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The phenomenon of altering the earnings in order to achieve certain goals is called Earnings Management. Healy and Wahlen (1999) formed a definition of earnings management: “Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”.
Based on this definition, the assumption is that managers use discretion granted by the reporting framework solely to mislead the stakeholders of the underlying economic performance.
However, managers may use earnings management to make financial reports more informative. Whereas I follow the approach of Healy and Wahlen, I deviate from their definition of earnings management. Healy and Wahlen (1999) choose to exclude the positive effect of earnings management, whereas I include this into my definition.
Dechow et al. (1995) set three criteria, which have to be met to apply earnings management. First, there must be a principal-agent relationship.
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The principal-agent problem is derived from the agency theory, which is a theory regarding information asymmetry. Consequently, the agent can maximize his own utility without the knowledge of the principal, which is beneficial to the agent's interest but not necessarily in the best interest of the company.
The second condition is that there must be a bonus system in place for the manager in order to maximize his own utility. (E.g. The height of the bonus depends on the height of the revenue.) Lastly, the manager must have the power to make a decision that influences the financial economic performance of the company.
When these conditions are met, managers have three types of earnings management at their disposal.
Namely, (I) real earnings management (II) accruals management and (III) classification shifting (Black et al., 2017)
For managers to employ real earnings management, they may decide to cut back on certain expenditures, e.g. R&D or advertising.
Every GAAP standard grants an amount of discretion to a manager to exercise judgment. Due to this discretion, managers will choose their accounting policies or accounting estimates based on their perceived goal.
Classification shifting is the act of shifting revenue or expenses out of the so-called core earnings and label it differently. As the final GAAP-earning does not change, this method is less susceptible to detection.
Accounting frameworks always provide a certain degree of freedom in the managers' reporting decisions. This freedom grants management to report according to their incentives, mainly for information provision. Raising capital in public markets provides a strong incentive for management to disclose information, which capital providers use for monitoring and evaluation purposes. They highly depend on this information, as investors normally do not have access to private information. Therefore, raising capital gives a strong incentive to present earnings in a way that benefits management. Next, to raising capital, research provided evidence regarding the manipulation of earnings with capital market incentives. It has been found that management engages in earnings management prior to an initial public offering (IPO) (Efendi, Srivastava & Swanson, 2007) or to meet capital market expectations (e.g. analysts’ forecast)(Burgstahler and Eames, 2006).
Furthermore, management may not only engage in perception management using earnings management for outsiders but could also use it to maximize their own utility. Evidence provided by Bergstresser and Philippon (2006) suggest that firms with compensations structures more closely tied to the performance (i.e. reported earnings number) show a higher level of earnings management. Likewise, management engages in earnings management for other contracting motives, like the violation of debt covenants. CEO's are more likely to publish financial statements that contain accounting irregularities when constrained by debt covenants or close to violating these debt covenants (Efendi, Srivastava & Swanson, 2007).
As explained in the previous paragraph, earnings management is divided into the following categories, namely: (I) accrual management, (II) real earnings management and (III) classification shifting. In light of perception management, the choice for the type of earnings management depends on firm-specific circumstances but also the cost of the type of earnings management relative to each other (Cohen, Dey and Lys, 2008).
Prior research suggests that managers have two main goals, which may be accomplished by the employment of earnings management. The research of Graham et al. (2005) provides evidence regarding the interest of managers; they mainly focus on the GAAP earnings, in particular, the EPS, which is derived from this GAAP-earnings number. Which implies that managers' main goal is to boost their reported GAAP-earning. On the contrary, in the perception of the investors, the most important target is whether the firm meets or beat the analysts' forecast (Skinner and Sloan, 2002). The available literature regarding the use and reason of these types of earnings management is outlined in the following paragraphs.
Accrual management is constrained by several factors, such as the quality of the external auditor and in the US the decrease in flexibility due to the passage of SOX 2002. Therefore, accrual management may only have an impact on earnings in the short term. This is because earnings are "borrowed" from the future or earnings are delayed, therefore having no direct consequences for the cash flow.
However, in the case of mergers accrual management may have a long-term effect. The earnings altered with accrual management may have an influence on the outcome of the negotiations of a merger, or even have an impact on whether the deals succeed at all. Therefore, a lot of research focusses on a particular event, in order to comprehend the short-term as well as the long-term effect of accrual management. Erickson and Wang (1999) conducted research about accrual management around a stock-for-stock merger. They test whether acquiring firms attempt to increase their own stock price prior to a stock-to-stock merger in an attempt to reduce the cost of buying the target firm. Their evidence suggests that acquiring firms indeed manage earnings upwards in order to drive up their stock price in the quarter preceding the merger announcement. This effect becomes stronger if the size of the merger increases.
This subsequently leads to an underperformance of the acquirer after the merger announcement. Louis (2004) finds that the effect of the earnings management conducted before the mergers is an important determinant of the short-term performance of the acquirer, as well as the long-term performance. These results are in line with the evidence provided by Erickson and Wang (1999), as Louis (2004) find that acquiring firms overstate their earnings in the quarter preceding the merger.
Erickson and Wang (1999) provide alternative views as an explanation of their findings, which contains the rational expectations argument. They state that the acquiring firm overstates the earnings preceding the merger agreement due to the fact that the target firms anticipate it, and therefore adjust for the earnings management in the negotiation of the purchase price.
In addition to the research of Louis (2004), Gong, Louis & Sun (2008) include litigation cost in the association with pre-merger earnings management, as lawsuits following the merger may be costly. Gong et al. (2008) argue that this is because the plaintiffs in class action lawsuits normally receive huge monetary compensation. Secondly, the pending lawsuits distract management from what they should be doing, which is integrating the merging parties. The reason for these lawsuits is mainly that the plaintiffs argue that the managers have misguided investors by the issuance of either false or misleading financial statements (Ball and Shivakumar, 2008).
Misleading financial statements may be the result of the fact that managers may use judgment in the preparation of financial statements; this judgment refers to the acceptable methods described in the applicable reporting framework to report financial transactions. The freedom granted by the applicable reporting framework thus makes it possible to have different outcomes for the same financial transactions. For example, managers may choose a different depreciation and amortization method, which suits the goal of the manager better. Some will choose straight-line depreciation, while others would prefer accelerated depreciation. (Healy and Wahlen, 1999).
The survey evidence provided by Graham et al. (2005) suggest that managers prefer this type of earnings management, namely real earnings management, over accrual management. An interesting detail is that management is more likely to cut R&D expenses or other discretionary expenses before they turn to accrual management in order to meet or beat the earnings benchmark. Zang (2012) backs the preference of real earnings management over accrual management. Furthermore, timing and the number of accruals bound the use of accrual management, which is a downside.
However, just like accrual management, the use of real earnings management is bounded by certain constraints, such as the firm’s competitiveness in the industry, its financial health or the tax consequences of earnings manipulation. These constraints decide the type of earnings management chosen by managers. (E.g., a lower accounting flexibility has the effect that managers will switch from accrual management to real earnings management (Ewert and Wagenhofer, 2005)).
Whereas the research regarding the employment of accrual management is mainly conducted around a particular event, the employment of real earnings management is mainly researched as a substitute for accrual management. As described, accrual management is constraint by several factors, whereas real earnings management has more flexibility, this is mainly because it can be managed throughout the whole fiscal year. This is increased flexibility of real earnings management is backed by studies of Graham et al. (2005) based on survey evidence and by Zang (2012) based on archival data.
A reason for the use of earnings management is to meet or beat the analysts' forecast. Evidence provided by Gunny (2010) about the use of real earnings management states that managers not only use real earnings management to meet or beat the analysts' forecast but also as an indicator for future performance. Gunny (2010) finds that firms that use real earnings management and therefore just meet the analyst forecast have a higher performance in the subsequent period in comparison to the firms that do not use real earnings management and therefore miss the analysts' forecast. Managers may favor real earnings management over accrual management. However, deciding to cut costs like R&D expenditures or advertising will have economic consequences for future periods. Therefore, real earnings management can be costly.
Looking at the literature, there seems to be a preference for real earnings management over accrual management. However, this relationship between real earnings management and accrual management with a preference for real earnings management could be the case because of the passage of SOx 2002 (Badertscher, 2011; Zang, 2012). The passage of SOx created an increase in regulatory scrutiny regarding accruals, therefore also accrual management. As this thesis focusses on a European setting, the preference for real earnings management over accruals may not necessarily be the case.
The last type of earnings management found in recent research evidence is called classification shifting; it classifies as neither accrual management nor real earnings management. Classification shifting is the act of moving costs or benefits to another item on the income statement by labeling it differently. Therefore, it does not change the bottom line net income. Consequently, this type of earnings management is less costly for management and less susceptible to detection by auditors.
Managers have incentives to manage earnings to enhance the performance of the firm by transferring expenses out of the core earnings, to special items. According to the FASB, a special item is an expense, which is the result of an event outside of the operating activities or a transaction that is both (i) unusual in its nature and (ii) non-frequent in occurrence. In comparison to other earnings management techniques, classification shifting is the one that comes the closest to non-GAAP reporting. Neither change any real activities or change the current or future performance of the company, both provide a different presentation of the earnings.
Research regarding classification shifting suggest that management shift certain expenses out of the core earnings and transfer these expenses to special items in order to meet or beat the analysts’ forecast (McVay, 2006). The earnings mentioned by the analysts are the so-called “street earnings”, which are therefore overstated by the expenses transferred to special items. The transfer of core expenses to special items is according to Fan et al. (2010) mainly used to inflate earnings, especially if the firms have a higher incentive to meet and beat analysts’ forecast. Managers most often use classification shifting in the fourth quarter, which makes sense in the light of the evidence provided by Abernethy et al. (2014). Managers tend to use classification shifting rather than accrual management or real earnings management when these are constrained. (E.g. high-quality auditor, tax consequences.)
McVay (2006) also mentions some reasons why management would prefer classification shifting to accrual management or real earnings management. First, accrual management, as well as real earnings management, change the bottom line of the GAAP earning, while classification shifting can affect the core earnings without having an impact on the bottom line GAAP earnings. Secondly, as this does not have an impact on the bottom line GAAP earnings, classification shifting is less susceptible to detection by auditors and is less scrutinized by regulation.
Lastly, accrual management and real earnings management will most likely have an effect on future periods. Whereas classification shifting has no effect on future periods, accrual management "borrows" earnings from the future or delays these earnings. Real earnings management can also have an impact as a decrease in advertising or R&D may have a negative effect on future earnings. This makes classification shifting less costly compared to the other two.
Due to the costless nature of the employment of non-GAAP earnings, non-GAAP earnings can be an interesting tool for perception management, as non-GAAP earnings are an alternative way of presenting the earnings. The SEC provided a definition of non-GAAP earnings.
"A non-GAAP financial measure is a numerical measure of a registrant's historical or future financial performance, financial position, or cash flow that:
a) excludes amounts, or is subject to adjustments that have the effect of excluding amounts, that are included in the most directly comparable measure calculated and presented in accordance with GAAP in the statement of income, balance sheet, or statement of cash flows of the issuer; or
b) includes amounts, or is subject to adjustments that have the effect of including amount, that are excluded from the most directly comparable GAAP measure so calculated and presented.”
Due to the increased popularity of non-GAAP earnings and their ability to report opportunistically, the Committee of European Securities Regulators (CESR) made recommendations for the use of alternative performance measures, the so-called CESR recommendation at the end of 2005. The main reason for this recommendation was that most of the used non-GAAP earnings had no link to the corresponding reported GAAP-earning. These recommendations were updated in 2015, by the successor of the CESR, namely the European Securities and Markets Authority (ESMA). Issuers of an APM should define the APM and include the calculation of the APM and they should disclose this in a clear and readable way (E.g. the labels given should prevent misleading of the user). Next, to the basic calculation, the issuer should provide a reconciliation to the corresponding GAAP line item.
Furthermore, the issuer should explain the relevance and the reliability of the APM in comparison to the GAAP-earning. In addition, in the essence of comparability and consistency, the issuer should include APM’s from previous periods so the user can compare these numbers. Subsequently, these APM’s should be calculated in the same way. If this is not the case, the issuer should explain the change and the reason for this change. Lastly, if the issuer disclosed APM’s in previous periods and suddenly stops disclosing those, he should explain the reason for not disclosing the APM’s in the current period.
These guidelines are mainly introduced to prevent any further misleading of investors or other users of the financial statements. However, non-GAAP earnings have, like earnings management, a negative as well as a positive side. The literature of non-GAAP can, therefore, be divided into two categories, relating to: (i) Opportunistic behavior of management and (ii) the decision usefulness of non-GAAP earnings for the participants of capital markets. I will elaborate on these two categories in the following paragraphs.
As the definition of earnings management state, provided by Healy and Wahlen (1999), earnings management may be used to mislead some stakeholders regarding the true economic performance of the company. Based on prior research, the main believe in the employment of non-GAAP earnings can be viewed in the same way. Namely, the purpose of the manager when they use non-GAAP earnings is to present an overly optimistic view of the economic performance of the company (Bowen et al., 2005). The possibility to use non-GAAP for opportunistic behavior is mainly these numbers are not audited by an external auditor when publishing these in press releases (Levitt, 1998).
Definition of Earnings Management and Its Approaches. (2024, Feb 26). Retrieved from https://studymoose.com/definition-of-earnings-management-and-its-approaches-essay
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