Earnings management and firm financial motives: A financial investigation of UK listed firms

This study focuses on the investigation of motives for and characteristics of UK firms that engage in earnings management activities. It concentrates particularly on the provision of voluntary accounting disclosures, the violation of debt covenants, management compensation, and on the equity and debt capital needs of firms and their relation with the use of earnings management. The study examines also the earnings management inclination of firms that seek to meet or exceed financial analysts' forecasts. The findings generally indicate that firms with low profitability and high leverage measures are likely to use earnings management. Also, firms that are in equity and debt capital need and are close to debt covenant violation also appear to be inclined to employ earnings management practices. Likewise, firms tend to use earnings management to improve their financial numbers and subsequently reinforce their compensation and meet and/or exceed financial analysts' earnings forecasts. In contrast, the study shows that firms that provide voluntary accounting disclosures appear to be less inclined to make use of earnings management.     

Why and how firms use operating cash flow in compensation**

This study considers the choice of operating cash flow (OCF) in contracts and further examines the sensitivity of the CFO's and CEO's compensation to OCF performance, conditional on our stylized indicator of the importance of working capital management (WCM). The analysis depicts OCF as conveying distinct information about WCM, and predicts that firms for which WCM is an important source of value are more likely to contract on OCF. The importance of WCM is instrumented by firm conditions that create strong demand for WCM, including large working capital, rapid growth in working capital, highly volatile working capital, and large debt relative to total assets. Using a sample of firms whose incentive plans explicitly include OCF measures and a control sample of firms without such plans, we show that all four indicators of the importance of WCM have positive association with the likelihood of contracting upon OCF, individually and collectively. In compensation regressions, we find that WCM importance has a pronounced positive effect on the weight of OCF, but muted effect on the weight of accrual earnings. The results suggest that firms include measures of OCF performance in contracts largely to provide incentives for WCM and internal cash generation.     

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.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

Auditors’ Economic Incentives and the Sensitivity of Managerial Pay to Accounting Performance

The use of managerial incentives to manage earnings in order to enhance accounting performance‐based compensation is greater when auditors have economic incentives to compromise their independence. Hence, compensation committees face more difficulties in determining cash compensation when earnings quality declines. This study investigates whether boards of directors can mitigate the agency problems between managers and shareholders by being aware of the opportunistic earnings management encouraged by auditors’ economic incentives and actively adjusting performance‐based compensation for the reduced earnings quality. To this end, it examines how auditors’ economic incentives affect the sensitivity of managerial pay to accounting performance. The findings show a negative association between the client's economic importance to the auditor and the sensitivity of managerial pay to accounting performance, with this association more pronounced for firms that opportunistically inflate earnings, suggesting that boards mitigate agency problems by actively intervening to modify performance‐based compensation schemes for the reduced earnings quality. Additional analyses show that board effectiveness in determining compensation depends on its characteristics. These results suggest the urgent need to oblige companies to establish compensation committees, particularly in countries that lack such a mandatory requirement or where few companies have such committees.     

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.     

Factors affecting biasing of capital budgeting cash flow forecasts: evidence from the hotel industry

This study contributes to a neglected aspect of the capital budgeting process, namely, the proposal development stage, which is primarily concerned with project cash flow estimation. Given that the deployment of sophisticated selection techniques is severely undermined when directed to input data suffering from bias, it is surprising that minimal empirical research has sought to explore for antecedent factors associated with biasing of capital budgeting cash flow forecasts. This paper reports the findings of a survey concerned with determining factors associated with biasing of capital budget cash flow forecasts in hotels that are mediated by a management contract. Statistically significant support is provided for the view that higher levels of biasing of capital budget cash flow forecasts occur in the presence of: high emphasis attached to the payback investment appraisal method; deficient reserve funds for furniture, fittings, and equipment (FF&E); low operator accessibility to reserve funds for FF&E; shorter periods of time to management contract expiry; and high emphasis attached to non-financial factors in capital budgeting appraisal.     

Does accounting conservatism pay?

We investigate whether or not there is a link between conservative accounting practices and the sensitivity of executive pay to accounting performance. Using several accrual‐based measures of accounting conservatism as well as alternative measures of accounting performance, we estimate an econometric model of CEO compensation that incorporates the interaction of accounting conservatism and accounting performance. Consistent with optimal contracting theory, we find that the sensitivity of executive pay to accounting performance is higher for firms that report conservative accounting earnings. These results support the hypothesis that accounting conservatism, by limiting earnings management opportunities and improving the reliability of accounting performance measures, allows firms to formulate contracts that tie executive compensation more closely to accounting performance.     

Earnings Manipulation and the Cost of Capital

The widespread use of accounting information by investors and financial analysts to help value stocks creates an incentive for managers to manipulate earnings in an attempt to influence short‐term stock price performance. This paper examines the role of earnings management in affecting a firm's cost of capital. Using an agency model with multiple firms whose cash flows are correlated, we demonstrate that the extent of earnings manipulation varies across the business cycle. Depending on a firm's earnings profile, it can have stronger incentives to overstate its performance in good times or in bad times. Because of this dependence on the state of the economy, earnings manipulation can influence a firm's cost of capital despite the forces of diversification.     

Does Earnings Management Relieve the Negative Effects of Mandatory Pension Contributions?

Mandatory pension contributions (MCs) are negative shocks to a firm's liquidity that can unfavorably impact its cost of capital, financing, and investment plans. We examine whether firms faced with MCs use both noncash (NEM) and cash‐generating earnings management (CEM) to partially offset their negative effects. Firms increase CEM, but not NEM, when they experience MCs. We also find that earnings management associated with MCs does not substantially lower the weighted cost of capital or boost external funding and investment. Our findings suggest that MC firms use CEM as it directly generates cash to fund MCs, while NEM does not.     

How fair-value accounting can influence firm hedging

The potential influence of accounting regulations on hedging strategies and the use of financial derivatives is a research topic that has attracted little attention in both the finance and the accounting literature. However, recent surveys suggest that company hedging can be substantially influenced by the accounting for financial instruments. In this study, we illustrate not only why but also how the accounting regulations may affect hedging behavior. We find that under mark-to-market accounting, most firms concerned with earnings smoothness adopt myopic hedging strategies relative to the benchmark, cash flow hedging. The specific influence of the accounting regulations depends on market and firm-specific characteristics, but, in general, the firms dramatically reduce the extent of hedging addressing price risk in future accounting periods. We illustrate that the change in hedging behavior significantly dampens the increase in earnings volatility stemming from fair value accounting of derivatives. However, the adjusted hedging strategies may substantially increase the firms’ cash flow volatility.     

Direct Evidence on the Informational Properties of Earnings in Loan Contracts

Using a sample of firms that disclose the realizations of earnings used for determining covenant compliance in loan contracts, we provide direct evidence on the informational properties of earnings used in the performance covenants included in debt contracts. We find that the earnings measure used in performance covenants does not exhibit asymmetric loss timeliness and has significantly greater cash flow predictive ability than GAAP measures of earnings. We suggest that these results reflect the idea that contracting parties design accounting rules for performance covenants to enhance their efficacy as “tripwires.”     

Accruals quality and the incentive contracting role of earnings

This paper investigates the association between accruals quality and the usefulness of accounting earnings in incentive contracting. Accruals quality, which measures the precision with which accruals predict future cash flows, has two potential opposing effects on the noise in earnings as a measure of managerial performance. Specifically, higher quality accruals should decrease the deviations of earnings from future cash flows and increase the sensitivity of earnings to cash flows that are not attributable to managerial actions. My evidence indicates that better accruals quality is associated with a higher weight on earnings in compensation contracts, which suggests that accruals quality overall reduces the noise in earnings. I also find that the positive association between accruals quality and the weight on earnings is mainly driven by innate accruals quality rather than discretionary accruals quality. Therefore, accrual errors resulting from the volatility of the operating environment are a primary source of noise in earnings considered by compensation committees.     

Changes in bonus contracts in the post-Sarbanes–Oxley era

We examine whether the relation between earnings and bonuses changes after Sarbanes–Oxley. Theory predicts that, as the financial reporting system reduces the discretion allowed managers, firms will put more weight on earnings in compensation contracts to encourage effort. However, the increased risk imposed by Sarbanes–Oxley on executives may cause firms to temper this contracting outcome. We examine and find support for the joint hypothesis that the implementation of Sarbanes–Oxley and related reforms led to a decrease in earnings management and that firms responded by placing more weight on earnings in bonus contracts. We find no evidence that firms changed compensation contracts to compensate executives for assuming more risk.     

The Role of Payback in the Investment Process

This study examines the use of the payback (PB) method as a means of evaluating a proposed asset's risk and its joint application with profit-oriented capital budgeting models. Previous research studies indicating a linkage between the PB method and risk analysis are reviewed. A certainty-equivalent model is used to demonstrate this relationship and the properties of the relationship exploited by PB when used as a heuristic. Results of the analysis indicate that using a hurdle PB as a filter for identifying proposals with acceptable risk and return attributes is consistent with more quantitatively oriented investment techniques under certain conditions. The study then examines the conceptual relationship between PB and profit-oriented capital budgeting models. Results suggest that PB and profit-oriented capital budgeting techniques measure different attributes of an investment and complement one another in describing and analysing its cash flows.     

The evolution of the application of capital budgeting techniques in enterprises

This study examines the evolution of the application of capital budgeting techniques. Previous studies mostly used cross-sectional inquiries to understand the capital budgeting practices of firms. Only a few researchers have undertaken longitudinal studies to generalise the findings of the individual cross-sectional studies to the wider population and to identify the emerging trends in the use of capital budgeting techniques (CBTs). This longitudinal study surveys 83 studies of capital budgeting practices across firms in India, South Africa, the United Kingdom (UK) and the United States of America (USA) for the period from 1966 to 2016. The findings show that six capital budgeting techniques, namely, the net present value (NPV), the internal rate of return (IRR), the payback period (PBP), the accounting rate of return (ARR), the return on investment (ROI) and the real option valuation (ROV), are the most popular methods for evaluating capital investments. Of these techniques, the ROV is the least used, and a general lack of familiarity with this technique and its complexity are the most commonly cited reasons for not using it. Another method that is used less than the first four techniques is the ROI. However, this technique is of growing significance and is mainly used in the UK, followed by the USA, South Africa, and India. Firms in the USA and UK have increased their use of the IRR as a primary method for evaluating capital projects and have retained the PBP as an ancillary technique to strengthen the available information when evaluating capital projects. Firms in India and South Africa are increasingly excluding both the PBP and ARR methods and are increasingly using the NPV when evaluating capital investments. Although this development is in line with the theory, it limits the scope of the available information when evaluating capital projects.     

Relative performance evaluation in board cash compensation: UK empirical evidence

This paper presents an empirical examination of whether evidence of the implicit use of relative performance evaluation (RPE) can be found in the cash compensation of boards of directors for 169 UK non-financial listed companies that existed for all of the period from 1971 to 1998. We perform two types of analyses. Initially, we estimate individual firm time series regressions of the change in board cash compensation against measures of firm and peer group performance. The measures of firm performance we use are annual cash stock market returns and pre-tax accounting earnings. Peer group measures of performance are industry value-weighted average cash stock market returns and industry value-weighted average pre-tax accounting earnings. Subsequently, we analyse the data as a balanced panel.We provide evidence that board cash compensation is positively related to accounting earnings and negatively associated with peer group pre-tax accounting earnings. Some evidence suggests that board cash compensation is related to firm stock market returns but none suggests it is related to peer group market returns. This result implies the presence of RPE based on accounting earnings in the design of UK board compensation, with the cash compensation of boards of directors implicitly (partially) protected from industry uncertainties.     

公允价值计量与管理层薪酬契约

本文以2007、2008年持有公允价值变动损益的A股上市公司为样本,分析了公允价值收益、公允价值损失与管理层薪酬之间的敏感系数。研究结果表明,A股上市公司存在着对公允价值变动损益的"重奖轻罚"现象。"重奖轻罚"现象表明我国上市公司激励有效而约束乏力的薪酬不对称特征也存在于盈余分项目层面,这将会助长管理层的机会主义行为,放大企业风险。本文还发现,公允价值"持有收益"并不必然增加股东财富,委托人不能辨别新增财富的可实现性与现实性的差异,也不能辨别市场优势地位与管理层努力程度对业绩的影响,常见的公司治理机制在该问题上并没有发挥应有的控制作用,表明中国的公司治理机制仍有待完善。     

Net working capital investment and capital budgeting analysis: Some pedagogical insights

Net working capital (NWC) investment, as a factor in discounted cash flow (DCF) analysis, receives little attention in the capital budgeting literature and accounting textbooks. The purpose of this paper is to explore the ways in which this important component of the analysis can be intregrated into the classroom and thus add to the student's overall understanding of capital budgeting. Four areas are discussed: (1) the significance of NWC investment in capital budgeting analysis, (2) the opportunity cost nature of the NWC investment, (3)measurement of the components of the NWC investment, and (4) use of the NWC investment to help restore the bottom line in DCF analysis to a pure cash flow basis. Integration of the fourth point into the topic of capital budgeting is found to be a convenient way to reinforce the student's understanding of the statement of cash flows.     

Managing Earnings with Intercorporate Investments

Abstract:  We explore to what extent firms deliberately manage their financial reports by exploiting the flexibility of generally accepted accounting principles. Using a sample of Oslo Stock Exchange-listed firms with 20–50% equity holdings in other firms, we find that firms with high financial leverage tend to maximize reported earnings from these investments through their choice between the cost method and the equity method, possibly in an attempt to reduce debt renegotiation costs or to avoid regulatory attention. In contrast, managers do not systematically bias reported earnings to extract private benefits or to signal revised expectations about future cash flows. Firms use different earnings management tools in a consistent way, as the earnings effect of the cost/equity choice is not offset by discretionary accruals.