Do foreign institutional investors monitor opportunistic managerial behaviour? Evidence from real earnings management

Employing a large sample of 13,860 firms in 41 economies from 2000 to 2017, we document that the ownership by foreign institutional investors (FIIs) is negatively associated with firms' real earnings management (REM) but unrelated to their accrual earnings management (AEM). We adopt a few identification strategies to tackle the endogeneity issues, including firm- and year-fixed effects regression, two-stage least squares (2SLS) regression, and difference-in-differences (DiD) estimation based on the passage of the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA). In addition, we show that the role of FIIs in curbing REM is achieved through the expertise channel and the monitoring channel. These results suggest that when facing disadvantages in curbing AEM, FIIs make the most of their monitoring strengths by curbing firms' REM, where they have both incentives and capabilities to monitor. Overall, this study highlights the important role of FIIs in monitoring opportunistic managerial behaviour.     

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.     

Do managers use earnings guidance to influence street earnings exclusions?

Despite the apparent importance of “street earnings” to investors, we know relatively little about the process through which this earnings metric is determined. The limited evidence in the extant literature provides analyst-centric explanations, suggesting that analysts’ abilities and incentives influence which line items forecast-tracking services exclude from GAAP earnings to arrive at street earnings. We propose an alternative explanation: managers actively influence analysts’ forecast exclusion decisions via earnings guidance. We test this explanation by examining how earnings guidance influences two aspects of analysts’ exclusions: (1) special item exclusions (i.e., nonrecurring items) and (2) incremental exclusions (i.e., recurring items). We find that for firms with no special items in the previous year, when managers guide, analysts exclude almost all current-year special items, whereas when managers do not guide, the proportion that analysts exclude is significantly lower. More importantly, we that analysts’ incremental exclusions are significantly higher when managers guide than when they do not guide. Overall, our evidence suggests that managers play an active role in influencing the composition of street earnings via earnings guidance.     

Do management EPS forecasts allow returns to reflect future earnings? Implications for the continuation of management’s quarterly earnings guidance

Using 18,253 firm-year observations from 1998 through 2003, we build on literature suggesting that more informative disclosures allow returns to better reflect future earnings and test whether management earnings per share forecasts and their characteristics influence the future earnings response coefficient (FERC). We find that FERCs are greater for forecasting firms and when forecasts are more frequent or precise. We suggest that more frequent and more precise forecasts assist investors in better predicting future earnings. Importantly, we find that quarterly and short-term forecasts incrementally increase the association between returns and future earnings beyond annual and long-term forecasts; thus, even short-term, quarterly forecasts allow investors to form better expectations about future earnings. This suggests a benefit of quarterly earnings forecasts possibly overlooked in recommendations from the United States Chamber of Commerce, CFA Institute, Business Roundtable Institute for Corporate Ethics, and The Conference Board to eliminate quarterly earnings guidance.     

Do facilitation payments affect earnings management? Evidence from China

This study examines whether facilitation payments drive managers to manipulate earnings, thus weakening financial disclosure transparency. I find economically and statistically significant evidence that facilitation payments relate positively to earnings management levels in China. The impact of facilitation payments on earnings management is more pronounced when firms have relatively weak political power, less effective external monitoring, fewer growth options, and when firms are located in regions that have less efficient juridical systems. Finally, the findings are strengthened by a set of additional tests to mitigate the endogeneity problem: a difference-in-differences estimation that exploits China’s anti-corruption campaign as the exogenous shock, a dynamic analysis, an instrumental variable approach, and a Heckman analysis to adjust for selection bias. This study contributes to debates regarding corruption and transparency from a micro-economic perspective.     

Do firms’ earnings management practices affect their equity liquidity?

This study investigates the relationship between earnings management and equity liquidity, positing that as incentives arise for the manipulation of firm performance through earnings management (due partly to conflicts of interest between firm insiders and outsiders), greater earnings management may signal higher adverse selection costs. If earnings manipulation reveals aggressive accounting practices, liquidity providers tend to widen bid-ask spreads to protect themselves. The empirical results indicate that companies with higher earnings management suffer lower equity liquidity.     

How does competition affect real earnings management to meet or beat targets? Evidence from import tariff reductions

Targets provide incentives for earnings management, and a longstanding question is whether earnings management is undertaken opportunistically or to communicate private information about future firm value. To discriminate between these motivations, I follow analytical research showing that an increase in competition through a large decrease in tariffs disciplines managers and better aligns their interests with those of shareholders. Thus, if earnings management reflects managerial opportunism, then an increase in competition will decrease earnings management; and if it signals future performance expectations, then an increase in competition will increase earnings management. Consistent with earnings management indicating managerial opportunism, I show that an increase in competition decreases real earnings management to avoid reporting negative earnings or a negative change in earnings. In addition, by showing that the lessening of trade barriers through import tariff reductions reduces the use of real earnings management to meet or beat earnings targets, I provide evidence on the role of macroeconomic conditions as a determinant of earnings quality.     

Connecting earnings management to the real World:What happens in the black box of the boardroom?

This British Accounting & Finance Association (BAFA) distinguished academic 2020 plenary address marries the researcher's two main research areas – financial reporting and corporate governance. Like Vivien Beattie (BAFA 2011 distinguished academic), the researcher commenced in the positivist tradition but was increasingly drawn to more qualitative, interdisciplinary perspectives, influencing the paper's positioning.“Accounting choice”, “income smoothing”, “earnings management”, and “earnings manipulation” are terms frequently used in the academic literature. This paper reviews these terms, highlighting the resonances and dissonances between them, and attempts to reconcile varied perspectives in the prior literature. The paper critiques taken-for-granted assumptions underlying this stream of research. The paper then examines prior earnings management research using alternative methodologies to deepen understanding of the four terms in praxis (best practice in practice). The paper reviews prior research on boards of directors using alternative methodologies to those adopted in mainstream corporate governance research, to provide a menu of opportunities to research earnings management inside the “black box” of the boardroom, including proposed research questions for future research. The paper concludes by considering the implications for policymakers and standard setters.     

Do UK firms manage earnings to meet dividend thresholds?

This paper examines earnings management by dividend-paying firms in cases where pre-managed earnings would fall below the expected dividend, and by non-dividend paying firms aiming to avoid reporting losses. We find that within the UK market the likelihood of upward earnings management is significantly greater in the former case than the latter, though both are drivers for earnings management. Large firms are less likely to upwardly manage earnings to reach dividend thresholds, consistent with prior UK evidence on the ability of the largest firms to avoid restrictive debt covenants. We also find that earnings management is more clearly observable through examining working capital discretionary accruals than through examining total discretionary accruals.     

Do more reputable financial institutions reduce earnings management by IPO issuers?

This study investigates whether financial intermediaries (FIs) participating in the IPO process play a significant role in restraining earnings management (EM). Specifically, we examine whether EM around IPOs is negatively related to investment banks (IBs) and venture capital (VC) investor reputations. In general, we do not find evidence that VCs as a group significantly restrain EM by IPO issuers. However, we uncover strong evidence that more reputable VCs and IBs are associated with significantly less EM, which is consistent with them implicitly certifying the quality of issuer financial reports. Moreover, a stronger reduction in EM is found when more reputable IBs are matched with more reputable VCs, which indicates that VC and IB reputation are complements rather than substitutes. These conclusions are invariant to adjustments for potential endogeneity of underwriter reputation and VC-backing or reputation.     

Do analysts overreact to extreme good news in earnings?

We provide an alternative explanation for the previous finding of analysts’ overreaction to extreme good news in earnings. We show that such finding could be a result of analysts’ rational behavior in the face of high earnings uncertainty rather than their cognitive bias. Extreme earnings performance tends to be associated with higher earnings uncertainty that generally leads to more forecast optimism. Once this effect is accounted for, the univariate result of analysts’ overreaction to extreme good news in earnings is subsumed, leaving only their underreaction in general.

Do regulations limiting management influence over auditors improve audit quality? Evidence from China

We use data from China to examine whether regulations that limit management influence over auditors improve audit quality. China’s State-owned Assets Supervision and Administration Commission of the State Council (SASAC) issued two rules in 2004 aimed at improving audit quality for state-owned enterprises ultimately controlled by the central government (CSOEs). These rules limit management influence over auditors by mandating that SASAC assign auditors for CSOEs and by requiring management to retain auditors for at least 2 years and at most 5 years. Since these rules apply only to CSOEs, we use a difference-in-difference design to study the impact of these regulations on audit quality. We find that audit quality for CSOEs relative to other companies improves after the enactment of these rules. Our results are robust to a battery of sensitivity analyses. Our findings suggest that limiting management influence over auditors helps improve audit quality.     

Do heterogeneous oil price shocks really have different effects on earnings management?

Under the modern corporate governance structure, there is a knowledge gap in how companies' financial reporting practices respond to oil price shocks in China. To fill this gap, we employ China's A-share listed companies and follow Kilian (2009) study to investigate how the three types of classical oil shocks affect corporate earnings management heterogeneously. We also consider the role of oil implied volatility in this relationship and further examine the possible heterogeneity between energy-related and non-energy-related subsamples. The empirical results show that there are variant effects among the heterogeneous oil price shocks on earnings management. Specifically, oil supply shocks stimulate firms to manipulate more accrual and real earnings, and firms are more likely to carry out accrual earnings management downward. Oil aggregate demand shocks weaken the degree of accrual earnings manipulation and mainly reduce the negative accrual earnings manipulation. Oil-specific demand shocks constrain the earnings management behavior of companies and improve their accounting quality. Besides, the increased uncertainty of oil price weakens the promotion effect of oil supply shocks on earnings manipulation, and the moderating effect occurs mainly in downward earnings management. Furthermore, the subsample estimated results reveal that oil price shocks do not affect the degree of accrual earnings management of energy-related companies. Instead, they impact the non-energy-related companies. Overall, our findings provide a series of targeted policy recommendations to mitigate the principal-agent problems and cope with energy price volatility risks.     

Does confucianism influence corporate earnings management?

This paper investigates the effect of Confucianism on corporate earnings management. Using a sample of Chinese listed firms from 2007 to 2017, we find that corporate earnings management is negatively associated with the popularity of Confucianism. Our findings also reveal that the effect of Confucianism is particularly strong among firms characterized with weaker internal control and external supervision or located in areas with lower level of marketization. Our findings shed important light on how culture improves the quality of financial reporting in emerging markets.     

A discussion of “Do managers use earnings guidance to influence street earnings exclusions?”

It is well known that both managers and analysts frequently define earnings by excluding various amounts from GAAP earnings. Christensen et al. (Rev Account Stud, 2011) make a prediction of causality whereby managers actively influence how analysts define earnings. They argue that the mechanism through which managers accomplish this is guidance of analysts’ earnings forecasts within a fiscal period. Using a large sample of firms actively followed by analysts, the authors examine whether the existence of earnings guidance is associated with higher levels of total exclusions in analysts’ definition of earnings. The study provides suggestive evidence that managers actively influence analysts’ definition of earnings that they forecast. However, the indirect nature of the research design calls for additional work to specifically link directed guidance of GAAP earnings exclusions to amounts actually excluded by analysts.     

Is enterprise risk management real?

Moving from the growing relevance of the enterprise risk management (ERM) concept, this paper provides empirical evidence of ERM in practice. The paper presents ERM actual uses in a panel of nine Italian companies from different industrial fields and legislative settings and analyses the relationship between the uses and the characteristics of the ERM tool implemented in each case. The data analysis highlights the existence of different activities that are supported by the ERM tool and also different types of use (i.e. responsive, discoursive and prospective) corresponding to a different contribution of ERM to managerial action. These uses related to the specific characteristics of the tools generally indicated with the label ‘ERM’.     

How efficient ownership structure monitors income manipulation? Evidence of real earnings management among Malaysian firms

This study investigates income manipulation through real earnings management, by listed companies in Malaysia, prior to being officially designated as “financially distressed”, by this country’s stock exchange listed rules. The hypotheses relate to whether the degree of upwards real earnings management, conducted during the four-year period prior to financial distress, can be explained by ownership structure (measured with three variables: managerial ownership, institutional ownership and foreign ownership). Using a sample of 1180 firm-year observations of financially distressed companies, over the investigation period 2001–2011, the findings suggest that the degree of real earnings management is not associated with ownership by management or institutional investors. Conversely, the evidence indicates that foreign shareholders are able to constrain upwards real earnings management related to discretionary expenditure but not the operating cycle. This study contributes to the importance of diversity of ownership structures in monitoring income manipulation among firms.     

Use of benchmarks in predicting earnings management?

This study conducts multiple approaches to identify whether earnings benchmarks are an indicator for earnings management within the Australian market. We investigate firms reporting small positive earnings and small positive earnings changes, referred to as benchmark beaters. Accrual quality models, earnings distributions and earnings persistence measures are applied to identify whether benchmark beating firms are manipulating earnings. Our findings suggest that the small positive earnings benchmark attracts earnings managers. However, we do not identify any evidence to indicate that the positive earnings change benchmark is a signal for earnings management.     

Do option traders on value and growth stocks react differently to new information?

This study compares the changes in implied volatilities of options on Nasdaq 100 and Russell 2000 value and growth portfolios, for the time period of 2004 and 2005. Following the methodologies in Stein (J Finance 44:1011–1024, 1989) and Heynen et al. (J Financ Quant Anal 29:31–56, 1994), we attempt to infer whether there are systematic differences in the degree of overreactions between value and growth options. The empirical evidence indicates that the reactions to information by investors in growth options, as proxied by options on Nasdaq 100 and Russell 2000 growth, are stronger than those of Russell 2000 value. Whether these reactions can be considered as overreacting, however, is not entirely conclusive. Nevertheless, the results imply that difference in investors’ behavior and styles is one potential explanation for the value stock effect.