Franceschetti financial crises and earnings management behavior; arguments and evidence against causality (2018)

16 2.3 Accruals Earnings Management, Real Activities Earnings Management, and Fraudulent Financial Reporting.. In line with priorstudies, it focuses on two types of earnings management:

Financial Crises and Earnings

Management

Behavior

Bruno Maria Franceschetti

Arguments and Evidence Against Causality

Bruno Maria Franceschetti

Financial Crises and Earnings Management Behavior

Arguments and Evidence Against Causality

123

University of Macerata

Macerata

Italy

Contributions to Management Science

DOI 10.1007/978-3-319-54121-1

Library of Congress Control Number: 2017946663

© Springer International Publishing AG 2018

This work is subject to copyright All rights are reserved by the Publisher, whether the whole or part

of the material is concerned, speci fically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission

or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed.

The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a speci fic statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use.

The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made The publisher remains neutral with regard to jurisdictional claims in published maps and institutional af filiations.

Printed on acid-free paper

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The registered company is Springer International Publishing AG

The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

To my son Valerio

I thank Carsten Felden and Claudia Koschtial, Technische Universität BergakademieFreiberg (DE), and Francesca Bartolacci, Nicola Castellano, Andrea Fradani,Antonella Paolini and Michela Soverchia, University of Macerata (IT), for thecontinuous constructive discussions and comments.

vii

1 Introduction 1

1.1 Introduction 1

1.1.1 The Research Question 1

1.2 A Brief Overview of the Book and its Structure 3

1.3 Theoretical Contributions of the Present Work 6

1.4 Practical Contributions of the Present Work 8

References 9

2 Earnings Management: Origins 15

2.1 Introduction 15

2.2 Definitions of Earnings Management, Earnings Quality, Fraud, and Earnings Manipulation 16

2.3 Accruals Earnings Management, Real Activities Earnings Management, and Fraudulent Financial Reporting 18

2.3.1 Studies Related to Accruals Earnings Management 21

2.3.2 Studies Related to Real Activities Earnings Management 34

2.3.3 Studies Related to Non-GAAP Earnings Management: Fraudulent Financial Reporting 38

2.4 Main Incentives to Manage Earnings and Offset Causes 44

2.5 Conclusion 49

Appendix: Earnings Management Detection Models 51

References 68

3 A Critical Realist Perspective on Earnings Management 75

3.1 Introduction 75

3.2 Critical Realism as an Alternative to Positivism 77

ix

3.3 A Critical Realist Conceptualization of Powers

and Tendencies 81

3.4 A Critical Realist Approach to Earnings Management 87

References 97

4 Financial Crisis as a Major Cause of Earnings Management: Theoretical Background and Literature Review 103

4.1 Theoretical Background 103

4.2 Literature Review 105

4.2.1 Methodology 105

4.2.2 Results 108

4.2.3 Discussion: Mainstream Approach to the Financial Crisis–Earnings Management Relation 108

References 115

5 Does Financial Crisis Cause Earnings Management? 119

5.1 Introduction 119

5.2 Positivist Mainstream Approach to the Research Question 120

5.2.1 Hypotheses Development 120

5.2.2 Measurement of Earnings Management: Beneish’s Model 126

5.2.3 Sample Selection 130

5.2.4 Empirical Results 132

5.3 Critical Realist (CR) Approach to the Research Question 139

5.3.1 Against the Causal Law of a Constant Conjunction Model: An Etymological Perspective 140

5.3.2 A New Critical Realist Conceptualization of Tendencies Applied to Earnings Management 141

5.4 Discussion and Conclusion 144

Appendix: Extended Tables 145

References 158

Abstract This opening chapter presents the research question, gives a briefoverview of the book, and pinpoints the main theoretical and practical contributions

of the present work The study examines whether the generative mechanism for

provides a critical realist evaluation of mainstream earnings management literature

realist approach to the research question

1.1 Introduction

1.1.1 The Research Question

Since earnings quality is essential to the decisions made by anyone with a vested

indicators associated with the use of earnings management is crucial to help detect

1 Accordingly, earnings management “includes the whole spectrum, from conservative through fraud, a huge range for accounting choices ” (Giroux 2006 , p 6).

© Springer International Publishing AG 2018

B.M Franceschetti, Financial Crises and Earnings Management Behavior,

Contributions to Management Science, DOI 10.1007/978-3-319-54121-1_1

1

cognitive resources are used to construct plausible models of the mechanisms

that represent cause and effect remain to be understood

hypothetical or imagined mechanisms are not imaginary but real; or, to put it the

this study examines whether the generative mechanism for managing earnings

power to improve or worsen earnings quality?

quality may improve or diminish, managers may adopt income-increasing orincome-decreasing strategies, and reported earnings may appear more or lesstimely, conditionally conservative, value-relevant, smoothed, managed, persistent,

approached from two philosophical perspectives: positivism and critical realism.First, a positivist approach is required to compare the presented results with those ofmainstream research The results of the positivist approach, which should be

does not differ from the pre-crisis to the crisis periods In this regard, earnings

2 Determining their precise cause and effect relationship is outside the scope of the present study and will be the subject of future work By acknowledging that the question cannot be investigated

in a closed system (laboratory) “where other mechanisms that are not being tested will not affect the outcome ” (Collier 2005 , p 329), I argue against the causal law of a constant conjunction model (whenever a financial crisis happens, earnings management happens), although I cannot exclude a priori the opposite (that earnings management causes financial crisis), or the presence of other generative mechanisms that may cause financial crisis, or the absence of any causal law of a constant conjunction model type.

Therefore, I set aside the search for predictive models and explore other structuresthat might be responsible for managing earnings.

of the mechanism responsible for the satisfaction of these intrinsic enabling

do so

1.2 A Brief Overview of the Book and its Structure

quality, earnings management, fraud, and earnings manipulation In line with priorstudies, it focuses on two types of earnings management: accruals earnings man-agement and real activities earnings management While accruals earnings man-agement refers to the manipulation of earnings through the exploitation of an

management and real activities earnings management can cross the line from

reporting (or non-generally accepted accounting principles, i.e non-GAAP earnings

will be presented and discussed as well

Furthermore, this chapter presents studies on managerial incentives for earningsmanagement since a common approach in the earnings management literature is tofirst identify conditions in which managers’ incentives to manage earnings arelikely to be strong, and then test whether patterns of earnings management are

instance, previous literature identified plausible causes for managing earnings

may also create an incentive to manage earnings In other words, to meet the

bonuses, i.e., compensation contracts and bonus schemes can trigger the manager to

etc.) However, I will present the most often discussed incentives (or causes) formanaging earnings and highlight the contradictory results provided by some of

earnings behavior

and introduces critical realism as an alternative philosophical perspective toinvestigate the earnings management phenomenon Evidence provided by prior

same contexts Similarly, studies providing evidence of income-increasing

research showing antithetical results under the same incentive Positivism is thephilosophy underpinning prior studies examining earnings management According

known by applying the same techniques as the natural world, a position referred to

positivism suggests that human behaviours can be reduced to the state of

nature of relationships and causes and effects, and employs empirical validation and

alike do not consist of discrete atomistic events whose regular co-occurrences is thetask of scientists to record, but of complex structures existing independently of

Critical realism is presented as a different philosophical perspective to explain

not imaginary but real; or, to put it the other way round, to discover what the real

Finally, this chapter provides a critical realist evaluation of mainstream earnings

earnings In short, it argues that the inconclusive results presented by prior researchcould be due to the openness of the system in which the earnings managementphenomenon occurs since in open systems, constant conjunctions of events do not

quantitative methodologies lose their capacity to explain or predict phenomena, andthe assumption that the external world can be accurately described and causally

financial crisis as a major cause of earnings management A review with selective

3 Fink ( 2013 ) de fines a research literature review as “a systematic, explicit, and reproducible method for identifying, evaluating, and synthesizing the existing body of completed and recorded work produced by researchers, scholars, and practitioners ” (p 3) Literature reviews are often considered to be “the Cinderella of research, being less valued than primary research, or dull preludes to research reports ” (Steward 2004 , p 495) However, literature reviews represent “the backbone of almost every academic piece of writing ” (Seuring and Gold 2012 , p 544) and provide

“a framework for relating new findings to previous findings” (Randolph 2009 , p 2) Speci fically,

“condensed overviews of relevant literature allow for grounding the authors’ research on the state

of the art of existing research, thus highlighting the particular scholarly contribution to the research field” (Seuring and Gold 2012 , p 544) Furthermore, researchers can “extract new ideas from others ’ work by synthesizing and summarizing previous sources” (Bolderston 2008 , p 86) In addition, performing a literature review is a fundamental step in hypothesis building.

ambiguous results, depicting different scenarios depending on the choice offirm

of consensus on the direction and magnitude of earnings management in times ofrecession Thus, more evidence is needed The results of the literature reviewperformed will be operationalized into a hypothesis presented in Chap 5,

have the power to affect the earnings behavior of managers and companies.However, this chapter presents both the positivist and the critical realist approach tothe research question To enable comparability with prior mainstream studies in the

presents the research design, data collection, hypothesis testing, and results from a

However, in contrast to some prior research that looked for evidence of earnings

financially distressed firms; etc.), only high earnings quality firms in which earnings

man-agement incentives and causes

critical realist perspective to search for the underlying mechanisms of earnings

for managing earnings from an etymological point of view and applies retroductivereasoning to explore other potential generative mechanisms for earnings manage-

pos-sibilities for future research

1.3 Theoretical Contributions of the Present Work

From a theoretical standpoint, the present work makes several contributions

– To the earnings management literature by adopting a non-mainstream sophical perspective alongside a mainstream positivist perspective to investigate

mainstream accounting research is conducted within the positivist paradigm

“which since the time of Hume has fashioned our image of science” (Bhaskar

non-mainstream philosophical paradigm in earnings management literature To

man-agement literature to take a critical realist philosophical position

– By shedding some light on managers’ earnings behavior in times of economicdownturn Since previous research, assuming the existence of causal laws of a

‘constant conjunction’ type, has investigated the impact of financial crisis on

management behavior tends not to differ from pre-crisis to crisis periods

both pre-crisis and crisis periods Moreover, the critical realist perspective

a generative mechanism for managing earnings, thus contributing to theliterature

– By revealing managers’ incentives to manage earnings (or causes for managing

(e.g., compensation contracts, lending contracts, earnings forecasts, ment buyouts, seasoned equity offerings, seasoned bond offerings, etc.).Academics have engaged in numerous efforts to discover the causal laws of a

happens), such as whenever a management buyout/a seasoned equity offering/aseasoned bond offering, etc., happens, earnings management happens Roughly

investigated in the context of a closed system As an alternative, futureresearchers might aim to explore other structures or generative mechanisms

research drawing on hitherto unexplored or under-utilised intellectual

body of conceptual, methodological and empirical work is that informed by

(Modell 2017, p 21).4 Thus, the present work contributes to this emergingavenue of research.

– By providing further stimuli for testing theories in a rigorous manner sinceaccounting researchers should endeavor, whenever possible and practicable, to

direction earnings management takes, are consistent with relevant theories Inthis regard, prior studies have robust theories supporting the results Forinstance, transaction cost theory and prospect theory (Burgstahler and Dichev

research designs

1.4 Practical Contributions of the Present Work

From a practical standpoint, the present work provides useful evidence for

inves-tors, and crediinves-tors, by enabling a judgment that takes into account two different

ownership and management in the decision making process

Finally, from a practical research standpoint, the present work acts as an tation to positivist accounting researchers to seek out conditions of quasi-closure indesigning research in an open system, so that certain activities of interest are

invi-4 However, according to Modell ( 2017 ), the in fluence of critical realism “on the accounting erature was long rather cursory (e.g Armstrong 2004 , 2006 ; Manicas 1993 ; Whitley 1988 ) It is only over the past decade that accounting scholars have made more explicit and extensive use of it

lit-to debate paradigmatic and methodological issues (Ashraf and Uddin 2015a ; Brown and Brignall

2007 ; Llewellyn 2007 ; Modell 2009 , 2013 , 2015a , b ), examine processes of accounting change (Ashraf and Uddin 2013 , 2015b , 2016 ; Mutiganda 2013 ; Stergiou et al 2013 ) and advance critical commentaries on emerging accounting policies and practices (Burrowes et al 2004 ; Smyth 2012 ) ” (p 21).

controlled and particular results are obtained For instance, managers’ causal

between the variables or precise description of the mode of operation of the

social phenomena cannot be investigated in a closed system (laboratory), Tsoukas

when quasi-closed systems are constructed that a set of desirable regularities

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Earnings Management: Origins

con-cepts of earnings quality, earnings management, fraud, and earnings manipulation

comes It reviews the mainstream studies, and focuses on two types of earningsmanagement: accruals earnings management and real activities earnings manage-

accepted accounting principles, i.e non-GAAP earnings management) will bepresented and discussed as well Furthermore, this chapter presents studies onmanagerial incentives for earnings management The most important incentives (orcauses) for managing earnings are discussed and the contradictory results provided

by some of them highlighted Finally, a few offsetting causes that may interferewith these main incentives for managing earnings are presented

2.1 Introduction

earn-ings quality, earnearn-ings management, fraud, and earnearn-ings manipulation, and focuses

on two types of earnings management: accruals earnings management and realactivities earnings management Both accruals earnings management and realactivities earnings management can cross the line from legitimate to fraudulent in

non-generally accepted accounting principles (non-GAAP) earnings management,will be presented as well Furthermore, this chapter presents studies on manage-rial incentives for earnings management The most important incentives (or causes)for managing earnings are discussed since it is not clear whether these factors have

© Springer International Publishing AG 2018

B.M Franceschetti, Financial Crises and Earnings Management Behavior,

Contributions to Management Science, DOI 10.1007/978-3-319-54121-1_2

15

2.2 De finitions of Earnings Management, Earnings

Quality, Fraud, and Earnings Manipulation

“Earnings management has a lot in common with earnings quality,” and clearly

p 351) In other words, earnings management affects earnings quality but the

earn-ings as those that are persistent, derived under conservative accounting rules or

(CFOs) and standard setters to provide new insights into the

behaviors that positively affect the quality of earnings include, among others,consistent reporting choices over time, avoiding unreliable long-term estimates as

earnings are not managed, while highly managed earnings are of low quality and,therefore, unreliable

within the constraints of generally accepted accounting principles to bring about a

reports to either mislead some stakeholders about the underlying economic

1 As well as in-depth interviews of CFOs.

2 Dechow et al ( 2010 ) provide a comprehensive review of earnings quality studies.

3 Davidson et al ( 1987 ) has been cited by Schipper ( 1989 ).

accepted, these definitions are difficult to operationalize directly using attributes ofreported accounting numbers since they center on managerial intent, which is

identify in the practical literature as well The Public Company Accounting

wide variety of legitimate and illegitimate actions by management that affect an

whole spectrum, from conservative through fraud, a huge range for accounting

accounting choices that are fraudulent (e.g., recording sales before they are realized

conservative and neutral, suggesting transparency, as well as more aggressive or

the earnings management continuum crosses the line from legitimacy to fraud in a

espe-cially investors and creditors, by preparing and disseminating materially misstatedfinancial statements” (p 279) He posited that financial statement fraud may involvemany schemes, such as

sup-porting documents, or business transactions; (2) material intentional misstatements,

misapplication, intentional misinterpretation, and wrongful execution of accountingstandards, principles, policies and methods used to measure, recognize, and reporteconomic events and business transactions; (4) intentional omissions and disclo-sures or presentation of inadequate disclosures regarding accounting standards,

accounting techniques through illegitimate earnings management; and (6) lation of accounting practices under the existing rules-based accounting standards

fraud, considering it to be marked by intentional misstatements or omissions infinancial reporting to deceive financial statement users More specifically, financial

statement on accounting standards no 99 defined fraud as “an intentional act that

individuals among management, those charged with governance, employees, orthird parties, involving the use of deception to obtain an unjust or illegal advan-

financial statement fraud as “the deliberate misrepresentation of the financial dition of an enterprise accomplished through the intentional misstatement or

Another term often used in earnings management literature is earnings

managers violate generally accepted accounting principles (GAAP) to favorably

continuum, where someone clearly violates generally accepted accounting ples (GAAPs)

a violation of GAAPs, for the purposes of this study, the concepts of fraud andearnings manipulation, as part of earnings management practices, are synonymoussince they are both on the illegal end of the spectrum of accounting choices

2.3 Accruals Earnings Management, Real Activities

Earnings Management, and Fraudulent Financial

Reporting

from operations is a measure of cash earnings while accruals are non-cash earnings

when revenues and expenses are not entirely cash based Therefore, earnings are the

where E is reported earnings, TACC is total accruals, and CFO is cashflow fromoperations.

increase (decrease) in reported income Accordingly, accounting researchers havetraditionally focused on two types of earnings management: accruals earnings

as accruals earnings management, as opposed to real activities earnings

manipulation of earnings through the exploitation of an opportunity set of generally

changing the depreciation rate of assets, (delaying) asset write-offs, or (under)provisioning for bad debt expenses may underlie non-cash income-increasing/decreasing strategies

actions that deviate from normal business practices, undertaken with the primary

Usually business decisions about expenditures on research and development,offering price discounts, changes in credit policy, and about (intensifying or cutting)other discretionary expenditures may underlie cash income-increasing/decreasingstrategies

Real activities earnings management is harder to detect than accruals earnings

countries, managers are not liable for honest mistakes or errors of judgment; theyare protected by business judgment rules or similar procedures meant to limit their

errors in judgment when their decisions result in an unfavorable outcome for the

earnings behavior are subject to the examination of several actors (e.g., auditors,

manager, the less likely it is that he or she will engage in easy-to-detect earningsmanagement, and the more elaborate will be the plans for concealment to evade

management

Fraud is not self-contained; therefore it cannot be considered a third category of

management and real activities earnings management can cross the line from

trans-actions may be for deceptive or fraudulent purposes rather than genuine business

A related party is a person or entity that is related to the entity that is preparing

services, or obligations between a reporting entity and a related party, regardless ofwhether a fee is charged (International Accounting Standards No 24 [IAS

No 57) states that transactions between related parties are considered to be relatedparty transactions even though they may not be given accounting recognition (e.g.,

an enterprise may receive services from a related party without charge and notrecord receipt of the services) Related party transactions are real activities that may

earnings management activities

4 “Unlike economic transactions with an unrelated counterparty, in related party transactions, the same individual is on both sides of the transaction ” (Gordon et al 2007 , p 96).

5 IAS No 24 de fines a related party as a person or entity that is related to the entity that is preparing its financial statements (in this Standard it is referred to as the ‘reporting entity’) (a) A person or a close member of that person ’s family is related to a reporting entity if that person: (i) has control or joint control over the reporting entity; (ii) has signi ficant influence over the reporting entity; or (iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity (b) An entity is related to a reporting entity if any of the following conditions apply: (i) the entity and the reporting entity are members of the same group (which means that each parent, subsidiary, and fellow subsidiary is related to the others); (ii) one entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member); (iii) both entities are joint ventures of the same third party; (iv) one entity is a joint venture of a third entity and the other entity is an associate of the third entity; (v) the entity is a post-employment bene fit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity; (vi) the entity is controlled or jointly controlled by a person identi fied in (a); (vii) a person identified in [a(i)] has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity); (viii) the entity, or any member of a group of which it is part, provides key management personnel services to the reporting entity or to the parent of the reporting entity The Statement of Financial Accounting Standards No 57 (FAS No 57) de fines related party transactions as transactions between (a) a parent company and its subsidiaries; (b) subsidiaries of a common parent; (c) an enterprise and trusts for the bene fit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the enterprise ’s management; (d) an enterprise and its principal owners, management, or members of their immediate families; and (e) af filiates.

Other accounting behaviors such as recording sales before they are realized or

non-GAAP earnings management, earnings misstatement, earnings manipulation,

an area that has been somewhat neglected in the earnings management (quality)

2.3.1 Studies Related to Accruals Earnings Management

Managers exercise their discretion to estimate numerous future events such as

“expected lives and salvage values of long-term assets, obligations for pension

For instance, under IAS 16, the depreciable amount of an asset shall be mandatorilyallocated on a systematic basis over its useful life but a variety of depreciationmethods can be used to allocate the depreciable amount These methods include thestraight-line method, the diminishing balance method and the units of productionmethod Similarly, to determine the cost of inventories for items that are inter-

average cost formula

Generally accepted accounting principles often require that discretion be

amount of accounts receivable that are likely to be collected, the appropriateallocation pattern for the cost of equipment, or how long a marketable security is

open the door to opportunistic earnings behavior Managers might manipulateearnings through the exploitation of an opportunity set of generally accepted pro-

6 Account schemes through which management commits fraud by manipulating financial ments are (among others): overvalued assets and understated expenses; omitted or understated expenses/liabilities; fictitious assets; other methods to overstate revenues; overvalued assets/equity; and misclassi fication (Gao and Srivastava 2007 ).

state-As shown in Sect.2.3, Eq.2.1, earnings are calculated by summing the cashflow from operations and total accruals Therefore, the difference between earnings

operations

statements, such as the statement of working capital or the balance sheet For

(reported in the funds statement) less changes in inventory and receivables, plus

accruals required an additional effort

from reported earnings, prior research represented total accruals by approximatemeasures mainly based on balance sheet variables According to Bartov et al

balance sheet approach:

7 For example, under US GAAPs, the Statement of Financial Accounting Standards No 95 (FAS

No 95) issued in 1987 became effective for the annual financial statements of fiscal years ending after July 15, 1988 While in 1992, the International Accounting Standards Board issued International Accounting Standard No 7 (IAS No 7), which became effective only in 1994, mandating that firms provide cash flow statements.

accruals (TACC) using the so-called cashflow approach, as the difference between

(CFO) from continuing operations were obtained directly from the statement of

total (or aggregate) accrual measures are typically scaled by total assets (TA) from

consist of discretionary accruals and non-discretionary accruals:

where TACC is total accruals, DACC is discretionary accruals, and NDACC isnon-discretionary accruals

While non-discretionary accruals are accounting adjustments mandated by the

8 Hribar and Collins ( 2002 ) took both components of accruals directly from the statement of cash flows Specifically, they took the following data items from the Compustat database: Compustat

#123 to determine earnings before extraordinary items; and to determine cash flows from ations (CFO), they subtracted from net cash flow (Compustat #308) the amount of extraordinary items and discontinued operations (Compustat #124).

oper-9 In a subsequent article, Healy ( 1996 ) changed the terminology and stated: “I regret that I bear much of the responsibility for the current labels, which I first used in my bonus plan paper (Healy

1985 ) If I were to rewrite that paper today, I would certainly change the terminology What I termed ‘discretionary’ accruals would be renamed ‘unexpected’ accruals and what I called

‘nondiscretionary’ earnings would be relabeled as ‘expected’ earnings” (p 114) The perspective has changed; the main point is not to detect earnings management but to forecast accruals However, following conventional practice (Peasnell et al 2000 ), I use the terms “managed accruals, ” “discretionary accruals,” “unexpected,” and “abnormal accruals” interchangeably Similarly, the terms “unmanaged accruals,” “non-discretionary accruals,” “expected,” and “normal accruals ” are used interchangeably.

10 Healy ( 1985 ) speci fied: “These bodies require, for example, that companies depreciate long-lived assets in some systematic manner, value inventories using the lower of cost or market rule, and value obligations on financing leases at the present value of the lease payments” (p 89).

11 As Healy ( 1985 ) pointed out, “the manager chooses discretionary accruals from an opportunity set of generally accepted procedures de fined by accounting standard-setting bodies For example, the manager can choose the method of depreciating long-lived assets; he can accelerate or delay delivery of inventory at the end of the fiscal year; and he can allocate fixed factory overheads between cost of goods sold and inventories ” (p 89).

management” (Kothari 2001, p 161) The discretionary component of accruals

The majority of studies have used aggregate or total accruals (see following

discretionary portion of total accruals Although some researchers employ multiple

sub-stantial proportion of the literature

Despite the widespread use of total or aggregate accruals to predict residual

focus on the discretionary portion of a single accrual account or on a number of

goals (e.g., accounts receivable, special items, allowance for bad debts, depreciation

earnings management in situations where other discretionary components (besides

Comprehensiveness is a characteristic of the broad measures of earnings

12 Healy and Wahlen ( 1999 ) explained: “many studies begin with total accruals, measured as the difference between reported net income and cash flows from operations Total accruals are then regressed on variables that are proxies for normal accruals, such as revenues (or cash collections from customers) to allow for typical working capital needs (such as receivables, inventory, and trade credit), and gross fixed assets to allow for normal depreciation Unexpected accruals are thus the unexplained (i.e., the residual) components of total accruals ” (p 370).

its entirety, “whereas specific accruals may represent only a small portion of the

In summary, two main approaches have been adopted in prior research to capture

accruals that are likely to be managed in contingent circumstances

of Related Studies

Prior research relied on total (aggregate) or unexpected accruals to detect the

used discretionary accruals and voluntary changes in accounting procedures todetect earnings management He examined whether bonus schemes create incen-tives for managers to select accounting procedures and accruals to maximize thevalue of their bonuses The results provided evidence of a strong association

when the upper or lower limits of their bonus plans are binding, and overstate

examined whether business-unit managers manage earnings to maximize theirshort-term bonuses The results showed that business-unit managers make discre-tionary accrual decisions to maximize their short-term bonus compensation

hypothesis that managers manipulate earnings downwards when their bonuses are

use income-decreasing discretionary accruals when they are at the upper limit of

that exceeds the upper bound does not reduce the current bonus but instead

so low that target earnings will not be met, managers have incentives to furtherdecrease earnings to maximize the expected future bonus By contrast, Gaver et al

income-increasing discretionary accruals (and vice versa) In short, their results are

inconsistent with the “big bath” argument (Walsh et al 1991)13 and are instead

Firms use discretionary accounting choices to manage earnings around the time

firms whose managers proposed going private Management buyouts “engender

fiduciary duty to negotiate fair value for the publicly-held shares are themselves thepurchasers of those shares, and thus have a countervailing incentive to minimize the

hypothesis that managers who propose to take a public corporation private

dis-cretionary accruals downward in the year preceding the public announcement of

results showed that companies seeking import relief exercised income-decreasingdiscretionary accruals during the import relief investigations However, other forms

management techniques to reduce the probability of cost-increasing legislation (i.e.,

periods when gasoline prices are rising to mask excessively high accounting rates of

13 Big bath accounting is a managerial stratagem (Walsh et al 1991 ) based on the assumptions that

“when circumstances are bad, making things just a little bit worse by cleaning out the rubbish does little harm to either reputation or prospects ” and that “little damage will ensue when the market is

so depressed that nothing can hurt it more ” (Walsh et al 1991 , p 174).

14 Under the income-smoothing hypothesis, “earnings are manipulated to reduce fluctuations around some level that is considered normal for the firm” (Bartov 1993 , p 840) Income smoothing is an earnings management technique and is de fined as follows: “Income smoothing is the process of manipulating the time pro file of earnings or earnings reports to make the reported income stream less variable, [ …] To smooth income, a manager takes actions that increase reported income when income is low and takes actions that decrease reported income when income

is relatively high; this latter aspect is what differentiates income smoothing from the related process of trying to exaggerate earnings in all states ” (Fudenberg and Tirole 1995 , pp 75 –76).

15 Perry and Williams ( 1994 ) argued that the principal reason for such contrasting results is sample size Compared to the DeAngelo ( 1986 ) study, Perry and Williams ( 1994 ) examined a much larger sample of firms going private (175 management buyout proposals).

return Similarly, Byard et al (2007) investigated the managers’ earnings behavior

of US-based oil companies facing heightened political scrutiny due to increased

Their results showed that

investigated the earnings behavior of cable television managers surrounding the

managers increasing negative discretionary accruals during the period of scrutiny tomitigate the effects of political scrutiny and potential regulation Finally, Chen et al

the boom of the Chinese real estate sector in 2001 The rapid growth of the Chinese

(p 92)

well-established hypothesis in the accounting literature: i.e., managers make

covenant violation, the authors found substantial evidence of income-increasingdiscretionary accruals in the year prior to covenant violation Therefore, supporting

firms exhibit large negative accruals

Earnings management activity seems particularly plausible around seasoned

firms engage in earnings management around the time of the issuance of new stock

upwardly managed earnings) during the year around the SEO, perhaps to increase

16 “Hurricanes Katrina and Rita caused widespread disruption to the US-based oil industry and were followed by large price increases for both crude oil and gasoline These large price increases triggered a widespread public outcry that companies in the oil industry were engaged in price gouging Various proposals were floated for investigations, regulations, and a windfall profits tax speci fically aimed at companies in the oil industry If passed, these proposals could have imposed large additional costs on these companies, thus adversely affecting their future pro fitability” (Byard

et al 2007 , p 734).

the offering proceeds,17 and that these accruals subsequently reverse in the lowing year, causing declines in earnings.

fol-However, earnings management surrounding seasoned bond offerings (SBOs)seems to also be plausible Indeed, managers may manipulate earnings beforeissuing bonds to achieve a lower cost of borrowing, or more in general, to improve

earnings before issuing bonds to achieve a lower cost of borrowing Their results

upward prior to the offering After the offering, however, earnings management

manage earnings Convertible bonds give creditors the opportunity to convert their

years when convertible bonds are issued and redeemed Their results demonstratedthat convertible bonds issuers generally use positive discretionary accruals in theissuing year to promote their convertible bonds and to reduce the costs of issuance.Furthermore, results indicate that the magnitude of earnings management is higher

in the year following the issue of convertible bonds than in the year before the issue

Proxy contests for board seats may incentivize incumbent managers to

man-agers typically increase earnings via positive discretionary accruals during anelection campaign to paint a favorable picture of their own performance However,

auditors hold legitimate divergent perspectives regarding the appropriate tion of accounting procedures However, managers may threaten to dismiss auditors

17 Issuing companies manage earnings upward through income-increasing accounting adjustments

in order to increase the offering proceeds However, the high earnings reported around SEOs temporarily overvalue issuing firms until the subsequent fiscal period in which discretionary accruals reverse.

DeFond and Subramanyam (1998) observed that “if management believes theincumbent auditors accounting choice preferences are more conservative than thoseexpected from the average auditor, management has an incentive to dismiss the

year with their successor

Earnings forecasts may also create an incentive to manage earnings Somestudies have shown that earnings are managed to meet the expectations of managers

rec-ommendations (e.g., buy, hold, or sell) may create an incentive to manage earnings

manage reported earnings toward their forecasts In particular, the results provided

accruals to manage reported earnings upward when earnings would otherwise fall

firms’ earnings generally represent an incentive to manage earnings because even

forecasts Firms that meet/beat their earnings expectations enjoy a higher return

negative earnings surprises: earnings management and forecast guidance (or

18 The difference between the current earnings and analysts ’ forecast earnings is called “earnings surprise ” (Kinney et al 2002 , p 1299).

19 Bartov et al ( 2002 ) de fined habitual beaters as firms that have met or beaten expectations in at least 9 (75%) of the previous 12 (100%) quarterly earnings forecasts.

managed20 upward and forecasts are managed downward to achieve zero (i.e., tomeet analyst forecasts) and small positive (i.e., to slightly beat analyst forecasts)earnings surprises.

forecasts However, their results also suggest that analysts discount the credibility

of bad news management forecasts when revising their forecasts; i.e., analystforecast revisions are weaker in response to bad news provided by habitual thannon-habitual meet/beaters

stock ownership) and earnings management They found that managers withhigh-equity incentives, relative to managers with low-equity incentives, are more

top brokerage houses or by experienced analysts have stronger effects againstearnings management

20 Burgstahler and Eames ( 2006 ) “view earnings management as encompassing both actions that increase current earnings without decreasing future earnings and actions that increase current earnings at the expense of future earnings ” (p 635) The authors called the former type of earnings management “business management” and the latter “reporting management.” To proxy for busi- ness management (reporting management) the authors used changes in operating cash flows (discretionary accruals).

21 Overall, Cheng and War field’s ( 2005 ) results “suggest that CEOs with high equity incentives take more income increasing abnormal accruals than those with low equity incentives ” (p 467).

Institutional investors (e.g., insurance companies, superannuation and pension

with institutional investors monitoring managers and thus constraining them from

share-holders is associated with the magnitude of discretionary accounting accruals and

strategies (aggressive accruals management) The results suggested that long-terminstitutional investors constrain accruals management while transient institutional

earnings management strategies and on incentives created by meeting/beatingearnings thresholds (such as earnings decline and loss avoidance) The authors

owner-ship levels, they can act as an effective corporate governance mechanism in

between (short) long-term institutional ownership and earnings management

prior studies, the results suggested that long-term institutional investors mitigateaccruals management, while transient institutional ownership is associated with

22 Chung et al ( 2002 ) speci fied: “When managers have incentives to increase reported profits, institutional investors put pressure on them to limit the use of income-increasing DAC (discre- tionary accruals) Similarly, when managers have incentives to decrease reported pro fits, institu- tions apply pressure on them to limit the use of income-decreasing discretionary accounting accruals ” (p 46).

23 Koh ( 2003 ) used the level of institutional ownership to proxy institutional ownership types, where a lower (higher) ownership region approximates short-term-oriented (long-term-oriented) institutional ownership Furthermore, he examined the association between levels of institutional ownership and income-increasing discretionary accruals He found a positive (negative) associa- tion between levels of institutional ownership and aggressive accruals management in a lower (higher) institutional ownership region More generally, Velury and Jenkins ( 2006 ) found a positive association between institutional ownership and several attributes of earnings quality By examining the impact of institutional ownership on overall earnings quality, the authors provided evidence on whether the quality of earnings improves as investment by institutions increases However, this positive association between institutional ownership and earnings quality is nega- tively affected by increased ownership concentration (Velury and Jenkins 2006 ).

aggressive earnings management, although only amongfirms that manage earnings

to meet/beat their earnings benchmarks

recom-mendations (e.g., buy, hold, or sell) have the power to incentivize managers to

more (less) frequently in extreme, income- decreasing earnings management,indicating that they have relatively stronger (weaker) incentives both to take

firms rated a Buy (Sell) are more (less) likely to engage in earnings management

generally engaged in negative earnings management behavior (decreasing earnings

United States Bankruptcy Code The results of this latter study showed that in the

firms (bankrupt firms that ex ante do not appear distressed) materially overstate

24 Rosner ( 2003 ) used a sample of 51 s sanctioned and 242 non-sanctioned bankrupt firms Within the non-sanctioned bankrupt firms, she created subsamples of stressed bankrupt firms (SB) and non-stressed bankrupt firms (NSB) Analyzing financial statements in a five-year window, she found evidence of earnings overstatement in the NSB which “resemble the SEC-sanctioned fraud firms” (Rosner 2003 , p 401).