Introduction

Financial reporting serves two main purposes in modern business life. On the one hand, it determines tax
liabilities as well as residual income which is distributable amongst owners. On the other hand, it ought to
inform further stakeholders about the value of their explicit and implicit claims in the firm. Stakeholders are
manifold and include, but are not limited to, auditors, creditors, customers, employees, labor unions,
suppliers and other contractors. Contemporary accounting principles view stakeholders as mere consumers
of financial statements. As a consequence, research on earnings management primarily focuses on the
techniques and the degree to which firms deceive stakeholders through their earnings management
activities.

In this study, we focus on the analysis of how traditional financial variables and cultural variables influence
earnings managements

Earnings Management

Earnings management is the action of corporate officers that affects a firm’s short-term earnings results
(Sevin & Schroeder, 2005). Schipper (1989, p. 92) defined earnings management as “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).” In addition, Healy and Wahlen
(1999, p. 368) documented that “Earnings management occurs when managers use judgement in financial
reporting and in structuring transactions to alter the financial reports to either mislead some stakeholders
about the underlying economic performance of the firm or to influence contractual outcomes that depend
on the reported accounting numbers.”

On the other hand, Healy & Wahlen (1999) posit that earnings management involves managers using their
judgment in financial reporting and in structuring transactions to alter financial statements so as to either
mislead some shareholders about the underlying economic performance of the company, or to influence
contractual outcomes that depend on reported accounting numbers. The problem with this approach is that
management intent is unobservable. No one can be certain if earnings are manipulated for management or
firm’s benefit, or to mislead information users.

In other words, earnings management is the manipulation of reported earnings so that they do not
accurately represent economic earnings at every point in time (Goel & Thakor, 2003). The problem with this
approach is that no one knows a firm’s underlying or economic earnings due to information asymmetry,
making the direct measurement of earnings management defined in this way impossible too.

Earnings are a most important metric to internal or external parties of the firms (Degeorge et al., 1999) and
earnings information reveals the position of firm values (Graham et al., 2005). This reflects that positive
earnings play an important role in attaining positive firm performance that increases firm value. Thus,
earnings are managed or smoothed through earnings management with the intention to achieve the
objectives aligning to shareholders interest or for managers’ self-interest, which gives impact to the firm
performance.

Habbash and Alghamdi (2015) conducted a study on motivation of earnings management in Saudi Arabia
under developed-economy listed firms and identified several motivating factors for managers to engage in
earnings management. Among the factors that cause managers to engage in earnings management are “to
increase the amount of remuneration; to report a reasonable profit and avoid loss; to obtain a bank loan; to
increase share price” (p. 137). This shows that earnings management action is for a purposeful reason,
either for the benefit of the firm and shareholders or the managers.

Essentially, managers do possess a sufficient degree of freedom to operate a firm effectively and efficiently
on behalf of shareholders. This degree of freedom gives rights to managers to exercise discretion over the
accounting numbers through contracts. Thus, accounting numbers are the outcome of these contracts. As
for the accounting treatment, the managers undertaking the contracts have an impact on shareholders’
wealth. Most companies do not engage in managing short-term earnings (Jooste, 2013). Income-increasing
earnings management is more widespread than income-decreasing earnings management (Beneish, 2001).

Earnings manipulation has three different forms: earnings management, earnings fraud, and creative
accounting. This paper distinguishes earnings management from earnings manipulation, earnings fraud, and
creative accounting. In the paper, “earnings manipulation” means that management takes deliberate steps
to bring reported earnings to a desired level; “earnings management” refers to the earnings manipulation
through exercising the discretion accorded by accounting standards and corporate laws, and/or structuring
activities in such a way that expected firm value is not affected negatively; “earnings fraud” refers to the
earnings manipulation by violating accounting standards and corporate laws, and/or structuring activities in
such a way that reduces expected firm value; while “creative accounting” refers to the earnings
manipulation practices that do not violate accounting standards or corporate laws because of the lack of
relevant standards or laws, for example, when firms engage in business innovations.

Some accounting standards are so sketchy as to leave too much room for manipulation. In terms of Enron
case, its business transactions with related companies, though not violating GAAP or corporate laws of
United States, reduced expected firm value because firm risks were increased due to considerably increased
debts.

After a series of accounting scandals involving Enron, WorldCom, and others, the former chairman of the
Security and Exchange Commission, Arthur Levitt (1998), stated that “if earnings management problems are
not addressed soon, they will have adverse consequences for America’s financial reporting system.
Furthermore, they will further damage America’s financial system as well as investor’s confidence in the
stock market”.

Earnings management is the use of judgment in financial reporting to mislead stakeholders about firm
performance or to influence contractual outcomes (Healy and Whalen, 1999). Earnings management is the
use of judgment in financial reporting to mislead stakeholders about firm performance or to influence
contractual outcomes (Healy and Whalen, 1999).
Dechow and Skinner (2000) make the distinction between fraud and earnings management. Earnings
management results from aggressive accounting choices that adhere to generally accepted accounting
principles (GAAP). They may follow conservative accounting practices such as overly aggressive recognition
of provisions or reserves, overvaluation of acquired inprocess research and development in purchase
acquisitions, or overstatement of restructuring charges and asset write-offs. At the other end of the
earnings management spectrum aggressive accounting practices include the understatement of the
provision for bad debts and overlyaggressive drawing down of provisions or reserves. This is in contrast to
fraudulent accounting that violates GAAP by recording sales before they are realizable, recording fictitious
sales, backdating sales invoices, or overstating inventory by recording fictitious inventory.

Also there are positive views on earnings management. These follow the notion that true economic earnings
are rather volatile and convey only little information about future earnings and cash flows. Managerial
accounting discretion, thus, merely conveys private information through making long-term sustainable
earnings more visible (e.g., Sankar & Subramanyam (2001)).

Leuz et al. (2003) investigate the relation between a country's institutional framework to protect the
rights of outside investors and the extent to which firms in that country engage in earnings
management. Managers are said to have an incentive to manage reported earnings to mask true
firm performance so as to conceal private control benefits and minimize interference from outsiders.
The incentive to manage earnings is reduced in those countries with legal systems that effectively
protect outside investors, and they test this hypothesis by examining the relation between two
measures of investor protection and an aggregate measure of earnings management. 

Haw et al. (2004) examine the role that both legal and extra-legal institutions have on the variation
in discretionary accruals across a sample of East Asian and Western European countries. They find
that a common law legal tradition, an efficient judicial system, and effective tax enforcement
mitigate earnings management. Wysocki (2004) points out several problems with Haw et al.'s
specific measure of discretionary accruals and questions their claim that tax compliance influences
earnings management.

Earnings management has been defined as the use of judgment in financial reporting to
mislead some stakeholders about firm performance or to influence contractual outcomes
(Healy and Wahlen, 1999). Prior research has investigated a variety of incentives for
earnings management, including to influence stock prices, to increase management
compensation and to avoid violation of lending covenants. Most of these incentives relate
to an immediate benefit to be enjoyed, such as a bonus, or an immediate harm to be
avoided, such as a drop in stock price. Managers can use discretion available in accrual
accounting to report earnings to achieve certain targets, or to avoid reporting small losses.
This aspect of earnings management generally is associated with income-increasing
accruals, and is referred to in this study as earnings discretion.
Another form of earnings management is earnings smoothing (Dechow and Skinner,
2000), which can be defined as the process of manipulating the time profile of earnings to
make the reported income stream less variable (Fudenberg and Tirole, 1995).
Historically, smoothing was undertaken to ensure the distribution of dividends in years of
poor performance (Buckmaster, 2001). A more recent explanation for smoothing
behaviour is that it reduces the cost of capital through a lowering of the assessment of firm
risk, which in turn benefits shareholders (Trueman and Titman, 1988). Another
explanation is that it serves as a mechanism through which management conveys
information useful for predicting future earnings (Barnea et al., 1976).

The incentives to misrepresent firm performance through earnings management arise from the
conflict of interest between the firms' insiders and outsiders. As Jensen and Meckling (1976) point
out, insiders have an incentive to use the firm's resources in a way that benefits them, but outsiders
do not. In the presence of extensive earnings management, financial reports inaccurately reflect
firm performance and consequently weaken outsiders' ability to govern the firm. The insiders' ability
to acquire private control benefits is limited by an explicit institutional framework, through corporate
governance mechanisms and the legal system, in protecting the interests of outside minority
shareholders (e.g., Shleifer and Vishny 1997; La Porta et al. 2000).

Conclusion

To sum up, earnings manipulation is management’s action taken to bring about a desired level of reported
earnings. When earnings manipulation is performed through exercising the discretion accorded by
accounting standards and corporate laws, and/or structuring activities in such a way that expected firm
value is not affected negatively, it is earnings management, otherwise it is earnings fraud. The paper
contributes to the theoretical framework of earnings management by developing an explicit and vigorous
definition of earnings management, specifying different forms of earnings manipulation, and distinguishing
earnings management from earning manipulation, earnings fraud and creative accounting.

The need to precisely define earnings management arises also because it concerns many other parties
including regulators, firms and investors.

With an ambiguous definition of earnings management, firms that practice earnings management might be
treated in the same manner as those that practice earnings fraud, provoking wasteful conflicts and
unnecessary disputes between firms and regulatory bodies, and indirectly encouraging earnings fraud.

In general, everything has two sides. In terms of earnings manipulation, earnings fraud is its negative side
while earnings management is its positive side. Earnings management is firms’ strategic tool for maximizing
firm value and reducing risks. A systematic and scientific study of the value-adding functions of earnings
management is presented in Ning (2005).

Essentially, earnings management is an action taken by managers to mislead shareholders; it is healthy for
the firm and shareholders if the managers undertake efficient earnings management.

From the moment it is clear the need to harmonize accounting standards to allow cross country
comparisons.

Prior research extended about the effect of IFRS adoption on earnings management have few
contradiction. In general, extant literature has found a positive impact of IFRS adoption on
accounting quality. IFRS is supposed to improve the market infrastructure, decrease information
processing costs, increase reporting quality and thus, attract foreign investments (Amiram, 2012;
Ball et al., 2000). Barth et al. (2008) Argues that IFRS statement demonstrate less earnings
management in terms of income smoothing and loss avoidance, compare to the local GAAP. In
recent study of Wong and Wong (2014) indicates that the IFRS adoption helps to reduce the
complexity of financial reporting as well as improve the transparency of the financial reporting in
Hong Kong. On the other hand, some authors argue that cross-country differences in accounting
quality are likely to remain following IFRS adoption, because accounting quality is also a function of
the firm’s overall institutional setting, including the legal and political system of the country in which
the firm resides (Ball et al., 2000; Soderstrom & Sun, 2007).

Since 2005, all listed companies in the European Union are obliged to prepare their consolidated
financial statements in accordance with IFRS. One of the main reasons for such universal rules is
that it makes financial reporting more transparent and comparable. That's why it is believed that the
introduction of IFRS has led to a decrease in earnings management. Due to more and stricter rules,
managers should have less influence on the financial statements. However, not everyone agrees on
this statement.

When there is a change in the level of earnings management, it might be due to the implementation
of IFRS, but there can also be another reason. The only thing that can be said is whether the
implementation of IFRS is associated with a lower level of earnings management compared to
another accounting standard. Prior research showed that there could be a relation between IFRS and
a lower level of earnings management, but it is impossible to state that IFRS really caused this
decrease in earnings management. The results are also in line with the statement of Christensen, Lee
and Walker that only voluntary adopters of IFRS show a decrease in the level of earnings
management and that this effect is not expected to be present for companies who mandatory shifted
to IFRS.
Whether the overall effect of IFRS on earnings management is positive or negative is hard to say
and depends on the country and the prior standard of that country.