The Covid-19 outbreak,corporate financial distress and earnings management

This study explores the association between the Covid-19 outbreak, corporate financial distress and earnings management practices in China. We investigate whether firms took advantage of the downturn in economic conditions during the pandemic to adjust their earnings using different earnings management techniques. Utilising a sample of 1832 listed firms and underlying theoretical frameworks (i.e., positive accounting and signalling theory), we find that firms were more inclined to manage earnings during the pandemic period. They favoured using the accrual-based rather than the real activity-based earnings management technique. We also find that firms engaged more in income-increasing practices in the shadow of the outbreak. In addition, our results further demonstrate that financially distressed firms were involved in earnings management, particularly accrual-based earnings management. However, compared to privately-owned firms, state-owned enterprises seem to be involved less in earnings management during the Covid-19 pandemic. Findings from this study raise some concerns for policymakers about the credibility of financial reporting information during Covid-19.     

Reversing an impairment loss and earnings management: The role of corporate governance

This paper examines whether the reversal of a previously recognized impairment loss provides an opportunity for earnings management, and whether such behavior is associated with managers' incentives. It also examines whether a corporate-governance mechanism can mitigate this behavior. Since 2005, listed companies in Taiwan have been required to comply with accounting standards, equivalent to International Accounting Standards (IAS) No. 36 “Impairment of Assets,” which allow reversals of asset-impairment losses. Data on a sample of 55 firms that reversed impairment losses between 2005 and the first quarter of 2007 were matched by industry and size with 55 control firms. Empirical results show that firms recognizing more impairment losses are more likely to reverse impairment losses when doing so would avoid an earnings decline in a subsequent period, which is consistent with the “cookie jar” reserve hypothesis. We also show that such behavior is more pronounced for firms with higher debt ratios, consistent with earnings management being associated with the incentive to avoid violation of debt covenants. However, an effective corporate governance mechanism could mitigate such behavior. Our study may contribute to the debate on global convergence with IFRS, especially convergence between IFRS and U.S. GAAP with respect to the “Impairment of Assets,” by providing a rationale for the latter's prohibition of reversals. It may also contribute to the corporate-governance literature by showing the effect of governance mechanisms on deterring earnings management.     

The effect of earnings management on firm performance: The moderating role of corporate governance quality

This paper investigates the relationship between earnings management and financial performance of firms in Anglophone sub-Saharan African Countries in a dynamic framework. The study shows how this relationship is moderated by aggregate disclosure and best-practice corporate governance quality metrics. The findings indicate that earnings management's performance effects persist even after controlling for dynamic endogeneity, simultaneity, and unobserved time-invariant heterogeneity inherent in the earnings management and performance relationship. Again, the results support the prediction of agency theory regarding the efficient monitoring effect of adherence to best-practice internal governance systems in constraining firms' earnings management practices and subsequently enhancing firms' performance. Moreover, the study's findings regarding the positive effect of earnings management on performance, which suggests efficiency motives behind earnings management practices in Africa, demonstrate that the African context is uniquely different from other emerging markets that report opportunistic motives. Concerning the moderating role, our study reveals that the positive effect of earnings management on the financial performance of firms tends to be stronger in the presence of corporate governance quality.     

The role of bank monitoring in corporate governance: Evidence from borrowers’ earnings management behavior

In this paper, we examine the corporate governance role of banks by investigating the effect of bank monitoring on the borrowers’ earnings management behavior. Our analyses suggest that a borrowing firm’s earnings management behavior generally decreases as the strength of bank monitoring increases. The strength of bank monitoring is measured as (1) the magnitude of a bank loan, (2) the reputation (rank) of a lead bank, (3) the length of a bank loan, and (4) the number of lenders. These results imply that bank monitoring plays an important role in the corporate governance of bank-dependent firms. We further examine other bank loan characteristics (collateral, refinancing, loan types, and loan purposes) and their effects on borrowers’ earnings management behavior. Our analyses show that collateral and loan types are significantly associated with borrowers’ earnings management behavior while refinancing and loan purposes have no association.     

Issues management: The evolving corporate role

Public issues of concern are increasingly influencing corporate decision making, and a new social contract is evolving. This article suggests that there is now a need for management to anticipate the emergence of new issues and their likely impact, and describes the process of issues management in practice.     

Top management team expertise and corporate real earnings management activities

This study investigates the effects of top management team (TMT) expertise on real earnings management (REM) activities by examining a hand-collected data set that contains 4,690 firm-year observations from Taiwanese listed firms during 2006 to 2010. The results of this study show that the percentages of TMT members possessing master's degrees (PMS) and managing core functional areas (CORE) negatively relate to REM activities, whereas the percentage of TMT members possessing a CPA certificate (PCPA) has the opposite effect. We also find that the PMS and CORE effects are mainly demonstrated through the channel of raising firm performance and thereby reduce managers' incentives to manage earnings. In addition, the effect of TMT expertise on REM activities becomes weaker with increasing firm age. Finally, the outcomes of several robustness tests, such as suspect firm analyses, endogeneity analyses, employing other TMT expertise variables, and additionally controlling for accrual-based earnings management also support our results.     

Earning investor trust: The role of past earnings management

Does earnings management, even though legal, hinder investor trust in reported earnings? Or do investors regard earnings management as a way for firms to convey private information, or simply as a neutral feature of financial reporting? We find that past abstinence from earnings management increases investor responses to future earnings surprises. Importantly, this effect occurs in industries where investor trust has recently been violated, and where managers would in the past have had incentives and opportunities to misrepresent earnings. Overall, investors seem to interpret the extent to which management resists temptations for misreporting as a “litmus test” of trustworthiness.     

China-US trade dispute investigations and corporate earnings management strategy

This paper studies Chinese firms’ earnings management strategy in response to the trade dispute investigations initiated by the U.S. from 2001 to 2018. This topic is important given the increasingly severe international trade environment and the significant influence of macro economy on financial reporting. We find that firms affected by the U.S.-initiated trade dispute investigations engage in more upward earnings management. Additionally, the result is more pronounced in firms with a more negative market reaction around the announcement of the investigations. Cross-sectional tests provide evidence that the positive relation is stronger among firms whose U.S. operating revenue and management ownership is high, firms in provinces with weak investor protection, and firms that performed well one year after initiation of the investigations. Moreover, investors react positively to the earnings management by the affected firms. Our results are robust to a variety of sensitivity checks. Overall, our findings suggest that companies will manage their earnings upward to mitigate the negative impacts of the U.S.-initiated trade dispute investigations.     

The association between corporate governance and earnings quality: Further evidence using the GOV-Score

This paper reexamines the relation between corporate governance and quality of earnings using a summary governance measure. Prior research has used many surrogates for corporate governance including size and composition of board of directors, existence and composition of audit committee, and extent of institutional ownership. However, the criticism of the extant research has been that corporate governance comprises many facets and is not uni-dimensional. In this study we fill this void by using the Gov-Score developed by Brown and Caylor [Brown, D., and Caylor, M.L., (2006). Corporate governance and firm valuation. Journal of Accounting and Public Policy 25, 409-434.] to measure corporate governance. In the post-Sarbanes-Oxley period, we find evidence of a significant inverse relationship, namely higher levels of corporate governance are associated with lower absolute discretionary accruals and higher quality of earnings. Furthermore, our results suggest that only firms in the highest category of corporate governance experience significantly improved quality of earnings. Finally, as a test of robustness, we document that corporate governance is negatively associated with small earnings surprises. This implies that firms with weak corporate governance are more likely to manage earnings in order to meet or beat analyst forecasts.     

Deferred taxes,earnings management,and corporate governance: Malaysian evidence

This study examines whether Malaysian public listed companies (PLCs) use deferred taxes to avoid an earnings decline. In addition, this study also examines whether corporate governance mechanisms attenuate the extent to which deferred taxes are used to manage earnings. Using a sample of 221 PLCs listed on the main and second boards of Bursa Malaysia in 2008 with a complete set of data available from 2005 to 2008, this study finds that Malaysian PLCs use both the accrual and valuation allowance components of net deferred tax liabilities to avoid a decline in earnings. The study also finds that ownership structure and board structure affect the extent to which earnings management is associated with a deferred tax component.     

The effects of corporate name changes on firm information environment and earnings management

We study how corporate name changes affect a firm's information environment and its earnings management. We show that the stock market reacts negatively to name changes. This effect is specifically pronounced for firms that have lower visibility. We also find that firms that change their names tend to have a relatively worse information environment. Finally, we show that earnings management is positively related to firm name changes.     

Financial distress and corporate risk management: Theory and evidence

This paper extends the current theoretical models of corporate risk-management in the presence of financial distress costs and tests the model's predictions using a comprehensive data set. I show that the shareholders optimally engage in ex-post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts a positive (negative) relation between leverage and hedging for moderately (highly) leveraged firms. Consistent with the theory, empirically I find a non-monotonic relation between leverage and hedging. Further, the effect of leverage on hedging is higher for firms in highly concentrated industries.     

Internal corporate governance,CEO turnover,and earnings management

The likelihood and speed of forced CEO turnover – but not voluntary turnover – are positively related to a firm's earnings management. These patterns persist in tests that consider the effects of earnings restatements, regulatory enforcement actions, and the possible endogeneity of CEO turnover and earnings management. The relation between earnings management and forced turnover occurs both in firms with good and bad performance, and when the accruals work to inflate or deflate reported earnings. These results indicate that boards tend to act proactively to discipline managers who manage earnings aggressively, before the manipulations lead to costly external consequences.     

Crossed-listed foreign firms' earnings informativeness, earnings management and disclosures of corporate governance information under SOX

The passage of the Sarbanes-Oxley Act (SOX) marks the beginning of the mandatory disclosure of audit-committee composition and other corporate governance information for cross-listed foreign firms. We posit that the provisions of SOX improve the effectiveness of an independent audit committee and other corporate-governance functions in monitoring the earnings quality of cross-listed foreign firms, and we use cross-listed firms' earnings informativeness and earnings management to measure earnings quality. Our findings show earnings informativeness is significantly associated with audit-committee independence as well as with board independence in the post-SOX period. In contrast, we do not find a significant association between earnings informativeness and audit-committee independence in the pre-SOX period. Our findings also show a consistently negative association between earnings management and audit-committee independence after SOX, an association that is not found in the pre-SOX period. Similarly, a negative association between earnings informativeness and the CEO duality as the chair of the board is only found in the post-SOX period. Furthermore, our results show a positive (negative) association between earnings informativeness (earnings management) and an aggregate corporate-governance score as a measure of overall corporate-governance functions in both the pre- and post-SOX periods. Our findings on the change of magnitude in the relationship between earnings informativeness (earnings management) and corporate governance suggest that the SOX provisions improve the effectiveness of cross-listed foreign firms' corporate-governance functions in monitoring the quality of accounting earnings.     

Product market power,industry structure,and corporate earnings management

This is the first study to establish a link between product market power of firms and the degree of earnings management. We hypothesize and document a significant and robust association between (a) a firm’s product market pricing power and its degree of earnings management, and (b) industry competitiveness and the degree of earnings management in the industry. Our study reveals that firms with inferior product market pricing power engage in greater discretionary earnings accruals, adding a new dimension to our understanding of the transparency and informativeness of firms’ financial statements. These findings are mirrored at the industry level where we document that more competitive industries are associated with greater earnings manipulation. The empirical evidence has direct implication on the informativeness and earnings quality of firms based on their product market power and competitiveness.     

Do targets grab the cash in takeovers: The role of earnings management

Extant research on Mergers and Acquisitions (M&A) provides evidence that acquirers underperform subsequent to the takeover completion. Such evidence is more unequivocal for acquirers that finance the acquisition by issuing equity relative to those that use cash. Current literature recognizes various reasons for this underperformance, most of which suggest overvaluation of the acquirers and/or overpayment for the targets at the time of acquisition announcement. Alternatively, this paper aims to investigate whether acquirers' post-takeover abnormal return is also attributed to target firms' real and/or accrual earnings management. Our results indicate that, on average, targets manage earnings upwards using real transactions rather than accruals, during the year preceding the takeover. More specifically, we find evidence of earnings management through sales among targets of cash acquisitions and that it is significantly and negatively related to the post-acquisition performance of the acquirers. These findings suggest that there is an association between the method of financing in acquisitions and earnings management in target firms, which could impact the post-takeover performance of acquirers.     

Regulations,earnings management,and post-IPO performance: The Chinese evidence

In this study, we examine whether government regulatory initiatives in China involving IPO by SOEs may have contributed to opportunistic behaviors by the issuer. We focus on two sets of IPO regulations issued between January 1, 1996 and February 11, 1999: pricing regulations, which stipulate that IPO prices be a function of accounting performance, and penalty regulations, which penalize IPO firms for overly optimistic forecasts. We find that IPO firms that report better pricing-period accounting performance have larger declines in post-IPO profitability, lower first-day stock returns and worse long-run post-IPO stock performance. Furthermore, IPO firms that make overoptimistic forecasts also have lower first-day returns and worse post-IPO stock performance. Using non-core earnings as the proxy for earnings management, we document some evidence that IPO firms that report higher pricing-period accounting performance have engaged in more income-increasing earnings management. Hence, pricing regulations may have induced IPO firms to inflate pricing-period earnings and affect the post-IPO performance negatively. On the other hand, penalty regulations have deterred IPO firms from making overoptimistic earnings forecast and therefore have a positive impact on the behavior of IPO firms.     

Financial distress,corporate control,and management turnover

We empirically investigate the effect of financial distress on corporate ownership and control. Our analysis is based on a panel of 267 German firms that suffered from repeated interest coverage shortfalls between 1996 and 2004. We track each firm’s development over the distress cycle with particular attention to corporate ownership, restructuring, and management turnover. We find a significant decrease in ownership concentration. Private investors gradually give up their dominating role and thereby cease to be an effective source of managerial control. By contrast, ownership representation by banks and outside investors almost doubles. Shareholdings by executive and non-executive directors also substantially increase but have no effect on managerial tenure. Forced management turnover is mostly initiated by outside investors and banks and often occurs subsequent to debt restructurings, block investments, and takeovers.     

The role of accounting disaggregation in detecting and mitigating earnings management

Though ample empirical evidence alludes to the importance of disaggregated accounting data in the context of earnings management, extant theory considers biases in reporting mostly at the aggregated level of the accounting report. By introducing accounting disaggregation into the conventional theoretical framework of earnings management, this study highlights the essential role that disaggregated accounting data play in detecting and mitigating reporting manipulations. Disaggregated reports are shown to be especially effective when they consist of accounting items that are tightly interrelated by their fundamental economic nature, differ considerably in their sensitivity to reporting manipulations, and vary in their signs.     

Effect of cash flow risk on corporate failures,and the moderating role of earnings management and abnormal compensation

In this study, we find that United States firms' average cash flow risk (CFR) shows a significantly increasing trend over the past four decades or so. This does not portend well considering the significance of cash flows in maintaining a firm's financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm's failure. Empirically, we find that CFR has a strong positive effect on a firm's financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm's failure. Our findings are also robust to alternative definitions of a firm's failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.