Forecasts in IPO Prospectuses: The Effect of Corporate Governance on Earnings Management

Prior research suggests that managers may use earnings management to meet voluntary earnings forecasts. We document the extent of earnings management undertaken within Canadian Initial Public Offerings (IPOs) and study the extent to which companies with better corporate governance systems are less likely to use earnings management to achieve their earnings forecasts. In addition, we test other factors that differentiate forecasting from non‐forecasting firms, and assess the impact of forecasting and corporate governance on future cash flow prediction. We find that firms with better corporate governance are less likely to include a voluntary earnings forecast in their IPO prospectus. In addition, we find that while IPO firms use accruals management to meet forecasts; the informativeness of the discretionary accruals depends on whether or not the firm would have missed its forecast without the use of discretionary accruals.     

Accrual usage to manage earnings toward financial analysts' forecasts

This study examines whether management uses discretionary accounting accruals to move earnings upward toward analysts' earnings forecasts when it appears that earnings before discretionary accruals will fall short of the forecast. An earnings shortfall relative to analysts' forecasts could lead management to fear lower compensation and an increase in the likelihood of job termination. The article finds that firms whose earnings before discretionary accruals are below analysts' forecasts use income-increasing discretionary accruals and do so to a greater extent than do firms whose earnings before discretionary accruals are above analysts' forecasts.     

Internal governance structures and earnings management

This paper investigates the role of a firm's internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross‐sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non‐executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee.     

The impact of audit quality on real and accrual earnings management around IPOs

We examine the relation between audit quality and the earnings management activities of IPO firms. The impact of high quality auditors on real earnings management has been researched in a number of settings e.g. SEOs. However, to date, there has been no work on the effect of high quality auditors on real activities-based manipulation around IPOs. We examine UK IPOs between 1998 and 2008 and find evidence that high quality auditors constrain the use of real activities manipulation that occurs via the management of discretionary expenses. We also find evidence, consistent with prior research, that high quality auditors constrain the manipulation of discretionary accruals. Crucially, we find IPO firms audited by high quality auditors undertake sales-based manipulation in order to manage earnings upward at the end of the IPO year. The presence of high quality auditors is not, therefore, sufficient to constrain all forms of earnings management.     

Earnings management in the pre-IPO process: Biases and predictors

We analyze a sample of 3,293 IPOs from 29 countries to investigate the firm, industry, and country characteristics related to earnings management during the IPO process. We find that IPO firms tend to have significantly positive discretionary accruals (DCA) both prior to and after the IPO, suggesting that IPO firms tend to engage in pre-IPO earnings management. However, we also find that using a proxy for earnings management in the IPO year may lead to biased conclusions concerning pre-IPO earnings management. Firms that are more likely to need access to capital markets in the future (firms with high leverage, and firms backed by a venture capitalist) are less likely to engage in pre-IPO earnings management. Firms operating in countries with a superior rule of law are also less likely to engage in earnings management. Lastly, we find that firms may engage in pre-IPO earnings management in part to avoid returning to the capital markets to raise more funds (capital market staging). This result is robust to possible endogeneity bias stemming from management self-selection.     

Institutional investor type,earnings management and benchmark beaters

This paper classifies institutional investors into transient or long-term by their investment horizons to examine the association between institutional investor type and firms’ discretionary earnings management strategies in two mutually exclusive settings – firms that (do not) use accruals to meet/beat earnings targets. The results support the view that long-term institutional investors constrain accruals management among firms that manage earnings to meet/beat earnings benchmarks. This suggests long-term institutional investors can mitigate aggressive earnings management among these firms. Transient institutional ownership is not systematically associated with aggressive earnings management and is evident only among firms that manage earnings to meet/beat their earnings benchmarks. This indicates transient institution-associated managerial myopia may not be as prevalent as posited by critics. This study highlights the importance of explicitly considering the type of institutional investor and the specific setting when investigating the association between institutional ownership and corporate earnings management.     

Earnings management of seasoned equity offering firms in Korea

We investigated 249 Korean seasoned equity offering (SEO) firms during the period 1995-1997 to determine if the SEO firms manage earnings in the year before a planned issue of seasoned equity stocks. Using three test methods (accrual difference, correlation, and sign-change), we found that the Korean firms contemplating SEOs in the following year do manage earnings particularly when their relative performances have been poor. The results are robust irrespective of control samples. Analysis of operating performances around SEOs shows that SEO firms tend to increase reported earnings in the year immediately preceding and the year of SEOs, but no differences were found in operating cash flows between the SEO firms and the control firms. By using a regression analysis for discretionary accruals, we found that SEO firms are more likely to manage earnings if the operating performances are poor and if the offer sizes are relatively large. Association tests between stock returns and discretionary accruals indicate that the market reacts positively to net income but negatively to discretionary accruals. The results indicate that the market correctly analyzes the cash flow implications of the SEO firms' opportunistic use of discretionary accruals.     

Debt,diversification and earnings management

In this article we use panel-estimation techniques to calculate discretionary accruals (DAC) and to produce a better understanding of the nature of the relation between debt and earnings management. Consistent with the transparency hypothesis (which suggests that diversification increases the complexity of firms’ activities and reduces their transparency to outsiders), we find that for less-diversified (more transparent) firms, debt reduces positive discretionary accruals, whereas in relatively more-diversified (less transparent) firms the impact of debt becomes positive. Our paper shows that marginal increases in debt provide the incentives for managers to manipulate earnings, and diversification provides the needed context for this accounting practice to be possible. We have also found that only in the sub-sample of aggressive firms, those that manage discretionary accruals with enough magnitude to increase income, do lenders exert their control. Some firms, however, take advantage of diversification to avoid this control. Our findings are robust to several earnings-management measures and methodologies.     

Predictive versus opportunistic earnings management,executive compensation,and firm performance

We examine the association between earnings management and an important component of corporate governance, the incentives provided through compensation. We argue that firms with predictive (opportunistic) earnings management, in which discretionary accruals do (do not) relate to future cash flows, provide a more (less) ideal setting for the use of compensation as incentives. Our empirical tests show that CEO compensation levels (measured by salary, bonus, and other forms of compensation) are positively related to predictive earnings management and negatively related to opportunistic earnings management. We also find that predictive earnings management is positively associated with future returns, whereas opportunistic earnings management is negatively associated with future returns. Overall, our results suggest that firms provide more incentives if their earnings are also more informative because of discretionary accruals.     

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.     

Cash from operations and earnings management in Korea

Our study investigates the relationship between the operating performances of Korean industrial firms and the behavior of discretionary accruals during the period 1994-1997. We hypothesize that the degree of earnings management will depend on the firm operating performances. We construct 10 “cash from operations (CFO)” portfolios to test if there are systematic differences in discretionary accruals across portfolios.Four test methods (a mean accrual test, a correlation test, a regression analysis, and a sign-change test) are used to investigate if operating performances affect discretionary accruals differently. We compare three accrual estimation approaches (two discretionary accruals and total accruals) in testing the earnings management hypotheses.The results support the hypothesis that Korean industrial firms manage earnings. When operating performance is poor, the firms tend to choose income-increasing strategies. In addition, when operating performance is extremely poor, some firms tend to take a big bath, while some of the exceptionally well-performing firms tend to select income-decreasing strategies.     

The incidence of earnings management on information asymmetry in an uncertain environment: Some Canadian evidence

In this study, we investigate the association between earnings management and information asymmetry considering environmental uncertainty. Results show that a complex and dynamic environment weakens the relationship between discretionary accruals and information asymmetry measured as share price volatility and bid-ask spread. More specifically, the positive relationship between earnings management and information asymmetry is weakened for diversified firms, those intensively investing in R&D, and those facing high sales volatility. This highlights the difficulty for investors to assess earnings management in an uncertain environment. Finally, in such a context, discretionary accruals are more likely to be detected by investors for firms cross-listed on a U.S. stock exchange, a more liquid and transparent stock market compared with the Canadian stock market.     

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.     

Financial crisis,GDP variation and earnings management in Europe

The purpose of this study is to examine the consequences of the financial crisis on the European companies’ in conjunction with earnings management practice. It focuses on financially distressed companies that audited by a big 4 auditor during recession years. The study makes use of discretionary accruals as a proxy for earnings management and studies the influence of big 4 auditor, in order to shed more light on possible causes for shifting earnings. The findings of the study provide evidence that financially distressed companies that audited by a big 4 auditor exhibit lower discretionary accruals. The results reveal that Greek and Spanish companies reduce earnings management manipulation during recession. In contrast, Portuguese, Irish and Italian companies show mixed results. They tend to reduce earnings management practices, but there are reasons that influence managers’ behavior to increase earnings management. The findings of this study can be useful for both investors and standard setting authorities.     

Earnings management and initial public offerings: Evidence from the Netherlands

This paper presents one of the first studies of earnings management by initial public offering (IPO) firms in a European country. Using a sample of 64 Dutch IPOs, we investigate the pattern of discretionary current accruals (DCA) over time. We find that managers manage their company's earnings in the first year as a public company but not in the years before the IPO. We also examine the impact of earnings management on the long-run stock price performance of IPOs. We find a negative relation between the size of the DCA in the first year as a public company and long-run stock price performance over the next 3 years. A number of additional tests support these findings.     

Executive compensation and earnings management: Empirical evidence from Japan

This study investigates the relation between discretionary accounting choices and executive compensation in Japanese firms. The results show that the use of discretionary accruals increases executive compensation. The analyses also show that firm managers receiving no bonus adopt income-decreasing accruals and extraordinary items. In particular, evidence shows that negative extraordinary items are strongly associated with no bonus payment. Finally, the research indicates that the association between discretionary accruals and executive bonus varies depending upon the circumstances of the firm. This study contributes to the literature on earnings management from an international comparative perspective since most previous studies on earnings management and executive compensation have focused on U.S. firms.     

Earnings management following chief executive officer changes: the effect of contemporaneous chairperson and chief financial officer appointments

Using a sample of listed Australian firms from 1999 to 2007, we examine the relationship between discretionary accruals and concurrent senior management appointments. Employing panel data regression models and focusing on a measure of discretionary accruals that excludes the effect of transparent write‐downs such as restructuring charges, we find that chief executive officer (CEO) appointments, as a general phenomenon, are not significantly associated with opaque earnings management in the year of appointment or the following year. However, we find that CEO changes accompanied by a concurrent change in board chairperson are associated with significant income‐decreasing earnings management in the year of appointment. We detect no significant relationship between contemporaneous CEO and chief financial officer changes and discretionary accruals. We find no evidence of earnings management in the first compete financial period following CEO appointment, regardless of whether or not concurrent Chair or chief financial officer appointments occurred.     

Market perceptions of discretionary accruals by debt renegotiating firms during economic downturn

This study addresses how a stock market prices earnings components around a sudden and severe economic downturn. In particular, the study examines the market valuation of discretionary accruals for debt renegotiating Malaysian firms during the Asian financial crisis. Our analysis shows that negative discretionary accruals for debt renegotiating firms are associated with higher market values of equity and are not related to the firms' future earnings. These findings are consistent with investors placing a positive value on the probability that negative accruals increase the likelihood that concessions can be extracted from lenders during renegotiation. In contrast, discretionary accruals for a control sample of non-debt renegotiating firms are not significantly associated with stock prices but are positively associated with future earnings.     

Overvaluation and earnings management

Consistent with Jensen’s [Jensen, M., 2005. Agency costs of overvalued equity. Financial Management 34, 5–19] agency-costs-of-overvalued-equity prediction, we find that overvaluation is statistically and economically related to subsequent income-increasing earnings management. This relation is robust to a series of tests that address potential endogeneity concerns, including omitted variable bias and reverse causality. The agency costs of overvalued equity are substantial. Overvaluation-induced income-increasing earnings management is negatively related to future abnormal stock returns and operating performance, and this negative relation becomes more pronounced as prior overvaluation intensifies. Among the most overvalued firms, those with high discretionary accruals underperform those with low discretionary accruals during the following year by 11.88% as measured by the three-factor alphas, and by 12.87% points as measured by industry-adjusted unmanaged EBITDA-to-assets ratio.     

How do stock-for-stock acquirers manage earnings? The accruals feature of real earnings management

This paper investigates whether stock-for-stock acquirers undertake real activities to manage earnings before merger announcements. Our results show that stock-for-stock acquirers present unusually high levels of credit sales and overproduction in the quarter immediately before the merger announcement. We also find that the accruals feature of real earnings management can explain the stock-for-stock acquirers’ high discretionary current accruals. In addition, stock-for-stock acquirer firms that accelerate their credit sales experience subsequent market underperformance. Overall, we provide a novel insight into the accruals feature of real earnings management.