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

Series Editor:

Joel S. Demski Fisher School of Accounting University of Florida

Books in the series:

Christensen, Peter O., Feltham, Gerald A. 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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To Ruth, Tavy, and Asaf For Uzi, Hila, Linor, and Rona 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 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 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 Contracts...... 159 4.3.3 Earnings Management and Debt Contracts...... 161 4.4 Regulators...... 171 4.4.1 and Deferred ...... 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. ...... 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 ...... 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 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 ...... 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 ...... 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 ...... 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

Introduction

Historically, bubbles are followed by crashes, which in turn are followed by punitive legislation. The 1999–2003 era is fully consistent with this pattern…. (Coffee, 2003a, p. 46) …During the collapse of the high tech bubble in 2000 and 2001, publicly held firms audited by the Big Five fell by over $1 trillion in market value. (Coffee, 2003a, p. 66)

The accounting scene in the United States changed dramatically at the beginning of the twenty-first century. The prosperity of the late-twenty- century stock markets attracted small investors as well as large ones. Lynn Turner, (2001b), cites a 2000 study that finds that in 1998, some 43.6% of the adult population owned shares (84 million shareholders). These stockholders come from all walks of life, young and old, rich and not so rich. … And interestingly, half of those stockholders have income of less than $57,000 and only 18 percent have family incomes that exceed $100,000. Indeed, the average stockholder today is the average American who lives next door, is your aunt or uncle, a close friend or family member. (Turner, p. 1, emphasis added) With the bursting of the Internet bubble in 2000, the previously bullish stock markets became bearish, and the ugly truth eventually caught up with companies that allegedly tried to obscure unpleasant reality in their accounting reports. The first big scandal occurred in 2000, when Xerox revealed that it had overstated profits by $1.4 billion over a 4-year period. Unfortunately, Xerox was not an isolated instance. Twenty large and highly publicized scandals followed between October 2001 and the enact- ment of Sarbanes-Oxley Act of 2002, including those involving World- Com, Adelphia, Tyco, and Global Crossing (see figure 1 in Cohen, Dey, and Lys, 2005a). The corporate meltdowns in the wake of the scandals caused hundreds of millions of dollars in losses to investors. The largest collapse was that of WorldCom in May 2002, with estimated losses ap- proximating $180 billion. Besides accounting scandals, the current era is marked by the fall of the firm that prepared Enron’s , Arthur Andersen LLP. Andersen, which was the fifth-largest accounting firm in the world, xiv Introduction collapsed because the company’s Dallas office shredded documents perti- nent to the Congressional investigation of Enron’s bankruptcy.1 These scandals shook the faith of investors in the integrity of the capital markets. The government stepped in through the enactment of the Sarbanes-Oxley Act of July 2002,2 which is implemented by rules laid down by the Secu- rity and Exchange Commission (SEC) and strengthened by rule-making in individual states (see the Introduction to Part 2).

The Demand for Earnings Management Research

The new environment raises a host of questions that are of concern to aca- demics, regulators, and practitioners. In this book, we restrict our attention to those that are concerned with firms’ earnings management practice. Earnings management can be loosely defined as a strategy of generating accounting earnings, which “is accomplished through managerial discre- tion over accounting choices and operating cash flows” (Phillips, Pincus, and Rego, 2003, p. 493). Earnings management is an umbrella for acts that affect the reported accounting earnings or their interpretation, starting from production and investment decisions that partly determine the under- lying economic earnings, going through the choice of accounting treatment and the size of accruals when preparing the periodic reports, and ending in actions that affect the interpretation of the reported earnings, such as pre- senting non-GAAP earnings (commonly known as pro forma earnings) and asking the auditor who prepares an opinion casting doubt on the firm’s ability to remain a “going concern” not to use the term (Butler, Leone, and Willenborg, 2004, footnote 2). The accounting debacles of the current era have driven demand for two types of research. The first strand—as exemplified by, Healy and Palepu (2003),3 Coffee (2003a),4 and Ronen (2002a,b,c)5—makes suggestions for

1 On October 16, 2001, Enron Corp. announced that it was reducing its after-tax by $544 million and its stockholders’ equity by $1.2 billion. On November 8, Enron reduced stockholders’ equity by an additional $508 million by restating its previously reported net income for the years 1997–2000. Within a month, equity was lower by $1.7 billion (18% of the $9.6 billion previously reported on September 30, 2001). On December 2, 2001, Enron filed for bank- ruptcy under Chapter 11 of the United States Bankruptcy Code. 2 The official title of the Act is the Public Company Accounting Reform and In- vestor Protection Act of 2002.

3 Healy and Palepu argue for transforming the audit committee of the board of di-

, rectors into a , transparency,, committee that provides investors the information The Demand for Earnings Management Research xv improvements. The second strand attempts to make sense of the earnings management phenomenon (e.g., Demski, 2002; Coffee, 2003b; Dechow and Schrand, 2004; Erickson, Hanlon, and Maydew, 2004; Yaari, 2005; Ronen, Tzur, and Yaari, 2006; Ronen and Yaari, 2007). According to these researchers, if we know why earnings management takes place, and how it is achieved, we will be able to uproot it. Erickson, Hanlon, and Maydew (2006) elaborate on the demand for this sort of research: Some of the largest alleged accounting frauds in history occurred in the last several years, leading to the well-known upheaval in the ac- counting industry and sweeping legislative and regulatory changes. These events have left legislators, regulators, practitioners, and aca- demics searching for answers about the causes of these alleged frauds. Understanding the underlying forces that gave rise to the alleged frauds is a necessary precursor to effectively preventing future oc- currences. Many have suggested that the explanation lies in the incen- tives and opportunities for personal gain faced by executives. (p. 113, emphasis added) Understanding earnings management may also reveal that not all earn- ings management is bad, so taking action to uproot the undesirable variety runs the risk of “throwing the baby out with the bath water.” As Arya, Glover, and Sunder (2003) observe [A]ccounting research shows that income manipulation is not an unmitigated evil; within limits, it promotes efficient decisions. Our ar- gument, admittedly controversial, is worth airing: earnings manage- ment and managerial discretion are intricately linked to serve multiple functions; accounting reform that ignores these interconnections could do more harm than good. (p. 111, emphasis added) From the first strand, we choose to focus on Financial Statements Insur- ance (FSI); see Parts 2 and 3. We follow the second strand of research comprehensively. Of course, restatements and earnings management had

required to understand a firm's strategy, from vision and mission down to objec- tives, success factors, and risks. 4 Coffee points to gatekeepers in the stock market as the parties to be blamed for the accounting scandals because they failed in their function of diminishing the asymmetry of information between management and outsiders. He suggests a penalty system that increases the of collusion between gatekeepers and management. 5 In these studies, Ronen proposes restructuring the audit industry by letting audi- tors be hired by insurance companies that undertake to insure the quality of fi- nancial statements. See Ronen (2002a,b,c), Ronen and Berman (2004) and Dontoh, Ronen, and Sarath (2007). xvi Introduction been taking place long before the turn of the century,6 and research on earnings management started some time ago as well. The first author of this book, Joshua Ronen, collaborated with Simcha Sadan in 1981 on a book that studied whether companies removed volatility in their series of reported incomes—intertemporal smoothing––and whether they signaled value to investors by choosing to present a material transaction in operat- ing income or in extra ordinary items—classificatory smoothing. The ear- liest studies cited in Ronen and Sadan’s book are two papers that appeared in The Accounting Review: Hepworth (1953), and Gordon (1964).7 The following subsection describes the progress of research on earnings management since the 1980s. We refer the reader, who is interested in ear- lier research, to the surveys in Ronen, Sadan, and Snow (1977), Ronen and Sadan (1981), and Stolowy and Breton (2000).

Historical Perspective: The Milestones

The accounting field and the research on accounting have been marked by a few events that have had a major impact on our knowledge and un- derstanding of earnings management. We divide these milestones into theoretical research contributions, empirical research contributions, and regulatory innovations. On the theoretical front, new insights have been provided by the pene- tration of game-theory tools into accounting, including studies by the following:

• Lambert (1984), examines real smoothing, a strategy whereby management uses its flexibility in making investment and production decisions to reduce the variability of the firm’s total value. Lambert models real smoothing as the outcome of the principal–agent relationship between the owners and the manager.

6 The “hall of infamy” for the late twentieth century includes Waste Management, Microstrategy, Rite Aid, Cendant, Sunbeam, Oxford Health, McKessom HBOC, and others. Accounting and Auditing Enforcement Release No. 1405 (SEC, June 19, 2001) states the following: In February 1998, Waste Management announced that it was restating its fi- nancial statements for the five-year period 1992 through 1996 and the first three quarters of 1997 (the “Restatement” ). 7 An excerpt from Journal of Corporate Communications (August, 22, 2002) cites accounting scandals in the 1930s. Historical Perspective: The Milestones xvii

• Dye (1988), rationalizes the internal and external demand for cosmetic earnings management. The internal demand follows from the principal– agent relationship between the firm’s owners and the management, and the external demand follows from the capital market’s need to price the firm. • Dye (1985a), Arya, Glover, and Sunder (1998, 2003), and Ronen and Yaari (2002), challenge the applicability of the Revelation Principle. The Revelation Principle is a game-theory tool that states that whatever the equilibrium of a game in which players have private information, there is no loss of generality in restricting analysis to another equilibrium in which players reveal the truth. The Revelation Principle puts a question mark on the value of a formal analysis of earnings management. • Sankar (1999), Ronen and Yaari (2001, 2002), and Ronen, Ronen, and Yaari (2003), among others, examine the effect of earnings management on the magnitude of the earnings response coefficient, voluntary disclosure, and the demand for additional information.

In empirical research, shifting attention to instances when manage- ment may demand earnings management has been fruitful. The following are noteworthy:

• Healy (1985), shows that compensation contracts may induce management to take measures to decrease reported income when it cannot increase its bonus, thus hoarding reported income. • Schipper (1989), provides a discussion of the different definitions of earnings management (see our Chap. 2) and critically summarizes recent empirical developments. Her commentary appeared after a Journal of conference, Studies on Management’s Ability and Incentives to Affect the Timing and Magnitude of Accounting Accruals. The most cited paper from this conference in the earnings management literature is by McNichols and Wilson (1988), on manipulation of the bad-debt expense (see Chap. 11). • Jones (1991) separates discretionary accruals from non-discretionary accruals when she examines the demand of regulators for the earnings numbers during import relief investigations; the same approach to detecting earnings management has been examined further by Dechow, Sloan, and Sweeney (1995), Bartov, Gul, and Tsui (2000), Dechow and Dichev (2002), Kang (2005), Kothari, Leone, and Wasley (2005), Ye, (2006), Yaari, DaDalt, Ronen, and Yaari (2007). xviii Introduction

At the regulatory level, we find the following significant develop- ments:

• The 1998 “Numbers Game” speech by the then chief commissioner of the Securities and Exchange Commission, Arthur Levitt, Jr., which foreshadowed the subsequent regulatory measures to improve the quality of accounting earnings, including SAB 99 (), SAB 100 (timing and recognition of restructuring), and SAB 101 ( recognition.) • The Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board, an independent body responsible for the issuance of audit and ethics standards that effectively replaced self- regulation of . • Increased monitoring of accountants and accounting statements, including augmentation of the SEC staff by about 800 people at the time this is being written.

Our purpose in this book is to provide a comprehensive view of earnings management and to inspire further research. Although there are already a few literature reviews (e.g., Schipper, 1989; Healy and Wahlen, 1999; Stolowy and Breton, 2000; McNichols, 2000; Beneish, 2001; Fields, Lys, and Vincent, 2001), we believe that the breadth of our coverage will pro- vide readers with an integrated view of the subject. We focus on later con- tributions, as the bibliography tops 2,000 items.

The Plan of the Book

The book is divided into four parts: the conceptual framework, the ac- counting scene and the findings of empirical research, theoretical contribu- tions, and the design of the empirical research. In Part 1, we explain the focus on earnings by consumers of financial in- formation, which in turn explains the demand for earnings management. We present and discuss the definition of earnings management. Part 2 contains a review of the accounting scene, the key players, and the earnings management incidents that are associated with them. We di- vide the participants into three major categories: management, other stake- holders (such as shareholders, debtors, employees, customers, and suppli- ers), and gatekeepers, who provide monitoring value (such as analysts, boards of directors, auditors, and the press). As examples of our analysis, we associate management with firms’ managing earnings in order to Acknowledgments xix increase the value of management’s compensation, creditors with inducing firms to manage earnings in order to not violate debt covenants, and ana- lysts with firms’ motivation to meet or beat market expectations. We discuss in Part 3 the theoretical contributions to the literature, divid- ing them according to the patterns of earnings management behavior:

• Truth-telling (and truth-revealing)—the choice of accounting treatment is neutral. • Smoothing—dampening the fluctuations in the series of reported earnings by inflating low earnings and deflating high earnings. The outcome is that in the long run, the average reported income equals the average economic income but with smaller variability of the series of reported incomes. • Income-maximizing and income-minimizing behavior, and taking a bath. The firm inflates, deflates, or super-deflates earnings (writing off , providing for expected future , and generally “clearing the deck”).8

In Part 4, we describe the empirics of the earnings management litera- ture. We start with the process because a great deal of research ex- amines the management of accruals. Understanding what accruals man- agement is in turn requires familiarity with the unmanaged accruals process. We also review the progress of the research on earnings man- agement that started with Ronen and Sadan (1981) and ended with the 1991 Jones model. The last chapter in this section contains a discussion of the modifications to the Jones model and alternative tests of earnings man- agement.

Acknowledgments

We are grateful to our colleagues for their valuable input and inspiring dis- cussions: Bill Baber, Sudipta Basu, Donald Byard, Masako Darrough, Salma Ibrahim, Joseph Kerstein, Joseph Tzur, Jimmy Ye, Amir Ziv. Like- wise, we appreciate the helpful comments of our Ph.D. students: Nana Amoah, Loretta Baryeh, C.J., Alina Lerman, Arthur Wharton, and Jan Williams. We are indebted to our editor, Harry Butler, and we are particularly thankful for

8 Mulford and Comiskey (2002, p. 15), define “taking a bath” as follows: “A wholesale write-down of assets and accrual of liabilities in an effort to make the conservative so that there will be few to serve as a drag on future earnings.” xx Introduction the valuable help and support of our families: Ruth, Tavy, and Asaf Ronen, and Uzi, Hila, Linor, and Rona Yaari. The second author also acknowl- edges a research grant from Morgan State University. We hope that this book will serve to introduce our readers to the ac- counting scene and to the players and their incentives, as well as the inter- actions among the participants. We also hope that the book will inspire new ideas. The feedback received so far indicates that there is a good chance of accomplishing these goals, and so we wish the readers a fruitful and enjoyable reading. We appreciate feedback from the readers: [email protected] and [email protected].