In this paper, we model earnings management as a consequence of the interaction among self‐interested economic agents ‐ namely, the managers, the shareholders, and the regulators. In our model, a manager controls a stochastic production technology and makes periodic accounting reports about his or her performance; an owner chooses a compensation contract to induce desirable managerial inputs and reporting choices by the manager; and a regulatory body selects and enforces accounting standards to achieve certain social objectives. We show that various economic trade‐offs give rise to endogenous earnings management. Specifically, the owner may reduce agency costs by designing a compensation contract that tolerates some earnings management because such a contract allocates the compensation risk more efficiently. The earnings‐management activity produces accounting reports that deviate from those prescribed by accounting standards. Given such reports, the valuation of the firm may be nonlinear and s‐shaped, thereby recognizing the manager's reporting incentives. We also explore policy implications, noting that (1) the regulator may find enforcing a zero‐tolerance policy ‐ no earnings management allowed ‐ economically undesirable; and (2) when selecting the optimal accounting standard, valuation concerns may conflict with stewardship concerns. We conclude that earnings management is better understood in a strategic context that involves various economic trade‐offs

We find that in general, both accrual-based and real earnings management decrease after the passage of shareholder-sponsored governance proposals. However, when accounting for the type of proposal, we observe significant heterogeneity in the effects on earnings management. Specifically, proposals focused on changing the governance structure (e.g., board independence) lead to reductions in both types of earnings management, whereas proposals specifically targeted at improving financial reporting quality lead to decreased accrual-based earnings management but increased real earnings management. The results suggest that constraints on accrual-based earnings management induce a shift toward real earnings management. Our paper indicates that the nature of the shareholder proposal has a significant impact on shareholder intervention

Despite a recent focus on the ethics of earnings management, research has generally not examined the specific ethical dilemma that arises when a choice to engage in earnings management results in positive organizational consequences. This study focuses on the consequences of earnings management behavior in response to the question: Do the ends of positive organizational consequences justify the means of earnings management? We investigate manager evaluations of, and reactions to, a scenario in which a hypothetical employee makes a choice whether or not to engage in earnings management behavior, with consequences that are either favorable or unfavorable to the organization. Two hundred and sixty-four experienced managers provided responses to the scenario in a controlled experimental research design. The results indicate that managers may be motivated to discount the ethical impact of earnings management behavior when the consequence has a favorable impact on the organization—implying that the ends justify the means. This finding, in turn, suggests that incrementalism, or the ethical “slippery slope” of overlooking seemingly minor ethical breaches, can undermine efforts to establish a strong ethical tone throughout the organization. Implications of these findings for corporate governance and future research are discussed

A vast literature following Hayn [1995] and Burgstahler and Dichev [1997] attributed the so‐called “discontinuities” in earnings distributions around zero to earnings management. Despite recent evidence that these discontinuities are likely caused by other factors, researchers and teachers continue to point to the shapes of these distributions as evidence of earnings management. We provide three sets of further evidence that these discontinuities are likely caused by factors other than earnings management: (1) we provide, as an example, a detailed analysis of the severe effects of sample selection in a recent study; this study erroneously concludes that the shape of an earnings distribution is evidence of earnings management, (2) we provide a simple explanation for the shape of the earnings distribution that is most often cited as evidence of earnings management; the relation between earnings and prices differs with the magnitude and the sign of earnings, and (3) we provide further examples that support the main point of our paper; evidence beyond the mere shape of a distribution must be brought to bear before researchers can draw conclusions regarding the presence/absence of earnings management

We examine whether recent regulatory reforms requiring majority board independence reduce the extent of earnings management. Firms that did not have a majority of independent directors before the reforms (referred to as noncompliant firms) are required to increase their board independence. We find that, while noncompliant firms on average do not experience a significant decrease in earnings management after the reforms compared to other firms, noncompliant firms with low information acquisition cost experience a significant reduction in earnings management. The results are similar when we examine audit committee independence and when we use alternative proxies for information acquisition cost and earnings management. These findings indicate that independent directors’ monitoring is more effective in a richer information environment

We examine how cross-country differences in product, capital, and labor market competition, as well as earnings management affect mean reversion in accounting return on assets. Using a sample of 48,465 unique firms from 49 countries, we find that accounting returns mean revert faster in countries where there is more product and capital market competition, as predicted by economic theory. Country differences in labor market competition and earnings management are also related to mean reversion in accounting returns—but the relation varies with firm performance. Country labor competition increases mean reversion when unexpected returns are positive but slows it when unexpected returns are negative. Accounting returns in countries with higher earnings management mean revert more slowly for profitable firms and more rapidly for loss firms. Thus earnings management incentives to slow or speed up mean reversion in accounting returns are accentuated in countries where there is a high propensity for earnings management. Overall, these findings suggest that country factors explain mean reversion in accounting returns and are therefore relevant for firm valuation

We find evidence consistent with Italian nonlisted subsidiaries engaging in accrual and real earnings management, so that their listed parents can meet or beat benchmarks. Thus, the parent firm drives the earnings management of the subsidiaries. We identify parents that are more likely to have managed earnings as the ones that avoid a small loss or meet or beat analyst forecast by a few cents. Cross‐sectional analysis reveals that Big 4 auditors mitigate accrual earnings management at the subsidiary level and that family‐owned firms use earnings management through nonlisted subsidiaries mainly to avoid reporting losses. Finally, we find that parent firms communicate earnings management strategies to their subsidiaries using board proximity. Our evidence shows that business groups manage earnings differently from single firms, pushing earnings management down to subsidiaries. It also supports the monitoring role of Big 4 auditors in a business group setting and contributes to understanding financial reporting decisions in family‐owned firms

This study provides further evidence of earnings management around security offerings. We find positive and significant discretionary current accruals coincident with offerings of reverse LBOs. Issuers in the most aggressive quartile of earnings management have a one-year aftermarket return that is between 15% and 25% less than the most conservative quartile. We also find a negative and significant relation between abnormal accruals and post-issue abnormal returns within the first year after the offering. The relation remains after controlling for book-to-market ratio, firm size, offering size, and involvement of buyout specialists or management. Although earnings management has been used to explain post-issue long-term underperformance of IPOs and SEOs, our study shows that earnings management can explain post-offering returns of reverse LBOs, even in the absence of post-offering underperformance

We conduct two experiments to investigate the joint effect of two justification factors of earnings management—namely, attribution for the firm's underperformance and benefits accruing to other employees from inflating reported earnings. This investigation is important because prior research examines the effects of individual justification factors, whereas real‐world settings entail more complexity involving multiple justification factors. In Experiment 1, we predict and find that managers are more likely to manage earnings when the firm's underperformance is caused by an external event and misreported earnings benefit other employees besides the reporting manager. Furthermore, we show that the extent to which participants use moral justifications mediates the effect of benefits sharing on earnings management, but only when causal attribution is external, and that it mediates the effect of causal attribution on earnings management, but only when benefits are shared. In Experiment 2, we use a neutral control condition that makes no mention of inconsistent incentives to demonstrate that it is the combination of causal attribution and benefits sharing that triggers earnings management. We contribute to the accounting and psychology literature by proposing and testing a theory that explains how multiple justification factors interact to cause opportunistic behavior. Our results suggest that policy‐makers and governing parties should consider developing a holistic view of possible justification factors, focusing on situational opportunities created by combinations of factors rather than individual factors alone

We study how securities analysts influence managers’ use of different types of earnings management. To isolate causality, we employ a quasi-experiment that exploits exogenous reductions in analyst following resulting from brokerage house mergers. We find that managers respond to the coverage loss by decreasing real earnings management while increasing accrual manipulation. These effects are significantly stronger among firms with less coverage and for firms close to the zero-earnings threshold. Our causal evidence suggests that managers use real earnings management to enhance short-term performance in response to analyst pressure, effects that are not uncovered when focusing solely on accrual-based methods