Financial accounting theory



Generally, accounting provides economic information about the measurement and communication to decision makers (Watts and Zimmerman, 1986). Accounting can be dividend into internal and external accounting on the basis of the users of information. Internal accounting is used for decision making inside the firm while external accounting endeavors to help stakeholders in decisions concerning their relationship with the firm.

The aim of this essay is to analyse when, where and why earnings management occurs. Investors are eager to make judgments about the reliability of companies' financial statements when investment opportunities exist. Apparently, it would be of great benefit for investors if they could determine directly whether the earnings have been managed or not. However, it is impossible for investors to acquire knowledge needed to detect it in a specific case because earnings management is more likely to involve different forms and be invisible. This essay therefore adopts appreciable approach as it aims to identify situations when earnings management is likely to emerge. Moreover, the increased understanding of managers' motivations to use earning management may also be useful for regulators and auditors when they try to restrict opportunistic behaviour.

Earnings management

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A popular and more extensive definition has been given by Healy and Wahlen (1999, p368):

"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."

The definition of earnings management agree on the points that managerial intention is a prerequisite for earnings management, but whether this intention should be opportunistic in nature is not totally clear. Several presentations on earnings management also use the term in connection with managerial discretion that has the aim to communicate information to investors that is supposedly not opportunistic (Dechow and Skinner, 2000 and Scott, 2003). The view that earnings management is something opportunistic and harmful that is used to mislead at least some stakeholders is also expressed by the U.S. Securities and Exchange Commission (SEC) and in the earnings management review article by Healy and Wahlen (1999). The intention to mislead someone about financial performance usually requires that earnings management will be difficult to detect.

The search for a proper definition includes the questions as to what activities can be regarded as earnings management. Judgment in financial reporting that fits under the earnings management definition includes estimations of, for example, the economic lifetime of long-term assets, losses from bad debts and asset impairments that are dependent in the future and choices between accounting methods. Also judgment that goes beyond strictly accounting decision is usually considered as earning management, assuming that these activities are driven by the reporting incentive (Schipper, 1989 and Healy and Wahlen, 1999). Thus, earnings can be managed through shifting expenditures between periods or realizing an accounting gain by selling an asset that is undervalued on the balance sheet. Whereas the SEC often also includes outright fraud as earnings managements, academic literature usually focuses on earnings management activities that fall within Generally Accepted Accounting Principles (GAAP) (Dechow and Skinner, 2000).


Earnings management is used to influence company value. It can be loosely dividend into three groups. The first group presents evidence suggesting that earnings management continuously occurs to some extent in financial markets. Here managers are assumed to manage yearly or quarterly earnings to meet analysts' expectations or to smooth the income stream between periods. In the second group is research investing if managers use earnings management in an effort to manipulate the stock price to increase their stock based pay or to benefit from insider trading. The third group includes studies where the connection between earnings management and major financial transactions is considered.

Income Smoothing ----- Cookie Jar

The concept of 'cookie jar' accounting refers to the accounting practice by which management may use positive earnings and reserves from one year to mitigate or offset loses in another year. For example, liabilities that are not linked to a specific accounting period may be deliberately recorded against a period of high(er) profits so as to avoid a potential loss during those periods when income is low(er). In this respect, 'cookie jar' accounting presents a form of income 'smoothing' by which the income of a firm may be adjusted or manipulated by management so as to allow liabilities and expenditure to be more readily absorbed by the firm (Tucker and Zarowin, 2006).

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There are two key advantages associated with 'cookie jar' accounting. First, it can provide increased capacity for the firm to manage cash flows and liabilities on the basis of cash flow rather than debt as liabilities and expenditures can be booked against accounting periods in which cash flows are more robust. The implication is that the firm may be able to avoid costly capital raisings or debt refinancing. Provided that reserves are realised (and not merely booked as per mark to market methods), then the capacity of the firm to 'draw' upon reserves to finance expenditures and liabilities can represent an efficient utilisation of resources without necessarily altering the capital structure of the firm.

Second, 'cookie jar' accounting can provide the firm with the capacity to 'smooth' or average cash flows and income. This is important as it can promote greater certainty in firm earnings, as well as providing potentially more stability in returns or the meeting of debt financing obligations. In this context, 'cookie jar' accounting can provide investors in the firm with greater certainty as to income and dividend returns. 'Cookie jar' accounting may thus also prompt management to pay greater attention to forecast revenue and expenditure in the realisation that averaged returns will be closely monitored by shareholders.

While there are advantages associated with 'cookie jar' accounting, these advantages are nevertheless substantively offset by the limitations and problems associated with the technique. The principle limitation and problem associated with 'cookie jar' accounting is that it can promote opportunism on the part of management (Williamson, 1996). Opportunism (i.e. managerial self-gain) can arise because management under commonly employed equity-based compensation systems will have an incentive to shift or 'hide' liabilities and losses (Hall and Murphy, 2002; Robison and Santore , 2006). This is because under an equity-based compensation system management will be rewarded (whether in cash or equity issuances) in relation to the earnings of the firm. The consequence is that management will seek to shift liabilities and losses to more profitable years, with the problem being that such practices erode transparency and mask the substantive risk exposure of the firm. As Bruner, McKee and Santore (2008, p262) have observed, "it is ironic that the very market creating the incentive to use equity-based pay may be a victim of the incentive equity-based pay creates to improve accounting and financial statements, fraudulently if necessary." This is a limitation that was originally noted by Fama (1980) and which has been acknowledged by Bruner, McKee and Santore (2008).

The problem of opportunism also gives rise to potential concerns stemming from asymmetric information (which itself promotes opportunism) (Shleifer, 2000). As management will have an incentive to shift or 'hide' liabilities and losses, the 'cookie jar' accounting approach will result in minimised disclosure and information transparency. This is necessarily the case as the booking of liabilities and expenditure in one year over another, coupled with the utilisation of reserves to offset these liabilities and expenditure, provides an incentive for management to either underplay associated risk exposure or to deny any asymmetric risk. In other words, the 'cookie jar' approach relies on management's capacity to simply 'explain away' liabilities and debt by offsetting them against (shareholder) value previously created. In this context, the 'cookie jar' approach fails to provide assurances to shareholders that long-term value creation is being maximised (as reserves are essentially treated as a 'piggy bank' that can be drawn upon by management rather than invested or returned to shareholders) or that risk exposure is being minimised. Furthermore, the utilisation of past positive earnings and reserves means that current managerial performance may be masked by the value creation of previous management (i.e. today's managers can utilise the value created by yesterday's managers to mask their own ineptitude a problem that will be exacerbated by the incentives for opportunism under an equity-based compensation system).

The consequence of these limitations and problems is that the current and long term value of the firm are substantively affected by 'cookie jar' accounting (particularly in the absence of complete contracting that could remove capacity for managerial opportunism). As such, 'cookie jar' accounting does have the capacity to erode earnings, obscure the transparency of financial reporting, and to present an enormous threat to the long-term commercial and financial viability of the firm.

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On the empirical side, the evidence presents in Branson and Loits (1997), Branson and De Rijcke (1999) and Vander Bauwhede, Willekens and Gaeremynck (2003) is all consistent with the income smoothing hypothesis as an incentive for earnings management in Belgian firms. Branson and Loits (1997) examined for a sample of 517 large Belgian listed and non-listed companies whether there is an association between a decline in operating income or a negative operating income figure and the presence of positive extraordinary items in the income statement. They find as expected that large Belgian firms use their discretion over extraordinary items to avoid declines (but not losses) in operating income. In addition, they report that firms prefer to manager earnings through extraordinary items that do not result from real transactions. That is, they prefer managing earnings through, for example, provisions for exceptional risks from assets disposals.

Branson and De Rijcke (1999) studied a sample of 419 large and of 450 small and medium-sized Belgian firms from 9 industries where inventory is an important item. They hypothesise that firms report declines (increases) in inventory levels when gross margins (exclusive of "change in inventory") increased (decreased) or are positive (negative). Similarly, they hypothesis that firms report inventory write-down (take write-down back) when they report increases (decreases) in or positive (negative) gross margins (exclusive of write-downs). The evidence is consistent with these hypotheses. Further, Branson and De Rijcke (1999) also report that the avoidance of losses (but not earnings declines) is especially pronounced among small and medium sized firms. Note that these firms are not subject to mandatory external auditing.

Vander Bauwhede, Willekens and Gaeremynck (2003) test the income smoothing hypothesis for a sample of 31 listed Belgian companies, matched on size and industry with an equally large sample of non-listed companies, and find strong evidence that firms increase in bad years and decrease earnings in good years. More specially, they report that the sign of the unexpected accruals are significantly associated with the level of pre-performance earnings. That is, when pre-managed earnings are smaller than last year's earnings the unexpected accruals are positive and vice versa.

Income-increasing (decreasing) ---- Insider Trading

The fact that insider trading is based on private information suggests that insider trading motivates pernicious earning management. Most of the vast body of research investigating the relationship between earnings management and insider selling agrees that insiders earn abnormal returns in trading in their company's shares. Generally, these abnormal returns are considered to be a result of insiders' superior knowledge about the state of the firm, the industry or the company. Insiders are the first to know, for example, about a pileup in inventories, a successful product launch or a growing order book. More recently, research has emerged that tries to figure out more exactly what is the information insiders appear to trade on. Seyhun (1992) suggests that insiders have clear view on whether the firm value diverges from fundamentals. Insider trading has been connected to specific events, for example, announcements of share repurchases (Lee et al., 1992) and dividend announcements (Karpoff and Lee, 1991). Trading on this type of event specific price sensitive information that affects the stock price when made public clearly represents the illegal type of insider trading that is likely to draw the attention of regulators. A less risky way for insiders is to take advantage of non-public information that will also affect the stock price when made public but the use of which is difficult to prove. An example of this kind of information is knowledge of the quality of the firms' earnings that will most certainly have implications on future reported earnings.

Beneish finds that managers of firms with overstatements that violate GAAP are more likely to sell their holdings during the period when earnings are overstated then managers in a control group. Earnings management is then pernicious, in the sense that "managers' stock transactions during the period of earnings overstatement occur at inflated prices that reflect the effect of the earnings overstatement" (Beneish, 1999, p426).

Yet such findings need not imply that insider trading is always pernicious. Boyer, Ciccone, and Zhang (2004), examine whether discretionary accruals are consistent with pernicious earnings management, beneficial signaling earnings management, or smoothing. They rank stocks each year into deciles based on discretionary accruals (where the lowest/highest deciles represent firms with the greatest income-decreasing/increasing discretionary accruals). They then examine the direction of insider trading across the deciles. Their evidence is consistent with the opportunism hypothesis, which predicts that insiders are more likely to sell (buy) stocks if they manipulate earnings upward (downward), in contrast with the predicted pattern under signaling.

McVay, Nagar, and Tang (2006), find that managers who attempt to beat analysts forecast through earnings management sell their shares. Since the market rewards firms that meet to beat analysts' forecasts, such earnings management leads to an inflated price. Insiders' sales then are inconsistent with inability of the market to see through the earnings management.

The connection between earnings management and insider reading raises the following question: Do insiders manage earnings to make speculative gains, or does earnings management induce insider trading?

Analytical papers by Elitzur and Yarri (1995), and Bebchuk and BarGill (2003), prove that in equilibrium insider trading motivates managers to manipulate earnings because the opportunity to make profitable trades increases the benefit of managing earnings without affecting its cost. Thus, cost-benefit considerations tilt in favour of earnings management before trading. The empirical research offers mixed results. Beneish (1999), for example, studies 64 cases of fraudulent financial reporting earnings. In contrast, Beneish and Vargus (2002), provide evidence that manager sell before managing earnings upward. Similarly, Beneish, Press, and Vargus (2005), find that managing earnings follows insider trading, as a defence against potential class action suits alleging that insiders sold their shares for inflated prices at the expense of other investors. They find that insider selling in advance of period of poor corporate performance generates incentives for income-increasing earnings management. Moreover, they find no evidence of earnings management before managers engage in abnormal selling, suggesting that selling stock at inflated prices after artificially increasing earnings (a "pump and dump scheme") is unlikely to describe the insider trading-earnings management association. A difficulty in finding the answer is that both are decisions of management, so some endogeneity cannot be avoided in standard analysis. Park and Park (2004), consider insider trading after announcements in a two-stage least squares analysis. They find support for the notion that increasing discretionary accruals are followed by the selling if shares as part of managers' portfolio decisions. Sawicki (2005), examines earnings management both before and after insider trading. Similar to Beneish and Vargus (2002), she shows that the firm inflates earnings in the year following the one in which insiders purchase shares. Similar to Park and Park (2004), she also finds weak evidence that firm deflates earnings in the year before insiders sell shares.

Provide window dressing for IPOs

Initial public offerings (IPOs) are priced by discounting the company's future cash flows and by observing the market values of similar publicly traded companies. Ritter (1991) first documented the long-run underperformance of IPO firms. This underperformance has become known as the new issues puzzle. One possible explanation for the new issues puzzle is that managers may manipulate earnings upwards prior to IPOs, including mispricing that is reversed during the ears following the issue (Teoh, Welch and Wong, 1998).

Teoh, Wong, and Rao (1998) note that insiders have both the incentive and opportunity to manage earnings upward prior to an IPO. The incentive is clear. Insiders would like to issue shares at the highest price possible, as this would allow the company to raise the necessary capital with less dilution of earnings and control. Higher earnings lead to higher issue prices, as underwriters commonly use the P/E ratios of other firms in the IPO firm's industry and the IPO firm's earnings to set the offer price. Thus, firms have an incentive to manage earnings upwards as higher earnings lead directly to higher prices and higher prices lead to a lower cost of capital.

Empirical tests are conducted on a sample of 56 firms that went public on the Helsinki Stock Exchange between the beginning of 1994 and the end of 2000. The profitability of the total sample of 56 Finnish IPO firms showed a relatively high level of profitability in the critical period for which earnings management was tested when compared to three periods before and after the critical period. The most significant change in profitability occurred in the entrepreneur firms after IPO. To answer the question of whether high profitability was only a result of successful timing, earnings management tests were conducted on accruals. The results support the hypothesis that entrepreneurs' management earnings before the IPO. In contrast to expectations, earnings management behaviour seemed not be affected by how much of their ownership entrepreneurs gave up in the IPO. In the institutional owned IPO firms, no evidence of upward earnings management before the IPO was found. Among this study's limitation, the most significant is the small sample size. Another significant limitation is the common characteristics of the entrepreneur owned firms that may have influenced the results. These limitations notwithstanding, this study observed a systematic pattern of earnings management in entrepreneur owned IPO firms.

How to detect?

Earnings management is difficult to detect from the firms' financial statements because of its propensity to be invisible. One way to circumvent this problem is to choose a setting where researchers have strong priors that earnings management is likely to occur. Dechow et al. (1995) evaluates five accrual-based models for detecting earnings management. To test the power of the models, they choose firms that have been targeted by SEC for allegedly overstating annual earnings. They show all the models are able to detect earnings management (Dechow et al., 1995) and that the Modified Jones Model exhibits the most power. Bartov et al. (2001) evaluates the ability of the Cross-sectional Jones Model and Cross-sectional Modified Jones Model to detect earnings management vis-à-vis their time-series counterparts by investigating the association between discretionary accruals and audit qualifications. Their underlying assumption is that firms given qualified audit opinions are more likely to have managed earnings. They find that only the Cross-sectional Jones Model and Cross-sectional Modified Jones Model are able to consistently detect earnings management.

Recently, some effort has been applied to examining accrual-based model's abilities to detect "minor offenses", (i.e. earnings management of small magnitude), using samples of firms that report small profits or repot small increases in earnings. The underlying rational is based on the empirical findings in Burgstahler and Dichev (1997) that the number of observations is abnormally low (high) directly below (at or directly above) behavioral benchmarks such as analysts' forecasts, the breakeven point or the point where the (seasonal) change in earnings is equal to zero. The abnormal distribution suggests that some of the observations at or directly above behavioral benchmarks are the result of earnings manipulation to cross known benchmarks

Mixed results are found on discretionary accrual models' abilities to detect earnings management. Dechow et al. (2002) propose the Forward-looking Modified Jones model to detect earnings management and find that both total accruals and the discretionary accruals derived form the Forward-looking Modified Jones model are significantly higher for firms reporting small profits than for firms reporting small losses. Their results are consistent with the view that the Forward-looking Modified Jones model is able to detect the type of earnings management used to cross the breakeven point. However, Philips et al. (2002) find contrary evidence in the same setting. They find that although total accruals are significantly different between the two groups, there is no significant difference in discretionary accruals. They also examine the setting where managers manage earnings upwards to avoid earnings declines and find similar results. Their evidence is thus consistent with the notion that discretionary accruals are unable to detect earnings management. The missed evidence on this issue calls for independent evidence form a different perspective. This study adds to the ongoing debate by providing evidence on the abilities of a broad range of discretionary accrual models to detect earnings management of small magnitude in a setting different from previous studies.


This essay analyses critically the earnings management literature. Among the several possible motives driving earnings management behaviour in firms, this essay focuses on motives that aim to influence the valuation of the company. Earnings management that makes the company look better than it really is may result in disappointment for the single investor and potentially leads to a welfare loss in society when the resource allocation is distorted. A more specific knowledge of the occurrence of earnings management supposedly increases the awareness of the investor and thus leads to better investments and increased welfare. This essay also identifies empirical evidences between motivation and earnings management behaviour and finally analyses the empirical methods employed by researchers to detect earnings management.


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