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.     

Value relevance of discretionary accruals in the Asian financial crisis of 1997-1998

This study investigates whether and how the information values of reported earnings and their components changed around the Asian financial crisis of 1997-1998. Regression analyses on a sample of 10,406 firm-years from nine Asian countries from 1995 to 2000 reveal the following. First, the crisis led to a significant decline in the value relevance of discretionary accruals but had no significant impact on the value relevance of non-discretionary earnings components such as operating cash flows and non-discretionary accruals. Second, the decrease in the value relevance of discretionary accruals during the crisis was more severe for firms in countries with weak institutions than for those in countries with strong institutions. Third, the value relevance of discretionary accruals declined to a greater extent for firms with high information asymmetries than for firms with low information asymmetries. Our results are robust to a variety of sensitivity checks.     

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.     

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.     

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.     

Managerial Ownership, Information Content of Earnings, and Discretionary Accruals in a Non–US Setting

This study employs Danish data to examine the empirical relationship between the proportion of managerial ownership and two characteristics of accounting earnings: the information content of earnings and the magnitude of discretionary accruals. In previous research concerning American firms, Warfield et al. (1995) document a positive relationship between managerial ownership and the information content of earnings, and a negative relationship between managerial ownership and discretionary accruals. We question the generality of the Warfield et al. result, as the ownership structure found in most other countries, including Denmark, deviates from the US ownership configuration. In fact, Danish data indicate that the information content of earnings is inversely related to managerial ownership.     

Executive compensation and earnings management: Empirical evidence from Japan

This study investigates the relation between discretionary accounting choices and executive compensation in Japanese firms. The results show that the use of discretionary accruals increases executive compensation. The analyses also show that firm managers receiving no bonus adopt income-decreasing accruals and extraordinary items. In particular, evidence shows that negative extraordinary items are strongly associated with no bonus payment. Finally, the research indicates that the association between discretionary accruals and executive bonus varies depending upon the circumstances of the firm. This study contributes to the literature on earnings management from an international comparative perspective since most previous studies on earnings management and executive compensation have focused on U.S. firms.     

Insider Trading and Earnings Management

Abstract:  This paper analyzes the relationship between earnings management and insider trading, specifically investigating whether discretionary accruals are related to insider trading and valuation. We find strong evidence of insiders managing earnings downward when buying and managing earnings upward when selling. On the marginal basis, value (high book-to-market value) firms manage their earnings upward compared to growth (low book-to-market value) firms, consistent with a signaling hypothesis. However, the opposite is true on the average basis, consistent with an opportunistic hypothesis.     

Accruals and firm life cycle: Improving regulatory earnings management detection

Regulators have invested considerable energy into developing analytical tools to better detect earnings management. We propose that firms in similar life cycle stages (LCSs) face similar strategic concerns, managerial pressures, growth prospects, etc., and that the commonality in these factors contribute to the “normal” accruals generating process. Consistent with this prediction, we simulate various earnings management conditions and find that accruals models are misspecified in detecting manipulation within particular LCSs; in particular, introduction, shakeout, and decline firms are over-identified as manipulators, while growth and mature firms are under-identified as manipulators when LCS is not used to estimate accruals. Weighted average performance across life cycle stages reveals that LCS estimation of discretionary accruals substantially improves successful detection and reduces Type I errors relative to other grouping alternatives. The combined improvement across both Type I and Type II errors is over 70% for both the modified Jones and discretionary revenue models of accruals-based earnings management.     

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.     

Big Six auditors and audit quality: The Korean evidence

This study investigates the association between discretionary accruals and Big Six and non-Big Six auditors, and the direction of auditor change. We hypothesize that there is no significant difference in discretionary accruals between Big Six and non-Big Six clients when there is low incentive for auditors to provide high-quality audits, as in Korea.Upon examination of the discretionary accruals of firms listed on the Korean Stock Exchange from 1994 to 1998, we find there is no significant difference between the discretionary accruals of firms with Big Six and non-Big Six auditors. This holds true for firms that switch from non-Big Six to Big Six auditors and vice versa. These resources imply that there may be no difference in audit quality between Big Six and non-Big Six auditors in Korea. This is consistent with other studies in Korea, while inconsistent with the findings of previous studies on audit quality in other countries.     

Sarbanes–Oxley Act and the quality of earnings and accruals: Market-based evidence

In this paper we study the impact of the Sarbanes-Oxley Act (SOX) on the valuation weights of earnings and earnings components. The analysis seeks evidence that SOX is associated with changes in investors’ perception of earnings and accruals quality. Of particular interest in the analysis is the effect of SOX on the valuation weight of discretionary accruals that are perceived to be most vulnerable to manipulation prior to SOX. We find reliable increases in the valuation weights of earnings and earnings components after the passage of SOX. Nonetheless, we also find that the post-SOX shifts in the valuation weights of earnings and earnings components are indistinguishable from zero among firms in which the percentage equity shares held by institutional investors is 15% or greater.     

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.     

The effect of alternative goals on earnings management studies: An earnings benchmark examination

Firms’ management manages earnings because they have incentives or goals to do so. Earnings management studies have to account for these different goals as tests of earnings management can be compromised by the effect of conflicting goals. I illustrate this in the setting of Dechow et al. (2003). Their study examines whether firms with small profits and firms with small losses (loss-avoidance benchmark) have differing levels of discretionary accruals. Dechow et al. (2003) find that firms just above the loss-avoidance benchmark do not have discretionary accruals that are significantly different than firms just below the benchmark. However, they do not consider firms just below the loss-avoidance benchmark that might be using discretionary accruals to avoid missing an alternative benchmark. I find that after I consider these alternate earnings benchmark goals, firms just above the benchmark have significantly higher discretionary accruals. This provides direct evidence that the ‘kink’ in the distribution of earnings arises from earnings management. I find similar results for the earnings changes benchmark. These findings highlight the need to consider alternative earnings benchmark goals when examining firms immediately around benchmarks.     

Institutional investor type,earnings management and benchmark beaters

This paper classifies institutional investors into transient or long-term by their investment horizons to examine the association between institutional investor type and firms’ discretionary earnings management strategies in two mutually exclusive settings – firms that (do not) use accruals to meet/beat earnings targets. The results support the view that long-term institutional investors constrain accruals management among firms that manage earnings to meet/beat earnings benchmarks. This suggests long-term institutional investors can mitigate aggressive earnings management among these firms. Transient institutional ownership is not systematically associated with aggressive earnings management and is evident only among firms that manage earnings to meet/beat their earnings benchmarks. This indicates transient institution-associated managerial myopia may not be as prevalent as posited by critics. This study highlights the importance of explicitly considering the type of institutional investor and the specific setting when investigating the association between institutional ownership and corporate earnings management.     

Earnings quality and firm valuation: international evidence*

This study uses a sample of over 7000 firms in 38 countries to investigate the relation between firm valuation and earnings quality. We find a positive and significant relation between firm valuation and an aggregate earnings quality measure based on seven earnings attributes (accruals quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism). This relation is particularly strong for firms with greater investment opportunities and more need for external finance, and for firms in low investor protection countries. Thus, firms are able to compensate for a weak legal environment by adopting higher earnings quality standards, particularly when they need to gain access to global capital markets. Overall, our findings suggest that firms with higher earnings quality are valued more highly in stock markets, supporting the idea that investors require a premium for the information risk associated with lower‐quality 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.     

Measuring discretionary accruals: are ROA-matched models better than the original Jones-type models?

Discretionary accruals estimated from Jones-type models are elevated or depressed for firms with extreme performance. Kothari et al. (J Acc Econ 39:163–197, 2005) propose performance matching to address the issue, that is, to difference discretionary accruals estimated from Jones-type models for treatment and control firms matched on current ROA. This study shows (1) performance matching will systematically cause discretionary accruals of either sign to be underestimated, and (2) the measurement error will be negatively correlated with the true discretionary accruals. As a result, using discretionary accruals estimated with performance matching to test whether certain events induce earnings management will increase the frequency of Type II errors, and using them as the dependent or an independent variable in regression analysis will bias the regression coefficient toward zero. The results of our empirical tests are consistent with these predictions.     

Earnings management of initial public offering firms: evidence from regulation changes in China

Discretionary current accruals of Chinese initial public offering (IPO) firms decreased after the abolition of fixed‐price offering systems that directly linked offering price to reported earnings. Results suggest IPO firms that decrease managerial ownership manage earnings upward during the fixed‐price offering period, but this relationship disappeared after the introduction of a book‐building system. We also find that bank debt is negatively related to discretionary current accruals during the fixed‐price offering period, but no relation exists for the book‐building period. Leverage has a significant positive relationship with earnings management. However, this finding is potentially attributable to nonoffering price objectives or endogeneity biases.