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. © 2008 Springer Science+Business Media, LLC All rights reserved. This work may not be translated or copied in whole or in part without the written permission of the publisher (Springer Science+Business Media, Inc., 233 Spring Street, New York, NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in con- nection with any form of information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now know or hereafter developed is forbidden. The use in this publication of trade names, trademarks, service marks and similar terms, even if they are not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rights. 9 8 7 6 5 4 3 2 1 springer.com 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 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