Managerial Choice between Earnings Management Alternatives

• In Event: Financial Accounting and Reporting 8

Abstract

This paper examines the impact of mandatory restatement on managers’ earnings management behavior. Prior research showed evidence of managers trade-off between real activates manipulation (REM) and accrual-based earnings management (AEM) in choosing their earnings management tools based on the relative costs. Prior research also suggested a switch from AEM towards REM when firms facing tightening rules and stringent litigation environment. Mandatory restatement likely restrict the room of accruals manipulation and put firms under close scrutiny by auditors, investors, and regulators. Aggressive accounting treatments, mainly refers to aggressive accruals manipulations, may be at higher risk of being caught. According to prior research, managers are likely to switch from accrual-based earnings management towards real activities after the occurrence of mandatory restatement. However, we find a positive correlation between AEM and REM for both restatement firm sample and regular firm sample, which does not support a switch effect between the two earnings management tools. Specifically, although the use of accrual-based activity management decreases after firms’ mandatory financial restatement, the abnormal real activities are unexpectedly decreased as well in the post-restatement period. The decreases in both components of earnings management result in a decrease in total level of earnings management (combination of accrual-based earnings management and real activity management) after being investigated and required to restate their financial statements by SEC. The results of the tests using relative measure (proportion of REM over total earnings management) do not support the switch effect either. We also find that earning management behavior varies, heavily depending on factors such as the industry in which a firm plays in and whether reports loss or profit in prior years of restatement.

Authors

• Han Jin, West Verginia University

• Arron Scott Fleming, West Virginia University