An extensive body of accounting literature is devoted to earnings management, broadly defined as the opportunistic exercise of managerial discretion that causes reported earnings to differ from earnings that would have resulted from a neutral application of generally accepted accounting principles (e.g., Dechow and Skinner 2000). Most studies in this line of research, however, have focused on firms’ motives to engage in, and the detection and quantification of, upward earnings management. We extend prior earnings management research by considering downward earnings management, a topic less thoroughly explored in the accounting literature relative to upward earnings management. Specifically, we investigate the relation between the motives for, and the ensuing strategies to accomplish, downward earnings management. Our research thus contributes to a more complete understanding of earnings management activity.
The relative scarcity of research examining downward earnings management is somewhat surprising in light of concerns expressed by regulators. For example, former SEC Chairman Levitt, in his widely cited “numbers game” speech (Levitt 1998), made explicit the SEC’s concerns that earnings management raises questions about the integrity of financial reporting. Relevant to our setting, Levitt highlighted five common “accounting gimmicks,” of which three were examples of downward earnings management. (Also see Turner 1999.)
We analyze firms that restated their earnings (hereinafter, misstatement firms), focusing on the subset of firms that restated earnings upward due to accounting irregularities and thus presumably had managed earnings downward (e.g., Palmrose et al. 2004; Hennes et al. 2008). The restatement setting allows us to quantify the amount of pretax earnings management as the difference between original and restated pre-tax income. This setting also allows us to study how tax and non-tax motivations for downward earnings management affect the way earnings are managed, and consequently, the probability of an upward restatement.
We first distinguish between book-tax conforming and nonconforming accruals and note that, in general, accruals with little discretion, such as receivables, prepaid expenses, and payables, are conforming but accruals with the most discretion, such as bad debt reserves, unearned revenues, and post retirement benefits, are nonconforming. Because tax-motivated downward earnings management must be book-tax conforming (i.e., reduces both book and taxable income), we thus conjecture that firms managing earnings downward for tax reasons cannot rely primarily on accounting choices (hereinafter nominal earnings management). Instead, to reduce taxes firms must rely primarily on conforming real transactions management, such as the acceleration of research and development and advertising expenditures and the deferral of revenue transactions to future periods. In general, real transactions management strategies do not violate GAAP, resulting in a near zero probability of an earnings restatement. We thus hypothesize that firms managing earnings downward for tax reasons are not likely to subsequently restate earnings.
Real transactions management, however, alters a firm’s operations and thus is arguably more costly than nominal earnings management. We expect that firms engaging in downward earnings management for non-tax reasons (which we discuss in detail below) rely primarily on less costly nominal accrual management methods, such as the inflation of reserve accounts, including the allowance for doubtful accounts, restructuring reserves, and contingent liabilities. These types of downward earnings management strategies more frequently violate GAAP (relative to real transactions management) and thus are more likely to attract the attention of auditors and regulators, resulting in a non-zero probability of an earnings restatement. Hence, we predict that firms managing earnings downward for non-tax reasons are more likely to subsequently restate their earnings.
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PDF Ebook Evidence on Motivations for Downward Earnings Management
