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Abstract
The paper provides a perspective on earnings management. I begin by addressing the following questions: What is earnings management? How pervasive is it? How is it measured? Then, I discuss what we, as academics, know about incentives to increase and to decrease earnings. The research presented relates to earnings management incentives stemming from regulation, debt and compensation contracts, insider trading and security issuances. I also discuss issues relating to problems in measuring the extent of earnings management and propose extensions for future work.
1. Introduction
An issue central to accounting research is the extent to which managers alter reported earnings for their own benefit. In the 1970s and early 1980s, a large number of studies investigated the determinants of accounting choice. These studies provided evidence consistent with managers' incentives to choose beneficial ways of reporting earnings in regulatory and contractual contexts (see Holthausen and Leftwich, 1983, and Watts and Zimmerman, 1986 for reviews of these studies). Since the mid-1980s studies of managerial incentives to alter earnings have focused primarily on accruals.
I trace the explosive growth in accrual-based management research to three likely causes. First, accruals are the principal product of Generally Accepted Accounting Principles, and, if earnings are managed, it is more likely that the earnings management occurs on the accrual rather than the cash flow component of earnings. Second, studying accruals reduces the problems associated with the inability to measure the effect of various accounting choices on earnings (Watts and Zimmerman, 1990). Third, if earnings management is an unobservable component of accruals, it is less likely that investors can unravel the effect of earnings management on reported earnings.
The main challenge faced by earnings management researchers is that academics, like investors, are unable to observe, or for that matter, measure the earnings management component of accruals. Indeed, managerial accounting actions intended to increase compensation, avoid covenant default, raise capital, or influence a regulatory outcome are largely unobservable. Consequently, prior work has drawn inferences from joint hypotheses, that test both incentives to manage earnings as well as the construct validity of the various accrual models which are used to estimate managers' accounting discretion. Because extant models of expected accruals provide imprecise estimates of managerial discretion, questions have been raised about whether...