Public companies consistently face demands to meet or beat market earnings estimates. Earnings management by companies has been found to be pervasive throughout the world, caused by the pressure on management to meet earnings targets of market forecasts and, in so doing, obtain private gains.
There is considerable evidence that managers in the United States, Europe, and other countries engage in earnings management (EM). Companies that consistently meet or beat their market forecasts can enjoy such advantages as an elevated reputation within their industry, a valuation premium, and potentially a lower cost of capital compared with companies that do not. Conversely, when companies miss their earnings benchmarks, they can experience severe stock losses, which can negatively impact executive compensation. Managers and insiders have strong personal financial incentives to meet performance expectations because compensation is often coupled with either the stock price or accounting earnings; these incentives can include bonuses, stock-based compensation, and promotion prospects.
How Is This Research Useful to Practitioners?
One of the fundamental conflicts in a company is the conflict between managers and outside investors. The authors define EM as purposeful intervention by management in the external financial reporting process with the intent of obtaining some private gain. EM can also include managers making the choice to alter financial reports either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. EM is reaching an insidious level that significantly compromises the reliability of financial reporting. Arthur Levitt, former US SEC chair, called it a “‘gray area between legitimacy and outright fraud.’”
The amount of managed earnings is the difference between reported earnings and true earnings. One way to manage earnings is by manipulating accruals, which consist of discretionary and nondiscretionary portions. Discretionary accruals vary widely during the period studied (2008–2011). The authors find that discretionary accruals averaged 2.9%, as a percentage of assets, for all Indian companies, whereas discretionary accruals for US companies are estimated to average about 1.0%. They also report that during the period, the construction sector and mining sector had the largest percentage of discretionary accruals at 9.4% and 3.4% of total assets, respectively. The service sector’s and manufacturing sector’s discretionary accruals were 3.3% and 2.6% of total assets, respectively. In contrast, the trade sector, including both wholesale and retail, observed negative discretionary accruals.
In additional analysis, the authors find relationships between discretionary accruals and company size, audit quality, and analyst coverage. They find an inverse relationship between company size and discretionary accruals. For example, small companies’ discretionary accruals were 10.6%, as a percentage of total assets, compared with 0.4% for medium-sized companies and 0.3% for large companies. Companies that were examined by the “Big 6” accounting firms showed lower discretionary accruals than companies audited by non–Big 6 firms. Companies with large outside analyst coverage also showed lower EM.
The findings indicate that companies with strong boards and audit committees combined with outside auditors can notably reduce EM. The authors suggest increased company oversight by regulatory authorities when EM is suspected of being above the industry average. In addition, they support the need for an overall improvement in accounting information.
How Did the Authors Conduct This Research?
The authors study 2,229 (nonfinancial) listed Indian companies during the period from 2008 to 2011. They exclude 2012 because they consider it to be an anomaly as a result of finding an extraordinary amount of discretionary accruals. This study is the largest empirical exploration of Indian companies because previous studies were based on a relatively small number of companies and lacked robustness. The authors’ data are focused on India, but the findings are consistent with evidence from other countries.
Although detecting EM can be difficult, isolating discretionary and nondiscretionary accruals can be the key factor in determining which companies are managing their earnings. Accounting adjustments known as accruals are the difference between economic activities and actual cash received. To carry out the study, the authors use the modified Jones model, widely used in empirical investigations, to find discretionary accruals at Indian companies by measuring changes in financial statement accounts. These discretionary accruals are then used as an estimate for EM.
One of the easiest ways to manipulate a company’s earnings is by the early recognition of revenue, which affects several financial statement accounts, including revenue, accounts receivable, and total assets. Adding to the challenge of detecting EM, often executives and insiders use multiple EM techniques simultaneously.
Accurate financial reporting helps support an efficient capital market, enabling investors to evaluate and compare various investment opportunities. I agree with the authors that a strong board of directors and external auditors are paramount in reducing EM, which ultimately supports a stronger financial industry. Another consideration is the impact that activist investors have and what additional role they can play in holding management accountable for accurate financial reporting.