A Reveiw of the Earnings Managemnet Literature and Its Implications for Standard Settings

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® 1999 American Accounting AssociationAccounting HorizonsVol. 3 No. 4December 1999pp . 365-383

COMMENTARY

Paul M Healy and James M Wahlen

Paul M Healy is a Professor at Harvard University and James M

Wahlen is an Associate P rofessor at Indiana University Bloomington

Review of the EarningsM an ag em en t Literature and ts

Implications for Standard SettingSYNOPSIS: In this paper we review the academic evidence on earnings manage-

ment and its impiications for accounting standard setters and regulators. We struc-ture our review around questions likeiy to be of interest to standard setters. In par-ticular we review the empirical evidence on which specific accruals are used tomanage earnings the magnitude and frequency of any earnings management andwhether earnings management affects resource allocation in the economy. Our re-view also identifies a number of opportunities for future research on earnings man-agement.

INTRO U TION

In this paper we review the academic evidence on earnings management. The

primary purpose of th is review is to summ arize the implications of scholarly evi-dence on earning s manag emen t to help accounting stand ard sette rs and regulatorsassess the pervasiveness of earnings m anagement and the overall integ rity of financial reporting. This review is also aimed at identifying fruitful areas for futureacademic research on earnings managem ent.

This paper is a summary of the empirical evidence on earnings management and its implications for accounting standard setters. It was writ ten for presentation and discussion at th e 1998 AAA/FASB Finan cialReporting Issues Conference. We than k th e conference pa rticipan ts for comments and suggestions. We alsoacknowledge helpful comm ents £md suggestions from Dsmiel Bene ish Greg Miller Ch ristop her Noe KathyPetroni Jerry Salamon Nathan Stuartand two 2inon5rQious reviewers on early drafts of this paper. Although we have tried to refer to all relevant recent studies we recognize th at there may be some tha t wehave inadvertently not cited We apologizein advance to the authors of any such studiesand welcomeany



366 Accounting Horizons /December 1999

Standard setters define the accounting language th at managem ent uses to communicate with the firm's external stakeholders.' By creating a framework that independent auditors and the SEC can enforce, accounting standards can provide a relatively

low-cost and credible means for corporate managers to report information on their firms'performance to external capital providers and other stakeholders.^ Ideally, financiareporting therefore helps the best-performing firms in the economy to distinguish themselves from poor performers and facilitates efficient resource edlocation and stewardship decisions by stakeholders.

The above role of financial reporting and standard setting implies that stan-dards add value if they enable financial statements to effectively portray differ-ences in firms' economic positions and performance in a timely and credible m anner. In fulfilling this objective, standard setters are expected to consider conflictsbetween the relevance and reliability of accounting information under alternative

stan dar ds. S tand ards t h at over-emphasize credibility in accounting data are likelyto lead to financial statements that provide less relevant and less timely information on a firm's performance. Alternatively, standards that stress relevance andtimeliness without appropriate consideration for credibility will generate accounting information that is viewed skeptically by financial report users. In either extreme , external investors and m anagem ent will likely resort to nonfinancial statement forms of information, such as that provided by investment bankers and financial analysts, bond-rating agencies, and the financial press, to facilitate theefficient allocation of resources.

If financial reports are to convey m anagers' information on their firms' performance,

standard s must permit managers to exercise judgm ent in financial reporting. Managers can then use their knowledge about the business and its opportimities to selecreporting methods, estimates, and disclosures tha t match the firms' business economics, potentially increasing the value of accounting as a form of communication. However, because auditing is imperfect, management's use of judgm ent also creates opportunities for earnings management, in which managers choose reporting methods andestimates that do not accurately reflect their firms' underlying economics.

The Chairman of the SEC, Arthur Levitt, recently expressed concerns over earnings management and its effect on resource allocation.^ He noted that managemenabuses of big bath restru cturin g charges, prem ature revenue recognition, cookie jar

reserves, and write-offs of purchased in-process R&D are threa ten ing the credibility offinancial reporting. To address these concerns, the SEC is examining new disclosurerequirements and has formed an earnings management task force to crack down onfirms that manage earnings. The SEC also expects to require more firms to restatereported earnings and will step up enforcement of disclosure requirements.

' In Financial Accounting Concepts Statement No. 5, Recognition and Measurement in Financial State-ments of Business Enterprises the Financial Accounting Stan dard s Board state s, Financial stateme ntsare a central feature of fmancial reporting—a principal means of communicating fmancial information tothose outside an entity (FASB 1984, pa ra. 5).

^ Stakeholders include current or potential providers of debt and equity capital, providers of labor, financial intermediaries (e.g., auditors, financial analysts, hond rating agencies), regulators, suppliers, andcustomers.



Reuiew of the Earnings M anagement Literature and its Implications for Standard Setting 367

A central question for stan dard sette rs and regulators, therefore, is to decide howmuch judgm ent to allow managem ent to exercise in financial reporting.'' To help re-solve this general question, stand ard setters are likely to be interested in evidence on 1) the m agnitude and frequency of any earnings m anagement, 2) specific accruals andaccounting methods used to manage earnings, (3) motives for earnings management,and (4) any resource allocation effects in the economy. We therefore use these fourquestions to structure our review.

Evidence on the magnitude and frequency of earnings management and on resourceallocation effects should help standard setters assess the extent of earnings manage-ment and w hether investors are deceived by it. Does this evidence show that earningsmanagement effects are widespread enough to warrant new standards or additionaldisclosures? Alternatively, does the evidence indicate that earnings management isinfrequent? If so, can standard sette rs infer that existing standards facilitate communi-cation between managers zrnd investors? Evidence on which accruals and methods areused to manage earnings should help standard setters identify which standards arepotential candidates for review. Finally, evidence on management's motives for earn-ings managemen t helps regu lators such as the SEC better allocate scarce resources forenforcement of standard s.

Research on earnings management (described in more detail in the following sec-tions) provides some evidence on these questions. The primary focus of earnings man-agement research to date, however, has been on detecting whether and when earn ingsmanagement takes place. Researchers have typically examined broad measures of earn-ings management (i.e., measu res based on total accruals) and samples of irms n whichmotivations to manage earnings are expected to be strong. In general, the evidence isconsistent with irms managing earnings to window-dress financ ial statem ents prior topublic securities' offerings, to increase corporate managers' compensation and job secu-rity, to avoid violating lending contracts, or to reduce regulatory costs or to increaseregulatory benefits.

A number of recent studies, however, sharpen the focus of the ir tes ts to examineearnings management using specific accruals, such as bank loan loss provisions, claimloss reserves for property-casualty insurers, and deferred tax valuation allowances.There is evidence that banks use loan loss provisions and insurers use claim loss re-serves to manage earnings, particularly to meet regulatory requirements. There is littleevidence that firms manage earn ings using deferred tax valuation allowances.

Much of the evidence on the capital marke t consequences of earnings managementshows that investors are not fooled by earnings managem ent and th at financial state-ments provide useful information to investors. Current earnings, which refiect man-agement reporting judgm ent, have been widely found to be value-relevant and are typi-cally better predictors of future cash fiow performance than are current cash flows.Stock retu rn evidence also suggests tha t investors discount abnormal accruals rela-tive to normal accruals, indicating tha t they view abnormal accruals as more likely toreflect earnings management.

Several recent studies, however, indicate that earnings msinagement does affectresource allocation for at least some firms. For example, the overpricing observed fornew equity issues may be partly attributable to earnings managem ent prior to the issue.•* Elim ination of m anag em ent judg m ent in financial rep orting is not optimal (or even feasible) for investors,



368 Accounting Horizons /December 1999

There is also evidence of significant negative stock market responses to allegations ofearnings management by the financial press or the SEC, suggesting that investors donot perfectly see through cases of earn ings management.^

We conclude that much of the academic research on earnings management is ofonly limited value to standard setters and regulators. The hterature provides littleevidence on questions of interest to standard setters, such as whether earnings man-agement is commonplace or relatively infrequent, which accruals are managed, andeffects on resource allocation decisions. As a result, there are many opportunities forfuture research on earnings management. For example, few studies have examinedwhether observed earnings management is attributable to a few firms or is widespread,both in the sample and in the population. This information is likely to be helpful forstandard setters in assessing the pervasiveness of earnings managem ent and th e over-all integrity of financial reporting. Fu ture research can also contribute additional evi-dence to further identify and explain which types of accruals are used for earningsmanagem ent and which are not Fu ture research is also needed to determ ine the condi-tions in which discretion in financial reporting is primarily used to improve communication vs. manage earn ings. As noted above, recent concerns about earn ings manage-ment by the SEC cite a number of specific abuses of management s reporting judgm entFinally, the mixed findings on the resource allocation effects of earnings managem entw arran t further research. When do stakeholders see through earnings managem entand w hen do they tolera te or fail to detect it?

The remainder of the paper proceeds as follows. As a preface to our review of theearnings management literature, in section two we define earn ings management. Sec-tions three and four discuss the findings reported by earnings management studies.Section three focuses on tests of earnings management across a variety of earningsmanagement incentives, whereas section four focuses on tests of the distribution ofreported earnings and accruals. s we review the evidence we also identify unansw eredquestions that create a number of opportunities for future research. Section five offersconcluding rem arks .

WHAT IS EAR NING S MANAGEMENT?

Our goal of reviewing the earn ings m anagem ent research re levant to stan dard set-ters shapes the following definition of earn ings m anagement:*

Definition Earnings m anagement occurs when managers use judgm ent infinancial reporting and in structuring transactions to alterfinancial reports to either mislead some stakeholders about theunderlying economic performance of the company or to infiuencecontractual outcomes tha t depend on reported accounting num -bers.

Several aspects of this definition merit discussion. First, the re are many ways thatmanagers can exercise judgment in financial reporting. For example, judgment is

Evidence also suggests tha t investors may m isvalue firms w ith earnings shocks caused by accruals. Whatis not yet clear is whether these shocks are attributable to earnings management.

^ Schipper (1989) also provides an overview of the earning s m anage men t litera ture although not from the





370 Accounting Horizons December 1999

existing accounting standards and expand disclosure requirements to enhance finacial reporting. Alternatively, if earnings m anagem ent exists but is not commonplacand has only a modest effect on resource edlocation, there is less need for financi

reporting standards to be revised.TESTS OF E RNINGS M N GEMENT INCENTIVES

Despite the popular wisdom that earnings management exists, it has been remarkab ly difficult for research ers to convincingly document it. This problem ariseprimarily because, to identify whether earnings have been managed, researchefirst have to estimate earnings before the effects of earnings management. This not an easy task. One common approach is to first identify conditions in whicmanagers incentives to manage earnings are likely to be strong, and then teswh ether pa tte rn s of unexpected accruals (or accounting choices) are consistent wi

these incentives. Two critical research design issues arise for these studies. Firsthey have to identify managers reporting incentives. Second, they have to measure th e effects of m anagers use of accounting discretion in unexpected accruals oaccounting method choices.

With regard to the first research design issue, researchers have examined mandifferent incentives for earnings management, including: (1) capital market expectations and valuation; 2) contracts written in terms of accounting numbers; and (3) anttru st or other government regulation. In the following sections we outline the findinfrom th e studies th at have examined these motivations.

With regard to the second design issue, estim ates of unexpected accruals measur

the effects of managers use of accounting discretion with some (inevitable) degree error. To estimate unexpected accruals, many studies begin with total accruals, measured as the difference between reported net income and cash fiows from operationTotal accruals are then regressed on variables that are proxies for normal accrualsuch as revenues (or cash collections from customers) to allow for typic l working capi-tal needs (such as receivables, inventory, and trade credit), and gross fixed assets tallow for normal depreciation. Unexpected accruals are thus the unexplained (i.e., thresidual) components of total accruals.^ A number of recent studies have developeestimates of the unexpected components of specific accruals, such as loan loss provsions for banks, claim loss reserves for property-casualty insurers, and deferred tavaluation allowances.^

Capital M arket M otivationsThe widespread use of accounting information by investors £ind financial analys

to help value stocks can create an incentive for managers to manipulate earn ings in a

Jon es (1991) (the Jon es approach ) introduced this appro ach. A nvimber of recent stu dies exam ine tproperties of unexpected accruals using the Jones approac h and their association w ith share r etu rns (e.Warfield et al. 1995; Sub ram any am 1996). Several othe r recen t studies have questioned the reliabiliand power of this a pproach (see Guay et al. 1996; Bene ish 1998). Kan g and Sivaram eikrishnan (1995) aKang (1999) introduce another model of unexpected accruals £ind show that their approach is more poerful t ha n th e Jones approach. These studies point to the value of further research to explain how bu

ness factors drive accruals. It remains to be seen whether business factors that are omitted from thcurren t m odels are correlated w ith Einy of the earnings man agem ent incentives discussed in the earninmanagement l i terature.



Review of the Earnings Managem ent Literature and its Implications for Standard Setting 371

attempt to influence short-term stock price performEince.^ We review this evidence infour parts. First, we discuss evidence on whether earnings management appears tooccur for stock market reasons. Second, we examine which specific accruals appear tobe used for earnings management. Third, we review evidence on the magnitude andfrequency of stock-market-motivated earnings management. Finally, we review whetherearnings management for stock market purposes affects resource allocation.

Do firms manage earnings for stock market purposesRecent studies on stock market incentives to manage earnings have focused on

unexpected accrual behavior during periods when capital market incentives to manageearnings are likely to be high. These include studies of earnings management in peri-ods surrounding capital market transactions and when there is a gap between firmperformance and analys ts' or investors' expectations. We d iscuss each of these earningsmanagement contexts in turn .

Several studies examine earnings management prior to management buyouts.DeAngelo (1988) reports tha t earn ings information is important for valuations in man-agement buyouts and hypothesizes that managers of buyout firms have an incentive to understate earnings. She finds little evidence of earnings management by buyoutfirms from an examination of changes in accruals. A more recent study by Perry andWilliams (1994), however, examines unexpected accruals controlling for changes in rev-enues and depreciable capital. The results indicate tha t unexpected accruals are nega-tive (income-decreasing) prior to a management buyout.

Recent studies have also examined whether managers overstate earnings in periodsprior to equity offers. The fin ings ndicate that firm s report positive (income-increasing)imexpected accruals prior to seasoned eqviity offers (Teoh, Welch, and Wong 1998b), initialpublic offers (Teoh, Welch, and Wong 1998a; Teoh, Wong, and Rao 1998), and stock-fi-nanced acquisitions (Erickson and Wang 1998). There is also evidence of a reversal ofunexpected accruals following initial public offers (Teoh, Wong, and Rao 1998) and stock-financed acquisitions (Erickson and Wang 1998). Finally, Dechow et al. 1996) report tha tfirms that are subject to SEC enforcement actions for financial reporting violations fre-quently make seeisoned equity offerings subsequent to the infraction but before its detec-tion.

Other stud ies of earnings m anagement for capital market reasons have shown th atearnings are managed to meet the expectations of financial analysts or management(represented by public forecasts of earnings). For example, Burgstahler and Eames (1998)find tha t firms manage earnings to meet analysts' forecasts. In particular, B urgstahlerand Eames (1998) fin ha t managers take actions to manage earnings upward to avoidreporting earnings lower than analysts' expectations. Abarbanell and Lehavy 1998) usefinancial analys ts' stock recommendations (e.g., buy, hold, or sell) to predict the direc-tion of earnings managem ent. They argue and find th at firms that receive buy recom-mendations are more likely to manage earnings to meet analysts' earnings expecta-tions, whereas firms tha t receive sell recommendations are more likely to show nega-tive unexpected accruals. Kasznik 1999) fin s evidence th at is consistent with firms indanger of falling short of a management earnings forecast using unexpected accruals to

manage earnings upward.' Dye 1988) and Trueman and Titmeui 1988) develop analytical mod els that dem onstrate examples of



3''2 Accounting Horizons December 1999

Finally, there is evidence on earnings management to influence expectations ofspecific types of investors. Bushee (1998) reports that flrms with a high percentage oinstitutional ownership typically do not cut R&D spending to avoid a decline in reported earnings. Firms do appear to manage earnings upw ard through R D cuts, how-ever, ifthey have a high percentage of ownership by institutions with momentum trading strategies and high portfolio turnover.

Wh ich specific accruals are managedAs noted ahove, many of the studies to da te use unexpected accruals as a proxy fo

earnings m anagem ent. S tandard setters are very likely to be interested in evidence onwhich specific accruals or accounting methods are used for earnings managemeht.

Teoh, Wong, and Rao (1998) examine depreciation estimates and bad debt provi-sions surrounding in itial pubhc offers. They find that, relative to a matched sample onon-IPO firms, sam ple firms are more likely to have income-increasing depreciationpolicies £uid bad debt allowances in the IPO year and for several subsequent years.

Banking and insurance companies have also provided a fertile ground for researchon specific accruals used to manage earnings. Loan loss reserves of banks and claimloss reserves of insu rers are directly related to their most critical assets and liabilitiesare typically very large relative to net income and equity book values, and are h ighlydependent on management's judgment. Studies of bank loan loss provisions includeBeaver et al. (1989), Moyer (1990), Scholes et al. (1990), Wahlen (1994), Beatty et al(1995), Collins et al. (1995), Beaver and Engel (1996), Liu and Ryan (1995) and Liu et al.(1997).'° Overall these studies find compelling evidence of earn ings management amongbanks, presumably (in part) for stock mEirket purposes. Many of these s tudies, howeversuggest that the market sees through such earnings management (discussed in moredetail below.) Studies of property-casualty insurance claim loss reserves, includingPetroni (1992), Anthony and Petroni (1992), Beaver and McNichols (1998), Penalva(1998), and Petroni et al. (1999), also find evidence of earnings management amonginsurers. It is not clear, however, whether th is is motivated by stock market incentives orby regulatory concerns.

Other recent earnings management tes ts th at use specific accruals have examineddeferred tax valuation allowances. Under FAS No. 109, managers with deferred taxassets are required to forecast tax benefits th at are not expected to be used. One criti-cism of this standard is that it permits too much judgment in reporting. Visvanathan(1998), Miller and Skinner (1998), and Ayers (1998) test this hypothesis, and all con-clude that there is little evidence tha t m anagers m isuse reporting judgm ent relating tothe valuation reserve to manage earnings. However, since these studies have not di-rectly examined settings in which managers have strong stock market incentives tomanage earnings (e.g., to meet ana lysts' earnings expectations or to window-dress re-sults prior to an equity issue), their te sts m ay lack power.

Overall, there is remarkably little evidence on earnings management using specificaccruals, suggesting tha t this is Hkely to be a fi uitful area for fiittire research. By exam-ining specific accruals, researchers cam provide direct evidence for standard set ters ofareas where standards work well and where there m ay be room for improvement. As asecondary benefit, such studies m ay be able to develop more powerful accrual models.' Some of these studies also find evidence that ba nks engage in earnings m anage men t by strategically



Review of the Earnings M anagement Literature and its Implications for Standard Setting 37 3

W hat is the magnitude and frequency of stock-based earnings managem .ent?There is also relatively little evidence on the magnitude or frequency of earnings

management for capital market purposes. Teoh, Wong, and Rao (1998) find that, for

firms making initial puhlic offerings, median unexpected accruals in the offer year a re4-5 percent of assets. Erickson and Wang (1998) report th at unexpected accruals are 2percent of assets in the quarter of a stock acquisition. These values are surprisinglylarge, representing 25-50 percent of typical asset retu rns . One potential explanation isthat the model of unexpected accrual used in these studies is misspecified for thesetypes of unusual events.

Teoh, Wong, and Rao (1998) also report that approximately 62 percent of firmsmaking initial puhlic offers h ve higher unexpected accruals than have a matched sampleof control firms. If the unconditional frequency is 50 percent, th is implies that roughly12 percent of the issuing firms manage earnings. One difficulty in generalizing fromthis evidence, however, is tha t th e au thors selected a sample of firms engaging in simi-lar transactions (initial puhlic offerings) to maximize the power of the ir tes ts to detectearnings management. The frequency of earnings m anagement for this sample, there-fore, does not necessarily indicate the overall frequency of earnings management forother capital market reasons.

Does stock-based earnings m anagemen t affect resource allocation?Overall, the w ealth of evidence on the stock-market effect of earnings num hers clearly

indicates that, despite concerns about earnings management, investors view earnings asvalue-relevant data that is more informative than cash fiow data. This fin ing has beenreplicated over long periods of time and in many different countries. It suggests that inves-tors do not view earnings m anagement as so pervasive as to make earnings data unreli-able. This interpretation is confirmed by Dechow's (1994) fin ings hat current earningsare better predictors of future cash fiows han are current cash fiows.

A number of studies examine stock price responses to accounting method changesand abnormal accruals to test explicitly whether investors fixate on earnings or aremore sophisticated in processing accounting information. For exEimple, Hand (1992)indicates that investors appear to recognize that firms have tax incentives to adoptLIFO during periods of rising input prices and do not react nmvely to the accompanyingdecline in reported earnings.

Studies of lo n loss accruals in the banking industry show tha t stock retu m s are nega-tively related to normal changes in loan loss provisions, and are positively related to ab-normal lo£m loss provisions (Beaver et al. 1989; Wahlen 1994; Beaver and Engel 1996; Liuand Ryan 1995; Liu et al. 1997). Fvirther, banks with abnormally low loan loss provisionstend to have relatively poor futvire earnings and cash fiow performance (Wahlen 1994).One interpretation of these fin ings s that investors view normal loan loss provisions asrefiecting underlying loan portfolio performance, but suspect that firms with abnormallylow loan loss provisions are managing earnings upward and discount the ir reported per-formance accordingly.'^ Similar results emerge from stock retums associated with unex-pected claim loss reserve revisions for property-casualty insurers (Petroni 1992; Anthonyand Petroni 1992; Penalva 1998; Beaver and McNichols 1998; Petroni et al. 1999).

This interpretation is consistent with the results of these studies, but this is not the interpretation tha tthese authors provide for their results. These studies emphasize that stock market retums and future




Several recent studies hav e challenged th e view tha t investors see through earnings m an-agement. For example, the studies of earning s managem ent surroxmding equity issues showthat irms with incom e-increasing abnorm al accrua ls in the year of a seasoned equity ofiFer have

significant su bsequent stock underperformance (Teoh, Welch, and Wong 1998b). Teoh, W elch,and Wong (1998a) and Teoh, Wong, and Rao (1998) find a sim ilar pa ttern for initial publicoffers. Th e implication of the se findings is th at , prior to public equity offers, some ma nagers inflate reported e arn ings in £m atte m pt to increase investo rs' expec tations of futurperformance and increase the offer p rice. Subse quent rev ersals of the earning s m anagement are disappointing to investors, leading to some of the negative stock performancthat has been widely docvmiented in finance studies. These findings, therefore, suggesth at earning s ma nage me nt prior to equity issues does affect share prices.

Several other studies have investigated mar ket reactions when earnings m anag em enis alleged or detected. For examp le, Fos ter (1979) finds tha t firms criticized by Ab raha m

Briloff in the financial pre ss for misleadin g financial reportin g practices suffered an average d rop in stock price of percent on publication date. Dechow et al. (1996) report thatfirms subject to SEC investigation for earnings management showed an average stockprice decline of 9 percent wben the earnings management was first announced. Using asample of firms that actually violated GAAP (i.e., firms that either were charged by theSEC or publicly admitted GAAP violations), Beneish (1997) shows that GAAP violatorea rn significant negative a bno rma l retu rn s for two ye ars following the violation. Althoughthe se stud ies analyzed firms for which the repo rting practices in question were flagranviolations of accepted accounting principles or were fi-audulent, they no neth eless suggesth at investors do not completely see throu gh earnings man agem ent.

Sloan (1996) repo rts th at future abno rma l stock re tur ns are negative for firms whosearnings include large current accrual components and positive for firms with low curren t accrual components. Xie (1998) shows tha t thes e resu lts are largely attrib utab le toshocks to abnormal accruals, rather than to normal accruals. Xie (1998) also provideevidence that the shocks to abnormal accruals are consistent with earnings management incentives. One interpretation of these findings is that investors do not fully sethrough earnings ma nage me nt reflected in abnorm al accruals. Consequently, firms th amanaged earnings upwEird show subsequent stock price declines whereas firms withdownw ard-managed earning s hav e positive subse quen t retur ns . This raise s a questionfor future research as to whether earnings management, as reflected in abnormal accruals, can explain the success of earnin gs mom entum-based trad ing strategie s.

Finally, experimental evidence suggests tha t, although sophisticated a naly sts m aynot fully detect earning s m ana gem ent w hen pricing the common sha res of a firm, an alysts are more likely to see throug h earn ings m anag em ent when financial sta tem en tclearly display the balances and activity of the man aged item. For exam ple. Hir st andHo pkins (1998) conduct a beha vioral exp erim ent with experienced financial a na lys ts totes t conditions in which they sire more likely to detect and undo th e stra tegic tim ing orealized gain s on inve stm ent s ecu rities. The y find th a t clear display of th e c omp onentof comprehensive income enhances analysts ' detection of earnings management andimproves their vsiluation relative to footnote disclosure. Thus, the results suggest thaear nin gs m an ag em en t may be less likely to affect resource allocation wh en financiareports make i t more t ran spa ren t .

In simimary, the evidence shows th at a t least some firms appe ar to ma nag e e arning s



A Review of the Earnings Managem ent Literature and its Implications for Standard Setting 375

has an effect on stock prices. Several recent studies indicate that there are situations inwhich investors do not see through earnings management. In other cases, notably inthe hanking and property-casualty industries, it appears tha t investors do see throughearnings management. ne explanation for these appsirently conflicting findings s that,as a resu lt of regulation, investors in banking and insurance firms have access to exten-sive disclosures that are closely related to the key accruals.''^ These disclosures may helpinvestors make more informed estimates of the likelihood ofany earnings msinagement.

The studies tha t examine the effects of earnings m anagem ent on the capital mar-kets leave a num ber of unanswered questions for future research . First, as noted abovehow pervasive is earnings management for capital market reasons, both among thefirms sampled and for the population of firms? Second, what is the m agnitude of anyearnings management? Third, what specific accruals do firms (other than banks andinsurers) use to manage earnings? Fourth, why do some firms appear to manage earn-ings whereas others with similar incentives do not?^^ Finally, under what conditionsdo market participants detect and, therefore, react to earnings management, and un-der what conditions do they fail to detect earning s management? For example, do required disclosures tha t m ake the use of accounting judgment more transparen t help tomitigate the impact of earnings managem ent on resource allocation?

ontracting M otivationsAccounting data are used to help monitor and regulate the contracts between the

firm and its many stakeholders. Explicit and implicit management compensation contracts are used to align the incentives of managem ent and externa l stakeholders. Lend-ing contracts are written to limit man agers' actions tha t benefit the firm 's stockholders

at the expense of its creditors . W atts and Zimmerman (1978) suggested that thesecontracts create incentives for earnings management because it is likely to be costly forcompensation committees and creditors to undo earnings management.

Earn ings mjinagement for contracting reasons is likely to be of interest to standardsette rs for two reasons. First, earn ings m anagem ent for any reason can potentially leadto misleading financial statem ents and affect resource allocation. Second, fin nci l re-porting is used for commvmicating management information not only to stock inves-tors, but also to debt investors and to investors' represen tatives on boards of directors

A large literature has emerged to test whether the incentives created by lendingand compensation contracts can explain earnings management.'® We review the evi-

dence on the association between contracting incentives and voluntary changes in ac-counting m ethods, estimates , or accruals.'*'

These include disclosures of nonperforming loans and loan write-offs for bank loan portfolios and loss rserve development for insurance claims of property-casualty firms.

'^ Peasnell et al. (1999) examine whether board composition affects earnings management They conclude thaoutside directors limit earnings man agem ent for firms w here th e separation of ownership and control is acute.

See W atts and Zimm erman (1986), Sm ith and W arne r (1979), and Leftwich (1983) for analyses of howlending contracts use accounting data.

'^ Many of these studies focused on the contracting effects of changes in accounting methods mandated baccounting stand ard setters and on ma nag ers' choices of accounting method s at a point in time. M andatorchanges in accounting methods provide little insight into etimings management, however. Also, firms' ac

counting decisions at a point in time are difficult to interpret from an earnings management perspectivbecause, as W atts an d Z immerm an (1990) note, these decisions reflect e x ante efficient repo rting choices aswell as x post opportunism.



^''6 Accounting Horizons December 1999

Lending ontractsA number of studies have examined whether firms hat are close to lending coveneints

manage earnings. For example, Healy and Palepu 1990) and DeAngelo et al. 1994) exam-ine whether firms close to their dividend constraint changed accoimting methods, accountinestimates, or accruals to avoid cutting dividends or making costly restructuring decisions.Holthausen (1981) examines whether firms close to their dividend constraint switched tostraight-line depreciation. All three studies conclude that there is little evidence of e£im-ings management among firms close to their dividend covenant Instead, firms n financialdifficulty tended to place more emphasis on managing cash fiows by reducing dividendpayments and restructuring their operations and contractual relations.

Of course, dividend-paying firms can avoid violating their dividend constraint bycutting dividends when necessary, whereas firms m ay have fewer options available tmeet other covenants, such as restrictions on interest coverage or debt-equity ratiosDeFond and Jiambalvo (1994) and Sweeney (1994) examine a sample of firms thaactually violated a lending covenant The evidence from these studies is mixed. DeFondand Jiambalvo (1994) find tha t sample firms accelerate earnings one year prior to thcovenant violation. They interpret this as evidence of earnings management by firmthat are close to the ir lending covenants. Sweeney 1994) also finds hat covenant viola-tors make income-increasing accoimting changes, but these typicEilly take place fter th eviolation. This finding ndicates tha t the sample firms did not make accounting changesspecifically to avoid violating the lending covenant It is certadnly possible, however, th atthe changes were made to reduce the hkelihood of future covenant violations.

Sweeney (1994) also reports evidence on the frequency and resource allocation effects of earnings m anagem ent for lending contract purposes. From a detailed analysiof 22 firms that violated debt covenants, she concludes that only five succeeded in delaying technical default by one or more quar ters through an accounting change. Givethe s tu d /s focus on firms that have a strong incentive to manage earnings, this frequency is quite low. However, because Sweeney 1994) only sampled firms that actuallyviolated loan covenants, the sample does not include firms that successfully managedearnings to avoid a technical default. As a result, he r findings may und ersta te the frequency of earnings management for debt covenant purposes.

Management ompensation ontractsA number of studies have examined actual compensation contracts to identify manag-

ers' earnings management incentives. On balance, the evidence reported in these studieis consistent with m anagers using accounting judgm ent to increase earnings-based bonusawards. For example, Guidry et al. (1998) find hat divisional managers for a large multi-national firm are likely to defer income when the earnings target in their bonus plan willnot be met and when they are entitled to the maximum bonuses permitted under theplan.i8 Healy (1985) and Holthausen et al. (1995) show that firms with caps on bonusawards a re more likely to report accruals tha t defer income when tha t cap is reached thanfirms that have comparable performance but which have no bonus cap.

Several other studies have examined whether implicit compensation contracts haveany effect on earnings m anagement incentives. These studies have tested whether there

An altem ative explanation is th at the sample flrms restructure d the ir operations (and made corresponding changes in accounting policies and estimates) in response to their flnancial difficulties



Review of the Earnings M anagement Literature and its Implications for Standard Setting 37 7

is an increase in the frequency of earnings m anagement in periods when top manag ers'job security is threatened or their expected tenure with the firm is short. DeAngelo(1988) reports that, during a proxy contest, incumbent m anagers exercised accountingdiscretion to improve reported earnings. Dechow and Sloan (1991) show that CEOs inthe ir final years in office reduced R D spending, presumably to increase reported earn-ings. ̂̂ They argue that this behavior is consistent with the short-term nature of theircompensation contracts and their short employment horizons.

In summary, these stud ies suggest tha t compensation and lending contracts induceat least some firms o manage earnings to increase bonus awards, improve job security,and mitigate potential violation of debt covenants. However, there is very little evi-dence on whether th is behavior is widespread or infrequent, and no evidence on whichaccruals are most likely being used to manage earnings for contracting purposes. Inaddition the existing studies do not provide evidence on the magnitude of earningsmanagement. Finally, there is little evidence that earnings management for contract-ing reasons has any effect on stock prices or resource misallocation.^ These open ques-tions suggest many avenues for future research.

Regulatory otivationsThe earnings managem ent literatu re h as explored the effects of two forms of regu-

lation: industry-specific regulation and anti-trust regulation.^' Accoimting standard set-ters have demonstrated an interest in earnings management to circumvent industryregulation. Indeed, the shifts toward fair value accounting and increased risk-relateddisclosures (as well as specific changes in regulatory accounting standards for banksand other financial institutions) were instigated in the aftermath of the financial tur-

moil in the savings and loan industry in the 1980s. These accounting changes wereintended, at least in part, to mitigate earnings management, provide information forstakeholders, and improve decision making by bank regu lators. S tandard setters m ayalso be interested in earnings m anagement for anti-tru st purposes. We, therefore, re-view evidence on both of these earnings management motives.

ndustry RegulationsIn the U.S., virtually all industries are regulated to some degree, but some (such as

the banking, insurance, and utility industries) face regulatory monitoring that is ex-plicitly tied to accounting da ta. Banking regulations require tha t banks satisfy certain

capital adequacy requirements tha t are written in term s of accounting numbers. Insur-ance regulations require that insurers meet conditions for minimum financial health.Utilities have historically been rate-regulated and permitted to earn only a normalreturn on their invested assets. It is fi equently asserted that such regulations create

Some may argue that changes in actual research expenditures do not qualify as earnings management,since they involve changes in investment decisions rather than accounting decisions. In addition, thesechanges in research plans may be optimal for the firm's owners if they provide new management withflexibility to set new directions for future researc h.A num ber of studies have examined wh ether earnings m anage men t for compensation purposes increasesexecutive compensation. Healy et al. (1987) find that changes in accounting methods from accelerated to

straight-lin e dep reciation or from FIFO to LIFO have little effect on bonu s compen sation for top mana ge-me nt. Defeo et al. (1989) analyz e th e com pensation effects of gain s repo rted on equity-for-debt swaps andreport similar findings.



37 8 Accounting Horizons December 1999

incentives to manage the income statement and balance sheet variables of interest tregulators. A num ber of studies provide evidence consistent with th is hypothesis.

There is considerable evidence that banks that are close to minimum capital requirements overstate loan loss provisions, understate loan write-offs, and recognizeabnormal realized gains on securities portfolios (Moyer 1990; Scholes et al. 1990; Beattyet al. 1995; Collins et al. 1995). There is also evidence that financially weak propertycasualty insurers th at risk regulatory attention unders tate claim loss reserves (Petron1992) and engage in reinsurance transactions (Adiel 1996).

Several of these studies provide evidence on the frequency with which firms engagin earnings management for regulatory purposes. For example, Collins et al. (1995find tha t nearly half of their sample banks use five or more of seven options for m anag-ing regulatory capital.̂ ^ Adiel (1996) also provides evidence on the frequency of regulatory management behavior. He examines data for 1,294 insurer-years in the period1980 to 1990 and reports that for 1.5 percent of the ssimple insurer-years financiareinsurance appeared to be used to avoid failing regulatory tests .

The evidence offers strong support that accounting discretion is used to manageindustry-specific regulatory constra ints. However, the frequency of the accounting management varies considerably across studies. Further, little is known about whetheregulators see through earnings management for regulatory purposes.

Anti Trust and Other RegulationsOther forms of regulation can also provide firms with incentives to m anage earn

ings. For example, it is often alleged th at managers of firms vulnerable to an anti-trustinvestigation or other adverse political consequences have incentives to m anage earnings to appear less profitable (Watts and Zimmerman 1978). M anagers of firms seekinggovernment subsidy or protection may have similar incentives.^^

A number of papers have examined whether regulatory scrutiny increases the likelihood of earnings managem ent. C ahan (1992) showed tha t firms under investigatiofor anti-trust violations reported income-decreasing abnormal accruals in investigatioyears. Jones (1991) found that firms in industries seeking import relief tend to defeincome in the year of application. Key 1997) examined unexpected accruals for firms inthe cable television industry at th e time of Congressional hearings on whether to deregulate th e indus try. Her evidence is consistent with firms in the industry deferringearnings during the period of Congressional scrutiny.

Evidence from these studies on the frequency of earnings management for regulatory purposes is difficult to interpret. The num ber of firms sampled in the above studiesis relatively sm all: Cahan's (1992) sample is 48 firms subject to an ti-trus t investigationduring the period 1970 to 1983, Jones' (1991) sample comprises 23 firms in industriesseeking import relief between 1980 and 1985, and Key (1997) examines 22 firms in thecable industry. The frequency of negative unexpected accruals for these firms is relatively high, however: 70 percent for the cable firms and 90 percent for firms seekinimport relief If the expected frequency of negative unexpected accruals is 50 percentthese findings suggest that as many as 20 percent of cable firms and 40 percent o

Collins et al. (1995) also examine th e use of two options to ma nag e repo rted e arni ngs . Across the samp lof 60 banks, over 75 percent used at least one option, tuid almost 20 percent used both options to managereported earnings.



Review of the Earnings M anagement L iterature and its Implications for Standard Setting 37 9

import relief firms managed earnings. A question th at is tinanswered by these studies iswhether regulatory motives for earnings management affect only the limited number offirms sampled, or a wider segment of the economy.

Finally, there is no direct evidence on how regulators respond to earnings manage-ment. There is also no direct evidence on how investors respond to earn ings manage-ment for anti-trust purposes.

In summary, the earnings management studies strongly suggest that regulatoryconsiderations induce firms to m anage eairnings. There is limited evidence on whetherthis behavior is widespread or rare, however, and very little evidence on the effect onregulators or investors.

TESTS OF DISTRIBUTION OF REPORTED E RNINGS ND CCRU LS

Several recent studies adopt a new approacb to test for earnings management. Tbesestudies examine tbe distribution of reported earnings to assess wbetber tbere is any evi-dence of earnings management (Burgstabler and Dicbev 1997,1998; Degeorge et al. 1998).Tbese studies bypotbesize tbat corporate managers bave incentives to avoid reportinglosses or reporting declines in earnings, and examine tbe distribution of reported earningsaround tbese points. Tbe fin ings ndicate tba t tbere is a bigber-tban-expected fi-equencyof firms witb sligbtly positive earnings (or earnings cb£inges) and a lower-tban-expectedfi equency of firms witb sligbtly negative earnings (or earnings cbanges). Tbese patternalso appear in studies using quarterly data (Burgstabler and Eames 1997 and using ana-lysts' earnings forecasts as tbe tbresbold (Degeorge et al. 1998). Tbe autbors interprettbese fin ings as evidence tba t some firms use earnings m anagement to avoid reportingnegative earnings, or earnings declines, or falling sbort of market expectations.

Tbese studies bave several appealing features. First, tbe autbors do not bave toestimate (potentially noisy abnormal accruals; instead, tbey inspect tbe distribution ofreported earnings for abnormal discontinuities at certain tbresbolds. A related advan-tage is tbat tbis approacb captures tbe effects of earnings management tbrougb casbflows (i.e., reduced R&D or advertising expenditures), tbat may not be captured byunexpected accrual measures. Second, tbe autbo rs are able to estimate tbe pervasive-ness of earnings management at tbese tbresbolds. For example, Burgstabler and Dicbev(1997,1998) find tb at 8-12% of tbe firms witb sm all pre-managed earnings decreasesexercise discretion to report earnings increases and 30-40% of tbe firms witb sligbtlynegative pre-managed earnings exercise discretion to report positive earnings. Tbisevidence suggests tba t tbe frequency of eeimings management is relatively bigb amongtbe subset of firms confronted witb reporting losses.̂ * Tbis approacb bas several disad-vantages, bowever, because it does not capture tbe magnitude of earnings managementor tbe specific m etbods by wbicb earnings are managed.

In summ ary, tbese te sts provide convincing evidence tbat some firms do manageearnings wben tbey anticipate reporting a loss, reporting an earnings decline, or fallingsbort of investors' expectations. As it stands, tbis evidence does not bave d irect implica-tions for standard setters . W bat is currently lacking from tbese studies is a clear under-standing of tbe steps tb at tbese firms take to increase reported earnings, tbe magni-tude of earnings management, tbe effect of tbis type of earnings m anagem ent on re-source allocation, and wbetber sucb earnings management can be mitigated by addi-tional standards.




SUM M RY ND CONCLUDING REM RKS

Overall, we conclude that the earnings management literature currently provideonly modest insights for standard setters. Prior research has focused almost exclusiveon understanding whether earnings m anagement exists and why. The findings indcate tha t earnings management occurs for a variety of reasons, including to influencstock market perceptions, to increase management s compensation, to reduce the liklihood of violating lending agreements, and to avoid regulatory intervention .

For stand ard setters, these findings are likely to confirm their in tuition that firmdo m anage earnings. However, if there is to be a more informed debate about the impcations of earnings m anagement for standard setting, we need additional evidence othe following questions. Which accounting standards are used to manage earningsWhat is the frequency of managers use of reporting judgment to manage earningra ther than to communicate firm performance to investors? What is the effect of anearnings management on resource allocation? What factors limit earnings managementFor exam ple, are firm s with effective corporate governance or disclosure policies lelikely to engage in earnings management?

Answers to the above questions are difficult to infer from curren t studies for a num-ber of reasons. First, most academic studies attempt to document earnings management, but do not provide evidence on its extent and scope. Consequently, existing evdence does not help standa rd setters to assess whether cu rrent standards are largeleffective in facilitating communication w ith investors , or whether they encourage widspread earning s management. Second, most stud ies have examined unexpected accruals for evidence of earnings managem ent. While this research provides a useful summary index of earnings m anagement, it does not show which standards are effective ifacilitating communication between managers and investors and which are ineffectivThird, most studies examine research settings where earnings management is molikely to be observed. This increases the likelihood of detecting earnings managem enbut m akes it difficult to aggregate across different settings to infer the overall fi-equencyof earnings management in the economy. Finally, findings on resource allocation effects of earn ings management are conflicting, suggesting the need for future empiricand theoretical research.

One implication of this review is that the earnings management area remains fertile ground for academic research. However, future research in the area is morlikely to provide new insights if it broadens the questions that have been addressedFu ture contributions are less likely to come from more powerful tes ts of whether earnings managem ent exists. Instead, we believe th at contributions will come from documenting i ts extent and magnitude for specific accruals, from reconciling conflicting finings on the effect of earnings m anagem ent on stock prices and resotrrce allocation in theeconomy, and from identifying factors that limit earnings management.

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A Reveiw of the Earnings Managemnet Literature and Its Implications for Standard Settings