Earnings Management Vehicles for Korean Firms

We investigated the vehicles that Korean firms use when the firms manage earnings. We partitioned our sample into low, mid and high accrual sub‐samples based on discretionary accruals. Low accrual firms are defined as income‐decreasing firms whereas the high accrual firms are considered income increasing firms in this study. We decomposed accounting earnings into cash from operations and various components of accruals in a systematic way. Next we examined the types of accruals individual firms use when the respective firms increase reported earnings. The empirical results of the study indicate that there are clear discrepancies in the earnings management vehicles firm use when the firms manage earnings depending on the directions of earnings management. More specifically, income‐increasing firms frequently employ non‐cash revenues including asset‐disposal gains. Income‐decreasing firms employ non‐cash expenses including bad‐debt expenses and asset‐disposal losses. Firms also tend to use current accruals but to a limited extent as current accruals entail cash flow implications in the following years.     

The Stewardship Role of Analyst Forecasts,and Discretionary Versus Non-discretionary Accruals

We examine the interaction between discretionary and non-discretionary accruals in a stewardship setting. Contracting includes multiple rounds of renegotiation based on contractible accounting information and non-contractible but more timely non-accounting information. We show that accounting regulation aimed at increasing earnings quality from a valuation perspective (earnings persistence) may have a significant impact on how firms rationally respond in terms of allowing accrual discretion in order to alleviate the impact on the stewardship role of earnings. Increasing the precision of more timely non-accounting information (analyst earnings forecasts) increases the ex ante value of the firm and reduces costly earnings management. There is an optimal level of reversible non-discretionary accrual noise introduced through revenue recognition policies. Tight rules-based accounting regulation, as opposed to leaving firms more choice over non-discretionary accrual policies, may lead firms to rationally respond by inducing costly earnings management. More generally, regulating both earnings persistence and the tightness of admissible auditing policies may not result in less equilibrium earnings management.     

Real and Accrual‐Based Earnings Management in the Pre‐ and Post‐IFRS Periods: Evidence from China

The purpose of this study is to investigate the prevalence of both accrual‐ and activities‐based earnings management for Chinese A‐share firms surrounding the adoption of substantially IFRS‐convergent accounting standards. Since 2007, all listed A‐share firms in China have been required to comply with a new set of accounting standards that have substantially conformed to IFRS. The new reform also produced a set of new auditing standards and internal control reporting requirements. Based on a sample of 4,050 firm‐year observations from 2002 to 2011, we find that Chinese firms in the post‐IFRS period (2007–2011) are less likely to engage in accrual‐based earnings management. The magnitude of discretionary accruals also declines after IFRS adoption. In response, we see firms turning to real activities manipulation as a substitute for upward earnings management. The reduction in accrual‐based earnings management could stem from higher quality accounting standards associated with IFRS adoption and/or concurrent changes in the governance regimes introduced with the IFRS mandate. A further analysis, however, indicates that the benefits of IFRS adoption in curbing upward accrual‐based earnings manipulation are not evenly distributed across firms. Specifically, the benefit diminishes for firms that are controlled by Chinese central or local governments, are located in less developed regions, and that have weak financial performance and therefore subject to delisting status. We also find that the benefit is less pronounced for manufacturing firms than for their non‐manufacturing counterparts.     

Earnings Management and the Accrual Anomaly: Evidence from China

Using the unique Chinese setting in which the “delisting regulation” is based on accounting numbers, we separate earnings management into (1) earnings management responding to regulation and (2) earnings management prompted by market pressures and further document that earnings management responding to market pressures produces the accrual anomaly (Sloan, 1996) and earnings management responding to regulation does not. Initially unable to detect the accrual anomaly in China's stock market, we were reluctant to conclude that China's market is more efficient than that in the United States. After observing a disproportionate number of “big‐bath” loss firm‐years in the lowest decile of accruals for our sample, we estimated the apparent earnings distortion induced by the delisting regulation. When we excluded this distortion from our analysis, we documented the presence of the accrual anomaly in China's stock market. We conclude that the delisting regulation creates an artificial distribution of firm earnings in China that affects the market pricing of accruals and masks the accrual anomaly. The results have implications for policy makers and regulators in general, and those in emerging markets in particular.     

Ownership Structure and Accounting Information Content: Evidence from France

This paper investigates how family and bank ownership affect the accounting information content of French firms. In Continental Europe, the existence of block‐holders triggers specific corporate governance issues, including the transparency of financial reporting. Our test results for the clean surplus model show that book value carries a significantly greater weight for family‐controlled firms. This finding is attributed to their lack of incentive to report timely and relevant earnings to outside (minority) investors. In contrast, bank owners are under more market pressure to achieve earnings persistence through the use of accounting accruals. Bank ownership is also associated with higher levels of debt. These results are consistent with findings that in code law countries, insiders dominate as a source of finance, and financial reporting is aimed at creditor protection.     

Camouflaged Indicators of Earnings Management†

Abstract

We argue that, in response to increased scrutiny and greater attention to accruals versus sales, firms become more likely to engage in accrual conversion (AC) cash management aimed at aligning cash and accruals with earnings and sales (e.g. by factoring of receivables). In doing so, they reduce the statistical power of standard indicators of accrual-based earnings management – in effect, camouflaging their earnings management activity. This proposition is of interest because many influential papers on earnings management have utilized accrual-based indicators to reach their conclusions. Our results indicate that firms indeed became more likely to engage in AC cash management after the passage of the Sarbanes-Oxley Act (SOX), and that this tendency was particularly pronounced among firms with strong incentives (or enhanced ability) to perform and hide earnings management. In particular, our findings suggest that the post-SOX decrease in standard measurements of accrual-based earnings management, identified in prior research, is partially attributable to firms’ increased engagement in AC cash management activity.     

An Investigation of Stock Price Declines Following Corporate Financing Events: Further Evidence

Prior research documents a large downward drift in stock prices following issuances of debt and equity by US firms. We conduct tests based on both stock price and trading volume to provide evidence on the reasons for this apparent market anomaly. We document evidence of earnings management through accruals prior to external financing and lower operating performance afterward that is associated with the amount of capital raised. The earnings management that precedes external financing and the amount of capital raised are associated with both the post-financing decline in stock price and trading volume around earnings announcements that follow for a period of three years. This evidence is consistent with the proposition that firms raise external capital prior to predictable declines in their operating performance and they release upward biased earnings before these events to manage investor expectations. The failure of many investors to incorporate this information into their trading decisions in a timely manner consistent with limited attention and over-confidence appears to drive stock mispricing. Our evidence does not support the conjecture that the financing anomaly is primarily a statistical artifact or that it is a manifestation of the accrual anomaly.     

SFAS 133 and income smoothing via discretionary accruals: The role of hedge effectiveness and market volatility

This study investigates whether the Statement of Financial Accounting Standard No. 133 (SFAS 133) influences firms’ income smoothing via discretionary accruals decisions. Moreover, we investigate whether the level of hedge effectiveness and market volatility affects the impact of SFAS 133 on firms’ income smoothing via discretionary accruals decisions. Consistent with our predictions, we find a significant increase in income smoothing via discretionary accruals activity after the adoption of SFAS 133. We also find that income smoothing via discretionary accruals after the adoption of SFAS 133 increases with the level of hedge ineffectiveness. By contrast, we find that perfect hedgers do not engage in more income smoothing via discretionary accruals after the adoption of SFAS 133. Finally, we find that the higher the market volatility is the larger the income smoothing is via discretionary accruals after the adoption of SFAS 133. This implies that higher market volatility makes it more difficult for firms to meet hedge accounting requirements, thereby increasing unmanaged earnings volatility and income smoothing. Prior studies suggest that regulators are expressing concern about the effect of earnings management on the quality of reported earnings and the functioning of capital markets (e.g., Barton, 2001 ). In this regard, our findings imply that accounting standard setters should take into account the trade‐off between transparency and income smoothing.     

Japanese Corporate Groupings (Keiretsu) and the Informativeness of Earnings

This paper examines the effect of Japanese corporate groupings, keiretsu , on the informativeness of earnings. Keiretsu firms maintain close financial and personal ties through cross-shareholding, credit holding, interlocking corporate directorates, and various business transactions. We propose that the strong interrelations of the keiretsu ownership structure enhance the informativeness of earnings through efficient monitoring of managerial performance. Our empirical results show that keiretsu firms have higher earnings response coefficients than those of non- keiretsu firms, the earnings response coefficient increases as the strength of the keiretsu relationship increases, and discretionary accruals by keiretsu firms are smaller than discretionary accruals of non- keiretsu firms. All of these results suggest that the monitoring ability of the keiretsu improves the informativeness of earnings.     

Managing Underpricing? The Case of Pre‐IPO Discretionary Accruals in China

Previous studies have found that companies use income‐increasing positive discretionary accruals (DAC) prior to initial public offerings (IPOs) to inflate earnings as a signal to anticipate future income and future dividends. This study, directly explores the role of DAC in prospectus information of 691 A‐shares IPOs in China during the period 1995–2002 and its relationship with market‐adjusted returns. The results suggest that in China, pre‐IPO non‐discretionary accruals (NDAC) as well as DAC have informative value in explaining first‐day returns as well as first‐year adjusted returns. However, in yearly cross‐sectional models, I find that firms use income‐decreasing accruals (conservative accounting) in prospectus financial statements. This downward manipulation or income “understatement” creates a regulatory setting that could explain initial underpricing and abnormally high IPO returns for A‐shares. In addition, the results show that as state ownership (SO) increases, cash flow also increases, exacerbating agency costs and adverse selection problems. These findings may suggest that managers might be using more conservative accounting in Prospectus financial data to offset the agency costs related to high cash flow, and high SO, by “banking income” and possibly therefore “smoothing” the effects of possible future suboptimal earnings.     

Accounting Accruals and Stock Returns: Evidence from European Equity Markets

Abstract

In this paper, I show a generalisation of the negative relation of traditional accruals and percent accruals with future returns in 11 of 16 European countries. Positive abnormal returns from hedge portfolios on both accrual measures summarise the economic significance of this generalisation. The magnitude of returns obtained from traditional accruals is higher than that obtained from percent accruals, contrary to existing evidence from the U.S. capital market. The magnitude of the accrual effect on stock returns based on both accrual measures is stronger in countries with higher individualism, lower uncertainty avoidance, higher equity-market development, higher equity-market liquidity, lower transaction costs, higher analyst coverage, lower analyst optimism, and lower ownership concentration. In markets where minorities have legal protection against expropriation by corporate insiders and where accrual accounting is permitted, the accrual effect based only on percent accruals is positive. Earnings opacity does not appear to exhibit a significant influence. Overall, the evidence suggests that cross-country differences in culture, equity-market setting, analysts' research output, investor protection, and ownership structure play an important role in explaining variation on the magnitude of the accrual anomaly in Europe.     

Shareholder Activism and Earnings Management Incentives: An Empirical Examination of Shareholder Proposals in the United States

In this article, we investigate the effect of shareholder activism on earnings management. Using a US sample of shareholder pay‐for‐performance proposals sponsored by institutional investors, we find that when compared to control firms, firms targeted by shareholder proposals have a greater magnitude of discretionary accruals (DA) in their reported earnings. In addition, we find that the likelihood of meeting or beating earnings benchmarks through the use of DA is higher for targeted firms whose managers have job security concerns due to the firms’ inferior stock performance in the past or have plans to sell company stock. Our results are consistent with the notion that pay‐for‐performance proposals have unintended consequences by introducing or exacerbating incentives to manage earnings for short‐term gains. The results also indicate that, for financial reporting, the short‐termism effect may dominate the alignment and/or disciplinary effect of shareholder monitoring.     

Variations in the Financial Reporting Environment and Earnings Forecasting

This paper examines variations in the financial reporting environment internationally. In particular, I investigate the relation between variations in accounting‐related institutional factors (choice, accrual accounting and enforcement) and the accuracy of analysts' earnings forecasts. Controlling for firm‐ and country‐level factors, I document that the extent of choice among accounting methods is associated with lower forecast accuracy. This finding is consistent with analysts' performance suffering from the increased task complexity (and/or managers using flexibility for purposes other than to provide information). The degree of prescribed accrual accounting is positively correlated with forecast accuracy, consistent with both accruals providing useful information and with the smoothing function of accruals. Enforcement of accounting standards is positively related with forecast accuracy, suggesting that enforcement encourages managers to follow prescribed rules, which, in turn, reduces analysts' uncertainty. Finally, I examine whether the roles of accrual accounting and choice vary with the level of enforcement. Although univariate tests support these interaction hypotheses, multivariate tests do not.     

The Information Content of Earnings Components: Evidence from the Chinese Stock Market

China's listed firms report substantial non-operating revenues and expenses. We argue that these non-core earnings should have different properties and different valuation implications than operating or core earnings. Furthermore, the different types of firm ownership may have differential impacts on the information content of earnings components. Based on data from 1996 to 2008, we find that core earnings are more persistent than non-core earnings. Because of this, core earnings have a greater association with contemporaneous stock returns. However, the stock market does not fully incorporate all the information in earnings; we find that core earnings are undervalued and non-core earnings are overvalued. This effect is much reduced for privately controlled listed firms. We develop an investment trading strategy to exploit these market inefficiencies.     

The Effect of CEO Stock-Based Compensation on the Pricing of Future Earnings

This paper examines whether CEO stock-based compensation has an effect on the market’s ability to predict future earnings. When stock-based compensation motivates managers to share their private information with shareholders, it will expedite the pricing of future earnings in current stock prices. In contrast, when equity-compensated managers attempt to temporarily manipulate the stock price to maximize their own benefit rather than that of shareholders, the market may not fully anticipate future performance. We find that a CEO’s stock-based compensation strengthens the association between current returns and future earnings, indicating that more information about future earnings is reflected in current stock prices. In addition, we find that the positive effect is weaker for firms that have a high level of signed discretionary accruals or a low management forecast frequency. Overall, our study suggests that on average, equity-based compensation improves the informativeness of stock prices about future earnings, while opportunistic discretionary accruals or lowered earnings guidance hamper this improvement.     

Reprint of "The role of state ownership and institutions in the innovation performance of emerging market enterprises: Evidence from China"

Although it has been suggested that institutional context influences a firm's innovation performance, the role of regulatory institutions has been underexplored. Extending previous research, this study investigates whether and how regulatory institutions (i.e. state ownership, region-specific marketization and industry-specific institutional policy) affect innovation performance of emerging market enterprises (EMEs). Evidence derived from a large sample of Chinese manufacturing firms demonstrates that state ownership positively moderates the effect of R&D intensity on innovation performance. However, state ownership is not equally beneficial for all firms. Our analysis shows that region-specific marketization and industry-specific institutional policy enhance the innovation-enhancing effect of state ownership. By revealing the role of regulatory institutions, our study points to the importance of looking beyond firm boundaries to understand why EMEs are able to innovate despite their weak internal capabilities.     

Earnings quality and corporate payout policy linkages: An Indian context

We investigate the role of accounting quality as an antecedent of dividend payout decision of firms, for both dividend levels and dividend event, in an emerging market context. Using the data for Indian firms through the years 2006–2016, we evaluate the impact of discretionary accruals on payout decision employing Tobit and Logit regression models amid set of idiosyncratic controls. We report that better earnings quality, on average, is associated with large dividend payments for Indian firms. Moreover, the likelihood of dividend payment reduces with poor earnings quality and more so when earnings manipulation is done to increase earnings. Nonetheless, we show that higher earnings quality reduces dividends during the crisis period and also for group-affiliated firms. However, the same doesn’t hold true for dividend likelihood. The relationship is robust to the idiosyncratic controls and the causality test confirms that results are not susceptible to endogeneity issue. Overall, we conclude that better earnings quality takes care of free cash flow problems and alleviates the agency and information asymmetry related costs, thereby stimulating payout policy.     

On the Relationship between Voluntary Disclosure,Earnings Smoothing and the Value-Relevance of Earnings: The Case of Switzerland

Abstract

This paper examines whether voluntary disclosure by Swiss firms constrains the use of discretionary accruals to smooth earnings, and explores the effect of voluntary disclosure on the value relevance of earnings. We focus on Swiss firms because Switzerland's financial reporting system provides managers with extensive discretion in corporate disclosure, and there are important variations in the level of information provided in their annual reports. We consider that managers can choose two different ways to voluntarily convey information, either through the quality and quantity of annual report disclosure or, through compliance with International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS) or US Generally Accepted Accounting Principles (GAAP). Relying on a simultaneous equations approach, our results suggest that Swiss firms use discretionary accruals to smooth earnings. However, this relation is reduced for firms that voluntarily disclose more information in their annual report or comply with IAS/IFRS or US GAAP. Moreover, we show that discretionary accruals of high disclosers or of firms voluntarily complying with IAS/IFRS or US GAAP receive a lower valuation weight.     

Individual and Institutional Investors’ Response to Earnings Reported by Conservative and Non‐Conservative Firms: Evidence from Chinese Financial Markets

In this study, we document that there are significant differences in individual and institutional investors’ perception and interpretation of information based on accounting conservatism, as reflected by their trading behavior in the Chinese financial market. Our findings show that institutional investors, who are more sophisticated and have better skills, engage in higher purchases of equities of firms that use high accounting conservatism compared to the firms that use low/no accounting conservatism. Institutional investors’ equity purchases are even higher if these firms are associated with higher growth opportunities. On the other hand, individual investors are attracted more by the attention‐grabbing events and are motivated to purchase equities of firms that either do not use accounting conservatism or use low accounting conservatism, and their purchases are even higher when the firms report positive earnings surprises. Additionally, we find that abnormal returns are higher for the firms using high accounting conservatism and have experienced higher purchases by institutional investors.     

MBO过程中的盈余管理行为——基子中国上市公司的实证研究

本文选取截至2002年底公认实行了MBO而又可获取资料的15家公司，研究其在MBO过程中是否存在减少报告盈余的应计会计处理。通过扩展的Jones模型进行实证分析，发现有证据支持管理层在MBO前一年采用了减少会计应计的统计证据。同时针对线下项目和费用的统计发现MBO公司和对照样本相比，在MBO的前一年度和当年度中，前者的投资收益、补贴收入和营业外利润比后者小，而前者的管理费用、销售费用比后後者大。这些证据表明在MBO过程中确实存在着盈余管理行为。