Introduction to Earnings Management

By Malek El Diri

This book provides researchers and scholars with a comprehensive and up-to-date analysis of earnings management theory and literature. While it raises new questions for future research, the book can be also helpful to other parties who rely on financial reporting in making decisions like regulators, policy makers, shareholders, investors, and gatekeepers e.g., auditors and analysts. The book summarizes the existing literature and provides insight into new areas of research such as the differences between earnings management, fraud, earnings quality, impression management, and expectation management; the trade-off between earnings management activities; the special measures of earnings management; and the classification of earnings management motives based on a comprehensive theoretical framework.

• Language: English
• Publisher: Springer
• Release date: Aug 20, 2017
• ISBN: 9783319626864

Book preview

© Springer International Publishing AG 2018

Malek El Diri Introduction to Earnings Managementhttps://doi.org/10.1007/978-3-319-62686-4_1

1. Introduction

Malek El Diri¹ 

(1)

Accounting and Finance Division, Leeds University Business School, Leeds, UK

1.1 Introduction

As a result of separating ownership from control in public companies, an agency problem appears between the principals (shareholders) and the agents (managers) (Holmstrom and Milgrom 1987). Under this conflict in interests, managers might not reveal the truth because of the high contracting costs between managers and firms, shareholders’ bounded rationalities that do not enable them to understand management actions, and the information asymmetry derived from the costly communication in the market (Milgrom and Roberts 1992; Ronen and Yaari 2008; Walker 2013). In this sense, managers may exercise discretion over financial reporting that can take the shape of earnings management if performed under the umbrella of Generally Accepted Accounting principles (GAAP) (Harris and Raviv 1979; Fama 1980; Strong and Walker 1987; Walker 2013).

From the previous theoretical perspectives, modern research has introduced three different groups of motives to explain earnings management behaviour including contracting motives that arise from the deficiencies in the contract terms between the firm and its stakeholders, capital market motives that are related to the inefficiencies of stock markets, and third-party motives driven by external parties that influence the cost of communicating information in the market (Ronen and Yaari 2008; Walker 2013). The earnings management literature has separately studied the previous groups of motives and identified a number of factors under each group. Among the contracting motives, management compensation, CEO turnover, managerial ability, corporate governance, and loans were identified (Godfrey et al. 2003; Boone et al. 2004; Defond and Francis 2005; Yu 2008; Iatridis and Kadorinis 2009; Laux and Laux 2009; Demerjian et al. 2013). To examine capital market motives, the literature has focused on the influence of the stock market, issuance of equity, new listing and cross-listing, mergers and acquisitions, insider trading, management buyouts, meeting or beating a benchmark, and the effect of analysts on earnings management (Kothari 2001; Lang et al. 2006; Efendi et al. 2007; Fan 2007). Finally, from the external motives the literature has studied the impact of industry, industrial diversification, regulations, political environment and country-specific policies, accounting standards, tax considerations, competitors, suppliers and customers (Bagnoli and Watts 2000; Goldman and Slezak 2006; Jiraporn et al. 2006; Barth et al. 2008).

Accordingly, earnings management can be defined as the within GAAP management discretion over external financial reporting by abusing some contracting deficiencies, stakeholders’ bounded rationalities, and information asymmetry in the market, through some economic decisions, a change in the accounting treatment, or other sophisticated methods. The purpose of management is to present earnings in a way different (up or down) from what is known to them to achieve private benefits while misleading the stakeholders; although such discretion may not always be harmful to them.

Overall, this book aims to examine earnings management as it was the underlying reason for some of the financial scandals of large companies like Enron, WorldCom, Adelphia, and Tyco in the early 2000s and ultimately resulted in the failure of those companies. These incidences have raised more concern about the role of financial reporting in reflecting the performance of firms (Giroux 2004). Therefore, understanding earnings management behaviour is expected to have implications to the regulators, policy makers, shareholders, investors, academics, and some of the gatekeepers e.g., auditors and analysts.

1.2 Book Structure

This book is divided into five chapters. Chapter 1 provides an introduction and presents the structure that will be followed for the remaining parts of the book. Chapter 2 explains the definitions of earnings management and its specific characteristics compared to fraud, earnings quality, impression management, and expectation management. It presents the different activities of earnings management and how they might be traded off in addition to the models of measuring accrual and real earnings management. Finally, the chapter discusses some special issues in measuring earnings management including the combined models, the specific measures in the financial sector, and the qualitative measures.

Chapter 3 provides a brief description of the firm and agency theories. It discusses the revelation principle and the relevant theories to explain its conditions including contracting theory, bounded rationality theory, and information asymmetry theory. Finally, it presents the three main theoretical approaches of earnings management that include the costly contracting approach, the decision-making approach, and the legal-political approach.

Chapter 4 provides a comparison between earnings management and truth telling. It explains the contracting motives of earnings management that include management compensation, CEO turnover, managerial ability, corporate governance, and loans. It also presents the capital market motives of earnings management that consist of the effect of the stock market, issuance of equity, new listing and cross-listing, mergers and acquisitions, insider trading, management buyouts, meeting or beating a benchmark, and the role of analysts. Finally, the chapter discusses the third-party motives of earnings management including industry and industrial diversification, regulations, political environment and country-specific policies, accounting standards, tax considerations, competitors, suppliers and customers. Finally, Chap. 5 concludes this book by providing a summary of the main chapters.

References

Bagnoli, M., & Watts, S. G. (2000). The effect of relative performance evaluation on earnings management: A game-theoretic approach. Journal of Accounting and Public Policy, 19, 377–397.Crossref

Barth, M. E., Landsman, W. R., & Lang, M. H. (2008). International accounting standards and accounting quality. Journal of Accounting Research, 46, 467–498.Crossref

Boone, A. L., Field, L. C., Karpoff, J. M., & Raheja, C. G. (2004). The determinants of corporate board size and composition: An empirical analysis. AFA 2005 Philadelphia meeting. SSRN eLibrary. Available at http://​ssrn.​com/​abstract=​605762

Defond, M. L., & Francis, J. R. (2005). Audit research after Sarbanes-Oxley. Auditing: A Journal of Practice and Theory, 24, 5–30.

Demerjian, P. R., Lewis, M. F., & Mcvay, S. E. (2013). Managerial ability and earnings management. Working paper, Emory University.

Efendi, J., Srivastava, A., & Swanson, E. P. (2007). Why do corporate managers misstate financial statements? The role of option compensation and other factors. Journal of Financial Economics, 85, 667–708.Crossref

Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of Political Economy, 88, 288–307.Crossref

Fan, Q. (2007). Earnings management and ownership retention for initial public offering firms: Theory and evidence. The Accounting Review, 82, 27–64.Crossref

Giroux, G. (2004). Detecting earnings management. New Jersey: Wiley.

Godfrey, J., Mather, P., & Ramsay, A. (2003). Earnings and impression management in financial reports: The case of CEO changes. Abacus, 39, 95–123.Crossref

Goldman, E., & Slezak, S. L. (2006). An equilibrium model of incentive contracts in the presence of information manipulation. Journal of Financial Economics, 80, 603–626.Crossref

Harris, M., & Raviv, A. (1979). Optimal incentive contracts with imperfect information. Journal of Economic Theory, 20, 231–259.Crossref

Holmstrom, B., & Milgrom, P. (1987). Aggregation and linearity in the provision of intertemporal incentives. Econometrica, 55, 303–328.Crossref

Iatridis, G., & Kadorinis, G. (2009). Earnings management and firm financial motives: A financial investigation of UK listed firms. International Review of Financial Analysis, 18, 164–173.Crossref

Jiraporn, P., Kim, Y. S. & Mathur, I. (2006). Does corporate diversification exacerbate or mitigate earnings management? An empirical analysis. SSRN eLibrary. Available at http://​ssrn.​com/​abstract=​879803

Kothari, S. P. (2001). Capital markets research in accounting. Journal of Accounting and Economics, 31, 105–231.Crossref

Lang, M., Smith Raedy, J., & Wilson, W. (2006). Earnings management and cross listing: Are reconciled earnings comparable to US earnings? Journal of Accounting and Economics, 42, 255–283.Crossref

Laux, C., & Laux, V. (2009). Board committees, CEO compensation, and earnings management. The Accounting Review, 84, 869–891.Crossref

Milgrom, P. R., & Roberts, J. (1992). Economics, organization, and management. Englewood Cliffs, NJ: Prentice-Hall.

Ronen, J., & Yaari, V. (2008). Earnings management: Emerging insights in theory, practice, and research. New York: Springer Science and Business Media.

Strong, N., & Walker, M. (1987). Information and capital markets. Oxford: Basil Blackwell.

Walker, M. (2013). How far can we trust earnings numbers? What research tells us about earnings management. Accounting and Business Research, 43, 445–481.Crossref

Yu, F. (2008). Analyst coverage and earnings management. Journal of Financial Economics, 88, 245–271.Crossref

© Springer International Publishing AG 2018

Malek El Diri Introduction to Earnings Managementhttps://doi.org/10.1007/978-3-319-62686-4_2

2. Definitions, Activities, and Measurement of Earnings Management

Malek El Diri¹  

(1)

Accounting and Finance Division, Leeds University Business School, Leeds, UK

Malek El Diri

Email: [e-mail]

2.1 Introduction

This chapter starts by providing a summary of the definitions of earnings management in the literature and accordingly it suggests a four-stage process for a comprehensive definition of earnings management that includes its characteristics, conditions, activities, and targets. Following this approach, the chapter attempts to distinguish between earnings management and other concepts like fraud, earnings quality, impression management, and expectation management.

The chapter also explains the different methods of earnings management and how managers trade them off based on their different needs. It also discusses in detail the models to calculate the different activities of earnings management—particularly focuses on the measurement of accrual and real earnings management and evaluates each of the models introduced in this area. Finally, the chapter throws some light on special issues in measuring earnings management including the models that combine between more than one manipulation activity and the measurement of earnings management in the financial sector and qualitative research.

The remainder of this chapter is organized as follows. Section 2.2 explains the definitions of earnings management and its specific characteristics compared to fraud, earnings quality, impression management, and expectation management. Section 2.3 presents the different activities of earnings management and how they might be traded off. Section 2.4 explains the models of measuring accrual earnings management. Section 2.5 explains the models for measuring real earnings management. Section 2.6 discusses some special issues in measuring earnings management including the combined models, the specific measures in the financial sector, and the qualitative measures. Finally, Sect. 2.7 provides a conclusion to the chapter.

2.2 Definitions

In this section I discuss some of the most common definitions of earnings management in the literature. Afterwards, I introduce my own definition of earnings management taking into consideration some of the deficiencies in the previous definitions of the literature. Because earnings management has been frequently confused with other concepts like fraud, earnings quality, impression management, and expectation management, I also discuss each of these definitions separately and distinguish them from earnings management.

2.2.1 Earnings Management Definition

No single definition exists for earnings management in the literature. Researchers have provided different explanations that mainly define earnings management as the manipulation of financial reporting to achieve specific targets. I present here some of the most common definitions of earnings management in a chronological order. Schipper (1989, p. 92) focuses in her definition on the manipulation of external reporting to achieve private benefits like improving managers’ compensation whereby,

Earnings management means disclosure management in the sense of 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.

Healy and Wahlen (1999, p. 368) also focus on changing financial reporting to mislead the stakeholders and achieve contractual benefits where,

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

Mulford and Comiskey (2002, p. 3) emphasize management discretion to meet earnings targets which may be set by internal or external parties. In this sense, their definition of earnings management is as follows:

The active manipulation of earnings toward a predetermined target, which may be set by management, a forecast made by analysts, or an amount that is consistent with a smoother, more sustainable earnings stream.

Phillips et al. (2003, p. 493) provide a brief definition of earnings management that emphasizes the manipulation of accounting choices and operating cash flows as follows:

Managerial discretion over accounting choices and operating cash flows.

Giroux (2003, p. 280) also focuses on management discretion to achieve specific income targets. Therefore, he defines earnings management as:

The operating and discretionary accounting methods to adjust earnings to a desired outcome.

In his second definition, Giroux (2004, p. 2) emphasizes the incentives of management to manipulate earnings under different conditions and thus defines earnings management as follows:

The planning and control of the accounting and reporting system to meet the personal objectives of management.

Ronen and Yaari (2008, p. 5) provide a general definition for earnings management that focuses on the target of management to influence the interpretation of its reported earnings, whereby earnings management involves:

Deliberate actions to influence reported earnings and their interpretation.

However, Ronen and Yaari (2008, p. 27) later provide a comprehensive definition for earnings management that distinguishes between the two main activities to manipulate earnings—real vs. accrual—and shows that such activities are not necessarily bad all the times whereby,

Earnings management is a collection of managerial decisions that result in not reporting the true short-term, value-maximizing earnings as known to management. Earnings management can be beneficial: it signals long-term value; pernicious: it conceals short- or long-term value; neutral: it reveals the short-term true performance. The managed earnings result from taking production/investment actions before earnings are realized or making accounting choices that affect the earnings numbers and their interpretation after the true earnings are realized.

Finally, Walker (2013, p. 446) also emphasizes both the accrual and real earnings management in the following definition:

The use of managerial discretion over (within GAAP) accounting choices, earnings reporting choices, and real economic decisions to influence how underlying economic events are reflected in one or more measures of earnings.

While some of the previous definitions are brief, others might better explain the meaning of earnings management. Overall, they emphasize how managers manipulate their earnings. Among the different methods of manipulation, the literature emphasizes the treatment of accruals by using different accounting principles (Baber et al. 2011; Walker 2013), real economic decisions that influence cash flows (Graham et al. 2005; Roychowdhury 2006), smoothing earnings to decrease their volatility over time (Coffee 2003; Graham et al. 2005; Walker 2013), shifting the classification of some items in the financial statements (McVay 2006; Athanasakou et al. 2009; Barua et al. 2010; Walker 2013), and other advanced methods like using derivatives and special purpose entities (Giroux 2004; Petrovits 2006; Feng et al. 2009). I will discuss these activities in detail in the next section of this chapter.

The previous definitions have also emphasized the motives that drive managers to manage earnings. There are different incentives of earnings management at the contracting level like compensation (Healy 1985; Jensen and Murphy 1990; Dechow and Huson 1994; Laux and Laux 2009),