PRESENTACIÓN DE LOS RESULTADOS DE LAS ENCUESTA

THESIS INTRODUCTION

Many aspects of financial reporting are within the discretion of managers. For example, managers could make a choice between permitted accounting methods, exercise managerial judgements over accounting estimations (e.g. depreciation, allowance etc.), or even engage in more pernicious practices such as frauds to influence reported earnings. The popular wisdom among both academics and practitioners suggests that managers do manage earnings from time to time (Healy and Wahlen, 1999). Hence, “how far can we trust earnings numbers?”, as asked by Walker (2013), among many others, is a sensible and important question to ask.

The pursuit of a general answer to the above question attracts a great deal of interest from accounting academics during the last few decades and has since grown into one of the largest strands of the accounting literature, namely the literature on earnings management. Research in earnings management provides the insights for market participants to make more informed decisions, boards of directors to play more effective monitoring roles, and regulators to put in place more suitable rules to ensure well-functioning capital markets. The series of recent significant accounting scandals (such as Enron, WorldCom, Lehman Brothers, Toshiba to name just a few) could only make it more important that we investigate and understand more about earnings management. The importance of research in earnings management is, therefore, cannot be understated. Walker (2013) reports that research on earnings management on average accounts for between 7% to 10% of accounting publications in leading

2

journals during the period from 2001 to 2011 and that the rate is still increasing. It is not an overstatement, hence, to say earnings management research is currently one of the major items on the agenda of the accounting research community. This thesis aims to make significant and meaningful contributions to that agenda.

The main component of the thesis comprises of three empirical chapters investigating three inter-related topics on the general theme of earnings management. The next section (Section 1.1) will set the background on which the empirical chapters are based by discussing the adopted definition of earnings management before Section 1.2 explores the theoretical framework which explains why and how earnings management would happen. The discussions in Section 1.1 and 1.2 are only meant to provide the background for the rest of thesis and put subsequent empirical chapters in context while a complete review of the whole literature on earnings management is avoided because the size of it is too large for the thesis to attempt1_{. Instead, only the definitions and theoretical foundations of}

earnings management are reviewed in this introduction chapter, while the literature which is directly related to the issues investigated in each of the empirical chapters will be reviewed separately later in the corresponding chapters. Section 1.3 will then introduce the topics investigated in each of the empirical chapters and highlight the original and important contributions made in each chapter. All empirical chapters in this thesis are based on the UK stock market. Section 1.4 will explain the characteristics of the UK stock market which makes it an interesting and suitable setting for the purposes of the thesis.

3

1.1. DEFINITION OF EARNINGS MANAGEMENT

Although the term ‘earnings management’ has been used widely in the literature, it does not always mean the same thing. When used for different research purposes, earnings management could be defined differently. An early definition of earnings management is provided by Schipper (1989) with the aim is to provide a framework to analyse the implications and trade-offs between various research design choices and to describe the connection between research in earnings management and other accounting research areas. In particular, Schipper (1989, p. 92) defines earnings management as “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)”. Schipper’s (1989) definition does explicitly assume earnings management is only engaged for private gains and is restricted to the manipulation through intervening the financial reporting process regardless of whether or not such intervening has violated Generally Accepted Accounting Principles (hereafter GAAP). Healy and Wahlen (1999, p. 368), taking the view of standard setters, define earnings management as “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.” The definition covers both accounting manipulation and changing real economic decisions to influence earnings, but it does emphasize the nature of earnings management is to “mislead” or “influence contractual outcomes”.

Earnings management, however, is not always ‘bad’. Managers could also manage earnings to make it more informative (Holthausen and Lefwich, 1983). Allowing for both the misleading and informative nature of earnings management, Walker (2013, p. 446) makes a broader definition of earnings management as “the use of managerial discretion over (within GAAP) accounting choices, earnings

4

reporting choices, and real economic decisions to influence how underlying economic events are reflected in one or more measures of earnings.” This definition, however, focuses only on practices which are allowed in existing regulations. Ronen and Yaari (2008, p. 27) provide a more complete definition of earnings management, which is also the one adopted in this thesis:

Earnings management is a collection of managerial decisions that result in not reporting the true short-term, value-maximizing earnings as known to management.

Earnings management can be

Beneficial: it signals long-term value;

Pernicious: it conceals short- or long-term value;

Neutral: it reveals the short-term true performance.

The adopted definition does not exclude any means of earnings management or presume any intention of the managers so long as the resulting effect is that the reported earnings is different from the “true” earnings known to management. Earnings management under this definition is not necessarily “pernicious”, but it could also be “neutral”, or even “beneficial” if it could provide information for financial statement users to better understand the firm’s long-term value. For policy makers and regulatory authorities, the above definition implies that rules in financial reporting should not be directed to eliminate earnings management by, for example, stifling away all flexibilities which managers could exploit to influence reported earnings. Studies which adopted the above definition, including this thesis, often take the stance that leaving room for earnings management, such as allowing flexibilities or development of principle-based accounting standards, could in effect even make

5

financial reporting more informative. Therefore, all the policy implications drawn from the results of the thesis should be taken with this perspective in mind.

1.2. THE THEORETICAL PERSPECTIVE OF EARNINGS MANAGEMENT

As discussed in the previous section, the thesis adopts the definition of earnings management following Ronen and Yaari (2008) as any course of actions, regardless of intentions, which results in reported earnings being different from the earnings known to management. Having defined earnings management this way, it is important to understand the theoretical foundation which explains why managers would want to engage in earnings management. Theoretically earnings management could be explained within the framework of the well-developed agency theory (Jensen and Meckling, 1976). Under the agency theory, there are conflicts of interest between managers (the ‘agent’) and shareholders (the ‘principal’). Managers often have more power and possess better information set compared to external investors, and they generally work to maximize their rewards (e.g. remuneration) and not necessarily shareholders’ wealth (Goergen and Renneboog, 2011). Shareholders, on the other hand, rely on managers to run the business and are the residual claimants to what is left after all other stakeholders have taken their shares of the firm’s profit (including managers’ rewards). This creates a moral hazard problem in which managers could potentially abuse the power entrusted in them to report earnings in a way that maximizes their private rewards rather than shareholders’ wealth. Earnings management in this case is costly, including direct cost (e.g. decline in share prices) and indirect cost (e.g. costs associated with establishing monitoring measures).

It has been argued earlier, however, that earnings management is not necessarily always ‘bad’. The signalling theory suggests that in equilibrium, it could be the optimal solution that one party with information advantage (i.e. insiders) signals some private information to the other party (i.e. outsiders) (Spence, 1973; Myers and

6

Majluf, 1984). In the context of financial reporting, this could create an adverse selection problem in which shareholders would be reluctant to make capital investments because they know managers possess superior information and are afraid that managers could take advantage of such information to pursue their self- interest (Walker, 2013). To deal with this problem, managers might use earnings management as a signalling tool and therefore make reported earnings more informative (Holthausen and Lefwich, 1983). The positive accounting theory also suggests that earnings management could be a tool to optimize the nexus of contracts firms have signed up with various stakeholders (Watts and Zimmerman, 1986; Watts and Zimmerman, 1990).

1.3. THE MAIN COMPONENTS OF THE THESIS

This thesis aims at making contributions to the growing literature on earnings management. The main components of the thesis comprise of three empirical chapters, each contributing significantly to an important topic within the earnings management theme. This section is devoted to introduce the topic investigated in each of the empirical chapters and highlights the main contributions along the line.

1.3.1. Chapter 2: A signal-based composite index to detect the context of