Misvaluation and Insider Trading Incentives for Accrual‐based and Real Earnings Management

We investigate the incentives that misvaluation creates for: (1) insider trading; and (2) concurrent earnings management through both accruals and real activities. Managers of overvalued firms have an incentive to sustain overvaluation through income increasing earnings management and, at the same time, to sell their shares (Jensen, 2005 ). Managers of undervalued firms benefit from buying their firm's shares, however the negative effects of downward earnings management may offset incentives to enhance trading advantages. The results indicate that managers of both over‐ and under‐valued firms act opportunistically, managing earnings upward (downward) with accruals while selling (buying) shares. The Sarbanes‐Oxley Act of 2002 (SOX) has been largely ineffective in eliminating trading motivated earnings management. Finally, we do not find evidence of a relationship between managerial trading and real earnings management.     

Accruals Management to Avoid Losses

This study examines whether firms engage in accruals management to beat the zero earnings benchmark from the perspective of earnings per share (EPS). Based on net income scaled by lagged market value of equity (E/MV) to define just‐miss and just‐beat test bins, previous studies provide no or inconclusive evidence of accruals management to beat the zero earnings benchmark. I conjecture that because managers focus on shares scaled earnings performance rather than market value scaled earnings performance, forming test bins based on EPS instead of E/MV is a better approach to detect accruals management. As expected, I find evidence of accruals management to beat the zero EPS benchmark. I also find that firms are more likely to manipulate accruals when managers have stronger incentives to beat the zero EPS benchmark. In addition, accruals of firms just beating the zero EPS benchmark are more likely to reverse the next year, resulting in relatively lower future earnings for firms just beating the benchmark compared with firms just missing the benchmark.     

Is ‘benchmark beating’ by Australian firms evidence of earnings management?

We investigate the extent to which Australian firms that report small profits and/or small increases in earnings (i.e. benchmark beaters) have done so by the upward manipulation of these earnings. Although evidence of an unusually large number of firms managing to just beat such earnings benchmarks has been interpreted as evidence of earnings management, this approach fails to identify those firms that are the manipulators from those where unbiased earnings fall naturally into the benchmark beating group. Our results suggest that caution is required in interpreting benchmark beating as an indicator of the extent of earnings management. Using several methods for estimating the unexpected accrual component of earnings, we show that although benchmark beaters have larger positive unexpected accruals than other firms, a similar result holds when firms with small losses or earnings declines (i.e. ‘just miss’ firms) are compared with other firms. Moreover, there is no statistically significant difference between unexpected accruals for the benchmark beating and just miss groups. At a minimum, we reject the joint hypothesis that unexpected accruals capture earnings management and that an unusual kink around zero in the distribution of earnings levels or earnings changes is caused by earnings management.     

Use of benchmarks in predicting earnings management?

This study conducts multiple approaches to identify whether earnings benchmarks are an indicator for earnings management within the Australian market. We investigate firms reporting small positive earnings and small positive earnings changes, referred to as benchmark beaters. Accrual quality models, earnings distributions and earnings persistence measures are applied to identify whether benchmark beating firms are manipulating earnings. Our findings suggest that the small positive earnings benchmark attracts earnings managers. However, we do not identify any evidence to indicate that the positive earnings change benchmark is a signal for earnings management.     

Meeting or Missing Earnings Benchmarks: The Role of CEO Integrity

This paper examines the role of CEO integrity in determining whether a company's earnings benchmarks will be met, beaten or missed. Prior literature provides evidence that managers have incentives for meeting or beating earnings benchmarks and are rewarded by the market for doing so (Lopez and Rees, 2002; and Skinner and Sloan, 2002). Managers also have incentives to miss their earnings targets for the benefit of a lower strike price on subsequent option grants (McAnally et al., 2008). A CEO's involvement in backdating is taken here as a measure of his or her integrity. This paper shows that CEO integrity significantly influences whether benchmarks are met or beaten. In other words, backdating CEOs are more likely to meet or narrowly beat all three earnings benchmarks examined in the paper: positive earnings, last year's earnings and analysts’ forecasts. At the same time, they are also less likely to narrowly miss a zero‐earnings benchmark. The results presented in this paper further validate the use of benchmark meeting/beating as a measure of earnings manipulation.     

The effect of alternative goals on earnings management studies: An earnings benchmark examination

Firms’ management manages earnings because they have incentives or goals to do so. Earnings management studies have to account for these different goals as tests of earnings management can be compromised by the effect of conflicting goals. I illustrate this in the setting of Dechow et al. (2003). Their study examines whether firms with small profits and firms with small losses (loss-avoidance benchmark) have differing levels of discretionary accruals. Dechow et al. (2003) find that firms just above the loss-avoidance benchmark do not have discretionary accruals that are significantly different than firms just below the benchmark. However, they do not consider firms just below the loss-avoidance benchmark that might be using discretionary accruals to avoid missing an alternative benchmark. I find that after I consider these alternate earnings benchmark goals, firms just above the benchmark have significantly higher discretionary accruals. This provides direct evidence that the ‘kink’ in the distribution of earnings arises from earnings management. I find similar results for the earnings changes benchmark. These findings highlight the need to consider alternative earnings benchmark goals when examining firms immediately around benchmarks.     

An analysis of the reasons for the asymmetries surrounding earnings benchmarks

Several studies report an asymmetry in the distribution of earnings around specified benchmarks. However, doubt has arisen over whether the observed ‘kink’ in the distribution of earnings is solely caused by earnings management. We use a ratio analysis approach to examine a range of specific accruals for evidence of earnings management. We find little evidence that firms immediately above the benchmark have abnormal receivables, inventories or provisions. However, they do increase cash‐from‐customers and reduce inventory. Thus, our results support the recent research that suggests that firms engage in real actions to meet earnings benchmarks.     

Corporate Life Cycle and Earnings Benchmarks

We examine whether and how corporate life cycle significantly influences meeting or beating earnings benchmarks (MBE). We find that corporate life cycle plays a significant role in a firm's meeting or beating earnings benchmarks behaviour. Developing strategies that fit into the stage of corporate life cycle is crucial for corporate success. MBE is an important financial goal that requires strategies. In this study, we examine whether and how corporate life cycle significantly influences MBE. Specifically, we focus on the incentives of MBE in growth and mature firms. We find that corporate life cycle significantly influences a firm's tendency to meet or beat zero earnings, prior earnings and analysts’ earnings forecasts. Based on logit regressions for the period from 1988 to 2008, the results indicate that growth firms are more likely to meet or beat all three earnings benchmarks. Overall, the results of this study indicate that a firm's MBE behaviour should be examined in the context of its life cycle stage.     

Corporate investment and earnings surprises

ABSTRACT

We find that firm-level investment is negatively related to the likelihood of meeting or beating analysts’ short-term EPS forecasts. In a 35-year panel dataset of US based companies, we find evidence that suggests firms with the best growth opportunities, opaque firms, and firms with higher than usual bonus compensation, are the ones to alter investment in order to beat benchmarks. Utilizing the passage of Sarbanes-Oxley as a natural experiment we find that firms trade off accruals-based earnings management in lieu of investment cuts. Results are robust to a number of covariates, and endogeneity or reverse causality does not seem to drive our inferences. This study suggests that, consistent with survey results from Graham, Harvey, and Rajgopal [2005. “The Economic Implications of Corporate Financial Reporting.” Journal of Accounting and Economics 40: 3–73], managers may reduce or delay corporate investment to meet or beat short-term earnings benchmarks.     

On-market share buybacks, exercisable share options and earnings management

Chan et al. (2006b ) suggest that managers might announce a share buyback to manipulate investors’ perceptions and capitalize on the positive price reaction usually associated with the announcement. The incentive to do so is greater when managers have exercisable options. Prior studies document that managers engage in upwards earnings management for opportunistic reasons related to option holdings (Bergstresser and Philippon, 2006). We examine the association between earnings management and exercisable option holdings for buyback firms to investigate if earnings management in the pre‐buyback period is greater for firms with equity incentives to increase share price. Our results, using 138 buybacks over the period 1996–2003, support our prediction. We find that buyback firms with both exercisable options that are in‐the‐money prior to the buyback announcement as well as options that are exercised in the buyback period have higher discretionary current accruals than buyback firms with no exercisable options, unexercised options or with out‐of‐the‐money options. Overall, our results are consistent with buyback firms with exercisable options using earnings management and buyback announcements to maximize option payoffs, and buyback firms without exercisable options signalling undervaluation.     

Duration of equity overvaluation and managers’ choice to use aggressive underlying earnings disclosure and accrual-based earnings management: Australian evidence

This paper examines whether equity overvaluation duration influences managers’ choice of different earnings management mechanisms and how corporate governance and the Australian Securities and Investment Commission’s underlying earnings disclosure guidelines influence managers’ choices. The study samples Australian Securities Exchange 200 firms from 2009 to 2016. Findings show that on average, firms more likely engage in accrual-based earnings management in the early overvaluation stage. In later stages, firms more likely disclose underlying earnings aggressively to sustain overvaluation. Additionally, firms with a high proportion of independent directors on the board prefer to disclose underlying earnings aggressively to sustain the equity overvaluation; firms with a low proportion of independent directors prefer both accrual-based earnings management and aggressive underlying earnings disclosure to sustain the overvaluation. Moreover, firms that conform to the Commission’s underlying earnings disclosure guidelines use neither accrual-based earnings management nor aggressive underlying earnings disclosure to sustain overvaluation, but non-conforming firms use both mechanisms.     

Accruals Management to Achieve Earnings Benchmarks: A Comparison of Pre-managed Profit and Loss Firms

Abstract:  This study examines whether firms with profits before accruals management are more likely than firms with losses before accruals management to meet or exceed earnings benchmarks when pre-managed earnings are below those benchmarks. We extend Brown (2001) by documenting that the differential propensity to achieve earnings benchmarks by profitable and nonprofitable firms results from differential accruals management behavior. We find that firms with profits before accruals management are more likely than firms with losses before accruals management to have pre-managed earnings below both analysts' forecasts and prior period earnings and reported earnings above these benchmarks.     

Firm Accrual Quality Following Restatements: A Signaling View

We consider whether and how firms improve their financial reporting credibility following a restatement by comparing two alternative views. The compliance view predicts that firms simply correct errors to comply with regulations; the signaling view predicts that improvements are broader to allow firms to signal higher reporting quality and thereby reduce information uncertainty. We find that accrual quality improves significantly following the restatement and that this improvement is observed for both earnings and non‐earnings error restatements. We also find that the extent of real earnings’ management decreases significantly. Further, we find that improvements in accrual quality are higher for firms with CEO turnover and higher incentives to improve, but lower for firms switching to an auditor of lower quality. Collectively, our findings suggest that firms signal improved reporting credibility following a restatement through higher accruals quality and lower real earnings management.     

Product market competition and earnings management: A firm‐level analysis

In this paper, we employ a firm‐level measure of product market competition constructed from the textual analysis of firms’ 10‐K filings to examine the relationship between managers’ perceived competition pressure and earnings management. We find that accounting irregularities and accrual‐based earnings management are positively related to product market competition. This finding is consistent with the notion that competition pressure increases managerial incentives to manage earnings, due to their career concerns. We also find that real earnings management is negatively related to product market competition. This finding suggests that real earnings management involves actions that decrease firms’ competitiveness and thus is costly for firms confronted with high competition pressure.     

The association between non-financial performance measures in executive compensation contracts and earnings management

Executive compensation, especially cash bonus compensation, has come under fire by the Securities and Exchange Commission (SEC), the US Federal government, and the media for its role in the current economic crisis. Specifically, the SEC has argued that some compensation packages provide incentives for risk-taking that may undermine shareholder value over the long-term. Short-term incentive payments to executives in the form of cash bonuses are mostly contingent on reaching targets of accounting-related measures or financial performance measures (FPMs). However, the incentives from these payments may lead to accrual manipulation and earnings management (EM). Alternative measures are non-financial performance measures (NFPMs). We expect that firms that employ NFPMs in bonus contracts will have a lower prevalence of EM, since these measures tend to focus executives on the long-term. In this paper, we examine the type of performance measures used by firms in the S&;P 500 index in their cash bonus compensation. We find that firms that use both FPMs and NFPMs have lower discretionary accruals compared to firms that use only FPMs, consistent with lower income-increasing EM. However, we do not find evidence of a reduction in EM behavior using the incidence of meeting or just beating analyst earnings benchmarks, another common EM proxy. In additional tests on a subset of firms with equity offerings, in which incentives for income-increasing manipulation are likely high, we find that firms with NFPMs have lower discretionary accruals. The implication is that NFPMs can be used in compensation contracts to reduce EM behavior and mitigate erroneous executive compensation. This is important to investors as well as regulators, especially in light of the recent debate on compensation reform.     

Earnings Management During Antidumping Investigations in Europe: Sample‐Wide and Cross‐Sectional Evidence

This paper examines earnings management by EU firms that initiate an antidumping investigation. We first document economically and statistically significant income‐decreasing earnings management around the initiation of an antidumping investigation. We show that earnings management increases when accounting data directly affect the magnitude of the tariffs imposed in the trade investigation. We also find that earnings management decreases as the number of petitioning firms increases or as the distance between petitioning firms increases, suggesting free‐rider and coordination problems. We find that earnings management increases when the petition is directed at a country that imports more goods from the petitioning firm's home country, suggesting that retaliation threats affect incentives. We document that raising equity or debt financing moderates income‐decreasing earnings management, consistent with the idea that sample firms trade off capital market and regulatory considerations. Our results indicate that contemporary research methods can detect accruals‐based earnings management in settings in which the incentives for earnings management can be clearly identified.     

Earnings benchmark hierarchy

We examine the hierarchy of earnings benchmarks in Australia. Our results demonstrate a disconnect between the actions managers appear to take and the market reaction to firms exceeding or just missing earnings benchmarks. The actions of managers appear consistent with them acting in a manner to avoid making losses and earnings decreases. On the other hand, the market reacts in a manner where the analysts’ earnings forecast is at the top of the earnings benchmark hierarchy. However, for firms without analyst coverage, the reporting of positive earnings is the predominant earnings benchmark.     

Quarterly earnings guidance and real earnings management

We examine if quarterly earnings guidance induces real earnings management. Quarterly guidance may cause myopia and inefficient decision-making, if managers become overly concerned with setting and beating short-term earnings targets. We test these associations on a large sample of US firms. Our evidence suggests that quarterly guidance is informative and lowers myopic incentives. However, our analyses also reveal endogenous associations exist between guidance and real earnings management. In contrast with existing concerns over frequent guiders, we find that guidance appears problematic in infrequent guiders, and in firms that issue good news earnings guidance and that operate in settings where earnings pressures are high.     

Do managers manage earnings to ‘just meet or beat’ analyst forecasts?: Evidence from Australia

This paper examines whether managers manage earnings to ‘just meet or beat’ analyst forecasts in Australia. Previous Australian studies on benchmark-beating have focused on loss avoidance and small earnings increases as benchmarks [Coulton, J., Taylor, S., & Taylor, S. (2005). Is ‘benchmark beating’ by Australian firms evidence of earnings management? Accounting and Finance, 45, 553-576; Holland, D., & Ramsay, A. (2003). Do Australian companies manage earnings to meet simple earnings benchmarks? Accounting and Finance, 43, 41-62]. This paper extends this earlier research on benchmark-beating in Australia by incorporating analyst forecast as an important benchmark. Using three different models of unexpected accruals as proxies for earnings management, this study did not find any significant difference between the mean and median unexpected accruals of the “‘just meet or beat” group as against the “just miss” group. Furthermore, for a long period of time (1997-2002), the proportion of Australian firms ‘just meeting or beating’ analyst forecasts benchmark increased, although such increase was not statistically significant.     

Earnings quality and short selling: Evidence from real earnings management in the United States

Prior research provides evidence consistent with managers using real earnings management (REM) to increase earnings. This study examines whether short sellers exploit the overvaluation of firms employing REM. I find that firms with more REM have higher subsequent short interest. The positive relation between REM and short interest is more pronounced in settings where the costs associated with accrual‐based earnings management are high, such as when a firm has low accounting flexibility or faces greater scrutiny from a high quality auditor. I also find some evidence that short sellers respond to REM more than to other fundamental signals of firm overvaluation. My inferences are robust to the use of propensity score matching. Collectively, my evidence suggests that short sellers not only trade on REM information, but they also trade as if they understand the substitutive nature of alternative earnings management methods. This study provides additional insight into the important role that short sellers play in monitoring managerial operating decisions and overall earnings quality.