Content area
Full Text
SYNOPSIS: In this paper we review the academic evidence on earnings management and its implications for accounting standard setters and regulators. We structure our review around questions likely to be of interest to standard setters. In particular, we review the empirical evidence on which specific accruals are used to manage earnings, the magnitude and frequency of any earnings management, and whether earnings management affects resource allocation in the economy. Our review also identifies a number of opportunities for future research on earnings management.
INTRODUCTION
In this paper we review the academic evidence on earnings management. The primary purpose of this review is to summarize the implications of scholarly evidence on earnings management to help accounting standard setters and regulators assess the pervasiveness of earnings management and the overall integrity of financial reporting. This review is also aimed at identifying fruitful areas for future academic research on earnings management.
Standard setters define the accounting language that management uses to communicate with the firm's external stakeholders.1 By creating a framework that independent auditors and the SEC can enforce, accounting standards can provide a relatively low-cost and credible means for corporate managers to report information on their firms' performance to external capital providers and other stakeholders.2 Ideally, financial reporting therefore helps the best-performing firms in the economy to distinguish themselves from poor performers and facilitates efficient resource allocation and stewardship decisions by stakeholders.
The above role of financial reporting and standard setting implies that standards add value if they enable financial statements to effectively portray differences in firms' economic positions and performance in a timely and credible manner. In fulfilling this objective, standard setters are expected to consider conflicts between the relevance and reliability of accounting information under alternative standards. Standards that over-emphasize credibility in accounting data are likely to lead to financial statements that provide less relevant and less timely information on a firm's performance. Alternatively, standards that stress relevance and timeliness without appropriate consideration for credibility will generate accounting information that is viewed skeptically by financial report users. In either extreme, external investors and management will likely resort to nonfinancial statement forms of information, such as that provided by investment bankers and financial analysts, bond-rating agencies, and the financial press, to facilitate the efficient allocation...