The Construct Surrounding Earnings Management - Literature review Example

Literature Review The construct surrounding earnings management Earnings management was defined as ‘actions by division managers which serve to increase (decrease) current reported earnings of a division without a corresponding increase (decrease) of the long-term economic profitability of the division’ (Fischer & Rosensweig, 1995 quoted in Farag & Elias, 2012, p.185). While such actions are not per se specifically violative of the Generally Accepted Accounting Principles (GAAP), they may impact adversely on the accuracy of the information that may be drawn from financial statements. Two important elements that are identified by the definition are inextricably linked to the concept of earnings management – specifically, consequences and intent (Farag & Elias, 2012). The necessary outcome of the actions is that the parties relying on the standards financial analysis procedures to gain information from the financial statements are misled as a direct consequence of these actions. The actions are also motivated by the clear intent by management to portray the business in a more favorable light, in a manner that is contrary to the moral or ethical standards to which the business management and the accounting professionals involved should be held. Actions constituting earnings management There are two types of intentional misstatements which are significant in the auditor’s assessment of fraud. These are (1) misstatements that arise from fraudulent financial reporting, and (2) misstatements that arise from the misappropriation of assets (also known as defalcation). Classified under the first type are those intentionally false and misleading statements, or the omissions of amounts or disclosures that should be included in financial statements. Included in the second type are acts that constitute theft of an entity’s assets which are attended with misrepresentation thereof in the financial statements. Misappropriation of assets include such acts as ‘embezzling receipts, stealing assets, or causing an entity to pay for goods or services not received’ (Public Oversight Board, 2002). There are situations where a fine line may be drawn between earnings management motivated by a desire to mislead or misrepresent, and a legitimate resort to management prerogative is being made. As noted by the official document from the Public Oversight Board (2002), in par. 3.10: Many of the factors cited in SAS No. 82 are subjective and difficult to assess, and risk factors may exist in circumstances where fraud does not exist. Even when risk factors are present and the auditor’s response to them is not definitively prescribed by the standard, SAS No. 82 states that ‘the auditor’s judgment may be that audit procedures otherwise planned are sufficient to respond to the risk factors.’” (p.76). Thus it is important to assess whether the actions that may be attribute to earnings management are actually motivated by the intent to defraud, mislead or misrepresent. In this matter, the auditor is admonished to exercise professional skepticism as the general standard of due professional care. This means ‘having an attitude that includes a questioning mind and a critical assessment of audit evidence’ (par. 3.8, p. 76). The standard requires the auditor to take a position that does not assume the management is dishonest on the one extreme, nor that the management possesses unquestioned honesty on the other, but that the auditor should be persuaded by the evidence unearthed by his or her investigation (Public Oversight Board, 2002).. The motivation behind earnings management The foregoing definition notwithstanding, some authors defend some of the actions of corporate management by distinguishing between ‘good earnings management’ from ‘bad earnings management’ (Farag & Elias, 2012, p. 187). Ostensibly, good earnings management are legitimate business decisions which effectively stabilized the financial performance of the company, while bad earnings management are violations of the GAAP. Good earnings management were also seen as operating manipulations, and were differentiated from bad earnings management which were viewed as accounting manipulations; the former is taken to be more ethical than the latter (Farag & Elias, 2012). There are a number of reasons why managers would wish to resort to earnings management to create the impression that the company is doing better than it actually is. One reason is to avoid sudden tax increases due to tax rates being raised (Lee & Swenson, 2011). Another is that certain investors rely on simple heuristics (i.e., experience-based assessment in contrast to indepth analysis) when they evaluate firm performance, and because they are risk-averse they tend to be more sensitive to reports of losses than of gains, no matter how slight (Barua, et al., 2010). Companies also experience market rewards for exceeding financial benchmarks; for instance, firms that consistently report higher than previous year’s earnings have higher price-earnings multiples than firms that do not, for which reason they have a lower cost of equity (Jiang, 2008). Devices in carrying out earnings management There are a number of methods by which management may exercise earnings management, a few of which are through discretionary expenditure, discontinued operations, the use of real activities and of asset restructuring. A few of them which have been the subject of academic studies are described here for illustrative purposes. Earnings management through discretionary expenditure is undertaken when management accelerates the reporting of discretionary deductions that have income-reducing expenses, with the intention of lowering taxes. Discretionary real expenditures include research and development (R&D) expenditures, selling, general and administrative expenses (SG&A), and advertising expenditures, among others. According to the study by Lee & Swenson (2011), empirical evidence suggest that income taxes have a strong incentive effect in financial reporting, and that when statutory tax rates are raised in a year, the firms react by accelerating expenses into that year in order to take advantage of their beneficial tax effects. This observation is most evident in the U.S. and Canada, although it may have policy implications for other countries as well. The study obtained financial data from the Compustat Global for all U.S., Canadian, Hong Kong, Korean, Japanese and Taiwanese firms from 1990 to 2007, and used the Jones model as modified by Kothari, et al. (2005). The model uses regression analysis and derives abnormal accruals as residuals (Lee & Swenson, 2011). Barua, Lin and Sharaglia (2010) conducted an academic investigation concerning earnings management using discontinued operations. Their study set out to determine whether managers used classification shifting to manage earnings in the course of reporting discontinued operations. Prior literature has established the firms manage earnings to meet or beat three earnings benchmarks, namely zero earnings, prior year’s earnings, and analysts’ forecasts. Results from discontinued operations are typically reported at a point on the income statement lower than special items, and managers have a greater incentive to shift expenses to this classification. Doing so has the effect of increasing core earnings, operating income, and income from continued operations – items on the financial report which many investors believe to be good indicators of corporate performance. Discontinued operations are not given as much attention from investors, auditors and regulators than the special items. Furthermore, discontinued operations appear on the income statement in aggregated form which imposes a level of information asymmetry between managers and investors. In this study, the sample used was comprised of data from the 2007 Annual Compustat and I/B/E/S Summary files, for the years 1989 to 2005. The method of analysis followed McVay (2006), using regression to measure core earnings, expected core earnings, unexpected core earnings, and unexpected change in core earnings, where core earnings are defined as operating earnings before depreciation and special items, scaled by revenue. To infer classification shifting, the study tested for positive association between unexpected core earnings and discontinued operations for the same year. While the study found out that managers do resort to classification shifting, the frequency at which this is done has declined since SFAS No. 144 and the Sarbanes-Oxley Act were introduced (Barua, et al., 2010). There have also been evidence gathered on earnings management using real activities. In the study by Eldenburg, Gunny, Hee and Soderstrom (2011), activities across 432 nonprofit hospital years in California, for the period 1998 to 2003. Data included detailed expenditures at department level in order to identify those instances when managers were engaged in real activity management, and in which areas these occurred. Using this method, the researchers were able to obtain insight to the extent to which managers altered firm operations to attain specific income benchmarks. The study employed descriptive statistics, and regression and sensitivity analyses for statistical inference. The dependent variable was change in non-operating or non-revenue-generating activity expenditure, while independent variables included dummy variable decrease, increase, and nopred to indicate whether the projected income was below or above benchmark range, or if projected income was below benchmark range by an amount greater than prior year expenditure in that category, respectively. Other explanatory variables were logarithm of total assets, change in sales, and year, a dummy variable indicating the year of the sample. The study concluded that managers in nonprofit hospital settings have great incentive to avoid high levels of net income to decrease the probability of scrutiny by government and other stakeholders. Managers are able to avoid large positive net incomes by management of asset dispositions, while in cases where the hospital has a stronger incentive to manage earnings upwards, this is achieved by large reductions in expenditures in non-revenue-generating and non-operating activities (Eldenburg, et al., 2011). The degree to which earnings management using asset restructuring has been explored by the study of Cheng, Aerts and Jorissen (2010), which observed the effects of a 2001 revision in the China revising the listing standards and requiring compulsory stock suspension for firms reporting three-year consecutive losses. The suspended stock faced delisting if it reports losses during the year of suspension, thereby putting pressure on the company to report gains on that year. Earnings management activities were found by empirical evidence to increase with the severity of losses and decline with asset restructuring activities, suggesting a negative relationship between earnings management and asset restructuring. The study sampled consecutive loss firms which were listed on domestic Chinese exchanges (Shanghai and Shenzhen). The sample of 130 firms were segregated into three groups, the first group consisting of 81 non-financial firms which reported bottom-line losses for two consecutive years or longer and were therefore under threat of delisting under the new regulation. The second group was composed of 28 firms which were suspended due solely to the two-year consecutive losses regulation, but which eventually resumed stock trading. The last group include 21 sample firms that reported losses in three or four consecutive years and which have been eventually delisted from the exchange. Earnings management measurement was undertaken by accruals management measure, real earnings management measure, and measurement of asset restructuring. The descriptive and empirical models used were the earnings management around loss reversals, and regression models with dependent variables earnings management and asset restructuring, and independent variables as firm size, leverage, sales growth, service dummy, suspension status dummies and controlling ownership. The study concluded that contrary to widely held expectations, there was only minor evidence that suspended firms with three-year losses (i.e., for which delisting was a more tangible threat) used more earnings management than the firms which were only in their second year of reported losses. Firms with decreased sales used less accruals management than real earnings management, because it was not always feasible to manage earnings for severe loss firms with substantially reduced operations. Theoretical Framework The foregoing brief review suggested a wide range of approaches and measures for the study of earnings management to provide direction for policy implications. An integrated framework is suggested by Yaping (2007) in the diagram presented in the following page. The framework suggests a typology of earnings manipulation practices which could impose some order in the description of different activities that are attributed to earnings management. The study quite pragmatically draws attention to the ambiguity of earnings management in academic literature. There is a need to more precisely define earnings management, within the continuum of ‘good’ earnings management which is positive and used by firms as a strategic tool, and ‘bad’ earnings management which employs earnings manipulation, earnings fraud, misrepresentation and misinformation. 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