Corporate accounting scandals during the early 2000s made stringent corporate governance and disclosure measures necessary. Regulatory emphasis shifted toward ensuring reliability of accounting numbers, which reduced the potential for accounting manipulation. Managers who are subject to significant performance pressure from shareholders and analysts now potentially have to resort to real earnings management.
What’s Inside?
The authors’ main objective is to identify the unintended potential impact of board governance and takeover protection on the earnings reporting process. Such research would provide regulators with key policy implications and emphasize the unintended consequences of board monitoring and the extent to which takeover protection distorts the managerial decision-making process. Financial analysts base their research on reporting and guidance provided by company management. They would find this analysis useful in discerning the earnings management proxies that could affect financial reports for a listed company.
How Is This Research Useful to Practitioners?
The authors base their research on sample data for US firms relevant to the period 2004–2006 (after the introduction of the Sarbanes–Oxley Act, or SOX). The post-SOX period assumes a transparent corporate governance setting and thereby limits noise from potential fraudulent accounting practices significantly. This situation differentiates the analysis from that of earlier researchers who focused either on US firms, considering sample data from both pre- and post-SOX periods, or on UK firms.
Most researchers analyze the effect that corporate governance measures have on accrual-based earnings management. The authors provide additional and methodical evidence on the impact of stringent board governance and takeover protection on real earnings management.
Based on regression models they adopt, the authors conclude that board governance is positively associated, and takeover protection negatively associated, with sales manipulation, reduction in R&D, and other discretionary expenses. The results of the analysis on overproduction are weaker.
Accounting and securities regulatory bodies may find this analysis particularly useful in framing future policies and monitoring accounting/reporting practices of firms.
How Did the Authors Conduct This Research?
Using an empirical evaluation process, the authors establish the correlation between various earnings management proxies and board governance/takeover protection provisions. They identify four proxies to analyze the correlation between board governance/takeover protection and real earnings management—abnormal cash flow from operations (sales manipulation), abnormal production cost (overproduction), abnormal reduction in R&D expenditure, and abnormal reduction of discretionary expenses.
The authors consider earlier surveys and anecdotal evidence and further analyze how firm managers use real earnings management techniques to manipulate reported numbers.
They also perform regression analyses on subsamples of firms within the manufacturing sector and firms in R&D-intensive industries. The authors test the potential substitution between real and accrual-based earnings management.
Certain limitations in the analysis—equal weighting of proxies and a tilt toward managerial opportunism rather than the outcome of optimal business decisions—are noted by the authors. Another limitation is that the dataset considered for the regression analysis is for the period 2004–2006, which was before the financial crisis, during the bull market phase.
Abstractor’s Viewpoint
The authors have provided a renewed perspective on an underresearched area of potential earnings management that could be overlooked by regulators. In my opinion, a longer time series should be considered for this analysis to provide a true perspective of the factors under research.