Definition
Healy and Wahlen (1999) define earnings management as occurring when managers use judgment in financial reporting and in structuring transactions to mislead some stakeholders about the company's underlying economic performance or to influence contractual outcomes that depend on reported numbers. Because accrual accounting requires estimates and judgment, it leaves room for this discretion.
Motives
- Compensation contracts: Healy (1985) reported that under earnings-based bonus plans, managers choose to lower earnings further when earnings fall below the bonus floor. This is a classic explanation of the big bath.
- Debt contracts: raising earnings to avoid covenant violations.
- Capital markets: avoiding losses, sustaining last year's earnings and meeting analyst forecasts. Burgstahler and Dichev (1997) showed that the interval just below zero in the earnings distribution is unusually thin.
- Regulation: Jones (1991) presented evidence that firms lowered earnings during import relief investigations.
Methods
Accrual-based management adjusts accounting numbers while leaving cash flows unchanged, for example through estimates of bad debts, inventory and provisions or changes in depreciable lives. Real activities management, as set out by Roychowdhury (2006), changes actual operations: pulling sales forward with discounts, overproducing to lower cost of goods sold, and cutting R&D or advertising.
The big bath
A big bath is taking large asset impairments, restructuring charges and provisions in a year that is already bad or in which management has changed. Blame for the losses goes to the predecessor or to one-off factors, and future costs are cleared early, so later earnings improve more easily. Strong and Meyer (1987) reported that large asset write-downs are associated with management changes, and Murphy and Zimmerman (1993) analyzed discretionary accounting choices around CEO turnover. In a 1998 speech, SEC Chairman Arthur Levitt named the big bath as a leading earnings manipulation technique.
Measurement and responses
Research splits total accruals into normal and discretionary parts. The Jones model (1991) estimates normal accruals from changes in revenue and property, plant and equipment, and the modified Jones model (Dechow, Sloan and Sweeney, 1995) refines it by adjusting for changes in receivables. Earnings management is a case of the shareholder-manager conflict described by agency theory, and external audits, audit committees and disclosure rules are mechanisms to curb it.
References
- Healy, P. M. (1985). The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, 7(1-3), 85-107.
- Jones, J. J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193-228.
- Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1995). Detecting earnings management. The Accounting Review, 70(2), 193-225.
- Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24(1), 99-126.
- Healy, P. M., & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(4), 365-383.
- Roychowdhury, S. (2006). Earnings management through real activities manipulation. Journal of Accounting and Economics, 42(3), 335-370.
- Strong, J. S., & Meyer, J. R. (1987). Asset writedowns: Managerial incentives and security returns. The Journal of Finance, 42(3), 643-661.
- Murphy, K. J., & Zimmerman, J. L. (1993). Financial performance surrounding CEO turnover. Journal of Accounting and Economics, 16(1-3), 273-315.
- Levitt, A. (1998, September 28). The "numbers game". Speech at the NYU Center for Law and Business, New York.