high accruals in the periods before stock offerings presage an earnings decline following offerings, which is consistent with the claim that managers shift earnings to the present at the expense of the future. Interestingly, earnings declines often lead to shareholder lawsuits, suggesting that earnings management may result in costly litigation
The capital markets are sensitive to companies that miss analysts' earnings expectations or management's earnings forecasts. Companies in danger of falling below these earnings targets may use their discretion to manage earnings upwards.
research indicates that managers may manipulate earnings in an effort to report positive earnings and earnings growth
investors may look beyond a onetime loss and only focus on future earnings. Companies having a bad year may include an unusually large amount of expenses in current-year earnings (i.e., a "big bath") to ensure an earnings turnaround in future years. Big bath charges are quite common, particularly when there has been a change in top management, in order to clean up the balance sheet and provide a fresh start.
Initial Public Offerings (IPO)
Aharony et al. (1993) examine earnings reporting prior to initial public offerings and find little evidence of earnings manipulation
An initial public offerings (IPO) occurs when a security is sold to the general public for the first time, with the expectation that a liquid market will develop.
Firms making IPOs do not have an established market price. This raises the question of how to value the shares of the IPO firms.
Earnings management during IPOs consists of window dressing or enhancing financial reports to attract better valuations. Firms making these IPOs do not have an established market prices and one way of valuating their shares is looking at the prospectus of these firms, which contain information concerning financial reports.
Clarkson, Dontoh, Richardson, and Sefcik (1992) is earnings forecast, with gain favourable responds in the market towards the value of the firm.
the reporting earnings and firm's value are closely linked, management might seek to manipulate earnings in the hope of receiving a higher price for their shares and this matter was tested by Fredlan (1994
Regulatory incentives
Regulatory incentives to manage earnings arise when reported earnings are thought to influence the actions of regulators or government officials. By managing the results of operations, managers may influence the actions of regulators or government officials, thereby minimizing political scrutiny and the effects of regulation.
Banking regulators use accounting numbers to determine compliance with capital adequacy ratios. Banks close to regulatory minimums have an incentive to avoid noncompliance and the costs of increased regulation. Some banks close to minimum capital adequacy ratios have undertaken a variety of accounting actions designed to avoid regulatory noncompliance.
Taxation motivation
Burilovich (1997) looked at specific incentives to manage reported earnings in the case of alternative minimum tax
However taxation authorities tend to impose their own accounting rules for the calculation of taxable income, thereby reducing firms' room to manoeuvre.
Little room to manipulation as tax authorities apply different accounting methods to calculate the chargeable profit of a business (Scott, 1997). In other words, not all expenses incurred by a business are allowed to be deducted against profits. Also, deduction like depreciation on tangible non-current assets is not allowed for tax purposes.
Contractual incentives
Contractual incentives to manage earnings arise when contracts between a company and other parties rely upon accounting numbers to determine exchanges between them. By managing the results of operations, managers can alter the amount and timing of those exchanges.
Debt covenants
Debt covenants frequently involve accounting numbers or derivatives of those numbers (i.e., working capital, number of times interest earned). Managers of firms close to violating those covenants can avoid default by making income-increasing accounting choices. Even firms that have violated debt covenants are candidates for managing earnings because such actions may improve the firm's bargaining position in case of renegotiations. These incentives are likely to be compelling because violations of debt covenants usually lead to higher cost of borrowing or new restrictive covenants.
Debt covenants are tied to a public company's ability to borrow funds.
To improve access to capital, executive tend to manage earnings in a manner that leads creditors to believe that a firm has strong potential to generate future net cash inflow (Dechow, Sloan and Sweeney, 1996; Sweeney, 1994)
If a company needs to borrow, management has an incentive to enhance the position reflected in the company's financial reports. Improving the balance sheet reduces the debt-equity ratio, whereas boosting income makes interest coverage ratios look better.
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 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.
If the company would rather borrow funds to finance a project, it must show that potential creditors (such as banks or other lenders), that the company can make its debt service payments.
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. Concrete
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
The impact of debt financing on earnings management is an empirical controversy
Press and Weintrop (1990) provide evidence that high leverage is positively associated with the likelihood of violating debt covenants
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
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
completely opposite view is found in literature that adopts the control hypothesis by Jensen (1986), which suggests that debt creation reduces managers' opportunistic behaviour.
Arise from long-term lending contracts, which typically contain covenants to protect the lenders against actions by managers that are against the lenders' best interests
Another motivation for earnings management is long-term lending contracts, which usually contain covenants to protect the lenders against actions by managers. These covenants restrict management's actions that do not benefit the lenders.
In order to raise more funds from debt holders at an acceptable or lower rate of interest, the firm needs to adhere towards the interests of the latter (for i.e. not undertake high-risk projects and pay reasonable dividends). Such adherence comes in the form of agreement s which management needs to sign and therefore binds them towards working in the debt holders' interest. Since violation of covenants involves huge cost to management or the firm as a whole, managers practice earnings management to avoid this to happen. Even being close to violation managers got to do so else that will have a subsequent impact on them as this will limit their independence to manage the firm.
In a contract it is might be stipulated that the debt ratio is to be maintained below a certain level. Since it is being calculated by taking debt divided by total assets of the firm, there will be incentive to increase total assets if the ratio exceeds the specified level (Christie, 1990; Watts and Zimmerman, 1990). Sweeney (1994) showed that earnings were indeed manipulated upwards by those companied that defaulted on those covenant. Debt contract is a motivation for earnings management, as managers will manipulate the accounting figures to show debt holders a good leverage and no violation of debt covenants.
Bonus scheme
The separation of ownership form control in today's corporation leads to the conflicts of interests between mangers and shareholders seek to maximise wealth. Thus to minimise conflicts corporation create compensation contract by linking managerial pay to the improvement of firm value.
In order to reduce the agency costs and prevent managers from acting in their own interests, organisations will put in place mechanisms that align the interests of the managers of the firm with the interests of the owners of the firms.
Healy (1985) entitled "the effect of Bonus schemes on Accounting Decision" is perhaps the best-known empirical investigation of earnings management. He put forward that since managers have insider information on the firm's net income before earnings management managers try to opportunistically maximize their bonuses under the firms' compensation plans
Management compensation agreements typically provide for bonuses that are determined, in part, by firm earnings. By managing accounting numbers, managers can influence their current and future compensation.
Manger's compensation contract is based on earnings numbers. For example, a manager may receive a bonus based on achieving certain earnings targets. Thus, by inappropriately shifting revenue or expense figures to current or future periods, the manager can manipulate when and how much of a bonus is received
Healy (1985) who examines how bonus schemes affect the choices of accounting policy argues that managers tend to maximise their bonus through opportunistic earnings management. When earnings fall within expected range, mangers will choose appropriate accounting policy to raise earnings. However, when earnings fall outside the expected range, managers tend to defer earnings to futures to maximise their bonus in the long run.
Holthausen et al. (1995) find that managers who are at their bonus maxima manage accruals so as to lower reported earnings
Prior researchers have provided evidence on the influence of bonus contracts on earnings management behavior.
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.
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).
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). 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
If managers are rewarded on the performance of the firm, that is accounting-based bonus plans, then there will be incentives for manipulation of figures so as to increase the bonus
Given that managers will be rewarded if the company is going well, they will have the tendency to manipulate the related accounting numbers to improve the apparent performance of the firm and more importantly their related rewards. Thus, through the accounting-based bonus scheme, mangers will opportunistically try to maximise their bonus (Healy, 1995).
For instance, when profits are not expected to reach the threshold set, managers will try to reduce the profit further as in either case no bonus will be received. This current reduction will lead to higher income in subsequent periods. For example, writing off non-current assets in current year will imply that no further depreciation will be charged in future years, thereby increasing future profits. Thus, these bonus scheme acts as an incentive for managers to manipulate the reported earnings, either upwards or downwards.
Since manipulation numbers is likely to happen under the bonus scheme, it is important for owners to have their financial statements audited and monitored by independent auditors. The latter will exercise judgement on the reasonableness of the accounting methods used by manager. However, following the huge corporate collapses in the US (i.e. Enron and WorldCom), replying confidently on the auditor's work too is becoming questionable.
Dividend motivation
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
Daniel, Denis, and Naveen (2008) report evidence that firms manage earnings upward when pre-managed earnings are expected to fall short of dividend payments.
Equity incentive
management compensation contracts (stock option, bonus plan) and capital markets encourage managers to increase earnings. Theoretically, incentive mechanisms set up to align interest of managers and shareholders perversely gives birth to information asymmetry that Stein (1989) calls "managerial myopia". Empirical literature investigating equity incentive includes Bergstresser and Philippon (2006), Efendi, Srivastava, and Swanson (2007) and Harris and Bromiley (2007). Therefore, crunching markets put manager under pressure to save shareholder value.
