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.