Indeed, appreciating the importance and the roles of accounting earnings, as discussed earlier in this chapter (see section 2.2), is an indispensable foundation needed to clearly understand the firms’ rationale for managing their reported earnings. The assumptions underlie the Positive Accounting Theory can be a start for explaining the firms’ motivation to undertake earnings management. Viewing the firm as a nexus of contracts with managers, employees, regulators, suppliers and capital providers (i.e. lenders and investors), suggests that the firms operations are efficiently conducted if the firm has minimised the associated contracting costs (Jensen and Meckling 1976). However, the Positive Accounting Theory also assumes that managers are rational individuals - just like investors. Thus, the firm’s choice to manage earnings is not necessarily explained by efficiency but could also be driven by managerial opportunism (Scott 2003).
The literature investigates different motivations for executing earnings management. Following Healy and Wahlen (1999), Dechow and Skinner (2000) and Beneish (2001), earnings management motivations can be presented under three main classes as follows:
2.3.2.1.Security market motivations
The informativeness role of accounting earnings and the value-relevance of the periodic income from the perspective of investors can justify the managerial incentive to alter the firm’s reported earnings in order to affect the firm’s market valuation (Chambers and Penman
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1984; Trueman and Titman 1988; Houmes and Skantz 2010). For example, managers may use earnings management to align the firm’s earnings with the market expectations by meeting or beating ex ante earnings’ forecasts (Waymire 1984; Payne and Robb 2000; Burgstahler and Eames 2006; Bartov and Cohen 2009). It is argued that managers may use earnings management to avoid reporting lower periodic earnings than what the market expects (i.e. analysts forecasts) (Burgstahler and Eames 2006)14.
Moreover, there are several events where it is argued that managers may attempt to affect the firm’s share prices (either positively or negatively) by exercising a planned earnings management strategy. Management buyouts represent an example of a severe agency problem where incentives to the firm’s managers to adopt income-decreasing reporting strategies arise to reduce the share’s purchase price (DeAngelo 1986; Perry and Williams 1994; Fischer and Louis 2008).
In addition, a number of studies investigate income-increasing earnings management preceding events that involve offering equity shares such as in initial equity offerings (Aharony et al. 1993; DuCharme et al. 2001), seasoned equity offerings (Rangan 1995; Rangan 1998; Teoh et al. 1998; Shivakumar 2000; Kim and Park 2005) and non-cash M&A (Erickson and Wang 1999; Louis 2004; Gong et al. 2008).
14 Ronen and Yari (2008) noted that investors may prefer the analysts’ earnings forecasts over GAAP
earnings when they predict the future risks and expected cash flows. The increasing value-relevance of the earnings forecasts should add more pressure on managers to follow and meet the analysts’ expectations and avoid negative surprises, which would reflect negatively on the firm’s valuation.
31 2.3.2.2.Contractual motivations
Recalling the stewardship role of accounting earnings, the reported earnings can be used by the firm’s stakeholders as a monitoring and evaluating tool (Watts and Zimmerman 1986). More specifically, the contracting parties may develop their contractual terms based on the firm’s earnings. However, incentives to misrepresent the periodic earnings may arise due to the conflict of interests between the insiders and the outsiders (Leuz et al. 2003). Therefore, managers are expected to use their discretion over accruals and make the best choice (i.e. income-decreasing or income-increasing) to influence the potential contractual outcome, given the designated contractual terms (Chung et al. 2002).
There are many examples regarding such contractual arrangements. For example, it has been constantly asserted that earnings management should be more pronounced at firms where the managers’ compensation contracts are closely tied to the firms’ earnings and performance (Healy 1985; Gaver et al. 1995; Holthausen et al. 1995; Guidry et al. 1999; Lambert 2001; Leuz et al. 2003; Bergstresser and Philippon 2006; Kuang 2008; Grant et al. 2009).
Debt contracts are another example where a firm’s earnings reporting strategies are associated with the presence of accounting-based leverage constraints (Press and Weintrop 1990). Watts and Zimmerman (1990) and Mohrman (1996) argue that firms with higher debt-financing are more likely to manage earnings upward due to increasing pressures. Correspondingly, Sweeney (1994) and, DeFond and Jiambalvo (1994) provide evidence that managers adopt income-increasing accounting choices as a response to the threat of potential credit default.
32 2.3.2.3.Regulatory and tax motivations
Earnings management can also be driven by the political environment, taxation and governmental regulations (Ronen and Yaari 2008). Some renowned examples on regulatory- driven earnings management include the evidence documented by Jones (1991) on the negative discretionary accruals (i.e. income-decreasing earnings management) by firms that are under import relief investigation to benefit from the governmental protection from competing imports as well as the evidence reported by Cahan (1992) on the downward earnings management by firms under investigation for anti-trust laws.
Likewise, industry regulations can explain the firms’ incentives to manage their reported earnings. Insurance industry, for instance, is one the most regulated industries as their financial health is monitored and subject to minimum requirements (Healy and Wahlen 1999). Therefore, insurance companies are likely to manage their loss reserves if they reach alarming financial indicators (Gaver and Paterson 1999; Beaver et al. 2003).
A convincing theory that has been examined several times in the literature is that managers have the incentive to decrease the present value of a future income tax expense by manage earnings downwards (Maydew 1997; Phillips et al. 2003). Firms may adopt earnings for different types of tax-planning. Dhaliwal et al. (2004) assert that firms influence their effective tax rates to manage their earnings in order to achieve their targets.
In summary, the managers’ discretion over earnings can be driven by capital market motivations as earnings management is used to influence the market valuation. Moreover, earnings management may also be induced by the firm’s contractual and regulatory
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motivations as earnings management is used to the firm’s economic results in line with the associated economic incentives and political pressures. Finally, earnings management motivations can be understood given the crucial stewardship and informativeness roles of the periodic earnings reported by firms and by assuming the potential agency problems between the management and the spectrum of stakeholders.