Research Bytes: Earnings management

Real earnings management is preferred over accrual-based earnings management in countries with stronger investor protection.

Thus report Masahiro Enomoto, Fumihiko Kimura, and Tomoyasu Yamaguchi in ‘Accrual-Based and Real Earnings Management: An International Comparison for Investor Protection,’ after studying earnings management data of 2,89,055 firm-year observations from 1991 to 2010, across 38 countries ( >www.ssrn.com).

For a start, the paper defines ‘earnings management’ as the choice by a manager of accounting policies, or real actions that affect earnings so as to achieve a specific reported earnings objective. “The methods of earnings management are categorised as either the change in the accrual process or the deviation from normal business activity. The former is called Accrual-based Earnings Management (AEM) and the latter, Real Earnings Management (REM).”

It should interest researchers that the authors measure AEM in three proxies, following Leuz et al. (2003): one, the ratio of the standard deviation of operating income to that of operating cash flow, which is calculated by time-series data from each firm; two, the correlation between changes in accruals and changes in operating cash flow computed from the pooled data in each country; and three, the ratio of the absolute value of accruals to that of operating cash flow calculated in each firm-year. REM is measured in two proxies, thus: “(1) the correlation between changes in sales and production costs; and (2) the correlation between changes in sales and discretionary expenses.”

Recommended study for finance professionals.