Direct and substitution effects of regulations impacting the scope for classification shifting

We exploit two historic changes to Australian accounting standards to examine the direct and substitution effects of regulations impacting the scope for classification shifting. First, we consider whether reforms to the standard prescribing the format of the income statement (AASB 1018) introduced during 2001/02 reduced the extent to which core expenses were opportunistically misclassified as ‘abnormal’ in an attempt to boost ‘core earnings’ (the ‘direct effect’), and whether any reduction in classification shifting behavior induced greater use of accrual-based earnings management (the ‘substitution effect’). We then examine the impact of the introduction of AASB 101 in 2005, which effectively reversed the constraints on classification shifting introduced in 2001/02. We find that classification shifting using abnormal items was significantly reduced following the 2001/02 reform. However, this reform also appears to have induced an increased use of accruals management to manipulate core earnings, thus potentially impairing earnings quality. We find some weak evidence of an increase in classification shifting behavior following the adoption of AASB 101, but no evidence of any substitution effects involving accrual-based earnings management.     

Strategic revenue recognition to achieve earnings benchmarks

I examine whether managers use discretion in revenue recognition to avoid three earnings benchmarks. I find that managers use discretion in both accrued revenue (i.e., accounts receivable) and deferred revenue (i.e., advances from customers) to avoid negative earnings surprises, but find little evidence that discretion is used to avoid losses or earnings decreases. For a common sample of firms with both deferred revenue and accounts receivable, I find evidence that managers do not prefer to exercise discretion in either account. However, further tests show that managers preferred to use discretion in deferred revenue before the Sarbanes–Oxley Act of 2002 went into effect, consistent with them choosing to manage an account with the lowest real costs to the firm (i.e., future cash consequences). My results suggest that the revenue recognition joint project undertaken by the FASB and IASB to reduce managerial estimation in revenue recognition may have the unintended consequence of leading to greater real costs imposed on shareholders as firms are likely to use even greater discretion in accounts receivable.     

Female leadership and borrowing constraints: Evidence from an emerging economy

This study investigates the differences in credit access between male-managed and female-managed firms using two Enterprise Censuses in Vietnam. Our findings reveal that women-managed firms are less likely to borrow from commercial banks than their male counterparts, even when controlling for other determinants such as CEO education and experience, firm size, and ownership. No difference in credit access is documented for firms borrowing from non-commercial banks. Once we control for firm characteristics and CEO demographic factors, approved loan size is higher for firms managed by female CEOs regardless of the borrowing source. Using decomposition analysis, we find firm size contributes most in explaining the difference in credit access between female and male-managed companies.     

Valuation consequences of regulatory changes in revenue recognition: Evidence from advertising barter sales

This study compares the valuation of advertising barter sales recognized under APB Opinion No. 29, relative to transactions recorded under EITF Issue No. 99-17. EITF 99-17 was the FASB's response to the perception that Internet-related firms were overstating revenue. The results indicate an inverse relation between price-to-sales ratios and the amount of advertising barter recorded under APB 29 by e-tailing firms. In contrast, we find no evidence of a discount for similar transactions recognized under EITF 99-17. This change in value relevance is consistent with increased credibility of recorded revenue. These results have implications for revenue recognition practices and accounting regulation.     

Risk shifting and regulatory arbitrage: Evidence from operational risk

We document a robust negative relation between operational risk exposure and bank capital levels for a sample of large U.S. banks under the Basel I Capital Accords. The results are consistent with the notion that capital-constrained banks increased operational risk exposure at the time when Basel I regulations did not require an explicit capital charge for operational risk. More broadly, our results show new channel by which financial regulations incentivize banks to shift their risk taking to less regulated risk areas. We focus on the case of operational risk because it went from a largely unregulated risk type to a major risk that accounts for about 25% of large U.S. banks’ risk-weighted assets.     

Economic policy uncertainty and leverage dynamics: Evidence from an emerging economy

We test capital structure adjustments under dynamic trade-off theory using the standard partial adjustment framework, in light of long- and short-run economic policy uncertainties (EPU). Analysing a sample of Indian firms listed on the National Stock Exchange (NSE500) for 2009 to 2018, we report a positive association between EPU and leverage but a negative association between EPU and speed of adjustment. An additional analysis indicates that the positive influence of long-run policy shocks on leverage is channelled through the growth prospects available to them. The leverage of firms in industries that are more sensitive to government subsidies reports a stronger positive association between the two variables both in the long and short run. Also, analysis using the suppliers of credit emphasizes that the increase in cost of debt drives the positive association between EPU and leverage for Indian firms. By delving into the mechanisms that impact the association between EPU and speed of adjustment, we find that the negative impact of EPU on leverage adjustments is moderated through the change in investments and the cost of debt only in the long run. The group affiliated firms display a strong positive association between EPU and leverage but a stronger negative association between EPU and speed of adjustment. Our results are robust across alternative measures of EPU, leverage, technique vis-à-vis endogeneity, large sample (4165 listed Indian companies) and heterogeneities based on firm size.     

Tacit vigilance in an emerging economy: An institution-based perspective of passive blockholder monitoring

We argue that the relative effectiveness of active and passive blockholder monitoring is driven by the institutional context of the Korean financial market, characterized by the dominance of chaebols and the pressure sensitivity of institutional blockholders. We believe that the extensive business ties between chaebols and blockholders effectively increase the cost of shareholder activism in Korea, making passive monitoring a more applicable governance mechanism for blockholders. We test whether passive monitoring affects a firm’s earnings quality, represented by earnings persistence, value relevance, and timeliness. Furthermore, we decompose institutional shareholding by portfolio turnover and nationality and then determine the monitoring channel that influences earnings quality. We find that passive monitoring by domestic blockholders is most effective in improving earnings quality in Korea. In addition, our findings highlight that the difference between the institutional context of developed economies and that of Korea results in different outcomes related to blockholder monitoring.     

Philanthropic giving,market-based performance and institutional ownership: Evidence from an emerging economy

This paper investigates the association of philanthropic giving with market-based performance and institutional ownership using data from banks in Bangladesh from 2007 to 2013. Our findings suggest that banks with a higher level of philanthropic giving achieve better performance, with a positive association also found between philanthropic giving and institutional ownership. This implies that institutional owners invest in banks that contribute more to philanthropic activities. These findings should be of interest to managers, regulators and policy makers in countries that share similar financial and socio-economic systems.     

Directors' Recommendations on Takeover Bids and the Management of Earnings: Evidence from Australian Takeovers

This article investigates whether Australian companies manage their earnings during takeover bids in a manner consistent with the earnings-management hypothesis. This hypothesis predicts that directors who reject a bid use accrual accounting to increase current earnings, supporting their claim that the bid, relative to earnings, is inadequate. Likewise, directors who accept a bid are predicted to use accrual accounting to decrease current earnings. Overall, the results are not consistent with the earnings-management hypothesis. However, some components of unexpected accruals (our proxy for managed earnings) change in the direction predicted by the earnings-management hypothesis, although these changes are not statistically significant. Using industry adjusted performance measures the conclusion is that unexpected accruals are primarily a manifestation of poor financial performance of target firms in the period leading up to the takeover bid.     

Political Connections and Related Party Transactions: Evidence from Indonesia

This paper examines whether politically connected firms use related party transactions as a tunneling mechanism in Indonesia. We further investigate whether the presence of tunneling compels managers to manage earnings to conceal such expropriation of resources. Our study is motivated by conflicting evidence in the extant literature about the role of political connections and related party transactions. Using data from Indonesia, we document that politically connected firms use related party loans to tunnel resources, and that this effect is more pronounced for firms with government connections. We further document that politically connected firms manage earnings to conceal their tunneling activities. By documenting the role of related party transactions as a specific channel through which connected firms expropriate resources, we enrich the political connection and related party transactions literature.     

Split-share reform and earnings management: Evidence from China

This paper investigates the impact of split-share structure reform on earnings management in China. A unique institutional feature of China was the co-existence of two types of share that endowed all shareholders with equal voting and cash flow rights but different tradability. This split-share structure significantly constrained the tradability of shares that led the Chinese Securities Regulatory Commission to make it mandatory for the conversion of non-tradable shares into tradable shares from 2006 onwards. We investigate whether such a conversion has any effect on information quality through reduced earnings manipulation. We specifically examine the incentives for earnings management during the reform-transition period. A unique feature of the split-share reform has been the requirement for non-tradable share holders to compensate the tradable share holders. We argue that the rational response from the non-tradable share holders would be to pay a lower consideration to tradable share holders by portraying a favorable picture through income-increasing earnings management. We also test for the effect of an increase in tradable shares on earnings management during the reform-transition and post-reform period.     

Information asymmetry,mutual funds and earnings management: Evidence from China

This paper investigates how information asymmetry and mutual fund ownership affect listed companies’ earnings management. We show that (1) reducing information asymmetry improves firms’ earnings management behavior; (2) relative to short-term mutual funds, long-term mutual funds promote earnings quality by adopting a monitoring role; and (3) by dividing firms into high/low information asymmetry groups, we find that the information environment significantly increases the effect of long-term mutual funds on firms’ earnings management. In this paper, we provide new evidence for the role that institutional investors play in a typical emerging capital market. Our results have clear policy implications: to increase earnings quality, it is essential to improve information transparency and develop long-term institutional investors.     

Earnings management and initial public offerings: Evidence from the Netherlands

This paper presents one of the first studies of earnings management by initial public offering (IPO) firms in a European country. Using a sample of 64 Dutch IPOs, we investigate the pattern of discretionary current accruals (DCA) over time. We find that managers manage their company's earnings in the first year as a public company but not in the years before the IPO. We also examine the impact of earnings management on the long-run stock price performance of IPOs. We find a negative relation between the size of the DCA in the first year as a public company and long-run stock price performance over the next 3 years. A number of additional tests support these findings.     

Earnings management using classification shifting of revenues

This paper examines a novel form of classification shifting as an earnings management tool using a sample of 12,804 UK listed firm-year observations for the 1995–2014 period. It proposes a new approach to classification shifting whereby firms have scope to misclassify revenues from non-operating activities as operating revenues. The results establish that firms engage in classification shifting of non-operating revenues to inflate operating revenues. They indicate that firms in the period following mandatory IFRS adoption are associated with an increase in this practice, consistent with IFRS offering greater scope for manipulation. Further tests reveal that classification shifting of revenues is more pervasive for firms that report operating losses or have low growth.     

Earnings management at rights issues thresholds—Evidence from China

Burgstahler and Dichev (BD) (Burgstahler, David, Ilia, Dichev, 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 23(1), 99–126.) and Degorge, Patel, and Zeckhauser (DPZ) (Degeorge, Franscois, Patel, Jayendu, Zeckhauser, Richard, 1999. Earnings management to exceed thresholds. Journal of Business 72(1), 1–33.) examine earnings management among American firms by looking at actual distributions around critical thresholds. Chinese firms must meet minimal ROE requirements if they are to have rights issues. Using a distribution approach, we examine whether Chinese firms manipulate their earnings to meet the regulatory requirements. Our empirical findings indicate that Chinese firms indeed heavily engaged in earnings management to meet the rights issue thresholds during the period 1994–2002. In addition, we show that these firms changed their behavior in response to changes in regulatory requirements. Furthermore, we analyse the pervasiveness of this practice and the means used in earnings management at the relevant ROE thresholds. Our findings have direct policy implications for the China Securities Regulatory Committee (CSRC).     

Unintended consequences of expense ratio guidelines: The Avon breast cancer walks

This case study examines how donor and rating agency focus on percentage-based expense ratios exacerbated pressures on the Avon Product Foundation’s breast cancer walks. Beginning in 2002, Avon changed its business and accounting practices in ways that eventually helped it report better compliance with charity monitor guidelines. However, the number of walkers and amounts of funds raised dropped; the new accounting practices are less transparent and of questionable conformity with GAAP.     

Discretion in revenue recognition timing and comparability: Evidence from the implementation of SOP 97-2

An objective of financial reporting regulation is to encourage the production of decision-useful information. This paper examines the association between the level of discretion allowed in accounting standards and comparability, a key characteristic of decision-useful reporting. To study this link, I investigate changes in comparability around regulation SOP 97-2, which decreased discretion in the timing of revenue recognition on software-related transactions. Using a difference-in-differences research design, I find a positive association between discretion and comparability for affected firms, relative to control firms. This result is attenuated for firms with low reporting quality prior to the rule change and those that experienced a larger direct impact on their revenue recognition practices. This paper furthers understanding of the linkage between reporting discretion and the decision-usefulness of accounting outputs. Additionally, the results highlight the complex interactions between various financial reporting attributes.     

Earnings management,audit adjustments,and the financing of corporate acquisitions: Evidence from China

Acquirers are motivated to overstate earnings prior to stock-financed acquisitions. We hypothesize that audits help to detect and correct such overstatements. We test this using a difference-in-differences design, which compares audit adjustments to earnings for stock-financed and cash-financed acquirers before versus after the acquisitions. Consistent with our hypothesis, we find larger downward adjustments in the audits immediately before stock-financed acquisitions. Further analysis of regulatory sanctions suggests the downward adjustments are in fact warranted, rather than auditors being overly conservative. Moreover, modifications in audit reports suggest that downward adjustments do not correct all of the reporting irregularities in audited financial statements.     

External financing and earnings management: Evidence from international data

Corporate financing conditions in the external capital market are significantly affected by information asymmetry, while internal financing is not. Given that earnings information influences market perceptions regarding firms’ quality, firms relying on external financing should have incentives to manage earnings to improve their financing conditions. This study investigates the effect of corporate external financing behavior on earnings management. Using a sample comprising 75,790 observations of 12,874 firms in 43 countries, we find that accrual-based and real earnings management are positively associated with firms’ reliance on external financing. This positive relationship holds especially true for firms that rely on equity rather than debt financing. We argue that reliance on external financing (especially equity financing), which is subject to problems arising from information asymmetry, generates a motive for earnings management.     

A game of accounting numbers in asset pricing: Evidence from the privatization of state-owned enterprises

This study examines a public policy issue: whether government officials engage in earnings management to collude with private investors in the privatization of state-owned enterprises (SOEs). We find that the managers of listed Chinese SOEs, who are de facto bureaucrats, employ income-decreasing earnings management to reduce the price of shares to be sold to private investors. We also find that more aggressive income-decreasing earnings management is associated with a lower CEO turnover rate in the year following the privatization. These findings highlight the need to consider the opportunism of government agents when accounting information is used in redistribution of state assets.