19 Financial: Earnings management

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    Bank affiliated directors and earnings management: Evidence from India
    ( 2018-09-01) Jadiyappa Nemiraja ; Hickman, Emily
    We examine the governing impact of creditors, i.e. Bank Appointed Directors (BAD), on the earnings management of corporate firms in a context which is characterized by underdeveloped financial institutions, a weak legal (contract) enforcement system and lack of insolvency resolution framework, i.e. India. Unlike the US, where BADs play a limited monitoring role, BADs in India play an active role in firm monitoring and thus have a negative impact on the discretionary accruals. Further, we document that the impact is greater for firms with a greater degree of information asymmetry and the agency problem. These results remain robust even after controlling for potential endogeneity issue.
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    Non-GAAP Tax Rate: Do Managers Use It to Achieve Earnings Targets?
    ( 2018-09-01) Chen, Xi ; Chiu, Peng-Chia ; Wang, Jiani
    In this study, we examine tax reporting in a non-GAAP setting. We focus on non-GAAP tax rates, which we define as the tax rates applied to non-GAAP exclusions (hereafter, exclusions). Using detailed hand-collected data, we find that non-GAAP tax rates are systematically lower (higher) when exclusions are income-increasing (income-decreasing), leading to higher after-tax non-GAAP earnings. In addition, using GAAP effective tax rate (hereafter, GAAP ETR) and the statutory tax rate as proxies for the non-discretionary portion of the non-GAAP tax rate, we find robust evidence that managers opportunistically use non-GAAP tax rates to achieve after-tax non-GAAP earnings targets. Finally, we document that firm-reported after-tax non-GAAP earnings are less persistent for future GAAP earnings, compared to non-GAAP earnings calculated using GAAP ETR or the statutory tax rate. The lower persistence of firm-reported non-GAAP earnings implies that non-GAAP tax rates are sometimes too high or too low, thus contaminating the after-tax non-GAAP earnings with mostly transitory exclusion items.
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    Analysts’ Suspicions of Earnings Management and Conference Call Narratives
    ( 2018-08-31) Ji, Yuan ; Rozenbaum, Oded
    The Q&A section of earnings conference calls allows participants to ask questions and resolve uncertainties. We examine whether conference call participants question managers when they obtain signals that discretionary expenses contributed to firms meeting or narrowly beating analysts’ expectations. We observe more questions on discretionary expenses when abnormal discretionary expenses are lower only for firms that meet or narrowly beat analysts’ expectations. We also find that there are more questions on discretionary expenses when discretionary expenses are lower compared to both the prior and subsequent year, again, only for firms that meet or narrowly beat analysts’ expectations. We then examine the consequences of analysts’ suspicions of real earnings management. We find that questions on discretionary expenses are associated with lower market reaction and analysts’ revisions for firms that meet or narrowly beat analysts’ expectations. These results are stronger when firms’ cost of engaging in real earnings management and abnormal discretionary expenses are lower. Our findings suggest that analysts identify signals of real earnings management, inquire about them at conference calls, and update their expectations accordingly.
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    Financing Constraints, Investment, and Financial Reporting
    ( 2018-08-29) Tomy, Rimmy
    The literature on financing constraints has found, as evidence of the existence of financing frictions, that decreases in internal financial resources causes firms to reduce investment activity. However, the literature is inconclusive on the effect of financing constraints on R&D versus capital expenditures. Using a novel setting, this paper finds firms that face a negative shock to internal capital do not uniformly cut back on all types of investment, but allocate capital away from investments with uncertain returns. I use the setting of the 1999 Taiwan earthquake, which disrupted the global semiconductor supply chain and increased production costs for a subset of US high-technology manufacturing firms that sourced semiconductor wafers and other components from Taiwan, causing a drain on internal capital. I find firms negatively impacted by the shock did not cutback on capital expenditures, but reduced R&D investment. In additional analysis, I find affected firms became more aggressive in their revenue recognition practices after the shock, potentially in response to an increase in competition from rivals, or to window-dress financial statements prior to raising equity.
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    Foreign capital and Earnings Management: International Evidence from Equity Market Opening
    ( 2018-08-23) Hou, Fangfang ; Ng, Jeffrey ; Rusticus, Tjomme ; Xu, Xinpeng
    The opening of equity markets to foreign investors provides financing opportunities and disrupts the stock ownership structure for firms in these markets. In this paper, we study the effects of equity market opening on firms’ earnings management. Using international firm-level data, we find a significantly positive effect of equity market openness on firms’ income-increasing earnings management. We show that there are substantial heterogeneous effects across industries and firms. The positive effect is more pronounced in industries that are more dependent on external financing and firms that are financially constrained, suggesting that firms’ intrinsic need for equity finance contributes to income-increasing earnings management behaviors. In addition, the effect is weaker in the presence of BigN auditors, indicating the monitoring effect of relatively more reputable auditors. Overall, our results suggest that incentives to attract financing when a country opens its equity market to foreign investors have a detrimental effect on domestic firms’ reporting bias.
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    Do the SEC Whistleblower Provisions of Dodd Frank Deter Aggressive Financial Reporting?
    ( 2018-08-22) Wiedman, Christine ; Zhu, Chunmei
    The stated goal of the 2011 SEC Whistleblower (WB) Program introduced as part of the Dodd-Frank Act was to strengthen investor protection through greater deterrence of securities law violations and more effective regulatory enforcement. While the SEC has articulated the success of the program for detecting and prosecuting violations, there is no evidence on the effect of the program in deterring violations. In this paper, we consider the deterrent effect by examining the impact of the Program on aggressive financial reporting by U.S. firms. Despite ongoing challenges, including the high number of tips received and efforts by some managers to circumvent the new rules by muzzling whistleblowers, we document a significant reduction in abnormal accruals following the introduction of the regulation. In a difference-in-differences design, we also find that reductions in aggressive reporting are significantly greater for U.S. firms than for Canadian firms. Using a sample of firms with ratings of internal reporting program quality just prior to the introduction of WB Program, we find that reductions in aggressive reporting are greater for firms with weaker internal programs. We also find that the reporting of internal control weaknesses decreased significantly in the years following the introduction of the Program. Collectively, these findings provide important evidence of significant benefits of the SEC WB Program of Dodd-Frank Act for deterring financial reporting fraud.
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    Bad News Herding, Excessive Write-offs, and Reversals of Restructuring Charges
    ( 2018-08-02) Fedyk, Tatiana ; Khimich, Natalya
    This paper demonstrates that bad news herding is actually accompanied by bad news over-reporting. By focusing on write-offs during two major recessions of 2001 and 2008 and taking advantage of a unique hand-collected dataset on reversals of restructuring charges, we document that when firms herd in their negative reports, they over-state bad news, creating a cushion that can be reversed in the future. Specifically, we show that: (1) large write-offs by early firms are followed by clustered write-offs by their peer firms; (2) herding firms over-report and subsequently partially reverse their write-offs; and (3) the reversals help herding firms to meet financial analysts’ earnings forecasts that otherwise would not be met. Taken together, these results lend credence to the following mechanism behind bad news herding: firms strategically engage in herding with excessive bad news reports to benefit from subsequent reversals.
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    The Importance of Director External and Internal Social Networks to Stock Price Crash Risk
    ( 2018-07-14) Fang, Xiaohua ; Pittman, Jeffrey ; Zhao, Yuping
    Prior research documents that information transmitted via director networks affects firms’ policies and real economic activities. We explore whether information flow through director networks influences managers’ ability to hoard bad news. We find that the extent of external connections of the board of directors is negatively associated with future stock price crash risk. Additional analysis implies that this evidence is driven by firms with more powerful executives, with weaker auditor monitoring, or subject to strong investor protection, and by directors with greater monitoring incentives or responsibilities, with less firm-specific knowledge, and with more valuable reputations to protect. We further find that director external network size is negatively associated with a variety of bad new hoarding signals. Collectively, our research lends empirical support for the monitoring view under which better informed directors narrow the scope for bad news hoarding evident in stock price crash risk. In another series of tests, we fail to find evidence consistent with the information leakage view under which directors pass sensitive firm-specific information to connections who trade on the information before its public release. Other analysis helps dispel the concern that the endogenous match between directors and companies is spuriously responsible for our core results. In contrast to our strong, robust evidence on the role that director external networks play, we only find some results implying that CEO-director internal networks shape stock price crash risk.