India Economy

Earnings management

D. MURALI | Updated on June 02, 2012 Published on June 02, 2012

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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 starters, 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. Recommended study for finance professionals.

Wisdom of crowds

How do investors react to acquisition announcements: Do they make the objective, rational estimates of a deal's value-creation potential, or do they draw heavily on management's perception as inferred from the premium it pays? The answer is the latter, according to ‘‘ The Vicarious Wisdom of Crowds: Toward a Behavioural Perspective on Investor Reactions to Acquisition Announcements,'' a research paper by Mario Schijven and Michael A. Hitt ( www.ssrn.com). Adding, however, that investors do not blindly follow management's perception, but actively attempt to assess its reliability based on the public information available to them, the authors note that the ‘wisdom of crowds' typically ascribed to investors' stock market reactions may, above all, be a vicarious form of ‘wisdom.'

The paper, based on a multi-industry sample of more than 1,600 acquisitions over the 15-year period from 1990 through 2004, reminds that despite management's superior information, many acquisitions destroy acquirer value, and that the management is often susceptible to overpayment.

Arguing, therefore, that although information about the premium paid should, in principle, reduce the information asymmetry that investors face, it may not provide an unbiased signal of the actual synergy to be had from a deal, the authors observe that the investors draw on a variety of additional pieces of public information in an attempt to assess the reliability of management's perception as reflected in the premium.

Work that adds value to the efforts on understanding investors.

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Published on June 02, 2012
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