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Earningsmanagment:quantitativemethods

AlessandroMuraDipartimentodiScienzeEconomicheeAziendali

UniversityofCagliari

ScuoladiDottoratoinScienzeEconomicheeAziendali,24November2016

Earningsquality(EQ)(1)

• Earnings quality – Dechow et al.(2010):“Higherqualityearnings providemoreinformationaboutthefeatures

ofafirm’sfinancialperformance thatarerelevanttoaspecificdecisionmadebyaspecificdecision-maker”

Threemainfeatures:

• EQ– dependsonthecontextofaspecificdecisionmodel• Which users?

• EQ– dependsonwhetheritis informativeaboutthefirm’sfinancialperformance(whichispartiallyunobservable)

• EQjointlydeterminedbyrelevanceofunderlyingfinancialperformancetothedecisionAND byabilityoftheaccountingsystemtomeasureperformance

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Earningsquality(EQ)(2)

• EQisamulti-dimensionalconcept

“thechoiceofanearningsqualitymeasuredependsontheresearchquestionposed(whichdimensionofearningsqualityisimpliedbytheresearchquestion)andtheavailabilityofdataandestimationmodels(wichmeasurecanbeestimated)”Francisetal.(2006)

Roleoffinancialreporting

• Financialreportingshouldprovide informationaboutanenterprise’sfinancialperformanceduringaperiod.“

• Reportedearnings ≡f(X)

• X=financialperformanceduringaperiod

• f(·)=acc. system,convertsunobservableXintoobservableearnings

• (note:reported earnings ≠financialperformance)

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Implementation of an accounting system

• Implementation of f(·): An accounting system that measures anunobservable construct (Financial performance) (X) inherentlyinvolves estimations and judgment … has the potential forunintentional errors and intentional bias (i.e., earnings management).

• Critical challenge is how to adequately distinguish the impact offundamental performance on EQ from the impact of themeasurement system.

Earningsmanagement(EM)

•Managershavediscretioninreportedearnings

– Discretioncanbeusedopportunistically(ifconditionsallow– Fieldsetal.,2001)

– EMreducesinformativenessofearnings

– EMdoes notautomatically imply fraud

Earningsmanagementmayerodeearningsquality

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Centralroleof accruals

•Simple (but complete)definition:E=OCF+Accruals

•Accountingchoices andmanipulations manifestthrough accruals(e.g.,Ramsay,2003;Roychowdhury,2006)

•AccrualsarebasedonestimatesaboutfutureCFsandsubjectiveallocationsofpastCFs

•Accruals have different properties than CFs (Dechow,Kothari &Watts,1998)

Proxies forearnings quality(Properties ofearnings)

• Earnings persistence

• Abnormal accruals

• Earnings smoothness

• Asymmetric timeliness andtimely loss recognition

• Targetbeating

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Empirical proxy:Earnings persistenceSimplestmodel

• Earningst +1=𝛼 +𝛽Earningst +𝜀t𝛽measurespersistence

• Logic

Firmswithmorepersistentearningshaveamore‘‘sustainable’’earnings/cashflowstreamthatwillmakeitamoreusefulinputintoDCF-basedequityvaluations

Empirical proxy:Earnings persistence (2)• Extensionsofthemodel• Earningst+1 =𝛼 +𝛽1 CF+𝛽2Accrualst +𝜀t

• Earningst+1 =𝛼 +𝛿1 Earningst +𝛿2Financialstatements componentst +𝛿3Other information+𝜀t

• Pros:Fitswellwiththeviewofearningsasasummarymetricofexpectedcashflowsusefulforequityvaluation.• Cons:Persistencedependsbothonthefirm’sfundamentalperformanceaswellastheaccountingmeasurementsystem.

Disentanglingtheroleofeachisproblematic.Persistencemaybeachievedintheshortrunbyengaginginearningsmanagement

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Empirical proxy:Abnormal accrualsGeneralprocedure:1)step:Models that estimatenormal levels ofaccruals.2)step:Residuals fromthemodels areused as ameasure of‘‘abnormal”accruals

• Jones(1991)modelAcct =𝛼 +𝛽1𝛥Revt+𝛽2PPEt+𝜀t

• LogicAccruals areafunction ofrevenue growth anddepreciation is afunctionofPPE.All variables arescaled bytotal assets

• Modified Jonesmodel(Dechow etal.,1995)• Acct=𝛼 +𝛽1 (𝛥Revt - 𝛥Rect)+𝛽2PPEt+𝜀 t

Empirical proxy:Abnormal accruals (2)• Performancematched (Kothari etal.,2005)DisAcct - Matched firm’s DisAcct

• LogicMatches firm-year observation withanother fromthesame industry andyear withtheclosest ROA.Discretionary accruals arefromtheJonesmodel(orModified Jonesmodel)

• Dechow andDichev (2002)approach𝛥WC=𝛼 +𝛽1CFOt-1+𝛽2CFOt+𝛽2CFOt+1+𝜀t

• LogicAccruals aremodeled as afunction ofpast,present,andfuturecashflowsgiven their purpose toalterthetimingofcashflowrecognition inearnings

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• Measuredas:σ(earnings)/σ(cashflow)

Alower ratioindicates moresmoothing oftheearnings stream relativetocashflows

• OK:earningssmoothfluctuationsinthetimingofcashpaymentsandreceipts,makingearningsmoreinformativeaboutperformancethancashflows• BUT:Whenmanagershaveaccountingchoicesthatcaninfluencesmoothness,dotheymakechoicesthatresultingreaterearningssmoothness?

• Realchallenge:disentanglingnaturalsmoothingfromartificialsmoothing

Empirical proxy:Earnings smoothing (2)

Earningssmoothinginpublicfirms• Early evidence– Burgstahler &Dichev (1997),Degeorge et al.(1999)for publicly-quoted firms:• Toavoid losses• Toavoid earnings decreases• Tomeet orbeat analysts forecasts

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Earningssmoothinginprivatefirms• Garrod,RatejPirkovic &Valentincic (2007,WP):

• Notanormaldistribution!

Earnings proxy:timely loss recognition (TLR)• Timely loss recognition (TLR)

Earningst+1=𝛼0+a1Dt+𝛽0Rett+𝛽1DtRett+et• where Dt=1if Rett<0.

Ahigher 𝛽1implies moretimely recognition oftheincurred losses inearnings.

• LogicThere is ademand forTLRtocombat management’s natural optimism.TLRrepresents highquality earnings

Ability ofaccounting tocapture losses

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• Ball &Shivakumar (2006)- 2roles of accruals are:• (-):Timely recognitionofgainsandlosses throughaccruals asbasedinpartonrevisionsoffuture CFexpectations,madebefore theiractualrealization• (+):Revisions incurrent-periodCFarelikelyto bepositivelycorrelatedwithrevisionsinitsexpectedfuturecashflows.

InstitutionalFramework

• Accountingsystembasedonhistoricalcostmodel

• Highalignmentbetweentaxandfinancialreporting

• Speciallawsallowdiscretionaryupwardassetsrevaluationsinspecificyears(asubstitutetaxwasoftenrequired)

• Downwardrevaluationbelowassetscostarecompulsoryincaseofimpairmentlossesandarenotdeductiblefortaxpurposes

ResearchQuestion

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Investigatewhetherupward(writeups)anddownwardrevaluations(writeoffsareabletopredictfutureprofitabilityofprivatefirms.

Mura,Piras,Valentincic,2016,When accruals exchange their roles:thecaseofwrite ups andwrite-offs?WP

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Motivation

ResearchQuestionInvestigatewhetherupward(writeups)revaluationsareabletopredictfutureperformanceofItalianprivatefirms.

Examining write-ups (and write-offs) in the Italian setting offers the chance toenhance our understanding on how financial reporting and tax accountinginteract and how they impact the quality of accounting properties in thecontext of private firms:

• both treatments aim at adjusting asset values originally recorded in thefinancial statements at historical cost

• both treatments require critical accounting estimates: their (lack of)reliability depends on the uncertainty inherent in forecasting futureeconomic conditions but also on opportunistic behaviour to cope with that

• Write-ups are discretionary; Write-offs are compulsory Alessandro Mura Università di Cagliari

Mura, Piras, Valentincic, 2016, When accruals exchange their roles: the case of write-ups and write-offs? WP

Extant literature• Mainly related to public firms offers conflicting findings (Whittered & Chan

1992; Barth & Clinch 1998; Aboody et al. 1999; Lopes & Walker, 2012)

• Barlev et al. (2007) analyse motivations for and effects of write-ups across35 countries. Main finding: they are not uniform and conclusions fromprevious studies are not applicable to countries with different institutionalfeatures

• Two studies relate to write-ups in private firms. Main finding: a highproportion of financial debts and weak solvency conditions make thisaccounting choice more likely (Gaeremynck & Veugelers, 1999; Piras &Mura, 2015)

• A few studies on write-offs in private firms (Garrod, Kosi & Valentincic,2008; Kosi & Valentincic, 2013; Szczesny & Valentincic, 2013)

• no existing studies investigate jointly the effects of write ups and write-offsAlessandro Mura

Università di Cagliari

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Institutional setting andconceptual framework

• Accounting system based on historical cost model

• High alignment between tax and financial reporting

• Special laws allow discretionary write-ups in specific years (a substitute taxis often required)

• Great differences between the revaluation laws issued in 2003 and 2005and the revaluation law issued in 2008.

Alessandro Mura Università di Cagliari

Institutional setting andconceputal framework

Italian Tax system creates interesting variation in(net)cost ofsignal:Variation intax cost ofrevaluation2003and2005highsubstitute taxvs.2008low substitute tax orrevaluing withnotax implications

• Write-offs are compulsory in case of impairment losses and are notdeductible for tax purposes

2003 2005 2008CorporateIncome Tax Rate(%) 34 33 27,5Substitute Tax forRevaluation (%)19 12 3Undiscounted NetTax Benefit(%) 15 21 24,5

Theory: Attaching a cost to a voluntary reporting choice can enhancesignal credibility (Gigler JAR 1994)

Alessandro Mura Università di Cagliari

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Hypothesisdevelopment

H1a:write-upsoffixedassetsinprivatefirmsreliablypredictpositivefutureoperatingperformancewhenthereportingchoiceisexpensive

H1bwrite-upsoffixedassetsinprivatefirmsdonotpredictpositivefutureoperatingperformancewhenthereportingchoiceischeaporfree

Thenon-taxcostofappearingworseofftooutsidepartiesduetowrite-offscombineswiththeirfiscalneutralityastheyarenotrecognisedfortaxpurposesinItaly.Unlikelytheirusetoadmitthepresenceofimminentlosses

H2:write-offsoffixedassetsinprivatefirmsdonotpredictnegativefutureoperatingperformance

Alessandro Mura Università di Cagliari

Firms that will have taxable earnings in future reporting periods that aresufficiently high to absorb the fiscal deduction of the depreciation in thefollowing years will be able to fully exploit this net tax benefit.Reliably forecasting the firm’s future profitability when the revalued asset isdepreciated is essential for gaining the tax relief.

Main Model

Model: Persistence of earnings components; adaptation of Ball and Shivakumar(2006) Asymmetric Timely loss and gain recognition

• Sample:around14.000ItalianprivatefirmsselectedusingAIDAdatabase.• AllfirmsconformingtoLocalGAAP(Civile CodeandOIC)• OnlyNonfinancialfirms• Firmsthatfileanabridgedversionoffinancialaccounts removed fromthe

sample• Year:2003-2005-2008splitintotwosub-periods(2003-2005;2008)

Research design

𝑂𝐼)*+, 𝑂𝐶𝐹)*+ = (𝛽1 + 𝛽3𝑅𝐸𝑉𝐴𝐿) + 𝛽9𝑊𝑂) + 𝛽;𝑂𝐶𝐹) + 𝛽<𝐴𝐶𝐶𝑂𝑇𝐻)) @

𝐷𝑂𝐶𝐹)+𝛽31𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑠) + 𝜖)

Alessandro Mura Università di Cagliari

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Dependent variables𝑶𝑰𝒕*𝒏: Operating income in year t + n

𝑶𝑪𝑭𝒕*𝒏:Operatingcashflowsoffirm i inyeart+n

REVALit:dummyvariableequals1ifthefirmi revaluateinyeart

Controlvariables

WOit:dummyvariableequals1ifthefirmi write-offinyeart

ACCOTHit:ΔInventory +ΔDebtors +ΔOther currentassets– ΔCreditors – ΔOthercurrentliabilities– Depreciation– Provisions,deflatedbytotalassetsatthebeginningofyeart

OCFit:Operatingcashflowsoffirm i inyeart

DOCFt:dummyvariableproxyforbadnewsequals1ifCF0<0

Main independent variable

Alessandro Mura Università di Cagliari

ACCOTHit-1:laggedACCOTH,deflatedbytotalassetsatthebeginningofyeart

OCFit-1:laggedOCF,deflatedbytotalassetsatthebeginningofyeart

QRit:ratiobetweencurrentassets– inventoriesandcurrentliabilities

LEVit:totaldebtsdeflatedbytotalassetsatthebeginningofyeart

DIMit:logarithmofsales

SECTit:vectorofdummyvariablesforindustrycontrol

REGit:vectorofdummyvariablesforgeographicalcontrol

YEARit:vectorofdummyvariablesfortimecontrol

Other controlVariables

Alessandro Mura Università di Cagliari

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ItalianPrivateFirms

Year Nonwriting-upfirms Writing-upfirms Total Writing-upPercentage

2003 7,997 896 8,893 10.08%

2005 8,979 781 9,760 8.00%

2008 9,174 3,729 12,903 28.90%

Year Nonwriting-offfirms Writing-offfirms Total Writing-offPercentage

2003 8,702 191 8,893 2.15%

2005 9,588 172 9,760 1.77%

2008 12,639 264 12,903 2.05%

Samplecomposition(2003,2005,2008)

Alessandro Mura Università di Cagliari

Resultsforsub-sample2003-2005 DependentvariableVARIABLES OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt.3

Earningscomponents

REVAL 0.0103*** 0.0097*** 0.0058 0.0164*** 0.0170*** 0.0160*** (3.27) (2.90) (1.47) (8.57) (6.85) (5.26)WO -0.0084 0.0154** 0.0001 0.0069* 0.0026 0.0011

(-1.27) (2.14) (0.01) (1.69) (0.56) (0.21)

ACCOTHt 0.4889*** 0.5096*** 0.4607*** 0.9335*** 0.9182*** 0.9217*** (13.79) (13.05) (10.82) (29.58) (20.85) (18.88)OCFt 0.5793*** 0.7358*** 0.6954*** 1.1379*** 1.1447*** 1.1703*** (16.12) (18.24) (15.96) (35.70) (25.88) (23.48)BadnewstimelinessrecognitionDOCF -0.0013 0.0071* 0.0026 0.0077*** 0.0094*** 0.0095*** (-0.37) (1.91) (0.64) (3.54) (3.54) (3.03)DOCF× ACCOTHt

-0.0191 -0.2039*** -0.1194* -0.3865*** -0.4236*** -0.4788*** (-0.35) (-3.01) (-1.79) (-8.62) (-7.81) (-8.20)DOCF×OCFt -0.3303*** -0.5101*** -0.5052*** -0.6881*** -0.7672*** -0.9139*** (-5.45) (-6.83) (-6.68) (-14.81) (-13.42) (-13.40)Controlvariables ACCOTHt-1 0.1517*** 0.0365 0.1265*** 0.1679*** 0.1651*** 0.1504*** (4.35) (0.97) (3.05) (6.28) (4.71) (3.52)OCFt-1 0.2134*** 0.1073*** 0.1927*** 0.2408*** 0.2341*** 0.2112*** (6.27) (2.90) (4.73) (9.16) (6.76) (5.04)QR -0.0001 -0.0007* -0.0003 -0.0003 -0.0003 -0.0001

(-0.26) (-1.81) (-0.78) (-1.22) (-1.05) (-0.32)

LEV -0.0378*** -0.0263*** -0.0207*** -0.0414*** -0.0354*** -0.0182*** (-6.53) (-4.27) (-2.94) (-11.67) (-7.87) (-3.35)DIM -0.0054*** -0.0084*** -0.0125*** -0.0055*** -0.0102*** -0.0152*** (-4.78) (-6.95) (-8.73) (-7.63) (-11.34) (-12.96)GROUP -0.0031 -0.0028 0.0016 0.0023 0.0005 0.0025

(-1.32) (-1.09) (0.52) (1.53) (0.25) (1.03)TimeDummies Yes Yes Yes Yes Yes YesSectorDummies Yes Yes Yes Yes Yes YesGeographicdummies Yes Yes Yes Yes Yes YesConstant 0.1670*** 0.1995*** 0.3164*** 0.1563*** 0.2418*** 0.3113*** (7.28) (7.21) (9.73) (10.32) (11.38) (13.40)

Observations 18,653 18,653 18,653 18,653 18,653 18,653

R-squared 0.1103 0.1119 0.1007 0.4945 0.3758 0.2962

levelsofsignificance:***p<0.01,**p<0.05,*p<0.1.Boldfacedestimatessignificantat5%orbetter.

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Resultsforsubsample2008 DependentvariableVARIABLES OCFt+1 OCF(t+1)+(t+2) OCF(t+1)+(t+2)+(t+3) OIt+1 OIt+1)+(t+2) OI(t+1)+(t+2)+(t+3) Earningscomponents REVAL -0.0017 -0.0076** -0.0134*** -0.0068*** -0.0162*** -0.0283*** (-0.85) (-2.46) (-3.23) (-5.33) (-6.58) (-7.60)WO 0.0065 0.0279** 0.0509*** 0.0155*** 0.0352*** 0.0575*** (0.98) (2.30) (2.91) (3.23) (3.56) (3.75)ACCOTHt 0.4834*** 0.9980*** 1.5143*** 0.8531*** 1.6081*** 2.3285*** (13.24) (16.44) (18.06) (31.18) (29.18) (27.26)OCFt 0.5833*** 1.2656*** 1.9343*** 1.0111*** 1.9717*** 2.9073*** (15.43) (20.44) (22.50) (36.76) (35.58) (33.76)BadnewstimelinessrecognitionDOCF 0.0018 0.0039 0.0012 0.0055** 0.0122** 0.0225*** (0.43) (0.62) (0.14) (2.33) (2.58) (3.07)DOCF×ACCOTHt 0.0513 -0.0775 -0.1854 -0.2019*** -0.4802*** -0.7516*** (0.72) (-0.73) (-1.25) (-4.16) (-5.09) (-5.26)DOCF×OCFt -0.2326*** -0.5929*** -0.9694*** -0.3703*** -0.9227*** -1.4759*** (-3.17) (-5.14) (-6.06) (-7.49) (-9.60) (-10.29)Controlvariables

ACCOTHt-1 0.1249*** 0.1212* 0.1690* 0.0249 0.1325** 0.3282*** (3.19) (1.86) (1.84) (0.85) (2.26) (3.77)OCFt-1 0.1741*** 0.2448*** 0.3455*** 0.1178*** 0.3215*** 0.6151*** (4.54) (3.83) (3.79) (4.14) (5.62) (7.18)QR -0.0005 -0.0012** -0.0006 -0.0001 -0.0003 -0.0003

(-1.64) (-2.15) (-1.12) (-0.63) (-0.73) (-0.44)

LEV -0.0398*** -0.0711*** -0.0774*** -0.0197*** -0.0453*** -0.0659*** (-7.16) (-7.91) (-6.23) (-5.61) (-6.37) (-5.97)DIM -0.0036*** -0.0151*** -0.0273*** -0.0045*** -0.0146*** -0.0303*** (-3.01) (-7.46) (-9.60) (-5.86) (-8.90) (-11.47)GROUP 0.0012 0.0035 0.0048 0.0019 0.0032 0.0029

(0.47) (0.84) (0.85) (1.08) (0.95) (0.56)

SectorDummies Yes Yes Yes Yes Yes YesGeographicDummies Yes Yes Yes Yes Yes YesConstant 0.1502*** 0.4009*** 0.6421*** 0.1320*** 0.3505*** 0.6936*** (5.97) (9.42) (9.97) (8.26) (10.34) (11.47)Observations 12,903 12,903 12,903 12,903 12,903 12,903

R-squared 0.1429 0.2099 0.2394 0.4453 0.4497 0.4400

levelsofsignificance:***p<0.01,**p<0.05,*p<0.1.Boldfacedestimatessignificantat5%orbetter.

Highbottom-lineprofitability(>5%) Lowbottom-lineprofitability(<5%)VARIABLES OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt+3 OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt+3 REVAL 0.0073 -0.0100* 0.0022 -0.0017 -0.0086* -0.0143*** -0.0037* -0.0049** -0.0060** -0.0037*** -0.0054*** -0.0082*** (1.22) (-1.66) (0.35) (-0.40) (-1.84) (-2.92) (-1.89) (-2.15) (-2.58) (-3.09) (-4.01) (-5.28)WO 0.0340 -0.0071 0.0336 0.0196 -0.0033 -0.0015 -0.0004 0.0188** 0.0138 0.0140*** 0.0220*** 0.0242*** (1.64) (-0.31) (1.59) (1.31) (-0.24) (-0.09) (-0.06) (2.11) (1.49) (2.99) (3.55) (3.77)

ACCOTHt 0.6109*** 0.5445*** 0.6156*** 0.8615*** 0.7983*** 0.8430*** 0.4496*** 0.3681*** 0.3374*** 0.6076*** 0.4756*** 0.4689*** (11.52) (9.66) (10.12) (22.74) (17.27) (15.65) (11.72) (8.58) (7.85) (25.64) (17.91) (15.84)OCFt 0.6174*** 0.6808*** 0.7504*** 1.0138*** 1.0038*** 1.0388*** 0.5208*** 0.5061*** 0.4566*** 0.7225*** 0.6131*** 0.6218*** (13.14) (12.97) (13.76) (29.95) (23.81) (21.58) (13.49) (11.80) (10.67) (30.79) (23.27) (21.23)QR -0.0004 -0.0009 0.0020 0.0003 -0.0005 0.0005 -0.0006** -0.0007** 0.0003 -0.0002 -0.0004 -0.0002

(-0.22) (-0.62) (1.54) (0.26) (-0.50) (0.45) (-2.26) (-2.11) (0.67) (-1.61) (-1.64) (-1.20)

LEV -0.0320** -0.0249 0.0266 0.0145 -0.0088 -0.0078 -0.0411*** -0.0257*** -0.0105 -0.0056 -0.0090** -0.0055

(-2.07) (-1.48) (1.43) (1.27) (-0.69) (-0.54) (-6.61) (-3.63) (-1.37) (-1.53) (-1.98) (-1.07)

Observations 3,001 3,001 3,001 3,001 3,001 3,001 9,902 9,902 9,902 9,902 9,902 9,902

R-squared 0.1169 0.1433 0.1239 0.3582 0.3035 0.2781 0.0568 0.0633 0.0404 0.2065 0.1507 0.1393

levelsofsignificance:***p<0.01,**p<0.05,*p<0.1.Boldfacedestimatessignificantat5%orbetter.

Resultsforsub-sample2008splitbylow/highprofitability

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Conclusions

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Italianprivatefirmsweightaxcostsagainstexpectedfuturetaxbenefitstodecidewhethertorevaluetheirfixedassets.

- where current tax costs are relatively high, firms will revalue assets if futurenet tax benefits are positive: current revaluations are positively related tofuture profitability.

- Ifcurrenttaxcostsarerelativelylow(orzero),revaluationchoicewillbefollowedforopportunisticreasons.

- finding is consistent withGigler’s theory:avoluntary signal is effective when itis costly.As soon as thesignal is “cheap”,it does not work.

- Main implications:

• theinteraction offinancial andtax accounting creates atrade-offthatcanimprove thesignal quality ofreported numbers

• Book-tax-conformity canenhance credibility offinancial reporting

- Write-offsarepositivelyrelatedtofutureprofitability.Thisisnotconsistentwithaccountingstandards,butisconsistentwithfirmsobtainingeconomicbenefitsotherthanmaximizingfirmvalue(includingsmoothing).

• Many thanks foryour attention