Earning Management free essay sample

Based on a literature review of major accounting journals, this paper attempts to offer a comprehensive overview of recent earnings management research and provide a critical classification of articles on the matter as well as a search for voids in current literature. A selection of leading journals was reviewed systematically from January 2000 onwards resulting in 145 articles examining ‘earnings management’. Each article was thoroughly screened in terms of research question, methodology and findings. The paper attempts to be in keeping with prior review articles from around the turn of the century (Healy and Wahlen 1999; Fields, Lys and Vincent 2001) and focuses on the latest evolutions given that earnings management remained a focal research topic. The study resulted in four research categories: motives for earnings management, earnings management techniques, restrictions to earnings management, and research design issues. In every category, main research conclusions as well as methodological issues are discussed. Screening and classifying earnings management literature did not only generate a structured overview of the work performed in this area, it also provided insights in some important voids, such as a focus on non-listed and small companies, ‘real’ earnings management and non-financial motives. Finally, this paper offers a systematic literature review and evidences that there is ample room for further research. 1 1. Introduction Researchers (re)directing their focus to earnings management are confronted with an extent body of literature regarding the subject. Prior review articles such as those by Schipper (1989), Healy and Wahlen (1999) and Dechow and Skinner (2000) on earnings management and by Fields, Lys and Vincent (2001) on accounting choice have created structure in the enormous number of articles dedicated to the subject. McNichols (2000) has focused on design issues while reviewing recent literature. These prior review articles focused mainly on research done in the 1990’s. We extend this by examining the literature on earnings management in the early years of the new decade: January 2000September 2006. We selected 11 major accounting journals and screened them systematically on earnings management in title, abstract and/or author supplied keywords. As such, we read 153 articles focusing on or relating to earnings management. The articles are quite evenly spread over the entire period. This indicates that there is an continuous interest in this field of research. The articles deal with a variety of issues related to earnings management. We narrow this broad research area down into different categories to provide structure in the existing literature. This allows us to assess whether there is a shift in the research focus and to detect voids in current research. The remainder of the paper is organized as follows. In the next two sections we briefly discuss three prior review articles and our methodology (section 3). We discuss the first category (motives for earnings management) in section 4, followed by techniques of earnings management in section 5. How earnings management can be restricted is outlined in section 6. We discuss several research design issues in section 7. A summary concludes our paper. 2. Prior review articles Three important review articles from around the turn of the century serve as a basis for our research. Healy and Wahlen (1999) have reviewed earnings management literature in respect to the usefulness of prior research for standard setters. Fields, Lys and Vincent (2001), have structured their analysis around three types of market imperfections. The third review paper (McNichols, 2000) discusses the trade-offs associated with three research designs commonly used in earnings management literature. 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’ (Healy and Wahlen, 1999, p. 365). Healy and Wahlen’s often cited definition sets the tone for several papers on earn ings management. While it indicates that there are two motives and two techniques for earnings management, it leaves ample room to refine these goals and modi operandi. Healy and Wahlen came across three different motives for earnings management: capital market expectations and valuations, contracts written in terms of accounting numbers and antitrust or other government regulation. They concluded that research has not been able to assist standard setters in their attempts to restrain earnings management nor to provide evidence on the extent and scope of earnings management practices. Even though Fields et al. 2001) review accounting choice research articles, their classification is also useful for earnings management studies: ‘Although not all accounting choices involve earnings management, and the term earnings management extends beyond accounting choice, the implications of accounting choice to achieve a goal are consistent with the idea of earnings management. ’ They organized the accounting choice literature into three groups based on as many market imperfections: agency costs, information asymmetries and externalities affecting no n-contracting parties. Once again, the motives for earnings management were made apparent. Managers want to influence the outcome of contracts (e. g. compensation agreements and debt covenants), stock prices and policies of third parties (e. g. taxes, industry specific regulations). They argued that progress in the field of accounting choice 2 has slowed. They defined three fields for further research: measuring the implications of alternative accounting methods, building analytical models that provide guidance to empiricists, designing more powerful statistical techniques and improving research designs? This last issue is the main subject of the review paper by McNichols (2000). She discussed the characteristics of the three most commonly applied designs in the earnings management literature: aggregate accruals models, specific accruals models and the frequency distribution approach. One of the main arguments against using aggregate accruals models is that we do not have enough knowledge on how these accruals ‘behave’ in the absence of earnings management. That’s one of the reasons why McNichols argued that progress in earnings management research would come from specific accruals research. The frequency distributions (of different earnings metrics) approach introduced by Burgstahler and Dichev (1997) is another often used method to distinguish between companies who are thought to be managing their earnings and those companies who are probably not. This method, although quite easy to put into practice, is also being criticized. This will be addressed in section 7. 3. Methodology and contribution We selected eight major accounting journals, based on research conducted by Ballas and Theoharakis (2003). They have ranked accounting and finance journals, according to their main focus. Based on the top ten journals of their rankings, we selected the following: Accounting Horizons (AHO), Accounting, Organizations and Society (AOS), Accounting Review (TAR), Contemporary Accounting Research (CAR), Journal of Accounting, Auditing and Finance (JAAF), Journal of Accounting and Economics (JAE), Journal of Accounting and Public Policy (JAP) and Journal of Accounting Research (JAR). To make sure we conduct a worldwide screening, we also added Abacus (ABA) and European Accounting Review (EAR) to the list. We selected articles that are dedicated to or linked to earnings management by systematically screening the chosen journals on ‘earnings management’ in either title, abstract and/or author supplied keywords. This selection process resulted in a list of 145 articles. Nine out of ten journals dedicate at least 1 article to earnings management. There are no articles selected in Accounting, Organizations and Society during the entire research period. We have added Review of Accounting Studies (rather new journal but with growing importance) to our list and selected 8 papers following the same selection procedure.