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A study of the factors affecting the goals of earnings management

This way of manipulating outcomes takes place when managers make suboptimal decisions in terms of timing and volume of operating activities. This study tests the hypothesis that firms engaged in earnings management through real operating activities might have a negative impact on future returns. Empirical tests involving regression on panel data and estimation of future firm returns and outcomes indicate a negative impact on return on assets ROA related to manipulation through real operating activities.

This finding is useful for several stakeholders. It demonstrates that manipulation through real operating activities takes place in the Brazilian capital market, suggesting that earnings management extends beyond discretionary accounting choices in this country.

The main contribution is demonstrating a negative relation between earnings management by using real operating activities and future returns.

This finding is relevant for investors, a study of the factors affecting the goals of earnings management for the purposes of comparison and valuation of securities. The term "earnings management" describes the decision made by some managers to employ accounting methods or direct operating activities in order to meet specific goals concerning the outcomes reported in financial statements. Based on the existing literature, Martinez 2013p. Dechow, Ge and Schrand 2010 stand out by contributing to raise awareness about earnings management and how this practice negatively affects the firm.

One reason for this interest lies on the fact that book profit is used for several purposes, such as contractual obligations e. Therefore, accounting data provide relevant informational content that is useful for a wide range of stakeholders.

For instance, creditors use the figures reported to assess aspects related to firms' financial health, credibility, and viability Ge, 2010. In turn, shareholders use earnings, among other indicators, to monitor operational performance. However, conclusions on a given entity's performance may be erroneous if shareholders are unable to identify and adjust the effects of earnings management embedded in financial statements.

This distortion becomes clear in future outcomes, when an entity's performance does not match forecasts. The hypothesis underlying this study is related to the impact of RAM on organizations' future returns. In general, earnings management distorts the financial status of a given firm, it has a negative impact on the quality of accounting figures disclosed and increases information asymmetry between managers and stakeholders Ge, 2010.

When the outcome is manipulated through operational decisions, a firm deviates from its optimum business performance and long-term financial implications emerge Gunny, 2010. Empirical evidence Gunny, 2010; Roychowdhury, 2006 ; Li, 2010 shows that manipulation through RAM affects firms' cash flow and it is likely to increase volatility.

Future cash flow forecasts incorporated into share price are readjusted only when investors become aware of manipulation. Galdi 2008 argues that powerful influence of a country's taxation rules on financial statements and weak enforcement mechanisms are among the factors that contribute to reduce the relevance of accounting figures to a low level.

In this scenario, there is a delay before investors identify the practice of earnings management through real operating activities, and within this period they fail to adjust forecasts to firm's performance. This fact, in turn, constitutes an incentive for manipulation. Whereas engaging in RAM managers may sacrifice future returns to manipulate current outcomes Gunny, 2010a negative relation between RAM and return on assets ROA is expected in subsequent periods, and this is the essence of our research hypothesis: The next section consists in a literature review, covering the current state of the art and illustrating the foundations of our research hypothesis.

This is followed by an explanation of the methodology and a presentation of the outcomes observed. The paper is concluded with a synthesis of knowledge.

  1. Review 2 2 8 —14 Nico Alexander and Hengky 2. Thus, outcomes that have been manipulated through RAM are unreliable measures distorting the quality of profits and they increase asymmetry between managers and external stakeholders.
  2. Accounting, Organizations and Society, 34 6 797-802.
  3. These results are consistent with research conducted by Guna and Herawaty , Widyaningsih , Armetha , and Nozarpour and Norouzi
  4. It is appropriate to include this variable in the models because the leverage of the company might encourage managers to manipulate earnings, for example, to prevent the violation of debt covenants e. In other words, the abnormal component of real operating activities consists in the difference between the actual value observed and the estimate obtained by applying the models Gunny 2010 ; Roychowdhury, 2006.
  5. It shows that a higher profitability of the company will make it more likely that the company will engage in earnings management.

This practice differs from manipulation by accruals, because it involves activities related to the firm's actual business activities. As defined by Ewert and Wagenhofer 2005p.

RAM can be achieved by restricting operational activities, such as delaying a new project that could increase production capacity or cutting discretionary expenses, e.

Graham, Harvey and Rajgopal 2005 analyzed the main factors that influence disclosure level in financial reports. They found that executives assign great importance to profit targets, either to meet forecasts made public by analysts or maintain the current period's outcomes in line with outcomes reported for previous financial periods.

The authors also claim that executives aimed to manipulate outcomes through operational decisions even when aware that the procedure reduces the firm's financial value, relying on the belief that they might gain credibility by hitting outcome targets. This view is proposed by Burgstahler and Dichev 1997who claim that firms gain prestige from several stakeholders - creditors, suppliers, customers, among others - when they report expectations of future growth.

Graham, Harvey and Rajgopal 2005 add that executives are more keen to employ RAM if the sacrifice involved is not too big, i. Authors such as Demski 2004 and Ewert and Wagenhofer 2005 point out that RAM is chosen when the costs for implementing it are low when considering the risks associated with manipulation by accruals.

Examination of Factors Affecting Earnings Management Practices: Evidence from ISE

For instance, if management resorts to RAM by cutting research and development costs, this measure is not subject to scrutiny by regulating agencies or auditors.

Additionally, reversal of accruals brings restrictions to accounting flexibility, i. Although RAM offers some advantages when compared to manipulation by accruals, it has certain restrictions, too.

  • Predicting Recessions in Brazil;
  • In the evaluations made for Brazil, there were long periods where there is a product growth;
  • Total accruals were calculated as the difference between the change in current assets and the change in cash and cash equivalents, less the difference between the change in current liabilities and the variation in provision for IRPJ and CSLL both income taxes to which Brazilian companies are subject , less depreciation and amortization;
  • Discussion Table 3 shows that profitability ROA has a positive effect on earnings management;
  • Dechow, Ge and Schrand 2010 stand out by contributing to raise awareness about earnings management and how this practice negatively affects the firm;
  • Total accruals were calculated as the difference between the change in current assets and the change in cash and cash equivalents, less the difference between the change in current liabilities and the variation in provision for IRPJ and CSLL both income taxes to which Brazilian companies are subject , less depreciation and amortization.

RAM has a direct impact on cash flow and, as a result, it is more expensive from a financial perspective. Ge 2010 noticed how RAM masks current financial performance, destroys feasible long-term competitive advantages, and potentially reduces the firm's financial value.

Thus, outcomes that have been manipulated through RAM are unreliable measures distorting the quality of profits and they increase asymmetry between managers and external stakeholders. Zang 2012 argues it is unlikely that managers restrict themselves to use RAM for manipulation. The studies conducted in Brazil seem to be incipient regarding ABM models.

Despite the pertinent criticism by Paulo 2007most scholars have not used rather refined models to estimate discretionary accruals, instead they stick with the modified Jones and KS models, except for efforts to adjust by performance or sector and analysis of panel data.

The same trend may be observed in the international literature, because since 2005 it has converged to models aimed at earnings management by operational decisions. Although this subject still needs further discussion in the Brazilian literature, some recent doctoral theses address earnings management by operational decisions.

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Machado 2012 studied the relation of earnings management with executive compensation. In turn, Cupertino 2013 focused on, among other issues, investors' perception of the effects of this manipulation type, as well as the relation between earnings management strategies and their determining costs and the impact on firms' future performance. It is also worth mentioning Almeida-Santos, Verhagem and Bezerra 2011 and Rey 2011who incorporated operational decisions into their earnings management models.

  • CRISESII which equals 1 for years defined as a crisis 1997-1999, 2001, 2002 and 2008 , and 0 for non-crisis years 2000, 2003, 2004-2007 and 2009;
  • Despite the differences in conceptual premises, variables and statistical treatment, in these models, the discretionary accruals and therefore EM evidence are not subject to direct observation and, therefore, are estimated by regressions;
  • Nevertheless, when firms face barriers to manage earnings by accruals, it is more likely that manipulation is achieved through real operating activities;
  • National Bureau of Economic Research;
  • Energy Economics, 27 2 , 279-304.

Cupertino 2013 observed that the adoption of the International Financial Reporting Standards IFRS in Brazil triggered a shift from earnings management by discretionary accruals to manipulation by operational decisions. In short, there was an increase in earnings management by operational choices and a decrease in management by accruals. Reis, Cunha and Ribeiro 2014 showed that, among the main management practices by real operating decisions, the companies listed on the IBrX did not use volume of sales and production levels to increase or decrease book outcomes.

Moreover, manipulation of accounting accruals may have been preferred over operational decisions, since it is usually not reflected on cash flows and does not influence the firms' operational structure. Managers' preferences for practices that do not affect future cash flow Xu, 2008 may have contributed to the focus on manipulation by accruals in academic research.

Nevertheless, when firms face barriers to manage earnings by accruals, it is more likely that manipulation is achieved through real operating activities. For instance, Ewert and Wagenhofer 2005 found that the more rigid the accounting rules, the greater the barriers preventing firms from manipulating outcomes by accruals.

  1. Assets representing financial companies insurance, banking, and investment funds or companies operating in the energy or telecommunications sectors were excluded from the analysis, it is a common practice in studies like ours Gunny, 2010 ; Badertscher, 2011.
  2. The results are presented in Table 3.
  3. Review 2 2 8 —14 Nico Alexander and Hengky 2. A technique consists in offering discount on prices charged for goods to boost sales, which is focused on the short term and has the effect of increasing earnings for the current period.

Consequently, earnings management is not reduced in the presence of stricter accounting standards, rather only the modus operandi changes. Regardless of the method chosen to deal with earnings management - accruals or operational decisions - the primary goal is inducing stakeholders to an erroneous perception of the firm's actual financial status.

Strategies differ in terms of their impact on cash flow, among other aspects. Specifically, real operating activities consume resources and they divert firms from normal business practices. These consequences of using RAM may be illustrated by discussing some techniques employed to achieve manipulation. A technique consists in offering discount on prices charged for goods to boost sales, which is focused on the short term and has the effect of increasing earnings for the current period.

The outcome reported for the period increases and a positive profit margin remains after the discount. However, this kind of discount has an adverse effect on future earnings, since consumers are no longer willing to buy when price come back to their previous levels.

According to Gunny 2010this impact on future sales may lead to lower profit margins in subsequent periods. Another method to boost sales is increasing credit, offering more flexible terms, such as longer settlement periods or less stringent guarantee requirements. Although this may improve sales during the current period, the practice also increases the risk of nonpayment Ge, 2010 and it forces a review of cash flow management, since receipts are spread more thinly across a larger number of installments.

Alternatively, production may be increased in order to dilute fixed costs across a larger number of units, accumulating larger stocks of finished products to be sold during subsequent financial periods. However, if it is hard for the firm to sell this excessive production, i. Regarding the effects of these techniques, Li 2010 argues that the relation between abnormal levels of operational activity and future firm performance is an empirical issue, since the various management techniques have different consequences for cash flow during the financial period.

For instance, both cutting discretionary expenses and increasing production levels consist in techniques to adjust operations in order to achieve real operating activities management. However, whereas the first method increases cash flow during the period assuming that discretionary expenses are paid in cash or cash equivalentsthe second option reduces cash flow, assuming sale volumes are unchanged.

Additionally, RAM does not always affect cash flow and profits in the same direction Gunny, 2010. Although increasing production to reduce the cost of products may increase profits, it may reduce cash flow if the increase in sales is not enough to absorb the increase in unsold stocks. Academic interest in the relation between RAM and profitability of shares is recent Zang, 2012.

Gunny 2010 published a pioneering study in the area, where four proxies for activities linked to manipulation through real operating activities were analyzed with data from 1988 to 2000 on U. It was found that all proxies tested were associated with significantly lower performance both in terms of profitability of shares and future cash flow.

These findings contrast with evidence reported by Bhojraj, Hribar, Picconi and McInnis 2009where the return per share was lower in years following periods with use of RAM. Accounting data were extracted from financial statements of individual companies. Assets representing financial companies insurance, banking, and investment funds or companies operating in the energy or telecommunications sectors were excluded from the analysis, it is a common practice in studies like ours Gunny, 2010 ; Badertscher, 2011.

A reason for excluding such shares is the fact that these sectors are heavily regulated, there is proprietary legislation, and these specific standards have an idiosyncratic effect on a study of the factors affecting the goals of earnings management Gunny, 2010.

Companies classified by Economatica r as "Other Sector" were also excluded, because they are not associated with sectors covered by this study. Observations were collected on an annual basis for the period from 1989 to 2012. Although the Economatica r provides data going back to 1986, the small number of companies tracked between 1986 and 1988 means that excluding these 3 years does not lead to relevant loss of information.

Furthermore, this procedure considerably reduced the number of extreme observations outliers. Thus, 1989 was chosen as the initial year of analysis. In turn, 2012 was the final year of analysis because it was the last year for which data were available on the Economatica r when the research was conducted.

To neutralize the effects arising from changes in the purchasing power of money, historical data was collected considering the adjustment for inflation.

Sample size for identifying RAM refers to the number of observations in the data used for regressions to estimate the expected level of accruals and real operating activities and, as a result, for residuals, which represent the level of earnings management. These models estimate the "normal" level of operational activities, thus their regression residuals represent the "abnormal" level, i.

In other words, the abnormal component of real operating activities consists in the difference between the actual value observed and the estimate obtained by applying the models Gunny 2010 ; Roychowdhury, 2006. The abnormal level of discretionary expenses was estimated by using a model derived from the seminal study by Dechow, Kothari and Watts 1998and Roychowdhury 2006 a study of the factors affecting the goals of earnings management, formulated as follows: For the sake of simplicity, the subscript "i" was suppressed hereafter.

Equation 1 resorts to specification with panel data, considering all shares and the entire sampling period. Additionally, Hausman test was employed to detect correlated random effects.

The model defines discretionary expenses for the current period as a function of the current level of sales, so that the regression residual represents the magnitude of manipulation by cutting discretionary expenses RAMDEt.

Martinez and Cardoso 2009 stress that the functionality of this formulation allows it to be applied to any sector.