Earnings Management

Importance to increase earnings
Whether
How
Why
SEO, IPOs and M&As
Earnings management as a pervasive strategic tool

Whether, how and when firms manage their numbers?
Prof.dr. James Thewissen
Earnings management 1 / 104

Whether
How
Why
SEO, IPOs and M&As

Whether
How
Why
SEO, IPOs and M&As

Whether
How
Why
SEO, IPOs and M&As
Importance of earnings for managers

Graham et al. (2005)
Importance for managers to maintain and create an increase in earnings
Managers believe that earnings are important to external constituents and that meeting or beating
analysts’ expectations and prior period earnings is important to build credibility with the capital
markets and uphold stock prices.

Whether
How
Why
SEO, IPOs and M&As
Firms breaking a pattern of consistent earnings growth

Whether
How
Why
SEO, IPOs and M&As
Avoidance of earnings decreases and losses

These observations lead us to believe that managers have incentives to manage
earnings in order to avoid earnings decreases and losses.
In this session, we investigate
1 Whether
2 How
3 Why
managers avoid earnings decreases and losses

Whether
How
Why
SEO, IPOs and M&As
Earnings (change) distribution
No earnings management
Normal distribution for earnings numbers and
earnings changes

Whether
How
Why
SEO, IPOs and M&As
Earnings (change) distribution
Test statistic used to test the null hypothesis that the distribution is smooth is the difference between
the actual number of observations in an interval and the expected number of observations in the
interval, divided by the estimated standard deviation of the difference. Under the null hypothesis, these
standardized differences will be distributed approximately Normal with mean 0 and standard deviation 1.
Whether
How
Why
SEO, IPOs and M&As
Case of earnings management

Earnings changes slightly less than zero occur
less frequently than would be expected given
the smoothness of the remainder of the
distribution
Earnings changes slightly greater than zero
occur more frequently than would be expected
For the change in earnings: the standardized
difference for the interval immediately to the
left of zero is - 8.00
For the loss in earnings: the standardized
difference for the interval immediately to the
left of zero is - 13.16
→ Provides evidence of the existence of
earnings management to avoid decreases
and losses in earnings

Whether
How
Why
SEO, IPOs and M&As
Sensitivity tests for earnings changes

Incentives to avoid earnings decreases become
stronger with the length of the previous run of
positive earnings.
These stronger incentives should lead to a
more pronounced effect of earnings
management in the intervals close to zero.
Categorize observations based on the length
of the preceding string of earnings
The three categories are observations
following
1 earnings losses,
2 one or two consecutive years of positive
increases
3 three or more years of positive earnings
Significantly not normally distributed
Whether
How
Why
SEO, IPOs and M&As
Sensitivity tests for earnings level
Incentives to avoid earnings decreases become

stronger with the length of the previous run of
earnings increases.
These stronger incentives should lead to a
more pronounced effect of earnings
management in the intervals close to zero.
The three categories are observations
following
1 earnings decreases,
2 one or two consecutive years of earnings
increases
3 three or more years of earnings increases.
Not significantly not normally distributed,
but visually confirms earnings management

Whether
How
Why
SEO, IPOs and M&As
A common phenomenon?

Whether
How
Why
SEO, IPOs and M&As
Earnings management – Contagion

Earnings management is a contagious activity – Unless accompanied by SEC
enforcement or class action
A firm has a significantly higher probability of beginning earnings management if a
higher fraction of its industry and its geographical neighborhood has already revealed
that they managed earnings via a public restatement announcement in the prior year.
Restatement announcements accompanied by SEC enforcement actions or class action
litigations are not associated with contagion in earnings management.
Reasonable manipulation – Extreme restatements involve substantial manipulation and
are likely to be perceived as too severe for peer firms to imitate
Large and visible firms are more likely to cause peer firms to adopt such practices or
lead to contagion
→ Observing others cheat changes an individual’s understanding of the social norms
related to dishonesty and incentivizes them to adopt a similar conduct

Whether
How
Why
SEO, IPOs and M&As
Trend in earnings management

Whether
How
Why
SEO, IPOs and M&As
Pervasive phenomenon
Pervasiveness of earnings management

Earnings management occurs when managers use judgment 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.
Emphasis
Methods – judgment in financial reporting & structuring transactions
Motives – Influence the economic performance & contractual outcomes that depend
on accounting numbers
→ Key to understand how and why it happens?

Whether
Playing with accruals
How
Real earnings management
Why
SEO, IPOs and M&As
Continuum of earnings management practices

Whether
How
Why
SEO, IPOs and M&As
Continuum of earnings management practices

Whether
How
Why
SEO, IPOs and M&As
Accruals
The use of accrual accounts has greatly increased the amount of information on accounting
statements. Before the use of accruals, accountants only recorded cash transactions on these
statements.
But cash transactions don’t give information about other important business activities, such as
revenue based on credit and future liabilities.
By recording accruals, a company can measure what it owes in the short-term and also what cash
revenue it expects to receive. It also allows a company to show assets that do not have a cash
value, such as goodwill.
Using the accrual method, an accountant makes adjustments for revenue that has been earned
but is not yet recorded in the accounts, and expenses that have been incurred but are not yet
recorded in the accounts.

Whether
How
Why
SEO, IPOs and M&As
Accrual accounting

Whether
How
Why
SEO, IPOs and M&As
Cookie jar & Big-bath
Cookie Jar Accounting – One type of

earnings management and eanrings
manipulation. Treats the balance sheet as a
cookie jar. In good years, the company stores
cookies (reserves) in the jar (balance sheet)
so that it can take them out and eat them
(place them on the income statement) when
management is hungry (needs extra income to
look good).
Big-bath accounting – When a company
makes a large one-time write off, it is said to
take a big bath to improve future earnings.
Many firms take a big bath (often in the form
of restructuring or inventory write-downs)
when earnings performance is already poor

Whether
How
Why
SEO, IPOs and M&As
Proxy for earnings management – Discretionary accruals
Current accruals (CA) are regressed on the change in sales in a cross-sectional regression using all
firms in the same two-digit SIC code
The cross-sectional regression is performed each fiscal year, and all variables are scaled by lagged
firm assets.
The fitted current accruals are calculated using the estimated coefficients from the regression and
the change in sales net of the change in trade receivables. The change in trade receivables is
subtracted from the change in sales to allow for the possibility of sales manipulation.
The fitted current accruals are considered to be the level necessary to support the firm’s sales
increase and is termed nondiscretionary current accruals (NDCA).
The regression residual is presumed not dictated by firm and industry conditions and is considered
to have been managed and so is termed discretionary current accruals (DCA)

Whether
How
Why
SEO, IPOs and M&As
Manage earnings through deviating from the normal business activities. Three proxies
1 Acceleration of the timing of sales through increased price discounts or more

lenient credit terms. Leads to a temporary increase in sales volumes, likely to
disappear once the firm reverts to old prices.
2 Reporting of lower cost of goods sold through increased production. Managers
can increase production more than necessary in order to increase earnings. When
managers produce more units, they can spread the fixed overhead costs over a larger
number of units, lowering fixed costs per unit.
3 Decreases in discretionary expenses including advertising, R&D and SG&A
expenses. Reducing expenses will lead to an increase in current period earnings.

Whether
How
Why
SEO, IPOs and M&As
Comparison
Real earnings management is more costly than accrual earnings management – More
costly to depart from normal business practices, in particular for firms that face
competitive pressure within the industry as it would reduce their competitive
advantage relative to their industry peers which face less competition (Zang 2012)
Yet, real earnings management is much more difficult to identify
Graham etal.(2005) provides evidence that, although more expensive to shareholders,
managers prefer real earnings management activities to accrual earnings management.
The main reason is that activities are less likely to be scrutinized by auditors and
regulators, and thus potentially have a lower probability of being detected.

Importance to increase earnings Prospect theory
Whether Transaction cost theory
How Opportunistic behavior
Why Making the CEO look good
SEO, IPOs and M&As Investors’ reaction to earnings announcement
Earnings management – A balance between risk and benefit
Engaging in earnings management is not a

risk-free operation
Companies and CEOs risk to damage their
reputations and there are litigation risks
involved with such manipulation
Therefore, companies will only engage in
earnings management when the benefits of
this behaviour are higher than the risks and
costs involved

Earnings management – A balance between risk and benefit
We review four incentives for managers

to manage earnings
1 Prospect theory
2 Transaction cost theory
3 Opportunistic behavior
4 Making the CEO look good
We then investigate whether investors

are aware of this pervasive manipulation

Quotes from Arthur Levitt, Chairman of the SEC
Increasingly, I have become concerned that the motivation to meet Wall Street earnings
expectations may be overriding common sense business practices. Too many corporate
managers, auditors, and analysts are participants in a game of nods and winks. In the zeal
to satisfy consensus estimates and project a smooth earnings path. wishful thinking may be
winning the day over faithful representation. As a result, I fear that we are witnessing an
erosion in the quality of earnings, and therefore, the quality of financial reporting.
Managing may be giving way to manipulation; integrity may be losing out to illusion. While
the problem of earnings manipulation is not new, it has swelled in a market that is
unforgiving of companies that miss their estimates. I recently read of one major U.S.
company, that failed to meet its so-called numbers by one penny, and lost more than six
percent of its stock value in one day.

Theoretical anchor – Prospect theory
Due to Kahneman and Tversky (1979).

Postulates that decision-makers derive value
from gains and losses with respect to a
reference point, rather than from absolute
levels of wealth.
Prospect theory also suggests that individuals’
value functions are concave in gains and
convex in losses (S-shaped). In other words,
value functions are steepest around wealth
reference points. Thus, for a given increase in
wealth, the corresponding increase in value is
greatest when the increase in wealth moves
the individual from a loss to a gain relative to
a reference point.

Earnings management around the reference point

Different decision-makers likely have different
reference points. Zero change in earnings is a
natural reference point for decision-makers
who estimate wealth as a multiple of earnings.
Later introduced financial analysts’
consensus forecast as benchmark
Zero level of earnings is a natural reference
point if wealth is measured by net accounting
assets.
Assuming that the cost of earnings
management to achieve a given amount of
earnings increase is constant, one can expect
to observe earnings-increasing management
around wealth reference points - in this case,
in the vicinity of zero changes of earnings and
zero levels of earnings.
Main reason for earnings management – Stock price reaction
The interaction between accounting numbers

and stock markets reaction can indeed push
management towards earnings management.
Premium to beat expectations remains even
in cases for firms that achieved such a
performance through earnings management
Premium to MBE is a leading indicator of
future performance

Beat the market benchmark
Incentive to beat the market expectations

Analysts’ consensus forecast = market
expectations
In other words: beat or meet expectations
(analysts’ consensus forecast)
Earnings surprise for profits is generally
positive (53.0% of the sample), indicating
that mangers reporting profits usually beat
analyst estimates
→ Provides evidence of the existence of
earnings management to avoid missing
analysts’ estimates

Main reason for earnings management – Stock price reaction
β2 estimated from the full sample, is positive

and significant, suggesting that the earnings
surprise affects the return for the quarter
Beating expectations is associated with a
higher return than just meeting expectations
as borne out by the positive and significant
coefficients on DBEAT (β4 )
Quarterly return for firms that meet or beat
their earnings expectations (MBE firms) is
2.3% above that of all other firms,
independent of the magnitude of the positive
earnings surprise

Beat the market benchmark
More analysts agree, the stronger the

incentive is to meet the consensus forecast.
If pre-managed earnings are below the
forecast, managers use income-increasing
earnings management.
If pre-managed earnings are higher then the
forecast, managers can choose between
income-decreasing earnings management
(saving it for a rainy day) or not managing
the earnings (hoping for an increase in stock
return).

Beat the market benchmark in function of analysts’ dispersion
These results demonstrate that managers prefer to present pleasant eamings surprises as
opposed to eamings disappointments, especially when analysts are in agreement regarding
expected eamings.

A lasting effect – Post earnings announcement drift
CAR in the first quarter is more negative

than positive :
Highest quantile of the forecast error
distribution: CAR over four quarters:
3.47%
Lowest quantile of the forecast error
distribution: CAR over four quarters:
-4.65%
Negative returns have a larger magnitude
than positive (Prospect theory)

PEAD – Lasting impact
Missing the forecasts leads to a negative stock price reaction that lasts for several
months
Most of the drift occurs in the first 60 trading days subsequent to the earnings
announcement
Little evidence that there exists a significant drift after 180 days
If we assumed that all of the drift occurs within 480 days, the fraction of the drift
experienced within 60 days is 53%, 58% and 76% for small, medium and large firms.

PEAD – Lasting impact
100% of the drift occurs within nine months for small firms, within 6 months for large
firms
A disproportionately large amount of the 60-day drift occurs within 5 days of the
earnings announcement
If the drift were constant over the 60-day interval, we would expect 8% of the drift to
arise within 5 days. However, the actual percentage of the 60-day drift that occurs
within 5 days is 13%, 18% and 20% for the small, medium and large firms, respectively
Hence, if the drift is explained by an incomplete adjustment for risk, the risk must
exist only temporarily and must persist longer for small firms than for large firms
→ Missing analysts’ consensus forecasts has a substantial and lasting impact on the
stock price

Transaction cost theory
A theory that states that the goal of an organization is to minimize the costs of exchanging ressources
in the environment and the costs of managing exchanges inside the organization.
The transactions costs theory relies on two assumptions:

1 Information about earnings affects the terms of transactions between the firm and its stakeholders
and, more specifically, terms of transactions are generally more favorable for firms with higher,
rather than lower, earnings.
2 The costs of storing, retrieving, and processing information are sufficiently high that at least some
stakeholders determine the terms of transactions with the firm based on heuristic cutoffs at zero
levels or zero changes in earnings.

Transaction cost theory
Examples
1 Customers are willing to pay a higher price for goods because the firm is assumed more likely to
honor implicit warranty and service commitments.
2 Suppliers offer better terms, both because the firm is more likely to make payments due for
current purchases and because the firm is more likely to make larger future purchases.
3 Lenders offer better terms because the firm is less likely to either default or delay loan payments.
4 Valuable employees are less likely either to leave or to demand higher salaries to stay.

Meeting or beating forecasts and cost of debt

Whether and how creditors use earnings benchmarks in evaluating firm
performance.
Three benchmarks
1 earnings per share,
2 changes in earnings per share,
3 single most recent analyst’s
forecasted earnings per share

Proxy cost of debt: firm credit ratings
and initial bond yield spread



Meeting or beating forecasts and change in rating
Beating any of the three earnings benchmarks is associated with a higher probability of a ratings
upgrade
Columns (4)–(9) test whether the effect of beating earnings benchmarks exists for both the high
and low default risk samples. Reporting profits and earnings increases have a stronger impact on
ratings changes for high default risk firms than for low default risk firm

Meeting or beating forecasts and spread
Beating the profit benchmark and the most recent analyst’s earnings forecast is associated with a
smaller yield spread in the aggregate sample.
In particular, firms reporting profits have a bond yield spread that is 28 basis points less than
those reporting losses

Labor unions and earnings management

Prior research finds that managers’
accounting choices are affected by contracts
that are either explicitly or implicitly tied to
the firm’s accounting numbers
One type of contract with implicit ties to a
firm’s protability is a collective bargaining
agreement that is negotiated between a firm’s
management and its unionized employees.
Evidence suggests that negotiated wages in a
unionized setting are an increasing function of
a firm’s prior profitability
Given this implicit link between protability and unionwages, researchers have posited that managers
may have an incentive to intimate a negative outlook to their unionized workers in order to improve
the firms bargaining position.

Air France

Because meeting or beating analysts’ expectations constitutes an important signal

about a firm’s current and future protability: labor force unionization is expected to
have a positive effect on management’s incentive to miss mean consensus analysts’
earnings estimates to increase their negotiating position with respect to the labor
union.
In other words, the paper tests whether managers of unionized firms do seek to
manipulate protability signals when contracting with unionized employees.
UNION is significantly negative, suggesting

that, on average, unionized firms are less
likely than their nonunionized counterparts to
meet or beat expectations
Replace the binary UNION variable with a
continuous proxy for a union’s negotiation
power, PCTUNI . Results remain similar.
The results imply that managers of unionized
firms are more (less) likely to miss (meet or
beat) expectations, and in particular to just
miss expectations (just meet or beat
expectations), compared to their
nonunionized counterparts.

The mechanism through which this increased

propensity to miss estimates arises.
Test whether unionized firms are less likely
than their nonunionized counterparts to meet
or beat expectations when the earliest
quarterly forecast error is negative
FENEG = 1 when FEearliest is negative. FEearliest
is defined as reported earnings, E, for firm i in
quarter q, less analysts’ forecasts at the
beginning of the quarter Fearliest
Firms with FENEG = 1 are firms with more
likelihood of managing expectation

PCTUNI · FENEG is signed negatively, implying

that unionized firms are less likely than their
nonunionized counterparts to walk down
forecasts
Managers of unionized firms take less action
than their nonunionized counterparts do to
guide forecasts downward.
This evidence is also consistent with results
that suggest that managers of unionized firms
provide less information to the market in
general.


Whether relative to their nonunionized
counterparts, unionized firms are more likely
to manage earnings downward to miss
estimates
Find that the coefficients on UNION · EMNEG
and PCTUNI · EMNEG are both negative and
significant, implying that when unionized
firms deflate earnings, they are more likely to
miss estimates than nonunionized firms.
The author does not obtain a significant
coefficient on the EMNEG main effect. This
result implies that nonunionized firms that
report negative discretionary accruals are not
more likely to miss expectations than those
that produce positive discretionary accruals

Compensation contracts with CEOs

Opportunistic explanation
Tests the impact of CEOs’ compensation
on firms’ incentive to maximize profits



Earnings management and insider trading
Value of CEO option exercises, as a proportion of firm equity market value, is 3.82 basis points
higher in periods when the firms they manage have levels of accruals that are in the top 10% of
firms in that year.

Making the CEO look good
Other than financial motives for the CEO to manage earnings

CEO tenure
CEO turnover
Event study around CEO turnover

CEO tenure and earnings management
CEOs have incentive to overstate

earnings in earlier years of their service,
favorably influencing the market’s
perception of their ability
Avoid earnings management in later
years to protect their reputation
Economically significant – Discretionary
accruals increase ROA by 0.37% per year
Overstatement increases reported ROA
by about 25% on average



CEO tenure and earnings management – Effect of monitoring

Longer tenure leads managers to be less myopic in

managing earnings to meet short-term financial
reporting goals. Findings are consistent with this
prediction as they suggest that, when there are
incentives to manipulate firms performance,
entrenched managers are less prone to engage in
earnings management activities that hurt
shareholders.

CEO turnover and earnings management
Does earnings management increase the

risk of CEO turnover?
How do internal controls work to
discipline managers who engage in such
practices

CEO turnover and earnings management
Earnings management is an important

determinant of forced CEO turnover
A one percent decrease in earnings
management implies a decrease in the
odds of forced ouster of between 15%
and 26%
Comparison: one-year industry-adjusted
stock return is associated with a 46-52%
decrease in the odds of forced CEO
turnover (remains the most important
reason a CEO can be fired)

SEC enforcement
Increased turnover because of external

consequencees (e.g., SEC sanctions)?
Impact is insignificant. Hence negative
external consequences do not explain
turnover because of earnings
management

CEO change vs. earnings increase/decrease
Decreased transparency in financial

information.
Both increase and decrease lead to a
significant change in CEO
→ Boards of directors act to
discipline managers who aggressively
manage earnings
→ Managers are forced out because
by managing eanrings they impose
costs on shareholders by decreasing
firm transparency

Do investors know that managers manipulate earnings?

Focus on firms’ propensity to meet or beat the consensus
Some evidence showing that investors provide a premium to firms that MBE and only slightly discount
for earnings management

The coefficients β4 and β6 are negative and mostly significant.

The premium to MBE is significantly lower in instances in which the MBE is more
likely to have been driven by expectations management.
Overall, however, the premium to MBE in these cases still exists and is lower by only a
small amount as compared with the premium to MBE in other cases.
This is evident from the small negative coefficient for DMBE subset , β4 (-0.039), which
is the conditional intercept dummy, relative to the coefficient for DMBE, β3 (0.075)
the unconditional intercept dummy.

Accrual informativeness – Whether one can use accruals to

predict future performance
The paper distinguishes between cash flows
and accruals components
Reasoning is that earnings should be
distinguish between the ”earnings”
component from the ”accrual” component to
predict future earnings
It is believed that accruals are less likely to
recur in future periods’ earnings → The
persistence of current earnings performance is
decreasing in the magnitude of the accrual
component of earnings
It is believed that cash flows are more likely to
recur in future periods’ earnings → The
persistence of current earnings performance is
increasing in the magnitude of the cash flows
Earnings persistence
Earningst+1 = α0 + α1 Earningst +t+1
Earnings performance is slowly mean

reverting
Average persistence is about 0.8

Earningst+1 = γ0 + γ1 Accrualst + γ2 Cashflowst +t+1
γ1 is statistically smaller than γ2

The smaller coefficient on Accruals
reflects the lower persistence of earnings
performance attributable to the accrual

Figure shows the lower persistence of earnings

performance attributable to the accrual
Provides the time-series plots of earnings
performance for firm-years in the extreme
deciles when ranked based on acruals,
earnings and cash flows

Mean reversion for earnings that is slow (far

from complete by the fifth year)
Mean reversion for accruals is very fast
(within one year)
Mean revesion for cash flows takes place in
more than five years
→ Persistence of earnings performance is shown
to depend on the relative magnitudes of the cash
and accrual components of earnings.

Functional fixation hypothesis
Based on this result, develop a trading

strategy
Functional fixation hypothesis: if
investors fixate on earnings and fail to
distinguish between the accrual and cash
flow components of current earnings.
In other words, one could profit from
investors’ inability to distinguish betwene
accrual and cash flow components

Calendar trading strategy

Hedged portfolio
Long position: portfolio with the lowest
accrual level (1.6% return)
Short position: portfolio with the highest
accrual level (-3.2% return)
→ Hedge portfolio return 10.4% in the first
year

First evidence of the accrual anomaly
Positive in all years but two

Not explained by the risk
One can use accruals to predict future
returns
Reflects investors’ inability to
identify firms that manage earnings
→ Challenges the view that investors see through earnings management.

Subsequent reversals of the earnings management are disappointing to investors,
leading to some negative stock performance
→ Are investors irrational?

Accrual Anomaly
An explanation that has been offered for the accrual anomaly, the earnings fixation
hypothesis, holds that investors fixate upon earnings and fail to attend separately to
the cash flow and accrual components of earnings.
Since the cash flow component of earnings is a more positive forecaster of future
earnings than the accrual component of earnings, investors who neglect this distinction
become overly optimistic about the future prospects of firms with high accruals and
overly pessimistic about the future prospect of firms with low accruals.
As a result, high accrual firms become overvalued, and subsequently earn low
abnormal returns. Similarly, low accrual firms become undervalued and are followed by
high abnormal returns.
Leads to a trading strategy that yields significant abnormal returns that cannot be
explained by risk

Whether Initial Public Offering
How M&As
Why Stock repurchase
SEO, IPOs and M&As
Initial Public Offering
Several key events increase the likelihood of earnings management
1 Initial public offering
2 Seasonal equity offering
3 Mergers & acquisitions
4 Share repurchase
What is the impact of earnings management on the long term value of the firm
after each of these events?

How M&As
SEO, IPOs and M&As

How M&As
SEO, IPOs and M&As
Initial and Seasonal Public Offering
Initial public offerings (IPOs) underperform after the issue.

Over a three-year holding period after the offering, Ritter (1991) reports substantially
lower stock returns (mean of -27 percent and median of -55 percent) for a sample of
1,526 IPOs going public between 1975 and 1984 than for a size- and industry-matched
sample of seasoned firms.
Investors are periodically overoptimistic about the earnings potential of young growth
companies.
Could earnings management be the source of this overoptimism?

How M&As
SEO, IPOs and M&As
Issuers can report unusually high earnings by adopting discretionary accounting accrual
adjustments that raise reported earnings relative to actual cash flows.
If buyers are guided by earnings but are unaware that earnings are inflated by the
generous use of accruals, they could pay too high a price.
As information about the firm is revealed over time by the media, analysts’ reports and
subsequent financial statements, investors may recognize that earnings are not
maintaining momentum, and the investors may thus lose their optimism.
Other things equal, the greater the earnings management at the time of the offering,
the larger the ultimate price correction. Therefore, can discretionary accruals predict
the cross-sectional variation in post-IPO long-run stock return performance?

How M&As
SEO, IPOs and M&As
Before an IPO
Very high level of information asymmetry

No analyst covering the stock – scarcity of information about the issuer forces
investors to rely heavily on the prospectus, which itself may contain only one to three
years of financial statements.
Investors are unable to understand fully the extent to which IPO firms engage in
earnings management by borrowing from either the past or the future, high reported
earnings would translate directly into a higher offering price.

How M&As
SEO, IPOs and M&As
After an IPO
Incentive to boost earnings soon after the IPO to maintain a high market price
Initial entrepreneurs may wish to sell some of their personal holdings at the end of the
lockup period (after the lockup period, usually 180 days)
Furthermore, verbal earnings projections are also made to investors during road shows
at the beginning of issue marketing.

How M&As
SEO, IPOs and M&As
After an IPO – Analysts
After trading begins, security analysts initiate coverage of the firm and disseminate
these earnings projections widely.
To keep the aftermarket price from dropping below the initial offer price, analysts at
the underwriting investment banking firms are under pressure to make the most
favorable earnings projections possible.
In turn, the issuing firm is under pressure to meet those projections in the aftermarket
to safeguard its reputation for reliability; to maintain the goodwill of investors,
investment bankers, and analysts who made the initial earnings projections; and to
avoid lawsuits by disgruntled shareholders after a shortfall in post- IPO earnings.

How M&As
SEO, IPOs and M&As
Timeline

How M&As
SEO, IPOs and M&As
Sample characteristics

How M&As
SEO, IPOs and M&As
Decrease in earnings management over the years after the IPO

How M&As
SEO, IPOs and M&As
Measure long term performance
Two performance measures

1 Buy and hold abnormal returns
2 Cumulative abnormal returns
With variations based on

Benchmarks (raw, market-adjusted, FamaFrench adjusted, matching firms adjusted)
Cumulation periods, sample partitions,
Regression test specifications (cross-sectional, time-series, and FamaMacBeth)
regressions.

How M&As
SEO, IPOs and M&As
Event study

How M&As
SEO, IPOs and M&As
Event study

How M&As
SEO, IPOs and M&As
Results
On a CAR measure, the aggressive accruals portfolio underperforms the conservative accruals
portfolio by 21.6 percent in raw returns, 26.2 percent in CRSP value-weighted market-adjusted
returns, and 25.4 percent in Nasdaq composite index-adjusted returns.
On a BH measure, the underperformance is somewhat larger (24.9 percent) in raw returns, 30.7
percent in CRSP market-adjusted returns, and 29.2 percent in Nasdaq-adjusted returns.
The fourth row in Panel A shows adjusted returns using the Fama and French (1993) benchmark.
For each firm, returns are constrained to be
Rt = rft + γ1 (Mt − rft ) + γ2 SMBt + γ3 HMLt + ARt
The Fama-French procedure suggests a smaller underperformance differential of 19.0 percent on a
CAR basis and 23.9 percent on a BH basis
Fifth row: matched firms as benchmark. Following Ritter (1991) procedure, each IPO firm is
matched with a nonissuing firm from CRSP based on industry membership and market
capitalization.
The matched-firm benchmark suggests a performance differential between aggressive and
conservative accruers of 25.5 percent on a CAR measure and 38.5 percent on a BH measure.
62% of firms making initial public offers have higher unexpected accruals than a matched sample
of control firms
How M&As
SEO, IPOs and M&As
Event study

How M&As
SEO, IPOs and M&As
Event study

How M&As
SEO, IPOs and M&As
Calendar strategy
Using a calendar time-series approach (shown to be reliable for random samples by

Lyon, Barber, and Tsai (1998))
We construct two portfolios that differ in their discretionary current accruals
We then compare their estimated intercepts in a regression of portfolio returns on the
FamaFrench (1993) three-factor returns
Rpt − Rft = a + b · (Rmt − Rft ) + s · SMBt + hHMLt + t

Firms are considered IPOs from the fourth to the thirtyninth month after the first
fiscal year-end.

How M&As
SEO, IPOs and M&As

How M&As
SEO, IPOs and M&As
Results
Conservative DCA IPOs experience little underperformance while the aggressive DCA
IPOs suffer significant post-issue underperformance.
The estimated intercept for the conservative DCA IPOs ranges from 0.052 percent to
0.078 percent per month
The aggressive DCA IPOs have intercepts ranging from -0.658 percent to -0.554
percent per month
→ Aggressive IPOs have statistically significantly poorer post-issue performance
than conservative IPOs

How M&As
SEO, IPOs and M&As
Results
IPO firms have positive abnormal accruals during the year around the IPO
Accruals predict both earnings reversals and future poor stock returns
The stock market is misled by the upward managed earnings, temporarily over valuing
issuing firms and then being disappointed by their predictable earnings declines
→ Decline in post-IPO stock performance is attributed to accrual reversals

How M&As
SEO, IPOs and M&As
SEOs and earnings management type
As for IPOs, we test for earnings management

around SEOs
Characterized by negative performance
post-SEO
Focus is here on HOW managers manipulate
earnings
Accrual earnings management

How M&As
SEO, IPOs and M&As
Two reasons to also use real earnings management
1 Accrual-based EM is likely to draw audtior and regulatory scrutiny than real EM. For
instance, Dechow and Sloan (1991) find that executives near the end of their tenure
reduce R&D expenditures to increase short-term earnings
2 Relying on accruals alone is risky. If reported income falls below the threshold and all
accrual-based strategies to meet it are exhausted, managers are left with no options
because real earnings activities cannot be adjusted at or after the end of te fiscal
reporting period.
→ Yet, real earnings management has a negative impact on future operating

performance

How M&As
SEO, IPOs and M&As
→ Evidence of real earnings management activities around SEO

Significant use of accruals
Significant positive abnormal production costs
Negative abnormal discretionary expenses
Negative abnormal CFO
How M&As
SEO, IPOs and M&As
Impact of accrual- and rea-based EM on post-SEO earnings

Effect of real-EM on post-SEO performance likely greater than accrual-EM

How M&As
SEO, IPOs and M&As
Stock-based M&A and earnings management

Acquiring firms use their stock to purchase
the target firm’s stock or assets. Unlike cash
deals, in stock transactions the value of the
consideration received by target shareholders
is contingent on the market value of the
acquiring firm. That is, the number of
acquiring firm shares exchanged with target
shareholders is normally determined by the
value of the acquiring firm’s stock on the
merger agreement date.
A higher stock price reduces the number of
shares that the acquiring firm must use in the
exchange; the acquiring firm has an incentive
to increase its stock price before the
agreement of a stock for stock corporate
merger.

How M&As
SEO, IPOs and M&As
Stock repurchase and earnings management

External monitoring effects of venture
capitalists (VCs) on IPO firms’ accrual
earnings management
VC-backed IPOs, especially those backed
by reputable VCs, have significantly
lower EM and better post-IPO
performance than non-VC-backed IPOs
In this paper, the authors show that
government-controlled VCs are most
associated with IPO firms who
window-dress accrual and real earnings,
have poorer long-run stock performance
and most likely to exit immediately after
VC share lock-up expiration
How M&As
SEO, IPOs and M&As
Whether share repurchases provide

management with incentives to
misrepresent firm performance
Hypothesized that pre-repurchase
earnings are managed downward in order
to induce shareholders to sell their
shares at sub-par prices.
Post-repurchase earnings are higher than
expected as the accruals management
process is reversed.

How M&As
SEO, IPOs and M&As

Earnings Management

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Earnings Management

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Importance to increase earnings

Earnings management as a pervasive strategic tool

Prof.dr. James Thewissen

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Earnings management 2 / 104

Earnings management 3 / 104

Importance of earnings for managers

Earnings management 4 / 104

Firms breaking a pattern of consistent earnings growth

Earnings management 5 / 104

Avoidance of earnings decreases and losses

In this session, we investigate

managers avoid earnings decreases and losses

Earnings management 6 / 104

Earnings (change) distribution

Earnings management 7 / 104

Earnings (change) distribution

Case of earnings management

Earnings management 9 / 104

Sensitivity tests for earnings changes

Sensitivity tests for earnings level

Incentives to avoid earnings decreases become

Earnings management 11 / 104

Earnings management 12 / 104

Earnings management – Contagion

Earnings management 13 / 104

Trend in earnings management

Earnings management 14 / 104

Pervasiveness of earnings management

→ Key to understand how and why it happens?

Earnings management 15 / 104

Continuum of earnings management practices

Earnings management 16 / 104

Continuum of earnings management practices

Earnings management 17 / 104

Earnings management 18 / 104

Earnings management 19 / 104

Cookie jar & Big-bath

Cookie Jar Accounting – One type of

Earnings management 20 / 104

Proxy for earnings management – Discretionary accruals

Earnings management 21 / 104

Real earnings management

1 Acceleration of the timing of sales through increased price discounts or more

Earnings management 22 / 104

Earnings management 23 / 104

Earnings management – A balance between risk and benefit

Engaging in earnings management is not a

Earnings management 24 / 104

Earnings management – A balance between risk and benefit

We review four incentives for managers

We then investigate whether investors

Earnings management 25 / 104

Quotes from Arthur Levitt, Chairman of the SEC

Earnings management 26 / 104

Theoretical anchor – Prospect theory

Due to Kahneman and Tversky (1979).

Earnings management 27 / 104

Earnings management around the reference point

Main reason for earnings management – Stock price reaction

The interaction between accounting numbers

Earnings management 29 / 104

Beat the market benchmark