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EARNINGS MANAGEMENT: A REVIEW OF LITERATURE

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 EARNINGS MANAGEMENT: A REVIEW OF LITERATURE

a b
Imen MAHJOUB and Anthony MILOUDI
a
Doctorante - Université de Poitiers, Centre de recherche sur l'intégration
économique et financière (CRIEF)
Poitiers-France
imen.mahjoub@univ-poitiers.fr
b
Professeur Associé en Finance, Groupe Sup de Co la Rochelle (CRIEF,
EA 22493), Université de Poitiers
Poitiers-France
miloudia@esc-larochelle.fr

Abstract
Research on the quality of accounting information was developed following the
increase in the number of financial scandals in recent years. Earnings
management, indeed, is one, of the most widely forms used, usually by the managers to
fulfil a number of objectives by manipulating accounting data. Prior studies define
earnings management as a manner of influencing the income of firm by using
the discretionary accruals. The empirical literature on earnings management is
extensive and obviously the evidence of earnings management has been
examined in the context of different events. This paper provides a literature
review of earnings management based on five theories that explain the use of
earnings management: the signal theory, the agency theory, the positive
accounting theory, the threshold theory and the entrenchment theory.
Keywords: Earnings management, Positive accounting management, Signal, Agency
theory, Entrenchment theory.
JEL Classification: M41; G320

1. INTRODUCTION
Earnings management is defined as a “purposeful intervention in the
external financial reporting process with the intent to obtaining one private
gain” (Schipper, 1989). Earnings management, therefore, occurs through
manipulations in accounting tools such as balance sheet and income statements,
yet, these changes, though comply with the law, may mislead some stakeholders
(Wu, 2014). While this definition highlights the opportunistic aspect that drives
the executive to adopt such behaviour, many others consider earnings
management as a means to bring value to shareholders.
The review of the literature has revealed that earnings management is
defined from two perspectives; opportunistic perspective and an informational
perspective. The first one considers earnings management as an opportunistic
tool used by managers to avoid certain situations that may affect the company
and then mislead investors about the situation of the company. In this way,
through the increase or decrease of income, managers transmit to investors that
outcomes were being met and they will be compensated by a maximizing of
personal profit. This opportunistic aspect of earnings management supports the
positive accounting theory (which will be discussed below). Similarly earnings
management provides some security to managers because it displays for better
incomes even during difficult times of the firm and this preserves to executives
to maximize their profit and maintain their positions or their jobs.
The informational perspective, considers earnings management as a tool to
signal private information related to the company’s future performance to the
capital market. This optimistic analysis is often noticed before some capital
transactions such as mergers acquisitions (Erickson & Wang, 1999).
According to this perspective, earnings management can be defined as any
decision of reasonable, legal and appropriate management that provides value to
stakeholders. Once the earnings management is carried out through
management measures, it allows reaching the objectives. Thus, informational
aspect supports the signal theory.
The graph below provides a summary of the definition of earnings management.
Figure 1: Definition of earnings management

Accounting choice Specific operations

Earnings Management

Opportunistic perspective Informational perspective

The positive accounting

The signal theory
theory
(Source: inspired by the schema of Stolowy & Breton, 2003, p.132)
 Our paper contributes to the literature of earnings management by
providing (1) a literature review of the different motivations that lead to manage
the result, and (2) an analysis of the main theories that explain the use of such
tool.
The rest of the paper is organized as follows: sections 2 provides different
incentives of earnings management. Section 3 reports the hypothesis of earnings
management, and section 4 concludes the paper.

2. INCENTIVE OF EARNINGS MANAGEMENT

The excessive use of earnings management leads us to raise the following
question: What are the principal incentives of earnings management?
The review of the academic literature revealed three main motivations which
encourage the manager to follow such behaviour. We distinguish first,
incentives related to executives, second, incentives associated with the company
and third, incentives linked to investors and financial analysts.

2.1. Incentives related to company executives

The motivation to manipulate the result may be influenced by factors
related to manager himself. Indeed, the company can experiences hardships
when it is weak in its performance. Having planned and announced incomes
different from those anticipated, managers can choose to manage their results
upward to save their reputations, their jobs (Sun et al., 2013), and may even
receive a premium and increase their chances in the job market (Fortin at al.,
2011). They can also participate in the company's capital if there is a
compensation system based on the results achieved. (Mc Nichols & Wilson,
1988, Jeanjean, 2001 and Mard, 2004).
Ashiq and Weining (2015) studied earnings management in the early years
of the executives service and affirmed that new managers increase the result to
improve their ability in the market.

2.2. Incentives related to the company

Earnings management may be influenced by endogenous variables
related to the company itself. Indeed, Mard (2003) outlined four main objectives
that can incite to manage earnings. Firstly it is used to avoid losses: managers
performing a negative result or a result close to zero, seek to avoid these losses
by using earnings management. Indeed, a result equal to zero or slightly
positive will be better appreciated than a slight loss. Secondly is also used to
avoid declines of the result: the desire to present a boost result is an incentive to
executives to manage the result. This behaviour is explained by the premium
assigned by the market for companies with regularly growing results (Myers &
Skinner, 1999). Thirdly earnings management is used to achieve earnings
forecasts: this goal is an incentive for executives to manage earnings to correct
forecasting errors. The use of earnings management as correcting tool forecast
by managers limit losses that can be generated (Kasznik, 1999). The last
objective is to reach a psychological result. This hypothesis takes its inspiration
from the field of marketing. The price of a product that costs 199€ will be more
attractive than 201€. Mard (2003) used the same principle but he reversed the
process. Therefore, the announcement of a result of 201€ instead of 199€ will
be better appreciated in the market as individuals memorize primarily the first
number of the result. Thus the leaders manipulate the result upward to achieve a
psychological result.

2.3. Incentives related to investors and financial analysts

In some situations, executives apply earnings management not to
disappointing investors. This behaviour is justified by the desire to save and
maintain the company’s good reputation by trying to realize theirs commitments
to stakeholders 1. Thus, executives are compelled to engage in certain earnings
management to meet investors' expectations for future growth. By using
earnings manipulation tool, managers hide the real value of their company in
order not only to encourage investors to invest in the firm as a shareholder or as
a creditor but also to influence investors about the current and future prospects
of the company (Lamrani, 2012 and Chan and Gao, 2014). Dechow et al. (1996)
confirms this idea by asserting that one of the motivations for the use of
earnings management is to attract external funding with the least cost.

3. THEORETICAL APPROCHES OF EARNINGS MANAGEMENT

Earnings management is increasingly used by manager in their companies.
According to Sellami & Adjaoud (2010), 23% of French companies actually
manage their results. Affecting both the richness of the executives and that of
other market participants, earnings management is no longer a simple tool but
also a strategic element that influence the investment decision and the resource
allocation of different stakeholders. Several theoretical approaches have tried to
explain the use of this strategic tool. Indeed, a review of the literature has
allowed us to identify five theories explaining motivations for earnings
management: the positive accounting theory, the signal theory, the threshold
management theory, the agency theory and the entrenchment theory.

3.1. The signal theory

The signal theory considers that the same information is not shared by all
economic agents. Indeed in the reality of market economies, there is a lot
imperfect information between various stakeholders within the company (Myers
& Majluf, 1984). Thus managers are considered as the most informed party on
the future prospects of the company because they have some privileged
information that allows them to emit a signal to different investors and market
participants. Initiated by Spence (1973), the theory of signal was then developed
by Ross (1977), which examined the relationship between managers and

1
According to Breton & Schatt (2004), stakeholders in addition to shareholders, are also bankers, employees,
customers, suppliers or public authorities and all citizens.
investors in a context of asymmetric information. By having information about
the expectations and future prospects of the firm, managers can use earnings
management by increasing reported earnings and thus report the correct
performance of the company. Deprived of this information, the market is
dependent on both the behaviour of leaders and the published results to be able
to formulate its own expectations (Aerts et al., 2013). Therefore, through these
accounting practices, managers may report and share private information of the
future performance of the company. This leads to the alignment of market
expectations with those of the managers (Sun et al., 2013). According to Xue
(2004), only companies that have growing opportunities can manage their result
to send signals to the market and investors. In the same sense Altamuro et al.
(2005) reported that the use of earnings management is explained by the fact
that the managers want to give relevant information about the future
performance of the company.
The literature devoted to the signal theory reveals two types of signals:
informational and opportunist signal. The first type supports the idea that
managers having privileged information choose to communicate this
information to the market in order to adjust the values of securities and thereby
reflect the real value of the company and this reduces the information
asymmetry between the different actors on the capital market. According to
Ahmed et al. (1999), companies with high growth prospects use earnings
management to report these investment opportunities. The second type of
signal, opportunist, considers that managers can use this type of signal to
camouflage unprofitable investments and mislead investors in order to obtain
personal gain as job security or to maximize their wealth through salary bonus
based on the result. This type of behaviour refers us to the theory of
management thresholds which may explain the false signals from executives to
achieve some result thresholds (this theory will be presented below).
Finally, other researches consider that firms choose to reduce or increase
their results to look like other firms or rather to be distinguished from others
(Chalayer-Rouchon et al., 2001). So through earnings management a company
sends some signals to compare itself to other companies or to the sector.

3.2. The agency theory

The agency theory was initiated first by Ross (1973) and developed by
Jensen & Meckling (1976). It treats the relationship between an officer and a
principal. This theory is founded on the divergence of interests and information
asymmetry between these two parties. In fact the agent (manager) acts in
egocentric manner to maximize his/her wealth to the detriment of the principal
(shareholder). So there is a transfer of wealth from the company to the manager
(Jensen & Meckling, 1976).
According to the agency theory, managers seek to maximize their personal
utility to the detriment of other stakeholders. In order to reduce this behaviour
and motivate them to take care of the right company management, managers are
paid according to achieved result. This generates an incentive for managers to
manage earnings to maximize their personal wealth. This point is supported by
Jensen & Meckling (1976) when they argue the greater the percentage of capital
held by the manager, the greater the deviation from the traditional objective of
maximizing the value is low and the company is performing consequently well.
However, focusing on their own interests, leaders can manage earnings to
strengthen their positions by neglecting the interests of other internal and
external investors which can intensified conflicts between managers and
shareholders rather than mitigate it. Indeed, the divergence of interests between
shareholders and managers encourages the creation of compensation contracts
based on the income of the company. Thus to increase their remuneration and
benefit from these contracts executives tend to manage their results upward and
maximize their well-being by presenting to shareholders the results they were
expecting. In addition, in order to limit expenditure and unnecessary spending
of managers, shareholders proceed to allocate charges. This distribution causes
pressure on the managers and stimulates them measures to reduce their costs.
Hence, leaders can use earnings management to defer some of these charges and
show their good management.

3.3. The positive accounting theory

The political-contractual theory, also called positive accounting theory is
one of the most theories cited in the literature. Initiated by Watts & Zimmerman
(1978 and 1986), the positive accounting theory consists of different accounting
practices used to affect the result of the company. So that managers can adopt
two types of behaviour: opportunistic behaviour by favouring their interest at
the expense of other stakeholders, and behaviour intended to apply accounting
standards efficiently to maximize the company’s value.
Watts & Zimmerman (1986) suggested three explanatory factors that can
explain the use of earnings management: compensation, debt and the size.
a/ Compensation: According to the criterion of compensation, executives
choose to accelerate and increase earnings in order to maximize their wealth
especially if there is a straightforward relationship between the ratio of
compensation and the results achieved. Jeanjean (2002) indicated that such
steps are expected to improve the welfare of the manager though the interest of
other stakeholders may be affected.
However, the incentive based on compensation contracts is not always
valid: incentive contracts are commonly used in the USA, but are rarely used in
Europe (Jeanjean, 1999). The table below shows some figures about the
constitution of executive pay in different countries.

Table 1: Comparison of Wages composition in different countries

Country USA France UK Germany Italy Belgium

executive salaries
Percentage of variable part 61% 23% 34% 22% 23% 13%

Percentage of fixed part 39% 77% 66% 78% 77% 87%

(Source: Table inspiration from Jeanjean, 1999, p. 23)

The compensation is no longer a factor to earnings management once the
maximum result is achieved and managers will no longer receive bonus for the
achieved result. According to Healy (1985) the compensation criterion is not
automatic once the payment of managers is capped.
b/ Debt: Indeed, through the executive incentive systems based on
compensation indexed on the income of companies, shareholders seek to align
their interests with those of managers. This behaviour can harm the creditors
since it can lead to a transfer of wealth to the shareholders in the detriment of
creditors. The latter can protect themselves against this opportunistic behaviour
of shareholders through managers by the limitation clauses in debt contracts
(such as the limitation of dividend distribution policy or the level of the debt
ratio). Thus two explanations justify the introduction of contractual clauses: (1)
preventing the transfer of wealth from creditors to shareholders through the
limitation of the dividend rate and (2) restraining the transfer of wealth from old
to new creditors’ by increasing the level of debt (Avelé, 2013).
According to Duke et al. (1995), three contract terms are used in the
United States: (1) requiring a minimum level of non-distributable earnings, (2)
compelling a minimum level of working capital, (3) commanding a maximum
debt level. Below these clauses no new debt can be taken. Exceeding these
clauses causes the renegotiation of the debt which generates additional costs or
may allow the creditors to take the company’s control. Thus to move away from
a situation where the contractual limits are close, executives use earnings
managements to prevent the violation of debts covenants.
The debt assumption has also been criticized by Jeanjean (1999) as it
does not include the cultural context of the country. Indeed, in some European
countries, these contractual clauses are not in common use, for example the use
of contractual clauses debt is very rare in France, unlike the United States where
they are widespread. Thus the study of Jeanjean (2001) conducted on companies
listed on the Paris Stock Exchange has not validated the positive theory; the
author explains this result by the difference in economic and social context
between the United States and France.
c/ Size: The third criterion refers to the "size" of the company (Ben Othman et
al., 2007). The latter was considered by many studies as a factor motivating
executives to manage earnings downward. In their research, Watts &
Zimmerman (1978 and 1986) and Healy & Whalen (1999) have argued that
since the companies could generate enough important results, they are more
likely to be monitored and to avoid violating antitrust law and to evade
sanctions of the state, the big firms are obliged to supervise or even reduce their
results through the use of earnings management.
 Jeanjean (1999) disapprove this criterion: first the size of the company may
present other aspects than an indicator for the presence or not of political costs
such as good management can show the competence of executives. Moreover
jeanjean (1999) criticizes the tool used to measure the size of the company (total
assets), he believed that this tool is dependent on accounting measurement mode
and financing strategies. In the same way, the study of Turki & Abdelmoula
(2007) conducted on the Tunisian market has shown that big companies are not
trying to diminish their political visibility by reducing their results. On the
contrary they are indifferent to the risk of political costs. They explain the
rejection of that criterion by those firms’ interest in other issues as reducing the
risk of violation of debts covenants.

3.4. The threshold management theory

According to the theory of management thresholds of Burgstahler &
Dichev (1997) the company's managers use earnings management to reach a
level of expected result called "threshold". Burgstahler & Dichev (1997) were
the first researchers who examined the irregularities in the distributions of
accounting results. They note the existence of two types of thresholds: the
threshold of zero result (to avoid losses) and the threshold of variation nil of the
result (avoiding the decrease in income), yet the study by Degeorge et al. (1999)
has allowed to add a new threshold: the threshold of analysts' expectations.
Analysts in the financial market use these thresholds as a tool to evaluate
the performance of companies. Thus, the presence of irregularities around its
threshold was interpreted as a manipulation of the accounting result. Companies
manage their results to reach or even exceed these thresholds (Vidal, 2010). In
fact, executives avoid publishing a loss and prefer a null result or even a weak
positive result. From a sample of 294 French listed companies, Mard (2003)
found that between 35% and 48% of companies with risk of loss run their
profits to create positive gains.
Apart from maximizing their compensation, managers have interest to give
a good image of their managements which encourage them to manage earnings
in order to realize or exceed objectives (thresholds), (Aerts et al., 2013) and thus
maintain their good reputation and increase their demand on the job market.
Degeorge et al. (1999), attempted to rank the three thresholds mentioned in
the literature by treating the psychological effect of negative numbers on
investors. These authors considered a preference firstly for a weakly positive
result then a result in growth and finally the respect for predictions. Considering
from the psychological principle that the human mind experiences a natural
aversion to negative numbers, it is more pleasant to executives to announce
positive results than negative, null or declining results. This behaviour was
explained by the cognitive theory of Schelling (1960) who claimed that the
human mind makes a big difference between positive numbers and negative
ones. This prevents managers from publishing negative results and encourages
them to find their accounting tools to prevent such result.
 Finally, the realization of thresholds indicates the stability and the growth
of the financial performance of the company (Jiang, 2007). Which helps firms
to reduce the cost of debt. Draief Chouaya (2008) tested whether the
achievement of benchmarks is appreciated by creditors or not and the results
showed that the market attributes a lower cost of debt to companies that achieve
their objectives.

3.5. The entrenchment theory

Entrenchment is to strengthen the presence of leaders within the company
by making their replacement expensive and difficult. Through their
managements, managers will try to increase their discretionary position to
maximize their welfare and obtain significant compensation. Thus through
entrenchment strategies the presence of the executives is indispensable.
Earnings management is based on the theory of entrenchment. Indeed, by
holding some shares in the company, the manager's interest converges with that
of shareholders, so we expect a correct management of the result. However,
according to the entrenchment theory, the shareholder-manager may act on
his/her own interests by trying to increase his/her share in capital through
earnings management (Mard & Marsat, 2009).
The study by Klein (2002) shows a positive relationship between earnings
management and participation of executives in the capital. He explains the use
earnings management to increase their share of capital held. This type of
behaviour has been observed especially before the capital transactions such as
capital increase by issuing new shares, the purchase of action or the allocation
of stock-option (Stolowy & Breton, 2003 and Aboody & Kasznik, 2000). Thus,
managers opt for a decrease in the earnings before capital transactions to
temporarily reduce stock prices and take advantage of the operation at lower
costs. Thus the use of earnings management can be justified by the reduction in
funding costs, allowing the executives to be rooted and become majority
shareholders in the company with minimum costs.
Finally Mard & Marsat (2009) admit that to avoid the risk of forced
departure of the manager, following a challenge of non-performance, he can try
to manage earnings to limit the risk of being dismissed and save his reputation.

4. CONCLUSION
The purpose of paper is to present a literature review of the earnings
management through a review of the theoretical foundations. Our research on
earnings management find out that previous research is organized around five
main motivations encouraging executives to adopt such behaviour.

The first theory proposed by the literature is the signal theory; two signal types
were used to explain the use of earnings management: an information signal and
an opportunistic signal.
The second theory is the agency theory: the development of incentives plans for
executives is one of the motivations for earnings management.
Watts & Zimmerman (1978), proposed a third theory, the positive accounting
theory which is one of the first motivations suggested by researchers to explain
the use of accounting decisions affecting the income of the company. The
authors suggested three explanatory factors: compensation, debt and size.
The threshold management theory is the fourth theory. It consists of using the
accounting tools to achieve a level of anticipated results.
Finally, the entrenchment theory considers that managers employ earnings
management to increase their shares and to be deep-seated more in the
company.

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