The Hindu Business Line : Managing earnings management

IT IS A globally accepted fact that accounting standards are required to establish benchmarks for certain accounting complexities as also to ensure that there are checks and balances in their implementation.

However, over the years, a new concept called earnings management is doing the rounds, which is defined as nothing but the tendency of the management to keep a control over their earnings announcement rather that permit the law to do so.

However, it was felt that the extant accounting standards gave too many options to users, enabling them to indulge in earnings management. Tighter earnings management was advocated, not giving too many options to users in certain set situations.

In fact, the International Accounting Standards Project started an "improvements project" in 2003 where the sole intention was to close out the many options available to users of accounting standards.

As a result of the project, options given to entities using certain accounting standards were minimised. However, till recently, no detailed study was done to quantify the effect of such projects.

Ralf Ewert of Goethe University and Alfred Wagenhofer of the University of Graz have done research on the economic effect of tighter accounting standards on earnings management. In their model, they used two strategic players — a risk-neutral manager of a firm and a risk-neutral capital market.

In the first period, the manager engages is earnings management and reports potentially biased earnings and the capital market uses the reported earnings to adjust the market price.

And in the second period, the effects of the earnings management unwind. The two periods are representative of a multi-period setting in which the earnings management strategy is independently selected in each period and reverses in one or more subsequent periods.

Several authors have noted that tighter accounting standards may result in a substitution effect in that reduction of accounting earnings management is met with increased real earnings management, thereby counteracting the standard-setters' intention. In contrast to accounting earnings management, real earnings management consumes real resources.

The sources and consequences of such substation effect are seldom explicated. The distinction between accounting earnings management and real earnings management is that in the former accounting standards are applied to record given transactions and events whereas the latter changes the timing or structuring of real transactions. Real earnings management implies that the manager deviates from an otherwise optimal plan of action only to effect earnings, thus imposing a real cost to the firm. Prior to the research it was hypothesised that the accounting standard setter can tighten accounting standards to restrict the discretion for accounting earnings management but can do little to restrict real earnings management.

The results of the research confirmed that tighter accounting standards strictly increase earnings quality as measured by the variability of reported earnings and the association between reported earnings and market price reaction called value relevance. It was established that real earnings management increases because the value relevance increases which again increases the marginal benefit of real earnings management. Tighter standards strictly decrease firm value but the total costs can either increase or decrease depending on the changes in accounting and real earnings management induced by the resulting earnings quality change. An increase in expected total costs is more likely the more uncertain the market is about the managers' earnings objective. The expected total costs of earnings management can increase even if expected earnings management reduces.

Indian accounting standards generally do not give too many options to entities for them to indulge in earnings management. Certain accounting standards, such as Accounting for Inventory, do need to give options since there can be no one norm that can be universally applied.

However, the results of this research as also other studies reveal that it is prudent to dictate strict accounting standards from the beginning than announce standards with too many options only to tighten them later.

(The author is a Hyderabad-based chartered accountant.)

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