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Healy, P. M. and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons (December): 365-383.

Summary by Lisa Anderson
Master of Accountancy Program
University of South Florida, Summer 2003

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The purpose of this paper is to summarize the findings related to earnings management research and the overall integrity of financial reporting. This article also identifies areas for future research in the area of earnings management.

Earnings management literature provides only slight insight for standard setters. Much of the literature provides little evidence on some of the most important questions asked by standards setters, including whether earnings management is commonplace or occurs infrequently, which accruals are the focus of earnings management and what are the effects on resource allocation decisions. This information is necessary to assess the pervasiveness of earnings management and the overall integrity of financial reports.

The focus of earnings management research of the past has been mainly on detecting whether earnings management exists and when it exist. Researchers have examined broad measures of earnings management and samples from firms where the motivations to manage earnings are expected to be high. Studies have shown that earnings management does exist and it occurs for different reasons. These reasons include influencing capital market expectations and valuation, to increase management’s compensation, to avoid violating contracts written in terms of accounting numbers, and to reduce regulatory costs.

Earnings Management is said to have occurred “when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.1

The review is focused around four questions:

What motives drive earnings management?

Which accruals appear to be managed?

What is the magnitude and frequency of earnings management?

What are the economic consequences of earnings management?

By answering these questions, standard setters will be able to assess the effects of accounting standards that require management judgment. If there are areas where earnings management is common and has had significant effects, standard setters will be able to refine the existing standards and expand disclosure requirements to enhance the reliability of the financial reports.

For regulators and standard setters, research has confirmed their suspicions that earnings management is a problem that needs attention. But before these regulators can attempt to remedy the situation, they will need to do extensive research to determine which accounting standards are being managed, the frequency and effect of earnings management, and what factors limit earnings management.

The majority of studies on earnings management do not help standard setters to be able to answer these questions. The research that has been done documents that earnings have been managed but it doesn’t document the extent and magnitude of earnings management. This does not help regulators to know if current accounting standards are effectively facilitating communication with investors or whether they encourage earnings management. Most of the studies that have been done examined unexpected accruals for earnings management. Although this research does provide some very useful information, it does not show which accounting standards are effective in facilitating communication with investors and which are not. Lastly, most of these studies examine research settings where earnings management is likely to be observed, increasing the likelihood for detection. This makes it difficult to determine the frequency of earnings management in our economy.

Although it is known that earnings management exists, it is difficult to document it. The main reason being that to prove that earnings have been managed researchers must first determine what earnings should have been before the effects of earnings management. One approach that has been used is to identify conditions in which managers’ incentives to manage earnings are high. The next step would be to test whether patterns of unexpected accruals are consistent with these incentives.

Researchers have examined different incentives for earnings management including capital market expectations and valuation, contracts written in terms of accounting numbers and anti-trust or governmental regulation. The use of accounting information by financial analysts and investors to value stocks has created an incentive for managers to manipulate earnings to influence the short-term performance of the stock. The evidence gathered by researchers shows that some firms manage earnings for stock market reasons. The frequency of this occurrence has not yet been determined. Sometimes, contracts can give incentives for managers to manipulate earnings. Some studies show that compensation and lending contracts provide an incentive for firms to manage earnings to increase bonuses, improve job security and mitigate potential violation of debt covenants. Earnings management due to regulatory motivation is another area where researchers have begun to discover evidence. Studies suggest that regulatory considerations can induce firms to manage earnings. There is very little evidence, though, on the frequency of this behavior and the effect on regulators or investors.

After this review it is clear that earnings management is still a very new topic that it is only beginning to be researched. Future research will not focus merely on whether or not earnings management exists, but will broaden the questions to include the magnitude and frequency of the earnings management and the effect that earnings management has on stock prices and resource allocation.

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1 Schipper, K. 1989. Commentary: Earnings Management. Accounting Horizons (December): 91-102.

Related Summaries:

Collingwood, H. 2001. The earnings game: Everyone plays, nobody wins. Harvard Business Review (June): 65-74. (Summary).

Dechow, P. M. and D. J. Skinner. 2000. Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons (June): 235-250. (Summary).

Healy, P. M. and K. G. Palepu. 2003. How the quest for efficiency corroded the market. Harvard Business Review (July): 76-85. (Summary).

Romney, M. B., W. S. Albrecht and D. J. Cherrington. 1980. Red-flagging the white collar criminal. Management Accounting (March): 51-54, 57. (Note and list of Red Flags).

Schilit, H. 2002. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports. 2nd edition. McGraw Hill. (Summary).

Waddock, S. 2005. Hollow men and women at the helm ... Hollow accounting ethics? Issues in Accounting Education (May): 145-150. (Summary).