Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals?

Abstract:   This paper examines whether the incidence of earnings management by UK firms depends on board monitoring. We focus on two aspects of board monitoring: the role of outside board members and the audit committee. Results indicate that the likelihood of managers making income‐increasing abnormal accruals to avoid reporting losses and earnings reductions is negatively related to the proportion of outsiders on the board. We also find that the chance of abnormal accruals being large enough to turn a loss into a profit or to ensure that profit does not decline is significantly lower for firms with a high proportion of outside board members. In contrast, we find little evidence that outside directors influence income‐decreasing abnormal accruals when pre‐managed earnings are high. We find no evidence that the presence of an audit committee directly affects the extent of income‐increasing manipulations to meet or exceed these thresholds. Neither do audit committees appear to have a direct effect on the degree of downward manipulation, when pre‐managed earnings exceed thresholds by a large margin. Our findings suggest that boards contribute towards the integrity of financial statements, as predicted by agency theory.     

Strategic Conservative Earnings Management of Technology Firms: Evidence from the IPO Market

In this paper, we investigate the conservative earnings management strategies of technology firms in the IPO market. We hypothesize that technology IPOs, due to their fewer tangible assets, more information asymmetry, and higher uncertainties of future cash flows, tend to have higher litigation risk. At equilibrium, technology firms are more motivated to strategically employ conservative earnings management during the IPO process, to mitigate their higher litigation risk. Using a sample of U.S. IPOs, we find that technology IPOs, on average, involve significantly more conservative earnings management, especially during the bubble periods. Our results also show that the conservative earnings management strategies of technology firms tends to have a greater impact on their underpricing than for non‐tech firms, and thus effectively reduce their risk of being a target in the securities class action lawsuits.     

The consequences of earnings management for the acquisition premium in friendly takeovers

This study investigates the effect of earnings management (EM) on deal premiums in friendly takeovers. It examines both accruals and real EM in the year preceding the deal announcement, based on a sample of 578 European firms subject to an acquisition or acquisition attempt between 2005 and 2015. The empirical findings suggest that downward EM is associated with a higher premium offered by the acquirer. The results suggest that income-decreasing accounting choices could be a negotiated strategy between the acquirer and target firms’ managers to clean the balance sheet, reduce the likelihood of litigation, and create a fictive performance through an accrual reversal post-acquisition.     

Litigation environment and auditors’ decisions to accept clients’ aggressive reporting

This study contributes to accounting and auditing literature by addressing two empirical questions: (1) whether litigation environment affects auditors’ decisions to accept clients’ aggressive reporting and (2) whether litigation environment, client business risk, and client retention pressure interact and jointly affect auditors’ decisions to go along with clients’ preferred accounting choices. Fifty-nine (59) US and sixty-one (61) Hong Kong auditors employed by the Big-4 accounting firms participated in this study. The result shows that litigation environment has a significant effect on auditors’ decisions. Auditors who practice in more litigious environments tend to be less willing to go along with clients’ aggressive reporting than those who practice in less litigious environments. This study also confirms that there is a significant interactive effect between litigation environment, client business risk, and client retention pressure on auditors’ decisions to accept clients’ aggressive reporting choices. Implications of the empirical findings for policymakers, standard-setting organizations, and international accounting firms, as well as directions for future studies, are discussed.     

Litigation risk,underpricing, and money-losing IPOs

We examine the impact of firms' pre-IPO earnings on the relationship between litigation risk and IPO underpricing. We confirm the insurance effect of the lawsuit avoidance hypothesis; however, we find that the use of underpricing to reduce litigation risk is mainly associated with firms with negative earnings at the time of going public. Our results are robust to the timelines over which sample firms were sued, alternative underpricing measures, the addition of various control variables to our baseline regression models, and different proxies to categorize IPO firms. We also investigate the relationship between litigation risk, pre-IPO earnings, and underwriter gross spreads. The results indicate that, when dealing with firms facing a high risk of litigation, underwriters charge significantly higher spreads to negative-earnings issuers than profitable IPO firms.     

The Effect of Earnings Management on the Asymmetric Timeliness of Earnings

Abstract:   Is earnings management affecting (driving) the measures of earnings conservatism? Ball et al. (2000) point out that the asymmetry in the recognition of good and bad news in earnings (faster recognition of bad news: earnings conservatism) is more pronounced in common‐law than in code‐law based accounting regimes. However, comparative studies on earnings conservatism in Europe have failed to identify significant differences between common‐law and code‐law based countries. We argue that in code‐law based countries managers have incentives to reduce earnings consistently. This enhances the association between earnings and returns in bad news periods. We find that after controlling for discretionary accruals, the differential earnings response to bad news in Germany and France decreases significantly.     

The role of accounting conservatism in management forecast bias

We investigate whether management earnings forecasts fully incorporate information in historical accounting conservatism. We find that management earnings forecasts are more optimistic for firms with greater accounting conservatism in the previous year. We further examine whether this conservatism-related optimistic bias in management earnings forecasts varies with managers’ difficulty predicting earnings accurately, managers’ opportunistic incentives, and the firms’ litigation risk. We find that the negative association between management forecast errors and conservatism increases, to various extent, with the firms’ operating cycles, earnings volatility, and the width of forecast range but does not change with proxies for opportunistic incentives or litigation risk. These results suggest that forecast difficulty is the primary reason for managers’ failure to incorporate conservatism fully in their earnings forecasts.     

Relationship Networks and Earnings Informativeness: Evidence from Corruption Cases

The measurement difficulties arising from relationship‐based business transactions can result in accounting opacity. We test this hypothesis by exploiting a natural experiment. Using a sample of firms that were networked with 45 high‐level Chinese bureaucrats involved in corruption scandals between 1996 and 2007, we examine the patterns in the earnings informativeness of these firms before and after the exogenous break of the networks. We predict that the costs and benefits of business‐politics relationships, which are not measurable by the current accounting systems, diminish the ability of accounting earnings to track a firm's economic performance. In turn, a break in a political relationship due to anti‐corruption enforcement reduces the measurement noise and improves the earnings informativeness. We find that, relative to the matched control firms, there is indeed a significant increase in the earnings informativeness of the networked firms following the public exposure of a scandal. Robustness tests fail to show that the documented improvement in the earnings informativeness is primarily due to systematic changes in the firms’ earnings management behavior or disclosure policies.     

Regular Dividend Announcements and Future Unexpected Earnings: An Empirical Analysis

Previous studies have interpreted stock price reaction to dividend announcements as being consistent with the hypothesis that any changes are forecasts of future corporate profits. Recent studies seem to provide evidence to this effect. This study provides additional empirical evidence pertaining to the issue of whether quarterly cash dividend announcements convey useful information about a firm's future profitability, beyond that contained in contemporaneous quarterly earnings announcements. The association between unexpected changes in quarterly dividends and unexpected accounting earnings in subsequent quarters is examined, after controlling for information contained in past and current earnings series. The results, based on a large sample of regular quarterly cash dividend changes, indicate that firms that increased (decreased) their dividends realized, on average, greater (smaller) unexpected accounting earnings in subsequent periods than firms that did not change their dividends.     

Earnings Management and Antitrust Investigations: Political Costs Over Business Cycles

This paper examines evidence of earnings management pertaining to regulatory-imposed wealth transfers (i.e., political costs) over business cycles. The sample consists of firms subject to merger-related antitrust investigation under Section 7 of the Clayton Act. Industrial organization literature, together with the political cost hypothesis, suggests that these firms' earnings management incentives may vary over national business cycles. Our results indicate that investigated firms do indeed choose income-decreasing discretionary accruals during expansions but not during recessions, in order to reduce the political costs associated with Clayton Act cases.     

Investor Sentiment and Corporate Disclosure

This paper investigates how firms react strategically to investor sentiment via their disclosure policies in an attempt to influence the sentiment‐induced biases in expectations. Proxying for sentiment using the Michigan Consumer Confidence Index, we show that during low‐sentiment periods, managers increase forecasts to “walk up” current estimates of future earnings over long horizons. In contrast, during periods of high sentiment, managers reduce their long‐horizon forecasting activity. Further, while there is an association between sentiment and the biases in analysts' estimates of future earnings, management disclosures vary with sentiment even after controlling for analyst pessimism, indicating that managers attempt to communicate with investors at large, and not just analysts. Our study provides evidence that firms' long‐horizon disclosure choices reflect managers' desire to maintain optimistic earnings valuations.     

Earnings Conservatism, Litigation and Contracting: The Case of Cross‐Listed Firms

Abstract:   We compare earnings conservatism of UK companies cross‐listed in the US to that of UK companies without a US‐listing. We expect that conservatism will be more pronounced for cross‐listed firms than for firms with a UK listing only, because the cross‐listed firms face a stricter enforcement regime. Furthermore, cross‐listed firms may use a listing on a US exchange to signal high‐quality reporting to investors. Using a matched‐pairs research design, we find that earnings of UK cross‐listed firms are significantly more conservative than earnings of UK firms without a US listing. Moreover, cross listed firms display particularly high levels of conservatism during the early years of their cross‐listing. This indicates that firms use earnings conservatism to commit to highly demanding reporting requirements and in doing so communicate a perception of investor care.     

Discretionary accounting choices and the predictive ability of accruals with respect to future cash flows

Using a sample of restatement firms and a meet-or-beat model to classify firms as making discretionary accounting choices for opportunistic meet-or-beat (OP-MB) reasons, we show that originally reported earnings and accrual components are less predictive of future cash flows relative to the restated numbers. We find the opposite is true for firms classified as making discretionary accounting choices for non-OP-MB reasons. We consider a number of competing explanations for these latter results. Our findings are most consistent with the informational hypothesis, weakly consistent with conservative-motivated efficient contracting hypotheses, but inconsistent with opportunistic contracting and misapplication/errors of GAAP explanations.     

The Relevance of Analysts' Earnings Forecasts in Japan

Abstract:   This study examines the role of financial analysts in equity valuation in Japan by comparing the relevance of financial analysts' earnings forecasts, over financial statement information, to investors' decisions. We find that the value‐relevance of a set of accounting variables is very modest, but the incremental contribution of analysts' forecasts is very significant. This is in line with the expectation that the skill and expertise of analysts are more valuable in markets with poor financial disclosure, such as Japan. We also find that the importance of the financial statements increases over time while the importance of the analysts' forecasts does not change. We also provide evidence of the effect of Japanese corporate groupings, keiretsu, on the informativeness of accounting signals and earnings forecasts. The results show that the contribution of accounting variables to valuation is lower for keiretsu firms, which supports the exclusionary hypothesis that companies which are a part of keiretsu, disclose less information than do non‐keiretsu companies. The analysts' forecasts are equally important for investors in both types of firms.     

The Information Signaling Hypothesis of Dividends: Evidence from Cointegration and Causality Tests

This paper uses cointegration and causality tests to study the temporal behavior of dividends and earnings at the individual firm level. We find that, for a sample of 143 non‐utility firms, approximately one‐fifth of the firms exhibits a temporal relationship between dividends and earnings that is consistent with the information signaling hypothesis of dividends. In the case of 72 utilities, about a third exhibit dividend policies that are consistent with the signaling notion of dividends. Further examination of firm characteristic differences between signaling and non‐signaling firms shows that, in the case of non‐utility firms, signaling firms tend to be smaller, have a lower growth rate of total assets, and have a higher leverage ratio. In the case of utilities, we find no major differences in firm characteristics between signaling and non‐signaling firms.     

Earnings Management of Firms Subjected to Product Price Controls

This study documents Australian firms' earnings management activities in response to product price controls established by the Australian government in the early 1970s. We predict that firms subject to price controls will adjust their discretionary accounting accruals downward to reduce reported net income and to increase the likelihood of approval of the requested price increase. To control for the confounding effect of performance, we analyse the performance of two groups of firms subject to price scrutiny prior to the event window and estimate the earnings management of these firms and a control group of firms during the period of scrutiny. Our results based on both longitudinal and a cross sectional experimental designs confirm that firms that were subject to the greatest scrutiny engaged in significant negative earnings management during the period of scrutiny, but not outside that period. Further, firms that were not subject to price controls did not engage in any significant earnings management during the same periods.
JEL classification: M41; M43     

Accounting flexibility and managers’ forecast behavior prior to seasoned equity offerings

This study examines the effect of accounting flexibility on managers’ forecasting behavior prior to seasoned equity offerings (SEOs). Although SEO firms have a strong incentive to convey optimistic information to boost the pre-SEO stock price, they also face enhanced litigation risk arising from SEO-related regulations. Thus, I hypothesize that managers will release positive news through their forecasts (relative to the prevailing analyst consensus) prior to an SEO only if they have the accounting flexibility to manage subsequent reported earnings to meet or exceed their forecasts. I find that managers with greater accounting flexibility are more likely to issue a forecast prior to the SEO and that their forecasts are more likely to convey positive news and are more specific. Furthermore, I find no effect of accounting flexibility for non-SEO control firms or for non-SEO periods. My results suggest that when managers experience a tension between the incentive for voluntary disclosure and high litigation risk, accounting flexibility is an important factor that determines their forecasting behavior.     

Political corruption and accounting choices

We examine how political corruption affects firms’ accounting choices. We hypothesize and find that firms headquartered in corrupt districts manipulate earnings downwards, relative to firms headquartered elsewhere. Our finding is robust to alternative corruption measures, alternative discretionary accrual measures, alternative model specifications, the instrumental variable approach and difference-in-differences analyses based on firm relocation and high profile cases. We find that firms headquartered in corrupt districts prefer income-decreasing accounting choices and exhibit higher conservatism. Finally, we find that the effect of corruption on earnings management is more pronounced for geographically concentrated firms, for firms without political connections, for firms in politically sensitive industries, for firms with lower transient institutional investor ownership and for firms with less analyst coverage. In sum, our findings suggest that firms respond to corruption by lowering their accounting earnings.     

The decision relevance and timeliness of accounting earnings in Saudi Arabia

This study examines the decision relevance and timeliness of accounting earnings in Saudi Arabia during the 1995-1999 sample period. The empirical results suggest that the publication of accounting earnings does not cause significant revision to the market assessment of future cash flows of Saudi firms. On the other hand, it appears that the publication of accounting earnings leads individual investors to revise their security holdings. However, this evidence is limited to cases where firms reported profit. The empirical results further suggest that earnings are timely in terms of their association with security returns and that increasing the measurement interval significantly improves this association. The tests also show that positive and negative earnings have differential implications for the timeliness of accounting earnings. Further tests show that this evidence is not consistent with the loss liquidation argument [J. Account. Econ. 20 (1995) 125] and, potentially, may reflect the lack of tax incentives to liquidate investments in loss firms. Finally, the results show that Saudi managers do not incorporate economic losses into accounting earnings on a timely basis which may reflect reduced market demand for accounting information, low levels of public debt, low expected litigation costs, and weak monitoring by analysts and other stakeholders.     

International Accounting Standards and Accounting Quality

We examine whether application of International Accounting Standards (IAS) is associated with higher accounting quality. The application of IAS reflects combined effects of features of the financial reporting system, including standards, their interpretation, enforcement, and litigation. We find that firms applying IAS from 21 countries generally evidence less earnings management, more timely loss recognition, and more value relevance of accounting amounts than do matched sample firms applying non‐U.S. domestic standards. Differences in accounting quality between the two groups of firms in the period before the IAS firms adopt IAS do not account for the postadoption differences. Firms applying IAS generally evidence an improvement in accounting quality between the pre‐ and postadoption periods. Although we cannot be sure our findings are attributable to the change in the financial reporting system rather than to changes in firms' incentives and the economic environment, we include research design features to mitigate effects of both.