European Business Schools Librarian's Group

Financial Reporting Research Group Working Papers,
University of Aarhus, Aarhus School of Business, Department of Business Studies

No R-2005-03: Earnings management to avoid earnings decreases and losses

Finn Schøler ()
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Finn Schøler: Department of Accounting, Aarhus School of Business, Postal: The Aarhus School of Business, Fuglesangs Allé 4, 8210 Aarhus V, Denmark

Abstract: This study focuses on earnings management by investigating the frequency distribution of the reported earnings (changes) by use of the approach documented by Burgstahler & Dichev (1997). In this study, it is investigated whether Danish firms use earnings management to avoid earnings decreases (and losses) by examining the earnings (changes) frequency distribution. This approach captures neither the magnitude nor how earnings are managed. Consequently, the relation between main "manageable" elements of working capital, current assets (among these the key components inventory and accounts receivable) and current liabilities, and reported earnings (changes) is examined. To address the problem further the modified Jones (1991) model is used to identify and separate discretionary accruals in orderto identify pre-managed earnings (changes). The frequency distribution of these calculated pre-managed earnings and the reported earnings are then compared. The paper contributes to the literature on earnings management in three ways: a) by investigating the frequency distribution of earnings (changes) in a small non-US country, b) by comparing the irregularities in the frequency distribution with two specific "manageable" current asset accounts, and c) by using the well known Jones model to "identify" the pre-managed earnings in order to compare these pre-managed earnings with the reported earnings. It is shown that the combination of the research of earnings management based on studies of irregularities in the earnings frequency distribution and studies of discretionary accruals can be a powerful approach to examining the existence of earnings management. The results in the paper support two aspects with respect to earnings management. First: also Danish firm managers engage in earnings management to avoid earnings decreases (and losses); and second: firm managers control "manageable" accounting accruals in anticipation of managing earnings.

Keywords: Discretionary accruals; Earnings management; Frequency distribution; Reported earnings

25 pages, September 23, 2005

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