A three-category classification

Ronen and Yaari (2008) divide EM into three categories: beneficial, neutral and pernicious. They consider “Beneficial earnings management enhances the transparency of reports; the pernicious involves outright misrepresentation and fraud; the grey (neutral) is manipulation of reports within the boundaries of compliance with bright-line standards, which could be either opportunistic or efficiency-enhancing” (p. 25).

The first category includes studies inclined to stress the beneficial effect of EM. Researchers support the opinion that EM takes advantage of the available flexibility in choosing accounting treatments, without violating the requirements of accounting standards. EM is not always negative, and is expected and demanded from both inside and outside the business, and by stakeholders in the capital market (Parfet, 2000). EM can be beneficial in signalling managers about future cash flows (Beneish, 2001; Chtourou, Bedard, & Courteau, 2001; Demski, 1998; Demski, Patell, & Wolfson, 1984; Suh, 1990).

The second category, which is the neutral group, refers to studies that portray neutral attitudes about EM. Researchers who support this idea believe that EM can be either opportunistic or economically efficient (Fields, Lys, & Vincent, 2001). Scott (2012, p. 423) states EM is “ the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective.” Also, Scott (2012) demonstrates both the positive and negative perceptions of EM. The positive effect of EM mainly rests on its function in opening up communication with outsiders. It can be difficult and costly to translate a

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manager’s expertise and skills about a firm to the board directors and investors, and thus communication between managers, directors, and investors is blocked in many cases. Under these circumstances, EM can serve as a way to open up communication to give outsiders some inside information on management, the financial health of the firm, and the manager’s expertise, through financial statements. EM can also be beneficial in encouraging efficient contracting, given that EM provides an option for flexibility when a management contract imposes strict and incomplete terms on a manager. EM is considered “bad” when it reduces the reliability of financial reporting information. The negative effects of EM include being opportunistic, self-interested, and creating implications for accountants. Mulford and Comiskey (2002) explain that no matter whether it is within or beyond the flexibility afforded by GAAP, EM, as a tool to alter earnings, is desired and conducted to respond to certain motivations and incentives.

The third category, the pernicious group, includes studies that regard EM as detrimental. Researchers such as Chtourou et al. (2001); Levitt (1998); Miller and Bahnson (2002); and Tzur and Yaari (1999) assert that EM is harmful to the representation and transparency of financial reports. Schipper (1989) develops a framework to detect the intention to perform EM, and conditions that give rise to EM. Schipper (1989) notes that “by ‘earnings management’ I really mean ‘disclosure management ‘in the sense of a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to, say, merely facilitating the neutral operation of the process)” (p. 92). Although Schipper (1989) is in support of the argument that EM is harmful, he also acknowledges the beneficial aspects of EM; for instance, in revealing private information. One commonly cited study by Healy and Wahlen (1999) supports the view that EM is an abusive practice. “Earnings management occurs when managers

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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” (Healy & Wahlen, 1999, p. 368). EM in the pernicious group is opportunistic and driven by self-interest.

However, Arya et al. (2003) argue that unmanaged earnings are not necessarily always better for shareholders; to some extent, managed earnings to conceal information can also be beneficial to shareholders. The Chinese phrase “guoyoubuji”, from the Analects of Confucius, which states that excess is just as bad as a deficiency, precisely fits with Arya et al.’s observations on the extent of transparency and EM in financial reporting. Arya et al. (2003) suggest that transparency in financial report serves the shareholders only up to a turning point; beyond that point, the increased transparency will tend to damage the interests of shareholders due to the lack of company privacy. In other words, a certain level of transparency in financial reporting motivates better performance, but too much may inhibit it adversely.

Ronen and Yaari (2008, p. 27) disagree and point out two main weaknesses of the definition of EM provided by Healy and Wahlen (1999). First, there is no clear separation between EM and normal activities that output earnings. Second, it is arbitrary to conclude that EM is harmful and misleading. To make up for the two deficiencies, Ronen and Yaari (2008) develop a three-part alternative definition of EM, where “Earnings management is a collection of managerial decisions that result in not reporting the true short-term, value-maximizing earnings as known to management. Earnings management can be beneficial, it signals long-term value; pernicious, it conceals short- or long-term value; neutral, it reveals the true short- term performance. The managed earnings result from taking production/investment

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actions before earnings are realized, or making accounting choices that affect the earnings numbers, and their interpretation after the true earnings are realized” (p. 27). Ronen and Yaari (2008) propose that EM can fit in all categories, being potentially beneficial, neutral, or pernicious.

Thus the definition of Ronen and Yaari (2008) tends to be more comprehensive in describing EM.