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.     

Stock market listing status and real earnings management

This study analyzes real earnings management among privately held versus publicly listed firms. Our first finding is that public firms engage in more earnings management through operating activities. When a clear incentive to manage earnings in a specific direction is present we continue to find that public firms manage their earnings more than private firms. We reason that capital market pressure and ownership characteristics drive our results. Additional analyses reveal that public firms employ more real earnings management as a proportion of the total earnings management strategy. Furthermore, we find that mitigating factors of real earnings management have stronger impact in public firms. This study contributes to literature on non-accrual earnings management and to the broader understanding about the private vis-à-vis public firm reporting and operating behavior. Finally, we contribute by identifying an important societal cost of stock market listing, which is the increase in potentially value-destroying real earnings management.     

Female tainted directors,financial reporting quality and audit fees

This paper examines the association between the presence of female tainted directors on corporate boards and audit committees and (1) financial reporting quality and (2) audit fees. Female tainted directors are defined as female directors who have been directors of the firms that have previously been involved in financial failures and integrity indiscretions. Using real earnings management and audit fees as proxies for effective governance and board reputation, we find that firms with female tainted directors have higher real earnings management and higher audit fees. However, since prior literature has demonstrated that audit fees are higher for firms with female directors because female directors demand better auditing, we corroborate a supply-side effect of auditors charging higher audit fees when female tainted directors exist. We demonstrate this by showing that while there is an association between audit fee and real earnings management, this association is higher for firms with female tainted directors. Arguably, the governance and reputational benefits of female directors on boards are negated if such directors have tarnished professional reputations.     

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.     

Mandatory IFRS adoption: the trade-off between accrual-based and real earnings management

This paper examines whether firms substituted real earnings management for accrual-based earnings management after the International Financial Reporting Standards (IFRS) became mandatory. Using a sample of 101,331 firm-year observations from 33 countries between 2000 and 2010, we show that IFRS adoption came with the unintended consequence of certain firms substituting real earnings management for accrual-based earnings management, especially among firms in countries with strict enforcement regimes. Furthermore, we document that the trade-off is confined to EU countries in which strong firm-level characteristics (i.e. the firm-level mechanism of control, the market’s level of scrutiny, and firm-specific incentives to provide transparency) are coupled with strong enforcement. We also show that IFRS had an effect in countries outside the EU, albeit at a different time. Overall, the results suggest that accounting regulators’ efforts to increase earnings quality might have had the unintended consequence of increasing real earnings management activities.     

Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality

By employing a Heckman two-stage selection model, we identify whether employing a financial expert with or without accounting expertise on the audit committee is optimal and how earnings quality varies across these optimal and suboptimal choices. Using four earnings quality measures (informativeness, timely loss recognition, earnings persistence, and accruals quality), we find no differences in earnings quality between firms optimally choosing an expert with or without accounting expertise, consistent with Demsetz and Lehn (J Polit Econ 93:1155–1177, 1985) and others who argue that when firms optimize their choice (i.e., accounting expertise), there should be no difference across the characteristic (i.e., earnings quality) being examined. We do find, however, earnings quality is significantly higher for firms that optimally choose an accounting expert relative to firms that choose (with/without accounting expertise) suboptimally. Finally, firms suboptimally choosing an accounting expert exhibit no improvement, or even lower earnings quality, than firms that optimally choose no accounting expert. Our results provide important evidence of the impact accounting expertise has on earnings quality when considering the firm’s choice.     

Timing,earnings management and over-reaction around pure placings

This paper provides new evidence about firms conducting pure placings in the UK. It examines their abnormal performance (stock and operating), earnings management (accrual and real activities) and abnormal growth prospects for up to three years surrounding the event. It questions whether (i) timing, (ii) earnings management and/or (iii) over-reaction hypotheses can explain these performance, earnings quality and growth paths. The results document that pure placing firms have high earnings quality and abnormally high growth opportunities at the announcement. For this reason, the market is overenthusiastic. It expects more than what is eventually fulfilled, in line with the over-reaction hypothesis. Weak evidence that placing firms may exploit market timing is noted, whilst there is no supportive evidence of earnings management. These findings distinguish the earnings quality and growth opportunities of pure placing firms from that of firms conducting open offers, firm commitment offers and other seasoned equity offerings (SEO) that are not private placements, for which prior evidence reports mainly timing and/or earnings management prior to the event. This paper facilitates a better understanding of UK SEO.     

Earnings Quality, Insider Trading, and Cost of Capital

Previous research argues that earnings quality, measured as the unsigned abnormal accruals, proxies for information asymmetries that affect cost of capital. We examine this argument directly in two stages. In the first stage, we estimate firms' exposure to an earnings quality factor in the context of a Fama‐French three‐factor model augmented by the return on a factor‐mimicking portfolio that is long in low earnings quality firms and short in high earnings quality firms. In the second stage, we examine whether the earnings quality factor is priced and whether insider trading is more profitable for firms with higher exposure to that factor. Generally speaking, we find evidence consistent with pricing of the earnings quality factor and insiders trading more profitably in firms with higher exposure to that factor.     

Institutional investor distraction and earnings management

In this study, we explore the implications of institutional investor distraction for earnings management. Our identification approach relies on a firm-level measure of institutional investor distraction that exploits exogenous attention-grabbing shocks to unrelated parts of institutional investors' portfolios. We find that firms with distracted institutional shareholders engage more in both accrual-based and real earnings management. Further analyses show that the association between investor distraction and earnings management is stronger in firms with low analyst coverage and weak board monitoring, as well as in firms where managing earnings upward allows meeting or just beating their earnings target. Collectively, our results suggest that managers exploit the loosening in monitoring intensity resulting from investor distraction by engaging in earnings management. Even in the presence of institutional investors with superior monitoring abilities, limited attention may induce insufficient monitoring of earnings management practices.     

Are insiders equal? Evidence from earnings management in closely held East Asian firms

In analyzing newly collected data on the ultimate ownership structure of publicly traded firms in nine East Asian economies, we contribute to international accounting research by providing evidence on earnings management in insider-controlled firms in this region. We find that family-controlled firms engage in less (more) accrual-based (real) earnings management than other insider-controlled firms. Our analysis suggests that controlling families, unlike other types of ultimate owners, tend to substitute real earnings management for accrual-based earnings management. To help empirically clarify the role that two incentives (entrenchment versus signaling) play in driving the substitution between real and accruals-based earnings management, we examine their valuation impact and find that both types negatively affect the future valuation of family firms. In another set of results consistent with expectations, we document that country-level investor protection and firm external financing demand shape the practice of earnings management in family-controlled firms.     

Does pedigree matter? Earnings quality of U.S. listed domestic firms via reverse mergers

This paper examines earnings quality of U.S. domestic firms that access capital markets via a reverse merger transaction (RM firms) compared to those via the more traditional initial public offering (IPO firms) during the period from 1997 to 2011. In order to mitigate confounding effects of legal regime, law enforcement, and culture, we require both the acquiring and target firms to be incorporated and headquartered in the U.S. to be included in our sample. We also use the Heckman (1976) procedure to control for self-selection bias. To capture earnings quality, we use a battery of measures established in prior literature, including discretionary accruals, discretionary revenues, real activities earnings management, and accrual estimation errors. Our measures have both convergent and discriminant validity and therefore appear to capture earnings quality fairly well. We find consistent evidence that U.S. domestic RM firms have lower earnings quality compared with U.S. IPO firms. Our evidence suggests that investors and other stakeholders should take into account the fact and consequences of the method that firms use to access capital markets in their investment decision making process.     

To beat or not to beat? The importance of analysts’ cash flow forecasts

We investigate the implications of firms’ benchmark-beating patterns with respect to analysts’ quarterly cash flow forecasts for firms’ current capital market valuation and their future performance. We hypothesize that nonnegative earnings surprises are more likely to be supported by real operating performance and signal higher earnings quality if they are achieved via higher than expected cash flows or lower than expected accruals. We show that firms beating analyst earnings forecasts have larger positive capital market reactions and larger earnings response coefficients if they beat analyst cash flow forecasts or report lower than expected accruals. We also demonstrate that these firms’ superior future performance may provide an economic justification for their more favorable market response. Our findings suggest that firms’ ability to beat analyst cash flow forecasts is informative regarding the quality of their earnings surprises.     

External financing and earnings management: Evidence from international data

Corporate financing conditions in the external capital market are significantly affected by information asymmetry, while internal financing is not. Given that earnings information influences market perceptions regarding firms’ quality, firms relying on external financing should have incentives to manage earnings to improve their financing conditions. This study investigates the effect of corporate external financing behavior on earnings management. Using a sample comprising 75,790 observations of 12,874 firms in 43 countries, we find that accrual-based and real earnings management are positively associated with firms’ reliance on external financing. This positive relationship holds especially true for firms that rely on equity rather than debt financing. We argue that reliance on external financing (especially equity financing), which is subject to problems arising from information asymmetry, generates a motive for earnings management.     

Earnings management and market liquidity

The main purpose of this paper is to argue the extent that earnings management lowers disclosure quality. It should increase information asymmetry and impair trading liquidity. Using a large sample of NYSE firms from 1996 to 2001, we find evidence to suggest that firms which exhibit greater earnings management are associated with lower market liquidity. Our results are robust to both real and accounting based measures of earnings management and two well established measures of market liquidity. However, they are not consistent with the Easley et al. probability of informed trade measure.     

The use of earnings and operations management to avoid credit rating downgrades

Firms placed on negative credit watch face the threat of a credit rating downgrade. At the same time, they are given the opportunity to put recovery efforts in place to retain their current credit rating. In this paper, we test to what extent firms use earnings management as a short-term recovery strategy. We find that both accruals-based and real earnings management are associated with firms avoiding credit rating downgrades, and that these alternative earnings management strategies tend to be complements rather than substitutes. However, following the passage of the Sarbanes–Oxley Act, only real earnings management is significantly associated with the credit watch outcome. We find evidence that firms which maintain their rating via earnings management are better able to afford the inevitable earnings reversals, and that in the year following the credit watch period, the credit rating performance of these firms is significantly better than firms which undergo a downgrade, with fewer downgrades and more upgrades in this period. Our results also imply that credit rating agencies are not misled by earnings management but rather allow for some discretion in reporting earnings that facilitates the dissemination of private information about future firm performance.     

Real earnings management and cost of capital

This study investigates whether a firm’s cost of equity capital is influenced by the extent of a firm’s real activities management. Using a large sample of U.S. firms, we find that our proxy for the cost of capital is positively associated with the extent of earnings management through the real activities manipulation after controlling for the effect of the accrual-based earnings management. We also provide evidence suggesting that this positive association stems from managerial opportunism rather than from the measurement errors in our real earnings management proxies. The main findings are robust to a battery of sensitivity tests. Collectively, our results suggest that real earnings management activities exacerbate the information quality of earnings used by outside investors, and thus the market demands a higher risk premium for these activities, which is incremental to the risk premium for the accrual-based earnings management.     

Cross‐Firm Real Earnings Management

Our analysis is rooted in the notion that stockholders can learn about the fundamental value of any firm from observing the earnings reports of its rivals. We argue that such intraindustry information transfers, which have been broadly documented in the empirical literature, may motivate managers to alter stockholders’ beliefs about the value of their firm not only by manipulating their own earnings report but also by influencing the earnings reports of rival firms. Managers obviously do not have access to the accounting system of peer firms, but they can nevertheless influence the earnings reports of rival firms by distorting real transactions that relate to the product market competition. We demonstrate such managerial behavior, which we refer to as cross‐firm real earnings management, and explore its potential consequences and interrelation with the practice of accounting‐based earnings management within an industry setting with imperfect (nonproprietary) accounting information.     

Strategic Conservative Earnings Management of Technology Firms: Evidence from the IPO Market

In this paper, we investigate the conservative earnings management strategies of technology firms in the IPO market. We hypothesize that technology IPOs, due to their fewer tangible assets, more information asymmetry, and higher uncertainties of future cash flows, tend to have higher litigation risk. At equilibrium, technology firms are more motivated to strategically employ conservative earnings management during the IPO process, to mitigate their higher litigation risk. Using a sample of U.S. IPOs, we find that technology IPOs, on average, involve significantly more conservative earnings management, especially during the bubble periods. Our results also show that the conservative earnings management strategies of technology firms tends to have a greater impact on their underpricing than for non‐tech firms, and thus effectively reduce their risk of being a target in the securities class action lawsuits.     

Cash holdings and earnings quality: evidence from the Main and Alternative UK markets

In this paper we investigate the importance of earnings quality as a determinant of cash holdings by companies, exploring among other factors the nature of earnings (positive or negative) and the level of financial disclosure, proxied by the market where firms are listed (Main or AIM-Alternative Investment Markets in the United Kingdom). Based on a sample covering the period of 1998–2015, we provide evidence that as earnings quality decreases, firms tend to hold more cash except when firms are facing losses in both Main and AIM markets. In addition, we document that information conveyed by earnings quality is a more important determinant of cash reserve levels for Main Market than for AIM firms (where the level of financial disclosure and oversight is lower). Overall, our evidence suggests that cash balances are positively influenced by the presence of greater information asymmetries arising from poor earnings quality but also from the existence of lower levels of regulatory oversight and the occurrence of losses, both of which reduce the importance of earnings quality as a determinant of cash levels. Our results also imply that companies with higher levels of earnings opaqueness seem to benefit from having higher cash holdings so as to avoid dependence from costly external funding.     

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.