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Earnings Management: A Perspectiveby Messod D. Beneish, Indiana University, Kelley School of Business, Bloomington, In-diana 47401

Abstract

The paper provides a perspective on earnings management. I begin by addressing the fol-lowing questions: What is earnings management? How pervasive is it? How is it meas-ured? Then, I discuss what we, as academics, know about incentives to increase and todecrease earnings. The research presented relates to earnings management incentivesstemming from regulation, debt and compensation contracts, insider trading and securityissuances. I also discuss issues relating to problems in measuring the extent of earningsmanagement and propose extensions for future work.

1. Introduction

An issue central to accounting research is the extent to which managers alter reportedearnings for their own benefit. In the 1970s and early 1980s, a large number of studies in-vestigated the determinants of accounting choice. These studies provided evidence con-sistent with managers incentives to choose beneficial ways of reporting earnings inregulatory and contractual contexts (see Holthausen and Leftwich, 1983, and Watts andZimmerman, 1986 for reviews of these studies). Since the mid-1980s studies of manage-rial incentives to alter earnings have focused primarily on accruals.

I trace the explosive growth in accrual-based management research to three likelycauses. First, accruals are the principal product of Generally Accepted Accounting Prin-

ciples, and, if earnings are managed, it is more likely that the earnings management oc-curs on the accrual rather than the cash flow component of earnings. Second, studyingaccruals reduces the problems associated with the inability to measure the effect of vari-ous accounting choices on earnings (Watts and Zimmerman, 1990). Third, if earningsmanagement is an unobservable component of accruals, it is less likely that investors canunravel 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 managementcomponent of accruals. Indeed, managerial accounting actions intended to increase com-pensation, avoid covenant default, raise capital, or influence a regulatory outcome arelargely unobservable. Consequently, prior work has drawn inferences from joint hypothe-ses, 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. Be-cause extant models of expected accruals provide imprecise estimates of managerial dis-cretion, questions have been raised about whether the unobservable earningsmanagement actions do in fact occur. 1

Notwithstanding research design problems, a variety of evidence suggestive of earn-ings management has accumulated. In Section 2, I raise three general questions aboutearnings management: What is it? How frequently does it occur? How do researchers es-timate earnings management? Prior investigations of managerial incentives to alter earn-ings typically fall in three categories, namely studies that examine the effect of contracts

Volume 27 Number 12 2001 3

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in accounting choices, and studies that examine the incentive effects associated with the

need to raise external financing. Rather than discussing the evidence along those lines, Ihave chosen to present the evidence depending on the direction of the incentive context.Thus, I summarize in Sections 3 and 4, what is known about incentives to increase anddecrease earnings. In Section 5, I discuss evidence on incentive contexts that provide in-centives either to increase or to decrease earnings, and in Section 6, I present conclusionsand suggestions for future work.

2. Earnings Management

2.1 Definitions

Notice the plural: It reflects my view that academics have no consensus on what is earn-ings management. There have been at least three attempts at defining earnings manage-

ment:

(1) Managing earnings is the process of taking deliberate steps within the con-straints of generally accepted accounting principles to bring about a desiredlevel of reported earnings. (Davidson, Stickney and Weil, 1987, cited inSchipper, 1989, p.92).

(2) Managing earnings is a purposeful intervention in the external financial re-porting process, with the intent of obtaining some private gain (as opposed tosay, merely facilitating the neutral operation of the process). ... A minor ex-tension of this definition would encompass real" earnings management, ac-complished by timing investment or financing decisions to alter reportedearnings or some subset of it." (Schipper, 1989, p.92).

(3) Earnings management occurs when managers use judgment in financial re-porting and in structuring transactions to alter financial reports to either mis-lead some stakeholders about the underlying economic performance of thecompany or to influence contractual outcomes that depend on reported ac-counting numbers. (Healy and Wahlen, 1999, p.368).

A lack of consensus on the definition of earnings management implies differing in-terpretations of empirical evidence in studies that seek to detect earnings management, orto provide evidence of earnings management incentives. It is thus useful to compare theabove three definitions.

All three definitions deal with actions management undertaken within the context offinancial reporting - including the structuring of transactions so that a desired accounting

treatment applies (e.g. pooling, operating leases). However, the second definition also al-lows earnings management to occur via timingreal investment and financing decisions. Ifthe timing issue delays or accelerates a discretionary expenditure for a very short periodof time around the firms fiscal year, I envision timingreal decisions as a means of man-aging earnings. A problem with the second definition arises if readers interpret any realdecisions - including those implying that managers forego profitable opportunities - asearnings management. Given the availability of alternative ways to manage earnings, Ibelieve it is implausible to call earnings management a deviation from rational invest-ment behavior. This reflects my view that earnings management is a financial reportingphenomenon.

Managerial Finance 4

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There are two perspectives on earnings management: the opportunistic perspective

holds that managers seek to mislead investors, and the information perspective, firstenunciated by Holthausen and Leftwich (1983), under which managerial discretion is ameans for managers to reveal to investors their private expectations about the firms fu-ture cash flows. Much prior work has predicated its conclusions on an opportunistic per-spective for earnings management and has not tested the information perspective.

The three definitions allow earnings management to occur for the purposes of hidingdeteriorating performance, but the word mislead in the Healy and Wahlen (1999) defi-nition appears to preclude the possibility that earnings management can occur for the pur-poses of enhancing the signal in reported earnings.

2

This may be due to the inclusion ofcontractual incentives in the third definition. To explain, prior work has not been able todistinguish whether managers exercise of discretion is intended to mislead or to inform,and the typical conclusion in contractual studies is that incentives result in de-facto op-

portunistic earnings management. Under the third definition, earnings managementshares much fraud. That is, fraud is defined as one or more intentional acts designed todeceive other persons and cause them financial loss. (National Association of CertifiedFraud Examiners, 1993, p.6). Thus, the main difference between the third definition andfraud is that stakeholders may have anticipated managers behavior and negotiated con-tract term that provide price protection.

2.2 Incidence of earnings management

If one believes former SEC Chairman Levitt (1998), earnings management is widespread,at least among public companies, as they face pressure to meet analysts expectations.Earnings management is also widespread if one relies on analytical arguments. For exam-ple, Bagnoli and Watts (2000) suggest that the existence of relative performance evalua-

tion leads firms to manage earnings if they expect competitor firms to manage earnings.Similar prisoners dilemma-like arguments for the existence of earnings management ap-pear in Erickson and Wang (1999) in the context of mergers and Shivakumar (2000) inthe context of seasoned equity offerings.

At the other extreme, we can only be certain that earnings have indeed been man-aged, when the judicial system, in cases that are brought by the SEC or the Department ofJustice, resolves that earnings management has occurred. While it is likely that earningsmanagement occurs more frequently than is observed from judicial actions, it is not clearto me that earnings management is pervasive: it seems implausible that firms face thesame motivations to manage earnings over time. As later discussed, much of the evidenceof earnings management is dependent on firm performance, suggesting that earningsmanagement is more likely to be present when a firms performance is either unusually

good or unusually bad.

2.3 Alternative methods for estimating earnings management

Three approaches have been used by researchers to evaluate the existence of earningsmanagement. One approach studies aggregate accruals and uses regression models to cal-culate expected and unexpected accruals. A second approach focuses on specific accrualssuch as the provision for bad debt, or on accruals in specific sectors, such as the claimloss reserve in the insurance industry. The third approach investigates discontinuities inthe distribution of earnings.


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2.3.1 Aggregate Accruals

The Jones (1991) model is the most widely used model in studies of aggregate accruals.The model follows Kaplans (1985) suggestion that accruals likely result from the exer-cise of managerial discretion and from changes in the firms economic conditions. Themodel relates total accruals to the change in sales ( DSales) and the level of gross prop-erty, plant and equipment (PPE):

Total Accrualsi t

= a1 i

+ b1 i

DSalesi t

+ c2 i

PPEi t

+ e1 i t

(1)

The model is based on two assumptions. First, that current accruals (changes inworking capital accounts) resulting from changes in the firms economic environment arerelated to changes in sales, or sales growth since equation (1) is typically estimated withall variables deflated by either lagged assets or lagged sales. Second, that gross propertyplant and equipment controls for the portion of total accruals related to nondiscretionarydepreciation expense.

The second version uses current accruals as a dependent variable and only thechange in sales as an explanator:

Currenti t

= a2 i

+ b2 i

DSalesi t

+ e2 i t

(2)

These models are either estimated in time series firm by firm or cross-sectionally us-ing all firms in a given two-digit industry and year. Each yearly estimation is used tomake a one-year ahead forecast of expected accruals which, subtracted from the depend-ent variable, yields unexpected accruals. Two alternative versions of the Jones (1991)model have also been proposed. In their total accrual form, the models are given by:

Total Accrualsi t

= a3 i

+ b3 i

(DSalesi t

- DReceivablesi t

)+c3 i

PPEi t

+ u3 i t

(3)

Total Accrualsi t

= a4 i

+ b4 i

DCash Salesi t

+c4 i

PPEi t

+u4 i

(4)

The expectation model in equation (3) is typically attributed to Dechow, Sloan andSweeney (1995) (e.g. see Gaver, Gaver and Austin, 1995), even though the modified-Jones model presented in Dechow et al. (1995) is the same as the Jones model in the esti-mation period and only has the receivable adjustment in the prediction period. Indeed, therevenue based variable in (3) equals Cash Sales

i t

-Salesi t - 1

. Since it is not clear what theconstruct means or how it proxies for the effect on accruals of changes in the firms eco-nomic environment, Beneish (1998b) proposed an alternative modification based on cashsales (equation 4). His evidence indicates that change in cash sales preserves the intuitionbehind using changes in sales to proxy for changes in economic performance and has the

advantage of using as an explanator an accounting construct that reduces the endogeneityproblem.3

Notwithstanding these modifications, the primary criticism leveled at extant accru-als models remains: The models fail to distinguish the accruals that result from managersexercise of discretion from those that result from changes in the firms economic per-formance (see McNichols, 2000) for an extensive discussion of research design issues re-lated to aggregate accrual models). This is exacerbated by the fact that we do not knowhow changing operating decisions that are ex-ante value maximizing affect measures ofearnings management. In other words, we do not know whether estimates of earnings


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management reflect efficient operating decisions or reporting considerations. To this ef-

fect Beneish (1997, p.275) states: ...a firms financial reporting strategy depends on itsbusiness strategy and should be evaluated ex-ante, not ex-post. To illustrate, consider apersonal computer manufacturer who seeks to gain market share on a competitor in-creased production and offers, before the holiday season, incentives to distributors whoincrease their demand. If the strategy is not successful and translates into lower than ex-pected earnings and a price drop, the manufacturer may be sued and its reporting criti-cized. While the firm ends up with higher discretionary accruals, it is, conditional on itsstrategy, an aggressive competitor rather than an earnings manager. This firm is, how-ever, not distinguishable from a firm who deliberately pushed sales on its distributors toimprove earnings. An additional problem is that if managers indeed have an incentive tomanage earnings, they are likely to do so in a way that is difficult to detect, thus reducingour ability to detect earnings management and weakening the power of our tests. 4

2.3.2 Other methods

Despite their widespread usage, models of aggregate accruals have been subject to sig-nificant criticism (cf. footnote 1). An alternative to using an aggregate accruals approachis to model a specific accrual, such as the provision for bad debt (McNichols and Wilson,1988), or to focus on accruals in specific sectors such as the claim loss reserve in the in-surance industry (Beaver and McNichols, 1998). McNichols (2000) provides an excellentdiscussion of the advantages and disadvantages of the specific accrual approach. For ex-ample, in terms of advantages she states (p.333): One advantage is that the researchercan develop intuition for the key factors that influence the behavior of the accrual, ex-ploiting his knowledge of GAAP. A second advantage is that a specific accrual approachcan be applied in industries whose business practices cause the accrual in question to be

material and a likely object of judgment and discretion. Among the disadvantages, sheargues that studying specific accruals require a costly investment in institutional knowl-edge, and limits the generalizability of the findings, since studies of specific accruals tendto be confined to smaller or sector specific samples.

Recent work by Burgstahler and Dichev (1997) and Degeorge, Patel and Zeckhauser(1999) use an interesting alternative methodology for studying earnings management.They investigate discontinuities in the distribution of reported earnings around threethresholds: (1) zero earnings, (2) last years earnings, (3) this years analysts expecta-tions. They make predictions about the behavior of earnings in narrow intervals aroundthese thresholds. The evidence appears consistent with predicted discontinuities: theretend to be less (more) observations than expected for earnings amounts just below(above) the zero earnings and last years earnings thresholds. While examining earnings

distributions is informative about which firms are likely to have managed earnings, thismethodology is silent about the form and extent of earnings management.

3. Evidence of Income Increasing Earnings Management

I discuss four sources of incentives for income increasing earnings management: (1) debtcontracts, (2) compensation agreements, (3) equity offerings, (4) insider trading. The firsttwo sources have been hypothesized in prior positive accounting theory research and thelast two sources are explicitly described as reasons behind earnings overstatement in theSECs accounting enforcement actions, and have been investigated in recent research.


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3.1 Debt Covenants

Debt contracts are an important theme in financial accounting research as lenders oftenuse accounting numbers to regulate firms activities, e.g. by requiring that certain per-formance objectives be met or imposing limits to allowed investing and financing activi-ties. The linkage between accounting numbers and debt contracts has been used in studiesinvestigation (i) why economic consequences are observed when firms comply with man-dated, or voluntarily make, accounting changes that have no cash flow impact, (ii) the de-terminants of accounting choice and managers exercise of discretion over accountingestimates that impact net income. The assumption is that debt covenants provide incen-tives for managers to increase earnings either to reduce the restrictiveness of accounting-based constraints in debt agreements or to avoid the costs of covenant violations.

The results of economic consequences studies have generally been mixed and re-

searchers recently turned to investigating accounting choice in firms that experience ac-tual technical default (Beneish and Press, 1993, 1995; Sweeney, 1994; Defond andJiambalvo, 1994; and DeAngelo, DeAngelo and Skinner, 1994). The idea is to increasethe power of the tests by focusing on a sample where the effect of violating debt cove-nants is likely to be more noticeable. While some of the evidence suggests that managerstake income increasing actions delay the onset of default (Sweeney, 1994; Defond andJiambalvo, 1994), other evidence does not (Beneish and Press, 1993; DeAngelo, DeAn-gelo and Skinner, 1994). Further, it is not clear such actions actually are sufficient to de-lay default.

5

Thus, the evidence in these studies on whether managers make income increasingaccounting choices to avoid default is mixed. However, examining a large sample of pri-vate debt agreements, and measuring firms closeness to current ratio and tangible net

worth constraints, Dichev and Skinner (2000) find significantly greater proportions offirms slightly above the covenants violation threshold than below. They suggest thatmanagers take actions consistent with avoiding covenant default.

3.2 Compensation Agreements

Studies examining the bonus hypothesis (Healy, 1985; Gaver et al., 1995; andHolthausen, Larker and Sloan, 1995) provide evidence consistent with managers alteringreported earnings to increase their compensation. Except for Healy (1985), these studiesprovide evidence consistent with managers decreasingreported earnings to increase fu-ture compensation. In addition, Holthausen et al. (1995) finds little evidence that manag-ers increase income and suggest that the income-increasing evidence in Healy (1985) isinduced by his experimental design.

3.3 Equity Offerings

A growing body of research examines managers incentives to increase reported incomein the context of security offerings. Information asymmetry between owners-managersand investors, particularly at the time of initial public offerings, is recognized in prior re-search. Models such as Leland and Pyle (1977) suggest that the amount of equity retainedby insiders signals their private valuation, and models such as Hughes (1986), Titman andTrueman (1986), and Datar et al. (1991) examine the role of the reputation of the auditoron the offer price. In these models, the asymmetry is resolved by the choice of an outsidecertifier or by a commitment to a contract that penalizes the issuer for untruthful disclo-


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sure. Empirical studies assume that information asymmetry remains and use various

models to estimate managers exercise of discretion over accruals at the time of securityofferings.

Four studies investigate earnings management as an explanation for the puzzling be-havior of post-issuance stock prices. Teoh, Welch and Rao (1998) and Teoh, Welch andWong (1998a) study earnings management in the context of initial public offerings (IPO),and Rangan (1998) and Teoh, Welch and Wong (1998b) do so in the context of seasonedequity offerings. These studies estimate the extent of earnings management using Jones-like models around the time of the security issuance, and correlate their earnings manage-ment estimates with post-issue earnings and returns. The evidence presented suggests thatestimates of at-issue earnings management are significantly negatively correlated withsubsequent earnings and returns performance.

The results in these studies suggest that market participants fail to understand thevaluation implications of unexpected accruals. While the results are compelling, the con-clusion that intentional earnings management at the time of security issuance successfullymisleads investors is premature. Beneish (1998b, p.210) expresses reservations aboutgeneralizing such a conclusion as follows: First, the conclusion implies that financialstatement fraud is pervasive at the time of issuance. To explain; fraud is defined by theNational Association of Certified Fraud Examiners (1993, p.6) as one or more inten-tional acts designed to deceive other persons and cause them financial loss." If financialstatement fraud at issuance is pervasive - e.g. managers are successful in misleading in-vestors - I would expect that firms would fare poorly post-issuance in terms of litigationbrought about by the Securities and Exchange Commission (SEC), disgruntled investors,and the plaintiffs bar. I would also expect managers to fare poorly post-issuance in terms

of wealth and employment. I would find evidence of post-issue consequences on firmsand managers informative about the existence of at-issue intentional earnings manage-ment to mislead investors and believe these issues are worthy of future research."

3.4 Insider Trading

Like raising capital, insider trading is a trading related incentive and a relatively new-comer to the set of potential antecedents to income increasing earnings management. Thereason is that, if one accepts two economic efficiency-based arguments, the study of suchincentives becomes futile. Specifically, the arguments are: (1) capital markets are infor-mationally efficient (a central hypothesis in capital research), and investors see throughmanagers accounting actions, (2) reputation effects and the labor market discipline insid-ers, preventing them from profiting in firms facing declining prospects.

The evidence on insider trading as an incentive to increase income to mislead inves-tors is less pervasive, but, in my opinion, more compelling that the evidence on equity is-suance as an incentive. One reason is that the evidence is drawn from firms that haveactually perpetrated financial statement fraud (Beneish, 1999), or committed illegal acts(Summers and Sweeney, 1998). It is consistent with professional views of causes of earn-ings management (National Association of Certified Fraud Examiners, 1993), and alsowith evidence that managers reduce their stake in the firms equity in the years precedingbankruptcy filings (Seyhun and Bradley, 1997). While Seyhun and Bradley (1997) do notspeak to earnings management, their sample firms face deteriorating performance, a fre-


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quently posited antecedent to corporate illegal behavior (National Association of Certi-

fied Fraud Examiners, 1993).

The most direct evidence linking financial statement manipulations and insider trad-ing is in Beneish (1999) who finds that managers of firms with earnings overstatementsthat violate GAAP are more likely to sell their holdings and to redeem stock appreciationrights during the period when earnings are overstated than managers in a control sampleof firms. I also find an average stock price loss of 20 percent when the overstatement isdiscovered and an average cost of settling litigation that is 9 percent of market value priorto discovery. This suggests that managers stock transactions during the period of earn-ings overstatement occur at inflated prices that reflect the effect of the earnings overstate-ment. (p.426)

Beneish (1999) relies on prior insider trading research to develop hypotheses about

manipulation incentives related to insider trading. This research suggests that managersact as informed traders, buying (selling) in advance of stock price increases (declines)(Jaffe, 1974; Seyhun, 1986) and views the gains managers as an efficient means of com-pensating managers for providing their private information to investors on a timely basis(Carlton and Fischel, 1983; Dye, 1984; Noe, 1997).

Beneish (1999) thus argues that: If managers act as informed traders, I expect themto use their information about earnings overstatement to trade for their own benefit. Thatis, if managers overstate earnings to provide market participants with positive private in-formation about the firms prospects, I expect them to either strategically increase theirstake in their firms equity (perhaps to provide another positive signal about firm pros-pects) or abstain from trading. Alternatively, if managers overstate earnings to hide dete-riorating firm performance, I expect them to sell their equity contingent wealth. If

overstatement is intended to mislead investors, managers may limit their selling to reducethe likelihood of attracting the attention of the SECs insider trading monitors. Alterna-tively, as argued by Summers and Sweeney (1998), managers who mislead investors maypossess low personal ethics, low risk aversion and/or a downwardly biased assessment ofthe probability of getting caught. Yet another possibility is that, in the event of detection,managers could justify their selling for personal liquidity reasons. (p.435)

Beneish (1999) also investigates the penalties facing managers after the manipula-tions are discovered. If reputation losses and the consequent disciplining in the stock mar-ket preclude managers from engaging in earnings manipulation and making profitabletrades, employment and monetary penalties subsequently imposed on managers shouldbe substantial if they are to serve as a deterrent. However, Beneish (1999) finds thatmanagers employment losses subsequent to discovery are similar in firms that do and

do not overstate earnings and that the SEC is not likely to impose trading sanctions onmanagers in firms with earnings overstatement unless the managers sell their own sharesas part of a firm security offering. (p.425)

4. Evidence of Income Decreasing Earnings Management

With the exception of bonus as a form of compensation, where evidence discussed in sec-tion 3.2 suggests that managers decrease current reported earnings so as to increase futurecompensation, much of the evidence in prior research on income decreasing earningsmanagement is consistent with managers depressing earnings on a temporary basis to in-


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crease the likelihood of a negotiated or regulatory outcome. For example, lower reported

earnings have been shown to increase the likelihood that utilities can obtain rate increases(Jarrell, 1979), to reduce the likelihood of wealth transfers (Watts and Zimmerman,1978), and to obtain import relief (Jones, 1991); Liberty and Zimmerman (1986) examineincentives to decrease earnings in periods surrounding union negotiations and DeAngelo(1986) examines incentives to decrease earnings in periods preceding management buy-outs. The power of the tests in these studies is low as samples are small, and evidence isnot always conclusive: Liberty and Zimmerman (1986) and DeAngelo (1986) find noevidence of downward earnings manipulations.

Recent survey evidence in Nelson et al. (2000) suggests that income decreasing inearnings management in the form of cookie jar reserves is pervasive. Surveying 526experiences of Big-5 audit partners and managers, they find that 40% of the responses de-scribe attempts at income decreasing earnings management. While the ratio suggests that

income decreasing earnings management is pervasive, it is difficult to make a more pre-cise assessment because the survey was conducted in the Fall of 1998, a period character-ized by economic expansion and a bull market.

5. Sector Specific Contexts that Provide Incentives Either to Increase or to DecreaseEarnings

Financial institutions and insurance companies are in sectors where managers have tobalance financial reporting incentives with regulatory constraints. For example, studies ofregulated financial institutions indicate that managers face multiple incentives to manageearnings. In particular, these studies suggest that incentives associated with regulatorycapital and decreasing taxes balance those associated with increasing earnings. Indeed,

these studies generally provide evidence consistent with income smoothing (see Moyer,1990; Beatty, et al., 1995; Collins et al., 1995).

Studies in these areas avoid the problems associated with using a model of expecta-tions for aggregate accruals, because they can focus on the discretion associated with par-ticular accruals such as loan loss provisions in the banking industry and claim lossprovisions in the insurance industry. Required disclosures in these industries enable re-searchers, with hindsight, to identify firms that under- or over-reserved, and to test hy-potheses about the factors motivating this behavior. For example, Petroni (1992) findsthat financially weak insurers tend to underestimate loss reserves relative to companiesexhibiting greater financial strength. Beaver, McNichols and Nelson (2000) analyze thedistribution of insurance company earnings and suggest that weak insurers have incen-tives to under-reserve while strong insurers have incentives to over-reserve.

6. Conclusions and Future Research

The accumulated evidence suggests that income increasing earnings management is morepervasive than income decreasing earnings management. While the results are mixed orsubject to confounding effects, there is weak evidence that debt covenants, and equity of-ferings provide income increasing incentives. There is also evidence that managers haveincentive to increase income to hide deterioration of performance, so as to sell their eq-uity contingent wealth at higher prices. The latter evidence is limited however, to smallsamples and generalizations will require further studies. With the exception of sector spe-


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cific studies, evidence on income decreasing earnings management is meager. At best, it

appears to be time and industry specific.

Future work needs to deal with the unobservability of managerial actions that pre-sumably result in income manipulations. The difficulties faced by aggregate accrual mod-els suggest that studies of specific accruals, perhaps even case studies, are needed. In hiscall for papers, Beneish (1998a, pp.86-87) suggests two avenues of research that have notbeen exploited to date. The study of the form of reporting discretion and its bounds inthe context of a particular industry. For example, what components of revenues and ex-penses are discretionary in the health care industry? How does discretion over these com-ponents earnings translate into discretionary accruals? What can we learn from theirbehavior over time? In a similar vein, one could investigate the discretion related torevenue recognition in the high-tech, health-care or construction industries, or the discre-tion related to the provision for inventory obsolescence among computer manufacturers.

One way in which one could assess the external validity of aggregate accrual modelsand learn about the exercise of discretion in specific industries is to study earnings re-statements. Beneish (1998a, p.87) also suggests an avenue of research that has not beenexploited to date: The analysis of instances where firms restate earnings, e.g. where ac-tual earnings management is more likely. Such instances are of interest because (i) rely-ing on external sources to establish ex-post that earnings were managed enables anassessment of the external validity of accrual models, (ii) such instances enable a descrip-tion of the form and extent of managers reporting discretion. For example, (a) What isthe relation between earnings management and shareholder litigation? independent audi-tor litigation? What is the relation between the magnitude of estimated discretionary ac-cruals and that of earnings restatements? (b) If actions brought by tax authorities againstfirms result in disallowances and or restatements, what is the relation between the magni-

tude of estimated discretionary accruals and that of earnings restatements?

A promising avenue of research is the study of the intersection of insider trading - anobservable management action - with earnings management - an unobservable manage-ment action. Large sample evidence in Beneish and Vargus (2000), and evidence on asample of technical defaulters in Beneish, Press and Vargus (2000) suggests that insiderstrading is useful in assessing the likelihood of earnings management.


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Endnotes

1. Criticism of extant accrual models ability to isolate the earnings management compo-nent of accruals includes McNichols and Wilson (1988), Holthausen, Larker and Sloan(1995), Beneish (1997, 1998), and McNichols (2000) who argue that when the incentivecontext studies is correlated with performance, inferences from the study are confounded;Guay, Khotari and Watts (1996) who suggest that accrual models estimate discretionaryaccruals with considerable imprecision and that some accrual models randomly decom-pose earnings into discretionary and non-discretionary components; Beneish (1997) whoprovides evidence that accrual models have poor detective performance even amongfirms whose behavior is extreme enough to warrant the attention of regulators; Thomasand Zhang (2000) who suggest that the performance of accrual models is dismal.

2. A conversation with one of the authors revealed that he would also interpret a situation

where could be signaling strength as misleading. Consider that a manager understates in-come by over-providing for bad debts, obsolescence or loan losses: the usual signaling ar-gument is that the manager action is informative as it helps investors distinguish betweenweak and strong firms; however, it is also possible that the manager action is misleadingbecause the manager may be setting aside income for a rainy day.

3. To explain; it is much harder to exercise discretion over cash sales than over creditsales. Indeed, examining firms whose financial reporting behavior is deviant enough towarrant SEC enforcement actions, Beneish (1997) finds that cash sales are rarely manipu-lated. He reports that one firm out of 64 (1.6%) engages in circular transfers of money tocreate the impression of receivable collection. In contrast, 43 of 64 firms (67.2%) engagein manipulations affecting credit sales (e.g. fictitious invoices, front loading with a rightof return, keeping books open past the end of the fiscal period, overstating the percentage

of completion).

4. I thank an anonymous referee for this suggestion.

5. Defond and Jiambalvo (1994) and Sweeney (1994) study a subset of firms for whichthey have constraint data and find that neither accrual discretion nor changes in account-ing techniques are effective in delaying default.


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