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There is considerable empirical evidence of accrual-based earnings management for US-based markets. Bagnoii and Watts (2000) suggest that relative-performance evaluation leads firms to manage earnings if they expect competitors to do so. Similar arguments are found in Erickson and Wang (1999) in the context of mergers. Additionally, managers may raise earnings to meet analysts’ expectations (DeGeorge et al., 1999), to avoid debt-covenant violations (DeFond and Jiambalvo, 1994; Parker, 2000), or to smooth earnings. According to former SEC chairperson Levitt (1998), earnings management is a widespread phenomenon among public companies under pressure to meet analyst expectations.

Several empirical studies have documented the use of accrual-based earnings management related to US securities offerings (IPOs and SEOs). Incentives for managing earnings upwards include raising stock prices prior to initial public offerings (Teoh et al., 1998), and before stock-financed acquisitions (Erickson and Wang, 1999). Teoh et al. (1998) study 1649 US IPO cases from 1980 to 1992 and present evidence that US issuers of IPOs manage their earnings by manipulating discretionary current accruals over time. The discretionary accruals, which are computed by using modified Jones (1991) model, proxy for the magnitude of accrual-based earnings management. Some other studies have been made on European markets, for example Roosenboom et al. (2003) observe 64 Dutch IPO

companies and also find that those IPO companies reported positive accruals in the first financial year. In the post-IPO years, managers reduce provisions for impairment in an attempt to mitigate the negative effect of the inevitable reversal of current accruals on reported net income.

Moreover, recent empirical studies on accrual-based earnings management further identify conditions for the occurrence of earnings management. Previous research also indicates that the likelihood of accrual-based earnings management is linked with corporate governance ineffectiveness. Accrual-based earnings management is often seen as sneaky managers pulling the wool over the eyes of gullible owners by manipulating accruals. Klein (2002) finds a negative relation exists between the abnormal accounting accruals and the percent of independent directors on audit committee among the US companies. Peasnell et al. (2001) also point out that there is a negative relationship between the proportion of non-executive board members and income-increasing earnings management in UK firms. The evidences are consistent with Fama and Jensen (1983) that the focus on corporate governance is grounded in agency theory that recognises the oversight, or control, function of the board as the most critical of directors' roles.

2.2.5 Market Reaction to Accrual-based Earnings Management

Certainly, classical finance theory leaves no room for noise traders and investors’ sentiment. If a market is efficient, no information or analysis can be expected to result in outperform a nee (and/or underperformance) of a stock relative to an appropriate market benchmark. Securities prices will be precisely determined with no regard to firms’ discretionary accounting choices and abusive practices in accounting flexibility, because earnings management practices, as discussed earlier, may be able to alter corporate short-term profitability; however, long-term corporate fundamentals can never be manipulated. For example, in an

accrual-based earnings management scheme, the total earnings in the long run cannot be altered through discretionary applications in accounting principles. In this sense, the valuation of the stocks will remain the same, and never be biased by earnings management schemes, if the market is efficient.

However, several recent studies have challenged the view that investors can fully see through earnings management (Healy and Whalen, 1999). If the investors’ ability to recognise earnings management is limited, investors may underestimate the magnitude of earnings management. They may be overoptimistic about the firm’s future returns and are willing to buy the stock at a higher price so as to push the stock price higher. For example, the studies of earnings management surrounding equity issues show that firms with income-increasing abnormal accruals in the year of initial equity offer have significant subsequent stock underperformance (Teoh et al., 1998). The implication of these findings is that prior to public equity offerings some managers inflate reported earnings in an attempt to increase investors’ expectations of future performance and increase the offer price. Subsequent reversals of the accruals management are disappointing to investors, leading to some of the negative stock performance. These findings suggest that earnings management prior to equity issues does affect share prices.

Secondly, several other studies provide evidence that investors do not completely see through earnings management, investigating market reactions when earnings management is alleged or detected. For example, Foster (1979) finds that firms criticised in the financial press by Abraham Briloff for misleading financial reporting practices suffered an average drop in stock price of 8% on publication date. Dechow et al. (1995) report that firms subject to SEC investigation for earnings management show an average stock price decline of 9% when the earnings management was first announced. By using a sample of firms that actually violated GAAP, Beneish (1997) shows that GAAP violators earn significant

negative abnormal returns for two years following the violation. Although these studies analysed firms for which the reporting practices in question are flagrant violations of accepted accounting principles or are fraudulent, they nonetheless suggest that investors do not completely see through earnings management.

Thirdly, there are some other interesting studies, whose findings are consistent with the claim that investors do not fully see through earnings management. Sloan (1995) reports that future abnormal stock returns are negative for firms whose earnings include large current accrual components and positive for firms with low current accrual components. Xie (1998) shows that results are largely attributable to shocks to abnormal accruals, rather than to normal accruals, Xie (1998) also provides evidence that the shocks to abnormal accruals are consistent with earnings management incentives. One interpretation of these findings is that investors do not fully see through earnings management reflected in abnormal accruals. Consequently, firms that managed earnings upward show subsequent stock price declines whereas firms with downward-managed earnings have positive subsequent returns.

In short, the empirical evidence shows that some firms appear to manage earnings for stock pricing reasons. Several recent studies indicate that there are situations in which investors do not see through earnings management.