We examine the determinants and consequences of earnings management by firms in the context of their relationships with suppliers and customers. We find that industry-level proxies for relationship-specific investments by suppliers/customers are positively associated with the magnitude of discretionary accruals, volatility of earnings, and the frequency of large earnings increases. We also find that firm-level proxies for the intensity of relationship-specific investments by actual suppliers are positively related to the magnitude of discretionary accruals. In addition, earnings management by the firm in one period is positively related to the magnitude of R&D investments by suppliers and customers in the next period. However, we find that earnings management adversely affects the duration of customer-supplier relationships. Overall, our findings suggest that earnings management is used opportunistically to influence the perception of suppliers/customers about the firm’s prospects

We examine the effects of audit quality on earnings management and cost of equity capital for two groups of Chinese firms: state-owned enterprises (SOEs) and non-state-owned enterprises (NSOEs). The differences in the nature of the ownership, agency relations and bankruptcy risks lead SOEs to have weaker incentives than NSOEs to engage in earnings management. As a result, the effect of audit quality in reducing earnings management will be greater for NSOEs than for SOEs. In addition, investors’ pricing of information risk as reflected in the cost of equity capital will be more pronounced for NSOEs than for SOEs with high and low audit quality. We find empirical evidence consistent with these hypotheses. Our findings indicate that (1) while high-quality auditors play a governance role in China, that role is limited to a subset of firms, and (2) even under the same legal jurisdiction, the effects of audit quality (in the form of lower earnings management and cost of equity capital) vary across firms with different ownership structures. Our study extends prior research by focusing on the economic consequences of SOEs’ and NSOEs’ auditor choices and underscores the importance of controlling for ownership type when conducting audit research

Conventional agency theory suggests that firms should benchmark CEO compensation to absorb systemic risk and to more efficiently incentivize executives to work hard. Yet empirical research has found only a modest use of benchmarking in CEO compensation contracts. In this paper, I highlight one weakness of relative performance evaluation (RPE). When earnings management is possible, benchmarking creates stronger incentives for misreporting performance measures compared to benchmark‐independent pay. The optimal contract will depend less on a correlated benchmark (e.g., a stock market index) if it is easier for the manager to misreport performance. Thus, the model predicts that firms with weak internal controls and bad auditors are less likely to use RPE, offering a theoretical explanation for the empirically observed lack of RPE use

We examine the governance transfer effect of corporate blockholders in a sample of 892 block acquisitions across 42 countries from 1990 to 2008. Using earnings management as a proxy for corporate governance outcome, we find that target firms' earnings management is aligned with that of block acquirers after acquisitions, implying that blockholders transfer their own governance quality to investee firms. We further identify three economic mechanisms that underlie the governance transfer effect, namely, monitoring effectiveness, monitoring cost, and monitoring environment. Our findings provide new insights into the governance role of blockholders

Sell‐side equity analysts serve as external monitors, yet evidence on how they fulfill this monitoring role remains limited. We examine whether analysts utilize earnings conference calls to monitor firms suspected of real earnings management and assess the implications of such monitoring. Our findings reveal that analysts are more likely to ask about discretionary expenses during conference calls of firms suspected of lowering these expenses to meet or narrowly beat analysts' expectations. These questions are associated with lower subsequent EPS forecast revisions, indicating a potential cost to managers. Moreover, analysts' questions on discretionary expenses to suspect firms are linked to subsequent increases in discretionary expenses and a lower likelihood of meeting or narrowly beating analysts' earnings expectations in the following 2 years. Overall, our results suggest that analysts' active participation in earnings conference calls potentially discourages managers from engaging in real earnings management

This study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process

Exploiting a quasi‐natural experiment in China in which some firms become investible to foreign investors across different times (i.e., pilot firms), we explore the role that stock market liberalization plays in shaping firms' earnings management activities. In one direction, the national‐level liberalization reform may elicit public attention from various stakeholders, piling pressure on managers to refrain from distorting their firms' earnings. In the other direction, the various restrictions that the government imposes on foreign investors cast doubt on whether China's capital control reform will materially affect pilot firms' incentives and scope to manipulate their earnings. To gauge which force is more dominant, we rely on a staggered difference‐in‐differences research design and find that pilot firms significantly reduce the magnitude of their discretionary accruals and the incidence of financial reporting irregularities from the pre‐ to the post‐liberalization period, compared to non‐pilot firms during the same time frame. Additional analysis implies that externalities in the form of stricter external monitoring from the media, institutional investors, and auditors is the major mechanism that helps market liberalization curb firms' earnings management. Our research provides insight on the importance of financial global integration to firms' earnings management practices

We study the impact of the recent government bailout, called Trouble Asset Relief Program (TARP), on bank accounting quality. By adopting a difference-in-difference (DID) method, we find a significantly positive impact of TARP on earnings management of recipient banks, compared with their non-recipient peers. Further, we observe that TARP-recipient banks engage more in earnings-decreasing manipulation rather than earnings-increasing manipulation. This behavior is more obvious for those banks that voluntarily request for TARP funds. Also, participant banks change their accounting strategy to manipulate earnings upwards after TARP funds are paid back. Our findings confirm our hypothesis that TARP-recipient banks are motivated to manipulate downwards (or hide some earnings) to obtain further favorable treatment by the program administrators

Using a large sample of both publicly traded and privately held firms in South Korea (hereafter “Korea”), we investigate whether, and how, the deviation of controlling shareholders' control from ownership, business group affiliation, and listing status differentially affect the extent of earnings management. Our study yields three major findings. First, we find that as the control‐ownership disparity becomes larger, controlling shareholders tend to engage more in opportunistic earnings management to hide their behavior and avoid adverse consequences such as disciplinary action. The result of our full‐model regression reveals that an increase in the control‐ownership wedge by 1 percent leads to an increase in the magnitude of (unsigned) discretionary accruals by 1.3 percent of lagged total assets, ceteris paribus. Second, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for group‐affiliated firms than for nonaffiliated firms by 0.8 percent of lagged total assets. This result suggests that business group affiliation provides controlling shareholders with more incentives and opportunities for earnings management. Finally, we find that for our full‐model regression, the magnitude of (unsigned) discretionary accruals is greater for publicly traded firms than for privately held firms by 1.2 percent of lagged total assets. This result supports the notion that stock markets create incentives for public firms to manage reported earnings to satisfy the expectations of various market participants that are often expressed in earnings numbers

This paper examines the classification of items within the income statement as an earnings management tool. Evidence is consistent with managers opportunistically shifting expenses from core expenses (cost of goods sold and selling, general, and administrative expenses) to special items. This vertical movement of expenses does not change bottom-line earnings, but overstates “core” earnings. In addition, it appears that managers use this earnings management tool to meet the analyst forecast earnings benchmark, as special items tend to be excluded from both pro forma and analyst earnings definitions