Accruals and the Conditional Equity Premium

Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.     

Highly Valued Equity and Discretionary Accruals

Abstract:  Overvalued equity provides a strong incentive for managers to report earnings that do not disappoint the market (  Jensen, 2005 ). We find that this can be extended to highly valued equity more generally. In the year following the classification as highly valued and compared to firms with less extreme valuations, highly valued firms have significantly higher discretionary accruals and exhibit a more pronounced positive association between discretionary accruals and proxies for the likelihood of failing to meet earnings targets. These findings are consistent with the use of discretionary accruals to manage earnings in support of extreme valuation. Because highly valued equity will likely result in CEOs with valuable stock and stock option portfolios, we test whether and show that the overvalued equity incentive is incremental to a CEO's equity portfolio incentive. One implication is that directors and audit committees should be especially on guard for possible earnings management when a firm has extremely high valuation multiples and when the CEO has a lot of equity at risk.     

Earnings Management in Public Family Firms under Economic Adversity

This paper explores the relationship between the ownership of public firms and their motivation to implement earnings management practices, providing evidence on whether family businesses differ from non‐family businesses in terms of earnings management practices. In addition, it focuses on the possibility of asymmetrical earnings management policies between periods of stability and economic adversity. Based on a sample of Portuguese listed family‐controlled firms for the 1999–2011 period and using a panel data approach, we find no significant differences in the incentive to manage earnings between public family and non‐family firms, suggesting a compensation between the alignment hypothesis, the long‐term orientation of family firms and the desire to pass firms onto succeeding generations, and the entrenchment effect. The evidence shows that earnings management decreases with firms’ profitability, and non‐family firms’ discretionary accruals are mainly influenced by the board of directors. In crisis periods, the discretionary accruals of family firms are especially influenced by firm size. After controlling for different earnings management measures, the determinants of earnings management practices seem somewhat sensitive to the earnings quality proxies. The results provide evidence that directors and policy makers should prevent earnings management procedures in particular situations.     

Insider-trading,discretionary accruals and information asymmetry

Using US data for the period from 2004 to 2012 and alternative discretionary accruals measures, we examine whether insiders manipulate earnings in an asymmetric information environment to profit from their informed trades, and whether the intervening information environment influences the relationship between earnings management and insider trading. We show that insider trading dominated by sell trades has a positive association with discretionary accruals. The incremental effect of information asymmetry as well as the interaction with insider trading is also prevalent in this relation, confirming the moderating effect of asymmetric information. Further, we show that the active involvement of some key insiders in high discretionary accruals is for personal benefit more in growth firms than in value firms. Our results also suggest that earnings management allows for insiders’ opportunistic, rather than routine, buy and sell trades. Our findings highlight that regulators should oversee and scrutinise both insider trading and earnings management to mitigate the risk of the opportunistic behaviour of insiders to avoid future corporate scandals.     

Does Investor Sentiment Affect Earnings Management?

I hypothesize and find that earnings management via accruals is driven partially by the prevailing market‐wide investor sentiment. Managers inflate earnings in periods of higher sentiment, but report more conservatively during periods of low sentiment. Moreover, the likelihood of income‐increasing earnings management to avoid negative earnings surprises is also positively associated with investor sentiment. These results are robust to: (i) controls for time‐varying firm characteristics such as growth, investment opportunity sets, future profitability, leverage and size; (ii) macroeconomic variables such as future inflation, GDP growth, and growth in industrial production; (iii) multiple proxies for investor sentiment; and (iv) discretionary revenues as alternative measure of earnings management. Cross‐sectional analyses reveal that firms whose stock returns co‐move more with investor sentiment are more (less) likely to manage earnings upward via abnormal accruals in quarters of higher (lower) sentiment. The findings of managers’ strategic use of abnormal accruals show the need for increased attention from boards of directors, auditors and regulators to heightened managerial incentives to overstate earnings and to report optimistic earnings numbers during periods of high investor sentiment.     

The Usefulness of Measures of Consistency of Discretionary Components of Accruals in the Detection of Earnings Management

Abstract:  Prior research has shown the prevalence of measurement error in models used to estimate aggregate discretionary accruals. In these models, the incremental information content of the various components of accruals is ignored. Limited prior research and data gathered from firms under Securities and Exchange Commission (SEC) litigation indicate that managers use either one or more than one component of accruals simultaneously, in a consistent way to manipulate bottom-line earnings in a given direction. I propose two measures that capture the consistency between the discretionary components of accruals and test their significance in earnings management (EM) detection in firms that have artificially added accrual manipulation and firms that were targeted by the SEC for accrual manipulation. There is evidence that this information is incrementally useful in detecting EM. This finding paves the way for improvements in the discretionary accruals measure by including consistency information from the components of aggregate accruals.     

Systematic Measurement Error in the Estimation of Discretionary Accruals: An Evaluation of Alternative Modelling Procedures

This paper evaluates the extent of predictable measurement error induced by five alternative approaches to the estimation of discretionary accruals. The source and magnitude of the error is assessed by reference to the strength of the association between the discretionary accrual estimate and proxies for the non-discretionary components of total accruals. Results indicate that discretionary accruals generated by the Healy model are associated with the highest level of predictable measurement error. While the remaining four models generate significantly lower error levels, the magnitude of error remains highly significant. Findings highlight the limitations of existing models and emphasise the need for further developments in relation to the measurement of earnings management activity.     

Discretionary accruals: signalling or earnings management in Australia?

We investigate the signalling effect of discretionary accruals (DAC). Although we find that discretionary accruals are insignificantly related to contemporaneous stock returns, we uncover that income‐increasing discretionary accruals of GAAP‐complying growth firms are significantly and positively related to contemporaneous stock returns. Furthermore, we find that this positive effect is stronger among firms with better corporate governance mechanisms, such as Board of Directors Independence, Audit Committee Independence and Large Shareholders’ Ownership. In addition to contemporaneous stock returns, we also find similar results with the future increase in dividends. Our findings are consistent with the argument that corporate governance can enhance the signalling effect of reported earnings of GAAP‐complying growth firms.     

Accrual usage to manage earnings toward financial analysts' forecasts

This study examines whether management uses discretionary accounting accruals to move earnings upward toward analysts' earnings forecasts when it appears that earnings before discretionary accruals will fall short of the forecast. An earnings shortfall relative to analysts' forecasts could lead management to fear lower compensation and an increase in the likelihood of job termination. The article finds that firms whose earnings before discretionary accruals are below analysts' forecasts use income-increasing discretionary accruals and do so to a greater extent than do firms whose earnings before discretionary accruals are above analysts' forecasts.     

Earnings management and abnormal returns: Evidence from the 1970–1972 Price Control Regulations

We examine the association between abnormal returns and earnings management in the context of price control regulations to test the construct validity of the earnings management model. Abnormal returns are used as a market–based measure, and discretionary accruals are employed to measure earnings management. Our results support the hypotheses that (1) price control regulations affect firms' security prices negatively, (2) firms make income–decreasing discretionary accruals to increase the likelihood of price increase approval, and (3) firms that are affected most negatively by the regulations manage earnings more aggressively. We conclude that the earnings management model we use in this study is capable of predicting opportunistic discretionary accruals.     

Economic Relations Among Earnings Quality Measures

Empirical studies on earnings quality use various measures that capture particular dimensions of earnings quality. This paper provides a theoretical foundation to evaluate and compare several common earnings quality measures: value relevance; persistence; predictability; smoothness; and discretionary accruals. We use a rational expectations framework in which a manager has market price, earnings, and smoothing incentives and can bias earnings reports. Taking the information content of reported earnings as a natural benchmark, we determine how variations of management incentives, operating risk, and accounting noise affect earnings quality and examine whether the different measures point in the same or in the opposite direction. We find that value relevance and persistence are measures that are closely aligned with each other and with our benchmark, followed by predictability and smoothness. Discretionary accruals measures are less aligned because they are based on the level of accruals, which confounds their information content. Our results also support the notion that smoother earnings and higher discretionary accruals are associated with greater earnings quality.     

Earnings Management and the Long-Run Underperformance of Firms Following Convertible Bond Offers

Abstract:  This paper examines whether the long-run underperformance of convertible bond issuers can be explained by earnings management, as reflected in discretionary current accruals around the time of the offer. Consistent with the earnings management hypothesis, we find that convertible issuers who adjust their discretionary current accruals to report higher net income in the issue year will generally experience inferior operating and stock return performance over the five-year post-issue period. Our findings indicate that there is some temporary overvaluation of convertible issuers by the stock market, but that the resultant disappointed investors will subsequently correct their valuation errors. The similarity of our results to those reported within the prior literature on initial public offers (IPOs) and seasoned equity offers (SEOs) suggests that the earnings management hypothesis is not unique to stock offers, but that it actually extends to convertible bond offers.     

The nature of information in accruals and cash flows in an emerging capital market: The case of China

Our study investigates the relative and incremental information content of earnings, operating cash flows, and accruals in the emerging capital market of China. The issue is tested by regressing stock returns on the levels of earnings and their components. Based on a sample of 1516 firm-years for listed Chinese firms during 1995–1998, our results demonstrate that earnings have relative information content over operating cash flows. The autocorrelations and cross-sectional correlations also imply that earnings have greater persistence and predictability than operating cash flows. We also find that discretionary accruals provide incremental information beyond that contained in nondiscretionary accruals, consistent with the argument that discretionary accruals improve the relevance of earnings in reflecting the fundamental values of the listed Chinese firms. Unlike prior findings in the studies on developed markets, we find no strong evidence that the value attached to discretionary accruals is lower than the value attached to nondiscretionary accruals. This is consistent with the argument that managerial policy choices available for the listed Chinese firms were rather limited during our sample period under relatively uniform People's Republic of China Accounting Standards (PRC-GAAP), thus, producing fewer opportunities for earnings management. An alternative interpretation could be that Chinese investors are functionally fixated on earnings.     

Non-audit fees, long-term auditor–client relationships and earnings management

We examine whether auditor independence is affected by the amount spent on non‐audit services. Faster growth in non‐audit fees and longer time periods over which non‐audit services are purchased might reduce the auditor's independence from that client. Our results do not provide any support for a relationship between non‐audit fee growth rates or the length of time of the non‐audit fee relationship with the client and discretionary accruals, our measure of earnings management. We do find some evidence that the interaction of the non‐audit fee time‐period measures and client importance is positive and significantly related to discretionary accruals.     

Internal governance structures and earnings management

This paper investigates the role of a firm's internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross‐sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non‐executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee.     

Market perceptions of discretionary accruals by debt renegotiating firms during economic downturn

This study addresses how a stock market prices earnings components around a sudden and severe economic downturn. In particular, the study examines the market valuation of discretionary accruals for debt renegotiating Malaysian firms during the Asian financial crisis. Our analysis shows that negative discretionary accruals for debt renegotiating firms are associated with higher market values of equity and are not related to the firms' future earnings. These findings are consistent with investors placing a positive value on the probability that negative accruals increase the likelihood that concessions can be extracted from lenders during renegotiation. In contrast, discretionary accruals for a control sample of non-debt renegotiating firms are not significantly associated with stock prices but are positively associated with future earnings.     

Cash from operations and earnings management in Korea

Our study investigates the relationship between the operating performances of Korean industrial firms and the behavior of discretionary accruals during the period 1994-1997. We hypothesize that the degree of earnings management will depend on the firm operating performances. We construct 10 “cash from operations (CFO)” portfolios to test if there are systematic differences in discretionary accruals across portfolios.Four test methods (a mean accrual test, a correlation test, a regression analysis, and a sign-change test) are used to investigate if operating performances affect discretionary accruals differently. We compare three accrual estimation approaches (two discretionary accruals and total accruals) in testing the earnings management hypotheses.The results support the hypothesis that Korean industrial firms manage earnings. When operating performance is poor, the firms tend to choose income-increasing strategies. In addition, when operating performance is extremely poor, some firms tend to take a big bath, while some of the exceptionally well-performing firms tend to select income-decreasing strategies.     

High accruals momentum

We examine the information content of high accruals momentum defined as a string of high discretionary accruals for four consecutive years. We find that firms that consistently report high levels of discretionary accruals experience low subsequent returns. The results are robust after we control for annual levels of discretionary accruals for the estimation period of high accruals momentum. Furthermore, the predictive power of the high accruals momentum for future returns is strongly persistent even after the existing accruals anomaly disappears. Our results also show that the high accruals momentum impact is more pronounced for low growth firms, suggesting that the overpricing of stocks with high accruals momentum is driven by managerial discretion to manage earnings.     

Asset write-offs discretion and accruals management in Taiwan: the role of corporate governance

Using a sample of Taiwan’s public firms, this paper examines whether managers use discretionary write-offs and abnormal accruals jointly to reach earnings targets and how corporate governance mechanisms react to such opportunistic behavior. We develop a set of simultaneous equations that capture executives’ incentives to manage earnings through write-offs and accrual management. These incentives include the existence and tightness of accounting-based covenants, “big bath,” income smoothing, and changes in senior management. The empirical results show that firms with larger discretionary write-offs also have lower discretionary accruals. In addition, we find that these earnings management tools are endogenous, suggesting that discretionary write-offs and discretionary accruals are partial complements for earnings manipulation and that their magnitudes are determined jointly. These findings contrast sharply with the tenor of discussion in the U.S. literature concerning the potential for using asset write-offs and discretionary accruals to manipulate earnings, which documents that managers use their discretion over accruals to signal economic realities rather than to obfuscate. Moreover, the results reveal that the empirical association between discretionary write-offs and abnormal accruals is more pronounced in weakly governed firms, suggesting that a strong governance setting is likely to constrain management’s discretionary behavior. The above implications are robust to a number of alternative specifications and variables definitions.     

Regulatory incentives and financial reporting quality in public healthcare organisations

English National Health Service Foundation Trusts are subject to a regulatory regime in which the level of monitoring and intervention is determined by performance against two key performance metrics: a ‘financial risk rating’, based on a number of performance metrics, such as the reported surplus margin and return on assets, and a ‘prudential borrowing limit’. In this paper, we investigate the variation in financial reporting quality, proxied by discretionary accruals, with the incentives introduced by this regime. We find: first, that discretionary accruals are managed to report small surpluses; second, that, consistent with the avoidance of regulatory intervention in both the short and medium term, discretionary accruals are more positive when pre-managed performance is below intervention triggering thresholds and more negative when well above threshold; third, that, despite a move away from financial breakeven as the primary performance objective, there remains an aversion to small loss reporting. We further find that the level of discretionary accruals is driven by two metrics of strategic significance: the surplus margin (a measure of retained earnings) and the prudential borrowing limit (a measure of borrowing capacity).