earnings management a perspective

First, accruals are the principal product of Generally Accepted Accounting Principles, and, if earnings are managed, it is more likely that the earnings management occurs on the accrual

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Earnings Management: A Perspective

Article in Managerial Finance · April 2001

DOI: 10.2139/ssrn.269625

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Earnings Management: A Perspective

By Messod D Beneish *

April 2001

Abstract

The paper provides a perspective on earnings management I begin by addressing the following questions: What is earnings management? How pervasive is it? How is it

measured? Then, I discuss what we, as academics, know about incentives to increase and

to decrease earnings The research presented relates to earnings management incentives stemming from regulation, debt and compensation contracts, insider trading and security issuances I also discuss issues relating to problems in measuring the extent of earnings management and propose extensions for future work

1 Introduction

An issue central to accounting research is the extent to which managers alter

reported earnings for their own benefit In the 1970s and early 1980s, a large number of studies investigated the determinants of accounting choice These studies provided

evidence consistent with managers' incentives to choose beneficial ways of reporting

earnings in regulatory and contractual contexts (see Holthausen and Leftwich 1983, and Watts and Zimmerman 1986 for reviews of these studies) Since the mid-1980s studies

of managerial incentives to alter earnings have focused primarily on accruals

I trace the explosive growth in accrual-based earnings management research to three likely causes First, accruals are the principal product of Generally Accepted

Accounting Principles, and, if earnings are managed, it is more likely that the earnings

management occurs on the accrual rather than the cash flow component of earnings Second, studying accruals reduces the problems associated with the inability to measure the effect of various accounting choices on earnings (Watts and Zimmerman 1990)

Third, if earnings management is an unobservable component of accruals, it is less likely that investors can unravel the effect of earnings management on reported earnings

The main challenge faced by earnings management researchers is that academics, like investors, are unable to observe, or for that matter, measure the earnings management component of accruals Indeed, managerial accounting actions intended to increase

compensation, avoid covenant default, raise capital, or influence a regulatory outcome are largely unobservable Consequently, prior work has drawn inferences from joint

hypotheses, that test both incentives to manage earnings as well as the construct validity

of the various accrual models that are used to estimate managers’ accounting discretion Because extant models of expected accruals provide imprecise estimates of managerial

*

Indiana University, Kelley School of Business, Bloomington, Indiana 47401 I thank the Editor and an anonymous reviewer for their comments and suggestions

discretion, questions have been raised about whether the unobservable earnings

management actions do in fact occur.1

Notwithstanding research design problems, a variety of evidence suggestive of

earnings management has accumulated In Section 2, I raise three general questions

about earnings management: What is it? How frequently does it occur? How do

researchers estimate earnings management? Prior investigations of managerial

incentives to alter earnings typically fall in three categories, namely studies that examine

the effect of contracts on accounting choices, studies that examine the effect of regulation

on accounting choices, and studies that examine the incentive effects associated with the need to raise external financing Rather than discussing the evidence along those lines, I have chosen to present the evidence depending on the direction of the incentive context Thus, I summarize in Sections 3 and 4, what is known about incentives to increase and decrease earnings In Section 5, I discuss evidence on incentive contexts that provide

incentives either to increase or to decrease earnings, and in Section 6, I present

conclusions and suggestions for future work

2 Earnings Management

2.1 Definitions

Notice the plural: It reflects my view that academics have no consensus on

what is earnings management There have been at least three attempts at defining

earnings management:

(1) Managing earnings is “the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about a desired level of reported

earnings.” (Davidson, Stickney and Weil (1987), cited in Schipper (1989) p 92)

(2) Managing earnings is “a purposeful intervention in the external financial reporting

process, with the intent of obtaining some private gain (as opposed to say, merely

facilitating the neutral operation of the process).”… “A 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.”

Schipper (1989) p 92

(3) “Earnings management occurs when managers use judgment in financial reporting

and in structuring transactions to alter financial reports to either mislead some

1 Criticism of extant accrual models ability to isolate the earnings management component of accruals includes McNichols and Wilson (1988), Holthausen, Larker and Sloan (1995) , Beneish (1997, 1998), and McNichols (2000) who argue that when the incentive context studied is correlated with performance, inferences from the study are confounded; Guay, Khotari and Watts (1996) who suggest that accrual models estimate discretionary accruals with considerable imprecision and that some accrual models randomly decompose earnings into discretionary and non-discretionary components; Beneish (1997) who provides evidence that accrual models have poor detective performance even among firms whose behavior

is extreme enough to warrant the attention of regulators; Thomas and Zhang (2000) who suggest that the performance of accrual models is dismal

stakeholders about the underlying economic performance of the company or to

influence contractual outcomes that depend on reported accounting numbers.” Healy and Wahlen (1999, p 368)

A lack of consensus on the definition of earnings management implies differing

interpretations of empirical evidence in studies that seek to detect earnings management,

or to provide evidence of earnings management incentives It is thus useful to compare

the above three definitions

All three definitions deal with actions management undertakes within the context

of financial reporting—including the structuring of transactions so that a desired

accounting treatment applies (e.g., pooling, operating leases) However, the second

definition also allows earnings management to occur via timing real investment and

financing decisions If the timing issue delays or accelerates a discretionary expenditure for a very short period of time around the firm’s fiscal year, I envision timing real

decisions as a means of managing earnings A problem with the second definition arises

if readers interpret any real decisions—including those implying that managers forego

profitable opportunities—as earnings management Given the availability of alternative

ways to manage earnings, I believe it is implausible to call earnings management a

deviation from rational investment behavior This reflects my view that earnings

management is a financial reporting phenomenon

There are two perspectives on earnings management: the opportunistic

perspective holds that managers seek to mislead investors, and the information

perspective, first enunciated by Holthausen and Leftwich (1983), under which managerial discretion is a means for managers to reveal to investors their private expectations about the firm's future cash flows Much prior work has predicated its conclusions on an

opportunistic perspective for earnings management and has not tested the information

perspective

The three definitions allow earnings management to occur for the purposes of

hiding deteriorating performance, but the word “mislead” in the Healy and Wahlen

(1999) definition appears to preclude the possibility that earnings management can occur for the purposes of enhancing the signal in reported earnings.2 This may be due to the

inclusion of contractual incentives in the third definition To explain, prior work has not

been able to distinguish whether managers’ exercise of discretion is intended to mislead

or to inform, and the typical conclusion in contractual studies is that incentives result in

de-facto opportunistic earnings management Under third definition, earnings

management shares much fraud That is, fraud is defined as "one or more intentional acts designed to deceive other persons and cause them financial loss." (National Association

of Certified Fraud Examiners (1993, p 6)) Thus, the main difference between the third

2

A conversation with one of the authors revealed that he would also interpret a situation where the firm could be signaling strength as misleading Consider that a manager understates income by over-providing for bad debts, obsolescence, or loan losses: the usual signaling argument is that the manager action is informative insofar as investors distinguish between weak and strong firms; however, it is also possible that the manager’s action is misleading because the manager may be setting aside income for a rainy day

definition and fraud is that stakeholders may have anticipated managers’ behavior and

negotiated contract terms that provide price protection

2.2 Incidence of earnings management

If one believes former SEC Chairman Levitt (1998), earnings management is

widespread, at least among public companies, as they face pressure to meet analysts’

expectations Earnings management is also widespread if one relies on analytical

arguments For example, Bagnoli and Watts (2000) suggest that the existence of relative performance evaluation leads firms to manage earnings if they expect competitors to

manage earnings Similar prisoner’s dilemma-like arguments for the existence of

earnings management appear in Erickson and Wang (1999) in the context of mergers and Shivakumar (2000) in the context of seasoned equity offerings

At the other extreme, we can only be certain that earnings have indeed been

managed, when the judicial system, in cases that are brought by the SEC or the

Department of Justice , resolves that earnings management has occurred While it is

likely that earnings management occurs more frequently than is observed from judicial

actions, it is not clear to me that earnings management is pervasive: it seems implausible that firms face the same motivations to manage earnings over time As later discussed, much of the evidence of earnings management is dependent on firm performance,

suggesting that earnings management is more likely to be present when a firm’s

performance is either unusually good or unusually bad

2.3 Alternative methods for estimating earnings management

Three approaches have been used by researchers to evaluate the existence of

earnings management One approach studies aggregate accruals and uses regression

models to calculate expected and unexpected accruals A second approach focuses on specific accruals such as the provision for bad debts, or on accruals in specific sectors, such as the claim loss reserve in the insurance industry The third approach investigates discontinuities in the distribution of earnings

2.3.1 Aggregate Accruals

The Jones (1991) model is the most widely used model in studies of aggregate accruals The model follows Kaplan's (1985) suggestion that accruals likely result from the exercise of managerial discretion and from changes in the firm's economic conditions The model relates total accruals to the change in sales ()Sales) and the level of gross

property, plant and equipment (PPE):

Total Accrualsit = a1i + b1i )Salesit + c2i PPEit + ,1it (1)

The model is based on two assumptions First, that current accruals (changes in

working capital accounts) resulting from changes in the firm's economic environment are

related to changes in sales, or sales growth since equation (1) is typically estimated with

all variables deflated by either lagged assets or lagged sales Second, that gross property plant and equipment controls for the portion of total accruals related to nondiscretionary

depreciation expense

The second version uses current accruals as a dependent variable and only the

change in sales as an explanator:

Currentit = a2i + b2i )Salesit + ,2it (2)

These models are either estimated in time series firm-by-firm or

cross-sectionally using all firms in a given two-digit industry and year Each yearly estimation

is used to make a one-year ahead forecast of expected accruals which, subtracted from

the dependent variable, yields unexpected accruals Two alternative versions of the Jones (1991) model have also been proposed In their total accrual form, the models are given by:

Total Accrualsit = a3i + b3i ()Salesit -)Receivablesit) +c3i PPEit + u3it (3) Total Accrualsit = a4i + b4i )Cash Salesit + c4i PPEit + u4it (4)

The expectation model in equation (3) is typically attributed to Dechow, Sloan

and Sweeney (1995) (e.g., see Gaver, Gaver and Austin(1995)), even though, the

modified-Jones model presented in Dechow et al (1995) is the same as the Jones model

in the estimation period and only has the receivable adjustment in the prediction period

Indeed, the revenue based variable in (3) equals Cash Salesit-Salesit-1 Since it is not clear what the construct means or how it proxies for the effect on accruals of changes in the

firm's economic environment, Beneish (1998b) proposed an alternative modification

based on cash sales (equation 4) His evidence indicates that change in cash sales

preserves the intuition behind using changes in sales to proxy for changes in economic

performance and has the advantage of using as an explanator an accounting construct that reduces the endogeneity problem.3

Notwithstanding these modifications, the primary criticism leveled at extant

accruals models remains: The models fail to distinguish the accruals that result from

managers’ exercise of discretion from those that result from changes in the firm's

economic performance (see McNichols (2000) for an extensive discussion of research

3

To explain; it is much harder to exercise discretion over cash sales than over credit sales Indeed, examining firms whose financial reporting behavior is deviant enough to warrant SEC enforcement actions, Beneish (1997) finds that cash sales are rarely manipulated He reports that one firm out of 64 (1.6%) engages in circular transfers of money to create the impression of receivable collection In contrast, 43 of 64 firms (67.2%) engage in manipulations affecting credit sales (e.g., fictitious invoices, front loading with a right of return, keeping books open past the end of the fiscal period, overstating the percentage of completion)

design issues related to aggregate accrual models) This is exacerbated by the fact that

we do not know how changing operating decisions that are ex-ante value maximizing

affect measures of earnings management In other words, we do not know whether

estimates of earnings management reflect efficient operating decisions or reporting

considerations To this effect Beneish (1997, p 275) states: “…a firm's financial

reporting strategy depends on its business strategy and should be evaluated ex-ante, not ex-post To illustrate, consider a personal computer manufacturer who seeks to gain

market share on a competitor increases production and offers, before the holiday season, incentives to distributors who increase their demand If the strategy is not successful and translates into lower than expected earnings and a price drop, the manufacturer may be sued and its reporting criticized While the firm ends us with higher discretionary

accruals, it is, conditional on its strategy, an aggressive competitor rather than an earnings manager This firm is, however, not distinguishable from a firm who deliberately pushed sales on its distributors to improve earnings.” An additional problem is that if managers indeed have an incentive to manage earnings, they are likely to do so in a way that is

difficult to detect, thus reducing our ability to detect earnings management and

weakening the power of our tests.4

2.3.2 Other methods

Despite their widespread usage, models of aggregate accruals have been subject to significant criticism (cf footnote 1) An alternative to using an aggregate accruals

approach is to model a specific accrual, such as the provision for bad debt (McNichols and Wilson (1988)), or to focus on accruals in specific sectors such as the claim loss

reserve in the insurance industry (Beaver and McNichols (1998)) McNichols (2000) provides an excellent discussion of the advantages and disadvantages of the specific

accrual approach For example, in terms of advantages she states (p 333) : “One

advantage is that the researcher can develop intuition for the key factors that influence the behavior of the accrual, exploiting his knowledge of GAAP A second advantage is that

a specific accrual approach can be applied in industries whose business practices cause the accrual in question to be material and a likely object of judgment and discretion.” Among the disadvantages, she argues that studying specific accruals require a costly

investment in institutional knowledge, and imposes limits to the generalizability of the

findings, since studies of specific accruals tend to be confined to smaller or sector

specific samples

Recent work by Burgstahler and Dichev (1997) and Degeorge, Patel and

Zeckhauser (1999) use an interesting alternative methodology for studying earnings

management They investigate discontinuities in the distribution of reported earnings

around three thresholds: (1) zero earnings, (2) last year’s earnings, (3) this year’s

analysts’ expectations They make predictions about the behavior of earnings in narrow intervals around these thresholds The evidence appears consistent with predicted

discontinuities: there tend to less (more) observations than expected for earnings

amounts just below (above) the zero earnings and last’s years’ earnings thresholds While examining earnings distributions is informative about which firms are likely to have

4

I thank an anonymous referee for this suggestion

managed earnings, this methodology is silent about the form and extent of earnings

management

3 Evidence of Income Increasing Earnings Management

I discuss four sources of incentives for income increasing earnings management:

(1) debt contracts, (2) compensation agreements, (3) equity offerings, (4) insider trading The first two sources have been hypothesized in prior positive accounting theory research and the last two sources are explicitly described as reasons behind earnings overstatement

in the SEC's accounting enforcement actions, and have been investigated in recent

research

3.1 Debt Covenants

Debt contracts are an important theme in financial accounting research as lenders often use accounting numbers to regulate firms' activities, e.g., by requiring that certain

performance objectives be met or imposing limits to allowed investing and financing

activities The linkage between accounting numbers and debt contracts has been used in studies investigating (i) why economic consequences are observed when firms comply

with mandated, or voluntarily make, accounting changes that have no cash flow impact,

(ii) the determinants of accounting choice and managers' exercise of discretion over

accounting estimates that impact net income The assumption is that debt covenants

provide incentives for managers to increase earnings either to reduce the restrictiveness

of accounting-based constraints in debt agreements or to avoid the costs of covenant

violations

The results of economic consequences studies have generally been mixed and

researchers recently turned to investigating accounting choice in firms that experience

actual technical default (Beneish and Press (1993, 1995), Sweeney (1994), Defond and Jiambalvo (1994), and DeAngelo, DeAngelo and Skinner (1994)) The idea is to

increase the power of the tests by focusing on a sample where the effect of violating debt covenants is likely to be more noticeable While some of the evidence suggests that

managers take income increasing actions delay the onset of default (Sweeney (1994),

Defond and Jiambalvo (1994)), other evidence does not (Beneish and Press (1993),

DeAngelo, DeAngelo and Skinner (1994)) Further, it is not clear such actions actually

are sufficient to delay default.5

Thus, the evidence in these studies on whether managers make income increasing accounting choices to avoid default is mixed However, examining a large sample of

private debt agreements, and measuring firms’ closeness to current ratio and tangible net worth constraints, Dichev and Skinner (2000) find significantly greater proportions of

5

Defond and Jiambalvo (1994) and Sweeney (1994) study a subset of firms for which they have constraint data and find that neither accrual discretion nor changes in accounting techniques are effective in delaying default

firms slightly above the covenant’s violation threshold than below They suggest that

managers take actions consistent with avoiding covenant default

3.2 Compensation Agreements

Studies examining the bonus hypothesis (Healy (1985), Gaver et al (1995), and Holthausen, Larker and Sloan (1995)) provide evidence consistent with managers altering reported earnings to increase their compensation Except for Healy (1985), these studies provide evidence consistent with managers decreasing reported earnings to increase

future compensation In addition, Holthausen et al (1995) find little evidence that

managers increase income and suggest that the income-increasing evidence in Healy

(1985) is induced by his experimental design

3.3 Equity Offerings

A growing body of research examines managers' incentives to increase reported income in the context of security offerings Information asymmetry between

owners-managers and investors, particularly at the time of initial public offerings, is recognized

in prior research Models such as Leland and Pyle (1977) suggest that the amount of

equity retained by insiders signals their private valuation, and models such as Hughes

(1986), Titman and Trueman (1986), and Datar et al (1991) examine the role of the

reputation of the auditor on the offer price In these models, the asymmetry is resolved

by the choice of an outside certifier or by a commitment to a contract that penalizes the issuer for untruthful disclosure Empirical studies assume that information asymmetry

remains and use various models to estimate managers' exercise of discretion over

accruals at the time of security offerings

Four studies investigate earnings management as an explanation for the puzzling behavior of post-issuance stock prices Teoh, Welch and Rao (1998) and Teoh, Welch and Wong (1998a) study earnings management in the context of initial public offerings

(IPO), and Rangan (1998) and Teoh, Welch and Wong (1998b) do so in the context of seasoned equity offerings These studies estimate the extent of earnings management

using Jones-like models around the time of the security issuance, and correlate their

earnings management estimates with post-issue earnings and returns The evidence

presented suggests that estimates of at-issue earnings management are significantly

negatively correlated with subsequent earnings and returns performance

The results in these studies suggest that market participants fail to understand the valuation implications of unexpected accruals While the results are compelling, the

conclusion that intentional earnings management at the time of security issuance

successfully misleads investors is premature Beneish (1998b, p 210) expresses

reservations about generalizing such a conclusion as follows: “First, the conclusion

implies that financial statement fraud is pervasive at the time of issuance To explain;

fraud is defined by the National Association of Certified Fraud Examiners (1993, p 6) as

"one or more intentional acts designed to deceive other persons and cause them financial loss." If financial statement fraud at issuance is pervasive e.g., managers are successful

in misleading investors I would expect that firms would fare poorly post-issuance in

terms of litigation brought about by the Securities and Exchange Commission (SEC),

disgruntled investors, and the plaintiff's bar I would also expect managers to fare poorly post-issuance in terms of wealth and employment I would find evidence of post-issue consequences on firms and managers informative about the existence of at-issue

intentional earnings management to mislead investors and believe these issues are worthy

of future research.”

3.4 Insider Trading

Like raising capital, insider trading is a trading-related incentive and a relatively new-comer to the set of potential antecedents to income increasing earnings management The reason is that, if one accepts two economic efficiency-based arguments, the study of such incentives becomes futile Specifically, the arguments are: (1) capital markets are informationally efficient (a central hypothesis in capital market research), and investors see through managers’ accounting actions, (2) reputation effects and the labor market discipline insiders, preventing them from profiting in firms facing declining prospects

The evidence on insider trading as an incentive to increase income to mislead

investors is less pervasive, but, in my opinion, more compelling that the evidence on

equity issuance as an incentive One reason is that the evidence is drawn from firms that have actually perpetrated financial statement fraud (Beneish (1999)), or committed illegal acts (Summers and Sweeney (1998)) It is consistent with professional views of the

causes of earnings management (National Association of Certified Fraud Examiners

1993),and also with evidence that managers reduce their stake in the firm's equity in the years preceding bankruptcy filings (Seyhun and Bradley 1997) While Seyhun and

Bradley (1997) do not speak to earnings management, their sample firms face

deteriorating performance, a frequently posited antecedent to corporate illegal behavior (National Association of Certified Fraud Examiners 1993)

The most direct evidence linking financial statement manipulations and insider

trading is in Beneish (1999) who finds “that managers of firms with earnings

overstatements that violate GAAP are more likely to sell their holdings and to redeem

stock appreciation rights during the period when earnings are overstated than managers in

a control sample of firms I also find an average stock price loss of 20 percent when the overstatement is discovered and an average cost of settling litigation that is 9 percent of market value prior to discovery This suggests that managers' stock transactions during the period of earnings overstatement occur at inflated prices that reflect the effect of the earnings overstatement.” (p 426)

Beneish (1999) relies on prior insider trading research to develop hypotheses

about manipulation incentives related to insider trading This research suggests that