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Earnings Management: A Perspective

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Earnings Management: A Perspective

By Messod D. Beneish*
April 2001
Abstract

The paper provides a perspective on earnings management. I begin by addressing

the following questions: What is earnings management? How pervasive is it? How is it
measured? Then, I discuss what we, as academics, know about incentives to increase and
to decrease earnings. The research presented relates to earnings management incentives
stemming from regulation, debt and compensation contracts, insider trading and security
issuances. I also discuss issues relating to problems in measuring the extent of earnings
management and propose extensions for future work.

1. Introduction

An issue central to accounting research is the extent to which managers alter

reported earnings for their own benefit. In the 1970s and early 1980s, a large number of
studies investigated the determinants of accounting choice. These studies provided
evidence consistent with managers' incentives to choose beneficial ways of reporting
earnings in regulatory and contractual contexts (see Holthausen and Leftwich 1983, and
Watts and Zimmerman 1986 for reviews of these studies). Since the mid-1980s studies
of managerial incentives to alter earnings have focused primarily on accruals.

I trace the explosive growth in accrual-based earnings management research to

three likely causes. First, accruals are the principal product of Generally Accepted
Accounting Principles, and, if earnings are managed, it is more likely that the earnings
management occurs on the accrual rather than the cash flow component of earnings.
Second, studying accruals reduces the problems associated with the inability to measure
the effect of various accounting choices on earnings (Watts and Zimmerman 1990).
Third, if earnings management is an unobservable component of accruals, it is less likely
that investors can unravel the effect of earnings management on reported earnings.

The main challenge faced by earnings management researchers is that academics,

like investors, are unable to observe, or for that matter, measure the earnings management
component of accruals. Indeed, managerial accounting actions intended to increase
compensation, avoid covenant default, raise capital, or influence a regulatory outcome are
largely unobservable. Consequently, prior work has drawn inferences from joint
hypotheses, that test both incentives to manage earnings as well as the construct validity
of the various accrual models that are used to estimate managers’ accounting discretion.
Because extant models of expected accruals provide imprecise estimates of managerial

*
Indiana University, Kelley School of Business, Bloomington, Indiana 47401. I thank the Editor and an
anonymous reviewer for their comments and suggestions.

1
discretion, questions have been raised about whether the unobservable earnings
management actions do in fact occur.1
Notwithstanding research design problems, a variety of evidence suggestive of
earnings management has accumulated. In Section 2, I raise three general questions
about earnings management: What is it? How frequently does it occur? How do
researchers estimate earnings management? Prior investigations of managerial
incentives to alter earnings typically fall in three categories, namely studies that examine
the effect of contracts on accounting choices, studies that examine the effect of regulation
on accounting choices, and studies that examine the incentive effects associated with the
need to raise external financing. Rather than discussing the evidence along those lines, I
have chosen to present the evidence depending on the direction of the incentive context.
Thus, I summarize in Sections 3 and 4, what is known about incentives to increase and
decrease earnings. In Section 5, I discuss evidence on incentive contexts that provide
incentives either to increase or to decrease earnings, and in Section 6, I present
conclusions and suggestions for future work.

2. Earnings Management

2.1 Definitions

Notice the plural: It reflects my view that academics have no consensus on

what is earnings management. There have been at least three attempts at defining
earnings management:

(1) Managing earnings is “the process of taking deliberate steps within the constraints of
generally accepted accounting principles to bring about a desired level of reported
earnings.” (Davidson, Stickney and Weil (1987), cited in Schipper (1989) p. 92).

(2) Managing earnings is “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).”… “A minor extension of this
definition would encompass “real” earnings management, accomplished by timing
investment or financing decisions to alter reported earnings or some subset of it.”
Schipper (1989) p. 92.

(3) “Earnings management occurs when managers use judgment in financial reporting
and in structuring transactions to alter financial reports to either mislead some

1 Criticism of extant accrual models ability to isolate the earnings management component of accruals
includes McNichols and Wilson (1988), Holthausen, Larker and Sloan (1995) , Beneish (1997, 1998), and
McNichols (2000) who argue that when the incentive context studied is correlated with performance,
inferences from the study are confounded; Guay, Khotari and Watts (1996) who suggest that accrual
models estimate discretionary accruals with considerable imprecision and that some accrual models
randomly decompose earnings into discretionary and non-discretionary components; Beneish (1997) who
provides evidence that accrual models have poor detective performance even among firms whose behavior
is extreme enough to warrant the attention of regulators; Thomas and Zhang (2000) who suggest that the
performance of accrual models is dismal.

2
 stakeholders about the underlying economic performance of the company or to
influence contractual outcomes that depend on reported accounting numbers.” Healy
and Wahlen (1999, p. 368).

A lack of consensus on the definition of earnings management implies differing

interpretations of empirical evidence in studies that seek to detect earnings management,
or to provide evidence of earnings management incentives. It is thus useful to compare
the above three definitions.

All three definitions deal with actions management undertakes within the context
of financial reporting—including the structuring of transactions so that a desired
accounting treatment applies (e.g., pooling, operating leases). However, the second
definition also allows earnings management to occur via timing real investment and
financing decisions. If the timing issue delays or accelerates a discretionary expenditure
for a very short period of time around the firm’s fiscal year, I envision timing real
decisions as a means of managing earnings. A problem with the second definition arises
if readers interpret any real decisions—including those implying that managers forego
profitable opportunities—as earnings management. Given the availability of alternative
ways to manage earnings, I believe it is implausible to call earnings management a
deviation from rational investment behavior. This reflects my view that earnings
management is a financial reporting phenomenon.

There are two perspectives on earnings management: the opportunistic

perspective holds that managers seek to mislead investors, and the information
perspective, first enunciated by Holthausen and Leftwich (1983), under which managerial
discretion is a means for managers to reveal to investors their private expectations about
the firm's future cash flows. Much prior work has predicated its conclusions on an
opportunistic perspective for earnings management and has not tested the information
perspective.

The three definitions allow earnings management to occur for the purposes of
hiding deteriorating performance, but the word “mislead” in the Healy and Wahlen
(1999) definition appears to preclude the possibility that earnings management can occur
for the purposes of enhancing the signal in reported earnings.2 This may be due to the
inclusion of contractual incentives in the third definition. To explain, prior work has not
been able to distinguish whether managers’ exercise of discretion is intended to mislead
or to inform, and the typical conclusion in contractual studies is that incentives result in
de-facto opportunistic earnings management. Under third definition, earnings
management shares much fraud. That is, fraud is defined as "one or more intentional acts
designed to deceive other persons and cause them financial loss." (National Association
of Certified Fraud Examiners (1993, p. 6)). Thus, the main difference between the third

2
A conversation with one of the authors revealed that he would also interpret a situation where the firm
could be signaling strength as misleading. Consider that a manager understates income by over-providing
for bad debts, obsolescence, or loan losses: the usual signaling argument is that the manager action is
informative insofar as investors distinguish between weak and strong firms; however, it is also possible
that the manager’s action is misleading because the manager may be setting aside income for a rainy day.

3
definition and fraud is that stakeholders may have anticipated managers’ behavior and
negotiated contract terms that provide price protection.

2.2 Incidence of earnings management

If one believes former SEC Chairman Levitt (1998), earnings management is

widespread, at least among public companies, as they face pressure to meet analysts’
expectations. Earnings management is also widespread if one relies on analytical
arguments. For example, Bagnoli and Watts (2000) suggest that the existence of relative
performance evaluation leads firms to manage earnings if they expect competitors to
manage earnings. Similar prisoner’s dilemma-like arguments for the existence of
earnings management appear in Erickson and Wang (1999) in the context of mergers and
Shivakumar (2000) in the context of seasoned equity offerings.

At the other extreme, we can only be certain that earnings have indeed been
managed, when the judicial system, in cases that are brought by the SEC or the
Department of Justice , resolves that earnings management has occurred. While it is
likely that earnings management occurs more frequently than is observed from judicial
actions, it is not clear to me that earnings management is pervasive: it seems implausible
that firms face the same motivations to manage earnings over time. As later discussed,
much of the evidence of earnings management is dependent on firm performance,
suggesting that earnings management is more likely to be present when a firm’s
performance is either unusually good or unusually bad.

2.3 Alternative methods for estimating earnings management

Three approaches have been used by researchers to evaluate the existence of

earnings management. One approach studies aggregate accruals and uses regression
models to calculate expected and unexpected accruals. A second approach focuses on
specific accruals such as the provision for bad debts, or on accruals in specific sectors,
such as the claim loss reserve in the insurance industry. The third approach investigates
discontinuities in the distribution of earnings.

2.3.1 Aggregate Accruals

The Jones (1991) model is the most widely used model in studies of aggregate
accruals. The model follows Kaplan's (1985) suggestion that accruals likely result from
the exercise of managerial discretion and from changes in the firm's economic conditions.
The model relates total accruals to the change in sales () Sales) and the level of gross
property, plant and equipment (PPE):

Total Accrualsit = a1i + b1i ) Salesit + c2i PPEit + , 1it . (1)

4
 The model is based on two assumptions. First, that current accruals (changes in
working capital accounts) resulting from changes in the firm's economic environment are
related to changes in sales, or sales growth since equation (1) is typically estimated with
all variables deflated by either lagged assets or lagged sales. Second, that gross property
plant and equipment controls for the portion of total accruals related to nondiscretionary
depreciation expense.

The second version uses current accruals as a dependent variable and only the
change in sales as an explanator:

Currentit = a2i + b2i ) Salesit + , 2it . (2)

These models are either estimated in time series firm-by-firm or cross-

sectionally using all firms in a given two-digit industry and year. Each yearly estimation
is used to make a one-year ahead forecast of expected accruals which, subtracted from
the dependent variable, yields unexpected accruals. Two alternative versions of the Jones
(1991) model have also been proposed. In their total accrual form, the models are given
by:

Total Accrualsit = a3i + b3i () Salesit -) Receivablesit ) +c3i PPEit + u3it . (3)

Total Accrualsit = a4i + b4i ) Cash Salesit + c4i PPEit + u4it (4)

The expectation model in equation (3) is typically attributed to Dechow, Sloan

and Sweeney (1995) (e.g., see Gaver, Gaver and Austin(1995)), even though, the
modified-Jones model presented in Dechow et al. (1995) is the same as the Jones model
in the estimation period and only has the receivable adjustment in the prediction period.
Indeed, the revenue based variable in (3) equals Cash Salesit -Salesit-1 . Since it is not clear
what the construct means or how it proxies for the effect on accruals of changes in the
firm's economic environment, Beneish (1998b) proposed an alternative modification
based on cash sales (equation 4). His evidence indicates that change in cash sales
preserves the intuition behind using changes in sales to proxy for changes in economic
performance and has the advantage of using as an explanator an accounting construct that
reduces the endogeneity problem. 3

Notwithstanding these modifications, the primary criticism leveled at extant

accruals models remains: The models fail to distinguish the accruals that result from
managers’ exercise of discretion from those that result from changes in the firm's
economic performance (see McNichols (2000) for an extensive discussion of research
3
To explain; it is much harder to exercise discretion over cash sales than over credit sales. Indeed, examining
firms whose financial reporting behavior is deviant enough to warrant SEC enforcement actions, Beneish
(1997) finds that cash sales are rarely manipulated. He reports that one firm out of 64 (1.6%) engages in
circular transfers of money to create the impression of receivable collection. In contrast, 43 of 64 firms
(67.2%) engage in manipulations affecting credit sales (e.g., fictitious invoices, front loading with a right of
return, keeping books open past the end of the fiscal period, overstating the percentage of completion).

5
design issues related to aggregate accrual models). This is exacerbated by the fact that
we do not know how changing operating decisions that are ex-ante value maximizing
affect measures of earnings management. In other words, we do not know whether
estimates of earnings management reflect efficient operating decisions or reporting
considerations. To this effect Beneish (1997, p. 275) states: “…a firm's financial
reporting strategy depends on its business strategy and should be evaluated ex-ante, not
ex-post. To illustrate, consider a personal computer manufacturer who seeks to gain
market share on a competitor increases production and offers, before the holiday season,
incentives to distributors who increase their demand. If the strategy is not successful and
translates into lower than expected earnings and a price drop, the manufacturer may be
sued and its reporting criticized. While the firm ends us with higher discretionary
accruals, it is, conditional on its strategy, an aggressive competitor rather than an earnings
manager. This firm is, however, not distinguishable from a firm who deliberately pushed
sales on its distributors to improve earnings.” An additional problem is that if managers
indeed have an incentive to manage earnings, they are likely to do so in a way that is
difficult to detect, thus reducing our ability to detect earnings management and
weakening the power of our tests.4

2.3.2 Other methods

Despite their widespread usage, models of aggregate accruals have been subject to
significant criticism (cf. footnote 1). An alternative to using an aggregate accruals
approach is to model a specific accrual, such as the provision for bad debt (McNichols
and Wilson (1988)), or to focus on accruals in specific sectors such as the claim loss
reserve in the insurance industry (Beaver and McNichols (1998)). McNichols (2000)
provides an excellent discussion of the advantages and disadvantages of the specific
accrual approach. For example, in terms of advantages she states (p. 333) : “One
advantage is that the researcher can develop intuition for the key factors that influence the
behavior of the accrual, exploiting his knowledge of GAAP. A second advantage is that
a specific accrual approach can be applied in industries whose business practices cause
the accrual in question to be material and a likely object of judgment and discretion.”
Among the disadvantages, she argues that studying specific accruals require a costly
investment in institutional knowledge, and imposes limits to the generalizability of the
findings, since studies of specific accruals tend to be confined to smaller or sector
specific samples.

Recent work by Burgstahler and Dichev (1997) and Degeorge, Patel and
Zeckhauser (1999) use an interesting alternative methodology for studying earnings
management. They investigate discontinuities in the distribution of reported earnings
around three thresholds: (1) zero earnings, (2) last year’s earnings, (3) this year’s
analysts’ expectations. They make predictions about the behavior of earnings in narrow
intervals around these thresholds. The evidence appears consistent with predicted
discontinuities: there tend to less (more) observations than expected for earnings
amounts just below (above) the zero earnings and last’s years’ earnings thresholds. While
examining earnings distributions is informative about which firms are likely to have
4
I thank an anonymous referee for this suggestion.

6
managed earnings, this methodology is silent about the form and extent of earnings
management.

3. Evidence of Income Increasing Earnings Management.

I discuss four sources of incentives for income increasing earnings management:

(1) debt contracts, (2) compensation agreements, (3) equity offerings, (4) insider trading.
The first two sources have been hypothesized in prior positive accounting theory research
and the last two sources are explicitly described as reasons behind earnings overstatement
in the SEC's accounting enforcement actions, and have been investigated in recent
research.

3.1 Debt Covenants

Debt contracts are an important theme in financial accounting research as lenders

often use accounting numbers to regulate firms' activities, e.g., by requiring that certain
performance objectives be met or imposing limits to allowed investing and financing
activities. The linkage between accounting numbers and debt contracts has been used in
studies investigating (i) why economic consequences are observed when firms comply
with mandated, or voluntarily make, accounting changes that have no cash flow impact,
(ii) the determinants of accounting choice and managers' exercise of discretion over
accounting estimates that impact net income. The assumption is that debt covenants
provide incentives for managers to increase earnings either to reduce the restrictiveness
of accounting-based constraints in debt agreements or to avoid the costs of covenant
violations.

The results of economic consequences studies have generally been mixed and
researchers recently turned to investigating accounting choice in firms that experience
actual technical default (Beneish and Press (1993, 1995), Sweeney (1994), Defond and
Jiambalvo (1994), and DeAngelo, DeAngelo and Skinner (1994)). The idea is to
increase the power of the tests by focusing on a sample where the effect of violating debt
covenants is likely to be more noticeable. While some of the evidence suggests that
managers take income increasing actions delay the onset of default (Sweeney (1994),
Defond and Jiambalvo (1994)), other evidence does not (Beneish and Press (1993),
DeAngelo, DeAngelo and Skinner (1994)). Further, it is not clear such actions actually
are sufficient to delay default.5

Thus, the evidence in these studies on whether managers make income increasing
accounting choices to avoid default is mixed. However, examining a large sample of
private debt agreements, and measuring firms’ closeness to current ratio and tangible net
worth constraints, Dichev and Skinner (2000) find significantly greater proportions of

5
Defond and Jiambalvo (1994) and Sweeney (1994) study a subset of firms for which they have constraint
data and find that neither accrual discretion nor changes in accounting techniques are effective in delaying
default.

7
firms slightly above the covenant’s violation threshold than below. They suggest that
managers take actions consistent with avoiding covenant default.

3.2 Compensation Agreements

Studies examining the bonus hypothesis (Healy (1985), Gaver et al. (1995), and
Holthausen, Larker and Sloan (1995)) provide evidence consistent with managers altering
reported earnings to increase their compensation. Except for Healy (1985), these studies
provide evidence consistent with managers decreasing reported earnings to increase
future compensation. In addition, Holthausen et al. (1995) find little evidence that
managers increase income and suggest that the income-increasing evidence in Healy
(1985) is induced by his experimental design.

3.3 Equity Offerings

A growing body of research examines managers' incentives to increase reported

income in the context of security offerings. Information asymmetry between owners-
managers and investors, particularly at the time of initial public offerings, is recognized
in prior research. Models such as Leland and Pyle (1977) suggest that the amount of
equity retained by insiders signals their private valuation, and models such as Hughes
(1986), Titman and Trueman (1986), and Datar et al. (1991) examine the role of the
reputation of the auditor on the offer price. In these models, the asymmetry is resolved
by the choice of an outside certifier or by a commitment to a contract that penalizes the
issuer for untruthful disclosure. Empirical studies assume that information asymmetry
remains and use various models to estimate managers' exercise of discretion over
accruals at the time of security offerings.

Four studies investigate earnings management as an explanation for the puzzling

behavior of post-issuance stock prices. Teoh, Welch and Rao (1998) and Teoh, Welch
and Wong (1998a) study earnings management in the context of initial public offerings
(IPO), and Rangan (1998) and Teoh, Welch and Wong (1998b) do so in the context of
seasoned equity offerings. These studies estimate the extent of earnings management
using Jones-like models around the time of the security issuance, and correlate their
earnings management estimates with post-issue earnings and returns. The evidence
presented suggests that estimates of at-issue earnings management are significantly
negatively correlated with subsequent earnings and returns performance.

The results in these studies suggest that market participants fail to understand the
valuation implications of unexpected accruals. While the results are compelling, the
conclusion that intentional earnings management at the time of security issuance
successfully misleads investors is premature. Beneish (1998b, p. 210) expresses
reservations about generalizing such a conclusion as follows: “First, the conclusion
implies that financial statement fraud is pervasive at the time of issuance. To explain;

8
fraud is defined by the National Association of Certified Fraud Examiners (1993, p. 6) as
"one or more intentional acts designed to deceive other persons and cause them financial
loss." If financial statement fraud at issuance is pervasive--e.g., managers are successful
in misleading investors--I would expect that firms would fare poorly post-issuance in
terms of litigation brought about by the Securities and Exchange Commission (SEC),
disgruntled investors, and the plaintiff's bar. I would also expect managers to fare poorly
post-issuance in terms of wealth and employment. I would find evidence of post-issue
consequences on firms and managers informative about the existence of at-issue
intentional earnings management to mislead investors and believe these issues are worthy
of future research.”

3.4 Insider Trading

Like raising capital, insider trading is a trading-related incentive and a relatively

new-comer to the set of potential antecedents to income increasing earnings management.
The reason is that, if one accepts two economic efficiency-based arguments, the study of
such incentives becomes futile. Specifically, the arguments are: (1) capital markets are
informationally efficient (a central hypothesis in capital market research), and investors
see through managers’ accounting actions, (2) reputation effects and the labor market
discipline insiders, preventing them from profiting in firms facing declining prospects.

The evidence on insider trading as an incentive to increase income to mislead

investors is less pervasive, but, in my opinion, more compelling that the evidence on
equity issuance as an incentive. One reason is that the evidence is drawn from firms that
have actually perpetrated financial statement fraud (Beneish (1999)), or committed illegal
acts (Summers and Sweeney (1998)). It is consistent with professional views of the
causes of earnings management (National Association of Certified Fraud Examiners
1993),and also with evidence that managers reduce their stake in the firm's equity in the
years preceding bankruptcy filings (Seyhun and Bradley 1997). While Seyhun and
Bradley (1997) do not speak to earnings management, their sample firms face
deteriorating performance, a frequently posited antecedent to corporate illegal behavior
(National Association of Certified Fraud Examiners 1993).

The most direct evidence linking financial statement manipulations and insider
trading is in Beneish (1999) who finds “that managers of firms with earnings
overstatements that violate GAAP are more likely to sell their holdings and to redeem
stock appreciation rights during the period when earnings are overstated than managers in
a control sample of firms. I also find an average stock price loss of 20 percent when the
overstatement is discovered and an average cost of settling litigation that is 9 percent of
market value prior to discovery. This suggests that managers' stock transactions during
the period of earnings overstatement occur at inflated prices that reflect the effect of the
earnings overstatement.” (p. 426).

Beneish (1999) relies on prior insider trading research to develop hypotheses

about manipulation incentives related to insider trading. This research suggests that

9
managers act as informed traders, buying (selling) in advance of stock price increases
(declines) (Jaffe 1974; Seyhun 1986) and views the gains managers as an efficient means
of compensating managers for providing their private information to investors on a timely
basis (Carlton and Fischel 1983; Dye 1984; Noe 1997).

Beneish (1999) thus argues that: “If managers act as informed traders, I expect
them to use their information about earnings overstatement to trade for their own benefit.
That is, if managers overstate earnings to provide market participants with positive
private information about the firm's prospects, I expect them to either strategically
increase their stake in their firm's equity (perhaps to provide another positive signal about
firm prospects) or abstain from trading. Alternatively, if managers overstate earnings to
hide deteriorating firm performance, I expect them to sell their equity contingent wealth.
If overstatement is intended to mislead investors, managers may limit their selling to
reduce the likelihood of attracting the attention of the SEC's insider trading monitors.
Alternatively, as argued by Summers and Sweeney (1998), managers who mislead
investors may possess low personal ethics, low risk aversion and/or a downwardly biased
assessment of the probability of getting caught. Yet another possibility is that, in the
event of detection, managers could justify their selling for personal liquidity reasons.” (p.
435).

Beneish (1999) also investigates the penalties facing managers after the
manipulations are discovered. If reputation losses and the consequent disciplining in the
stock market preclude managers from engaging in earnings manipulation and making
profitable trades, employment and monetary penalties subsequently imposed on managers
should be substantial if they are to serve as a deterrent However, Beneish (1999) finds
that “managers' employment losses subsequent to discovery are similar in firms that do
and do not overstate earnings and that the SEC is not likely to impose trading sanctions
on managers in firms with earnings overstatement unless the managers sell their own
shares as part of a firm security offering.” (p. 425)

4 Evidence of Income Decreasing Earnings Management.

With the exception of bonus as a form of compensation, where evidence

discussed in section 3.2 suggests that managers decrease current reported earnings so as
to increase future compensation, much of the evidence in prior research on income
decreasing earnings management is consistent with managers depressing earnings on a
temporary basis to increase the likelihood of a negotiated or regulatory outcome. For
example, lower reported earnings have been shown to increase the likelihood that utilities
can obtain rate increases (Jarrell (1979), to reduce the likelihood of wealth transfers
(Watts and Zimmerman (1978)), and to obtain import relief (Jones (1991)); Liberty and
Zimmerman (1986) examine incentives to decrease earnings in periods surrounding union
negotiations and DeAngelo (1986) examines incentives to decrease earnings in periods
preceding management buyouts. The power of the tests in these studies is low as
samples are small, and evidence is not always conclusive: Liberty and Zimmerman
(1986) and DeAngelo (1986) find no evidence of downward earnings manipulations.

10
 Recent survey evidence in Nelson et al. (2000) suggests that income decreasing in
earnings management in the form of “cookie jar” reserves is pervasive. Surveying 526
experiences of Big-5 audit partners and managers, they find that 40% of the responses
describe attempts at income decreasing earnings management. While the ratio suggests
that income decreasing earnings management is pervasive, it is difficult to make a more
precise assessment because the survey was conducted in the Fall of 1998, a period
characterized by economic expansion and a bull market.

5 Sector Specific Contexts that Provide Incentives Either to Increase or to

Decrease Earnings

Financial institutions and insurance companies are in sectors where managers

have to balance financial reporting incentives with regulatory constraints. For example,
studies of regulated financial institutions indicate that managers face multiple incentives
to manage earnings. In particular, these studies suggest that incentives associated with
regulatory capital and decreasing taxes balance those associated with increasing earnings.
Indeed, these studies generally provide evidence consistent with income smoothing (see
Moyer 1990; Beatty et al. 1995; Collins et al. (1995)).

Studies in these areas avoid the problems associated with using a model of
expectations for aggregate accruals, because they can focus on the discretion associated
with particular accruals such as loan loss provisions in the banking industry and claim
loss provisions in the insurance industry. Required disclosures in these industries enable
researchers, with hindsight, to identify firms that under- or over-reserved, and to test
hypotheses about the factors motivating this behavior. For example, Petroni (1992) finds
that financially weak insurers tend to underestimate loss reserves relative to companies
exhibiting greater financial strength. Beaver, McNichols, and Nelson (2000) analyze the
distribution of insurance company earnings and suggest that weak insurers have
incentives to under-reserve while strong insurers have incentives to over-reserve.

6. Conclusions and Future Research

The accumulated evidence suggests that income increasing earnings management

is more pervasive that income decreasing earnings management. While the results are
mixed or subject to confounding effects, there is weak evidence that debt covenants, and
equity offerings provide income increasing incentives. There is also evidence that
managers have incentive to increase income to hide deterioration of performance, so as to
sell their equity contingent wealth at higher prices. The latter evidence is limited
however, to small samples and generalizations will require further studies. With the
exception of sector specific studies, evidence on income decreasing earnings
management is meager. At best, it appears to be time and industry specific.

Future work needs to deal with the unobservability of managerial actions that
presumably result in income manipulations. The difficulties faced by aggregate accrual
models suggest that studies of specific accruals, perhaps even case studies, are needed.
In his call for papers, Beneish (1998a, pp. 86-87) suggests two avenues of research that

11
have not been exploited to date. “The study of the form of reporting discretion and its
bounds in the context of a particular industry. For example, what components of
revenues and expenses are discretionary in the health care industry? How does discretion
over these components earnings translates into discretionary accruals? What can we
learn from their behavior over time?” In a similar vein, one could investigate the
discretion related to revenue recognition in the high-tech, health-care or construction
industries, or the discretion related to the provision for inventory obsolescence among
computer manufacturers.

One way in which one could assess the external validity of aggregate accrual
models and learn about the exercise of discretion in specific industries is to study
earnings restatements. To this effect, Beneish (1998a, p. 87) suggests an avenue of
research that has not been exploited to date: “The analysis of instances where firms
restate earnings, e.g., where actual earnings management is more likely. Such instances
are of interest because (i) relying on external sources to establish ex-post that earnings
were managed enables an assessment of the external validity of accrual models, (ii) such
instances enable a description of the form and extent of managers' reporting discretion.
For example: (a) What is the relation between earnings management and shareholder
litigation? independent auditor litigation? What is the relation between the magnitude of
estimated discretionary accruals and that of earnings restatements? (b) If actions brought
by tax authorities against firms result in disallowances and or restatements, what is the
relation between the magnitude of estimated discretionary accruals and that of earnings
restatements?”

A promising avenue of research is the study of the intersection of insider

trading—an observable management action—with earnings management—an
unobservable management action. Large sample evidence in Beneish and Vargus (2000),
and evidence on a sample of technical defaulters in Beneish, Press and Vargus (2000)
suggests that insider trading is useful in assessing the likelihood of earnings management.

12
References

Bagnoli, M., and Watts S.G. 2000. "The effect of relative performance evaluation on
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