a firm's ownership and internal governance structure and the quality of the external auditor can constrain the ability to manage earnings in continental European countries.

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... They aim to clarify the earnings threshold having been the primary motivation of managers in recent years. We note that the majority of work related to earnings management pays particular attention to discretionary accruals and real earnings management for the purpose of estimating the manipulable part of earnings (Burgstahler & Dichev, 1997;Degeorge et al., 1999;Brown & Caylor, 2005; Barua et al., 2019;Halaoua et al., 2017). Halaoua et al. (2017) underline that the firms engage in earnings management measured via discretionary accruals with view to meet or exceed earnings thresholds. ...
... Managers use these tools to achieve earnings thresholds: avoiding losses, avoiding earnings decreases and avoiding negative earnings surprises. These concepts emerge through the studies of Burgstahler and Dichev (1997) and Degeorge et al. (1999). They focus on irregularities in the distribution of earnings. ...
... With the intention of studying the relative importance of the three earnings thresholds, previous studies are used to provide a hierarchy of the earnings thresholds that managers seek to achieve. Burgstahler and Dichev (1997) examine two earnings thresholds (avoiding losses, and avoiding earnings decreases). They use annual data for the period spanning from 1976 to 1994, and they come to the conclusion that managers tend to manage profits to avoid losses in the first place and to avoid the decline in them in the second place. ...
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Research Questions: Does the hierarchy of earnings thresholds differ between accounting systems? Does a temporal shift occur in the hierarchy of the earnings thresholds associated with earnings management? Motivation: A number of studies looked into the hierarchy of earnings thresholds based on the earnings distribution, capital market valuation, survey views, and discretionary accruals. Our study seeks to fill this gap by investigating the hierarchy of earnings thresholds based on real earnings management and by investigating if the hierarchy of earnings thresholds differs between accounting systems. Idea: This paper aims to examine the hierarchy of achieving certain earnings thresholds based on the magnitude of discretionary accruals and real earnings management under two different accounting models. Tools: Large samples of US and French firms for the period ranging from 2008 to 2018 are used. The relative extent of both discretionary accruals and real earnings management used to achieve three earnings thresholds is examined by regression analyses. Findings: Two hierarchies emerge from the US and French contexts. On the one hand, we find (1) avoiding earnings losses, (2) avoiding earnings decreases, and (3) avoiding negative Accounting and Management Information Systems 374 Vol. 21, No. 3 earnings surprises in the US context. On the other hand, we find out (1) avoiding earnings losses, (2) avoiding negative earnings surprises, and (3) avoiding earnings decreases in the French context. An analysis of the real earnings management behavior of these firms indicates that they have used the significant real earnings management for the purpose of avoiding earnings decreases in both contexts. These hierarchies are reorganized over time. Contribution: Our paper contributes to the existing literature in several ways. First, the majorities of studies on earnings management examine and validate opportunistic incentives, whereas our results validate incentives with reference to the signaling theory. Second, our findings are of interest to investors, auditors, regulators and academics with respect to the financial statement analysis, accounting earnings quality, and financial reporting. Research limitations: This study is subject to measurement error which is a common limitation in the earnings management literature.
... Previous research has found that the stage of the business cycle and performance have an impact on earnings data. According to Burgstahler and Dichev (1997), earnings contribute more to value when the business's current operating activities are successful, implying that earnings are more appropriate for the company during its growth and maturity stage. Basu (1997), on the other hand, shows that bad news spreads faster than positive news due to financial statement asymmetry. ...
... To meet profit forecasts, mature companies may encounter capital market pressure (Burgstahler & Dichev, 1997). Furthermore, in mature organizations, managers are more inclined to stake their reputation and credibility on reaching earnings targets (Graham et al., 2005). ...
... The results are inconsistent with Hussain et al. (2020). Because profits add more to value when the firm's present operational activities are effective, earnings during the maturity stage are more suited for the company (Burgstahler & Dichev, 1997). Furthermore, in this stage, companies have a sustainable position in the market. ...
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The study examined the relationship between firm life cycle (FLC) and earnings management (EM) in the Vietnamese context with the moderating role of state ownership (SOE). We used the sample of 622 Vietnamese listed companies over the period 2010-2019. To eliminate autocorrelation and heteroscedasticity violations, we utilized FE Robust on all models. The data show that accrual earnings management (AEM) behavior varies between FLC phases. The results revealed a U-shaped pattern, with discretionary accruals (DAs) being more remarkable in the introduction and decline stages and lower in the remaining stages. The findings on the connection between FLC and real earnings management (REM) varied depending on the REM technique used. The results support the involvement of SOE as a moderator in both the FLC-REM and the FLC-EM relationship. This study significantly contributed to the existing literature about FLC and EM behavior. Vietnam is a country with an incomplete legal framework for protecting investors and inefficiency in the corporate governance mechanism. With the rapid development of the financial market, the firm life cycle term attracts much attention from scholars and other related parties to select the most appropriate strategy for firms in each state. Although the FLC was ascertained for its impact on the organization's development in existing literature, the relationship between FLC and characteristics of earnings management is rarely explored by prior studies. Therefore, this is the first study to explore the relationship between firm life cycle and earnings management behaviors along with the moderating effect of state-ownership in the Vietnamese context. Depending on each stage and the method of earnings management, the relationship between earnings management and the firm life cycle is different. This study significantly contributed to the existing literature about FLC and EM behavior.
... Before testing the hypothesis in the context of REM, researchers must identify and establish a setting that provides incentives for managers to engage in earnings management. For example, meeting and beating earnings thresholds, such as avoiding a loss, beating last year's earnings, and meeting analysts' forecasts, are common incentives for managers to engage in earnings management (Burgstahler & Dichev, 1997;Graham et al., 2005). Suspect firms provide a setting within which managers have incentives to engage in earnings management. ...
... Therefore, they need to first examine how managers act when they are faced with missing a threshold, such as zero earnings or last year's earnings. 35 Future research, which uses non-US data, could follow procedures similar to those of Roychowdhury (2006), Burgstahler and Dichev (1997) and Gilliam (2021) in order to establish a setting, before moving to testing the determinants and consequences of REM. However, a caveat is in order. ...
... It would be more informative to examine exogenous shock(s) that might affect unmanaged earnings and then investigate firms' reporting behaviour. 35 Researchers often document the use of earnings management as the possible reason behind the kink (Burgstahler & Dichev, 1997). However, Gilliam et al. (2015) document that the zero-earnings discontinuity becomes less kinky after 2002: the year in which the SOX was enacted, and managers switched to REM. ...
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We provide a systematic literature review of the determinants and consequences of real earnings management (REM) in an international context. We provide a theoretical framework for REM, the development of REM measures, and review the determinants of REM, categorizing these into financial reporting, auditing, governance and controls, capital market incentives, and regulatory determinants. We then review the empirical literature on the consequences of REM. We provide some suggestions for future research on measurement issues related to REM, and on filling gaps in the empirical research investigating its determinants and consequences.
... A large and growing body of research tends to argue that the discontinuity reflects earnings management (e.g. Hayn 1995;Burgstahler and Dichev 1997;Roychowdhury 2006;Zang 2012;Halaoua et al. 2017;Elleuch Hamza and Kortas 2018;Trimble 2018), while others challenge this view and provide a variety of explanations, such as the effects of deflation and sample selection (e.g. Dechow et al. 2003;Easton 2005, 2009) as well as the asymmetric effects of income taxes and special items on profit and loss firms (Beaver et al. 2007). ...
... Since Hayn (1995) identified a discontinuity in the distribution of earnings at zero, various explanations have been suggested by the literature. The earnings management interpretation (Burgstahler and Dichev 1997;Hayn 1995) appears to be widely accepted, while alternative explanations are put forward showing that non-earnings management factors, such as scaling and sample selection Easton 2005, 2009;Dechow et al. 2003) as well as income taxes and special items (Beaver et al. 2007), could explain the zero-earnings discontinuity. However, those explanations may not be valid enough due to weaknesses in research design. ...
... Earnings management tends to be a widely accepted explanation for the discontinuity in the earnings distribution. Burgstahler and Dichev (1997) test for earnings management to avoid losses. The underlying assumption in their study is that in the absence of earnings management the distribution of earnings is relatively smooth at zero. ...
Article
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In this paper we argue that financing decisions contribute to the zero-earnings discontinuity. We find a discontinuity in the distribution of earnings before tax and earnings before special items, but not in the distribution of earnings before interest which suggests that interest expense contributes to the zero-earnings discontinuity. To investigate the role of interest expense in the zero-earnings discontinuity, we further show that there was a discontinuity in the distribution of the level of debt issues around zero earnings contemporaneous with the zero-earnings discontinuity. We also show that the recent disappearance of zero-earnings discontinuity is coincident with the disappearance of the discontinuity in the debt issuance distribution. Overall, our findings suggest that the level of debt contributed to the zero-earnings discontinuity when it existed.
... This finding is particularly important given that Collins et al (1997) document a dramatic increase in the US between 1953-93 in both the percentage of firms reporting unusual items and the size of the items relative to net income. Burgstahler and Dichev (1997) investigate the existence of earnings management by US firms to both avoid earnings decreases and losses. They discover that earnings changes of just below zero occur less frequently than would be expected relative to increases slightly greater than zero. ...
... However, when growth ceases the subsequent returns for revenuedriven firms are lower than other firms. Burgstahler and Dichev (1997) investigate the use of earnings management to avoid earnings decreases and losses. They discover that earnings changes of slightly less than zero occur less frequently than would be expected, whilst increases of slightly greater than zero were found more regularly than anticipated. ...
... This can be viewed in contrast to reported earnings, which are widely regarded as being subject to management (e. g. see Burgstahler and Dichev, 1997). It is often concluded that when managers make a commitment to initiate a dividend (with the exception of special payments), they intend to make the distribution not for just one ...
Thesis
p> The aim of this thesis is to investigate a number of different aspects of the dividend policy imposed by firms in the United Kingdom and the implications for shareholders. Dividends, and in particular dividend reinvestment, have previously been shown to have contributed significantly to long-term equity returns with capital gains representing a relatively small component. Recent evidence, however, from the United States has pointed to a considerable decline in the proportion of firms paying dividends. This has implications for investors that require a history of dividend payments and thus who are now constrained in a smaller portion of the equity market. This thesis reports that whilst there has been a decline in the percentage of firms making payments in the UK , this has been relatively modest compared to the US . Furthermore, the total market payment has increased in real terms as a concentration of dividends has occurred amongst the largest payers. The aggregate dividend payout ratio is also considered as a stand-alone investment tool. Contrary to conventional wisdom, it is reported that a positive relationship exists between the payout ratio and future real earnings growth. The remainder of the thesis studies factors that influence the dividend policy of individual firms and whether managers use this as a means of addressing informational asymmetries by signalling their expectations to investors. It is found that the major factor in dividend setting is profitability, however, there is ‘stickiness’ observed that leads to current dividends being influenced by past payments. There is only limited evidence presented of dividends conveying information regarding the future profitability of firms. </p
... However, even though managers may accrue benefits for themselves, they do not typically overextend their use of earnings management because of the advantages and disadvantages of reporting too low or high figures. Burgstahler and Dichev (1997) claim that firms may be discouraged from reporting too optimistic earnings because they could be subject to union wage negotiations, or stakeholders may bargain for better terms knowing the financial standing. ...
... For example, Roychowdhury (2006) suggests that executive managers use their earnings discretion to avoid reporting losses or missing financial forecasts, emphasizing managers' focus on self-serving motivations and personal benefits. Burgstahler and Dichev (1997) find similar evidence in their paper investigating the relationship between managers and earnings management, demonstrating that managers engage in earnings management to avoid earnings decreases and losses. However, Bergstresser and Philippon (2006) propose that managers are motivated by equity-based executive compensation rather than the potential risk of experiencing losses. ...
Thesis
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The purpose of this study is twofold. The first is to examine the board monitoring's impact on accrual-based earnings management, as reflected by the absolute value of discretionary accruals. The second is to investigate the moderating effect of CEO power on the relationship between board monitoring and accrual-based earnings management. The study follows a deductive approach and a quantitative method in analyzing secondary data retrieved from databases and annual reports. Moreover, we use pooled-OLS, fixed-effects, and instrumental variable approach models to test our hypotheses. From an agency theory perspective, we analyze board monitoring, CEO power, and their respective impacts on accrual-based earnings management. We discuss information asymmetry, moral hazard, risk aversion, and earnings retention, among other theories. The empirical analysis is based on a sample of 400 firms, making up 7,489 observations, included in the S&P 500 index between 2000 and 2021. We conclude that board monitoring, as proxied predominantly by the audit committee, followed by board independence, reduces earnings management. Further, we find that CEO power moderates the relationship between board monitoring and earnings management. More specifically, our results indicate that firms with a dual CEO structure experience less efficient and lower-quality board monitoring.
... Prior research studies different types of earnings benchmarks and whether investors reward differently firms that manage their accounting numbers to meet or beat these targets. 5 The results 4 Bird et al. (2019) argue that the benefits linked to earnings management to beat targets are expected to be larger after SOX, "consistent with the market rationally becoming less skeptical of firms that just meet benchmarks" (p. 1). 5 Early evidence documenting benchmark beating behavior, its determinants and consequences, includes Burgstahler and Dichev (1997), Degeorge et al. (1999) and Peasnell et al. (2000). of these studies vary with the type of benchmark, rewards and earnings management considered. 6 Some studies find that the rewards to meeting or beating earnings targets disappear for firms that manage earnings, while others show that rewards still exist for these firms. ...
Article
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Prior research finds that firms with patterns of consecutive earnings increases are rewarded by market participants with higher Price-Earnings (P/E) multiples, and that some firms manage earnings to sustain the earnings stream. We propose several fast and inexpensive heuristics to classify firms as suspect or non-suspect of maintaining the stream through earnings management and examine whether market rewards differ for suspect and non-suspect firms. We find higher P/E multiples for firms with a pattern of increasing earnings supported by the same pattern of increasing cash flows (non-suspect). This is an important result as it shows that cash flows can be used to assess the quality of earnings in scenarios prone to earnings management, where earnings quality is expected to be low. We also find lower price-earnings multiples for firms suspected of using accrual-based earnings management, sales manipulation, and overproduction to achieve the earnings pattern.
... Perry and Williams (1994) provides evidence of managers' manipulation of earnings in the predicted direction in the year preceding the public announcement of management's buyout intention. Prior research by Burgstahler and Dichev (1997), and Degeorge, Patel, and Zeckhauser (1999) found cross-sectional evidence that: (1) small reported losses are unusually rare while small reported profits are unusually common, and (2) small declines in reported earnings are unusually rare while small increases in reported earnings, suggesting that managers use their accounting discretion to avoid reporting losses and earnings declines. Managers exercise discretion over earnings to enhance earnings information by allowing communication of private information. ...
Article
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Aging or growing old is a normal phenomenon of human being. Replacing aged workers by younger ones is general practice. A large percentage of aged persons suffer from job insecurity in developing countries like Bangladesh. However Aged workers are in general experienced and supposed to be relatively more responsible. Employment status of aged persons is immensely important. Ironically share of aged employees in total employees is abnormally low - not more than three percent in corporate sector in Bangladesh - larger proportion aged employees are working as management staff. Human resource management (HRM) is now gaining importance across the world. Human Resource Administration Department (HRAD) has moderately been penetrated in company sector. HRM cannot ignore the management of aged employee for augmenting profitability of organisation and no less significant is the social norms of welfare of elderly persons. Involvement of HRAD in the sphere of aged employees in Bangladesh focuses both favorable and unfavorable trend in the company sector of Bangladesh. Keywords: Human resource management (HRM), Human Resource Administration Department (HRAD), Aged employee.
... We also include FSIZE to control for the differences in the accrual behaviors of managers of large and small firms (Dechow and Dichev, 2002;Van Tendeloo and Vanstraelen, 2005). LEV controls risk (Burgstahler and Dichev, 1997), where firm LEV is positively associated with discretionary accruals, as DeFond and Jiambalvo (1994) find that firms manage earnings before debt covenant violations. GROWTH captures the possible difference in accruals' behavior between firms with high and low. ...
Article
Purpose This study aims to examine the relationship between CEO busyness and financial reporting quality in a country which implements a two-tier board system. Design/methodology/approach This study includes firms listed on the Indonesian Stock Exchange during the 2010–2018 period. This study employs an ordinary least squares regression, the propensity score matching procedure, and a Heckman two-stage regression in testing the hypothesis. Findings This study finds that firms with busy directors have a higher financial reporting quality, and these results are robust to a battery or sensitivity analysis. The additional analyses also find that a busy CEO is negatively associated with the firm's financial reporting quality with decreasing income. Practical implications This paper provides implications for policy-makers in the emerging market on devising policies on CEOs' appointments, especially when involving multiple directorships. Despite the general belief on the detrimental workload effects of busy directors, this study offers evidence supporting the opposite effect. Originality/value As many previous studies focused on the effect of director busyness on firm’s performance, this study focusses on the effect of CEO busyness on financial reporting quality. To the best of our knowledge, this study is the first to investigate this issue in an emerging market.
... It is argued that the quality of reported earnings will be significantly impacted if discretionary accruals are used to adjust them (Bricker et al. 1995), 1 which, in turn, will have an impact on earnings reliability (e.g., Healy and Wahlen 1999). To have a better understanding of what motivates managers to engage in earnings management, researchers have examined the impact of various factors on the quality of reported information, and these factors especially include executive compensation (e.g., Shalev et al. 2013), issuance of IPOs (e.g., Detzen and Zulch 2012), market expectation (e.g., Burgstahler and Dichev 1997), etc. Findings of these studies suggest that a good understanding of factors that encourage managers to use discretionary accruals affecting the quality of reported information enables investors to evaluate the quality of reported information for pricing the securities. We extend this line of research and examine the link between the use of discretionary accruals and market expectations during different stages of firm life cycle. ...
Article
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We provide evidence that the differences in economic growth and stability of firms during different stages of their life cycle encourage managers to manage the reported earnings differently to achieve their goals. Our findings support the expectation that managers adjust the reported earnings upward using positive discretionary accruals during the introductory and decline stages of firm life cycle. The upward adjustment of reported earnings during the introductory stage enables them to achieve the objective of sending positive signals on firm performance when the firm is in a formative stage, and also provides a better base for prediction of future earnings. The upward adjustment of reported earnings during the decline stage are expected to enhance firm’s life, which would enable managers to take remedial actions to improve firm performance, especially when the firm is in a distress situation. On the other hand, our findings show that managers may consider using negative discretionary accruals during the growth and maturity stages so that they can save some earnings for use during later years when firm performance compared to market expectations is weak. The managers are, however, not likely to adjust the reported earnings downward when the reported earnings fall short of market expectations. Additionally, we find that large institutional shareholdings perform effective monitoring and discourage managers to use discretionary accruals because their use may result in lower reliability of reported earnings.
... Such motives include meeting analysts' earnings forecasts (DeGeorge et al., 1999) or avoiding reporting a loss (Burgstahler and Dichev, 1997). Daniel et al. (2008) and Atieh and Hussain (2012) add to this literature by examining dividends as one of the important thresholds that motivate managers to manage earnings. ...
Article
This thesis aims to investigate the reliability of using accrual-based measures as a proxy for earning management in the UK. The earnings management literature has undergone immense development over the last decades, initially having focused on the establishment of abnormal accruals as a proxy for earnings management, thereafter more critical papers questioned the reliability of the previously developed measures resulting in modifications of pre-existing measures. This thesis builds on the critique that earnings management is not as prevalent as commonly suggested and that there might be concerns about how earnings management is measured. Therefore, the main research question asks - how reliable are accrual-based measures in assessing earnings management in the UK? The following objectives have been set to answer this question: the first objective is to examine the association of abnormal accruals generated from different measures in the literature, and whether they differ from the actual accruals of a firm. The second objective is to examine the persistence of abnormal accruals generated from different measures, if earnings management are a one-time manipulation they should not be persistent. The third objective is to examine the power of accrual-based measures. The fourth objective is to examine the dependability of accrual-based measures in capturing earnings management in different scenarios. In order to meet these objectives this thesis empirically tests the correlation, power and persistence of 37 accrual-based measures of earnings management identified in the literature. In addition, it replicates five published UK papers that use abnormal accruals as proxies for earnings management, altering the estimation of their earnings management proxies to abnormal accruals generated from the 37 different measures, as well as using placebo tests such as actual accruals, lead and lagged abnormal accruals. The main findings of the thesis shows that abnormal accruals, which are used to proxy earnings management, generated from the 37 different measures are highly correlated to each other and to the actual accruals of the firm. These measures therefore have low power and could suffer from problems with regards to correlated omitted variables. The results of persistence show that abnormal accruals do not appear to reverse over time, which is a key assumption in earnings management. In terms of the replications, this research finds other explanations for the results which could have influenced the relationship with no direct attribution to earnings management. In other scenarios, results were not found using any of the 37 accrual-based measures of earnings management, or using the actual accruals of the firm, indicating that their relationship to accruals are not robust. This thesis contributes to the earnings management literature in theory and practice. In particular it provides evidence that the accrual-based measures of earnings management literature are not as insightful as projected by researchers. Therefore, regardless of researchers’ use of measures in estimating abnormal accruals, whether previously established, newly developed or actual accruals, the results do not differ. This may imply that the new measures still suffer from problems in correlated omitted variables, thus do not capture earnings management. Future research should contemplate the use of specific accruals such as allowance for bad debt, deferred revenue or tax expense instead of aggregated accruals.
... The analysis of the conglomerate and the maps of the characteristics of Kohonen are possible; however, they suffer from defects in the identification of fraud clusters and the possibility of numerically classifying entities on a scale of suspicions for future investigations. PRIDIT analysis takes a set of predictive variables (red flags or indicator variables of fraud) that can be observed for each entity and there is a "latent variable" suspected of fraud "that underlies the probability of a response in a particular variable indicator will be Resolved in the affirmative or negative By using these new techniques, the manager can [1] evaluate the relative likelihood of fraud in the entity being studied, [2] find out which predictive variables are most important to detect fraud, [3] classify entities in terms of relative level of suspicion, and [4] be able to incorporate the propensity score produced by PRIDIT frauds as input for future fraud fraud investigation. The comparative analysis also allows analysts and auditors to detect discrepancies in the company's financial statements. ...
Article
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Part of the problem in detecting fraud in accounting and marketing (and because such detection is difficult) is that in many situations scammers are actively trying to hide their behavior. Much of the trust market research or explicitly expects to observe the subjects revealing their behavior; it is likely that fraud cannot spread on its own. Moreover, although certain types of fraud can be detected using parametric statistical models (such as logistic regression) formed on a known sample of fraudulent transactions discovered; there are other types of fraud for which the identification of fraudulent actions is very difficult. An example of fraud that the parametric statistical analysis provided is credit card fraud where the legitimate user can identify fraudulent charges at the end of the billing cycle (or before) or credit card identifies a series of actions using theft of the suspect card.
... Some other reports in the literature mention the reasons why firms engage in earnings management by manipulating accruals and real operating activities. Burgstahler and Dichev (1997) state that firms manipulate reported earnings to avoid earnings decrease and loss. Similarly, Roychowdhury (2006) mentions that firms manipulate real operating activities to avoid reporting annual losses. ...
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Using a standard partial adjustment model and US firms, we study the relationship between managers’ failure to achieve target labor productivity and their tendency to manage earnings. To overcome the endogeneity problem, we employ an instrumental variable technique based on negative investment growth and find that managers, experiencing a labor productivity gap, tend to manage earnings by manipulating discretionary accruals and real operating activities. Additional analysis suggests that elements of personal value maximization biases drive the estimated effect of the labor productivity gap. Our results are robust considering variation and alternative measures of statistical sensitivity. The positive association between the labor productivity gap and earnings management is also consistent with the opportunistic financial reporting hypothesis and impression management theory.
... Serafeim [65] suggests that the introduction of IR attracts long-term oriented investors by providing more information about firms' long-term prospects because such information is more relevant in assessing the value of firm. Some previous studies [66,104] imply that the existence of long-term oriented investors can reduce aggressive earnings management, where earnings are inflated to avoid earnings decreases and losses [105]. Bushee [106] observes that high levels of transient shareholding are related to overweighting nearterm earnings and underweighting long-term earnings. ...
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Integrated reporting (IR) by firms is intended to improve not only the quality of information available to external parties, but also internal managerial decision making. IR is considered useful to address the short-term orientation of firms caused by pressure from short-term oriented shareholders. This study examines whether the introduction of IR discourages real activities manipulation, a form of myopic behavior. Using a large sample of Japanese listed companies, the study empirically tests the effect of IR on real activities manipulation through panel data regression analysis. We find that the introduction of IR is related to higher level of abnormal cash flows from operations, lower level of abnormal production costs, and lower level of total activities manipulation. These results generally suggest that firms tend not to engage in real activities manipulation after IR is introduced. Our results also show that while there is insignificant difference in the degree of real activities manipulation between IR and non-IR firms immediately after the introduction of IR, the degree of real activities manipulation is generally smaller in IR firms than in non-IR firms after more time has passed since the introduction of IR, consistent with the view of practitioners that IR is a continuous improvement process of internal decision making. Regarding the non-financial aspects, additional analysis shows that introducing IR is positively associated with the performance of environmental, social and governance (ESG). Our findings suggest that IR could discourage companies’ short-term oriented behavior and promote long-term value creation, which is of interest to a wide range of stakeholders. Thus, our findings provide insightful evidence for researchers, practitioners, and policy makers interested in the role of IR in stakeholder-oriented corporate governance mechanisms.
... Earnings management may therefore be used as a strategic tool by managers of such companies to mask true performance. The sample excludes certain industries due to the peculiar nature of their accruals and their need to meet other reporting requirements (Rusmin, 2010;Matis et al., 2010;Burgstahler and Dichev, 1997). For instance, the banking business in Ghana is of a peculiar nature and is subject to certain legal requirements by the regulatory authorities. ...
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This paper analyses the implications of earnings management and corporate tax avoidance on the value of firm. Using a sample of non-financial firms listed on the Ghana Stock Exchange over a period of ten years (2003-2012), The study focuses on two pertinent issues: first, it analyses the relationship between earnings management (EM) and corporate tax avoidance (CTA). Second, it empirically tests the effect of the interactions between the two variables on the value of the firm. The results suggest a pervasiveness of EM activities among sampled firms. It further reveals that managers employ avoidance techniques to manage earnings. Our sensitivity analyses suggests that, despite the positive influence of corporate tax avoidance on firm value, the effect is not significant to offset the negative impact of earnings management on firm value, thereby resulting in an overall negative effect on the value of the firm.
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The relationship between culture, earnings management and corporate governance has been studied in different ways, but the influence that culture has over the actual effectiveness of corporate governance to control earnings management has not, even though it should be a determinant factor to define successful governance schemes. Using Hofstede four organizational models as a framework, in this paper, we analyze a sample of companies listed in 16 different stock markets in terms of organizational culture, assessing their governance standards and performance in relation to earnings management, and measuring their actual effectiveness. The results confirm that earnings management is conditioned by organizational culture and that corporate governance acts as a brake on earnings management, regardless of the cultural field in which it is analyzed. However, its effectiveness depends on organizational culture, mostly on the uncertainty avoidance and the power distance. Therefore, modelling a country based on its organizational culture does limit the success of corporate governance policies and standards. This study brings in a new perspective for policy makers and practitioners to design and enforce their corporate governance policies targeting earnings management, according to the prevailing culture. The previous literature on the subject is complemented and enriched by this significant contribution, through which limitations in terms of the number of countries studied could be overcome by further studies addressing specific regions or sectors.
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We examine the impact of short sales deregulation on firms' disclosure of non‐financial qualitative information. Our simple analytical model predicts that, after short sales deregulation and when the cost of disclosing proprietary qualitative information to the firm and its executives is sufficiently high, shortable firms respond by disclosing less proprietary and more non‐proprietary qualitative information than non‐shortable firms. Using a textual analysis of qualitative information about the supply chain, available in the management disclosure and analysis sections of the annual reports of a sample of Chinese firms, and applying a staggered difference‐in‐differences research design, we find evidence consistent with the model's prediction.
We examine the implications of insider trading restrictions on firms’ real activities earnings management in an international setting. Using a sample of 28 countries over the period from 1992 to 2007, we find evidence that is supportive of the substitution hypothesis, in that managers have incentives to substitute accruals earnings management for real activities earnings management. This effect is found to be more pronounced for firms in countries with more restrictive insider trading regulation. Our result is robust to alternative measures of real activities earnings management and insider trading restrictions, alternative sub-samples, alternative regression specifications, and controlling for endogeneity. In addition, we find that the positive association between insider trading restrictions and the substitution effect is more prominent for firms in countries with strong institutional infrastructure. Overall, our results are important in highlighting the role of insider trading restrictions in shaping corporate financial reporting policies. In particular, we find strong evidence to suggest that the extent of restriction of such laws influence managerial incentives to engage in earnings manipulation through real activities.
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This study with the view to fill the gap by conducting a research to know that what impacts CSR has on earning management and financial performance. The meaning of corporate social responsibility (CSR) is to give anything of value other than the core product by the company which is in the favour of society, understanding the actual needs of the society, ensuring workplace safety of employees, employees' retention and maintaining a clear relationship between the employees and management results in enhanced financial performance in term of profits, committed employees, customer loyalty and increased sale to face a competitive environment. The main aim of this research is to find out the relationship between CSR, earning management and firm's financial performance in term of employees' retention, firm reputation and increased profits. The study is quantitative, data collected through questionnaire distributed among the employees and annual reports of different companies on Pakistan Stock exchange, OLS for earning management dummy of 0 and 1 were used to regress the result of DV and IDV of the companies performing business in Pakistan. The Firms' Financial Performance (FP) is dependent variable while Corporate Social Responsibility (CSR) and Earning Management (EM) are the independent variable of the study. Analysis of the study shows that there is a positive correlation between Earning Management and corporate social responsibility and performance. This means that there is a significant relationship between CSR, EM and Performance revealing impacts that CSR and EM have on performance. The purpose of this study is to observe the relationship between Corporate Social Responsibility (CSR), Earning Management (EM) in firms registered on Pakistan Stock Exchange. The resultant findings of the study expose that Corporate Social Responsibility and EM results in higher financial performance in Firms in PSX.
Article
We analyze the disposition of auditor‐proposed adjustments to financial statements. Our analyses address concerns, expressed by regulators and others, that auditors and their clients fixate on quantitative thresholds and overlook qualitative factors in assessing the materiality of discovered misstatements. Using a large sample of PCAOB‐inspected audits, we examine the frequency with which management records vs. waives auditor‐proposed adjustments and whether waiving proposed adjustments has consequences for reporting reliability and the audit process. We find waived adjustments are linked to lower financial reporting quality measured by material misstatements, to incentives to meet/beat earnings targets and to the audit process, as measured by higher next‐period audit effort and fees and higher next‐period proposed adjustments. These effects on the audit process are consistent with auditors responding to the increased risk associated with waived adjustments. In an exploratory analysis we find that controlling for the amount of proposed adjustments, auditor resignations are negatively associated with waived adjustments. This article is protected by copyright. All rights reserved
Article
Sell-side analysts are rewarded for forecasting accurately, yet prior literature shows that analysts’ earnings forecasts exhibit an optimistic bias, which is generally attributed to analysts’ compensation structure or a desire to extract private information from managers. Building upon the theoretical model from Beyer (2008), we propose that analysts make decisions about forecasting while considering both optimism and accuracy: analysts forecast optimistically in anticipation of managers’ upward manipulation of earnings in order to meet or beat forecasts. We find that the upward bias in analysts’ earnings forecasts is increasing in the cost of managers missing forecasts (measured using leverage) and the volatility of earnings (using the standard deviation of ROA), and decreasing in the cost of earnings management (measured using Big 4 auditor, a pre- vs. post-Sarbanes Oxley test, and a DID test of larger vs. smaller firms, pre- vs. post-Sarbanes Oxley Section 404 implementation). Further tests suggest that these results are attributable to a lower (higher) incidence of earnings management for Big 4 and post-Sarbanes Oxley firms (firms with higher leverage and more volatile earnings). Our results provide evidence of a rational explanation for analysts’ decision making that considers both forecast optimism and a strategy to forecast accurately.
Article
Purpose Based on socioemotional wealth theory, the authors explore the impact of founder domination (with the founder as the chairman or CEO) on the earnings management activities of family firms and examine the moderating effect of the industry environment on the above relationship. Design/methodology/approach Based on the multivariate regression model, the authors test the theoretical view on the empirical data of Chinese family-owned listed companies. Findings The authors propose and find that under founder domination, family firms are unlikely to engage in earnings management activities. Furthermore, the authors find that industry growth enhances the above relationship, while industry competition weakens it. Originality/value First, by clarifying the importance and heterogeneous impacts of the founder serving as chairman or CEO on China's family firms' earnings management, this research contributes to a fuller understanding of the impact of founder domination on the business activities of firms, especially family firms. Second, the authors contribute to the literature that examines the antecedents of earnings management, particularly in family firms. Third, the authors contribute to the study of the boundary conditions of the “founder domination-firms’ business activities” framework.
Article
This study examines whether bank audit regulations impact bank reporting quality. Using a multi-country panel of publicly traded banks, we find that regulations targeting auditor qualifications and independence improve bank reporting quality. In contrast, regulations that impose greater supervisory oversight of external auditors have little or even an adverse effect on bank reporting quality. Cross-sectional analysis further shows that the effects of bank audit regulations are concentrated among banks where supervisory regime is less independent. Our results hold after controlling for bank regulations pertinent to financial reporting and disclosure, the adoption of International Financial Reporting Standards, and time-varying country-level institutional characteristics. Overall, our findings suggest that audit regulations matter and their impact on bank reporting quality is sensitive to the type of audit regulation. JEL Classifications: G21; G38; M41; M42. Data Availability: The data used in this study are publicly available from the sources indicated in the text.
Article
This research examined the association between executive compensation and accounting irregularities in Indonesia. Employing 1,100 firm-year observations during 2014 to 2017 period, we found that executive compensation is positively associated with accounting irregularities. This result is robust after we mitigated a serial order correlation of accounting irregularities and a self-selection bias using propensity score matching. We also discovered a positive relationship after considering alternative measures of accounting irregularities. Furthermore, we documented that the positive association between executive compensation and accounting irregularities is stronger for firms with higher board independence. Our findings provide important insights for regulators and Asian emerging market regulators who are considering promoting equity incentives for listed firms.
Article
This paper investigates the earnings management (EM) practices of Portuguese municipal firms (MFs), which are a special type of public-sector entity. MFs are identified using a dedicated list maintained by the Portuguese Government. Accounting data are collected from the Bureau Van Dijk’sAMADEUS database. The Burgstahler and Dichev’s (1997) methodology and panel data regression methods are employed to examine the EM practices of Portuguese MFs. Portuguese MFs manage earnings to report small and positive net earnings and to avoid disclosing losses. There is evidence that such companies are more likely to engage in EM practices when facing higher liquidation risk and financial leverage, lower liquidity and in certain periods of the local election cycle. This is one of the first studies investigating the EM practices of MFs, directly contributing to the literature that explores the relationship between state ownership and the quality of financial statements. The paper has important implications for the MFs’ stakeholders, especially regulators and supervising authorities.
Article
We show that managers have a propensity to disproportionately report total revenues just above base‐ten thresholds (e.g., ten million, thirty million, one billion) and examine motives for and consequences of this behavior. Focusing on base‐ten thresholds in revenues is important because, despite being unusually prevalent in revenue targets set in executive compensation contracts, analyst forecasts, and management forecasts, they have not been previously explored. We also show that pressure to beat these targets provides one explanation for the base‐ten bias in reported revenues. However, these incentive effects do not offer a complete explanation because base‐ten threshold‐beating is observed even in the absence of these explicit targets. We further find that when firms beat a base‐ten threshold for the first time, they experience increases in news coverage, institutional ownership, liquidity, and analyst following, even after controlling for whether they have beaten other common benchmarks. These results suggest that managers also beat base‐ten thresholds in order to increase their firms’ overall visibility. Overall, we show that a preference for base‐ten numbers, which have no inherent economic meaning, has a measurable effect on the actions of market participants. These results open the door to a new range of managerial targets previously unexplored. This article is protected by copyright. All rights reserved.
Article
The zero-earnings discontinuity in the US disappeared around the time when the Sarbanes–Oxley Act (SOX) became effective, suggesting that SOX may have reduced the small loss avoidance by firms. In this paper, we examine a potential confounding effect arising from the dotcom boom at the turn of the millennium. Many newly listed dotcom firms had no revenues but high market capitalizations. Therefore, they mechanically fell into the smallest loss interval, artificially reducing the zero-earnings discontinuity. Once this dotcom effect is accounted for, our results no longer suggest a sharp (causal) effect of SOX on the decline in the zero-earnings discontinuity.
Article
This study investigates amendments to the other‐than‐temporary impairment (OTTI) measurement and recognition guidance for debt securities in the Financial Accounting Standards Board's Staff Position FAS 115‐2 and FAS 124‐2 (‘the FSP’). The FSP permits the OTTI charge for debt securities to be split into the credit loss amount recognized in net income (NI) and the amount related to all other factors (noncredit loss) recognized in other comprehensive income (OCI) under certain instances. Thus, the FSP provides banks with additional discretion in recognizing the amount of unrealized losses in NI. Using quarterly accounting data on US bank holding companies from the first quarter of 2010 to the fourth quarter of 2016, I examine whether banks’ decisions regarding OTTI bifurcation are associated with financial reporting and regulatory capital incentives. First, I predict and find that proxies for regulatory capital management, income smoothing, and big bath behaviour impact the percentage of OTTI recognized in OCI. Further evidence suggests that banks with histories of income smoothing through loan loss provision and realized security gains and losses assign a greater share of OTTI to OCI. Then, I predict and find that banks manage OTTI recognized in NI downward to meet quarterly financial reporting benchmarks. Finally, I show that banks with a higher discretionary proportion of OTTI recognized in OCI increase their lending over the subsequent quarter.
Article
This study examines to what extent auditors increase financial reporting quality in a civil law private firm context. Although such context provides little incentives to focus on financial reporting quality, the signalling role remains important. Therefore, we argue that auditors will also increase the quality of the financial statements in this context but will primarily focus on the form quality of the statements (i.e., the extent to which the required disclosures are made) while the substance quality (i.e., the extent to which the financial statements faithfully represent the economic reality) might become a smaller concern. A new measure for form quality is developed, and two matched samples of 278 and 316 Belgian private firms respectively are used to test our hypotheses. Our results confirm that having an auditor significantly increases the form quality of the financial statements while the effect on substance quality is more ambiguous.
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Purpose Using a sample of 9,898 firm-year observations from 1,821 unique Chinese listed firms over the period from 2004 to 2019, this study aims to investigate whether the market rewards meeting or beating analyst earnings expectations (MBE). Design/methodology/approach The authors use an event study methodology to capture market reactions to MBE. Findings The authors document a stock return premium for beating analyst forecasts by a wide margin. However, there is no stock return premium for firms that meet or just beat analyst forecasts, suggesting that the market is skeptical of earnings management by these firms. This market underreaction is more pronounced for firms with weak external monitoring. Further analysis shows that meeting or just beating analyst forecasts is indicative of superior future financial performance. The authors do not find firms using earnings management to meet or just beat analyst forecasts. Research limitations/implications The authors provide evidence of market underreaction to meeting or just beating analyst forecasts, with the market's over-skepticism of earnings management being a plausible mechanism for this phenomenon. Practical implications The findings of this study are informative to researchers, market participants and regulators concerned about the impact of analysts and earnings management and interested in detecting and constraining managers' earnings management. Originality/value The authors provide new insights into how the market reacts to MBE by showing that the market appears to focus on using meeting or just beating analyst forecasts as an indicator of earnings management, while it does not detect managed MBE. Meeting or just beating analyst forecasts is commonly used as a proxy for earnings management in the literature. However, the findings suggest that it is a noisy proxy for earnings management.
Article
In this study, we replicate and extend Dichev and Skinner's [DS: 2002] study on the debt covenant hypothesis (DCH). We start by replicating DS and find results consistent with theirs. We then extend their work by changing three aspects of the research design: histogram bin width, calculation of slack, and statistical test of discontinuity. We find that the inference from DS is generally robust to varying these choices, although sensitive to different bin widths, during their sample period. We extend our analysis to the period 2000 to 2019 and find that support for DCH remains robust. We do, however, find a lack of support for DCH when examining the most common financial covenant, debt‐to‐EBITDA. These findings suggest a more nuanced perspective on DCH, whereby different types of financial covenants provide different incentives and ability to avoid technical default. This article is protected by copyright. All rights reserved
Purpose The purpose of this paper is to present a bibliometric analysis of earnings management (EM), providing an overview of the main results and research trends in this area. EM is a relevant topic in financial studies. It has been widely studied over the past few decades as a phenomenon of intentional manipulation of financial reporting. Design/methodology/approach The Web of Science (WoS) database was used as a source, and this study has adopted VOSviewer as the bibliometric analysis tool to achieve an overview of EM research and understand current research trends on this matter. This study has collected data from 4,342 articles published from 1900 to 2020. Findings The conclusions of this study show that EM is strongly related to corporate governance, performance and quality of information. Publication trends and categories are useful to understand the development of trends and current domains in this area. This research analyses the most productive authors, countries and journals. This study conducted a cluster analysis using a keyword perspective to obtain emerging trends in EM. Research in EM through real activities represents a research gap, which can be an opportunity for future research. Research limitations/implications The authors recognize as limitations the fact that the study is limited to the WoS database. Another limitation is the keywords used for the search, as this study only uses “earnings management”, as it is the most used keyword in EM literature. An additional limitation is associated with the selection of only one type of document, “articles,” disregarding other types of publications. Originality/value Although there are some bibliometric studies on EM, this study found out that they focus on specific EM topics and fail to analyze this theme on a global scale. Most of the literature on this subject is disperse and consequently needs systematization. This research is also relevant for academic purpose, as this research contributes to understanding the state of art and contributes to the development of scientific knowledge by providing a systematization of the literature on the topic of EM.
Article
Using a sample of cross-listed and U.S. firms, we examine whether firms’ growth opportunities are associated with discretionary accruals and/or real activities management. While existing papers have reported mixed evidence for U.S. firms, we are the first to explicitly compare earnings management of cross-listed growth versus cross-listed value firms. Using the Tobin’s Q ratio as our proxy for growth opportunities, we compare earnings management by: (i) cross-listed growth versus cross-listed value firms, (ii) cross-listed growth versus U.S. growth firms, and (iii) cross-listed value versus U.S. value firms. We find significantly more management of discretionary accruals and real activities for cross-listed growth firms than the cross-listed value firms. In addition, the difference in earnings management between cross-listed and U.S. firms is concentrated in the growth firms, as there are no significant differences in earnings management between the cross-listed and U.S. value firms. Our findings have implications for analysts and investors interested in cross-listed firms. A better understanding of earnings management by firms with high or low growth opportunities can enable them to better assess the quality of earnings of these companies.
Article
While prior studies have linked the relationship between resources, time pressure, and audit quality, prior empirical studies generally measure the notion of audit offices' resources or capacity in relatively simplified, indirect, or context-specific ways. In this study, we use two measures of an audit office's unused capacity pertaining to normal audit tasks in Yu (2018) to examine their associations with several proxies for audit quality (discretionary accruals, earnings benchmarks, and going concern audit opinions). Empirical results show some evidence that higher (lower) unused capacity can result in better (worse) audit quality; and if any, this seems to occur only in Big 4 audit offices.
Article
The past 25 years have seen an exponential growth in the number of China studies in the leading accounting journals. The rise in China-related research mirrors the country’s increased importance on the global stage and a growing appreciation of the economic importance of Chinese institutions. We organize our review of the China literature around three central themes: 1) political and regulatory institutions, 2) China’s relationships with foreign investors, and 3) the availability of novel data and regulatory shocks. The former two themes address research questions that are more China-centric, while the third exploits the China setting to examine questions that are more universal. We highlight the contributions that China studies have made to the broader accounting literature, the limitations of the current literature, and we offer suggestions for future research directions.
Article
Prior literature established that managers engage in Revenue Shifting (RS) and Expense Shifting (ES) with an intent to report favourable operating performance; our paper extends such research in a new direction by investigating both forms based on the need, ease, and advantage of each form of shifting strategy. The study identifies firm-specific factors that incentivize firms to prefer RS over ES and vice-versa. We undertake a longitudinal study (2001-2019) using a sample size of 39634 firm-years, enlisted in the Bombay Stock Exchange (BSE). Our results show that peer-performance, size, financial leverage, growth opportunities, accounting flexibility, and age of the firm are important determinants of RS and ES. Specifically, our results exhibit that large, levered, old, and high-growth firms are engaged in RS, whereas small, young, firms with lesser accounting flexibility, and firms operating below peer-performance are involved in ES. These results are robust to controlling for accruals earnings management, real earnings management, endogeneity, self-selection bias, and alternative measures of RS and ES. Our findings are helpful to auditors and investors in improving awareness of forms of classification shifting.
Article
We examine how political corruption affects firms’ accounting choices. We hypothesize and find that firms headquartered in corrupt districts manipulate earnings downwards, relative to firms headquartered elsewhere. Our finding is robust to alternative corruption measures, alternative discretionary accrual measures, alternative model specifications, the instrumental variable approach, and difference‐in‐differences analyses based on firm relocation and high profile cases. We find that firms headquartered in corrupt districts prefer income‐decreasing accounting choices and exhibit higher conservatism. Finally, we find that the effect of corruption on earnings management is more pronounced for geographically concentrated firms, for firms without political connections, for firms in politically sensitive industries, for firms with lower transient institutional investor ownership, and for firms with less analyst coverage. In sum, our findings suggest that firms respond to corruption by lowering their accounting earnings. This article is protected by copyright. All rights reserved
Article
У статті проведено оцінку достовірності інформації у фінансовій звітності ПрАТ «Моршинський завод мінеральних вод «Оскар» за 2016-2020 рр. на основі моделі Дж. Монтьє (C-Score), моделі М. Д. Беніша (M-Score (8 variable) та моделі М. Л. Роксас (M-Score (5 variable). Запропоновано для оцінки достовірності інформації у фінансовій звітності вітчизняних суб’єктів господарювання різних форм і видів діяльності використовувати модель М. Д. Беніша (8 variable) та М. Л. Роксас (5 variable) на основі вивчення сутності, порядку застосування та обґрунтування їх переваг (відносна простота застосування, потенціал прогнозування, широта використання). Уточнено алгоритм розрахунку показників моделі Дж. Монтьє (C-Score), моделі М. Д. Беніша ( M-Score (8 variable) та моделі М. Л. Роксас (M-Score (5 variable) відповідно до затверджених в Україні форм фінансової звітності, що дозволить визначити рівень достовірності звітної інформації.
Article
Purpose The use of models for detecting earnings management in the academic literature, using accrual and real manipulation, is commonplace. The purpose of the current study is to compare the power of these models in a United Kingdom (UK) sample of 19,424 firm-year observations during the period 1991–2018. The authors include artificially-induced manipulation of revenues and expenses between zero and ten percent of total assets to random samples of 500 firm-year observations within the full sample. The authors use two alternative samples, one with no reversal of manipulation (sample 1) and one with reversal in the following year (sample 2). Design/methodology/approach The authors include artificially induced manipulation of revenues and expenses between zero and ten percent of total assets to random samples of 500 firm-year observations within the full sample. Findings The authors find that real earnings manipulation models have lower power than accrual earnings manipulation models, when manipulating discretionary expenses and revenues. Furthermore, the real earnings manipulation model to detect overproduction has high misspecification, resulting in artificially inflating the power of the model. The authors examine an alternative model to detect discretionary expense manipulation that generates higher power than the Roychowdhury (2006) model. Modified real manipulation models (Srivastava, 2019) are used as robustness and the authors find these to be more misspecified in some cases but less in others. The authors extend the analysis to a setting in which earnings management is known to occur, i.e. around benchmark-beating and find consistent evidence of accrual and some forms of real manipulation in this sample using all models examined. Research limitations/implications This study contributes to the literature by providing evidence of misspecification of currently used models to detect real accounts manipulation. Practical implications Based on the findings, the authors recommend caution in interpreting any findings when using these models in future research. Originality/value The findings address the earnings management literature, guided by the agency theory.
Article
We quantify the real implications of trade-offs between firm information disclosure and long-term investment efficiency. We estimate a dynamic equilibrium model in which firm managers confront realistic incentives to misreport earnings and distort their real investment choices. The model implies a socially optimal level of disclosure regulation that exceeds the estimated value. Counterfactual analysis reveals that eliminating earnings misreporting completely through disclosure regulation incentivizes managers to distort real investment. Lower earnings informativeness raises the cost of capital, which results in a 5.7% drop in average firm value, but more modest effects on social welfare and aggregate growth.
Article
Purpose The purpose of this study is to investigate the impact of the age diversity of the top management team (TMT) on firm performance and on the managerial ability of the TMT. Furthermore, this study investigates how the relationship between age diversity and firm performance is mediated by managerial ability and the contextual nature of the relationship. Design/methodology/approach This is an empirical study which uses regression analyses and mediation analyses to evaluate the hypotheses. Findings The authors observe a negative relationship between age diversity and firm performance and also between age diversity and managerial ability of the TMT. Further, the authors find that that the negative relationship between age diversity and firm performance is mediated by managerial ability. The authors also find that the relation between performance and age diversity is context specific – the negative relationship between age diversity and firm performance is ameliorated during times of financial crisis. Social implications In an environment where diversity is beginning to be valued, insights into the impact of different types of diversity on performance become important. Age diversity is a critical component of diversity. Therefore, insights into the impact of age diversity on performance will be of interest to managers, academics and even regulators. Originality/value To the best of the authors’ knowledge, this study is the first to evaluate the impact of age diversity on the market perception of firm performance of US firms using a large, comprehensive, multi-year data set. Furthermore, this is the only study to evaluate the impact of age diversity on managerial ability and show the mediating effect of managerial ability on the relationship between age diversity and firm performance.
Article
Purpose The purpose of this study is to examine the association between non-audit service fees provided by the auditor and auditor independence in stable and unstable economic conditions. Further, this study investigates whether client importance impairs auditor independence in two different Australian economic environments. Design/methodology/approach This study focuses on financially distressed firms listed on the Australian Stock Exchange from 2005 to 2014. The data is obtained from SIRCA and the Morning Star databases. The probit method is used as a baseline regression model, the two-stage least squares and the sensitivity of control variable tests are used to control for any endogeneity and self-selection bias concerns. Findings This study shows that in stable economic conditions, non-audit service fees provided by auditors impair auditor independence. This suggests that economic bonding between auditor and client serves as a threat to the auditor’s independence, perhaps because of the importance given to the larger clients. In contrast, the authors find no association between non-audit service fees and auditor independence in unstable (highly regulated) economic conditions largely because of higher litigation risk. The results of this study are robust to alternative model specifications and endogeneity concerns. Practical implications This study provides an important implication to regulators that macro-economic conditions influence the strength of incentives related to non-audit services for auditors. Furthermore, this study enhances the understanding of regulators (Australian Security Investment Commission) and the strategies adopted by Australian auditors in response to economic incentives and market-based incentives. Originality/value The authors contribute to the existing literature by providing evidence that there is a tradeoff between market-based incentives (i.e. lower litigation costs) and economic incentives (i.e. non-audit services fees) with economic uncertainty influencing the importance of these incentives to auditors.
Article
Previous research finds higher stock prices for firms with extended EPS meet-or-beat streaks benchmarked to analysts’ forecasts. Due to the different persistence and reliability properties of firms’ revenues and expenses, in this study, I test whether stock valuations are different when EPS streaks are extended by firms meeting their revenue versus expense targets. I find that EPS meet-or-beat streaks that are primarily extended by firms meeting or beating analysts’ revenue forecasts are positively valued by the market but EPS streaks extended by meeting implied-expense targets are not associated with equity valuations. I also find revenue meet-or-beat streaks are likewise positively associated with equity prices but extended expense meet-or-beat streaks are negatively associated with equity valuations. These relationships are stronger for growth firms and firms that report research and development expenses. In short, my results suggest investors only value firms’ ability to consistently achieve analysts’ revenue forecasts.
Article
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.
Article
Purpose The purpose of this study is to examine how auditors would react when there are exogenous negative shocks to their client portfolios. Design/methodology/approach Using a sample of 31,256 firm-year observations (2001–2016), the authors investigate whether industry shocks to a subset of an auditor’s clients distract the auditor and affect the professional skepticism applied in the audits of other clients. Findings The authors find that clients of distracted auditors are more likely to meet or beat analyst consensus forecasts, suggesting that auditors’ professional skepticism is compromised by distractive events. The cross-sectional analyses reveal that the negative impact of the distractive events on audit quality is more pronounced when the distracted auditors audit less important clients, face lower third-party legal liabilities and experience higher growth. Using an alternative measure of audit quality, the additional analysis shows that clients of distracted auditors exhibit a higher probability of restating their earnings in subsequent years. Overall, the empirical evidence suggests that when distracted, auditors render lower quality audit. Originality/value The study complements recent work by Cassell et al. (2019), which shows that the 2008–2009 financial crisis affected the quality of the audits of nonbank clients of bank-specialized auditors. While Cassell et al. (2019) focus on one shock (financial crisis) to one industry (i.e. the financial services industry), the study examines more frequent shocks over a wide range of industries to identify the potential effects of distractive events, improving the generalizability of the findings to all industries and all auditors (specialist and nonspecialist) in nonrecession periods.
Article
Using firm-level union membership data for the period of 2002–2016, we show that firms with higher union membership are more likely to engage in real earnings management than accrual-based earnings management, with abnormal production as the dominant form of real earnings management. We further show the causal effect of union membership on real earnings management by exploiting two natural experiments-the staggered enactment of state-level right-to-work (RTW) laws and the shock to unemployment insurance benefits (UIB)-as exogenous shocks to union power. Further exploration shows that the positive association between union membership and real earnings management is more pronounced for unionized firms with (1) high managerial incentives to reduce employee hiring and retention costs and (2) operating inflexibility created by labor overinvestment. Our evidence is consistent with managerial incentives for upward earnings management to mitigate employees' perceived job security and the cost of employee management in competitive labor markets.
Article
The rewards received by financial managers depend on both relative performance (e.g., fund inflows based on fund rankings, promotions based on peer comparisons) and absolute performance (e.g., bonus payments for meeting accounting targets, hedge‐fund incentive fees). Both relative and absolute performance rewards engender risk‐taking. In this paper, we show that these two sources of risk‐taking, relative and absolute performance rewards, mitigate the risk‐taking incentives produced by the other. This mutual incentive‐reduction effect generates a number of novel predictions about the relationship of managerial risk‐taking with the structure of relative and absolute performance rewards. This article is protected by copyright. All rights reserved
Article
We formalize the notion, first suggested by Burgstahler and Dichev (1997), that earnings discontinuities can be caused by reference dependence. We extend the signaling model by Guttman et al. (2006) to include loss-averse investors. The presence of loss aversion causes the separating equilibrium (without discontinuities in the distribution of reported earnings) to disappear, while the partially-pooling equilibrium (exhibiting discontinuities) may prevail. This implies that the presence of loss-averse investors will cause earnings discontinuities around reference points. The prime candidates for investors’ reference points are earnings benchmarks such as zero earnings, last year’s earnings and analyst forecasts. Our model provides an explanation for why earnings discontinuities appear around earnings benchmarks.
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A wine-loving economist we know purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only $10 when purchased would now fetch $200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price. Thaler (1980) called this pattern—the fact that people often demand much more to give up an object than they would be willing to pay to acquire it—the endowment effect. The example also illustrates what Samuelson and Zeckhauser (1988) call a status quo bias, a preference for the current state that biases the economist against both buying and selling his wine. These anomalies are a manifestation of an asymmetry of value that Kahneman and Tversky (1984) call loss aversion—the disutility of giving up an object is greater that the utility associated with acquiring it. This column documents the evidence supporting endowment effects and status quo biases, and discusses their relation to loss aversion.
Article
Abstract This paper investigates the association between,corporate voluntary disclosure and management’s discretion over accounting choices. In particular, it examines the role of earnings management,in mitigating costs associated with management,earnings forecast errors. The empirical results are consistent with the prediction that managers, fearing costly legal actions by shareholders and loss of reputation for credibility, use discretionary accruals to reduce their forecasting errors. Specifically, the paper documents that managers who overestimate the earnings number manage reported earnings upward, and that the extent of discretionaryaccruals is associated with various securities litigation cost factors and the amount,of management’s accounting flexibility. Having identified the role of accounting discretion in mitigating costs associated with management,earnings forecast errors, the study raises the possibility that the degree of accounting discretion affects corporate voluntary disclosure policies. 1.,Introduction The purpose of this paper is to investigate the extent to which voluntary disclosure and earnings management,are related. The notion that such an interaction exists stems from the premise that managers,use their accounting discretion to reduce the costs associated with voluntary
Article
This paper examines the association between patterns of increasing earnings and incremental firm value as reflected by earnings multiples, holding level of income constant. As predicted, we find firms exhibiting patterns of increasing earnings have larger earnings multiples than other firms and the incremental earnings multiple is reduced significantly when an increasing earnings pattern is broken. The findings are robust to controlling for growth, risk, earnings variability, measurement error in permanent earnings, persistence, dividend yield, and industry membership, using proxies identified in previous research. An extension of the Lang [1991] model indicates increasing earnings patterns can affect firm valuation by permitting market participants to update their prior beliefs about the firm. We conclude earnings patterns are a proxy for value-relevant firm characteristics such as growth that are not reflected fully in proxies identified in prior research.
Article
This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission for alleged violations of Generally Accepted Accounting Principles. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant earnings management hypotheses; (ii) the relation between earnings manipulations and weaknesses in firms' internal governance structures; and (iii) the capital market consequences experienced by firms when the alleged earnings manipulations are made public. We find that an important motivation for earnings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating earnings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a Chief Executive Officer who simultaneously serves as Chairman of the Board; (iii) more likely to have a Chief Executive Officer who is also the firm's founder, (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public.
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This paper evaluates alternative models for detecting earnings management. The paper restricts itself to models that assume the construct being managed is discretionary accruals, since such models are commonly used in the extant accounting literature. Existing models range from simple models in which discretionary accruals are measured as total accruals, to more sophisticated models that separate total accruals into a discretionary and a non-discretionary component. Prior to this paper, there had been no systematic evidence bearing on the relative performance of these alternative models at detecting earnings management. This paper evaluates the relative performance of the competing models by comparing the specification and power of commonly used test statistics across the measures of discretionary accruals generated by each model. The specification of the test statistics is evaluated by examining the frequency with which they generate type I errors for a random sample of firm-years and for samples of firm-years with extreme financial performance. We focus on samples with extreme financial performance because the stimuli investigated in previous research are frequently correlated with financial performance. The first sample of firms are targeted by the Securities and Exchange Commission for allegedly overstating annual earnings and the second sample is created by artificially introducing earnings management into a random sample of firms.
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This paper investigates circumstances under which accruals are predicted to improve earnings' ability to measure firm performance, as reflected in stock returns. The importance of accruals is hypothesized to increase (i) the shorter the performance measurement interval, (ii) the greater the volatility of the firm's working capital requirements and investment and financing activities, and (iii) the longer the firm's operating cycle. Under each of these circumstances, cash flows are predicted to suffer more severely from timing and matching problems that reduce their ability to reflect firm performance. The results of empirical tests are consistent with these predictions.
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We study the signaling content of managers' dividend decisions for 145 NYSE firms whose annual earnings decline after nine or more consecutive years of growth. Using a variety of model specifications and definitions of favorable dividend signals, we find virtually no support for the notion that dividend decisions help identify firms with superior future earnings. Dividends tend not to be reliable signals because (i) a behavioral bias (overoptimism) leads managers to overestimate future earnings when growth prospects fade; and (ii) managers make only modest cash commitments when they increase dividends, undermining the reliability of such signals.
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Based on theory and anecdotal evidence, we argue that ongoing implicit claims between a firm and its customers, suppliers, employees, and short-term creditors create incentives for management to choose long-run income-increasing accounting methods. Variables selected to proxy for the extent to which a firm depends on these implicit claims are found to be significant in explaining cross-sectional variation in inventory and depreciation methods. These variables remain incrementally significant when we include traditional variables found to have explanatory power in prior studies (i.e., leverage, bonus compensation, tax, and regulatory/political exposure variables).
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This study hypothesizes that because shareholders have a liquidation option, losses are not expected to perpetuate. They are thus less informative than profits about the firm's future prospects. The results are consistent with the hypothesis. They also show that the documented increase in the earnings response coefficent as the cumulation period increases appears to be due exclusively to the effect of losses. The liquidation option effect extends to profitable cases where earnings are low enough to make the option attractive. Alternating explanations for the low informativeness of losses such as mean reversal of earnings are not supported by the tests.
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Much experimental evidence indicates that choice depends on the status quo or reference level: changes of reference point often lead to reversals of preference. The authors present a reference-dependent theory of consumer choice, which explains such effects by a deformation of indifference curves about the reference point. The central assumption of the theory is that losses and disadvantages have greater impact on preferences than gains and advantages. Implications of loss aversion for economic behavior are considered. Copyright 1991, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
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This paper examines the abnormal accruals of a sample of 94 firms that reported debt covenant violations in annual reports. We expect debt covenant restrictions to influence accounting choices in the year preceding and the year of violation. Time-series and cross-sectional models are used to estimate ‘normal’ accruals. In the year prior to violation, both models indicate that ‘abnormal’ total and working capital accruals are significantly positive. In the year of violation, there is evidence of positive abnormal working capital accruals after controlling for management changes and auditor going concern qualifications.
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Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)
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This paper provides a review of the empirical earnings management literature. In particular, it presents a review of the factors that induce and constrain earnings management through accounting decisions. The consequences of actual or assumed earnings management are also discussed. The far majority of the literature focuses on the Anglo-Saxon context. However, major differences exist between Anglo-Saxon and continental European countries. This may result in differences in the importance of various incentives of and constraints on earnings management. In particular, we argue that explicit contracts and a firm's relations with capital markets may be less important sources of earnings management in continental Europe. Implicit contracts and the political and regulatory process may however be of major importance. We question further whether a firm's ownership and internal governance structure and the quality of the external auditor can constrain the ability to manage earnings in continental European countries.