The concern about the quality of accounting numbers and its relation with the quality of the auditing process is increasing over time following the periodical clusters of business failures, frauds, and the litigation (Tie 1999, Chambers 1999).
Recessions make the business environment more challenging for firms, while managers try to cope with it managing financial statements according to this adverse economic situation. Investors, auditors, policy makers and stakeholders would be benefited from knowledge of EM under economic downturns.
For many years, earnings management has been of grave concern for practitioners and regulators, and has received considerable attention in the accounting literature. This literature is immense and still developing. In their study "A Review of the Earnings Management Literature and its Implications for Standard Setting", Healy and Wahlen (1999: p.380) note that "prior research has focused almost exclusively on understanding whether earnings management exists and why." They conclude that earnings management remains a fruitful area for academic research, and suggest that future research contributions are likely to come from investigating the extent and magnitude of accruals, and determining the potential factors that restrict earnings management.
An increasing part of accounting research tries to examine the different factors that affect earnings management behavior of managers. Because part of the financial reporting process depends on the judgment of managers, they have the opportunity to manage reported earnings to achieve their own goals.
the bottom line of an income statement, i.e. the reported accounting earnings, is commonly used for evaluating a firm's performance, despite the fact it consists of two components; a cash component and an accrual component.
Therefore, it is crucial to recognize that a major portion of accruals could be subject to management's discretionary power, and this brings to light management's ability to shift earnings between accounting periods to influence users' perceptions.
While the conflict of interests between managers and stockholders due to separation of control and ownership is well known, an important aspect of managing these differing interests is the need to control the managers' behavior through monitoring mechanisms (Jensen and Meckling 1976; Watts and Zimmerman 1986).
Definition
Earnings Management is said to have occurred "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers", Schipper, K. 1989. Commentary: Earnings Management. Accounting Horizons (December): 91-102.
First, earnings management is an important dimension of accounting quality and in the extreme unlikely to be informative. (Accounting quality is a broad concept with multiple dimensions. Empirical operationalizations of this concept have focused on a variety of dimensions including timeliness and conservatism (e.g., Ball and Shivakumar, 2002) or quality of accruals (e.g., Dechow and Dichev, 2002). In this paper we focus on firms' relative tendency to manage earnings as another dimension of accounting quality.)
The rights of shareholders have long been considered an important external governance mechanism to align the actions of managers with the interests of owners (Berle and Means 1932).
There is no consensus on the definition of earnings management and there are several, in some degree different definitions in the literature (Healy & Wahlen 1999; Beneish 2001)
Healy & Wahlen (1999) find that it is obvious that managers can use accounting judgement to make financial reports more informative for users. This can arise if certain accounting choices or estimates are perceived to be credible signals of a firm's financial performance.
Dye (1988) and Scott (1997) find that the earnings management is the choice by firm of accounting policies so as to achieve some specific managerial objective.
Davidson et al. (1987) express their opinion that managing earnings is the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about desired level of reported earnings.
A large body of the accounting research suggests that in some instances managers use their accounting discretion to achieve predetermined results to the point where financial information no longer reliably represents a company's underlying economic condition.1 Although accounting research addresses the compensation incentive to manage earnings (Fields, Lys, & Vincent, 2001; Murphy, 1999), unresolved issues remain.
Gordon (1964), in an early attempt to derive a positive theory of accounting, assumes that management selects accounting procedures to maximize its own utility, thus suggesting that management acts in its own self-interest.
Jensen and Meckling (1976) indicate that as managers' percentage ownership of the residual claims of a firm decreases, increases in the value of those residual claims have less effect on managers' wealth.
An objective of financial reporting is to provide information that helps shareholders assess managerial performance. However, managers use their knowledge about the business and its opportunities to select reporting methods, estimates, and disclosures that might not accurately reflect their firms' underlying economics (Healy & Wahlen, 1999).
Because this behavior may have a significant effect on the quality of information provided to investors, the SEC recently is more concerned with earnings management behavior of firms' managers (Healy & Wahlen, 1998).
Fischer and Rosensweig (1995) defined earnings management as actions by division managers which serve to increase (decrease) current reported earnings of a division without a corresponding increase (decrease) of the long-term economic profitability of the division. This definition identifies two important components of earnings management: consequences and intent. Earnings management actions can have serious consequences for managers and users. In the last decade, many corporations practiced earnings management and subsequently their auditors were forced into bankruptcy (e.g. Enron). In addition, stakeholders lost the savings of their lifetime and their jobs (Sridharan, Dicks, & Caines, 2002).
Earnings management refers to the judgment used by managers to alter financial reports to either mislead some stakeholders about the economic performance of the firm or to influence contractual outcomes that are contingent on accounting numbers. [Cf. Healy/Wahlen (1999), p. 368. In this sense, earnings management refers to legal earnings management not illegal earnings manipulation or accounting fraud.]
Scott, W. (1997) defined earning management by the choice of accounting policies so as to achieve some specific managers' objective
Scott (2011), we define earnings management as the choice by a manager of accounting policies, or real actions that affect earnings so as to achieve a specific reported earnings objective.
Healy and Wahlen (1999: p.368) define earnings management by the use of "... judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers."
Earnings are often used in firm valuation by both the stock market and accounting valuation models. In particular, earnings are useful because they can capture truthful information relevant in assessing and predicting firm performance (Cheng, 2005). However, firms' deliberate earnings management activities may introduce errors into earnings and thereby reduce their ability to convey truthful information (Bernard, 1995).
Healy and Wahlen (1999) define earnings management as Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers.
managers by using EM (Earnings Management) tools manipulate accounting information in order to achieve some goals. Earnings management is one of the tools used for manipulating accounting information due to gaining profit through trade in capital markets. CFOs of firms sometimes manipulate earnings prior to specific date leading to IPO, Management Buyout, Mergers and acquisitions, and other important deals to reduce costs of them.
Duo to (Ronen & Yaari, 2008) studies three different definitions of earnings management will be mentioned in order to find the best description for its concept:
1. First of all, earnings management is a tool used for flexibility of accounting information which managers apply as signals of their own exclusive information from their respective organization to shareholders.
2. Second definition relies on the managers' utilization of accounting tools in ways that they could apply them in both aspects of opportunistic and optimistic managerial goals.
3. And finally, earnings management is a manipulation of accounting data in order to decrease transparency of financial reports and cause to mislead shareholders and other stakeholders in their decision making process that lead to enhance managements' personal profit.
(Degeorge, Patel, & Zeckhauser, 1999) defined earnings management as artificial earnings manipulation by managers to reach the expected level of profit for some special decisions like effects on analysts' forecasts or estimation of previous earning trends. They believed that the main goal of earnings management is investors' imagination management.
Earnings management involves the manipulation of revenues and expenses to obtain a desired financial reporting outcome (e.g., Ball 2006; Healy and Whalen 1999; Schipper 1989).
Schipper (1989), "purposeful intervention in the external financial reporting process with the intent of obtaining some private gain." She continues that minor extension of this definition would encompass "real" earnings management, accomplished by timing investment or financing decisions to alter reported earnings or some subset of it.
Earnings management is one example of an agency cost where the misalignment of interests between the agent (e.g., manager) and principal (e.g., firm, superior, shareholders) leads the agent to maximize his/her own economic interests at the expense of the principal (Eisenhardt 1989; Jensen and Meckling 1976).
Inflating earnings will bring higher returns to shareholders (Schipper 1989),
Earnings management complicates equity valuation as it conceals the company actual performance and masks underlying trends in revenue and earnings growth that help to build expectations of future growth and product demand (McNichols and Stubben, 2008).
Earnings management occurs when managers use this flexibility with the intent to mislead firm stakeholders about the underlying true economic performance of the firm. Healy and Wahlen (1999) and Dechow and Skinner (2000)
the term earnings management is generally used to indicate the use of discretion by those preparing the accounts in pursuing objectives of a personal or particular nature in order to obtain an advantage or mislead certain stakeholders in terms of knowledge of operations and corporate results (Dechow et al., 1995; Burgsthaler-Dichev, 1997; Dechow-Dichev, 2002). In other words, earnings management qualifies those accounting policies that - outside the scope of the quantitative determination of accounts - are aimed at the methodical alteration of periodic corporate reporting
earnings management largely depends on the degree of freedom that the accounting rules grant management in accounting estimates. In this sense, accounting standards must ensure an adequate reconciliation of rigidity and flexibility requirements: on the one hand, the adoption of excessively rigid accounting rules, whilst reducing management discretion, could lead to applications that are not particularly flexible and poorly adaptable to the variety of possible cases. On the other hand, excessive flexibility, "loosening the mesh" of accounting options and possible treatments, involves greater subjectivity in accounting estimates (Healy-Wahlen, 1999).
Haw, Hu, Hwang, and Wu [2004] (hereafter, H3W) examine the association between earnings management (as captured by absolute total discretionary accruals scaled by total assets), the separation of insiders' cash-flow and ownership rights, and institutional factors that affect both earnings management and control rights.
While some view earnings management as an unethical practice resulting in negative consequences, others posit a contrary view.
Merchant and Rockness (1994, p. 92) contend that earnings management is "probably the most important ethical issue facing the accounting profession."
Levitt (1998) notes that the overall consequence of earnings management is the erosion of trust between shareholders and companies and that such trickery is employed to obscure actual financial volatility, thereby masking the true consequences of management's decisions. Loomis (1999) echoes this viewpoint by noting that earnings management diminishes the clarity of facts investors ought to know, leaving them in the dark about the true value of a business.
Conversely, Parfet (2000) suggests that earnings management is not necessarily a negative phenomenon, but a necessary and logical result of the flexibility in financial reporting options. That is, if managers have a responsibility to maximize shareholders' value, then managers must choose among all legal options that will help achieve this goal.
Beneish (2001) states that there are two perspectives on earnings management: the opportunistic perspective that holds that managers seek to mislead investors, and information perspective, first expressed by Holthausen & Leftwitch (1983), under which managerial disretion is a menu for managers to reveal to investors, their expectations about firm's future cash flows.
Representational comment that anecdotally illustrates the opportunistic viewpoint of earnings management study is the comment by Leuz et al. (2003): "Managers can sometimes use discretionary accruals to increase the informativeness of financial reports."
Accounting information1 aims at facilitating efficient resource allocation in an economy. Earnings as one element of accounting information serve as performance measure and form part of many contractual agreements.
If earnings management leads to lower quality accounting numbers, then one should expect a negative correlation between an earnings management proxy and other measures of accounting quality.
Earnings management is closely related to the information asymmetry between managers and firm's other interest groups. Scott (1997) sees the earnings management as managers taking advantage of an asymmetry of information with shareholders.
Dye (1998) and Trueman & Titman (1988) show analytically that the existence of information asymmetry between management and shareholders is a necessary condition for earnings management.
Schipper (1989) states that there is information asymmetry between managers and other interest groups and that asymmetry cannot be totally eliminated by changing the contractual agreement.
EM is usually seen as undesirable from the investor's and stakeholders' point of view. It may thwart their efforts to make a correct assessment of the firm's fundamentals and determine the stock's fair value.
managerial discretion in financial earnings may lead to information asymmetry about cash flows between inside managers and outside existing and/or potential investors.
As such, earnings management may encourage corporate insiders engage in tunneling activities and/or overinvestment because it makes information about cash flows private to insiders. Increasing borrowing perhaps serves as an external control mechanism mitigating the free cash flow problem since interests must be repaid to avoid default (see, e.g., Jensen (1986) and Jensen and Meckling (1976)). Through reducing agency costs of free cash flow, debt generates positive values for firms with high levels of earnings management. Controlling for deadweight costs of debt, such as bankruptcy costs and agency costs of debt, more earnings management activities increase the demand for using debt as an external control mechanism.
Healy & Wahlen (1999) sum up that management's use of judgement in financial reporting has both costs and benefits. The costs are the potential misallocation of resources that arise from earnings management. Benefits include potential improvements in management's credible communication of private information to external stakeholders, thus improving resource allocation decisions.
Healy & Wahlen (1999) state that because the auditing is imperfect, management's use of judgement creates opportunities for earnings management, in which managers choose reporting methods and estimates that do not adequately reflect firms' underlying economics
Investigating the earnings management has been the question of how earnings management affects the information content of earnings.
Earnings management may hinder the quality of the earnings information, which in turn reduces the quality of the financial analyses based on earnings figures.
International evidence on the effect of the earnings management to the information content of earnings is mixed, most probably due to the problems in measuring the earnings management in many countries ( Kallunki & Martikainen 2003)
Shipper & Vincent (2003) state interestingly: "should we conclude that earnings management increases earnings quality if the result is to increase the predictive ability of earning?" for example, if managers are income smoothers, then the earnings are more predictable.
Leuz et al. (2003) however state that the resulting smoothed earnings is less informative as a result of the noise added by management intervention.
worldwide level clearly demonstrate that despite high quality accounting standards, the urge to manipulate results is still vigorous in the presence of managerial incentives, also in relation to the accounting standards implementation method (in this regard, Daske et al., 2008, distinguish between serious adopters and non-serious adopters).
(Yoon & Miller, 2002) believed that operational cash flow is a part in business which could be less manipulated by managers; therefore, it offers more real scale of business economic performance. Hence, it could be concluded that those business units that were likely to face weak performance have more incentive to enhance their reported earnings by earnings management or reverse. The probability for practices in artificially increasing earnings by managers is less for business units which have good performance.
(Burgstahler & Dichev, 1997) believed that most of the firms reported less earning changes rather than expected earning changes and these evidences are illustrated as opportunistic earnings management. The evidence indicated that firms have more incentive to escape from loss and reduction in profits.
Varian (2002) suggests that managers are more willing to disclose disappointing news in settings where the market is expecting it, such as during economic downturns where many companies record large write-downs of balance sheet accounts.
The auditing process is supposed to serve as a monitoring device (Wallace 1980) that will reduce managers' incentives to manipulate reported earnings
Wallace (1980) claimed that investors demand audited financial statements because these statements provide information that is useful in their investment decisions. This implies that the audit process adds some value to accounting information and is valued as a means of improving the quality of the financial information.
The methods of earnings management are categorized as either the change in the accrual process or the deviation from normal business activity. The former is called Accrual-based Earnings Management (AEM) and the latter, Real Earnings Management (REM)
AEM could lower the quality of earnings and mislead investors. On the other hand, REM is more costly with respect to future firm value (Chen et al., 2008), as it often cuts funding for research and development (R&D) and marketing, increases price discounts, and reduces capital investments, adversely affecting future revenue. However, it is hard for stakeholders to detect REM in comparison to AEM, as REM is included in operating, investing, and financing activities.
Leuz et al. (2003) suggest that AEM decreases in countries with stronger investor protection.
Earnings management may arise as a consequence of agency problem. Managers could manage earnings to windowdress financial statements with the aim of improving their position (Iturriaga and
Hoffmann 2005), obscuring facts that stakeholders ought to know (Loomis 1999), or influencing contractual outcomes that depend on reported accounting numbers (Schipper 1989; Dechow and Skinner 2000).The underlying managerial incentives to manage earnings are various. These include instances when a firm reported a loss in the previous financial year; influencing shortterm stock prices and fulfilling capital market expectations; carrying out lending agreements, and obtaining bonuses through management compensation contracts (Healy and Wahlen 1999; Dechow and Skinner 2000).
Problem with Earnings Management
Factors which determine Earnings Management.
Since managerial motives play a decisive role when exercising the discretionary power over
accruals, we learn more about other factors affecting earnings management if the motive effect is
neutralized. In other words, the empirical test needs to maintain the experimental setting where all firms
under study have the same motive that drives their decision toward earnings management.
As it is difficult to specify ex ante how firms manage earnings, we use four different proxies based on Leuz et al. (2003) to measure the pervasiveness of earnings management. These proxies are designed to capture a variety of earnings management practices, such as earnings smoothing and accrual manipulations, and are constructed taking differences in firms' economic processes into account.
the attainment of earnings thresholds (e.g.
Burgstahler & Dichev, 1997; Degeorge, Patel, & Zeckhauser, 1999; Frankel,
Johnson, & Nelson, 2002), the realization of initial public offerings or
seasoned equity offerings (e.g. Cohen & Zarowin, 2010; Rangan, 1998;
Teoh, Wong, & Rao, 1998), the attainment of bonus plans and compensation
(e.g. Holthausen, Larcker, & Sloan, 1995; Pourciau, 1993), for smoothing
income (DeFond & Park, 1997), in front of debt covenant restraints
(e.g. DeFond & Jiambalvo, 1994), etc.
Many of the previous accounting studies examined the different motivations of
earnings management and the factors that induce managers' incentives to manage reported
earnings.
managers try to manage the reported earnings as a result of bonus
plans motivations (Healy 1985), the motivations to satisfy the debt covenants (Sweeny
1994, Defond & Jiambalvo 1994), or the motivations to reduce the political costs (Cahan
1992, Jones 1991).
Accrual accounting is at the core of the financial reporting system and involves a myriad of
judgments and estimations. Extant research shows that managers use the discretion inherent to
accrual calculation to alter accounting numbers both for opportunistic and informative purposes.
Aside from this
(purely accounting) accrual-based type of manipulation, earnings can also be managed by
strategically timing and structuring transactions. This manipulation is denoted real earnings management, as it involves real operating, investment or financing decisions (Schipper 1989). For example, management may opportunistically increase earnings by reducing research and
development and other discretionary expenses (Bushee 1998), by strategically timing the sale of
some assets (Herrmann et al. 2003), by increasing production to decrease unit costs, or by
increasing credit sales or aggressively offering discounts (Roychowdhury, 2006).
Each type of manipulation has its associated benefits and costs. In terms of visibility and
accountability, management likely prefers real earnings management, since managers have to
answer for any accounting decisions that lead to earnings that fail to accurately reflect true
economic performance before auditors, corporate boards, audit committees, shareholders, and
even courts (Lo, 2008). It is however less likely that they have to respond for difficult-to-monitor
operating, investment or financing decisions that fully fall within their responsibilities and for
which outsiders find it nearly impossible to estimate deviations from optimal behavior.
Cohen et al.
make precisely that argument, and suggest that firms switched to real activities manipulation
because although it is potentially more costly for the firm, it is less costly for managers, as it is
harder to detect or, at least, to question. The evidence in Cohen and Zarowin (2010), Badertscher
(2011), Zang (2012) and Wongsunwai (2012) confirms this view that managers choose among
instruments depending on their expected net benefits.
LNW [2003] also provide direct evidence on the association between their earnings
management proxies and insiders' private control benefits. LNW regress their aggregate earnings
management proxy on the Dyck and Zingales [2004] private control benefits measure.
management may manage earnings to avoid falling short of a bonus threshold or earnings target or to maximize earnings around an IPO to improve the issue price (e.g., Chung et al. 2005; Cohen et al. 2008; Guidry et al. 1999; Healy 1985; Holthausen et al. 1995; Matsunaga and Park 2001; Shaw 2003; Teoh et al. 1998).
Discretionary Accrual
Discretionary accruals represent inter-period management where upward (downward) accrual
manipulation in the current period leads to lower (higher) accruals in a future period.
(Jones, 1991) in the purpose of investigation for earnings reported that manipulation of managers was used in the discretionary accrual in the time of import relief investigation and getting results that managers by means of discretionary accrual technique decreased income during import relief investigation.
One way to manage earnings and manipulate revenues or expenses is by using discretionary accruals (Levitt 1998; Noronha et al. 2008). Regarding expenses, management may underestimate costs when there is a need to maximize earnings in the current period or overestimate costs when the company is profitable.
cross-sectional
Jonesmodel to estimate discretionary accruals, my proxy for earnings management. This
measure accounts for the systematic difference in operating characteristics across
industries and specific firm effects (DeFond, 2002), such as an increase in sales in the
current period, which are not accounted for in Barton and Simko's (2002) measure.
managers' discretionary accruals tend to be income-decreasing when managers have incentives to defer earnings and income-increasing when managers have incentives to accelerate earnings.
Compensation Contracts (Bonus scheme)
The major motivation for our investigation lies within the boundaries of agency theory.
Prior researchers have provided evidence on the influence of bonus
contracts on earnings management behavior. For example, Healy (1985)
shows that income decreasing accruals are more likely when the upper or
lower bound of the bonus contract is binding, while income increasing
accruals are more likely when neither is binding. Using business unit-level
data within a single corporation, Guidry, Leone, and Rock (1999) support
Healy's bonus plan hypothesis. Holthausen, Larcker, and Sloan (1995) and
Gaver, Gaver, and Austin (1995) also confirm the existence of upwards and
downwards earnings management around the upper bound, suggesting that
managers have incentives to manage earnings around a target to maximize
bonus payments. Balsam (1998) finds a significant positive relation between
discretionary accruals and cash compensation, suggesting that firms reward
managers' efforts to manage earnings upwards. Matsunaga and Park (2001)
evidence indicates that CEO bonuses provide managers with incentives to
meet analyst earnings forecasts and the earnings for the same quarter of the
prior year. Therefore, management compensation contracts are designed to
motivate managers to maximize firm value and align the interests of
managers with stockholders (Smith & Watts, 1982). However, managers
choose reporting strategies that maximize their own expected compensation,
taking into account the effect of earnings reports on investors' perceptions
and subsequently management's compensation (Goel & Thakor, 2003).
Traditionally, firms have used financial measures to reward managerial
performance, where compensation plans formally tie compensation to
measures of firm value such as earnings per share, net income, and operating
income (Ittner, Larcker, & Rajan, 1997; Murphy, 2001).
When multiple measures that interact with each other are used in the
compensation contract, the direct effect of one measure may be undone
by the indirect effect of the other measure (Surysekar, 2003). Accordingly,
Nonfinancial Performance Measures and Earnings Management 61
the upward earnings manipulation motivated by earnings-based measures
could be undone by the use of NFPM
To influence managers' decisions and minimize the agency costs of earnings management, organizations can employ compensation contracts, which frequently include a base salary plus a cash bonus (Crocker and Slemrod 2007; Evans and Sridhar 1996; Jensen and Meckling 1976; Watts and Zimmerman 1986). A cash bonus can be either fixed (i.e., guaranteed as a fixed percentage of salary) or variable (i.e., based on the agent achieving certain financial targets).
it is the bonus aspect of the compensation contract that provides an incentive to manage earnings via self-interested discretionary accruals
Conversely, when bonus targets are guaranteed as a fixed percentage of salary, the CFO has little financial incentive to make decisions that are not aligned with the goals set by corporate executives
Debt covenants and lending contracts
During the last decades, numerous studies in the accounting literature have examined the debt covenant hypothesis that firms make accounting choice or manage accruals to avoid violating covenants in debt contracts.
According to Watts and Zimmerman (1990) debt covenants influence accounting choices. When firms face a covenant constraint
or a danger of a covenant violation, managers try to exercise discretion
by choosing income increasing methods that relax debts constraints.
Different studies found empirical evidence that firm's indebtedness is positively
associated with EM, and more concretely with income increasing
accounting practices (e.g. Duke & Hunt, 1990; Holthausen, 1981; Jelinek,
2007). Increasing firm income through EM, managers try to convey a more
favourable image of the financial position of the firm that would facilitate
access to loan granting. The extraordinary financial constraints in the
recent financial crisis will accentuate the influence of firm leverage on EM.
Given that financial constraints and the decrease in market firms' valuation
are important consequences of the recent financial crisis, we expect
that the interaction between the crisis and both mentioned consequences
will significantly impact firms' EM.
Apart from EM, the recent economic downturn is favouring the manipulation
of cash flow generation with the aim of alleviating the financial stress
of firms. The recent economic crisis is substantially reducing sales and
income, and subsequently affecting firms' cash flow generation and financing.
Ahmed et al. (1999) found that capital management is an important determinant of the loan loss provision. Annual reports identify the loss reserve as a subjective determination of loan losses (Cortland Bancorp 1999).
The impact of debt financing on earnings management is an empirical controversy. There are two
different streams are found describing the relationship between leverage and earnings management.
On one hand, evidence suggests that firms with high leverage are more likely to aggressively
manage their earnings. Press and Weintrop (1990) provide evidence that high leverage is positively
associated with the likelihood of violating debt covenants. Sweeney (1994) and DeFond and Jiambalvo
(1994) also explain that firms near default employ incomeincreasing
accounting changes in order to
delay their technical default. Watts and Zimmerman (1990) and Mohrman (1996) support this view by
arguing that firms with higher leverages are expected to adopt accounting procedures that increase current
income. Likewise, Becker et al. (1998) noted that managers of highly leveraged firms have incentives to
strategically report discretionary accruals in order to increase reported earnings in their efforts to avoid
debt covenant violation. Moreover, Gu et al. (2005) reported that variability of accruals is positively
related with leverage.
On the other hand, a completely opposite view is found in literature that adopts the control
hypothesis by Jensen (1986), which suggests that debt creation reduces managers opportunistic behavior.
This implies that high leverage may restrict managers' ability to manipulate incomeincreasing
accruals,
since management opportunism and earnings management are found to be associated (Christie and
Zimmerman 1994). In a study that compares firms of highaccruals
with firms of lowaccruals,
Dechow et
al. (2000) document that firms with high accruals are characterized by low leverage. In line with this
finding, Ke (2001) shows evidence that firms are less likely to show increases in earnings through
accruals if the firms are highly leveraged. Iturriaga and Hoffmann (2005) emphasize the monitoring and
governance role of leverage as they argue that there is a negative relationship between debt financing and
the use of discretionary power in managers' accounting decisions, since the higher the leverage the more
thoroughly is the control applied by lenders. They also suggest that managers of highly leveraged firms
have fewer motives to manage earnings because their creditors are interested in debt service rather than
accounting information, which means that financial statements have less relevant informational content in
this case. The empirical findings of Iturriaga and Hoffmann (2005) support the alternative hypothesis and
reveal a significant negative influence of leverage on earnings management. Jelinek (2007) examines the
impact of leverage increases on earnings management, across a fiveyear
sample period for firms that
undergo leverage increases and a control group of consistently highly leveraged firms. The results suggest
that increased leverage is associated with a reduction in earnings management.
Both sides of the arguments are supported by theory and evidence in their favor, but neither has
delivered a compelling, definitive answer. Furthermore, many studies either failed to find statistically
significant evidence on the relation between leverage and abnormal accruals, e.g. such as Chung and
Kallapur (2003), or they provide mixed evidence, such as Shen and Chih (2007). Therefore, the question
of the association between leverage and earnings management is still open. This study contributes to the ongoing debate over the implications of leverage on management's accounting discretionary power by
examining the leverage effect in a sample of firms that have the motivation for earnings management.
Political motivation
Dividend motivation
Jointly with Daniel et al. (2008), our paper provides interesting avenues for future research. Daniel et al. (2008) hold that past dividends represent an earnings threshold. We find that firms tend to cut dividends when reported earnings fall short of past dividends. This suggests that past dividends potentially serve as a useful heuristic to proxy for an earnings threshold in dividend covenants. Prior work uses leverage as a proxy for covenant tightness to examine the debt covenant hypothesis (Fields et al., 2001). But Fields et al. (2001) argue that a firm's leverage is at best a very crude proxy for tightness in debt covenants.
Daniel, Denis, and Naveen (2008) report evidence that firms manage earnings upward when pre-managed earnings are expected to fall short of dividend payments.
Taxation motivation
issues raised during the conference included the distinction between tax
compliance and tax enforcement, questions about of the relation between earnings management
and private control benefits, and concerns that absolute discretionary accruals scaled by total
assets captures correlated risk and other factors.
Burilovich (1997) looked at specific incentives to mange reported earnings in the
case of alternative minimum taxï‚•. She used a sample of 72 regulated life insurance firms
during the period 1984-1989 and found that income decreasing discretionary accruals (DA)
differ significantly across the companies audited by big auditing firms.
Initial Public Offerings (IPO)
Friedlan (1994) reported that IPO firms made income-increasing discretionary accruals in the latest period
prior to IPO relative to accruals in a comparable pervious period.
CFOs of firms sometimes manipulate earnings prior to specific date leading to IPO, Management Buyout, Mergers and acquisitions, and other important deals to reduce costs of them.
Pattern of earnings management
Prior
research has documented a discontinuity in the distribution of earnings around the
thresholds of three earnings benchmarks: zero earnings, previous year's earnings and
analysts' earnings forecasts (Degeorge et al., 1999; Burgstahler and Dichev, 1997; Hayn,
1995). This discontinuity in the distribution of earnings has been widely interpreted as
evidence that managers tend to manage earnings to meet or beat these earnings
benchmarks. Prior research suggests a broad set of mechanisms that managers use to
manage earnings to meet or beat earnings benchmarks. The first mechanism is
earnings management through real operating decisions such as delaying investment in
R&D, cutting selling, general and administration expenses, overproduction to reduce
cost of goods sold and cutting prices or extending credit terms at the end of the period
to accelerate sales (Roychowdhury, 2006). The second mechanism is to manage
working capital accruals to manage earnings upward (Caylor, 2010; Phillips et al., 2003;
Burgstahler and Dichev, 1997; Healy, 1985). The third mechanism is classification
shifting of core expenses to non-recurring item to inflate core earnings (McVay, 2006).
Hayn (1995) has documented that there
is a point of discontinuity around zero. Specifically, there is a concentration of cases
just above zero, while there are fewer than expected cases just below zero (small losses).
These results suggest that firms whose earnings are expected to fall just below the zero
earnings point engage in earnings manipulation to help them cross the "red line" for
the year. In subsequent research, Burgstahler and Dichev (1997) provide evidence that
8-12 percent of the firms with small pre-managed earnings decreases exercise
discretion to report earnings increases.
Earnings management to meet or beat earnings thresholds has spawned considerable
research in recent years,
we consider that
"not all earnings management is equal." The literature most commonly considers the ability of
governance mechanisms to prevent managers from engaging in upward earnings management
for opportunistic reasons (e.g., maximize compensation, reduce unemployment risk, meet
earnings benchmarks, and lower the cost of external financing). However, a smaller but growing
body of research considers that managers may strategically manage earnings downward (e.g.,
Healy 1985; Jackson and Liu 2010; Bratten et al. 2012). The extent to which such "cookie jar reserves" affect financial reporting quality is not yet clear. Nevertheless, it does appear from the
literature that the ability of firms to engage in downward earnings management is perhaps an
easier task for managers (Nelson et al. 2002).
The reversal nature of managed accruals suggests that when accruals are managed
upward (downward) in the current quarter, they will reverse downward (upward) in subsequent
quarters.
A large
amount of evidence shows that managers engage in upward earnings management, resulting in
announced earnings that meet or slightly beat analysts' expectations.
In addition, market rewards for meeting expectations are incrementally smaller as the
earnings surprise increases (Kinney et al. 2002). The concave relation between stock returns and
the earnings surprise suggests that managers may also be willing to reserve accruals when easily
beating analyst expectations. In other words, downward earnings management may exist where
the forecast is easily met if the benefits of slightly higher earnings now are less than the future
benefits of having reserves.
Taking a bath
`Big bath' in accounting is an earnings management strategy that manipulates a company's
income statement to make poor results look even worse. A number of empirical studies have
documented big baths used by managers, e.g. Walsh et al. (1991), Beattie et al. (1994), Hwang
and Ryan (2000), Christensen et al. (2008), and Riedl and Srinivasan (2010).
Kirschenheiter and
Melumad (2002) is one exception. They consider a situation where one manager issues _nancial
reports and outside investors infer the precision of reported earnings. They show that if true
earnings is bad, the manager will take a big bath to introduce additional noise into his report and
reduce the perceived precision of earnings report.
Beyer (2008)
also considers a leader-follower game, where an outside analyst _rst issues an earnings forecast and
then an inside manager issues an earnings report. She argues that when reporting earnings, the
manager trades o_ the dis-utility he obtains from falling short of the analyst's forecast against the
costs of manipulating earnings.
The earning management motivations may exist also around the time of
CEO change. In one hand, the CEO of a poorly performing firm may try to increase the
reported earnings to prevent or postpone being fired. On the other hand, consistent with the
findings of DeAngelo et al. (1994), a new CEO may take a "big bath" in the year of change
to increase the probability of higher future earnings when his/her performance will be
measured, especially when low earnings in the change year can be blamed on the previous
CEO.
Income minimisation
instrumental losses, earnings decreasing, especially in situations
where, in the presence of strong corporate restructuring and
management changes, it is desirable to shift responsibility of
negative results to the previous management and highlight the
greater abilities of the new management or the beneficial effects of
economic and financial restructuring or reorganization.
Income maximisation
increasing artificial earnings, typically arising from the
management's desire to present better results than actual in order
to obtain private benefits (esteem, reconfirmation, additional
remuneration) or to prevent unsustainable environmental pressures,
especially from external lenders
Income smoothing
(Michelson, Jordanâ€Wagner, & Wootton, 1995) in their research concluded that the firms doing earning smoothing are the large firms with less risk and return.
Agency theory (Jensen and Meckling, 1976) suggests insiders' incentives and
behaviours may not be aligned with the interests of parties external to the firm, in
particular capital providers. Managers have incentives to hide poor performance to
protect their reputation and compensation (Moses, 1987). The process of adjusting
reported earnings to be greater or lower than expected is referred to earnings
smoothing (Beidleman, 1973). Earnings smoothing produces information that is
biased, that is, it does not faithfully represent underlying economic performance. The
usefulness of the information to firm outsiders is reduced, thus it is argued that
earnings smoothing reduces accounting quality (Lang et al., 2003; Barth et al., 2008).
Chen et al. (2010) study listed EU firms in 15 countries prior and subsequent to
adoption of IFRS (2000-2007). They report higher levels of income smoothing and
less timely recognition of losses, although the authors argue that others measures,
based on discretionary accruals, suggest accounting quality has improved.
Another aspect of hiding poor performance relates to avoiding small losses. Although
managers have incentives to avoid losses of any magnitude, their ability to cover up
large losses is lower than for small losses. Thus there is a tendency for insiders to
manage earnings to a small positive net income (Leuz et al., 2003). This results in
biased information and thus lower accounting quality. Jeanjean and Stolowy (2008)
report that earnings management (measured as the ratio of small reported profits to
small reported losses) did not decrease in a sample of firms from France, the UK and
Australia following mandatory adoption of IFRS.
Recognition of losses is considered to be timely if they
By smoothing earnings over time, managers convey information to
stakeholders about the underlying economic performance of the company,
or attempt to influence contractual outcomes that depend on the reported
accounting numbers. Healy (1985) argues that managers of firms that perform
poorly have incentives to manipulate earnings downwards because
they have no chance of receiving a bonus in the current period. Deferring
income to the future periods would have no effect on their current total
compensation, while would have positive influence in their future bonus.
Yoon and Miller (2002) found empirical evidence that when operating
performance is extremely poor, firms tend to take a big bath. Future
research found empirical evidence of higher levels of EM in firms with
higher levels of stock-based incentives for CEOs (e.g. Benesih & Vargus,
2002; Bergstresser & Philippon, 2006).
earnings smoothing, aimed primarily at maintaining earnings - and
hence dividends - stable and substantially constant over time by
overestimating costs or underestimating revenues in the most
favourable periods, and to the contrary in less prosperous periods.
The financial market usually associates the stability of results over
time with lower corporate risk, with a consequential reduction in the
cost of capital
(Chaney & Lewis, 1995) in their study examined the effect of firm's size, debt, profit, return, discretionary accruals and growth on earning smoothing. Their study results illustrated that the smoothing maker firms are bigger than others in size, debt, returns, and discretionary
accruals. In addition, these results showed that the weak performance firms do less earning smoothing. Finally, they found a negative relation between earning smoothing and growth.
Summary of Empirical Studies on Earnings Management
Significant research has addressed the motivation for earnings management. Levitt (1998) noted that the major reason for earnings management is the stock market's unwillingness to forgive companies that miss their earnings estimates. Rosner (2003) confirmed this hypothesis by showing that financially distressed firms were more likely to misstate their financial reports compared to less-distressed firms. Adu-Boateng (2011) reviewed the literature on earnings management motivation and concluded that accountants may be pressurized to make decisions that conflict with their mora reasoning when certain actions are needed to counter an unfavourable outcome for the firm. Elitzur (2011) even suggested that investors were responsible for earnings management because it boosted their wealth. Elias (2004) found a link between corporate ethical values and managers' motivation to manage earnings.
Prior earnings management studies focus on identifying managers' incentives to manipulate earnings (Healy, 1985; Sweeney, 1994; DeFond and Jiambalvo, 1994; Burgstahler and Dichev, 1997; Teoh et al., 1998a, b; Erickson and Wang, 1999; Degeorge et al., 1999; Fields et al., 2001). While these studies usually show that earnings management exists, there is a missing link: the manager's latitude to manipulate earnings (Fields et al., 2001).
Additionally, there are the unpublished studies of Qinglu (2005) and Lin
and Shih (2002). The former found that EM is significantly larger during
recessions, as well as in strong economic growth periods, but they did not
consider the complete array of control variables used in accounting studies,
and used estimates of cash flow from operations (CFO) in the calculation
of accruals. The latter studied the influence of Gross Domestic Product
(GDP) growth on discretionary accruals, finding that during recessions
managers defer income from periods of weak earnings to future periods.
LNW [2003] tabulate four different measures of earnings management and then combine
these measures into an aggregate earnings management score for each of the 31 countries in their
sample. Their four earnings management measures are: (i) the standard deviation of operating
income scaled by the standard deviation of cash flow from operations to capture earnings
smoothing, (ii) the correlation between accruals and operating cash flows, (iii) the magnitude of
working capital accruals scaled by absolute cash flow from operations, and (iv) the prevalence of
small loss avoidance.
(Chan, Chan, Jegadeesh, & Lakonishok, 2001) in their study based on the US capital market data during 25 years indicated an inverse relation of accruals and future stock return. It means that increase in earnings along with a high degree of accruals which are indicators of low earning quality will lead to weak stock return.
GhaemMaghami, Livali & Bozorgi, 2009) examined the role of accruals items in describing the earning quality of publicly traded firms in Tehran Stock Exchange and studied the relation of earning quality through accruals and its components with normal and abnormal stock return. Their samples consisted of 136 firms during 1998 to 2005 and accruals item were divided into discretionary and non-discretionary accruals. Their research result indicated that firm's stock return was affected by accruals and its components.
(Kordlori, Hassani-A & Hassani-E, 2006) determined discretionary accruals as indicators for evaluation of earnings management and surveyed EM during IPO. Their survey results showed that managers manipulated earnings in a year prior to IPO and in the year of IPO. In addition, they examined the effect of EM on long run performance of stock price and illustrated that discretionary accruals and long run performance of stock price have a positive correlation.
(Dechow, Sloan, & Sweeney, 1995) illustrated that discretionary accruals are fixed and could not be used as income smoothing tools. The probability of earnings manipulation increases as much as the amounts of discretionary accruals and is more in total accruals.
Why earnings management matters for capital structure decision? Managerial discretion/judgment in reported earnings may make firms' underlying economic performance, e.g. operating cash flow, private information available only to insiders. As a consequence, earnings management has at least two implications that may be relevant for corporate finance policies.
First, earnings management can help managers finance sub-optimal investments that maximize their own utilities at the expense of some informationally disadvantaged stakeholders. Similarly, earnings management may facilitate insiders' tunneling activities.
From an agency perspective, debt may serves as an external control mechanism in mitigating the agency costs of free cash flow. (see, e.g., Jensen (1986) and Jensen and Meckling (1976)).
Second, earnings management can increase firms' external financing costs as predicted by the pecking order theory (Myers (1984) and Myers and Majluf (1984)). In particular, external equity financing becomes disproportionally less desired than debt when external funding is needed for investment because adverse selection costs increase in the riskiness of the security issued.
Jorissen and Otley ( 2010) use the broader term financial misrepresentation and state that academic research has concentrated almost exclusively on the management of earnings numbers, with most studies examining the presence of earnings management through the analysis of accrual decisions. They find that financial misrepresentation is broader than just earning management and include the management of balance sheet numbers and disclose management among other issues
(They refer to extreme cases such as Ahold, Parmalat,Enron and Worldcom where the balance sheet numbers were also managed)
