Program & Batch:

PGDM 2014-16

Term:

Course Name:

Managerial Accounting

Name of the faculty:

Topic/ Title :
Original

Dr. Ashish Varma

Journal Summary: Disclosure Quality and Earnings
Management
Original

or Revised Write-up:
Group Number:
Contact No. and email
of Group Coordinator:
Group Members:

9
9811351085 and ft14siddharthdhamija@imt.ac.in
Sl
.
1
2
3
4
5
6
7

Roll No.
1401-01170
1401-02002
1401-01055
1401-03089
1401-02096
1401-02101
1401-01181

Name
Siddharth Dhamija
Aalok Joshi
Gautam Aggarwal
Lahar Solanki
Priya Goel
Rahul Mishra
Surabhi Sharma

Disclosure Quality and Earnings Management

1. Summary

Paper gives empirical evidence on the relationship between financial disclosure and
earnings management of firms.
Prior research show that corporate disclosure is related to information asymmetry
between investors and managers, also, it indicated a relationship between information
asymmetry and earnings management.
With reference to these findings the author hypothesized that the extent of earnings
management is negatively related to the informativeness of corporate disclosure.
Author used rankings of firms overall disclosures published by the Corporate
Information Committee of the Association for Investment Management and Research
as a measure of the informativeness of corporate disclosure policies.
Author used discretionary accruals estimated with the modified Jones model as
measure of earnings.
Empirical analysis was conducted on a sample of 1,444 firms and observations were
over the 1990-1995 period.
A negative relationship can be seen between corporate disclosure and discretionary
accruals.
The results were consistent with the theoretical predictions and empirical findings of
prior research.
Results also provides empirical support for the SECs approach in curbing earnings
management. The SEC has been encouraging companies to disclose more information
citing reduced earnings management as the potential benefits of more information
disclosure.

2. Background and Hypothesis Development

Two streams of research that includes both analytical and empirical work provide the
underlying rationale for the hypothesis.
In first case the relation between information asymmetry and disclosure quality is
found.
Second research links earnings management to information asymmetry.
Together, these give predictions about the relation between disclosure quality and
earnings management.

2.1 Corporate Disclosure and Information Asymmetry

Glosten and Milgrom (1985) model show that information asymmetry decreases as
the level of corporate disclosure increases.
Welker (1995) provides empirical evidence consistent with above result. His findings
show that information asymmetry, is reduced and market liquidity increased as the
level of disclosure is increased.
Lang and Lundholm (1993) report show that disclosure levels are higher for for firms
that perform well , larger firms, and for firms with weaker earnings return relations.

They used correlation between earnings and returns as a measure of information

asymmetry.
A low correlation indicates that little information about firm value is captured by the
mandatory earnings disclosure, so remaining information asymmetry is high.
Firms have many incentives to disclose more information.
Expanded disclosure can improve intermediation for a firms stock in the capital
market.
Managers who wish to enhance the value of their firms can do so by communicating
to their superior, private information through increased disclosure.

2.2 Earnings Management and Information Asymmetry

Dye (1988) and Trueman and Titman (1988) show analytically that the existence of
information asymmetry between management and shareholders is a necessary
condition for earnings management.
Dye (1988) assumes that there exists overlapping generations of shareholders. Selling
shareholders allow management to follow a certain earnings management strategy to
create a favorable impression on the buying group.
Richardson (1998) found that the extent of information asymmetry, as measured using
the bid-ask spread. The dispersion in forecast is positively related to the degree of
earnings management.
As per Imhoff and Thomas (1994) report, if firms with more conservative reporting
engage in less earnings management, a negative relationship between earnings
management and corporate disclosure is present.
Firms engaging in less earnings management disclose more information and vice
versa.

2.3 Statement of Hypothesis

Hypothesis, is as follows:
Ha: Corporate disclosure and earnings management are negatively related.

Its validation will prove the negative relationship between disclosure and
opportunistic earnings management.

3. Data Requirements and Variable Measurement

3.1 Measuring Corporate Disclosure

Ratings of disclosure reported by the- Corporate Information Committee (CIC) of the

Association for Investment Management and Research during the 1990-1995 period is
used.
Ratings reflect assessments of analysts who specialize in specific industries about the
informativeness of disclosures made by firms in their respective industries.
Analysts evaluate the timeliness, details and clarity of the corporate disclosure.

The disclosure scores are based on a weighted average of analysts assessments of 3

dimensions of disclosure: annual published information, quarterly and other published
information, and investor relations and related aspects .
The weights assigned to these three categories range from 40-50 %, 30-40 %, and 2030 %, respectively.
Different groups of analysts rate disclosure policies of firms in different industries, so
author industry-adjusted the ratings by subtracting the mean rating for the industry to
which the specific firm belongs.

3.2 Measuring Earnings Management

Modified Jones model is the most powerful competing models for detecting earnings
management.
First measure total accruals. Employ two alternative measures of total accruals in this
study: 1) The traditional balance sheet approach. This facilitates an examination of the
sensitivity of results to the accruals measure.
Under this approach, total accruals are measured as follows:
TACCit = CAit - CLit - Cashit + STDEBTit - DEPTNit .............................(1)
where:
CAit = change in current assets during period t
CLit = change in current liabilities during period t
Cashit = change in cash and cash equivalents during period t
STDEBTit = change in the current maturities of long-term debt and other short-term
debt which is included in current liabilities during period t
DEPTNit = depreciation and amortization expense during period t.
Collins and Hribar (1999) found that studies using the balance sheet approach to test
for earnings management are contaminated because the balance sheet approach to
measuring total accruals introduces measurement error in the accruals.
They suggest that the cash flow method is a better way to calculate total accruals.
Under the cash flow approach, total accruals are measured as follows:
TACCit = EBXTit - OCFit ..............................(2)
where:
EBXTit = earnings before extraordinary items and discontinued operations for period
t
OCFit = operating cash flow for period t
Discretionary accruals (DACC) = difference between total accruals (TACC) and
nondiscretionary accruals (NDACC).
To estimate nondiscretionary accruals, first estimate the Modified Jones model,
TACCit = 1(1/Ai,t-1) + 2(REVit - RECit) +3PPEit + it .................................
(3)
where:
TACCit = total accruals for firm i in year t divided by total assets for firm i at the end
of year t-1,
REVit = change in revenue for firm i in year t divided by total assets for firm i at the
end of year t-1,
RECit = change in net receivable for firm i in year t divided by total assets for firm i
at the end of year t-1,

PPEit = property, plant and equipment for firm i in year t divided by total assets for
firm i at the end of year t-1.

Equation (3) is estimated each year using ordinary least squares(OLS) estimation. The
estimates of 1, 2, and 3 obtained from these regressions are then used to estimate
nondiscretionary accruals as follows:
NDACCit = 1(1/Ai,t-1) + 2 (REVit - RECit) + 3 PPEit .......................(4)
Discretionary accruals being estimated as:
DACCit = TACCit - NDACCit ......................(5)

3.3 Model for Testing the Hypothesis

It is unclear whether managements disclosure decision results from its choice of

disclosure policy or from desire to allow itself flexibility to manage earnings.
To account this simultaneity, the relation between disclosure quality and earnings
management is estimated using following simultaneous equation system:
DACCit = 0 + 1DPit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit +
it .............................(6)
DPit = 0 + 1DACCit + 2SIZEit + 3VWRETit + it ................................(7)
where:
DACC = discretionary accruals,
DP = disclosure policy,
CRP = current industry relative performance (based on current period net income
deflated by beginning total assets),
FRP = future industry relative performance ( based on next period net income deflated
by beginning total assets),
LEV = total liability over total assets,
SIZE = market value of the firm at the beginning of the year,
VWRET = market adjusted stock return.
Equation (6) specifies discretionary accruals (DACC), as a function of disclosure
policy (DP), and four exogenous variables that prior research indicates are related to
discretionary accruals. Equation (7) specifies disclosure policy as a function of
discretionary accruals and two exogenous variables that have been identified in prior
research.
Two-stage least squares (2SLS) method is used to estimate this two-equation system.
In the first stage, regress DP on DACC and all the exogenous variables in equations
(6) and (7), i.e., on SIZE, VWRET, CRP, FRP and LEV. In the second stage, estimate
equation (6) using the fitted value of DP from the first stage regression. The use of
OLS in the second stage provides consistent estimates of the parameters in equation
(6) since the fitted value of DP from the first stage is uncorrelated with the error term
in the second stage regression.

3.4 Data Requirements and Sample Description

To get included in the sample, firms should have disclosure policy scores available in
the 1990-95 AIMR reports.
These disclosure policy ratings serve as dependent variable.
Sample firms are required to have data available in Compustat for estimating
discretionary accruals, and should have data available in Compustat/CRSP for

measuring the control variables. The effects of these data requirements on sample size
are summarized in Table 1.

Table 1
Effect of Selection Criteria- Sample Size

Initial sample

199
0
563

199
1
559

199
2
498

199
3
341

199
4
295

199
5
275

Tota
l
253
1
18

Canadian banking

NA

NA

NA

Banking

75

75

50

NA

NA

NA

200

Savings institutions

NA

NA

NA

NA

14

Financial services

14

13

13

16

NA

NA

56

Insurance

28

30

35

31

29

28

181

Natural gas

23

23

23

23

21

12

125

Diversified companies

13

12

12

10

NA

NA

47

Software services

15

10

25

Computer and electronics

15*

15*

NA

NA

NA

NA

30

Data are not available from Compustat/CRSP

73

92

75

54

46

51

391

Remaining sample

315

299

283

201

178

168

144
4

NA: not applicable in that

year R: ranked in that
year
*: not ranked in that year

Table 2 reports descriptive statistics for the independent, dependent and control
variables. The disclosure policy rating is a weighted average of the scores received for
each of the three disclosure dimensions evaluated.
The score received for a given measure is computed as the ratio of points received to
total points assigned to that dimension. This allows to aggregate scores across
industries with different weights assigned to each dimension, while still preserving
any inter-industry differential weighting across the three dimensions.
The mean disclosure policy rating for sample is 70.38. This is close to the mean rating
of 70 from Lang and Lundholms (1993) sample, which had used data from 1985-89.

The lower quartile of disclosure was 61 and the upper quartile of disclosure was
81.11. The mean and median for the three components of disclosure for annual
disclosure are 70.91 and 72.5, respectively; for quarterly disclosure 69.94 and 71.6,
respectively, and for investor relations disclosure 72.39 and 74.4, respectively. The
mean and median discretionary accruals for the balance sheet approach were 0.005
and 0.006, respectively and for the cash flow approach were 0.001 and 0.00,
respectively. Median firm size was $2.26 billion. The lower quartile and upper
quartile of the firm size were $704.13 million and $6.1 billion, respectively. The mean
and median leverage were 0.58 and 0.57, respectively. The average return is 15% and
the mean and median of market adjusted return are 0.02 and 0.02, respectively.
Table 2
Descriptive Statistics for Exo and Endogenous Variables

Variable

Mean

Std Dev

DP

70.38

14.43

Lower
Quartile
61

ANN

70.91

14.16

61

72.5

82

QRT

69.94

15.85

60

71.6

81.48

INV

72.39

15.90

62.67

74.4

85

DACCBS

-0.005

0.07

-0.03

-0.006

0.02

DACCCF

-0.001

0.07

-0.03

0.00

0.03

CRP

0.04

0.09

-0.01

0.03

0.08

FRP

0.02

0.08

-0.01

0.02

0.05

SIZE(Millions)

5720.89

9942.41

704.13

2264.64

6099.42

LEV

0.58

0.20

0.47

0.57

0.68

RET

0.15

0.44

-0.10

0.08

0.32

VWRET

0.02

0.40

-0.20

-0.02

0.16

Variable definitions:
DP: disclosure
policy ANN:
annual disclosure
QRT: quarterly
disclosure
INV: investor
relations
disclosure
DACCBS: discretionary accruals being calculated using balance sheet
approach DACCCF: discretionary accruals calculated using cash flow
approach

Medium
71.8

Upper
Quartile
81.11

CRP: current- industry relative performance;

FRP: future - industry relative performance
SIZE: market value of the firm at beginning of the year
LEV: total liability over total
assets RET: current years
return
VWRET: market adjusted stock return

4. Empirical Results
4.1 Simple Correlations
Analysis is done using ranked data. First rank the dependent, independent and control
variables by industry and by year.
Then convert the ranks to percentiles using the transformation (rank - 1)/(number of
firms-1).
This gives the percentile equivalent of a firms rank within its industry. For each
variable, the lowest ranked firm gets a one in each industry and highest ranked firm
gets a zero.
Table 3 presents correlations between the transformed dependent, independent and
control variables. Consistent with hypothesis, disclosure policy is negatively related to
discretionary accruals. The correlation coefficient of -0.07 is less than zero (p = 0.01).
Disclosure policy is positively related to firm size (p = 0.01). Disclosure is positively
correlated with stock return.
The balance sheet and cash flow based measures of discretionary accruals are highly
positively correlated.
Neither variable is positively related to future relative performance.
Both measures of discretionary accruals are negatively correlated with leverage but
only the cash flow based measure of discretionary accruals is reliably negatively
correlated with firm size.
Table 3
Correlation among Endo and Exogenous Variables*
DACC
CF
DACC
BS
DP
ANN
QRT
INV
CRP
FRP

DACC
BS
0.62
(0.01
)

D
P

0.0
(0.
01)
0.0
(0.
02)

A
N
0.0
(0.
03)
0.0
(0.
02)
0.
82
(0.
01)

QR
T
0.0
(0.0
2)
0.0
(0.2
8)
0.8
1
(0.0
1)
0.6
3
(0.0
1)

IN
V
0.0
(0.0
1)
0.0
(0.0
3)
0.7
7
(0.0
1)
0.5
2
(0.0
1)
0.5
2
(0.0
1)

CR
P
0.4
(0.0
1)
0.3
(0.0
1)
0.1
3
(0.0
1)
0.1
5
(0.0
1)
0.1
0
(0.0
1)
0.1
2
(0.0
1)

FR
P
0.0
1
(0.6
6)
0.0
2
(0.4
0)
0.0
9
(0.0
1)
0.1
0
(0.0
1)
0.0
3
(0.2
2)
0.0
9
(0.0
1)
0.5
1
(0.0
1)

LE
V
0.1
(0.0
1)
0.1
(0.0
1)
0.0
7
(0.0
1)
0.0
2
(0.5
7)
0.0
9
(0.0
1)
0.0
8
(0.0
1)
0.2
(0.0
1)
0.3

SIZ
E
0.03
(0.1
9)
0.06
(0.0
2)
0.2
3
(0.0
1)
0.2
3
(0.0
1)
0.1
6
(0.0
1)
0.2
0
(0.0
1)
0.2
5
(0.0
1)
0.2
2

VWR
ET
0.0
2
(0.5
2)
0.03
(0.2
8)
0.11
(0.0
1)
0.0
8
(0.0
1)
0.0
6
(0.0
3)
0.1
3
(0.0
1)
0.2
1
(0.0
1)
0.2
7

LEV
SIZE

(0.0
1)

(0.0
1)
0.01
(0.7
3)

(0.0
1)
0.05
(0.0
4)
0.03
(0.1

* Figures in parentheses are p-values

4.2 Regression Analysis

4.2.1 Aggregate Disclosure Ratings

Panels A and B of Table 4 provides the results of estimating equations (6) and (7) as a
system of simultaneous equations.
Panel A reports results for discretionary accruals measured using the balance sheet
approach. Panel B presents results for the cash flow approach to measure
discretionary accruals.
To examine the sensitivity of estimation results ordinary least squares (OLS)
estimation results of equations (6) and (7) is used in panel C.
The 2SLS estimation results for equation (6) in panels A and B provide evidence in
support of hypothesis.
1, the coefficient relating disclosure policy and discretionary accruals, is less than
zero at the p = 0.01 level. This indicates that firms that disclose more information
engage less in earnings management.
The coefficient estimates of the exogenous variables in equation (6) are also
consistent with predictions. (CRP) and leverage (LEV) are each negatively related to
discretionary accruals, future relative performance (FRP) and firm size (SIZE) are
positively related.
Equation (7) also support the hypothesis. 1 is negative, implies firms that engage
more in earnings management disclose less information or information of lower
quality. Firm size (SIZE) and market adjusted return (VWRT) are positively related
to disclosure policy.
Panel C presents the OLS estimation results for equations (6) and (7). Results are
reported only for the cash flow approach because they differ little from the results of
the balance sheet approach.
OLS results is compared to the 2SLS results for the cash flow approach that are
contained in panel B. Comparison indicates little difference in the coefficient
estimates, 2 and 3, in equation (6).
The estimated OLS coefficient on discretionary accruals, 1, is 0.07 compared to an
estimate of 0.12 when the effects of potential simultaneity are considered.
The 2SLS estimation procedure reduces measurement error, resulting in a larger
absolute value estimate of 1.
The OLS estimate of 1 in equation (6) is only 0.02, 2SLS estimate is 0.82.
OLS estimate is not sufficiently negative to support the hypothesis of a negative
relation between discretionary accruals and disclosure policy, whereas, the 2SLS
estimate indicates rejection at 0.01 level of significance.

Table 4
Relation Between Discretionary Accruals & Overall Disclosure Policy
Panel A: Simultaneous Equation Estimation (2SLS) (Accruals are measured using
Balance Sheet Method)
Equation (6): DACCBSit = 0 + 1DPit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it
0

Coefficient

0.96

-0.86

-0.43

0.25

-0.07

0.19

t-statistics

10.72

-2.87

-9.13

6.38

-1.60

2.59

Equation (7): DPit = 0 + 1DACCBSit + 2SIZEit + 3VWRETit + it

0

Coefficient

0.41

-0.17

0.23

0.11

t-statistics

11.61

-3.36

8.55

4.26

Relation Between Discretionary Accruals & Overall Disclosure Policy

Panel B: Simultaneous Equation Estimation (2SLS Estimation)
(Accruals are measured using Cash Flow Method)
Equation (6): DACCCFit = 0 + 1DPit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it
0

Coefficient

0.98

-0.82

-0.60

0.31

-0.10

0.24

t-statistics

12.04

-3.03

-14.09

8.29

-2.52

3.85

Equation (7): DPit = 0 + 1DACCCFit + 2SIZEit + 3VWRETit + it

Coefficient

0.38

-0.12

0.23

0.12

t-statistics

13.79

-3.36

9.15

4.70

Relation Between Discretionary Accruals & Overall Disclosure Policy

Panel C: OLS Estimation
(Accruals are measured using Cash Flow Method)
Equation (6): DACCCFit = 0 + 1DPit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it
0

Coefficient

0.76

-0.02

-0.66

0.28

-0.18

0.08

t-statistics

33.05

-1.19

-25.56

10.70

-7.92

3.55

Equation (7): DPit = 0 + 1DACCCFit + 2SIZEit + 3VWRETit + it

0

Coefficient

0.35

-0.07

0.23

0.12

t-statistics

14.84

-2.93

9.23

4.68

4.2.2 Component Disclosure Ratings

The relation between dimensions of disclosure policy and earnings management is

done using the simultaneous equation approach.
Table 5 presents results of the relation between each dimension of disclosure and
earnings management.
The negative relation between the measure of disclosure policy and discretionary
accruals is similar across the three components of corporate disclosure.

Table 5
Relation Between Discretionary Accruals & Disclosure Policy Ratings (2SLS
Estimation)
Panel A: Relation Between Discretionary Accruals & Annual Disclosure and
(Accruals are measured using Cash Flow Method)

Equation (6): DACCCFit = 0 + 1ANNit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it

0

Coefficient

1.42

-2.20

-0.46

0.37

-0.07

0.51

t-statistics

5.16

-2.52

-3.96

4.50

-0.82

2.69

Equation (7): ANNit = 0 + 1DACCCFit + 2SIZEit + 3VWRETit + it

0

Coefficient

0.40

-0.13

0.23

0.08

t-statistics

13.78

-3.27

8.36

3.07

Relation Between Discretionary Accruals & Disclosure Policy Ratings Components

(2SLS Estimation)
Panel B: Relation Between Discretionary Accruals & Quarterly Disclosure
(Accruals are measured using Cash Flow Method)
Equation (6): DACCCFit = 0 + 1QRTit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it
0

Coefficient

1.64

-2.78

-0.43

0.30

0.15

0.44

t-statistics

3.97

-2.20

-2.92

3.13

0.86

2.32

Equation (7): QRTit = 0 + 1DACCCFit + 2SIZEit + 3VWRETit + it

0

Coefficient

0.45

-0.13

0.15

0.06

t-statistics

15.35

-3.36

5.48

2.27

Relation Between Discretionary Accruals & Disclosure Policy Ratings Components

(2SLS Estimation)
Panel C: Relation Between Discretionary Accruals & Investor Relation Disclosure
(Accruals are measured using Cash Flow Method)

Equation (6): DACCCFit = 0 + 1INVit + 2CRPit + 3FRPit + 4LEVit + 5SIZEit + it

0

Coefficient

0.88

-0.48

-0.64

0.33

-0.12

0.14

t-statistics

12.42

-2.03

-16.92

9.86

-2.95

3.01

Equation (7): INVit = 0 + 1DACCCFit + 2SIZEit + 3VWRETit + it

0

Coefficient

0.39

-0.12

0.20

0.13

t-statistics

13.51

-3.13

7.22

4.63

5. Summary and Conclusions

The study examines the relationship between disclosure quality and earnings
management.
It hypothesizes that disclosure quality and earnings management are negatively
related.
It uses ratings published by AIMR to measure disclosure quality.
It uses discretionary accruals from the Modified Jones model to measure earnings
management.
The empirical analysis show that corporate disclosure and earnings management are
negatively related.
Firms with lower disclosure ratings tend to engage more in earnings management and
firms engaging more in earnings management tend to have lower quality disclosures.
If earnings management is opportunistic, the predicted relation is negative.
If earnings management is for information communication, the predicted relation is
positive.
These results help policy-making bodies that set minimum disclosure requirements
for firms.
These requirements may play a significant role in a firms ability to manage its
earnings.
It provides empirical support to the SECs approach to earnings management.
When managers engage less in earnings management, the earnings is higher, and
managers disclose more information.