Earnings management is a way to manipulate financial results to avoid negative earnings surprises. The authors investigate the determinants of earnings smoothing behavior and link earnings quality to such macroeconomic factors as the economic growth rate and phase of the business cycle.
What’s Inside?
The authors investigate the influence of macroeconomic conditions on the propensity and motivation to manipulate the income of EU-listed companies. Based on the analysis of the 2008–09 financial crisis and prior periods, the authors confirm that earnings management behavior is linked to the level of economic activity and offer guidelines on how to assess earnings quality.
How Is This Research Useful to Practitioners?
Companies manage earnings to avoid negative earnings surprises or having to report losses. Another motivation comes from the agency relationship and is related to the intent to increase the stock- or earnings-based compensation of an insider.
The authors note that the propensity to engage in earnings management is dependent on macroeconomic conditions and the business cycle. They point out that the differences in the magnitude of earnings management occur between the expansion period (2006–2007) and the crisis years (2008–2009). The manipulations are more likely in the expansion phase than in the crisis years. The authors point out the intent to manipulate earnings to facilitate the success of security issues, among many other motives.
Although earnings management metrics indicate that income smoothing was less common in most EU countries in the crisis years, the authors note that some countries (e.g., Austria, Belgium, France, and Portugal) experienced an increase in income smoothing behavior during that period. They attribute the country differences to the legal and regulatory environments. Countries with effective law enforcement and stronger investor protection exhibit less income smoothing than do less-rigorous jurisdictions.
The improvement in accrual quality with a lower incentive to manipulate earnings is related to higher capital market tolerance for lower performance in downturns as well as higher litigation risk during crises.
How Did the Authors Conduct This Research?
The study is based on accounting data for EU-listed companies for the four-year period 2006–2009. The sample includes 3,357 public, nonfinancial companies with IFRS-compliant financial reporting. Fundamental data are from the Thomson Reuters Worldscope database.
The authors focus on income smoothing and accruals quality measured using econometric models. The measure to capture income smoothing is calculated by dividing the standard deviation of cash flow from operations by the standard deviation of net income. Significantly higher variability of cash flow compared with earnings indicates income smoothing.
Subsequently, the authors attempt to identify discretionary accruals by using a cross-sectional model that measures company performance relative to that of a company’s industrial peers. They interpret a low standard deviation of residuals as reflecting a low level of earnings management.
Furthermore, the authors measure the impact of investor protection, corporate governance, and law enforcement quality on earnings management behavior. To capture the relative strength of the regulatory environment, the authors use metrics and indices proposed by the World Bank and other recognized institutions.
To incorporate the impact of economic activity on earning management metrics, the authors use a separate sample divided into two subperiods and focus on the differences among earning management indicator values. Finally, they ensure that the conclusions are valid through the use of additional controls and a t-test to confirm the statistical significance of the value differences in earning management metrics between the pre-crisis and crisis subperiods.
Abstractor’s Viewpoint
The authors advise to seek earnings manipulations in the expansion phase rather than in crisis, and they explain the reasons for the improvement of accrual quality. In addition to the motives explained in the study, a decrease in the propensity to manipulate earnings during a crisis may be related to rare security issues in crisis periods and the lack of a need to support stock options owned by insiders that are already deeply out of the money.
The research is useful for stakeholders and regulators trying to assess accruals quality. There is also room for further study by academics, who could investigate income smoothing behavior across industries or ownership structures. The research is comprehensive, but the addition of more recent, post-crisis data would make it even more relevant.