Question

1. Explain why it is difficult for researchers to convincingly document earnings management.

Answer 1

Although it is known that earnings management exists, it is difficult to document it. The main reason being that to prove that earnings have been managed researchers must first determine what earnings should have been before the effects of earnings management. One approach that has been used is to identify conditions in which managers’ incentives to manage earnings are high. The next step would be to test whether patterns of unexpected accruals are consistent with these incentives.

Researchers have examined different incentives for earnings management including capital market expectations and valuation, contracts written in terms of accounting numbers and anti-trust or governmental regulation. The use of accounting information by financial analysts and investors to value stocks has created an incentive for managers to manipulate earnings to influence the short-term performance of the stock. The evidence gathered by researchers shows that some firms manage earnings for stock market reasons. The frequency of this occurrence has not yet been determined. Sometimes, contracts can give incentives for managers to manipulate earnings. Some studies show that compensation and lending contracts provide an incentive for firms to manage earnings to increase bonuses, improve job security and mitigate potential violation of debt covenants. Earnings management due to regulatory motivation is another area where researchers have begun to discover evidence. Studies suggest that regulatory considerations can induce firms to manage earnings. There is very little evidence, though, on the frequency of this behavior and the effect on regulators or investors.