Pension accrual management and research and development investment

This study investigates whether discretion in reporting pension expenses mitigates research and development (R&D) manipulation. Using a sample of Japanese manufacturing firms during the fiscal years 2001–2011 where both pension costs and R&D expenditures have large impacts on the bottom‐line earnings, I find that higher discount rates are associated with higher R&D investment among firms in which pension expenses could have large impacts on reported earnings. I also find that this relationship is found only among firms in high‐tech industries. These results suggest that pension accrual management substitutes costly R&D manipulation that may hurt future competitive edge.     

Hierarchy of earnings thresholds based on discretionary accruals

Prior studies identify hierarchies of earnings thresholds based on distributions of earnings (e.g., Degeorge et al., 1999) and survey opinions of CFOs (Graham, Harvey, & Rajgopal, 2005). We complement extant literature by investigating a threshold hierarchy in the context of accounting discretion exercised by managers. We examine the relative extent of discretionary accruals used to achieve three earnings thresholds—avoiding losses, avoiding earnings declines, and avoiding negative earnings surprises. Our empirical findings suggest that managers are likely to use the largest amount of discretionary accruals to avoid earnings declines, and the least amount of discretionary accruals to avoid negative earnings surprises. Thus, this study identifies the hierarchy of the earnings thresholds based on accounting discretion used in financial reporting. We also find that the hierarchy remains stable over the last two decades during our sample period. Then, we provide several explanations for why managers are likely to exercise more accounting discretion to avoid earnings declines. These explanations include earnings smoothing, reduction of stock returns volatility, and signaling of future growth potential. Overall, this study provides new insights into accruals management behavior.     

Annual report readability, current earnings, and earnings persistence

This paper examines the relation between annual report readability and firm performance and earnings persistence. I measure the readability of public company annual reports using the Fog index from the computational linguistics literature and the length of the document. I find that: (1) the annual reports of firms with lower earnings are harder to read (i.e., they have a higher Fog index and are longer); and (2) firms with annual reports that are easier to read have more persistent positive earnings.     

Economic policy uncertainty and bank earnings opacity

Using a sample of U.S. banks and an index for economic policy uncertainty developed by Baker et al. (2016), we investigate whether economic policy uncertainty is systematically related to bank earnings opacity. When economic policy is relatively uncertain, it is easier for bank managers to distort financial information, as unpredictable economic policy changes make assessing the existence and impact of hidden “adverse news” more difficult for investors and creditors. Economic policy uncertainty also increases the fluctuation in banks’ earnings and cash flows, thus providing additional incentives and opportunities for bank managers to engage in earnings management. Our results show that uncertainty in economic policy is positively related to earnings opacity, proxied by the magnitude of discretionary loan loss provisions and the likelihood of just meeting or beating the prior year’s earnings, and negatively related to the level of accounting conservatism (i.e., the timeliness of recognition of bad news relative to good news). Collectively, our results suggest that economic policy uncertainty leads to greater earnings opacity. We also find that the impact of economic policy uncertainty on financial reporting distortion is less pronounced for stronger banks (i.e., banks with high capital ratios).     

Earnings quality and short selling: Evidence from real earnings management in the United States

Prior research provides evidence consistent with managers using real earnings management (REM) to increase earnings. This study examines whether short sellers exploit the overvaluation of firms employing REM. I find that firms with more REM have higher subsequent short interest. The positive relation between REM and short interest is more pronounced in settings where the costs associated with accrual‐based earnings management are high, such as when a firm has low accounting flexibility or faces greater scrutiny from a high quality auditor. I also find some evidence that short sellers respond to REM more than to other fundamental signals of firm overvaluation. My inferences are robust to the use of propensity score matching. Collectively, my evidence suggests that short sellers not only trade on REM information, but they also trade as if they understand the substitutive nature of alternative earnings management methods. This study provides additional insight into the important role that short sellers play in monitoring managerial operating decisions and overall earnings quality.     

The impact of abnormal real earnings management to meet earnings benchmarks on future operating performance

Motivated by agency conflicts of real earnings management (e.g., opportunistic and signalling perspectives), this study investigates the association between firms that manipulate their business operations to meet earnings benchmarks (i.e., zero earnings, last year's earnings) and subsequent operating performance. We examine the effects of the magnitude of real earnings management on firms' future performance for the period 2009 to 2015 for UK firms. Our analysis shows that the manipulation of operating activities such as sales, discretionary expenditures, and production costs to meet earnings benchmarks has a significantly positive consequence for firms' subsequent operating performance and signals firms' good future performance. We also find that firms that manipulate their operating activities in the absence of meeting earnings benchmarks experience a decline in their subsequent operating performance. The findings of this research lend support to our understanding of the process that management follows to evaluate costs and benefits of real earnings management.     

The effect of voluntary clawback adoption on non-GAAP reporting

We examine the effect of voluntary adoption of clawback provisions on non-GAAP earnings disclosures. Prior literature documents that voluntary clawback adoption improves financial reporting quality by increasing the costs of misstating GAAP earnings. However, managers may respond to perceptions of reduced discretion over GAAP reporting by increasing their reliance on non-GAAP earnings disclosures. Using a propensity score matched sample, we find that non-GAAP earnings disclosure frequency increases and non-GAAP exclusion quality decreases after clawback adoption, consistent with a more opportunistic use of non-GAAP reporting. Additional cross-sectional tests help support this interpretation.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

Earnings quality at initial public offerings

We show that, contrary to popular belief, initial public offering (IPO) firms report more conservatively. We attribute this to the higher quality reporting demanded of public firms by financial statement users and consequentially higher monitoring by auditors, boards, analysts, rating agencies, press, and litigants, and to greater regulatory scrutiny [Ball, R., Shivakumar, L., 2005. Earnings quality in UK private firms: comparative loss recognition timeliness. Journal of Accounting and Economics 39, 83–128]. We also question the evidence of Teoh et al. [1998b. Earnings management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935–1974] supporting the alternative hypothesis that managers opportunistically inflate earnings to influence IPO pricing. We conjecture that upward-biased estimates of “discretionary” accruals occur in a broad genre of studies on earnings management around similar large transactions and events.     

Unexpected Accruals and Conditional Accounting Conservatism

Abstract:  This paper examines the impact of management discretion over accruals on conditional accounting conservatism, defined as the tendency of accountants to recognize bad news on a timelier basis than good news. Prior research suggests that conditional accounting conservatism reflected in earnings is mainly due to the accrual component of earnings, not the cash flow component of earnings. After decomposing total accruals into expected and unexpected accruals, I find that (1) conditional accounting conservatism reflected in accruals is mainly due to unexpected accruals; (2) the negative association between unconditional and conditional accounting conservatism is mainly attributable to unexpected accruals; and (3) firms with higher leverage exhibit conditionally more conservative accounting primarily through unexpected accruals. These results are robust to accrual models that take into account the systematic association between accruals and cash flows and their non-linearity and to the asymmetric persistence of earnings changes specification of conditional accounting conservatism. Taken together, these results suggest that managers exercise their discretion over accruals to expedite the recognition of bad news rather than good news.     

Quality of reported earnings by Chinese firms: The influence of ownership structure

This paper examines the influence of ownership structure on earnings quality of firms listed on the Chinese Stock Exchanges. We empirically test four contemporary earnings quality measures, including volatility of earnings, variability of earnings over cash flows, correlations between accruals and cash flows, and level of discretionary accruals, for 1438 firms listed on Shenzhen Stock Exchange and Shanghai Stock Exchange. We find that although state-owned firms are bigger in size and appear more profitable based on reported earnings; privately-owned firms, foreign-owned firms and society-owned firms outperform the state-controlled firms in earnings quality; and foreign-owned firms have the highest earnings quality among all types of ownership groups. We find that there is not much difference in earnings quality between collectively-owned firms and state-owned firms and employee-owned firms exercise least discretion in earnings management. The findings in particular will have direct policy implications for the China Securities Regulatory Committee (CSRC).     

Corporate lobbying: Resource-seeking or rent-seeking? Evidence from audit fees

Theory and prior research suggest that corporate lobbying is a primary means that corporations use to influence government policies either for improving firm performance (i.e., strategic decisions) or for rent-seeking activities (i.e., agency costs) but the evidence between lobbying activities and auditor assessments of audit risk remains unclear. Our results show that lobbying firms are associated with higher audit risks and fees, consistent with the idea that lobbying is related to rent-seeking and higher agency costs. In cross-sectional analyses, we find that the positive association between lobbying and audit fees is weaker for firms with strong corporate governance. Further analysis shows that firm financial returns or low earnings quality mediate the relationship between lobbying and audit fees. The results suggest that practitioners, users of financial statements and regulators could benefit by recognizing that lobbying activities could signal managerial opportunistic behavior.     

Disclosure timing: Determinants of quarterly earnings release dates

Existing research on discretionary disclosures provides valuable insights on the potentials causes and consequences of alternative forms of disclosure. However, relatively little is known about how managers choose to time the release of financial information. This paper focuses on the quarterly earnings release dates and investigates why some choose to release earnings information relatively early, compared to others. The results indicate that the reporting lag (days between fiscal period end and quarterly earnings release date) is shorter for firms facing greater demand for information from investors and greater litigation costs. The reporting lag, however, is longer for firms with greater block ownership and those whose operations are somewhat more complex.     

On-market share buybacks, exercisable share options and earnings management

Chan et al. (2006b ) suggest that managers might announce a share buyback to manipulate investors’ perceptions and capitalize on the positive price reaction usually associated with the announcement. The incentive to do so is greater when managers have exercisable options. Prior studies document that managers engage in upwards earnings management for opportunistic reasons related to option holdings (Bergstresser and Philippon, 2006). We examine the association between earnings management and exercisable option holdings for buyback firms to investigate if earnings management in the pre‐buyback period is greater for firms with equity incentives to increase share price. Our results, using 138 buybacks over the period 1996–2003, support our prediction. We find that buyback firms with both exercisable options that are in‐the‐money prior to the buyback announcement as well as options that are exercised in the buyback period have higher discretionary current accruals than buyback firms with no exercisable options, unexercised options or with out‐of‐the‐money options. Overall, our results are consistent with buyback firms with exercisable options using earnings management and buyback announcements to maximize option payoffs, and buyback firms without exercisable options signalling undervaluation.     

An analysis of earnings management by European private firms

This paper addresses the questions of whether private firms in eight European countries engage in earnings management, and if so, whether tax incentives affect such practices. To measure earnings management, we analyze the earnings distributions of private firms and compare these distributions with those of public firms in the same countries. The empirical evidence suggests that in absence of capital market pressures, firms still have incentives to manage earnings, as we find that private firms avoid reporting small losses. We further find that private firms in some countries where tax regulation strongly influences financial accounting do not avoid reporting small losses. We attribute this finding to tax incentives reducing firms’ benefits of (upward) earnings management. Finally, our results suggest that some types of earnings management are due to capital market pressures and are specific to public firms since we do not find evidence that private firms avoid earnings decreases.     

Using Real Activities to Avoid Goodwill Impairment Losses: Evidence and Effect on Future Performance

We examine whether managers postpone the recognition of goodwill impairment by manipulating cash flows and the consequences of such a strategy on future performance. According to SFAS 142, an impairment loss must be recognized if the reporting unit's total fair value to which goodwill has been allocated is less than its book value. A growing body of empirical evidence shows that managers delay the recognition of goodwill impairment in accounting books. However, past literature is silent on how managers convince various gatekeepers (e.g., auditors, financial analysts) that recognizing an impairment loss is unnecessary although it seems economically justified. SFAS 142 requires managers to forecast future cash flows to justify the decision to recognize, or not, an impairment loss. Therefore, we predict that managers manipulate upward current cash flows to support their choice to avoid reporting an impairment loss. We also test whether or not this real earnings management is detrimental to future performance. Based on a sample of US firms over the period 2003–2011, we document that firms suspected of postponing goodwill impairment losses exhibit significantly positive discretionary cash flows compared to various control groups. We also find that this real activities manipulation is detrimental to future performance.     

The relation between earnings management and financial statement fraud

This paper provides new evidence on the characteristics of firms that commit financial statement fraud. We examine how previous earnings management impacts the likelihood that a firm will commit financial statement fraud and in doing so develop three new fraud predictors. Using a sample of 54 fraud and 54 non-fraud firms, we find that fraud firms are more likely to have managed earnings in prior years and that earnings management in prior years is associated with a higher likelihood that firms that meet or beat analyst forecasts or that inflate revenue are committing fraud. We further find that fraud firms are more likely to meet or beat analyst forecasts and inflate revenue than non-fraud firms are even when there is no evidence of prior earnings management. This paper contributes to the fraud detection literature and the earnings management literature, and can help practitioners and regulators develop better fraud detection models.     

Deferred taxes,earnings management,and corporate governance: Malaysian evidence

This study examines whether Malaysian public listed companies (PLCs) use deferred taxes to avoid an earnings decline. In addition, this study also examines whether corporate governance mechanisms attenuate the extent to which deferred taxes are used to manage earnings. Using a sample of 221 PLCs listed on the main and second boards of Bursa Malaysia in 2008 with a complete set of data available from 2005 to 2008, this study finds that Malaysian PLCs use both the accrual and valuation allowance components of net deferred tax liabilities to avoid a decline in earnings. The study also finds that ownership structure and board structure affect the extent to which earnings management is associated with a deferred tax component.     

Do investors overreact to earnings warnings?

This study shows that contrary to what many managers argue, there is no overreaction to earnings warnings. Our sample consists of 986 firms that had significantly lower fourth-quarter earnings than analysts' forecasts during the period of 1983 to 1998. About 9% of these firms released quantitative earnings information while 6.5% of the firms disclosed qualitative earnings information prior to the formal earnings report dates. We find that although these firms experience significant stock price declines during the warning period, their share prices are still higher than the economic values, calculated using Ohlson's residual income model. Further, long-run operating and stock performance of these firms are not more positive than the performance of firms that do not warn. We also find that investor reaction to both warning and non-warning firms is positively related to the firms' long-run stock and operating performance. These findings support the argument that investors do not overreact to the warnings but base their reaction on anticipated long-term performance of the firms.     

Earnings management and the allocation of net periodic pension costs to interim periods

We examine the pattern of reported quarterly net periodic pension costs. Quarterly pension costs are one of the largest single expense items for firms with pension plans (around 15% of income before extraordinary items in our sample). Under ASC 270, net pension costs should be recognized as incurred, or as the benefit provided by the expense is realized. We find that over the period of 2004–2010, there is significant variation in the amount of quarterly pension cost firms report. In addition, we find that income-increasing changes in pension costs are significantly associated with meeting or beating analysts' forecasts in a given quarter. We also show that income-decreasing changes to net periodic pension costs that would cause a firm to miss its earnings forecast are extremely rare. Finally, we find evidence that income-increasing and income-decreasing changes in quarterly pension costs are “settled up” in the fourth quarter (e.g., they are reversed).