In line with the view that managers smoothearnings to maximize firm’s value, earnings smoothing also provides managers with the opportunity to withhold bad news. During good times, managers manage earnings downward, giving them opportunity to conceal bad news in the future. Graham et al. (2005) report that managers withhold bad news; in case things might turn around in the future, they may be able to bury the bad news. Similarly, Kothari et al. (2009) find that managers withhold bad news to a certain threshold, but disclosed good news as soon as possible. While their intention may be good (i.e. to increase firm’s value), earnings smoothing may lead to firm’s value being destroyed and putting firm at the risk of bankruptcy, especially when the news is particularly bad and managers cannot hoard the news any longer. Using firm-specific stock price crash, Chen et al. (2017) discover that earnings smoothing can lead to abrupt decline in stock price, due to managers dumping all bad news at once. Likewise, Khurana et al. (2017) find that real earnings smoothing influences stock price crash risk since real earnings smoothing facilitates bad news hoarding, allows poor-performing projects to continue, conceal resource diversion, and enables ineffective risk management for extended periods.
To empirically test the research questions, tax reserve data have been hand-collected from firms’ 2007-2010 annual reports (Note 2). The sample is limited to S&P 1500 Composite Index firms as of January 1, 2007. S&P 1500 index covers approximately 85% of the U.S. market capitalization and includes large, medium, and small cap firms. Consistent with Dhaliwal, Gleason, and Mills (2004) and Gleason, Pincus, and Rego (2017), this study investigates earnings management through tax reserves by examining the relationship between changes in tax reserves and pre-managed earnings (the earnings before the change of tax reserves), while controlling for other facts that might affect the changes in tax reserves. Findings are generally consistent with the expectations. I find evidence that non-large firms (firms with total assets less than $5 billion) are likely to make income-increasing changes in tax reserves when their pre-managed earnings barely miss the earnings forecasts, while large firms (firms with total assets of $5 billion or more) do not behave in the same way in the post-FIN 48 period. In addition, both large and non-large firms manipulate tax reserves to smoothearnings when their pre-managed earnings are far above or far below the earnings forecast. Moreover, evidence supporting the independence impairment hypothesis is provided through the analysis as the auditor providing more tax services to large clients facilitates earnings smoothing in the post-FIN 48 period (Note 3). This behavior does not exist within non-large firms as the auditor does not compromise independence for unimportant clients.
In fact, earnings as a final result of accounting process is influenced by procedures which are selected by managers. Selecting accounting procedures allow managers to decide about the time of recognition and measurement of costs and revenues. Managers are motivated to smoothearnings using various means such as asset sales. Since managers often can choose the sales period, the changes in the market value of assets are reported in the period of sale. Therefore, this is an opportunity for managers to manipulate earnings through timing of the sale of assets at relatively low cost (Bartov, 1993). Recently, there has been an increasing trend in investigating earnings management, which has been parallel with applying more strict regulations and less flexible accounting standards. Earnings management occurs when managers perform activities that depart from the first best obtainable practice or from standard business practices in order to meet certain objectives (Roychowdhury, 2006; Gunny, 2010).
demonstrate that if smoothed earnings reduce stock price fluctuation, then listed banks will have some incentive to smooth income to minimize stock price fluctuation and the volatility of stock return. This view argues that existing and potential investors view stable stock price as a good signal for high stock return, which in turn create incentives for managers of listed banks to smoothearnings to stabilize share prices. Anandarajan et al (2007) in their study compare the provisions-based income smoothing behavior of listed banks and non-listed banks in Australia. They find evidence that listed Australian banks use loan loss provisions to smooth income more than non-listed Australian banks, and conclude that listed Australian banks use provisions to smooth income for capital market reasons. Similarly, Leventis et al (2011) examine the case of listed European banks across 18 countries during the 1999 to 2008 period and document evidence that listed EU banks use provisions to smooth income but the income smoothing behavior is significantly reduced in the post mandatory IFRS period. Both study use bank earnings rather than stock returns to test for capital market motivations. With respect to African banks, Ozili (2015) examine listed banks in Nigeria and find evidence for income
In their survey of 401 financial executives, Graham et al. (2005) find that executives express a strong preference for smoothearnings. In investigation of the key underling factors, they find that executives believe that investors perceive firms with less volatile earnings to provide higher predictability of earnings. On the other hand, some maintain that earnings smoothing distorts information as a means of earnings management (e.g., Leuz et al., 2003; Bhattacharya et al., 2003; Barth et al., 2006). The discretionary applications of accounting rules and choices by opportunistic management have been found to induce earnings that are smoother or more volatile than cash flows (e.g., Dechow, 1994; Dechow and Dichev, 2002; Ball and Shivakumar, 2006). However, a large number of studies report that managers use earnings smoothing as a vehicle to reveal their private information. Theoretical and empirical studies show that earnings smoothing is informative (e.g., Arya et al., 2003; Demski, 1998). Hunt et al., (2000) show that earnings smoothing strengthens the contemporaneous price-earnings ratio and find evidence of the informativeness of earnings smoothing. Dichev and Tang (2009) investigate the link between earnings volatility and earnings predictability and show that earnings with low volatility have higher persistence and predictability. Tucker and Zarowin
Studies related to earnings smoothing have been around for more than six decades. However, the recent decades show the most development with more than 80 percent of studies in this field was published after year 2000. Following Hepworth's (1953) note that firms with smoothearnings signal stable corporate management to the shareholders and creditors, the study on corporate earnings smoothing has evolved ever since. Until recently, scholars have been trying to prove the existence of earnings smoothing activities (Beidleman, 1973; Boterenbrood, 2014; Khalil & Simon, 2014), figuring how (Atik, 2009; Francis et al., 2016) and when (Gassen et al., 2006; Gill de Albornoz & Alcarria, 2003) managers smoothearnings, characterizing earnings smoothing firms (Bigus et al., 2016; Bouwman, 2014; Z. Huang & Xue, 2016; Safdar & Yan, 2016; Silhan, 2014), and most importantly understanding the motivation (Goel & Thakor, 2003; Lambert, 1984; Trueman & Titman, 1988) and consequences (Houcine, 2017; Shubita, 2015; Tucker & Zarowin, 2006) of such behavior. This paper aims to review prior literatures, specifically on the role of earnings smoothing. Based on the discussion of the past literature, this paper also makes some suggestions for future research. To achieve these objectives, this paper reviews journal articles published in Web of Science database. A broad search was initiated based on the keywords used for the title. The literature of earnings smoothing is divided into 2 categories: (1) banks and (2) other business sectors. Since the regulations between banks and other sectors are governed by different policies (banks are governed by BAFIA Act while other firms are governed by Companies Act), the financial reporting practices between these firms are significantly different. Hence, this paper chooses to focus only on smoothing behavior in the latter category. In addition, the paper also does not review papers on dividend smoothing.
This paper starts with the observation that the wage led aggregate demand hypothesis has been tested in the UK using a variety of estimation procedures. Studies relying on equation-by-equation estimation procedures tend to ﬁnd support for wage led aggregate demand in the UK, while the single study using systems estimation ﬁnds no support for the hypothesis. In order to resolve this incongruity, we test the wage led aggregate demand hypothesis using VAR models estimated on quarterly data. We use a variety of data types, and take a relatively liberal approach to identiﬁcation. Particularly, we use a simple partial identiﬁcation strategy based on shocks to real earnings rather than the labour share. Our conclusions are unambiguous: all of our models indicate that positive shocks to real earnings increase both GDP and the labour share, indicating that aggregate demand in the UK is wage led. Thus our investigation provides support for the wage led aggregate demand hypothesis in the UK during the period of study.
Agency theory was first introduced by Jensen & Meckling , which explains the agency relationship as a contract between one or more parties (principal) that binds other parties (agents) to manage the company based on the principal’s benefit, including the delegation of decision-making authority to the agent. The focus of this theory is the agency conflict which arises due to differences in interests between principal and agent. Difference in information and conflict of interest between the principal and agent encourage the agent to give a false information to the principal. One of the agent’s doing is earnings management.
Second, Das et al. (2011) find managers are likely to use downward EXM as a substitutive tool when firms have constraints on using upward earnings management tools. Matsumoto (2002) suggests firms may experience negative market reactions if they walk down earnings forecasts too early in the period. Taken together, prior literature suggests firm managers are incentivized to initially use upward earnings management and switch to downward earnings guidance later in the period. Based on this evidence, I argue that firms that miss cash flow (accrual) forecasts in the prior period are likely to have difficulty in manipulating their reported cash flows (accruals) upwards to avoid negative cash flow (accrual) surprises. However, given the existence of cash flow (accrual) targets, firms’ managers have strong incentives to walk down cash flow (accrual) forecasts to a beatable level in the current period. Analysts are also relatively more likely to follow management guidance because downward cash flow (accrual) forecast revisions are more consistent with their past modus operandi than upward revisions.
The main contributions of this paper can be summarized as follows. Firstly, we provide a previously undocumented empirical explanation of the discontinuity observed at zero in the distribution of earnings relative to targets. Specifically, we report that accounting manipulation through DACC is a significant contributor to this discontinuity. Secondly, we quantify the extent to which firms achieve earnings targets with the aid of DACC. The evidence we report provides strong support for the use of DACC as a proxy for earnings management. However, this evidence also indicates that the extent to which, and direction in which, firms use DACC to manage earnings varies with the relationship between earnings before DACC and basic earnings targets. This has implications for the interpretation of previous studies, and design of future studies, using DACC to proxy for earnings management. The evidence we report also contributes to the literature examining the circumstances under which firms seek to manage earnings (e.g., Nelson et al. 2000).
One of the main characteristics of the Great Recession of 2008 was the reduction of labour earnings in many countries for a substantial number of employees. Although, this was particularly the case for European countries like Ireland, Spain, Portugal and Greece, other countries also experienced this trend (Jenknins et al, 2013). Apart from the obvious effects of pay cuts on purchasing power and living standards, falling labour earnings also affect psychological well-being and job satisfaction (for studies focusing on the link of earnings to well-being, see Sloane & Williams, 2000; Helliwell, 2003; Gasper, 2005; Clark, Frijters, & Shields, 2008; Studger, & Frey, 2010). Understanding the employees’ well-being is important because working exhibits a substantial psychological dimension for self-identity and sense of purpose. Furthermore, it contributes substantially to overall subjective well-being from a duration weighted perspective given that adults spend an average of about 33.6 hours per week at work (Kahneman et al., 2004; Tay & Harter, 2013). In addition, health and well-being at work are key dimensions of the overall European strategies for growth, competitiveness and sustainable development. It can be argued that low levels of health and job satisfaction are linked to falling worker productivity and to lower potential longevity and quality of life. In addition, work related stress is the focus of increased attention, as it can lead to incapacity for work (World Health Organization, 2011; Eurofound, 2012).
In comparison, we use panel data to investigate causality between variables. Panel data give unbiased and compatible estimations in comparison to time series data. As noted by Baltagi (2005), panel data give more informative data, more variability, less collinearity among the variables, more degrees of freedom, greater efficiency and so on. Our panel data includes 155 companies, while the BMH study has 70. According to BMH (2008) because of sensitivity to sample sizes, large sample sizes are required if conclusive results are to be reached. As noted by BMH, the size of the sample has an effect on the result of research. We conclude that for individual companies, causality exists between variables of earnings and variables from cash flow, but at the industry level this bidirectional relationship exists only between Profit Before Interest and Taxation (EBIT=X 1 ) and Cash Flow from Operating
The present study is based on a primary survey conducted in the city of Mandi in Himachal Pradesh, India. Mandi district is one of the educationally developed districts of Himachal Pradesh (Kaur, 2008). This district falls in mid-hill zone of the state and therefore the topography, climate conditions, access to resources as well as the cropping pattern, income and consumption pattern in this district bears similarities in some areas to that low hill zone, while in other areas to high hill zone of the state. The design of sample came out of the latest available electoral roll of Mandi town. The literacy rate of the town is quite impressive as per the census of 2011 (95.02 per cent). It is also the center of trade and commerce of the whole district. There were 9,947 households in Mandi town. The electoral divided the town in to 13 different wards. After arranging all the wards of town in ascending order on the basis of population, two wards have been selected at random which presents about 10 per cent of total households of the town. Stratified random sampling technique, strata being the level of education has been used in selecting the individual households from different wards. Basic information of educational attainment, earnings, experience, age, occupation and on the family background characteristics have been collected form 130 households which form 1.31 per cent of the total number of households in the city. Since present study is restricted only to the salaried employees and not on self- employed individuals, the households which fall in the latter category has been rejected and replaced by other in the sample list. The schedules have been administered by personal interviews with the head of household or if unavailable, with the senior most member of the households.
Information asymmetry reflects that managements of firms have better information on the value of the company’s assets and investment opportunities compared to shareholders (Copeland et al., 2005). Less informed investors may not be able to process the information compared to the investors who have more information; this situation creates asymmetry of information (Bhattacharya et al., 2013). Information asymmetry is manifested when informed traders have superior private information relative to uninformed traders in the finance market (Huang and Skantz, 2008). According Jayaraman (2008), information asymmetry factor influences earnings quality on the company’s performance. Bhattacharya et al. (2013) proved that lower is the earning quality, the lower is the liquidity of stocks in the capital market. This is because the risk of adverse selection that is realized in trading costs could be increase. If investors differ in their ability to process earnings-related information, then poor earnings quality can result in differentially informed investors and thereby exacerbate information asymmetry in financial markets (Diamond and Verrecchia, 1991; Kim and Verrecchia, 1994). Brown and Hillegeist (2007) found that better quality information reduces the information asymmetry by increasing the uninformed investor trading. Therefore, it reduces the possibility of trade private information. According to Easley and O’Hara (2004), investors need a higher return to hold stocks with greater private information with less public information. This higher return reflects that private information increases the risk to uninformed investors who hold the stocks and the informed investors are capable of shifting their portfolio based on the new information. Meanwhile, Abbasi et al. (2013); Ajward and Takehara (2011) asserted that there is a negative relationship between earnings quality and information asymmetry.
In our study we will consider, based on analysis of previous studies, that short sellers are informed traders. We solely consider both short sellers and institutional investor as informed traders but our analysis considers only short sellers, as we can only obtain daily information on short selling activities. Institutional investor activities are provided, but only quarterly; therefore, for the purpose of our study, we will only consider short sellers as informed traders. Investors by nature are forward looking, i.e. investors invest based on expectations of future cash flows, but expectations of future cash flows are also based on past performance. Investors extrapolate the expectations of future performance based on past performance. Investors, as noted in almost all earnings announcements, look at percentage increases in cash flows to base the price of a firm’s asset. Therefore, it is fitting that we model or research to consider benchmark stock prices as a proxy for past earnings increases in cash flow as a function of dividends (or earnings per share (EPS)). We apply Standardized Unexpected Earnings (SUE) to estimate earnings surprises. When actual earnings is eventually revealed during the quarterly earnings announcements, the revelation can either be one of three things, above consensus estimates, below consensus estimates, or in line with consensus estimates. The differentials between what the consensus is and what is actually revealed will be defined hereinafter as Unexpected Earning (UE):
The sample includes 3,287 firm-years, and Table 1 shows the descriptive statistics for each variable. The proxies of the companies’ growth, MB and SALESGR, have the minimums of 0.1538 and -49.9713 and the maximums 63.7075 and 49.9427, respectively. There is a thus huge spread between the highest and lowest values. MB and SALESGR have the means of 1.4934 and 5.1637 and the medians of 1.0965 and 5.3512. Because the mean and median of MB and SALESGR are similar, the data is not skewed, and there is an almost symmetrical distribu- tion. The proxies of earnings variability, StdROA and StdROE, have the minimums of 0.1463 and 0.0027 and the maximums 21.0498 and 3.4734, respectively, and thus a very large spread between the highest and lowest values. However, the mean of StdROA is 3.5057 and the median is 2.9765, with the distribution of earnings variability being weakly right-skewed. The proxies of the stock returns, RETURN and R3t, have the minimums of -87.2084 and -156.5391 and the maximums 2881.0573 and 2796.0395, respectively. There is an extremely large spread between the highest and lowest values. The means of RETURN and R3t are 3.5238 and 74.3257, and the medians are -4.4975 and 57.0998. The means of both variables are thus greater than the medians, and the distribution of stock returns is right-skewed. Because the standard deviations of RETURN and R3t are greater, this implies the stock returns of the sample firms are significantly different. The minimum and maxi- mum of the total assets growth rate (AG) are -46.05 and 341.04, respectively, and there is a huge spread be- tween these values. However, the mean and median of AG are 5.6097 and 3.69, respectively, and thus the distri- bution of the total assets growth rate is weakly right-skewed, although skewness is not serious problem in the data.