Earnings Management: Emerging Insights in Theory, Practice, and Research

586 Pages·2008·4.738 MB·English

by  Joshua Ronen, Varda Yaari (auth.)

EARNINGS MANAGEMENT
Emerging Insights in Theory, Practice, and Research
Springer Series in Accounting Scholarship

Series Editor:

Joel S. Demski
Fisher School of Accounting
University of Florida

Books in the series:

Christensen, Peter O., Feltham, Gerald A.
Economics of Accounting – Volume I
Information in Markets
Christensen, Peter O., Feltham, Gerald A.
Economics of Accounting – Volume II
Performance Evaluation
Ronen, Joshua, Yaari, Varda (Lewinstein)
Earnings Management
Emerging Insights in Theory, Practice, and Research
EARNINGS MANAGEMENT
Emerging Insights in Theory, Practice, and Research

Joshua Ronen
New York University

and

Varda (Lewinstein) Yaari
Morgan State University
Joshua Ronen Varda Yaari
Stern School of Business Earl G. Graves School of Business & Management
New York University Morgan State University
West 4th Street 1700 East Cold Spring Lane
New York, NY 10012 Baltimore, MD 21251

Series Editor:

Joel S. Demski
Fisher School of Accounting
University of Florida
PO Box 117166
Gainesville FL 32611-7166

Library of Congress Control Number: 2007931882

ISBN: 978-0-387-25769-3 e-ISBN: 978-0-387-25771-6

Printed on acid-free paper.

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Contents
Introduction.............................................................................................xiii
The Demand for Earnings Management Research..............................xiv
Historical Perspective: The Milestones..............................................xvi
The Plan of the Book.........................................................................xviii
Acknowledgments...............................................................................xix
Part 1...........................................................................................................1
1 The Importance of Earnings.................................................................5
1.1 The Dual Role of Accounting.........................................................6
1.2 The Value Relevance of Earnings..................................................8
1.2.1 The Costly-Contracting Approach....................................10
1.2.2 The Decision-Making Approach.......................................15
1.2.3 The Legal-Political Approach...........................................19
1.3 Summary.......................................................................................23
2 Definition of Earnings Management..................................................25
2.1 Definition......................................................................................25
2.2 The Methods to Manage Earnings................................................31
2.3 Managing GAAP Earnings Through Pro Forma Earnings...........34
2.4 Summary.......................................................................................38
Part 2.........................................................................................................39
The Players...........................................................................................41
The Sarbanes-Oxley Act.......................................................................43
The Motivation for the Sarbanes-Oxley Act.........................................44
Research on the Sarbanes-Oxley Act...................................................45
The Plan of Part 2.................................................................................53
3 The Management.................................................................................57
3.1 Background...................................................................................58
3.1.1 The Role of Management in Reporting Earnings.............58
3.1.2 The Management’s Objective Function............................60
viii Contents
3.2 Compensation...............................................................................69
3.2.1 The Compensation Package..............................................70
3.2.2 Cash Compensation: Salary and Bonus............................74
3.2.3 Managing Salary...............................................................76
3.2.4 Managing Bonuses............................................................77
3.2.5 More on Managing Cash Compensation...........................80
3.2.6 Stock and Options.............................................................80
3.2.7 Equity Holdings and Earnings Management.....................84
3.2.8 Options and Earnings Management..................................86
3.2.9 Grant Date.........................................................................87
3.2.10 Accounting Recognition....................................................89
3.2.11 Timing of the Exercise......................................................91
3.2.12 Related Operating, Investment, and Financing
Decisions...........................................................................92
3.3 CEO Turnover..............................................................................93
3.3.1 Departure...........................................................................93
3.3.2 CEO Departure and Earnings Management......................96
3.3.3 The Incoming CEO...........................................................99
3.4 Insider Trading............................................................................101
3.4.1 Insider Trading and Earnings Management....................108
3.5 Management Buyouts.................................................................110
4 Users....................................................................................................113
4.1 Shareholders...............................................................................114
4.1.1 The Price-Setting Process................................................115
4.1.2 The Impact of Earnings on the Share Price.....................116
4.1.3 The Effect of Earnings Management
on Shareholders’ Information..........................................116
4.1.4 When Does the Market Learn about Non-neutral
Earnings Management?...................................................121
4.2 Earnings-Management Events....................................................135
4.2.1 Benchmark Beating.........................................................135
4.2.2 Equity Issues and New Listings......................................145
4.2.3 Mergers and Stock-for-Stock Acquisitions.....................153
4.3 Bondholders and other Creditors................................................156
4.3.1 Background.....................................................................156
4.3.2 The Importance of Earnings to Debt Contracts...............159
4.3.3 Earnings Management and Debt Contracts.....................161
4.4 Regulators...................................................................................171
4.4.1 Tax Expense and Deferred Taxes...................................173
4.4.2 Regulated Industries: Insurance Companies
and Banks........................................................................178
4.5 Employees..................................................................................181
Contents ix
4.6 Competitors, Suppliers, and Customers.....................................182
Appendix....................................................................................184
5 Gatekeepers........................................................................................187
5.1 The Demand for Gatekeepers.....................................................187
5.2 Analysts......................................................................................191
5.2.1 Background.....................................................................192
5.2.2 Decision Making and Incentives.....................................196
5.2.3 Analysts in the TWENTY -FIRST Century.....................205
5.2.4 Meeting or Beating Expectations– – MBE......................207
5.3 Governance—Ownership...........................................................220
5.3.1 A Definition and the Framework of U.S.
Corporate Governance....................................................220
5.3.2 Shareholders....................................................................223
5.3.3 The Importance of Earnings............................................231
5.3.4 Earnings Management.....................................................234
5.4. Governance—the Board of Directors.........................................236
5.4.1 Introduction.....................................................................236
5.4.2 Board Characteristics......................................................242
5.5 Auditors......................................................................................263
5.5.1 The Institutional Setting of the Relationships
Between Auditors and Management Before SOX..........264
5.5.2 Earnings Management.....................................................277
5.6 The Press....................................................................................281
Part 3.......................................................................................................285
The Demand for Theory.....................................................................287
The Plan of Part 3...............................................................................289
Capital Markets..............................................................................289
Governance.....................................................................................290
Product and Factor Markets............................................................291
The Legal/Political/Regulatory System..........................................291
6 Truth-Telling......................................................................................293
6.1 Capital Markets..........................................................................293
6.1.1 The Disclosure Principle.................................................295
6.1.2 Signaling Equilibria........................................................296
6.1.3 Signal Jamming...............................................................298
6.1.4 Randomized Strategies....................................................299
6.2 Governance.................................................................................301
6.3 Product/Factor Markets..............................................................305
6.3.1 Credibility as a Valuable Asset.......................................306
6.3.2 Tacit Cooperation Among Firms....................................308
6.3.3 Multiple Audiences Exert Conflicting Pressures............309
x Contents
6.4 Regulation...................................................................................311
6.4.1 The Financial Reports Insurance Setting........................312
Appendix: The Disclosure Principle...........................................314
7 Smoothing...........................................................................................317
7.1 Capital Markets...........................................................................319
7.1.1 The Stock Market............................................................319
7.1.2 The Banking System.......................................................325
7.2 Governance.................................................................................328
7.2.1 Real Smoothing...............................................................329
7.2.2 Artificial Smoothing........................................................332
7.3 Product Market Competition......................................................333
7.4 Regulation...................................................................................335
Appendix: Artificial Smoothing Motivated by Consumption
Smoothing..................................................................................336
7.5.1 The Game........................................................................336
7.5.2 Issues...............................................................................339
8 Maximization and Minimization......................................................341
8.1 Capital Market............................................................................343
8.1.1 The Equilibrium..............................................................345
8.1.2 The Earnings Response Coefficient................................347
8.2 Governance.................................................................................353
8.3 The Competitive Environment....................................................358
8.4 Regulation...................................................................................361
8.4.1 The Effect of Voluntary Disclosure on the ERC
When the Firm Manages Earnings..................................361
8.4.2 The Analytical Model......................................................361
8.4.3 The Effect of Earnings Management on the Value
of Rule 10b-5...................................................................363
8.4.4 The Effect of Regulation on Earnings Management.......365
8.5 Summary.....................................................................................366
Part 4.......................................................................................................369
Accruals..............................................................................................371
The Plan of Part 4...............................................................................375
9 The Accruals Process.........................................................................377
9.1 Non-Discretionary Accruals.......................................................377
9.1.1 The Non-Discretionary Accruals Generation Process....377
9.1.2 The Statistical Properties of Accruals.............................380
9.2 The Effect of Earnings Management on Accruals......................381
9.2.1 The Statistical Properties of Managed Accruals.............382
9.3 Accruals and Cash Flows............................................................384
Contents xi
9.3.1 Accruals Mispricing........................................................384
9.3.2 Highlights of the Research..............................................385
Appendix: Accruals When the Firm Carries Inventories............387
The Model..................................................................................387
Accruals......................................................................................388
10 The Accruals Methodology.............................................................389
10.1 The Evolution of Accruals-based Research................................389
10.1.1 Ronen and Sadan (1981).................................................390
10.1.2 Healy (1985)...................................................................394
10.1.3 DeAngelo (1986, 1988a).................................................399
10.1.4 Dechow and Sloan (1991)...............................................402
10.1.5 The Jones Model.............................................................404
10.2 An Evaluation of the Jones Model..............................................407
10.2.1 Unexplored Questions.....................................................407
10.2.2 Evaluations of the Jones Model......................................414
10.2.3 The Tests of the Efficiency of the Jones Model..............424
11 Modifications to the Jones Model and Alternative Methodologies..433
11.1 Improved Jones Models..............................................................433
11.1.1 The Modified Jones Model.............................................434
11.1.2 The Forward-Looking Model..........................................437
11.1.3 The Performance-Adjusted Models................................439
11.1.4 The Business Model: A Synthesis..................................446
11.2 Alternative Methodologies for Detecting
Earnings Management.........................................................................449
11.2.1 Analysis of a Single Account..........................................450
11.2.2 The Distributional Approach..........................................454
11.2.3 Rounding EPS.................................................................454
Summary and Postscript.......................................................................457
Overview of the Book.........................................................................457
Lessons...............................................................................................459
Related Research................................................................................460
Bibliography...........................................................................................463
Index........................................................................................................577