CFA Institute Journal Review November 2015 Volume 45 Issue 11
Accrual-Based and Real Earnings Management and Political Connections (Digest Summary)
International Journal of Accounting
Politically connected firms favor relatively more costly real earnings management strategies over accrual-based earnings management strategies because of the need for secrecy. Furthermore, when public monitoring and the risk of detection increase, firms have increased incentives to use real earnings management strategies to mask the gains that they derive from their political connections.
The authors study earnings manipulation by comparing two earnings management strategies: accrual-based earnings management and real earnings management. Accrual-based earnings management aims to obscure true economic performance by changing accounting methods or estimates within the generally accepted accounting principles. Real earnings management alters the execution of real business transactions. The authors research the trade-off between real and accrual-based earnings management by examining whether the preference for one strategy over the other differs between firms with and without political connections. Moreover, they test whether politically connected firms in countries with more public monitoring are more likely to rely on real earnings management strategies than firms in other countries.
How Is This Research Useful to Practitioners?
Under real earnings management, firms change their operating activities to meet or beat short-term earnings targets by adapting the timing or structure of real transactions. This activity has direct cash flow consequences and potential long-term consequences for economic value. Real earnings management is considered to be more difficult to detect than accrual-based earnings management, thereby making it easier for firms to mask gains generated—possibly from political connections. Often, the legality of these gains is questionable.
The incentive for firms to use real earnings management strategies is high. When the media or other political parties detect earnings manipulation, the benefits from using political connections may disappear because the integrity of the firm and the reputation of the politicians may be damaged. The authors conclude that politically connected firms use more real earnings management strategies than accrual-based earnings management strategies. Furthermore, the more public scrutiny and monitoring, the more likely that firms rely on real earnings management strategies.
These conclusions are important to capital providers and other stakeholders in assessing the pervasiveness of earnings management and the overall integrity of financial reporting of politically connected firms. Politically, enhancing scrutiny and increasing constraints over accounting discretion do not eliminate earnings management activities altogether; these tactics only change managers’ preference for different earnings management strategies.
Stronger monitoring may actually reduce opportunities for accrual-based earnings management and would likely increase the level of real earnings manipulation, which may be even more costly for investors.
Furthermore, if firms use both strategies, any studies focusing on only one earnings management strategy are incomplete.
How Did the Authors Conduct This Research?
A politically connected firm is identified as a firm in which at least one of the large shareholders or top officers is a member of a parliament, a minister, or closely related to a politician or party. The authors use data from 5,493 publicly traded companies in 30 countries from 1997 to 2001 to test their hypotheses. Out of the 5,493 firms, only 457 are considered politically connected firms.
The authors use three variables as proxies for real earnings management: abnormally low cash flows from operations, abnormally high production costs, and abnormally low discretionary expenses. To proxy the accrual-based earnings management, the authors use a measure of discretionary accruals and a performance-adjusted measure of discretionary accruals. Finally, to assess a country’s level of public monitoring, the authors use “press freedom” as a variable to measure the extent of freedom for journalists and the efforts of the government to ensure freedom. The analysis is performed at both the country and industry level to observe correlations between the proxies. The hypotheses are tested using a regression analysis from the data.
There are limitations to this study. One is that different types of political connections may have different effects on firms’ choices. Another is that the authors do not examine the relationship between political connections and such other aspects of earnings management as timeliness, value relevance, and earnings conservatism.
Also, because the data are prior to 2001, regulation changes since 2001—for example, the Sarbanes–Oxley Act—may have changed current firm choices for earnings management.
Earnings management misleads investors and jeopardizes the integrity of financial reporting. Regardless of the strategies firms use, the goal is to mask certain earnings activities and political favors. As the authors demonstrate, real earnings management is more difficult to detect than accrual-based management. The outlook to improve the situation is by no means optimistic. More requirements for disclosure or more monitoring may create even more incentives for certain firms to stay obscure by relying on strategies more difficult to detect. The authors paint a gloomy picture of earnings manipulation, and their results warn investors to stay skeptical regarding the earnings reports of certain firms in certain countries.