Earnings Management: A problem of definition

Abstract

Earnings management is an important topic in accounting literature because of how pervasive it is. It has negative connotations, often associated with some sort of wrong-doing and market abuse. There have been a number of attempts to codify and define earnings management which as resulted in a great deal of confusion of what earnings management is, what motivates the actions and what the implications are. This paper examines six prior studies that use the same detection model, sample period and similar samples, and how the author's definitions of earnings management influence the conclusions that they draw from their results. This paper finds that authors definitions ofter have greater influence over the conclusions that are drawn that the detection model has. This can lead to bias and misleading conclusions. This paper offers a different perspective on earnings management, challenging the prevailing view of managerial opportunism.

Introduction

Earnings management is a pervasive topic within accounting literature. It infiltrates many aspects of business; financial reporting, executive remuneration, signalling and even the notion of efficient markets. Academics seek to understand how, why and when it occurs and what the implications are. Financial reporting is built on accruals. Accruals are more informative than cash because they remove the timing and matching problems associated with cash (Dechow 1994; Subramanyam 1996). Managers of companies have to use a great deal of discretion and judgement when preparing financial statements. The use of this flexibility is earnings management. Managers are able to use this flexibility to portray private information (Arya et al. 2003; Louis and Robinson 2005), reduce agency costs (Jiraporn et al. 2008) and protect share price fluctuations from transient shareholders (Matsumoto, 2002). However, this flexibility can be used for managerial opportunism. There is a range of literature that suggest that earnings management is used for insider trading (Beneish and Vargus 2002), increasing remuneration (Bergstresser and Philippon 2006; Bartov and Mohanram 2004; Carter et al. 2009) and to "win" at the "numbers game" (Levitt 1998).

There is no consistent definition of earnings management. Healy and Wahlen (1999) provide the most cited definition of earnings management. The intent is to "mislead some stakeholders about the underlying economic performance." (Healy and Wahlen 1999,368). This definition implies that it is a fraudulent activity. Dechow and Skinner (2000) attempt to clarify the definition. The definition that they create is that managerial discretion is a spectrum, with accounting choice at one end and fraud at the other. Accounting choice is observable (through notes to the accounts) and within GAAP (verified through audits). Accounting choice is beneficial for shareholders because GAAP aims to make financial reporting reflect underlying economic truth (Dechow and Skinner, 2000). Fraud is unobservable (managers engaging in fraud do not want to get caught), it breaches GAAP and is against the law. Fraud is not beneficial for shareholders because the accounting numbers do not reflect economic reality. Fraud damages shareholder wealth, and is for the purpose of manager's private gain. Earnings management lies somewhere between. It is not observable, but within GAAP. It can both enhance and destroy the informativeness of earnings.

Earnings management does not exists in a void. It is not controlled by remuneration design alone. Standard setting, law and remuneration all have a part to play in effective financial reporting. These three aspects of financial reporting all have the same goal; to provide an environment where shareholder wealth can be maximised. Earnings management is a concern for all three. Understanding the motivation to manage earnings is understanding how to get the best from this environment. Standard setting research has an interest in earnings management because it needs to encourage discretion and judgement, however not so much that the financial statements are not informative. Law is concerned with monitoring earnings management because it needs to adequately punish managers who use earnings management for fraud. Executive remuneration needs to align the interests of shareholders and managers but not to a point that encourages shareholder wealth damaging behaviour, as shown by Bergstresser and Philippon (2006). There are many factors influencing earnings management which may or may not be working in unison. Standard setting defines the degree of judgement and discretion that managers are allowed. The Law sets out what is and is not acceptable in society regardless of what the accounting standards say. Opposite the Law, remuneration acts a motivator to encourage behaviour rather than punish. These should all work together to achieve the same goal; enabling shareholder wealth to be maximised.

In order to understand whether or not earnings management is beneficial to shareholders, the intent of managers needs to be examined. As intent is unobservable, the underlying motivation can help shed light on managerial intention. Beneish (2001) examines four underlying motivations for managing earnings; debt contracts, equity offerings, remuneration agreements and insider trading. Debt contracts impose conditions on company activity and are largely based on accounting numbers. Managers may use earnings management to reduce the restrictiveness of debt contracts or to avoid a breach of the terms. Equity offerings provide an incentive to manage earnings because there is a large amount of information asymmetry between shareholders and managers (supported by Louis and Robinson, 2005). Inflating earnings can provide favourable terms on which to raise capital through IPOs. Remuneration agreements can encourage earnings management because managerial remuneration is often linked with accounting numbers. Managers can seek to maximise their remuneration through managing earnings (Bergstresser and Philippon, 2006). Insider trading is a clear fraudulent activity, which builds on the remuneration incentive. Managers can use their private information to find favourable situations in which to buy and sell their shares for private gain.

Bergstresser and Philippon (2006) find that during periods of earnings management CEOs and other insiders sell large numbers of shares. They suggest that this is due to the large rise in share and option based executive remuneration. There are a number of studies which document capital market incentives for managers to use earnings management. These studies find that managers manage earnings to meet or exceed analyst's expectations because capital markets have a large asymmetric reaction to firms missing analyst's expectations. Earnings management in capital markets can be used to attract more favourable transaction terms with stakeholders (Burgstahler and Dichev, 1997), to avoid share price drops due to transient shareholders (Matsumoto, 2002) and to communicate managerial expertise (Arya et al., 2003).

The majority of earnings management literature assumes managerial opportunism. However, there is a substantial body of research that suggests it is beneficial for shareholders. Interestingly the evidence that the opportunism literature provides is not inconsistent with the conclusions that can be drawn from the beneficial literature. In other words, managers can act opportunistically and signal for the benefit of shareholders. Remuneration is designed to align the interests of managers and shareholders, this can be achieved by managers acting selfishly to increase their remuneration, through increasing the companies earnings; within GAAP or otherwise. Subramanyam (1996) was an early proponent of the beneficial earnings management debate. Subramanyam investigates the pricing of discretionary accruals. Discretionary accruals are a proxy for manager's private information that is not reflected in historical cost accounting. Subramanyam argues that if the market prices discretionary accruals then there are two different, but not mutually exclusive, explanations; markets are efficient and pricing of accruals means they contain value, or the market is inefficient and discretionary accruals do not contain value. If the market is considered to be informationally semi-strong, then the two conclusions here are not inconsistent. Earnings management can be a bridge between informationally semi-strong and strong form efficiency. Informationally semi-strong markets do not reflect privately known information, earnings management could help to resolve this by providing the private information. Subramanyam finds that the pricing of discretionary accruals is due to the ability of managers to communicate private information. Communicating private information is an essential part of financial reporting. However, discretionary accruals are not the only method. Burgstahler and Dichev (1997) find that managers may also use analyst's expectations to signal private information.

Burgstahler and Dichev (1997) attempt to examine the motivation to avoid earnings decreases and losses. Burgstahler and Dichev state that there are strong incentives to avoid earnings decreases and losses (supported by Levitt, 1998). Burgstahler and Dichev find that there are more earnings increases and more cases where earnings marginally exceed zero earnings than should be expected. They find two approaches to explaining the motivation; transaction cost theory and prospect theory. The transaction cost theory suggests that firms with higher earnings attract more favourable transaction terms with non-owner stakeholders. It also suggests that information costs are sufficiently high that these stakeholders may use alternative measures for assessing performance, such as avoiding earnings losses or decreases. Prospect theory states that decision makers derive value from a reference point rather than absolute values. The authors find that the reference point for managers lies around an absolute change from loss to profit and the relative earnings increase or decrease. Both the Burgstahler and Dichev (1997) and Subramanyam (1996) papers focus on earnings management being beneficial, or at least not detrimental to shareholder wealth.

Transaction cost theory can help to explain the results in Matsumoto (2002). Matsumoto builds on the Burgstahler and Dichev (1997) study by investigating the incentives to avoid negative earnings surprises. Matsumoto finds that managers are motivated by the views of the companies stakeholders. Companies with implicit stakeholder claims are more likely to meet analyst's forecasts, suggesting that the stakeholders do not find it cost effective to conduct their own analysis of financial statements. Instead they rely on the signalling effect of meeting analyst's expectations. Managers may be protecting shareholder wealth by avoiding these surprises. These signalling effects are documented in Arya et al. (2003).

Arya et al. (2003) analyses whether or not unmanaged earnings are better for shareholders. They find that managerial expertise are portrayed through managed earnings. Their assumption is that managers that work hard are better able to run the firm and predicting future income. Smooth earnings allow managers to communicate that skill and hard work because it requires hard work to be able to predict future income. This can reduce the costs of motivating managers because the shareholders can easily monitor the manager's ability by looking at how they communicate their expertise. Shareholders can sack managers who lack expertise.

Similarly, Louis and Robinson (2005) investigate the signalling effect of earnings management. They find that discretionary accruals are valuable when they are used alongside stock splits. Discretionary accruals may be viewed as managerial opportunism if they are used alone, but if they are used with a stock split there is a much higher degree of credibility. Earnings management allows managers to signal optimism without the fear of litigation that is associated with press releases and other explicit signalling methods. Managers may be sued if explicit signals do not materialise; the risk from litigation is lower for implicit signals. Here the motivation for earnings management is the fear of litigation and to supply signals to the market. The litigation that managers face from shareholders is one example of the agency problem. If managers do not properly represent the views of shareholders there are frictional costs.

Jiraporn et al. (2008) investigate the agency costs in companies that manage earnings. The authors examine the relationship between agency costs and earnings management and, between earnings management and firm value. They find that on average, firms that manage earnings have lower agency costs and that earnings management is not detrimental to firm value. Interestingly, the authors find that there are no personal benefits for managers engaging in earnings management. Agency costs are frictional costs that arise from employing an agent. Excess remuneration could be seen as an agency cost because it is borne from the agency problem. Jiraporn et al. attribute lower agency costs to lower excess remuneration.

These papers advocate earnings management as a useful tool for managers and shareholders. However, earnings management is not without its critics. In 1998, Arthur Levitt, Chairman of the SEC delivered a scolding speech about the dangers of earnings management and the loss of accounting quality. Levitt acknowledges that earnings management lies in a grey area, "between legitimacy and outright fraud." (Levitt 1998). However, there is no official SEC definition of earnings management. The tone of Levitt's speech implies that earnings management is opportunistic and that American markets are at risk from earnings management. Levitt largely focuses on five "gimmicks" (Levitt 1998), or rather the methods that earnings are managed and the SEC's action plan to attempt to remove the practice. Motivation is an important aspect of earnings management, however Levitt fails to give much attention to the underlying motivations to manage earnings. Levitt assumes that the motivation to manage earnings lies solely in meeting or beating analyst's expectations and the capital market benefits that it brings, such as increased share price. This speech sums up the views of earnings management in the 1990's which was codified in the definition by Healy and Wahlen (1999). The 1990's saw a rise in option and share based remuneration which may have encouraged earnings management to appear more like fraud. One of the main causes was the change in the tax treatment for executive remuneration (Rose and Wolfram, 2002). The tax changes saw this type of remuneration become more attractive to companies and may have promoted more managerial opportunism.

Bergstresser and Philippon (2006) examine the link between earnings management and executive remuneration. Bergstresser and Philippon find that earnings management is much more prevalent in firms that have executive remuneration packages that are more closely aligned to firm value. Consistent with the tax examination by Rose and Wolfram (2002), Bergstresser and Philippon (2006) find that the direct wealth exposure of CEOs increased dramatically during the 1990's. This served as a direct motivator for managers to manage earnings. In this case executive remuneration had gone too far in aligning shareholder's and manager's goals and encouraged near fraudulent behaviour. The authors cite examples of Xerox, Tyco and Enron of examples where executive remuneration had gone too far, and promoted fraud. After these extreme examples the US Government introduced Sarbanes-Oxley, legislation which was designed to increase the quality of earnings. As a result it dramatically increased the costs of mis-reporting.

Beneish and Vargus (2002) investigate how earnings management is used as a tool to maximise the value derived from executive share options and whether or not insider trading is informative about earnings quality. Whilst Beneish and Vargus do not directly examine the motivation to manage earnings, it does comment on the effects. Beneish and Vargus find that when managers use earnings management to engage in insider trading, the increased earnings have a low persistence. Shareholders do not interpret the signals given by insider trading correctly, pricing the managed earnings as if they were high quality. Similarly, Bartov and Mohanram (2004) examine levels of earnings management before and after exercising of managerial share options. They find that there are abnormally large discretionary accruals before the exercise which subsequently reverse after the exercise. This is consistent with managers using earnings management in order to maximise their share based remuneration.

Carter et al. (2009) investigate the change in remuneration post-Sarbanes-Oxley. They find that after Sarbanes-Oxley, firms changed their remuneration packages to reduce the implicit incentive to manage earnings. This paper suggests that earnings management is opportunistic; managers were using earnings management to maximise their remuneration, not for the benefit of shareholders. Sarbanes-Oxley reduced the motivation for earnings management by increasing the costs.

This overview of literature demonstrates the conflicted nature of earnings management research. Extant literature focusing on managerial opportunism focuses too heavily on executive remuneration which, by design, will reveal opportunistic conclusions. The aim of executive remuneration is to turn managerial opportunism into increased earnings and ultimately, shareholder wealth. Literature focusing on the benefits of earnings management, sees earnings management as a signalling package. Managerial intent is unobservable; only the manager knows what they intend to achieve by managing earnings. Neither the beneficial or the opportunistic literature comment directly on the intent of managers. They can both make good suggestions, but they are flawed. The opportunistic literature has a much more tangible link, however is still open to interpretation. Do managers use earnings management to maximise remuneration, or is remuneration a byproduct of signalling private information? Both are credible explanations, as there are going to be managers that use earnings management both opportunistically and beneficially. Similarly, the beneficial literature has the causality issue. Do managers signal private information to shareholders, or do remuneration contracts encourage managers to reveal their private information? Again these are both credible links. Louis and Robinson (2005) find that discretionary accruals are valued when used around stock splits. They suggest that this is optimistic signalling; discretionary accruals and stock splits are more credible when used together. A more opportunistic interpretation could be that managers use discretionary accruals with stock splits to increase the price of the split stock, hence increasing remuneration. The opportunistic literature and beneficial literature can offer insights into each other and different aspects of earnings management.

This paper examines six articles that comment on the motivations for earnings management to shed light on whether or not it is opportunistic. I find that the definition of earnings management needs to be widened to incorporate the different aspects of earnings management. Opportunistic literature tends to focus around insider trading. This is an easily identifiable area of earnings management occurring, however it skews results towards opportunism. There is very little shareholder benefit involved in insider trading. This paper examines the current definition, examines identified literature and then makes recommendations for further academic research.

Definition

Accounting manipulations and fraud are not new concepts. During the early to mid-nineteenth century, railway Barons actively engaged in accounting manipulation (Arnold and McCartney, 2003). The latter part of the 1840's saw a collapse of shareholder confidence, the subsequent burst of the railway stock bubble, and a major shift from cash to accrual accounting (McCartney and Arnold, 2002). McCartney and Arnold (2002) suggest that the shift to more reliable forms of accounting was demanded by shareholders. They demanded better, more accurate and more informative accounting numbers. Managers realised that they could use this to their advantage, as it would likely lower the cost of capital (McCartney and Arnold, 2002). Almost 160 years later, participants in “The Numbers Game” (Levitt, 1998) are still trying to work out how to make accounting numbers more informative, reliable and credible. Motivation is the key element to achieving these aims. The nineteenth century saw railway owner-operators use accounting manipulation to reduce personal risk of starting a company, by taking on shareholders. Accounting manipulation helped make rail companies appear more safe then they were, in order to tempt potential shareholders (Edwards, 1989). Today, managers face different pressures and motivations to manage earnings. Subsequently earnings management has changed over the past thirty years.

Watts and Zimmerman (1978) first implicitly examine earnings management. They acknowledge that understanding managerial motivation is essential in developing a theory of standard setting. Watts and Zimmerman examine the effect of accounting standards on managerial wealth. They find that managers have greater incentives to encourage accounting standards that lower earnings, to avoid government intervention, than to increase earnings, to increase remuneration. This conflicts with current thinking about earnings management incentives. Healy (1985) continues the work by Watts and Zimmerman (1978) but finds a positive relationship between income increasing accruals and executive remuneration; managers use accruals to increase income and, as a result, their remuneration. Both Healy (1985) and Watts and Zimmerman (1978) investigate earnings management before a definition was created, they focus on general motivation for managerial actions. Healy (1985) started a trend to examine executive remuneration as a motivator for earnings management. Modern papers such as Bartov and Mohanram (2004); Bergstresser and Philippon (2006) and Carter et al. (2009) still find that managers use earnings management techniques to increase managerial remuneration.

Schipper (1989) provides one of the earliest definitions of earnings management. Schipper states that earnings management is important because of the influence it has on accruals, and ultimately their ability to help summarise financial performance using a single measure: earnings. Schipper defines earnings management as:

“[A] purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as oppose to, say, merely facilitating the neutral operation of the process).” (1989, 92).

This is an interesting definition of earnings management as it does not require a concept of earnings, it views earnings as information. Earnings has become a crucial summary statistic in business. Shareholders and other stakeholders can quickly and easily use the earnings figure to determine whether or not a company is making money. Some stakeholders rely on summary statistics because it is costly to analyse and interpret the information contained in financial statements (Burgstahler and Dichev, 1997; Louis and Robinson, 2005; Matsumoto, 2002). These summary statistics include; earnings, earnings increases and meeting or beating analyst's expectations. Throughout her paper, Schipper discusses the informational perspective of earnings management. This is consistent with earnings management as a signalling device. This perspective assumes that managers hold private information. This private information is not known to the company's stakeholders, and is revealed through the discretion and judgement allowed in financial reporting standards. The concept of earnings as a true economic value is not needed. Schipper also discusses earnings management from an economic income perspective. This perspective indicates that there is a number that relates to the economic reality of the company, and that earnings management deviates from the economic income of the company. Schipper highlights that GAAP is just one opinion of economic reality. Earnings management can be seen as a distortion of that economic reality. The 1990's saw executive remuneration rise dramatically (Bergstresser and Philippon, 2006). This was due to changes in the tax treatment of executive remuneration, share options were made more attractive from a tax perspective (Rose and Wolfram, 2002). Earnings management changed from a signalling phenomenon to an economic one. The changes in executive remuneration had encouraged earnings management on a larger scale, becoming more closely related to fraud. Towards the end of the millennium there were several major accounting scandals; Xerox, Tyco and Enron (Bergstresser and Philippon, 2006). Over the same decade, the definition of earnings management changed. In 1998 the Chairman of the SEC, Arthur Levitt, delivered a scolding speech on earnings management. A year later Healy and Wahlen (1999) defined earnings management from the perspective of standard setters. Their article reflects the feelings that Levitt (1998) makes clear.

Levitt (1998) expresses concern for the future of the American financial system because of earnings management. He states that the capital markets exist on the back of high quality earnings. This quality is being eroded. Levitt sees earnings management as a deliberate attempt to change accounting numbers to make them more appealing to shareholders and, to ultimately, increase managerial remuneration. Levitt suggests that the main motivation for managers to manage earnings is to meet or beat analyst and capital market expectations. There have been a number of papers since (Louis and Robinson, 2005; Matsumoto, 2002) showing that this may not be as bad as Levitt suggests. Levitt fails to investigate other motivations to manage earnings other than capital market and remuneration. This could be due to the remuneration packages of the late 1990's which encouraged more selfish managerial behaviour, due to the high dependence on share-based remuneration. Healy and Wahlen (1999) review earnings management literature from the perspective of standard setters. They have a cynical definition of earnings management, which reflects the views on earnings management during the 90's.

Standard setters, such as FASB and the IASB, act in the interest of shareholders. Standard setters provide a framework for the protection of shareholders. Shareholders depend on standard setters to create standards that increase the informativeness of earnings and financial statements. Healy and Wahlen (1999) characterise the role of standard setters as defining a common language that managers can use to communicate with stakeholder. Healy and Wahlen provide the most cited definition of earnings management:

“Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying performance of the company, or to influence the contractual outcomes that depend on reported numbers.” (1999, 368, emphasis added)

Healy and Wahlen (1999) provide two motivations for managing earnings; to mislead shareholders about performance, and to influence contractual outcomes. Judgement and discretion are key elements to the financial reporting system. Earnings can be made more informative, through private information, or they can be made less informative, by departing from economic reality. It is clear that Healy and Wahlen are not in favour of earnings management. Mislead means to cause someone to have the wrong idea about something (New Oxford American Dictionary), however some research (such as Louis and Robinson, 2005; Matsumoto, 2002; Subramanyam, 1996) cause shareholders to have the correct idea about earnings. As Schipper (1989) suggests, GAAP is only one opinion of economic reality. Earnings management may be a better interpretation of that reality. Healy and Wahlen's definition is a straight-jacket. It is restrictive in that it implies earnings management is undesirable. Whereas Healy and Wahlen's discussion acknowledges that at least some earnings management is needed. Dechow and Skinner (2000) provide a much more flexible definition.

Dechow and Skinner (2000) attempt to reconcile the differences in opinion between academics, regulators and practitioners. Dechow and Skinner seek to find why earnings management is viewed problematic and pervasive by industry (all market participants), but not by academia. The main differences between the groups appears that academia focuses on macro and industry focuses on micro. Earnings management can be defined through intent, but only detected through operations, such as managing accruals. This gives earnings management similar properties to fraud. Academics use statistical techniques to focus on the whole of industry in order to be able to comment on the phenomenon. Whereas industry is more likely to focus on specific cases to observe ex post earnings management, ie through regulator litigation and auditor reports. Most studies detect earnings management by using discretionary accruals as a proxy. Discretionary accruals are accruals that are not compulsory, unlike depreciation. Discretionary accruals are a measure of private information. Private information can be for the benefit of shareholders (signalling) or for managerial benefit (fraud). The relationship between accruals, cash and earnings are shown below.

EARNINGS = DA + NDA + CFO

The sum of discretionary accruals (DA), non-discretionary accruals (NDA) and cash flow from operations(CFO) equal earnings. Academics must establish total accruals (TA = DA + NDA) and then work back to find their measure of earnings management. A simple problem facing earnings management detection models is that discretionary accruals, not only hard to model, do not capture the motivation. The implicit definition of earnings management from the point of view of detection models is information not reflected by GAAP. These shortcomings are well documented in earnings management literature, as such detection models are not discussed in detail in this paper (Dechow et al. (1995) provide a discussion of detection models). Dechow and Skinner (2000) present accounting choice and fraud on opposing ends of a spectrum. Earnings management fits between the two in terms of intent, detectability and its relation with regulation. The definitions have changed over time. Dechow and Skinner find that the main incentives facing managers to manage earnings are to beat benchmarks set by the market, and when firms are about to issue equity. The source of these motivations are capital markets. Capital markets contain all potential and current shareholders of the firm and ultimately they judge the performance of a company. Signalling is essential to that market. Some earnings management needs to be tolerated (Schipper, 1989; Dechow, 1994; Dechow and Skinner, 2000; Healy and Wahlen, 1999; Louis and Robinson, 2005) so that the capital markets can adequately judge firm performance. Understanding the motivations is important to work out the optimal amount of earnings management. Dechow and Skinner find that understanding the incentives to manage earnings is key to understanding the desire to engage in the activity. Ultimately the incentives can help to better understand what the effects are.

Methods

There are two major types of earnings management research; accruals and real. Real earnings management are decisions that directly affect cash flow, such as slashing research and development or writing off debt. Real earnings management can be defined as “departures from normal operational practices” (Roychowdhury, 2006). This type of earnings management is even more difficult to model than accrual earnings management, as operational decisions are difficult to distinguish from real earnings management. This type of earnings management is not examined in this paper. This paper is concerned with the far bigger method of earnings management; accruals. Accruals earnings management is concerned with the use of managerial judgement and discretion in the financial reporting system to alter the stakeholder's views of financial statements. The prevailing view is that earnings management is managers acting opportunistically, usually to increase their remuneration. However, there is a growing body of literature suggesting that this may not be the case. This literature suggests that earnings management is a tool for supplying capital markets and users of financial statements with private information held by shareholders. Opportunistic literature suggests that earnings management is used to mislead shareholders to inflate share price, subsequently raising managerial remuneration. Beneficial literature suggests that earnings management is used to reveal privately held information. The two ideas are not mutually exclusive. Remuneration is designed to align the goals of shareholders and managers. Managers can both maximise their remuneration and maximise shareholder wealth. Remuneration design must convert opportunism into shareholder wealth. Literature from both thought streams is reviewed to shed light on the nature of earnings management.

Sample

This paper examines six earnings management articles (Bartov and Mohanram, 2004; Beneish and Vargus, 2002; Bergstresser and Philippon, 2006; Bowen et al., 2005; Jiraporn et al., 2008; Louis and Robinson, 2005). These articles demonstrate the conflicting results in earnings management literature. Bartov and Mohanram (2004); Beneish and Vargus (2002) and Bergstresser and Philippon (2006) focus on earnings management as a tool for managerial opportunism. Their implicit definitions of earnings management have a lot in common with insider trading. They find that managers use earnings management to inflate earnings and make personal gains (Bartov and Mohanram, 2004; Beneish and Vargus, 2002), the inflated earnings have low quality but are perceived as high quality (Beneish and Vargus, 2002) and that CEOs with more personal wealth dependant on company wealth are more likely to manage earnings (Bergstresser and Philippon, 2006). They are broadly interested in the same sample period, the 1990s. This is decade is usually associated with high levels of earnings management. This is due to the rise of share options as remuneration in the early 1990s and ends with the introduction of Sarbanes-Oxley, which was designed to reduce the prevalence of earnings management (Carter et al., 2009). Bowen et al. (2005); Jiraporn et al. (2008) and Louis and Robinson (2005) examine earnings management as signalling tool. These papers do not find evidence for earnings management as managerial opportunism. They find that earnings management may be beneficial for shareholder wealth. Bowen et al. (2005) finds that there is no drop in shareholder wealth in periods of earnings management, indicating that it is not opportunism. Earnings management is also associated with lower agency costs (Jiraporn et al., 2008) and can add information to stock splits (Louis and Robinson, 2005). These papers represent an interesting cross section of earnings management literature. They demonstrate the problems associated with inconsistent definitions across extant research.

Sample Characteristics

The six paper's samples span the period 1985 to 2002. Their data is drawn from execucomp and/or compustat. Information of executive remuneration is usually drawn from execucomp and the information needed to test for earnings management from compustat. There is a great deal of overlap of the sample periods, this is due to the rise of earnings management during the 1990s. Stock options began to rise as the predominant form of remuneration in the early 1990s, this was helped by preferential tax treatment for bonus remuneration in 1993 (Rose and Wolfram, 2002). Earnings management was curbed in 2002 with the introduction of the Sarbanes-Oxley legislation. Sarbanes-Oxley placed strict criteria on management and audit committee, and made management personally responsible for the financial reports. This legislation helped reduce the implicit incentives to manage earnings (Carter et al., 2009). Jiraporn et al. (2008) looks at a different sample to the other papers. Measures of governance were obtained from the Investor Responsibility Research Centre. The only years that were available were 1993, 1995 and 1997. Compustat was used to find the data for the earnings management detection models. Bowen et al. (2005) acknowledge that, on average, the firms in the Execucomp database are larger, more profitable and less levered that the average firm in Compustat. This may distort some of the comparability of results. However, since most of the studies draw some information from both, I do not consider that there is a substantial difference.

Earnings management is impossible to observe. In order to get an earnings figure, companies take the sum of total accruals and cash, total accruals can be split into two parts; discretionary and non-discretionary. Non-discretionary accruals are elements of accruals that the manager has to perform, which has little judgement applied. These accruals appear from the day-to-day running of the company. Discretionary accruals are the main proxy for earnings management because they represent a great deal of managerial discretion and judgement. The most common model is an aggregate accruals model, which Jones (1991) pioneered. Many detection models are based on the original Jones (1991) specification. A detection model has to have an explicit definition of earnings model, so that earnings management can be identified. The aggregate accrual models assume all discretion is earnings management. It is important to note the discrepancy between author's and the model's definition of earnings management. Authors present their idea of earnings management to test, but regardless of their opinion they have to measure it using the proxy in the model. The papers have been chosen because they use similar sample periods and earnings management detection models. This means that they are comparable, with the main difference being the author's definitions. Conclusions may be formed more by the author's definition rather than the definition of the detection model. Using the same models to compare ensures that differences in conclusions are differences in author's definitions. As detection models have to work in a variety of different situations, they have a very broad definition of earnings management. This can be problematic for academics because the model may not be testing the same definition that the authors use. Within the identified literature, two models are used. Both are modified versions of the Jones model. Bergstresser and Philippon (2006); Jiraporn et al. (2008) and Louis and Robinson (2005) used the (Dechow et al., 1995) Modified Jones model, whereas Beneish and Vargus (2002); Bowen et al. (2005) and Bartov and Mohanram (2004) use a cross-sectional Jones model, identified by Kothari et al. (2005). The main difference between the two models is that the Kothari et al. (2005) model works better when used on non-random samples of firms. This is useful as it means that all the studies use earnings management detection models that have the same definition of earnings management: discretionary accruals.

Author definitions vary across the sample papers. The definition of income increasing accruals is used by Bartov and Mohanram (2004) and Beneish and Vargus (2002) this leads to the hypotheses that earnings management gives low quality earnings figures when followed by insider selling and option exercises are timed to coincide with the inflated earnings. Beneish and Vargus hypothesise that income increasing accruals are low quality because they are less persistent, perhaps because these accruals depart from economic reality. Similarly, Bartov and Mohanram hypothesise that large option exercises indicate that earnings are going to perform unfavourably post exercise. Both these papers indicate that managers acting opportunistically damages shareholder wealth because shareholders incorrectly price these accruals. Bergstresser and Philippon (2006) take a slightly different definition to Bartov and Mohanram and Beneish and Vargus. They see earnings management as using accruals to temporarily alter earnings. This automatically implies some wrong doing. This leads to the hypothesis that managers use accruals as a tool to increase wealth, through option exercises. Despite the different definition, they all have similar hypotheses. Jiraporn et al. (2008) and Louis and Robinson (2005) define earnings management as discretionary accruals, which is the same as the detection model they use. This definition is free from bias, as it assume earnings management as all discretion. Jiraporn et al. hypothesise that if earnings management is undesirable, then it should result in higher agency costs. Louis and Robinson suppose that earnings management can signal optimism when used in conjunction with another signal, namely stock splits. Bowen et al. (2005) takes the most narrow definition, that earnings management is managerial actions that transfer wealth from shareholders to managers. This leads to the hypothesis that if earnings management is opportunistic then a decline in shareholder wealth should be observed.

Results

Managerial Opportunism

Beneish and Vargus (2002); Bartov and Mohanram (2004) and Bergstresser and Philippon (2006) conclude that earnings management is used for managerial opportunism. They imply that earnings management is detrimental to shareholder wealth. Beneish and Vargus (2002) find that managers use the private information they hold for their own personal benefit. Insider selling indicates that earnings are low quality, where low quality earnings have low persistence. Income increasing accruals are used to inflate earnings so that managers can opportunistically time their option exercises when they are at their most beneficial. Earnings that are followed by insider selling are low quality because they depart from economic reality. They document that insider buying indicates higher quality earnings. Managers use their inside knowledge to opportunistically sell shares when the earnings are low quality and buy when they are high quality. This leads to the conclusion that markets inefficiently price managed earnings and rationally price unmanaged earnings. Similarly, Bartov and Mohanram (2004) conclude that managers use income increasing accruals to inflate share prices and they exercise their share options to maximise their payout. They find earnings before and after option exercise are abnormally positive and negative respectively. There is a complex but apparent relationship between earnings and share price that indicates that managers use income increasing accruals opportunistically. Bartov and Mohanram also conclude that the relationship between accruals and earnings is sufficiently complex that analysts do not fully expect the abnormal earnings. This supports Beneish and Vargus's argument of market incorrect pricing. Beneish and Vargus's and Bartov and Mohanram's results differ in that Beneish and Vargus do not detect price reversals. Price reversals indicate that the market realised that the shares are overpriced. Bergstresser and Philippon (2006) also conclude that earnings management is opportunistic because they document a positive relationship between earnings management and executive remuneration. They find that when discretionary accruals increase so do option exercises. This is consistent with the opportunistic timing of option exercises.

Shareholder benefits

Louis and Robinson (2005) conclude that managers use earnings management to signal private information, rather than for their own personal gain. Louis and Robinson suggest that this is due to discretionary accruals being used alongside stock splits. Stock splits are signals to shareholders to indicate optimism. However, according to long run abnormal returns, there is an under reaction to the signal. Louis and Robinson document large positive reaction to discretionary accruals around a stock split, but not for non-discretionary accruals. This indicates that stock splits become effective signals when used in conjunction with discretionary accruals. Louis and Robinson's findings indicate that earnings management can be used beneficially for shareholders. The authors conjecture that without a second signal, discretionary accruals may be seen as opportunistic. Louis and Robinson use the same definition of earnings management as the selected detection model; discretionary accruals. This ensures that the conclusions that they draw are related to the item that they are measuring. Jiraporn et al. (2008) also conclude that earnings management is beneficial. This is because they document a negative relationship between agency costs and earnings management, and that earnings management does not lead to a lower firm value. They argue that if earnings management is opportunistic, firms with higher earnings management should show higher agency costs. Therefore a negative relationship indicates that earnings management is not opportunistic. Jiraporn et al. also posit that for earnings management to be opportunistic, there should be a negative relation between firm value and earnings management. Jiraporn et al. define earnings management as discretionary accruals, which is a very broad definition. Given this broad definition it would appear that Jiraporn et al. actually measure the benefit of judgement and discretion embedded in the financial reporting system, rather than earnings management per se. Bowen et al. (2005) also find earnings management to be beneficial for shareholders. They argue that for earnings management to be shown as opportunistic, then a drop in shareholder wealth should be documented. They argue that efficient contracting is an alternative to managerial opportunism. Allowing managers to trade on the private information that they generate, rewards them for generating the information. It is technically similar to insider trading, however Bowen et al. argue that it is not opportunism if there is no decline in shareholder wealth. Bowen et al. find a positive relationship between discretionary accruals arising from poor governance and performance (ROA and Cash Flows). They find earnings management can signal future performance. Bowen et al. define earnings management as actions that transfer wealth from shareholders to managers. Therefore if there is not decline in shareholder wealth, managers are not transferring wealth from the shareholders.

Results summary

It appears that insider trading is the manifestation of opportunistic earnings management. In these papers earnings management is seen as a method to increase income (Bartov and Mohanram, 2004; Beneish and Vargus, 2002) and to alter earnings (Bergstresser and Philippon, 2006). To a certain extent these definitions influence the authors conclusions. Increasing income and altering earnings indicate that there is an underlying economic reality, and that earnings management is a departure from this reality. Many share options take the form of American style options (Chhabra, 2008). American style options can be exercised at any point after vesting and before expiry, the opportunistic exit for American options is when the share price is at its highest, whereas European and Asian options do not have an opportunistic exit. It is possible that the relationship between option exercises and high discretionary accruals is coincidence. In the case of Bartov and Mohanram (2004); Beneish and Vargus (2002) and Bergstresser and Philippon (2006) this argument is discredited because a share price reversal is documented, indicating the accruals were low quality and for the purpose of inflating share price. Louis and Robinson (2005) and Jiraporn et al. (2008) adopt broad definitions of earnings management. They define it as discretionary accruals. It is possible that they are in fact not measuring earnings management, but measuring the effect of discretion and judgement in financial reporting. Bowen et al. (2005) has the most specific definition of the sample papers, yet does not immediately assume opportunism. They suggest that in order to state that earnings management is opportunistic, a drop in shareholder wealth needs to be shown. This leads them to conclude that insider trading is to shown to be opportunistic, it needs to affect shareholder wealth. Differences in the definitions of earnings management appear to encourage different conclusions.

Discussion

Earnings management has a variety of definitions. The definition can vary a great deal between and within research papers. Different authors can have different definitions, and authors can have different definitions from the detection model they use. Conflicts between the author's and detection model's definition can cause problems. The proxy used in the detection model is important because it will determine whether or not earnings management is found. The author's definition is important because it helps them to draw conclusions from their results. There are several themes that earnings management impacts on; earnings quality, signalling, agency costs, remuneration and the impact on shareholder wealth. These themes need to be examined in detail to understand whether earnings management is opportunistic or beneficial.

Earnings Quality

Earnings persistence is usually the proxy for earnings quality. Financial reporting endorses high quality earnings, these are earnings that repeat. Low quality earnings are not persistent, they do not repeat. This implies that there is an underlying economic reality that is expressed through GAAP. However, there are many interpretations of economic reality. USGAAP and IFRS are the two main financial reporting standards, however, prior to 2005, most European countries had their own financial reporting standards. Schipper (1989); Levitt (1998) and many other papers imply that earnings management is a departure from the underlying economic reality, and that this departure is used for the benefit of managers.

Bartov and Mohanram (2004) and Beneish and Vargus (2002) find that earnings management, when used in conjunction with insider selling, results in low quality earnings. Essentially, managers use the discretion in financial reporting to fabricate earnings that do not match economic reality, and then opportunistically exercise share options to personally benefit from the departure. Bartov and Mohanram (2004) and Beneish and Vargus (2002) both define earnings management as income increasing accruals, this implies that discretionary accruals are used to increase income, ultimately earnings. This lies on the boundary of aggressive accruals and outright fraud as defined by Dechow and Skinner (2000). Louis and Robinson (2005) suggest that managers may use earnings management to signal because there is less potential for litigation that other signalling methods. Louis and Robinson (2005) highlight that managers have a large range of techniques to signal optimism; including press releases and conference calls. However, the managers may be at risk from litigation if their optimism does not materialise because they make their optimism explicit. Earnings management can help them avoid litigation by passing the interpretation of the signal onto the users of financial statements. Low quality earnings and stock price reversals could be the optimism not materialising. Coupled with the fact that American options have an opportunistic exit, the relation between poor quality accruals and opportunism documented by Bartov and Mohanram (2004) and Beneish and Vargus (2002) may be a case of coincidence, though this does seem a naive assumption.

Financial reporting standards have to apply to a whole range of companies, in a variety of difference situations. One of the objectives of financial reporting is to achieve comparability. To a certain extent, allowing discretion acknowledges the problem that not all firms are comparable and that they may not operate in the same economic reality. Extraction industries such as gas and oil operate in very different ways to service industries such as retail. Discretion allows diverse industries to create relevant financial statements according to their economic reality. Contrary to the idea that earnings management departs from economic reality, Subramanyam (1996) implies that earnings management enhances the view of economic reality. This is because earnings management can provide private information to the market. Earnings management allows managers to present private information that is not reflected in GAAP. Schipper (1989) acknowledges that from an economic income perspective, GAAP acts as distortion to some underlying, unobservable economic reality. Whether or not GAAP accurately reflects economic reality is a moot point. GAAP is an economic reality that many companies and countries adhere to. It is the accepted economic reality.

The maximisation of shareholder wealth is the objective of the Company. Earnings are important because they are a proxy for success (Schipper, 1989). High quality earnings are important for shareholders because they indicate future performance. Low quality earnings are not especially helpful for investment decisions. Low quality earnings resulting from opportunistic accruals are damaging to shareholder wealth. As Beneish and Vargus (2002) demonstrate that shareholders price income increasing accruals as if they were high quality, possibly because of their faith in the financial reporting system. The shareholders make a pricing error equal to the difference in quality of earnings. Reversals in share price indicate the pricing error associated with low quality accruals. Opportunistic managers do not act in the interest of the shareholders by diverting wealth from the shareholders to the managers (Bowen et al., 2005), which causes agency costs to rise. High agency costs are associated with companies that have poor governance. It can be assumed that opportunistic managers operate in companies that have poor governance, as governance is specifically alleviate agency costs. Bowen et al. (2005) proxy for shareholder wealth with company performance and finds no drop in performance from opportunistic discretionary accruals, indicating that accruals in poor governance environments are signalling performance.

Earnings quality is relevant because it is an effect of earnings management. If earnings management is beneficial it should result in higher quality earnings. Lower quality earnings indicate either optimism gone wrong, or a deliberate attempt at opportunism. This intent is unobservable, but the effects are observable. Researching into the effects can, to a certain extent, comment on the underlying motivation to engage in earnings management. Bartov and Mohanram (2004) and Beneish and Vargus (2002) imply that low quality earnings are the result of managerial opportunism. Their results suggest that managers are wiling to decieve shareholders in order to increase their remuneration, which is clearly opportunistic behaviour. Their definitions adequately explain why earnings are low. The discrepancy between their definition and the detection model's definition does not appear to be a problem as they draw conclusions consistent with their selected detetion model. Althought their definition of earnings management may result in conclusion bias, their findings are difficult to interpret as beneficial under a different earnings management definition. Widening their definition to include all discretionary accruals, it would appear that discretion results in lower quality accruals. Although there is evidence to suggest that market participants value discretion, it may be that discretion is priced by an inefficient market. Pricing low quality earnings as if they are high quality implies an inefficient market, as efficient markets should always correctly reflect financial information.

Signalling

Earnings management can be used to signal information. Specifically, managers can use earnings management to reveal private information that is not captured by financial reporting standards. Several signalling themes occur in earnings management literature; signalling future performance (Bowen et al., 2005), managing shareholder and market participant expertise (Matsumoto, 2002; Xue, 2003) and managerial expertise (Arya et al., 2003). To certain extent, insider trading is also used to signal performance.

Bowen et al. (2005) finds that managers signal performance through earnings management. They find that instead of managers exploiting poor governance for their own gain, managers use earnings management to enhance the performance of the company. This opposes the findings in Beneish and Vargus (2002) who find that earnings management does not signal future performance. Beneish and Vargus (2002) find that earnings management does not signal future performance because the earnings are low quality. High quality earnings signal future performance because they reoccur, unlike low quality earnings. Insider trading looks for an opportunistic exit. Managers may be more likely to engage in earnings management, leading to insider trading, if they foresee that future performance is likely to be weak. If performance is likely to be strong, then there may be less incentive to manage earnings. This is demonstrated by their findings that high quality earnings are associated with insider buying. Signalling performance is tricky. Louis and Robinson (2005) suggest that managers use earnings management alongside stock splits to signal optimism. Stock splits are used to signal managerial optimism, however Louis and Robinson demonstrate that these signal are undervalued. Firms that split shares tend to have low book to market ratios, but significantly positive long-term returns. Positive long-term returns indicate manifest optimism, whilst the low book to market values suggest that the share price has not risen in response to the signal. Earnings management can enhance the signal of stock splits because, as Beneish and Vargus (2002) show, income increasing accruals are positively priced. Income increasing accruals used alone may appear to be opportunistic, as Beneish and Vargus (2002) show. However, with the stock split, they can signal optimism that is likely to occur. Louis and Robinson (2005) suggest that one reason that managers may use earnings management and stock splits to signal information is the fear of litigation. Whilst managers can use conference call or press releases to signal, they may face litigation from shareholders if the explicit optimism does not materialise. Earnings management signals optimism that must be interpreted from the financial statements. This rewards sophisticated market participants that have the technical expertise, time and economic resources to fully investigate the financial statements.

Many market participants are not sophisticated enough and lack the resources needed to fully interpret managerial signals. These market participants rely on different signals. One group of participants that do have the resources are analysts. Other groups rely on signals being interpreted by analysts. Analyst's expectations and coverage can act as benchmarks that companies use to signal performance. Matsumoto (2002) demonstrates the importance of avoiding negative earnings surprises. Non-owner stakeholders such as suppliers, customers and employees are interested in firm performance for a variety of reasons. Suppliers are interested in bad debt, customers may be interested in product guarantees and employees may want to know if they are going to be made redundant. Matsumoto (2002) finds that companies with more of these implicit stakeholder claims are more likely to meet or exceed analyst's expectations, this implies that these stakeholder do not find systematic analysis and interpretation of financial statements cost effective. They rely much more on signals given by the company. Matsumoto (2002) highlights that, although institutional shareholders should be sophisticated users of financial statements, they can act like transient shareholders and emphasise short term profits. Meeting or exceeding expectations is a method for signalling to these shareholders that the company has strong performance. Using the Modified Jones (Dechow et al., 1995) earnings detection model, Matsumoto (2002) finds that earnings management is used to meet or exceed the analyst's expectations. This paper is consistent with the idea of efficient contracting that Bowen et al. (2005) examines. Avoiding negative earnings surprises is important because, as Levitt (1998) also highlights, shareholder wealth can be greatly damaged. Matsumoto (2002) implies that managers use earnings management to protect shareholder wealth from more transient shareholders. This suggests efficient contracting rather than managerial opportunism because managers are not looking for an opportunistic exit. There is not demonstrable drop in performance or in shareholder wealth as a result of the earnings management. Earnings management enhances shareholder wealth. Xue (2003) and Burgstahler and Dichev (1997) examine earnings management to exceed thresholds and earnings decreases and losses respectively. They both document discontinuities around zero earnings for firms. Burgstahler and Dichev (1997), examined earlier, finds that managers use earnings management to avoid negative capital market reactions to negative earnings and negative earnings growth. Similarly, Xue (2003) finds that firms facing severe information asymmetry use earnings management to signal to the market. Earnings act as a summary information source for investors (similarly described by Schipper, 1989). Xue (2003) suggests that earnings management moves earnings from future periods to current periods, this causes future earnings thresholds harder to meet. Therefore earnings management is used to convey private information, by exceeding thresholds. Signalling in earnings management reduces information asymmetry (and potentially agency costs, examined later). Earnings management can also be used to signal managerial competence and ability.

Arya et al. (2003) examine the role of managerial expertise in financial reporting, specifically whether or not unmanaged earnings are better. They argue that increasing transparency does not always increase governance and implicit argument of theirs is that earnings management reduces agency costs. Arya et al. (2003) suggests that managed earnings are better because it allows managers to signal their own expertise, it limits owner intervention and it prevents posturing. Earnings management allows managers to signal their own expertise because they have to be good at their job, and ultimately good at predicting future income, in order to manage earnings convincingly; allowing managers to present smooth income streams gives them the opportunity to demonstrate their knowledge. Limiting owner intervention is important, as managers are hired specifically to act on behalf of the shareholders. This is largely because shareholders do not have the expertise to manage a company. Owners may intervene despite not having these expertise. earnings management also prevents posturing; managers may spend more time posturing than managing the company given transparent financial statements. Managers may spend more of their time demonstrating their versatility even when the action is not needed. The points that Arya et al. (2003) raise imply that unmanaged earnings raise agency costs. Like Bowen et al. (2005), efficient contracting appears to be an alternative to managerial opportunism. Earnings management allows managers to signal, without damaging shareholder wealth or company performance. Agency costs are undesirable as they are costly to shareholders. Insider trading results in high agency costs; the transferral of wealth from shareholders to managers. Agency costs are very real however, earnings management may not be too much of an agency problem.

Signalling appears to motivate a degree of earnings management. Earnings management is used to signal information to shareholders, effectively releasing information in an implicit way. Assuming that markets are informationally semi-strong efficient, markets rely on private information being signalled to make them more efficient. However, there is still a question of what motivates signalling? Remuneration is an obvious answer, but remuneration alone is not entirely convincing. Remuneration in the form of share options that are exercised for cash benefit is one option, and is essentially opportunism. Signalling may encourage a less volatile share price which may cause the manager to hold a less risky portfolio. Executives hold a portfolio which is heavily invested in a single company, which is contrary to the wisdom of Modern Portfolio Theory. Signalling may be a tool that managers use in order to thier own wealth as shareholders. Signalling does not immediately indicate opportunism or shareholder benefits. Signalling may be an example of efficient contracting, in that it is effective alignment of manager and shareholder goals. Low quaity earnings indicate pure opportunism, as there is a cash benefit. Whereas signalling may indicate that managers believe a higher share price is correct and it benefits shareholder's and their own share portfolio. Signalling may be an indicator of high quality earnings priced as low, whereas insider trading may indicate low quality earnings priced as though they were high. The signalling effect of earnings management is dependent on the definition. A definition of income increasing accruals implies signalling false information, whereas all discretionary accruals implies that more genreal information is being released.

Executive Remuneration

Executive remuneration has an important part to play in earnings management. Although it is not the only motivator, firms have some control over it. Companies cannot directly influence standard setting, nor can they directly influence the law. However, firms have a substantial influence over their remuneration packages which can influence the amount of earnings management and how beneficial it is. Remuneration can be split into three components: cash, non-pecuniary benefits and a performance element. Cash and other non-pecuniary benefits do not influence and are not influenced by earnings management, as they are awarded regardless of performance. A large part of performance related remuneration are in the form of share options, many share options that are granted are in the form of American style options. The options vest once certain conditions are met over a pre-determined period. After the vesting period executives are free to exercise the options whenever they like. American style options have an opportunistic exercise because they can be exercised at any point up until expiry. European and Asian style options do not have an opportunistic exit. European options are only exercisable on a certain date, so can be quite random as to the remuneration that an executive will receive, these options may not encourage performance in the same way the American options would. Asian options are similar to European options in that they can only be exercised on a certain date, however, instead of the share price at a given date, an average price over the period is used. Asian options are discussed later. Executive remuneration is designed to motivate managers to work hard at their job, generating earnings and other information that is not reflected in normal historical cost accounting. Cash only benefits only go so far to motivate. If a manager exhausts easy to find positive NPV projects, there is no extra motivation to find more projects because their remuneration would not compensate them for their additional work. Therefore some kind of performance related remuneration is needed. Options are a good form of performance remuneration because they align the interests of managers and shareholders. However, this may not be the case.

The opportunistic literature (Bartov and Mohanram, 2004; Beneish and Vargus, 2002; Bergstresser and Philippon, 2006) suggests that executive remuneration is the key motivator for earnings management. Beneish and Vargus (2002) demonstrate that there are large numbers of discretionary accruals prior to insider selling, implying that executives manage earnings to maximise the payouts of their options. Similarly, Bartov and Mohanram (2004) find earnings post exercise are abnormally negative, again implying maximisation of option payout. Bergstresser and Philippon (2006) find that there is a positive relationship between earnings management and remuneration. The definition of earnings management that these papers use suggests an element of wrong-doing. It is convenient to conclude that earnings management, therefore, is undesirable. As stated earlier, American options have an opportunistic exit. It is possible that discretion and the opportunistic exercises of options have some underlying correlation. Various papers demonstrate that discretionary accruals are priced (Subramanyam, 1996; Louis and Robinson, 2005), a jump in share price should be documented. It does not make economic sense for managers to exercise their options prior to the documented jump. Beneish and Vargus and Bartov and Mohanram are able to conclude that the exercises are opportunistic because the accruals are low quality and the share price subsequently reverses. Although Louis and Robinson suggest that this could be a result of optimism not materialising, managers would have to be consistently poor at estimating future company performance to happen with the frequency that Beneish and Vargus and Bartov and Mohanram document. Bergstresser and Philippon suggest that the evidence of a relationship between remuneration and accruals alone indicates insider trading. Again, it could be due to the fact that American options have an opportunistic exit. Bergstresser and Philippon define earnings management as a method to temporarily alter earnings. It is possible that they find earnings management to be opportunistic because of their definition. Defining earnings management as all accruals, could lead to the conclusion that executive remuneration encourages managers to part with the private information that they generate.

American options are the most common form of options. They encourage opportunism because they have an opportunistic exit. As mentioned earlier, European and Asian options do not have an opportunistic exit. European options have random payoff that are not necessarily related to the performance of the manager. Chhabra (2008) suggests that Asian style options may off an advantage over American style options. As Asian options rely on the average price of the underlying asset, not the price at the time of exercise, they can be used to motivate managers over the whole duration of the option. There can be a motivational dead-zone after the exercise of the American option, until the next set of options are granted and vest. Asian options can help to avoid this problem by encouraging managers to work hard over the vestment period, whilst they aim to keep the average stock price high. Asian style options have the potential to solve the problem of insider trading. By removing the opportunistic exit, Asian options remove the ability of managers to engage in accounting manipulation for insider trading. Insider trading may still exist, but managers lose their ability to engineer an opportunistic exit. Managers would still be able to engage in insider trading with information that they receive before other stakeholders, but they would not be able to utilise income increasing accruals to tease out higher share prices. Chhabra highlights that the accounting treatment of Asian options is simpler and less costly for companies. Asian options look like tempting remuneration devices. Manne (1966), quoted by Bainbridge (1998), suggests that insider trading could be deregulated and used as a remuneration device. With this in mind, American style options could be seen as a method for legalising insider trading, and regulating it through efficient contracting. Manne (1966) suggests two benefits that insider trading brings: increased price accuracy and a method for compensating information generation. Insider trading could be a method for making capital markets more informationally efficient by providing private information. Insider trading bridges the gap between informationally semi-strong and strong markets. Earnings management and insider trading are essentially agency problems. They arise out of a conflict of interest between managers and shareholders.

Managers, despite what Modern Portfolio Theory states, hold large amounts of stock in the firm they manage. Chhabra (2008) states that this is problematic because managers should attempt to reduce their shareholding and diversify their personal portfolio. This is not an especially comforting scenario, as it questions the validity of granting share options. Granting share options are simply a method of rewarding performance, it is a flexible method of performance related pay. Essentially, it allows the market to price the manager's performance. It is easier to administrate than a cash performance related bonus, because the remuneration committee do not have to calculate the cash value to award for performance, they allow the market to. Share options are better at aligning shareholder and manager interests in an attempt to reduce agency costs. Markarian and de Albornoz Noguer (2010) suggest that they also serve another purpose. Chhabra states that manages have large amounts of their portfolios tied up in a single companies stock; their own. Modern Portfolio Theory suggests that this is unwise, due to the large amounts of idiosyncratic risk. Markarian and de Albornoz Noguer paint a picture of risk adverse manages and suggest that managers use earnings management to reduce idiosyncratic risk, rather than sell their portfolio. This is appealing to shareholders because it reduces their portfolio risk, managers are able to signal their ability to the market (supported by Arya et al., 2003) and it increases CEO job security. Portfolio risk is reduced because the idiosyncratic risk of one investment is reduced and managers have the ability to signal their ability through presenting high quality (persistent) earnings. Markarian and de Albornoz Noguer find that job security has a negative relationship with idiosyncratic risk; jobs are less secure, the higher the idiosyncratic risk. Manager's portfolios are somewhat over-looked in relation to executive remuneration within earnings management. It would appear that more research into this area could shed more light on the earnings management debate.

Remuneration is an obvious motivator for earnings management. Any relationship between remuneration and a measure of earnings management can be interpreted as opportunism. This is because remuneration is designed to reward performance. Remuneration is designed to take advantage of the inherent opportunism displayed by managers and chanel it into benefits for the shareholders. It is the additional measures and relationships which can indicate the true nature of earnings management. As Louis and Robinson (2005) highlight, discretionary accruals alone may indicate opportunism. However, when discretionary accruals are coupled with stock splits they become a powerful signal of future performance. Indicating that discretionary accruals are not always used to inflate remuneration. Similarly, low quality earnings documented by Beneish and Vargus (2002) support their arguement of opportunism. Remuneration in itself is not an indicator of opportunism. Remuneration must be coupled with other measures in order to provide useful insights into the nature of earnings management. The definition of earnings management is important because a different definition can result in a different relationship that is being examined. Beneish and Vargus (2002) explicitly examine the effect that income increasing accruals and remuneration have on earnings quality, however they actually examine the effect that discretionary accruals and remuneration have on earnings quality. The former implies managers are aiming to improve their remuneration from the start. To a certain extent, in their study, managers are aiming to improve their remuneration because they examine insider trading. Changing the definition of earnings management can change the perceived relationship between earnings management and remuneration. Income increasing accruals tend to lead to the assumption that remuneration is the only motivator. All discretion, as a definition, may lead the author to assume that a relation between earnings management and remuneration is more coincidental.

Agency and Governance

Corporate governance is important for companies because it essentially establishes a moral code of conduct for the company. Governance also serves the purpose of ensuring that the managers of companies act as proper agents to the shareholders. Agency costs are unnecessary costs that arise from using agents. For example, a drop in shareholder wealth from insider trading can be seen as an agency cost because the managers do not act as efficient agents. Efficient governance reduces agency costs. Poor governance should result in increased opportunism because of the lack of a moral framework.

Bowen et al. (2005) see earnings management as a method for diverting shareholder wealth to managerial wealth. This implies that earnings management is an agency cost. The opportunistic literature agrees with this line of thinking. When managers engage in insider trading they opportunistically exercise their share options, in order to maximise their own wealth at the expense of shareholder wealth. Managers encourage shareholders to make a pricing error, which they subsequently take advantage of. Strong governance should prevent this type of action. Agents (managers) are meant to act in the interest of the principal (shareholders), insider trading is a clear example of when this is not the case. The definition used by Bowen et al. characterises earnings management as an agency problem. This is unique among the papers studied, which characterise earnings management as an accounting problem. It is more convenient to assume that earnings management is an accounting problem because it is much easier to detect. When presented as an agency problem, earnings management appears to be beneficial for shareholders. Whilst Bowen et al. find an association between poor governance and accounting discretion, this itself is not evidence of opportunistic earnings management. To conclude opportunism, a drop in shareholder wealth must be documented, which Bowen et al. do not find. On one hand, there is an apparent agency problem; poor governance is associated with discretion. However, there is no agency cost; no drop in shareholder wealth. This is interesting because it seems counter-intuitive. It agrees with the ideas presented by Manne (1966) that insider trading could be used as a remuneration device.

Jiraporn et al. (2008) investigate earnings management as if it is a agency or governance issue, however they must still define it as an accounting problem in order to detect it. Governance based issues are intrinsically more complex to measure because there is a great deal more subjectivity. Despite the empirical problems presented with measuring governance, Jiraporn et al. suggest that firms benefit from earnings management, as they exhibit a negative relationship between agency costs and earnings management; as earnings management rises, agency costs fall.

Managers generate information that is not reflected from ordinary accrual accounting. Flexibility in financial reporting allows managers to portray this additional information in financial statements. As demonstrated earlier, private information can be used for managerial, rather than shareholder, benefit. Beneish and Vargus (2002) and Bergstresser and Philippon (2006) find that earnings management is used opportunistically. They justify this assertion by demonstrating that managers engage in abnormal buying and selling of shares during periods of high earnings management. These studies characterise earnings management as an accounting and legislative issue, not an agency issue, like Bowen et al. (2005) and Jiraporn et al. (2008). This is empirically convenient, however does not fully explain the surrounding circumstances. As Lo (2008) states, there must be an opportunity to manage earnings, as well as a motive. Conventional wisdom suggests that poor governance provides an opportunity to manage earnings. Bowen et al. suggests that even though poor governance gives an opportunity to manage earnings, it does not necessarily mean that an opportunity results in opportunism. Bergstresser and Philippon acknowledge that the separation of ownership and control is a root cause of governance problems, but do not make the link between earnings management and agency costs. There appears to be a great deal of assumption rather than discussion. Assumption has led to the current prevailing view, whereas discussion can lead to more relevant view.

Governance is relevant to the study of earnings management because it can help comment on the underlying motivations. Opportunity, along with motive, make up the motivation to manage earnings. Without an opportunity, there is no reason to engage in managing earnings. Governance can ultimately make earnings management opportunistic or beneficial. By providing an effective framework, governance can decide how much judgement and discretion managers are allowed to use. Jiraporn et al. (2008) measure governance through a governance index, they assume that higher index coefficient results in higher agency costs, as there is a wider separation of ownership and control. This assumption suggests that firms with a narrower separation of ownership and control, have more earnings management. Effective governance helps alleviate asymmetric information, which can cause a degree on earnings management. Earnings management is an agency issue and research from this perspective will help shed light on the nature of earnings management. It can help to understand the underlying opportunities to manage earnings, and subsequent motivation.

Market Efficiency

Markets are generally assumed to be informationally semi-strong efficient. They reflect all publicly known private information. Strong form efficient markets, incorporate privately held information. Earnings management has a role to play in market efficiency. The role that earnings management plays can seem paradoxical. On one hand, the markets benefit from managers exercising judgement and discretion because it reveals private information. Alternatively, if markets are semi-strong efficient, then there is no benefit in managing earnings because the markets will price according to the information that they have. Theory suggests that markets should be tricked; empirical evidence suggests that they are. Strong form efficiency is an unobtainable nirvana of instantaneous, accurately priced securities. Insider trading laws, to a certain extent, prevent markets from achieving this goal. Insider trading is on the cusp of strong form efficiency. It brings future information into the present. Essentially, it turns hindsight into foresight.

Markarian and de Albornoz Noguer (2010) investigates income smoothing, this has interesting implications for markets efficiency. Smooth income does not necessarily contain any new information; it can simply be over-accruing in one period to release during the next. Levitt (1998) scoldingly refers to this practice as cookie jar reserves. In an efficient market, it does not make sense to smooth income because the market should be able to see thought he accounting manipulation. However, as Markarian and de Albornoz Noguer's study suggests, it does have an impact: it reduces idiosyncratic risk. High idiosyncratic risk could be interpreted as either lots of new information releases, or markets find it difficult to interpret the information. This assumption suggests that smooth earnings reduce idiosyncratic risk because it reduces the flow of mixed signals or, more likely, it helps markets interpret the information. Earnings management is not strictly evidence against market efficiency, but it does imply a great deal of variability of efficiency in markets. As discretionary accruals are priced (Dechow, 1994; Subramanyam, 1996; Louis and Robinson, 2005, etc), markets value discretionary accruals. Judgement and discretion add to market efficiency. Carter et al. (2009) examines the effect of Sarbanes-Oxley on earnings management. They state that their study suggests that Sarbanes-Oxley reduces the incentives to manage earnings. On closer inspection, their study seems to suggest that Sarbanes-Oxley legislates against the use of accounting judgement and discretion.

Carter et al. (2009) look at the relationship between earnings management and executive remuneration. Their paper suggests that companies changed their remuneration packages after Sarbanes-Oxley in order to reduce the implicit incentives to manage earnings. Carter et al. document a positive relationship between bonuses and non-discretionary accruals prior to Sarbanes-Oxley and that this relationship strengthens after Sarbanes-Oxley is introduced. Carter et al., like Bartov and Mohanram (2004) and Beneish and Vargus (2002), define earnings management as income increasing accruals, and in order to detect earnings management uses a Modified Jones (Kothari et al., 2005) model. Carter et al. conclude that Sarbanes-Oxley decreases earnings management because it increases the implicit costs to misreport. The major caveat to their work is their use of an aggregate accruals detection model because it proxies for earnings management by using discretionary accruals. It is possible that, by proxying for earnings management in this way, Carter et al. demonstrate that Sarbanes-Oxley reduces the incentives to use discretionary accruals. Sarbanes-Oxley may not discourage earnings management, but may in fact discourage judgement and discretion. Two information characteristics that markets are willing to pay for; shown by the pricing of discretionary accruals (Subramanyam, 1996; Dechow, 1994; Louis and Robinson, 2005). Sarbanes-Oxley may be preventing some market efficiency by legislating against accounting discretion. This is a clear example of how a discrepancy between author and detection model earnings management definition causes problems with interpretation. The model indicates one outcome, however the conclusion is based on the author's own definition.

Market efficiency is relevant to the study of earnings mangement because it poses an interesting question: if markets are efficient, why do managers engage in earnings management? Earnings management can help markets to become efficient suggesting that it is beneficial, not only to shareholders, but to many market participants. Academics can work back from the effects of earnings management, in an attempt to understand the motivation, which can help comment on the nature of earnings management. The definition of earnigns management is relevant to market efficiency because it helps inform the motivation. Defining earnings management as income increasing accruals or an attempt to mislead shareholders questions the motivations to manage earnings because the market should be able to see through the manipulation. However, widening the defininition does not imply trickery, but improving the efficiency of the market, by releasing information. Widening the definition brings earnings management inline with the Efficient Market Hypothesis.

Summary and Conclusion

Earnings management is a pervasive topic in accounting literature. It has an influence in many different areas. Earnings management can be seen as both an agency and an accounting problem. It can be an agency problem because managers may not be acting in the interest of the shareholders and promote their own personal agenda. Empirically it is seen as an accounting problem in order to detect and prevent it. Earnings management is an important area to research because it has so much influence; financial reporting, executive remuneration, signalling, agency and governance and market efficiency. Earnings management is problematic as it can lead to insider trading(Beneish and Vargus, 2002), be used to increase executive remuneration (Bergstresser and Philippon, 2006), decrease earnings quality (Beneish and Vargus, 2002) and be used for other market manipulation (Levitt, 1998; Beneish, 2001; Burgstahler and Dichev, 1997). Earnings management is a tantalising area to research because it implies wrong-doing, and to a certain extent there is some wrong doing. However, there is a growing body of research that suggests the contrary; that earnings management is beneficial for shareholders. Benefits include; reduced agency costs (Jiraporn et al., 2008), signalling private information (Arya et al., 2003; Louis and Robinson, 2005), and reduced idiosyncratic risk (Matsumoto, 2002; Markarian and de Albornoz Noguer, 2010).

This mixed interpretation of results is likely due to differences in the definition of earnings management. Some academics have attempted to define earnings management, but have defined the phenomenon in a variety of ways, including; an intervention in financial reporting (Schipper, 1989), an attempt to mislead shareholders (Healy and Wahlen, 1999) or a spectrum of accounting discretion (Dechow and Skinner, 2000). Despite academic attempts to define earnings management, there is still a lack of congruence of definition. Authors researching earnings management have their own definitions, including; income increasing accruals (Bartov and Mohanram, 2004; Beneish and Vargus, 2002; Carter et al., 2009), a method to temporarily alter earnings (Bergstresser and Philippon, 2006), discretionary accruals (Jiraporn et al., 2008; Louis and Robinson, 2005; Matsumoto, 2002) and as managerial action to divert wealth from shareholders to managers (Bowen et al., 2005). The definitions presented by academics researching earnings management help form how they interpret their results. Further definition problems arise when academics have to detect earnings management. As earnings management is unobservable, powerful statistical tool must be used in order to detect. The most used type of detection model is a Jones (Jones, 1991) type variant. It measures accruals using aggregate accruals; essentially the model measures all discretionary accruals as earnings management. These models have their own implicit definition of earnings management which may, or may not, be consistent with the prevailing or author definition.

The inconsistent definition problem can cause biased result interpretation. The definition implicit in the detection model should be overriding because it examines the dataset for earnings management. Carter et al. (2009) is a good example of definition conflict. They examine the effect that the Sarbanes-Oxley legislation has on the incentives to manage earnings. Their research suggests that Sarbanes-Oxley reduces the incentives to manage earnings, however this conclusion is based on their definition of earnings management; income increasing accruals. It is plausible that they in-fact measure the effect that Sarbanes-Oxley has on accounting discretion, given the detection model that they use. Using the detection model definition to form a conclusion, conflicts with using their own definition. The model's definition implies that Sarbanes-Oxley reduces incentives to use discretion rather than incentives to manage earnings.

This paper examines six articles that research earnings management. They use similar detection models, sample periods and sample datasets. Controlling for these aspects of the articles means that differences in result conclusions are largely due to the differences in author definitions of earnings management. Their results are mixed, some implying that earnings management is the result of managerial opportunism and some implying that earnings management is designed to provide benefits for shareholders. The Company legal form has one objective; to maximise shareholder wealth. With this in mind, it is important that research focuses on the impact that earnings management has on shareholder wealth. Assuming that earnings management is either beneficial or opportunistic skews results. Whilst Bowen et al. (2005) uses an earnings management definition that does not accurately reflect the definition used by the detection model, it takes an important step. Their research implies that in order to conclude opportunism a drop in performance or shareholder wealth needs to be documented. Likewise, a conclusion of beneficial would need documentation of an increase of shareholder wealth.

Real earnings management research has the problem that it is near impossible to distinguish between operational decisions and real earnings management. Similarly, accrual earnings management research has difficultly distinguishing between discretion and earnings management. This is because managerial intent is unobservable. Intent is only observable if the managers in question are interviewed, even then it relies on managers giving an honest answer. This paper recommends that the definition of earnings management is widened to include all accounting discretion, and that conclusions are drawn on the basis of supporting empirical evidence. Higher importance should be placed on the definition that the detection models use, rather than the definitions and assumptions that the authors use. This would aid earnings management research by discouraging bias conclusions. Had Carter et al. (2009) supported their argument with a rise in shareholder wealth or firm performance post-Sarbanes-Oxley, their conclusion may be more valid. A drop in either of these metrics post-Sarbanes-Oxley could lead to the conclusion that Sarbanes-Oxley legislates against discretion. Similarly, if Bergstresser and Philippon (2006) were able to demonstrate adverse firm performance and shareholder wealth changes with discretion, they could improve the credibility of their conclusion.

Earnings management research influences a number of areas. It is important to understand why earnings management occurs and what the effects are. Since it is difficult to observe and find why earnings management occurs, it may be easier to focus on what the effects are. This may provide useful insights and explanations as to why it occurs. Further research into the effect of earnings management and discretion on earnings quality would provide useful to earnings management research because, high quality earnings are a cornerstone of financial reporting. As Levitt (1998) makes clear, an erosion of earnings quality undermines the financial reporting system. If earnings earnings management does destroy earnings quality then it needs to be prevented in order to save the financial system. However, if discretion improves the quality of earnings then it needs to be encouraged. If earnings management does in-fact improve earnings quality, then there could be reason to investigate the nature of the economic reality that GAAP proposes.

Many market participants rely on the signals that managers, analysts and other insiders reveal to inform their investment behaviour. Further research into the signalling effect of earnings management may help decide whether it is or is perceived to be beneficial by market participants. Signalling is closely tied with the arguments to encourage earnings quality. The signals that managers present through financial reporting, insider trading and other methods could be investigated in greater detail to determine the role that signalling plays in motivating earnings management.

Agency and governance related research would benefit the earnings management literature because it reveals a little more about the opportunity to manage earnings. Viewing earnings management as an agency problem may help research as the agency problem is very real and very old. Agency costs represent an avoidable and direct drain on shareholder's economic resources. Given that the Company is designed to maximise shareholder wealth, it is important to focus on areas that have a direct effect on that measure.

Arguably executive remuneration research has the most important part to play in earnings management research. This is because it is the one measure that companies can act on; remuneration committees have the power to restrict executive remuneration. It is easy to see the relationship between earnings management and remuneration. However, it may be the wrong villain. It may be easy to observe apparent managerial opportunism because of the opportunistic exit that American style options have. Insider trading appears to be the manifestation of managerial opportunism, further research into prevalence of insider trades and the effect on shareholder wealth and performance would greatly benefit earnings management literature. Attractive remuneration packages attract top talem to a company. No one firm can benefit from a unilateral change of pay strategy, cracking down on the use of American style options, as they may not attract the expertise of top managers. Managerial opportunism and shareholders benefits are not mutually exclusive. Remuneration contracts are designed to convert opportunism into increased shareholder wealth. This is because remuneration assumes that opportunism cannot be removed. Therefore opportunism must be utilised in order to increase the shareholder wealth. Managers want to maximise their remuneration and will do so inside or outside GAAP. Curbing the amount of non-GAAP remuneration generation (ie insider trading) is an implicit task of executive remuneration design.

This study specifically refers to executive and managerial pay as remuneration, oppose to the majority of literature that refers to executive pay as compensation. There is a slight, but very importnat distinction between the two terms which should be addressed. According to the New Oxford American Dictionary, remuneration is “money paid for work or a service”. Compensation, on the other hand, is a “recompense for loss, injury or suffering”. Using the term compensation has a very different meaning, despite the two terms being used almost interchangeably. Remuneration implies choice and reward, whereas compensation implies that it is remedying an unfair situation outside of the executive's control. Executive pay should not be seen as a remedy. A remedy implies that the receiver is entitled to the amount, not rewarded. Perhaps part of the agency problem is that executives feel they need remedying for the work that they do, not rewarded.

The main caveat of this research is that the field of earnings management is very broad. A Google scholar search for earnings management returns in excess of 650,000 articles. The sheer quantity of earnings management articles meant that there was ample choice to pick the most appropriate ones to support the argument. However, in order to overcome this problem, papers were selected that had similar characteristics and that were referred to in other literature.

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