EM and its implication to stakeholders of the firm is one of the important branches in Accounting Academic Literature. Jensen & Meckling (1976) described Managers are entrusted by Owners for their Wealth in Corporate settings via agency cost to maximise wealth of Owners. Managers engage in EM practice through contractual relationship that provides them as stewards man of principal’s i.e owners wealth. Healy & Whelan (1999) defined EM as
“EM occurs when managers use judgement 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.”
EM can be done through unrealised or late revenue recognition, change in accruals or liabilities for positive financial performance of Firm, Excessive provision for reserves, deferring R & D or Maintenance expense, minor breaches of International Financial Reporting Standards which can aggregate to material breach, change in pension fund provisions.
Schipper (1989), Healy & Whalen (1999) have taken a normative approach in analysing previous EM Literatures. Accounting Literatures suggest Prevalence of EM is well appreciated by Shareholders, Regulators and Market. Research has identified detecting EM although detection is with considerable imprecision within models. Managers engage in EM practices for various reasons such as Market expectations i.e meet analyst forecast, to avoid earnings volatility, to increase their performance related bonus or to secure their position, to secure firm’s position within a sector or market, to avoid regulatory agency monitoring, to avoid any additional levy, to hide large material losses in business operation, to cover persistent irregularities in financial reporting.
However, empirical evidence on market based evaluation of EM shows that Market does adjust its earnings expectation, target price and usually filters through information deducting perceived managed earnings reported by managers. Investors typically adjust for high levels of discretionary accruals that they deem to be abnormal.
Since introduction of FRS3 in 1993, Cadbury Report in Corporate governance and changes made in UK GAAP the extent of Discretionary accrual based EM has shifted. This change in EM has been marked by dot com bubble and several high profile accounting scandals like Enron, World Com and Xerox to name a few. Barth et al (2007) looking at earnings quality in post IFRS transition concludes that there is lower evidence of EM adopting IFRS among UK firms. Embracing more transparent Financial reporting approach by UK Firms result in increased stock liquidity and lower cost of Capital confirmed by Daske et al (2007) who analyzes voluntary adoption of IFRS in pre-2005 period.
Post 2005 Earning Management research has evolved in exploring the new facets to manipulate markets. Athanasakou, Strong and Walker (2009) identified four prevailing forms in EM trend. Managers provide earnings guidance by sending earnings news in shaping analyst expectation and thereby meet or beat forecasts. Other forms are said to be Real EM whereby managers engage in cutting or adjusting real resource allocation within firm to deliver prior year earnings. While working capital accruals management involves changes in operational capital to meet expected earnings. Lastly, Classificatory form of involves inflation by reclassifying expense into non-recurring items. Literature review section of proposal would discuss recent developments in more details highlighting on context, research designs and findings. Key focus on Literature review will be Market response of investors, analysts from Real EM perspective.
Evidence from Zhang (2005), Elliott and Hanna (1996), Bhattacharya et al (2003) suggest investors recognise biased guidance & income smoothing and does not reward for merely...