Earnings management

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Understanding Earnings Management: Key Insights from Recent Research

Earnings Management in Multinational Corporations

Location and Strategy
Multinational corporations (MNCs) often manage their consolidated earnings through strategic reporting across their subsidiaries. The influence of the headquarters on subsidiary earnings management is notably higher when subsidiaries are more integrated and have greater opportunities for earnings management. MNCs exploit regulatory differences across countries, shifting earnings management to subsidiaries in countries with more lenient regulations when home-country regulations become stricter .

Shareholders' Demand for Earnings Management

Internal and External Demand
Shareholders may not always seek to eliminate earnings management due to its potential benefits. Internally, earnings management can minimize the cost of inducing managers to take desired actions. Externally, it can improve contractual terms with outsiders, such as suppliers or creditors, by presenting a more favorable financial position. This dual demand underscores the complex motivations behind earnings management practices.

Impact of Earnings Forecasts

Forecasts and Earnings Management
Earnings management is influenced by voluntary management forecasts. High earnings forecasts are more likely to lead to earnings management as managers attempt to meet or exceed these expectations. Interestingly, shareholders might find it beneficial to allow some level of earnings management to reduce the cost of obtaining truthful forecasts from managers.

Earnings Management and Equity Offerings

Seasoned Equity Offerings
Firms conducting seasoned equity offerings often experience poor stock price and earnings performance post-offering. This decline can be attributed to earnings management around the time of the offering, which temporarily inflates the firm's value, leading to subsequent market disappointment when the true earnings are revealed.

Corporate Governance and Earnings Management

Systematic Literature Review
Earnings management plays a significant role in corporate governance. Companies may engage in earnings management to present a healthier financial state and attract shareholders. A systematic review of literature from 2010 to 2023 highlights the pervasive impact of earnings management on corporate governance practices.

Avoiding Earnings Decreases and Losses

Incentives and Methods
Firms have strong incentives to avoid reporting earnings decreases and losses. This is often achieved by manipulating components of earnings, such as cash flow from operations and changes in working capital. The motivation behind this behavior can be explained by prospect theory and managerial opportunistic behavior, aiming to meet stakeholder expectations.

Earnings Management During CEO Changes

CEO Transitions
Earnings management is prevalent during CEO changes, particularly non-routine changes. Incoming CEOs may engage in "earnings baths," reducing income in the year of the change to set a lower performance benchmark for future periods. This practice is facilitated by the use of abnormal and extraordinary items.

Real Earnings Management

Measurement and Strategy
Real earnings management (REM) involves altering operating policies to meet short-term financial targets. Traditional models measuring REM may misinterpret cost differences due to competitive strategies as earnings management. Improved measurement models are suggested to avoid such misinterpretations and ensure accurate detection of REM.

Conclusion

Earnings management is a multifaceted practice influenced by various internal and external factors. From multinational corporations exploiting regulatory arbitrage to firms managing earnings around equity offerings and CEO changes, the motivations and methods are diverse. Understanding these dynamics is crucial for stakeholders to navigate the complexities of corporate financial reporting.