Ebook Earnings management and investor protection: an international comparison
This paper provides comparative evidence on corporate earnings management across 31 countries. At a descriptive level, we find large international differences across several earnings management measures, including loss avoidance and earnings smoothing. Our descriptive evidence suggests that firms in countries with developed equity markets, dispersed ownership structures, strong investor rights, and legal enforcement engage in less earnings management. We then delve deeper and present an incentives-based explanation for these patterns.
Based on prior research that identifies investor protection as a key institutional factor affecting corporate policy choices (see Shleifer and Vishny, 1997; La Porta, Lopez-de-Silanes, Shleifer, and Vishny, 2000), we focus on investor protection as a significant determinant of earnings management activity around the world. We argue that strong and well-enforced outsider rights limit insiders’ acquisition of private control benefits, and consequently, mitigate insiders’ incentives to manage accounting earnings because they have little to conceal from outsiders. This insight suggests that the pervasiveness of earnings management is increasing in private control benefits and decreasing in outside investor protection. Our empirical results are consistent with this prediction and suggest that investor protection plays an important role in influencing international differences in corporate earnings management.
Following Healy and Wahlen (1999), we define earnings management as the alteration of firms’ reported economic performance by insiders to either mislead some stakeholders or to influence contractual outcomes. We argue that incentives to misrepresent firm performance through earnings management arise, in part, from a conflict of interest between firms’ insiders and outsiders. Insiders, such as controlling owners or managers, can use their control over the firm to benefit themselves at the expense of other stakeholders. Examples of such private control benefits range from perquisite consumption to the transfer of firm assets to other firms owned by insiders or their families. The common theme, however, is that some value is enjoyed exclusively by insiders and thus not shared with non-controlling outsiders.
Insiders have incentives to conceal their private control benefits from outsiders because, if these benefits are detected, outsiders will likely take disciplinary action against them (see, e.g., Zingales, 1994; Shleifer and Vishny, 1997). Accordingly, we argue that managers and controlling owners have incentives to manage reported earnings in order to mask true firm performance and to conceal their private control benefits from outsiders. For example, insiders can use their financial reporting discretion to overstate earnings and conceal unfavorable earnings realizations (i.e., losses) that would prompt outsider interference. Insiders can also use their accounting discretion to create reserves for future periods by understating earnings in years of good performance, effectively making reported earnings less variable than the firm’s true economic performance. In essence, insiders mask their private control benefits and hence reduce the likelihood of outside intervention by managing the level and variability of reported earnings.
Legal systems protect investors by conferring on them rights to discipline insiders (e.g., to replace managers), as well as by enforcing contracts designed to limit insiders’ private control benefits (e.g., La Porta, Lopez de-Silanes, Shleifer, and Vishny, 1998; Nenova, 2000; Claessens, Djankov, Fan, and Lang, 2001; Dyck and Zingales, 2002). As a result, legal systems that effectively protect outside investors reduce insiders’ need to conceal their activities. We therefore propose that earnings management is more pervasive in countries where the legal protection of outside investors is weak, because in these countries insiders enjoy greater private control benefits and hence have stronger incentives to obfuscate firm performance.
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