Introduction
Earnings manipulation refers to the use of accounting practices to depict a false picture about a firm’s financial position. Earnings management refers to the manipulation that is within conventional accounting practices. Most of the time, earnings manipulation exceeds earnings management by magnitude. Managers faced with difficult financial conditions may choose to manipulate figures to make their firms appear to have higher financial performance. Managers may use real activities manipulation or accrual-based manipulation depending on their relative costs and timing. Most firms use real activities manipulation before engaging in accrual-based earnings manipulation. There are U.S. firms that manipulate the second digit in the income value to gain cognitive reference points. The M-score has been recognized as a more effective model than the accrual model in predicting the failure of firms that use the accrual method to report higher earnings. The M-score was able to predict the failure of Enron before public disclosure of its earnings manipulation. The revenue model is more effective in identifying earnings management than the accrual model. Recognizing motive is considered as the first step towards identifying companies that engage in earnings manipulation.
Literature review
Managers choose between real activities manipulation and accrual-based manipulations depending on their relative costs and timing. Zhang (2012, p. 700) elaborates that firms first use real activities manipulation, and base their future manipulation on the outcome of real activities manipulation. Roychowdhury (2006, p. 336) examines how such firms engage in overproduction activities to lower the cost of goods sold. Accrual-based manipulation is used to fill the gaps left by real activities manipulation. Firms consider using accrual-based manipulation depending on flexibility posed by manipulation in prior years (Zhang 2012, p. 700). Accrual-based manipulation is made difficult by accounting practices and increased scrutiny by regulators in adherence to Sarbanes- Oxley Act. Shorter operating cycles also make accrual-based manipulation difficult. Shorter operating cycles include the quarterly financial statements.
Accrual-based manipulation is used based on the outcome of manipulation in prior years. According to Zhang (2012, p. 701) increasing scrutiny does not eliminate earnings management activities. It only increases the preference of managers between one of the two categories of earnings manipulation. Real activities manipulation is preferred when there is more scrutiny.
Firms that have been identified as manipulating earnings have higher costs for external capital. Firms that have been announced as manipulating earnings have higher short interest which is an indication of higher costs of capital (Dechow, Sloan & Sweeney 1996, p. 26). Bid-ask spreads are relatively larger than years prior to the announcement. It is an indication that investors are demanding a higher rate of return to invest in the firms’ stock (Dechow, Sloan & Sweeney 1996, p. 28). The firms also have stock prices dropping by large margins.
The main motive of firms’ manipulation is to raise additional capital at a lower cost. Dechow, Sloan & Sweeney (1996, p. 21) give the impression that firms that manipulate earnings have a high motivation to appear creditworthy after failing to honor past debt agreements. Beneish & Nichols (2007, p. 26) explain that institutional investors are more likely to increase their holdings in firms that engage in manipulation because of attractive reports. The need for external financing and debt covenant constraints have been earmarked by Dechow, Sloan & Sweeney (1996, p. 21) as the main motivation for manipulation.
Firms that manipulate accounts have weak governance structures. Dechow, Sloan & Sweeney (1996, p. 21) elaborate that 58% of the SEC regulated firms had audit committees compared to 76% of the control group. The SEC regulated firms also had more CEOs as the chairmen of the boards making them more influential. They also had more CEOs as the co-founders of the corporations. These weak governance structures had been highlighted as factors that increase the likelihood of earnings manipulation.
Large stock holdings by CEOs reduce the propensity of engaging in earnings manipulation. Zhang et al. (2008, p. 242) examine the agency theory and the prospect theory to analyze how managers are influenced by stock ownership and options to avoid earnings manipulations. According to Zhang et al. (2008, p. 254), managers are more loss averse than risk averse. Managers will avoid earnings manipulation when they are part of the group that is likely to lose when earnings manipulation is made public. The tendency to avoid earnings manipulation is higher when they have large stock holdings.
Stock ownership by CEOs may sometimes be misaligned with the interest of other shareholders. The misalignment may depend upon tenure of managers, performance of the firm, and out-of-the-money stock options. Out-of-the-money option is a situation in which CEOs are assigned stocks at a higher price than the market price based on future expectations. The low performance of the firm increases the likelihood of manipulation when the manager has less stock holdings. Low firm performance also had an influential impact when large amounts of out-of-the-money options are held by the CEO. The CEO will have a higher propensity to manipulate earnings to avoid loss of wealth (Zhang et al. 2008, p. 251). Managers consider loss of personal wealth before risk.
Companies such as Enron and Global Crossing were able to conceal their distress using accrual-based manipulations. Rosner (2003, p. 385) explains that these firms had accrual-based net income that exceeded cash flows by a large margin. The companies went further to manipulate cash flows by delaying bill payments (Rosner 2003, p. 386). These firms displayed income-decreasing characteristics for payables, cost of goods sold, accrued expenses and operating expenses. However, Rosner (2003, p. 386) describes that income-increasing manipulations from inventory, receivables, and other current accounts surpassed the effect of the income-decreasing effect of the other accounts.
These firms’ manipulations differ sharply between the year prior to the announcement and the year after the announcement. One year prior to the announcement of earnings manipulation, these firms were expanding income-increasing accruals. One year later, these firms had expanded income-decreasing accruals (Rosner 2003, p. 394). Cash flows exceeded accrual-based income in the years after the announcement which is an indication of income-decreasing manipulation (Rosner 2003, p. 394).
Firms are inclined to manipulate the second digit when they want the first digit to appear higher. It is based on the cognitive reference of human minds that round off the first digit of a figure downwards for their memories (Jordan, Clark & Pate 2008, p. 98). Jordan, Clark & Pate (2008, p. 103) explain that they did not find manipulation of the second digit in firms that report negative earnings in the U.S. The frequencies of the nine digits in firms with negative earnings conform to Benford’s expected frequencies. The result is different for firms with positive earnings. Firms with positive earnings round off the second digit of their income amount to zero. There are higher occurrences for the digits above 5 in American firms’ reports than Benford’s expected frequencies, but only increases in digits 1 and 9 are statistically significant (Jordan, Clark & Pate 2008, p. 104).
Small firms are more likely to manipulate earnings than large firms. Jordan, Clark & Pate (2008, p. 104) findings indicate that small firms have fewer digits above digit 5 than expected with a statistical significance at 0.001 P-levels. They also have more zeros and ones than expected at the second digit. The large firms’ unexpected frequency of the second digit in income value is not statistically significant. It means it could be caused by other factors. Some of the reasons Jordan, Clark & Pate (2008, p. 110) have given as possible causes of small firms engaging in earnings manipulation for cognitive reference points include less public scrutiny, and difficulty in raising income.
Jordan, Clark & Pate (2008, p. 110) try to explain that low-leverage firms could also be small firms which can be a reason for firms with low leverage engaging in earnings manipulation. Small firms have a motive for creditworthiness. High performing firms are less motivated by earnings manipulation because they are already attractive to investors.
Jordan, Clark & Pate (2008, p. 105) findings show that firms with low return on assets (ROA) figures are more motivated to manipulate the figures than those with high ROA. Firms with low ROA manipulate all digits above five indiscriminately to make the first digit appear larger. High ROA firms rounding off are mostly limited to the digits 8 and 9. The study shows that low ROA firms are more aggressive at manipulating figures than high ROA firms.
Increasing-income manipulation may be used by firms in distress to successfully attract external capital. They can create investment opportunities that drive the companies out of their financial distress. Linck, Netter & Shu (2013, p. 2137) findings indicate that some firms that use accrual-based earnings to look attractive are able to attract external capital at a lower cost. They can invest in projects that have promising prospects for future growth. The growth opportunities may be able to create a situation in which the concealed distress is cleared before the public can notice. Linck, Netter & Shu (2013, p. 2136) describe that firms under financial constraint engage in more investment activities than those that are not under constraint. Their study shows that firms can use discretionary accruals to avoid panic and to attract external capital. The capital can be used for investing in activities that save the firms from further distress.
One of the factors that financially constrained firms use to conceal their distress is to announce higher earnings and returns (Linck, Netter & Shu 2013, p. 2118).
Despite scrutiny by regulators, U.S. firms still manipulate the second digit to appear better. According to Jordan, Clark & Pate (2008, p. 109), high scrutiny has not been able to eliminate the manipulation of the second digit with the intention of increasing the first digit’s value by one.
Dechow, Sloan & Sweeney (1996, p. 19) show that SEC regulated firms use income-increasing methods that are within GAAP to make their firms appear attractive to investors.
The M-score is considered a more accurate model for predicting companies that may fail. Beneish, Lee & Nichols (2013, p. 57) explain that companies with a high propensity for manipulation have low returns on every component such as declining profit margins, and return on assets. The M-score focuses on “the rate of growth of a firm, experiencing some economic headwind, and practicing aggressive accounting” (Beneish, Lee & Nichols 2013, p. 59). The M-score model was recognized as an effective tool for prediction of accruals after predicting 12 of the 17 companies that were later announced to have manipulated earnings such as Enron, and Global Crossing (Beneish, Lee & Nichols 2013, p. 60). Firms with a higher M-score value are likely to be engaging in earnings manipulation (Warshavsky 2012, p. 17).
The accrual model is only concerned about aggregate accrual figures. The U.S. firms that manipulate earnings may show income-increasing characteristics associated with “receivables, inventory, working capital, current, total, and discretionary accruals, net property, plant and equipment, sales and gross profit” (Rosner 2003, p. 394). These are some of the components of financial statements targeted by the discretionary accrual model. Stubben (2009, p. 713) explains that the revenue model detects earnings management by companies under SEC enforcement when the accrual model fails. The revenue model is a tool that analyzes revenues to arrive at conclusion of possible earnings manipulation. The accrual model examines firms with rapid growth, firms that change accounting practices, and change in the trend of profit growth among other factors (Vladu & Cuzdriorean 2011, p. 646). Investors may use the accrual model for identifying firms that manipulate earnings.
Findings
Motive is a strong indicator for earnings manipulation. Firms with low performance are more inclined to engage in earnings manipulation than firms with high performance. Poor governance structures have been identified as one of the factors that make firms engage in earnings manipulation. Firms with poor governance structures have CEOs who are influential in the board of directors. The CEOs may also be the co-founders of the corporation. Firms in the U.S. are less aggressive to rounding off earnings by sticking to rounding off the digits 8 and 9. Firms are able to avoid detection from regulators by using more of the real activities manipulation such as acquisitions than accrual-based manipulation. The M-score model is a more accurate tool for predicting firms that may have manipulated earnings than the accrual model. The revenue model is able to detect manipulation of a smaller magnitude that goes undetected in the discretionary accrual model.
Conclusion
Motive is the most important factor in identifying firms that engage in earnings manipulation. Firms seeking external capital, CEOs who want to avoid loss of personal wealth, and gaining cognitive reference points are some of the key incentives for earnings manipulation. The M-score is a more effective tool in predicting failure of firms with accrual-based earnings than the accrual model. The M-score uses forensic accounting tools and may be more useful to regulators than individuals. Revenue model may be used to detect earnings management through revenues.
Recommendations
- Regulators should use the M-score model as a tool for effective identification of firms that are likely to fail due to accrual-based earnings (Beneish, Lee & Nichols 2013, p. 60).
- The revenue model may be used instead of the accrual model for detecting earnings management because of their small magnitude (Stubben 2009, p. 713).
- Recognizing motive is the first step to identifying firms that use earnings manipulation (Vladu & Cuzdriorean 2011, p. 646).
- Discretionary accrual-based earnings may assist some firms to get out of financial constraint. It is not necessary to raise a red flag for such companies (Linck, Netter & Shu 2013, p. 2137).
Reference List
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