The second empirical chapter investigates the role of information uncertainty in explaining the opportunistic behaviour of managerial discretion when firms have high incentives to manage
Background of the thesis
This thesis advances earnings management research by evaluating and comparing the effectiveness of accrual-based and real-based earnings management models It specifically examines the specifications and detection power of real earnings management models, such as Roychowdhury's (2006) model, which captures three real activity manipulation strategies Despite its widespread use, there is limited empirical evidence on the model's effectiveness in uncovering real earnings management activities Prior research has predominantly focused on accrual manipulation models, highlighting a gap this thesis aims to address by providing deeper insights into the detection capabilities of real earnings management models.
While previous research (e.g., Srivastava, 2019; Cohen et al., 2020; Siriviyakul, 2021) has focused on either accrual-based or real earnings management models, no study has simultaneously evaluated both to compare their effectiveness in detecting manipulation This study offers valuable insights into the performance of models that incorporate reversal techniques (e.g., Dechow et al., 2000; Vorst, 2016; Srivastava, 2019) across different scenarios It finds that some models perform better when earnings manipulation does not reverse in the following year but have reduced power in cases where reversal occurs, thus highlighting the nuanced effectiveness of these tools These findings contribute to the ongoing discussion on whether accrual and real manipulation serve as substitutes or complements (e.g., Cohen et al., 2008; Cohen et al., 2010; Cohen and Zarowin, 2010; Ibrahim et al., 2011; Zang, 2012; Gao et al., 2017; Ipino and Parbonetti, 2017; Owusu et al., 2020) by directly comparing their ability to serve as reliable proxies for earnings management within the same sample.
Recent literature indicates that managers balance accrual earnings management and real earnings management according to their relative costs (Cohen et al., 2010; Zang, 2012) This study further explores how investor understanding (IU) influences managerial decisions between these two earnings management strategies Additionally, it compares the trade-offs managers face when choosing between accrual and real earnings management, highlighting the impact of IU on these choices.
2 accrual and real manipulation in a context that has never been investigated before, as far as my knowledge is concerned
Previous research consistently documents discontinuities in earnings distribution around key benchmarks, such as those identified by Burgstahler and Dichev (1997) and Holland and Ramsay (2003) While numerous empirical studies examine the impact of earnings management on various outcomes, their findings remain inconclusive This study offers new evidence that investigatory uncertainty (IU) influences managerial discretion in manipulating earnings to meet or beat benchmarks Specifically, under high IU conditions, managers tend to manage earnings to appear compliant with benchmarks, potentially misleading investors about future firm performance Consequently, there is a negative correlation between firms that beat earnings benchmarks and their long-term performance in high IU environments.
This thesis comprises three empirical chapters, with the first focusing on comparing the performance of accrual and real earnings management models It evaluates the specification and effectiveness of commonly used earnings management models, highlighting that real earnings management activities often resemble normal business operations, making them more challenging for market participants to detect than accrual-based earnings management Consequently, it is generally expected—both in theory and practice—that real earnings management is more difficult to identify than accrual earnings management.
This chapter investigates the impact of information uncertainty (IU) on accrual earnings management, highlighting how IU influences managerial decision-making It explores the role of IU in shaping managers' choices between accrual earnings management and real earnings management practices The findings emphasize that higher levels of information uncertainty significantly affect the tendency of managers to engage in different earnings management strategies, providing valuable insights into how uncertainty drives financial reporting behavior under varying conditions.
This chapter examines how Investor Uncertainty (IU) impacts firms' subsequent performance when they meet or beat earnings benchmarks High IU limits outside market participants' ability to accurately assess the integrity of reported earnings, providing managers with greater opportunities to engage in earnings management unnoticed Consequently, elevated IU can increase managerial opportunism, enabling managers to manipulate earnings to meet benchmarks and potentially mislead investors.
Motivation of the thesis
Under the UK Company Act 2006, financial statements must present a true and fair view of a firm's financial position, ensuring that accounting numbers credibly reflect company performance However, flexibility in accounting estimates allowed by standards can lead to information asymmetry between managers and external stakeholders This creates opportunities for managers to exercise discretionary judgment, often referred to as earnings management Consequently, earnings management has garnered significant attention from academics, regulators, and practitioners concerned with maintaining financial transparency and integrity.
Earnings management involves managers manipulating financial reporting and transactions to mislead stakeholders about a company's true economic performance or to influence contractual outcomes based on reported figures (Healy and Wahlen, 1999) This practice can compromise the reliability of financial reports, impacting market efficiency and investor decision-making Therefore, understanding earnings management is crucial for regulators and market participants aiming to ensure transparency and uphold financial integrity.
Recent studies have highlighted an increased interest in real earnings management, which involves managers manipulating financial reports through deviations from normal business activities (Graham et al., 2005; Kothari et al., 2016; Roychowdhury, 2006) While evidence suggests that real earnings management is more challenging to detect than accrual-based earnings management (Cohen et al., 2008; Jiang et al., 2018), there is a notable lack of research comparing the effectiveness of various detection models This study aims to fill this gap by analyzing and comparing the abilities of commonly used earnings management models to identify both accrual and real earnings management Additionally, despite the widespread application of Roychowdhury’s (2006) real earnings management model in academic research, limited evidence exists regarding its effectiveness in uncovering real earnings management, prompting this study to evaluate its detection power.
Although accounting standards allow managers to exercise accounting judgement to make financial reporting more informative for users, firm managers can use discretion in financial
4 statements to manage earnings Previous studies show that earnings management can occur when outside stakeholders are not able to uncover it (Healy and Wahlen, 1999) Jiang et al
Research by (2005) indicates that high levels of Information Uncertainty (IU) can lead to reduced public information availability for market participants In environments with high IU, investors struggle to distinguish between actual firm performance and earnings manipulated by managers (Dye, 1988; Trueman and Titman, 1988) However, there is limited empirical evidence on whether IU influences accrual earnings management This thesis aims to explore and address this research gap.
Recent research highlights a trade-off between accrual earnings management and real earnings management, especially as firms face increased professional scrutiny and reduced accounting flexibility, pushing them toward real earnings management to avoid detection (Cohen & Zarowin, 2010; Zang, 2012; Owusu et al., 2020) Studies suggest that in high institutional uncertainty (IU) environments, managers prefer methods offering higher short-term benefits, often leading to more aggressive earnings management practices Evidence indicates that real earnings management has a more detrimental long-term impact on firm performance compared to accrual earnings management (Graham et al., 2005; Cohen & Zarowin, 2010; Kothari et al., 2016) Consequently, firms tend to favor accrual earnings management over real earnings management under high IU conditions However, there is a lack of research examining whether institutional uncertainty influences the trade-off between these two earnings management strategies, a gap this study aims to address.
Research shows that firm managers have the strongest incentives to manage earnings when shifting from losses to gains, either relative or absolute (Burgstahler and Dichev, 1997; Degeorge et al., 1999; Coulton et al., 2015) Earnings management behavior is particularly evident when firms meet or beat key benchmarks, such as just above zero earnings or maintaining zero earnings changes, to create perceived performance benefits While some studies suggest that strategies like delaying R&D expenses to beat earnings benchmarks can signal private information about future firm prospects, benefiting market participants (e.g., Dinh et al., 2016; Al-Shattarat et al., 2018), the overall economic impact of earnings management practices remains unclear and debated in the literature.
Managers often manipulate earnings through discretionary accruals to meet benchmarks and mislead investors about future firm performance, leading to a situation where investors cannot accurately interpret the implications of benchmark-beating, which may result in long-term underperformance While market participants can sometimes detect and react to earnings management, high levels of Inconvenient Uncertainty (IU) make it difficult for them to do so, enabling managers to engage in opportunistic earning practices Previous research indicates that under high IU, investors tend to develop biased behaviors such as overconfidence, further facilitating earnings manipulation by firm managers Despite these findings, there is a lack of studies exploring how IU influences the subsequent performance of firms that beat earnings benchmarks, a gap this thesis seeks to address.
Objectives of the thesis
Recent research highlights limited evidence on the effectiveness of models designed to detect real earnings management, despite increasing interest in the topic Market participants often face uncertainty regarding reported earnings, prompting managers—particularly under high information uncertainty (IU)—to engage in earnings management strategies to mislead investors about firm performance This thesis aims to contribute to the earnings management literature by comparing the detection capabilities of models for both accrual and real earnings management and exploring how IU influences managerial behavior Key objectives include assessing the power of detection models, examining the impact of IU on accrual earnings management, analyzing the trade-offs between accrual and real manipulation under high IU, and investigating the long-term market effects of earnings manipulation in such environments.
Methodology and data
This thesis utilizes financial data from the Datastream database to assess the effectiveness of detecting earnings management and to examine the impact of Institutional Ownership (IU) on managerial behavior The study's sample comprises both active ("live") and inactive ("dead") firms listed on the London Stock Exchange.
This study analyzes earnings management from 1992 to 2018 using both univariate and multivariate methods It builds on established approaches by McNichols and Wilson (1988), and Brown and Warner (1985), to evaluate the prevalence of accrual and real earnings management models The methodology involves artificially adjusting managed earnings into accruals and real accounts to identify the likelihood of Type II errors when the null hypothesis is false To examine the trade-off between accrual and real earnings management under high Information Uncertainty (IU) conditions, the analysis focuses on firm-year observations most likely to manipulate earnings, following Burgstahler and Dichev (1997), emphasizing firms with small earnings increases and positive income The research employs ordinary least squares (OLS) regression to control for differences between firms surpassing or missing earnings benchmarks and utilizes advanced techniques like propensity score matching (PSM) and the Heckman two-step approach for robustness.
Main empirical findings
Recent research indicates that real earnings management is more challenging to detect than accrual earnings management, as existing methods struggle to uncover real manipulation activities effectively Roychowdhury’s (2006) model, widely used for identifying real earnings management, suffers from high mis-specification and low test power Conversely, the cross-sectional modified Jones model applied to UK firm data demonstrates greater effectiveness in detecting earnings management compared to the time-series approach with US data The study also finds that accrual-based models, including the modified-Jones, Kothari et al (2005), and Francis et al (2005) models, are better specified and more powerful in identifying accrual manipulation than Roychowdhury’s model for real activities Additionally, models targeting overproduction and sales manipulation, such as discount pricing, tend to be highly misspecified, which artificially inflates their perceived detection power.
The second study indicates that in high uncertainty avoidance (IU) environments, firm managers tend to favor accrual earnings management over real earnings management These findings are consistent across various analytical methods, including propensity score matching and Heckman two-step procedures, confirming the robustness of the results.
7 applying ordinary least square models and sorting firms by IU to test for differences between low IU group and high IU group, provide consistent results
Firms that manipulate earnings to surpass benchmarks tend to experience poorer stock performance, indicating they may be misleading investors through earnings manipulation The study highlights that unusual income (IU) significantly explains opportunistic earnings management behaviors Empirical evidence from various methods, including propensity score matching and Heckman two-step procedures, confirms that firms engaging in opportunistic benchmark beating under high IU levels tend to mislead investors about their future performance.
Structure of the thesis
Chapter 2 defines and classifies earnings management, offering a comprehensive overview of its various forms It explores the theoretical perspectives underpinning earnings management, with particular emphasis on agency theory and its implications The chapter also reviews key theoretical predictions found in the earnings management literature, providing a solid framework for understanding the motivations and practices behind earnings manipulation.
Chapter 3 presents the findings of the first hypothesis testing It compares the ability of models detecting accrual earnings management and real earnings management
Chapter 4 presents the findings of the second, third, fourth and fifth hypotheses testing It mainly investigates the role of IU in the choice of accrual versus real earnings management
Chapter 5 presents the findings from testing the sixth and seventh hypotheses, focusing on the impact of firms' subsequent performance in managing earnings to surpass earnings benchmarks The analysis reveals how strategic earnings management influences future financial outcomes, providing insights into corporate behavior aimed at achieving favorable regulatory and market perceptions These results underscore the significance of understanding earnings management practices and their implications for investor decision-making and financial analysis.
Chapter 6 concludes the thesis by summarizing the key findings and their implications for the field It highlights the main insights gained from the research and discusses how these contribute to existing knowledge The chapter also addresses the study's limitations and offers valuable suggestions for future research to build upon these results.
THEOREITCAL PERSEPCTIVE AND INCENTIVES OF
Introduction
This chapter defines earnings management and differentiates between accrual earnings management and real earnings management It explores agency theory as the theoretical framework underlying earnings management practices Additionally, based on existing literature, the chapter summarizes key motivations for earnings management, including achieving earnings benchmarks, facilitating equity offerings, influencing executive compensation, meeting debt covenants, and managing import relief and political costs.
This chapter is organized into several key sections to provide a comprehensive understanding of earnings management Section 2.2 defines accrual-based earnings management and real earnings management, highlighting their respective mechanisms Section 2.3 compares and contrasts these two approaches, emphasizing their differences Section 2.4 explores the theoretical frameworks underpinning earnings management practices Section 2.5 discusses the various incentives that motivate firms to manipulate earnings Finally, Section 2.6 offers a concluding summary of the key insights presented in this chapter.
Definition of earnings management
Earnings management has long been a subject of research, yet an universally accepted definition remains elusive Various terms like aggressive accounting, income smoothing, and cooking the books are often used interchangeably with earnings management, reflecting different approaches or perceptions of manipulating financial reports (Akpanuko and Umoren, 2018).
Earnings management, as defined by Healy and Wahlen (1999), involves managers using their judgment in accounting and operational decisions to manipulate financial reports and potentially mislead investors about a company's true economic performance While accounting standards permit professional judgment—such as estimating future economic events like asset amortization or selecting acceptable methods like LIFO or FIFO—managers may also influence contractual outcomes through their operational choices Understanding these nuances is essential for assessing financial transparency and the potential for earnings manipulation.
To overcome the limitations of current accounting standards, firms can adopt various strategies, such as capitalizing research and development (R&D) expenditures to manipulate reported earnings Earnings management occurs when managers utilize discretionary accounting choices or alter real operating activities with the goal of influencing contractual outcomes or presenting misleading earnings information These practices are often aimed at influencing stakeholder perceptions of a company's true financial performance, highlighting the need for regulatory and methodological improvements to ensure transparency and accuracy in financial reporting.
Fields et al (2001) highlight that earnings management involves managers exercising their discretion to manipulate reported earnings This practice is often driven by opportunistic motives, aiming to serve managers' personal interests or to enhance the firm's value Understanding earnings management is crucial for assessing financial transparency and integrity in corporate reporting.
Earnings management involves deliberate actions within the framework of generally accepted accounting policies to achieve specific reported earnings, as defined by Davidson et al (1987) This process is intentional and focused on influencing financial outcomes According to Schipper (1989), earnings management is a purposeful intervention in external financial reporting aimed at obtaining private gains, emphasizing that such manipulation occurs through deliberate efforts within or outside GAAP to influence reported earnings.
Classification shifting is a key tool in earnings management, involving the deliberate misclassification of items within the income statement (McVay, 2006) This opportunistic practice allows managers to influence reported earnings without affecting net income, as accruals are not reversed in subsequent periods Accounting standards provide managers with the discretion to classify items strategically in financial reports, facilitating earnings management Table 2.1 summarizes various terms and definitions related to earnings management.
Table 2.1 Alternative terms and definition of earnings management
Term Definition(s) Used in literature
“is a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain” (Schipper, 1989)
Earnings management involves managers using judgment in financial reporting and transaction structuring to intentionally alter financial statements This practice aims to mislead stakeholders regarding the company's true economic performance or to influence contractual outcomes that rely on reported accounting figures.
“is the choice by a manager of accounting policies so as to achieve specific objective”
“is the choice of a manager of accounting policies or other actions - including voluntary earnings forecasting, voluntary disclosure, and estimation of accruals - to affect earnings intentionally” (Man, 2013)
“is the deliberate misclassification of items within the income statement” (McVay, 2006)
Athanasakou et al (2009); Haw et al
“is the deliberate dampening of fluctuations about some level of earnings which is considered to be normal for the firm”(Barnea et al., 1976)
“is a deliberate attempt by management to signal information to financial users”(Ronen and Sadan, 1981)
Belkaoui and Picur (1984); Baik et al
Classification of earnings management
Accrual earnings management
Earnings management strategies are classified as two categories which are accrual-based earnings management and real earnings management As mentioned by Dechow and Skinner
(2000), earnings management can be implemented by exercising accounting choice or real cash-flow choices The first technique is based on estimates and accounting policies Specifically, the Generally Accepted Accounting Principles (GAAP) allow managers to exercise their judgement about accounting choices that can influence contractual outcomes relying on reporting accounting information For instance, to enhance earnings of financial reports, managers of firms might engage in a modification of abnormal loan provisions (e.g., Beaver et al., 1989, Wahlen, 1994, Beaver and Engel, 1996 and Liu et al., 1997).
Real earnings management
Recent studies have explored real earnings management, a practice involving operating activities that deviate from normal business operations to meet specific earnings targets (Roychowdhury) This method of earnings manipulation focuses on altering core business processes rather than relying solely on accounting adjustments, highlighting a significant strategy firms may use to influence reported financial results Recognizing real earnings management is crucial for investors and regulators seeking to assess true company performance and maintain financial transparency.
Real earnings management involves manipulating short-term earnings to meet financial targets, often at the expense of long-term firm performance (Graham et al., 2005; Cohen et al., 2010) According to a survey of executives, nearly 80% are willing to cut essential expenses such as research and development, advertising, and maintenance to achieve short-term earnings goals, highlighting the trade-off between immediate financial results and sustainable growth.
Accrual earnings management involves discretionary accruals limited by GAAP that do not impact cash flows, whereas real earnings management entails altering normal operating activities, directly affecting current and future cash flows Unlike accruals, real earnings management is less constrained by external oversight such as regulators and auditors, making it more opaque to capital markets (See Dichev et al., 2013; Abad et al., 2018; Roychowdhury)
In 2006, a methodology was introduced to detect real earnings management by employing three models to measure three specific activities: reduction in discretionary expenditures, sales manipulation, and overproduction The approach uses abnormal low levels of discretionary spending—such as R&D, administrative, and advertising expenses—as indicators of expense reduction It also considers abnormal low cash flows as a sign of sales manipulation through tactics like accelerating sales or offering discounts to boost sales temporarily Additionally, abnormal high inventory production serves as a proxy for overproduction, indicating efforts to inflate earnings artificially.
Income smoothing
Income smoothing is a common earnings management tool, aimed at reducing fluctuations in reported profits According to Copeland (1968), it involves consistently applying specific accounting measurement or reporting rules to produce a stream of income with less variation from the trend, thereby presenting more stable financial results Beidleman (1973) further explains income smoothing as the deliberate effort by management to dampen abnormal earnings fluctuations, maintaining earnings within a "normal" range while adhering to sound accounting principles Both definitions highlight the strategic use of accounting techniques to present a more consistent and predictable financial performance.
Income smoothing is a strategic tool used by managers to reduce earnings variability over time or within a single period by aligning reported income closer to expected earnings According to Graham et al (2005), managers prefer to smooth earnings because it creates a perception of more predictable and stable financial performance for investors, enhancing confidence and reducing uncertainty This practice helps firms present a consistent financial outlook, which can positively influence investor perceptions and the firm's valuation.
Theoretical perspective of earnings management
Agency theory
Before the 1960s, firms were viewed as black boxes focused solely on transferring outputs to the market to maximize profits, driven by profit or wealth-maximizing behavior (Williamson, 2002; Alchian, 1965) The classic theory of the firm assumed rational agents with free will, capable of making optimal decisions to maximize their utilities However, with the separation of ownership and control, concerns arose about the limitations of this theory, leading to the development of agency theory, which addresses issues like agency problems introduced by Ross (1973) and further expanded by Jensen and Meckling (1976) to better explain managerial behavior.
Under agency theory, the separation of ownership and control, between principals and agents (i.e., shareholders and managers), creates conflicts of interests Jensen and Meckling (1976)
Agency theory highlights that contractual relationships between principals and agents involve unavoidable costs due to inherent conflicts of interest Specifically, it addresses the challenges of incomplete contracts resulting from the delegation of tasks, where principals find it difficult or costly to monitor agents' activities Ultimately, agency theory emphasizes that it is impossible to create contracts that fully eliminate conflicts of interest between principals and agents, leading to inherent agency costs.
Agency problems primarily stem from two sources: moral hazard and adverse selection, both driven by information asymmetry Moral hazard occurs when agents act in their self-interest without principals being able to monitor these actions, leading to potential conflicts of interest Adverse selection arises due to hidden information that principals lack, which can result in selecting unsuitable agents or making misguided decisions before a contract is even established As Walker (1989) highlights, valuable information is often unavailable to principals within agency relationships, exacerbating these issues Addressing these challenges requires effective monitoring and information-sharing mechanisms to align incentives and mitigate risks.
Simon (1955) pioneered the concept of bounded rationality, emphasizing that individuals are intentionally rational but limited in their decision-making capabilities This theory, replacing the traditional assumption of full rationality under classical firm models, has gained widespread acceptance among researchers Notable authors like Alchian and Demsetz have contributed to the development and validation of bounded rationality within the context of agency theory, highlighting its significance in understanding firm behavior and decision-making processes.
In 1972 and 1979, researchers Williamson applied the bounded rationality assumption to view firms as interconnected networks of incomplete contracts, recognizing that individuals are only partly rational in decision-making processes (Simon, 1955) For instance, in employment contracts, owners face uncertainty about whether agents will consistently fulfill their promises and act in ways that maximize their wealth Due to bounded rationality, decision-makers may not always make optimal choices in every situation, reflecting the inherent limitations in human cognitive capabilities.
Modern agency theory posits that human behavior is primarily driven by self-interest, leading to potential conflicts between agents and principals who seek to maximize their own utilities (Jensen, 1994) This assumption underscores the importance of aligning interests to ensure effective governance and cooperation within organizations.
2.4.1.3 Agency theory and earnings management
Earnings management behavior is often explained by the agency theory proposed by Jensen and Meckling (1976), which highlights conflicts of interest between shareholders (principals) and managers (agents) Managers typically possess more private information and may pursue personal interests, such as maximizing their compensation, potentially harming shareholders’ wealth (Goergen and Renneboog, 2011) While shareholders aim to improve firm profits, this creates a moral hazard where managers might manipulate earnings to serve their own interests at the expense of shareholder value However, previous research offers inconsistent findings regarding the motives and prevalence of earnings management (e.g., Archibald, 1967; DeAngelo, 1986; Bartov, 1993; DeAngelo et al., 1994; Dechow et al., 1995).
Prior studies suggest that earnings management is not inherently harmful to outside stakeholders, as GAAP allows managers to exercise judgment in recognizing accruals to improve financial reporting Research by Dechow (1994) highlights that accruals help earnings better reflect firm performance by addressing cash flow matching issues The positive accounting theory indicates that earnings management can optimize contracts between firms and stakeholders, providing potential benefits (Watts and Zimmerman, 1986) Additionally, Jiraporn et al (2008) find that earnings management, from an agency theory perspective, can help managers communicate private information, reducing information asymmetry with shareholders Consequently, earnings management enhances the informativeness of earnings components regarding a firm's future performance (e.g., Holthausen and Leftwich, 1983; Healy and Palepu, 1993; Guay et al., 1996; Subramanyam, 1996; Demski, 1998; Arya et al., 2003).
Managers’ accounting choices in recording accruals serve to disseminate private information to capital markets, thereby reducing information asymmetry between managers and uninformed investors (Jensen and Meckling, 1976; Smith Jr and Warner, 1979; Watts and Zimmerman, 1986) However, Fields et al (2001) highlight that the flexibility in accounting choices can lead managers to select methods that maximize their self-interest rather than providing fully transparent and credible private information.
15 information to the market Therefore, there are two perspectives on earnings management, namely, beneficial earnings management and opportunistic earnings management
The dominant perspective in the literature views earnings management as opportunism, where managers manipulate earnings to serve their own interests, driven by incentives misaligned with shareholders (Healy and Palepu, 1993) This opportunistic behavior creates distortions in financial reporting and is closely linked to agency conflicts (Jiraporn et al., 2008; Hao and Yao, 2010) Empirical studies reveal that managers often manage earnings to optimize compensation, especially when reaching performance thresholds (Healy, 1985; Holthausen et al., 1995) Additionally, managers tend to use income-increasing discretionary accruals prior to IPOs and seasoned equity offerings to influence market perception and maximize share prices amid information asymmetry (Teoh et al., 1998a; Rangan, 1998; Kothari et al., 2016).
Stakeholder theory
Stakeholder theory, introduced by Freeman (1984), defines stakeholders as any group or individual who can affect or be affected by an organization’s objectives, emphasizing their importance for business success Unlike agency theory, which primarily focuses on the relationship between managers (agents) and shareholders (principals), stakeholder theory broadens this perspective to include all relevant parties (Donaldson and Preston, 1995) Stakeholders encompass both internal parties such as employees, managers, and shareholders, and external parties like customers, suppliers, and governments, highlighting the need for management to consider diverse stakeholder interests in decision-making processes.
Stakeholder theory has evolved from the traditional view that firms primarily aim to maximize profits for shareholders to a broader perspective of capitalism that emphasizes creating value for all stakeholders (Ibrahim et al., 2020) This approach highlights the importance of not only financial performance but also other measures of value, such as social and environmental impacts, aligning business success with the interests of a wider range of stakeholders.
16 assess firms’ effectiveness by measuring that the interests of non-shareholders are protected (McWilliams and Siegel, 2001)
Earnings management, driven by agency problems between managers and shareholders, leads to agency costs as managers often prioritize their own interests over accurately representing firm performance Recent studies highlight that earnings management not only affects shareholders but also impacts other stakeholders such as suppliers, customers, communities, and regulators For instance, Prior et al (2008) find that managers manipulate earnings to pursue private interests, which can harm the broader interests of stakeholders and undermine corporate social responsibility.
Prospect theory
Prospect theory, developed by Tversky and Kahneman in 1979, highlights that individuals are more sensitive to losses than to equivalent gains, emphasizing the concept of loss aversion This theory suggests that people evaluate gains and losses based on deviations from a reference point rather than absolute wealth, leading to a convex loss function where losses have a greater psychological impact than gains of the same size Additionally, under conditions of uncertainty, individuals tend to exhibit risk-seeking behavior when faced with choices involving gains and losses, as demonstrated by Kahneman and Tversky in 2013.
In which, people prefer sure gains rather than uncertain larger gains In contrast, people seek preference for uncertain losses rather than sure smaller losses
According to prospect theory, firms are motivated to avoid earnings decreases and losses, as the theory suggests that the greatest utility gains occur when earnings shift from a loss to a profit This drives managers to actively manage earnings to maintain or achieve zero changes and sustain zero levels of earnings, maximizing perceived financial stability and value.
Incentives of earnings management
Earnings benchmarks
Earnings benchmarks are crucial for capital market participants in assessing financial performance Managers often aim to meet or surpass these benchmarks, especially when expected earnings fall short Research by Hayn (1995) shows that many firms report small profits or minor losses, highlighting strategic behavior around these targets One common approach to achieving earnings benchmarks is earnings management Hansen (2010) provides evidence that firms just exceeding earnings thresholds tend to record significantly higher discretionary accruals, indicating deliberate manipulation to meet financial goals.
Previous research highlights three key benchmarks that managers strive to surpass or meet: first, avoiding the reporting of losses (Burgstahler and Dichev, 1997; Osma and Young, 2009); second, preventing the reporting of earnings decreases (Burgstahler and Dichev, 1997); and third, maintaining positive earnings to satisfy market expectations, which underscores the importance of financial performance targets in managerial decision-making.
Meeting analysts’ forecasts is a key performance indicator (Degeorge et al., 1999; Dechow and Dichev, 2002) One important benchmark in the capital markets is avoiding the reporting of losses and earnings declines (Burgstahler and Dichev, 1997) Evidence suggests that managers manipulate earnings upward using discretionary accruals to prevent reporting losses or declines, resulting in a disproportionately high number of firms posting positive earnings and minimal earnings growth.
Research indicates that firms employ real earnings management strategies, such as offering discounts, overproduction, and reducing discretionary expenditures, to avoid reporting losses and to meet analysts' forecasts (Roychowdhury, 2006) Managers also decrease advertising expenses to improve short-term earnings and avoid reports of losses (Cohen and Zarowin, 2010) Additionally, firms intentionally reduce current research and development expenses to meet specific earnings benchmarks, as evidenced by Osma and Young (2009), who analyzed 3,866 firm-year observations from 1989 to 2002 Furthermore, Hinkel and Hoffman (2020) reveal that companies engage in abnormal stock repurchases to artificially boost earnings per share, reflecting widespread use of earnings management techniques.
Prior studies demonstrate that firms that surpass earnings benchmarks receive significant market rewards For instance, Barth et al (1999) found that companies exceeding their previous year's earnings tend to have higher price-earnings ratios compared to those that do not Additionally, Brown and Caylor's research supports the positive market response to exceeding earnings expectations, highlighting the importance of consistent financial performance in driving investor valuation.
Research by (2005) shows that firms reporting positive earnings and growth in earnings often experience abnormal returns Similarly, Lento and Yeung (2017) found that S&P 500 companies from 1998 to 2007 engaging in accrual-based earnings management to meet or beat analyst expectations tend to enjoy larger abnormal returns Conversely, using abnormal accruals opportunistically for the same purpose can lead to market penalties and smaller abnormal returns.
Shin (2019) highlights that managers often take actions to avoid small negative earnings per share in order to meet market expectations, particularly during periods of high macroeconomic uncertainty Her research indicates that the frequency of firms surpassing earnings benchmarks is significantly higher in uncertain economic environments, whereas it remains low during stable periods The study extends previous findings by demonstrating that managers actively attempt to prevent negative earnings surprises to avoid adverse market penalties, aligning with earlier research by Degeorge et al (1999) and Burgstahler and Eames (2006) Importantly, Shin emphasizes that macroeconomic uncertainty plays a crucial role in shaping asymmetric market reactions to earnings news, influencing how earnings meet or fall short of expectations.
Equity offerings
Empirical evidence indicates that managers often engage in opportunistic earnings management around significant stock market events such as IPOs and SEOs Studies reveal that firms tend to artificially inflate earnings through accrual-based or real earnings management practices prior to IPOs to boost stock prices, as shown by Ritter (1991), Friedlan (1994), Teoh et al (1998a), Roosenboom et al (2003), and Morsfield and Tan (2006) This earnings manipulation is typically aimed at enhancing short-term stock performance but is negatively linked to long-term firm performance, since the temporary earnings improvements driven by abnormal discretionary accruals cannot be reversed by investors later.
Numerous studies demonstrate that firms often engage in income-increasing earnings management to boost performance prior to seasoned equity offerings (SEOs) (Yoon and Miller, 2002; Lee and Masulis, 2009) Evidence shows significantly higher discretionary accruals before SEO years, which tend to reverse afterward, indicating manipulative practices (Rangan, 1998; Teoh et al., 1998b; Ibrahim et al., 2011) Firms with elevated discretionary accruals during this period often experience negative long-term stock market performance, highlighting potential adverse effects of earnings management (Rangan, 1998; Teoh et al., 1998b) Additionally, managers utilize both accrual-based and real-based earnings management techniques during SEO years to inflate reported earnings (Cohen and Zarowin, 2010; Kothari et al., 2016) However, these earnings management practices are associated with subsequent declines in operating performance, suggesting distorted financial reporting can undermine long-term firm health.
Executive compensation
Healy (1984) explains that under the compensation-maximization hypothesis, managers manipulate earnings to maximize their bonuses as outlined in firm compensation plans Supporting this, subsequent studies such as Cheng and Warfield (2005), Bergstresser and Philippon (2006), and Efendi et al (2007) provide evidence that managers have incentives to inflate earnings through earnings management to boost their personal incentives.
Numerous studies explore how executive compensation influences earnings management aimed at meeting or beating financial benchmarks Cheng and Warfield (2005) demonstrate that CEO equity incentives, such as stock options, are linked to increased earnings management, particularly through accrual manipulation to surpass analysts’ forecasts between 1993 and 2000 Their findings suggest that CEOs intentionally inflate earnings to boost stock prices when capital markets harbor disappointing performance expectations Similarly, Bergstresser and Philippon (2006) reveal that US CEOs use accrual-based earnings management driven by stock-based compensation, especially in years when they sell significant shares These studies highlight the strong connection between executive pay structures and strategic earnings management to influence market perceptions.
(2011) prove that firms employing financial performance measures in bonus contracts have higher discretionary accruals
Dechow and Sloan (1991) explore the link between real earnings management and CEOs' performance-based compensation, revealing that CEOs often cut abnormal R&D expenses to boost short-term earnings Additionally, Tahir et al (2019), analyzing FTSE 350 firms from 2005 to 2014, found that incorporating non-financial performance measures into bonus contracts reduces managers’ tendency to manipulate earnings through discretionary accruals or real earnings management.
Debt covenants
Debt covenants are contractual terms based on accounting information that incentivize managers to engage in earnings management when a firm nears covenant violations, aiming to reduce the risk of default (Watts and Zimmerman, 1986) Several studies, including DeFond and Jiambalvo (1994), Sweeney (1994), and Dichev and Skinner (2002), demonstrate that firms often manipulate accrual-based earnings to avoid breaching debt covenants, highlighting the strategic use of earnings management to maintain financial compliance.
DeFond and Jiambalvo (1994) found that firms violating debt covenants exhibit significantly positive abnormal working capital accruals and total accruals, indicating a link between accrual-based earnings management and covenant violations Their study of 94 US listed companies from 1985 to 1988 highlights the tendency for firms to manipulate earnings around covenant breach events Similarly, Sweeney (1994) demonstrated that US firms actively engage in income-increasing earnings management during covenant violation years to mitigate default risks.
Several studies highlight that, beyond accrual-based earnings management, firms also employ real earnings management strategies to boost reported earnings and prevent debt covenant violations For example, Bartov (1993) provides evidence that managers manipulate earnings by selling long-term assets to meet financial targets Similarly, Roychowdhury (2006) demonstrates that firms increase earnings through real activities to avoid breaching debt covenants, emphasizing the strategic use of operational decisions for earnings management.
Import relief and political costs
Previous research indicates that company managers may manipulate earnings to prevent government intervention According to Watts and Zimmerman (1986), the political-cost hypothesis suggests that firms tend to alter their financial reports during periods of increased political costs to safeguard their operations and maintain favorable public and regulatory perceptions.
21 income-decreasing earnings management if they might experience potential industry deregulation
Research indicates that firms often engage in income-decreasing abnormal accruals during periods of investigation by the US International Trade Commission (ITC) or the US Federal Trade Commission (FTC) For instance, studies such as Cahan (1992) provide evidence of this behavior, suggesting strategic financial reporting practices during import relief investigations, as highlighted by Jones.
(1991) proves that firms use income-decreasing earnings management to obtain favourable regulation such as tariff increases and quota reductions
Han and Wang (1998) find that oil and gas firms in the 1990s use income-decreasing earnings management during the third and fourth quarters to avoid political costs like anti-trust scrutiny and government regulation Similarly, Monem (2003) observes that Australian gold-mining firms from 1985 to 1988 employ income-decreasing abnormal accruals to mitigate political costs associated with high earnings.
Conclusion
This chapter provides a comprehensive overview of earnings management, covering key definitions, theoretical foundations, and the incentives that drive both accrual and real earnings manipulation Recent research highlights that managers employ various techniques to influence reported earnings, emphasizing the differences between accrual-based and real earnings management strategies The chapter also discusses relevant theories, such as agency theory, which explain the motivations behind earnings management Additionally, it examines incentives like exceeding specific financial thresholds, which is a primary focus of this study The following chapter presents empirical analysis comparing the effectiveness of different models in detecting both accrual and real earnings management practices.
MANAGEMENT AND REAL EARNINGS MANAGEMENT
Introduction
This chapter compares the effectiveness of detecting earnings management through accrual and real activities, evaluating the power of different models used for identification It highlights the practical differences in detecting various types of accrual and real earnings management activities The study contributes to the literature by assessing the validity and efficiency of common measures for both accrual and real earnings management, extending previous research that primarily focused on discretionary accruals as a proxy Findings reveal that Roychowdhury’s (2006) models for detecting real earnings management exhibit misspecifications and low test power, indicating that real earnings management is inherently more challenging to detect than accrual earnings management.
Earnings management by firms can be achieved through accrual manipulation or real activities, as highlighted by Dechow et al (1995) and Cohen et al (2008) Research indicates a trend where firms tend to substitute real manipulation for accrual manipulation as increased monitoring and scrutiny make accrual strategies costlier or more difficult (Cohen et al., 2008; Cohen et al., 2010; Gao et al., 2017; Ipino and Parbonetti, 2017), or when the costs associated with accrual manipulation rise (Zang, 2012) Conversely, some studies suggest that both manipulation strategies can be complementary rather than substitutes (Li, 2019) Most of these analyses utilize established proxies to measure accrual and real manipulation tactics, providing robust indicators of earnings management behavior.
Previous empirical studies frequently utilize discretionary accruals as a proxy for accrual earnings management (Xie, 2001; Capalbo et al., 2014; Kothari et al., 2016; Ravenda et al., 2018) However, the models used to measure discretionary accruals have been shown in the literature to suffer from misspecification and low statistical power, particularly when applied to samples of firms exhibiting extreme performance levels.
Limited evidence exists on the detection capabilities of real earnings management models, highlighting a gap in current research This study addresses this gap by comparing the effectiveness of relative models in identifying both accrual-based and real earnings management Using a comprehensive UK dataset of 19,424 firm-year observations from 1991 to 2018, the research evaluates the power of these models to accurately detect manipulation practices.
The power of the test statistics is assessed by comparing how often accrual and real manipulation models correctly detect earnings management, focusing on their tendency to produce Type II errors These errors occur when the null hypothesis of systematic earnings management remains unrejected by the models designed to identify accrual and real earnings manipulation To evaluate this, artificial manipulation is introduced at various levels and types, including revenue recognition and expense manipulation through accruals and real activities like discretionary expenses and overproduction The analysis is based on two samples of 500 firms each: one with no reversal of manipulation (Sample 1) and another where manipulation is reversed in the following year (Sample 2), providing a comprehensive view of model effectiveness.
Although Roychowdhury's (2006) models for detecting real earnings management are widely utilized in empirical research, they tend to have lower detection power compared to accrual earnings management models Specifically, these models are less effective in identifying manipulation of discretionary expenses, such as R&D costs, and revenue manipulation Additionally, the real earnings management model used to detect overproduction often faces high test misspecification, which artificially inflates its perceived effectiveness An alternative model developed by Kothari et al (2016) demonstrates higher detection power for discretionary expense manipulation, offering a more accurate approach to identifying real earnings management practices.
This study advances the accounting literature by examining real earnings management models, expanding beyond traditional accrual-based approaches (e.g., Dechow et al., 1995; Kothari et al., 2005) Unlike prior research that primarily focuses on US data, this research extends analysis to a UK context, providing new insights into international practices Additionally, it contributes to understanding the substitution between accrual and real earnings manipulation, building on the work of Cohen et al (2008, 2010), Zang (2012), and Gao et al (2017), thereby enriching the evidence on how firms manage earnings through different techniques.
Ipino and Parbonetti, 2017; Owusu et al., 2020) by comparing the effectiveness of the current models of accrual and real earnings management as proxies of earnings management
The study's findings are valuable for academics and stakeholders examining earnings management prevalence through various techniques It underscores the limitations and current challenges associated with existing models used to detect earnings management, emphasizing the need for improved methodologies in this field.
The study proceeds as follows Section 3.2 reviews related literature and presents hypothesis development Section 3.3 discusses data and research methods Section 3.4 discusses empirical results Section 3.5 presents a discussion and Section 3.6 concludes.
Literature review: Earnings management detection models
Existing literature on accrual earnings management
Accounting standards provide managers with the flexibility to exercise judgment when preparing financial reports, enabling them to select reporting rules that convey private information Empirical studies, such as Beaver (1968a) and Ball and Brown (1968), demonstrate that accruals significantly enhance the informativeness of financial statements for share valuation As accounting-based performance contracts become more prevalent, accounting choices are increasingly viewed as opportunities for earnings management, where managers may selectively adjust accounting estimates to withhold private information about their firm’s financial performance.
Earnings management, as defined by Healy (1985) and Healy and Wahlen (1999), involves managerial discretion in accounting choices and operating activities to mislead investors or influence contractual outcomes dependent on financial reporting Managers may manipulate earnings through accrual adjustments or by altering real operating activities, such as timing business transactions to present more favorable financial performance Accrual-based earnings management allows managers to use their accounting judgment to serve private interests, while structuring the timing of operating activities can deviate from normal business operations to enhance reported earnings and influence stakeholder perceptions.
Healy (1985) was the first to examine earnings management through the lens of discretionary accruals, defining them as the difference between total accruals and non-discretionary accruals This foundational work provides insight into how firms may manipulate earnings to meet specific objectives, particularly under bonus-maximization incentives Understanding discretionary accruals is crucial for detecting earnings management practices and assessing financial reporting transparency.
Managers often select discretionary accruals that deviate from generally accepted accounting principles to influence their bonus payments Total accruals serve as a proxy for discretionary accruals since non-discretionary accruals are unobservable; consequently, it is assumed that non-discretionary accruals are zero.
DeAngelo (1986) investigates whether managers use decreasing-income discretionary accruals prior to buyouts, employing the change in total accruals as a proxy for discretionary accruals However, McNichols and Wilson (1988) highlight that this proxy can contain measurement errors, especially when firms have higher expected non-discretionary accruals They focus specifically on bad debt provisions as a measure of discretionary accruals and find that firms with unusually high or low earnings tend to have discretionary accruals related to bad debts.
Later research develops more comprehensive measures of discretionary accruals Jones
Research from 1991 demonstrates that during import relief investigations conducted by the U.S International Trade Commission (ITC), firms tend to engage in increased income-decreasing discretionary accruals Non-discretionary accruals, which reflect underlying economic conditions, are estimated using a regression of total accruals on changes in revenues and property, plant, and equipment, scaled by beginning-year assets The difference between total accruals and non-discretionary accruals constitutes discretionary accruals However, the study notes limitations of the non-discretionary accrual measure, particularly regarding managed accrual revenues.
Dechow et al (1995) address model weaknesses by excluding accrual revenues when estimating non-discretionary accruals, demonstrating improved accuracy Their research shows that all models are well specified with random samples, with the Modified Jones model outperforming previous models in terms of misspecification and power in detecting earnings management However, they also find that for firms exhibiting extreme financial performance, all models tend to produce type I errors, highlighting limitations in their applicability.
In the UK context, Peasnell et al (2000) introduce the margin model to estimate non-discretionary accruals, which differs from the Jones Model (Jones, 1991) and Modified Jones Model (Dechow et al., 1995) by substituting current year cash receipts for previous year sales Their research demonstrates that the margin model provides more accurate estimates of abnormal accruals when analyzing cash flow data.
26 performance is extreme, the power test of the margin model is lower than previous earnings models at detecting sales-based manipulation and bad debt expense manipulation activities
Kothari et al (2005) enhance the Jones and Modified Jones models by incorporating firms with similar annual financial performance, specifically matching firms based on closest return on assets (ROA) to control for the effects of extreme performance However, Dechow et al (2010) warn that matching firms by ROA similarity may introduce estimation errors in discretionary accruals, potentially diminishing the accuracy and power of the tests.
Dechow and Dichev (2002) proposed a model to estimate non-discretionary accruals by regressing past, current, and future cash flows on working capital accruals, with discretionary accruals identified as residuals between actual working capital accruals and estimated non-discretionary accruals However, Dechow et al (2010) criticized this model for producing biased estimates, as it overlooks long-term accruals when assessing non-discretionary accruals, potentially leading to inaccuracies in earnings management analysis.
Francis et al (2005) extend the Dechow and Dichev (2002) model by incorporating firm performance metrics, such as sales growth, and long-term accruals like depreciation expenses to address weaknesses highlighted by McNichols (2002) They also propose separating the standard deviation of residuals into innate and discretionary errors to enhance measurement accuracy However, Dechow et al (2010) warn that innate characteristics may influence estimation errors, potentially reducing the model's effectiveness and introducing bias into the discretionary accruals proxy.
Dechow et al (2012) propose a novel approach to detect earnings management by focusing on the reversal of discretionary accruals between periods, enhancing the accuracy of earnings management detection models They show that accounting for accrual reversals can improve the power of earnings management tests However, Gerakos (2012) challenges this method, highlighting uncertainties about the specific timing of discretionary accrual reversals and questioning the advancements in estimating discretionary accruals since the work of Dechow and Dichev (2002).
Despite extensive research enhancing the power and accuracy of estimating discretionary accruals, the Modified Jones Model (Dechow et al., 1995) remains the most superior tool in this field Therefore, this study will utilize the Modified Jones Model to assess discretionary accruals, serving as a reliable proxy for detecting accrual-based earnings management.
In addition to the Modified Jones model, I also use the Kothari et al (2005) and the Modified Dechow and Dichev (2002) model to measure accrual earnings management.
Existing literature on real earnings management
Earnings management, as defined by Healy and Wahlen (1999), involves the use of accounting judgment to influence financial reports and shape stakeholders' perceptions of a company's performance This can be achieved through accrual earnings management, where managers alter financial figures without changing actual operations, or by manipulating real activities, such as timing capital expenditures or asset sales Both methods serve to present a more favorable or controlled view of the firm's financial health to investors and other stakeholders.
Financial executives prefer using real manipulation activities like reducing discretionary expenses, such as R&D costs, to meet or surpass earnings targets, as these methods are harder for regulators and auditors to detect (Graham et al., 2005) Numerous studies have examined how firms opportunistically cut R&D expenses to inflate financial performance and achieve key earnings benchmarks (Dechow and Sloan, 1991; Baber et al., 1991; Bushee, 1998).
Research indicates that firms with negative earnings tend to generate higher income from asset sales, especially as R&D expenditures decline (Bartov, 1993) Additionally, prior studies reveal that companies often overproduce inventory to achieve their earnings targets (Thomas and Zhang, 2002) Furthermore, Jackson and Wilcox (2000) find that firms with small positive earnings frequently implement sales price reductions to meet financial goals.
In addition, Bartov (1993) shows that firms with decreasing earnings have high income from asset sales
There is limited systematic evidence on real earnings management, with Roychowdhury (2006) being a notable exception, demonstrating that managers may engage in real earnings management to avoid reporting losses Real earnings management involves altering normal operational activities—such as overproduction, offering price discounts, or reducing discretionary expenses—to mislead stakeholders about a firm’s true financial performance For example, managers might increase production levels to lower the cost of goods sold (COGS) by spreading fixed overhead costs over a larger output, thereby reducing per-unit costs Additionally, firms may temporarily boost sales through methods like offering discounts to manipulate short-term earnings figures.
In the current year, offering more lenient terms or price discounts attracts customers, but they may anticipate these discounts in the future Consequently, when a firm reverts to its previous pricing, the boost in sales diminishes, leading to reduced operating cash flows Therefore, temporary discounts can negatively impact long-term profitability despite short-term gains.
Practical ways to detect accrual earnings management and real earnings
Research by 2010 indicates that SEO firms engaging in real earnings management tend to experience greater underperformance in the subsequent period compared to those employing accrual earnings management Additionally, Ibrahim et al (2011) provide evidence that SEO firms increasingly adopt real earnings management strategies following the enactment of the Sarbanes-Oxley Act, highlighting a shift in managerial behavior post-regulation.
3.2.3 Practical ways to detect accrual earnings management and real earnings management
Previous research has primarily focused on detecting accrual manipulation, often overlooking misstatements due to real earnings management (e.g., Dechow et al., 1996; Lee et al., 1999; Bentley et al., 2013) However, a survey by Graham et al (2005) reveals that top executives tend to prefer real earnings management over discretionary accruals Lo (2008) explains that real manipulation activities, such as offering price discounts to inflate sales, are similar to normal operating activities, making them more opaque to outside stakeholders.
In 2016, research revealed that managers have various methods to inflate earnings, with some approaches being more opaque and harder for auditors or regulators to detect Unlike accrual-based manipulation, which is governed by accounting standards, there are no strict regulations for real earnings management As a result, managers strategically select operational or investment decisions that subtly influence earnings, making it difficult for market participants to identify signs of manipulation.
Accrual manipulation has been extensively studied in prior research, including works by Dechow et al (1995), Peasnell et al (2000), Francis et al (2005), and Dechow et al (2010) Unlike misstatements of cash flows, accrual manipulation involves artificially increasing accruals within a given year Firms engaging in accrual manipulation often reverse these manipulated accruals in subsequent periods, leading to a pattern where firms utilizing large accruals tend to exhibit cyclical behaviors over multiple years.
Investors, analysts, and auditors closely scrutinize company financials to detect irregularities (Hirst, 1994; Bartov et al., 2000) For example, firms engaging in premature or fictitious sales often leave behind unpaid accounts receivable, signaling potential fraud Auditors can identify suspicious or premature sales by examining these uncollected receivables Additionally, Lennox and Yu (2020) highlight that manipulating earnings through cash flow adjustments is harder to detect than other methods, often requiring a longer period to uncover such earnings fraud involving misstated cash flows.
Harrison (2003) highlights the common perception that cash cannot be easily misstated, leading many studies to assume that operating cash flows are less susceptible to manipulation However, evidence from prior research, such as Lennox and Yu (2020), shows that some companies manipulate earnings by misreporting cash from operations While accrual manipulation typically results in reversals that reduce reported earnings in subsequent periods, overstating operating cash flows can help firms sustain their earnings figures and avoid such reversals.
(2012) present that the disadvantage of accrual manipulation is that accruals will become larger in subsequent periods; hence, financial statement users might notice a red flag of misstatements of financial statements
Under GAAP, cash flows are categorized into three types in the statement of cash flows: operating, investing, and financing activities Firms’ managers may overstate cash flows through practices such as misclassifying items within these categories or incorrectly recognizing the timing of cash-related transactions Lee (2012) highlights that cash flow manipulation often involves delaying payments to suppliers or prepayments from customers to inflate reported cash flows, while Lennox and Yu also identify similar tactics used to distort cash flow figures.
In 2020, several case studies highlighted instances of firms overstating cash flows to mislead investors For example, Dynegy misclassified cash from financing activities as cash from operations to artificially inflate its financial performance Similarly, Bally deferred recognizing current year's expenses to future periods, thereby inflating earnings These deceptive practices undermine financial transparency and can distort investor perception of a company's true financial health.
Previous research on real earnings management highlights various strategies firms utilize to manipulate their reported cash flows either within Generally Accepted Accounting Principles (GAAP) or outside of GAAP, as discussed in studies by Roychowdhury (2006) and Zang (2012).
According to GAAP, firms can offer price discounts that inflate current year sales, a tactic often used in real earnings management However, this practice can negatively impact cash from operations during the same year of manipulation, as noted by Roychowdhury (2006) Despite its prevalence in academic accounting research, such real earnings management activities are difficult to detect in practice because they resemble normal business operations and often go unnoticed outside of rigorous scrutiny.
Overstating cash flows can serve as a strategic signal to the market regarding the credibility of a firm's overstated earnings (Siegel, 2006) While audit firms use analytical procedures to detect unusual fluctuations in financial statement items, they often struggle to identify misstatements caused by cash flow manipulation (Dyck et al., 2010) As a result, manipulated cash flows that inflate a firm's earnings are rarely detected by market participants, highlighting the difficulty in uncovering such financial misrepresentations.
Testable hypothesis
Previous research predominantly concentrates on detecting accrual manipulation, often overlooking misstated earnings caused by real earnings management activities (e.g., Dechow et al., 1996; Lee et al., 1999; Bentley et al., 2013) However, a survey conducted by Graham et al highlights the importance of considering real earnings management as a significant factor contributing to earnings misstatements, emphasizing the need for a comprehensive approach to financial reporting analysis.
Research by 2005 reveals that top executives often prefer real earnings management over discretionary accruals because it is more subtle and harder for outsiders to detect Lo (2008) explains that real manipulation activities, such as offering price discounts to boost sales, resemble normal operational practices, making them opaque to external stakeholders Kothari et al (2016) further note that managers choose earnings inflation methods that are less transparent to avoid scrutiny from auditors and regulators Unlike accrual manipulations, which are guided by established accounting standards, real earnings management lacks regulated guidelines, allowing managers to make operational or investment decisions that effectively manipulate earnings while remaining concealed from market participants.
Previous earnings management literature highlights various strategies firms use to manipulate their reported cash flows within or outside of GAAP For example, under GAAP, firms can offer price discounts to boost current-year sales, but this approach can negatively impact cash flows from operations during the manipulation year (Roychowdhury, 2006).
Real manipulation is quite common in academic accounting research, yet in practice, it often remains undetected as it mimics normal business activities Lennox and Yu (2019) highlight that firms overstating earnings through cash flow manipulation are more challenging to detect compared to cases without cash flow manipulation.
Audit firms use analytical procedures to detect unusual fluctuations in financial statement items, aiming to identify potential misstatements related to abnormal accruals However, uncovering misstatements caused by overstated cash flows remains challenging due to the lack of regulatory guidelines for real earnings management activities As a result, audit firms often under-detect low-quality financial reporting, highlighting limitations in current audit practices.
Research indicates that manipulated cash flows are more difficult to detect compared to accrual manipulation Consequently, efforts to identify accrual-based earnings management tend to be more successful than uncovering real earnings management This suggests that the ability to detect accrual manipulation is higher, making it a more reliable indicator of earnings management practices Therefore, the hypothesis to be tested is that accrual-based earnings management is more detectable than real earnings management.
H1: The ability to detect real earnings management is lower than that of accrual-based earnings management.