Volume 27 Number 12 2001

Earnings Management: A Perspective

by Messod D. Beneish, Indiana University, Kelley School of Business, Bloomington, Indiana 47401 Abstract The paper provides a perspective on earnings management. I begin by addressing the following questions: What is earnings management? How pervasive is it? How is it measured? Then, I discuss what we, as academics, know about incentives to increase and to decrease earnings. The research presented relates to earnings management incentives stemming from regulation, debt and compensation contracts, insider trading and security issuances. I also discuss issues relating to problems in measuring the extent of earnings management and propose extensions for future work. 1. Introduction An issue central to accounting research is the extent to which managers alter reported earnings for their own benefit. In the 1970s and early 1980s, a large number of studies investigated the determinants of accounting choice. These studies provided evidence consistent with managers incentives to choose beneficial ways of reporting earnings in regulatory and contractual contexts (see Holthausen and Leftwich, 1983, and Watts and Zimmerman, 1986 for reviews of these studies). Since the mid-1980s studies of managerial incentives to alter earnings have focused primarily on accruals. I trace the explosive growth in accrual-based management research to three likely causes. First, accruals are the principal product of Generally Accepted Accounting Principles, and, if earnings are managed, it is more likely that the earnings management occurs on the accrual rather than the cash flow component of earnings. Second, studying accruals reduces the problems associated with the inability to measure the effect of various accounting choices on earnings (Watts and Zimmerman, 1990). Third, if earnings management is an unobservable component of accruals, it is less likely that investors can unravel the effect of earnings management on reported earnings. The main challenge faced by earnings management researchers is that academics, like investors, are unable to observe, or for that matter, measure the earnings management component of accruals. Indeed, managerial accounting actions intended to increase compensation, avoid covenant default, raise capital, or influence a regulatory outcome are largely unobservable. Consequently, prior work has drawn inferences from joint hypotheses, that test both incentives to manage earnings as well as the construct validity of the various accrual models which are used to estimate managers accounting discretion. Because extant models of expected accruals provide imprecise estimates of managerial discretion, questions have been raised about whether the unobservable earnings management actions do in fact occur.1 Notwithstanding research design problems, a variety of evidence suggestive of earnings management has accumulated. In Section 2, I raise three general questions about earnings management: What is it? How frequently does it occur? How do researchers estimate earnings management? Prior investigations of managerial incentives to alter earnings typically fall in three categories, namely studies that examine the effect of contracts

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in accounting choices, and studies that examine the incentive effects associated with the need to raise external financing. Rather than discussing the evidence along those lines, I have chosen to present the evidence depending on the direction of the incentive context. Thus, I summarize in Sections 3 and 4, what is known about incentives to increase and decrease earnings. In Section 5, I discuss evidence on incentive contexts that provide incentives either to increase or to decrease earnings, and in Section 6, I present conclusions and suggestions for future work. 2. Earnings Management 2.1 Definitions Notice the plural: It reflects my view that academics have no consensus on what is earnings management. There have been at least three attempts at defining earnings management: (1) Managing earnings is the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about a desired level of reported earnings. (Davidson, Stickney and Weil, 1987, cited in Schipper, 1989, p.92). Managing earnings is a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain (as opposed to say, merely facilitating the neutral operation of the process). ... A minor extension of this definition would encompass real" earnings management, accomplished by timing investment or financing decisions to alter reported earnings or some subset of it." (Schipper, 1989, p.92). 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 economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers. (Healy and Wahlen, 1999, p.368).

(2)

(3)

A lack of consensus on the definition of earnings management implies differing interpretations of empirical evidence in studies that seek to detect earnings management, or to provide evidence of earnings management incentives. It is thus useful to compare the above three definitions. All three definitions deal with actions management undertaken within the context of financial reporting - including the structuring of transactions so that a desired accounting treatment applies (e.g. pooling, operating leases). However, the second definition also allows earnings management to occur via timing real investment and financing decisions. If the timing issue delays or accelerates a discretionary expenditure for a very short period of time around the firms fiscal year, I envision timing real decisions as a means of managing earnings. A problem with the second definition arises if readers interpret any real decisions - including those implying that managers forego profitable opportunities - as earnings management. Given the availability of alternative ways to manage earnings, I believe it is implausible to call earnings management a deviation from rational investment behavior. This reflects my view that earnings management is a financial reporting phenomenon.

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There are two perspectives on earnings management: the opportunistic perspective holds that managers seek to mislead investors, and the information perspective, first enunciated by Holthausen and Leftwich (1983), under which managerial discretion is a means for managers to reveal to investors their private expectations about the firms future cash flows. Much prior work has predicated its conclusions on an opportunistic perspective for earnings management and has not tested the information perspective. The three definitions allow earnings management to occur for the purposes of hiding deteriorating performance, but the word mislead in the Healy and Wahlen (1999) definition appears to preclude the possibility that earnings management can occur for the purposes of enhancing the signal in reported earnings.2 This may be due to the inclusion of contractual incentives in the third definition. To explain, prior work has not been able to distinguish whether managers exercise of discretion is intended to mislead or to inform, and the typical conclusion in contractual studies is that incentives result in de-facto opportunistic earnings management. Under the third definition, earnings management shares much fraud. That is, fraud is defined as one or more intentional acts designed to deceive other persons and cause them financial loss. (National Association of Certified Fraud Examiners, 1993, p.6). Thus, the main difference between the third definition and fraud is that stakeholders may have anticipated managers behavior and negotiated contract term that provide price protection. 2.2 Incidence of earnings management If one believes former SEC Chairman Levitt (1998), earnings management is widespread, at least among public companies, as they face pressure to meet analysts expectations. Earnings management is also widespread if one relies on analytical arguments. For example, Bagnoli and Watts (2000) suggest that the existence of relative performance evaluation leads firms to manage earnings if they expect competitor firms to manage earnings. Similar prisoners dilemma-like arguments for the existence of earnings management appear in Erickson and Wang (1999) in the context of mergers and Shivakumar (2000) in the context of seasoned equity offerings. At the other extreme, we can only be certain that earnings have indeed been managed, when the judicial system, in cases that are brought by the SEC or the Department of Justice, resolves that earnings management has occurred. While it is likely that earnings management occurs more frequently than is observed from judicial actions, it is not clear to me that earnings management is pervasive: it seems implausible that firms face the same motivations to manage earnings over time. As later discussed, much of the evidence of earnings management is dependent on firm performance, suggesting that earnings management is more likely to be present when a firms performance is either unusually good or unusually bad. 2.3 Alternative methods for estimating earnings management Three approaches have been used by researchers to evaluate the existence of earnings management. One approach studies aggregate accruals and uses regression models to calculate expected and unexpected accruals. A second approach focuses on specific accruals such as the provision for bad debt, or on accruals in specific sectors, such as the claim loss reserve in the insurance industry. The third approach investigates discontinuities in the distribution of earnings.

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2.3.1 Aggregate Accruals

The Jones (1991) model is the most widely used model in studies of aggregate accruals. The model follows Kaplans (1985) suggestion that accruals likely result from the exercise of managerial discretion and from changes in the firms economic conditions. The model relates total accruals to the change in sales ( DSales) and the level of gross property, plant and equipment (PPE): Total Accrualsit = a1i + b1i DSalesit + c2i PPEit + e1it (1) The model is based on two assumptions. First, that current accruals (changes in working capital accounts) resulting from changes in the firms economic environment are related to changes in sales, or sales growth since equation (1) is typically estimated with all variables deflated by either lagged assets or lagged sales. Second, that gross property plant and equipment controls for the portion of total accruals related to nondiscretionary depreciation expense. The second version uses current accruals as a dependent variable and only the change in sales as an explanator: Currentit = a2i + b2i DSalesit + e2it (2) These models are either estimated in time series firm by firm or cross-sectionally using all firms in a given two-digit industry and year. Each yearly estimation is used to make a one-year ahead forecast of expected accruals which, subtracted from the dependent variable, yields unexpected accruals. Two alternative versions of the Jones (1991) model have also been proposed. In their total accrual form, the models are given by: Total Accrualsit = a3i + b3i (DSalesit - DReceivablesit)+c3i PPEit + u3it Total Accrualsit = a4i + b4i DCash Salesit+c4i PPEit+u4i (3) (4)

The expectation model in equation (3) is typically attributed to Dechow, Sloan and Sweeney (1995) (e.g. see Gaver, Gaver and Austin, 1995), even though the modifiedJones model presented in Dechow et al. (1995) is the same as the Jones model in the estimation period and only has the receivable adjustment in the prediction period. Indeed, the revenue based variable in (3) equals Cash Salesit-Salesit-1. Since it is not clear what the construct means or how it proxies for the effect on accruals of changes in the firms economic environment, Beneish (1998b) proposed an alternative modification based on cash sales (equation 4). His evidence indicates that change in cash sales preserves the intuition behind using changes in sales to proxy for changes in economic performance and has the advantage of using as an explanator an accounting construct that reduces the endogeneity problem.3 Notwithstanding these modifications, the primary criticism leveled at extant accruals models remains: The models fail to distinguish the accruals that result from managers exercise of discretion from those that result from changes in the firms economic performance (see McNichols, 2000) for an extensive discussion of research design issues related to aggregate accrual models). This is exacerbated by the fact that we do not know how changing operating decisions that are ex-ante value maximizing affect measures of earnings management. In other words, we do not know whether estimates of earnings

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management reflect efficient operating decisions or reporting considerations. To this effect Beneish (1997, p.275) states: ...a firms financial reporting strategy depends on its business strategy and should be evaluated ex-ante, not ex-post. To illustrate, consider a personal computer manufacturer who seeks to gain market share on a competitor increased production and offers, before the holiday season, incentives to distributors who increase their demand. If the strategy is not successful and translates into lower than expected earnings and a price drop, the manufacturer may be sued and its reporting criticized. While the firm ends up with higher discretionary accruals, it is, conditional on its strategy, an aggressive competitor rather than an earnings manager. This firm is, however, not distinguishable from a firm who deliberately pushed sales on its distributors to improve earnings. An additional problem is that if managers indeed have an incentive to manage earnings, they are likely to do so in a way that is difficult to detect, thus reducing our ability to detect earnings management and weakening the power of our tests.4 2.3.2 Other methods Despite their widespread usage, models of aggregate accruals have been subject to significant criticism (cf. footnote 1). An alternative to using an aggregate accruals approach is to model a specific accrual, such as the provision for bad debt (McNichols and Wilson, 1988), or to focus on accruals in specific sectors such as the claim loss reserve in the insurance industry (Beaver and McNichols, 1998). McNichols (2000) provides an excellent discussion of the advantages and disadvantages of the specific accrual approach. For example, in terms of advantages she states (p.333): One advantage is that the researcher can develop intuition for the key factors that influence the behavior of the accrual, exploiting his knowledge of GAAP. A second advantage is that a specific accrual approach can be applied in industries whose business practices cause the accrual in question to be material and a likely object of judgment and discretion. Among the disadvantages, she argues that studying specific accruals require a costly investment in institutional knowledge, and limits the generalizability of the findings, since studies of specific accruals tend to be confined to smaller or sector specific samples. Recent work by Burgstahler and Dichev (1997) and Degeorge, Patel and Zeckhauser (1999) use an interesting alternative methodology for studying earnings management. They investigate discontinuities in the distribution of reported earnings around three thresholds: (1) zero earnings, (2) last years earnings, (3) this years analysts expectations. They make predictions about the behavior of earnings in narrow intervals around these thresholds. The evidence appears consistent with predicted discontinuities: there tend to be less (more) observations than expected for earnings amounts just below (above) the zero earnings and last years earnings thresholds. While examining earnings distributions is informative about which firms are likely to have managed earnings, this methodology is silent about the form and extent of earnings management. 3. Evidence of Income Increasing Earnings Management I discuss four sources of incentives for income increasing earnings management: (1) debt contracts, (2) compensation agreements, (3) equity offerings, (4) insider trading. The first two sources have been hypothesized in prior positive accounting theory research and the last two sources are explicitly described as reasons behind earnings overstatement in the SECs accounting enforcement actions, and have been investigated in recent research.

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3.1 Debt Covenants

Debt contracts are an important theme in financial accounting research as lenders often use accounting numbers to regulate firms activities, e.g. by requiring that certain performance objectives be met or imposing limits to allowed investing and financing activities. The linkage between accounting numbers and debt contracts has been used in studies investigation (i) why economic consequences are observed when firms comply with mandated, or voluntarily make, accounting changes that have no cash flow impact, (ii) the determinants of accounting choice and managers exercise of discretion over accounting estimates that impact net income. The assumption is that debt covenants provide incentives for managers to increase earnings either to reduce the restrictiveness of accountingbased constraints in debt agreements or to avoid the costs of covenant violations. The results of economic consequences studies have generally been mixed and researchers recently turned to investigating accounting choice in firms that experience actual technical default (Beneish and Press, 1993, 1995; Sweeney, 1994; Defond and Jiambalvo, 1994; and DeAngelo, DeAngelo and Skinner, 1994). The idea is to increase the power of the tests by focusing on a sample where the effect of violating debt covenants is likely to be more noticeable. While some of the evidence suggests that managers take income increasing actions delay the onset of default (Sweeney, 1994; Defond and Jiambalvo, 1994), other evidence does not (Beneish and Press, 1993; DeAngelo, DeAngelo and Skinner, 1994). Further, it is not clear such actions actually are sufficient to delay default.5 Thus, the evidence in these studies on whether managers make income increasing accounting choices to avoid default is mixed. However, examining a large sample of private debt agreements, and measuring firms closeness to current ratio and tangible net worth constraints, Dichev and Skinner (2000) find significantly greater proportions of firms slightly above the covenants violation threshold than below. They suggest that managers take actions consistent with avoiding covenant default. 3.2 Compensation Agreements Studies examining the bonus hypothesis (Healy, 1985; Gaver et al., 1995; and Holthausen, Larker and Sloan, 1995) provide evidence consistent with managers altering reported earnings to increase their compensation. Except for Healy (1985), these studies provide evidence consistent with managers decreasing reported earnings to increase future compensation. In addition, Holthausen et al. (1995) finds little evidence that managers increase income and suggest that the income-increasing evidence in Healy (1985) is induced by his experimental design. 3.3 Equity Offerings A growing body of research examines managers incentives to increase reported income in the context of security offerings. Information asymmetry between owners-managers and investors, particularly at the time of initial public offerings, is recognized in prior research. Models such as Leland and Pyle (1977) suggest that the amount of equity retained by insiders signals their private valuation, and models such as Hughes (1986), Titman and Trueman (1986), and Datar et al. (1991) examine the role of the reputation of the auditor on the offer price. In these models, the asymmetry is resolved by the choice of an outside certifier or by a commitment to a contract that penalizes the issuer for untruthful disclo-

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sure. Empirical studies assume that information asymmetry remains and use various models to estimate managers exercise of discretion over accruals at the time of security offerings. Four studies investigate earnings management as an explanation for the puzzling behavior of post-issuance stock prices. Teoh, Welch and Rao (1998) and Teoh, Welch and Wong (1998a) study earnings management in the context of initial public offerings (IPO), and Rangan (1998) and Teoh, Welch and Wong (1998b) do so in the context of seasoned equity offerings. These studies estimate the extent of earnings management using Joneslike models around the time of the security issuance, and correlate their earnings management estimates with post-issue earnings and returns. The evidence presented suggests that estimates of at-issue earnings management are significantly negatively correlated with subsequent earnings and returns performance. The results in these studies suggest that market participants fail to understand the valuation implications of unexpected accruals. While the results are compelling, the conclusion that intentional earnings management at the time of security issuance successfully misleads investors is premature. Beneish (1998b, p.210) expresses reservations about generalizing such a conclusion as follows: First, the conclusion implies that financial statement fraud is pervasive at the time of issuance. To explain; fraud is defined by the National Association of Certified Fraud Examiners (1993, p.6) as one or more intentional acts designed to deceive other persons and cause them financial loss." If financial statement fraud at issuance is pervasive - e.g. managers are successful in misleading investors - I would expect that firms would fare poorly post-issuance in terms of litigation brought about by the Securities and Exchange Commission (SEC), disgruntled investors, and the plaintiffs bar. I would also expect managers to fare poorly post-issuance in terms of wealth and employment. I would find evidence of post-issue consequences on firms and managers informative about the existence of at-issue intentional earnings management to mislead investors and believe these issues are worthy of future research." 3.4 Insider Trading Like raising capital, insider trading is a trading related incentive and a relatively newcomer to the set of potential antecedents to income increasing earnings management. The reason is that, if one accepts two economic efficiency-based arguments, the study of such incentives becomes futile. Specifically, the arguments are: (1) capital markets are informationally efficient (a central hypothesis in capital research), and investors see through managers accounting actions, (2) reputation effects and the labor market discipline insiders, preventing them from profiting in firms facing declining prospects. The evidence on insider trading as an incentive to increase income to mislead investors is less pervasive, but, in my opinion, more compelling that the evidence on equity issuance as an incentive. One reason is that the evidence is drawn from firms that have actually perpetrated financial statement fraud (Beneish, 1999), or committed illegal acts (Summers and Sweeney, 1998). It is consistent with professional views of causes of earnings management (National Association of Certified Fraud Examiners, 1993), and also with evidence that managers reduce their stake in the firms equity in the years preceding bankruptcy filings (Seyhun and Bradley, 1997). While Seyhun and Bradley (1997) do not speak to earnings management, their sample firms face deteriorating performance, a fre-

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quently posited antecedent to corporate illegal behavior (National Association of Certified Fraud Examiners, 1993). The most direct evidence linking financial statement manipulations and insider trading is in Beneish (1999) who finds that managers of firms with earnings overstatements that violate GAAP are more likely to sell their holdings and to redeem stock appreciation rights during the period when earnings are overstated than managers in a control sample of firms. I also find an average stock price loss of 20 percent when the overstatement is discovered and an average cost of settling litigation that is 9 percent of market value prior to discovery. This suggests that managers stock transactions during the period of earnings overstatement occur at inflated prices that reflect the effect of the earnings overstatement. (p.426) Beneish (1999) relies on prior insider trading research to develop hypotheses about manipulation incentives related to insider trading. This research suggests that managers act as informed traders, buying (selling) in advance of stock price increases (declines) (Jaffe, 1974; Seyhun, 1986) and views the gains managers as an efficient means of compensating managers for providing their private information to investors on a timely basis (Carlton and Fischel, 1983; Dye, 1984; Noe, 1997). Beneish (1999) thus argues that: If managers act as informed traders, I expect them to use their information about earnings overstatement to trade for their own benefit. That is, if managers overstate earnings to provide market participants with positive private information about the firms prospects, I expect them to either strategically increase their stake in their firms equity (perhaps to provide another positive signal about firm prospects) or abstain from trading. Alternatively, if managers overstate earnings to hide deteriorating firm performance, I expect them to sell their equity contingent wealth. If overstatement is intended to mislead investors, managers may limit their selling to reduce the likelihood of attracting the attention of the SECs insider trading monitors. Alternatively, as argued by Summers and Sweeney (1998), managers who mislead investors may possess low personal ethics, low risk aversion and/or a downwardly biased assessment of the probability of getting caught. Yet another possibility is that, in the event of detection, managers could justify their selling for personal liquidity reasons. (p.435) Beneish (1999) also investigates the penalties facing managers after the manipulations are discovered. If reputation losses and the consequent disciplining in the stock market preclude managers from engaging in earnings manipulation and making profitable trades, employment and monetary penalties subsequently imposed on managers should be substantial if they are to serve as a deterrent. However, Beneish (1999) finds that managers employment losses subsequent to discovery are similar in firms that do and do not overstate earnings and that the SEC is not likely to impose trading sanctions on managers in firms with earnings overstatement unless the managers sell their own shares as part of a firm security offering. (p.425) 4. Evidence of Income Decreasing Earnings Management With the exception of bonus as a form of compensation, where evidence discussed in section 3.2 suggests that managers decrease current reported earnings so as to increase future compensation, much of the evidence in prior research on income decreasing earnings management is consistent with managers depressing earnings on a temporary basis to in-

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crease the likelihood of a negotiated or regulatory outcome. For example, lower reported earnings have been shown to increase the likelihood that utilities can obtain rate increases (Jarrell, 1979), to reduce the likelihood of wealth transfers (Watts and Zimmerman, 1978), and to obtain import relief (Jones, 1991); Liberty and Zimmerman (1986) examine incentives to decrease earnings in periods surrounding union negotiations and DeAngelo (1986) examines incentives to decrease earnings in periods preceding management buyouts. The power of the tests in these studies is low as samples are small, and evidence is not always conclusive: Liberty and Zimmerman (1986) and DeAngelo (1986) find no evidence of downward earnings manipulations. Recent survey evidence in Nelson et al. (2000) suggests that income decreasing in earnings management in the form of cookie jar reserves is pervasive. Surveying 526 experiences of Big-5 audit partners and managers, they find that 40% of the responses describe attempts at income decreasing earnings management. While the ratio suggests that income decreasing earnings management is pervasive, it is difficult to make a more precise assessment because the survey was conducted in the Fall of 1998, a period characterized by economic expansion and a bull market. 5. Sector Specific Contexts that Provide Incentives Either to Increase or to Decrease Earnings Financial institutions and insurance companies are in sectors where managers have to balance financial reporting incentives with regulatory constraints. For example, studies of regulated financial institutions indicate that managers face multiple incentives to manage earnings. In particular, these studies suggest that incentives associated with regulatory capital and decreasing taxes balance those associated with increasing earnings. Indeed, these studies generally provide evidence consistent with income smoothing (see Moyer, 1990; Beatty, et al., 1995; Collins et al., 1995). Studies in these areas avoid the problems associated with using a model of expectations for aggregate accruals, because they can focus on the discretion associated with particular accruals such as loan loss provisions in the banking industry and claim loss provisions in the insurance industry. Required disclosures in these industries enable researchers, with hindsight, to identify firms that under- or over-reserved, and to test hypotheses about the factors motivating this behavior. For example, Petroni (1992) finds that financially weak insurers tend to underestimate loss reserves relative to companies exhibiting greater financial strength. Beaver, McNichols and Nelson (2000) analyze the distribution of insurance company earnings and suggest that weak insurers have incentives to under-reserve while strong insurers have incentives to over-reserve. 6. Conclusions and Future Research The accumulated evidence suggests that income increasing earnings management is more pervasive than income decreasing earnings management. While the results are mixed or subject to confounding effects, there is weak evidence that debt covenants, and equity offerings provide income increasing incentives. There is also evidence that managers have incentive to increase income to hide deterioration of performance, so as to sell their equity contingent wealth at higher prices. The latter evidence is limited however, to small samples and generalizations will require further studies. With the exception of sector spe-

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cific studies, evidence on income decreasing earnings management is meager. At best, it appears to be time and industry specific. Future work needs to deal with the unobservability of managerial actions that presumably result in income manipulations. The difficulties faced by aggregate accrual models suggest that studies of specific accruals, perhaps even case studies, are needed. In his call for papers, Beneish (1998a, pp.86-87) suggests two avenues of research that have not been exploited to date. The study of the form of reporting discretion and its bounds in the context of a particular industry. For example, what components of revenues and expenses are discretionary in the health care industry? How does discretion over these components earnings translate into discretionary accruals? What can we learn from their behavior over time? In a similar vein, one could investigate the discretion related to revenue recognition in the high-tech, health-care or construction industries, or the discretion related to the provision for inventory obsolescence among computer manufacturers. One way in which one could assess the external validity of aggregate accrual models and learn about the exercise of discretion in specific industries is to study earnings restatements. Beneish (1998a, p.87) also suggests an avenue of research that has not been exploited to date: The analysis of instances where firms restate earnings, e.g. where actual earnings management is more likely. Such instances are of interest because (i) relying on external sources to establish ex-post that earnings were managed enables an assessment of the external validity of accrual models, (ii) such instances enable a description of the form and extent of managers reporting discretion. For example, (a) What is the relation between earnings management and shareholder litigation? independent auditor litigation? What is the relation between the magnitude of estimated discretionary accruals and that of earnings restatements? (b) If actions brought by tax authorities against firms result in disallowances and or restatements, what is the relation between the magnitude of estimated discretionary accruals and that of earnings restatements? A promising avenue of research is the study of the intersection of insider trading - an observable management action - with earnings management - an unobservable management action. Large sample evidence in Beneish and Vargus (2000), and evidence on a sample of technical defaulters in Beneish, Press and Vargus (2000) suggests that insiders trading is useful in assessing the likelihood of earnings management.

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Endnotes

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1. Criticism of extant accrual models ability to isolate the earnings management component of accruals includes McNichols and Wilson (1988), Holthausen, Larker and Sloan (1995), Beneish (1997, 1998), and McNichols (2000) who argue that when the incentive context studies is correlated with performance, inferences from the study are confounded; Guay, Khotari and Watts (1996) who suggest that accrual models estimate discretionary accruals with considerable imprecision and that some accrual models randomly decompose earnings into discretionary and non-discretionary components; Beneish (1997) who provides evidence that accrual models have poor detective performance even among firms whose behavior is extreme enough to warrant the attention of regulators; Thomas and Zhang (2000) who suggest that the performance of accrual models is dismal. 2. A conversation with one of the authors revealed that he would also interpret a situation where could be signaling strength as misleading. Consider that a manager understates income by over-providing for bad debts, obsolescence or loan losses: the usual signaling argument is that the manager action is informative as it helps investors distinguish between weak and strong firms; however, it is also possible that the manager action is misleading because the manager may be setting aside income for a rainy day. 3. To explain; it is much harder to exercise discretion over cash sales than over credit sales. Indeed, examining firms whose financial reporting behavior is deviant enough to warrant SEC enforcement actions, Beneish (1997) finds that cash sales are rarely manipulated. He reports that one firm out of 64 (1.6%) engages in circular transfers of money to create the impression of receivable collection. In contrast, 43 of 64 firms (67.2%) engage in manipulations affecting credit sales (e.g. fictitious invoices, front loading with a right of return, keeping books open past the end of the fiscal period, overstating the percentage of completion). 4. I thank an anonymous referee for this suggestion. 5. Defond and Jiambalvo (1994) and Sweeney (1994) study a subset of firms for which they have constraint data and find that neither accrual discretion nor changes in accounting techniques are effective in delaying default.

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References

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Bagnoli, M., and Watts, S.G. (2000) The effect of relative performance evaluation on earnings management: A game-theoretic approach. Journal of Accounting and Public Policy, 19 (4/5), pp.377-397. Beatty, A., Chamberlain, S., and Magliolo, J. (1995) Managing financial reports of commercial banks: The influence of taxes regulatory capital, and earnings. Journal of Accounting Research, 33 (Autumn), pp.231-261. Beaver, W.H. and McNichols, M.F. (1998) The characteristics and valuation of loss reserves of property casualty insurers. Review of Accounting Studies, (3), pp.73-95. Beaver, W.H., McNichols, M.F. and Nelson, K.K. (2000) Management of loss reserve accrual and the distribution of earnings in the property-casualty insurance industry. Working paper. Stanford University. Beneish, M.D. (1997) Detecting GAAP Violation: Implications for assessing earnings management among firms with extreme financial performance. Journal of Accounting and Public Policy, 16(3), pp.271-309. Beneish, M.D. (1998a) A Call for Paper: Earnings Management. Journal of Accounting and Public Policy, 17, pp.85-88. Beneish, M.D. (1998b) Discussion of Are accruals during initial public offerings opportunistic? Review of Accounting Studies, 3(1/2), pp.209-221. Beneish, M.D. (1999) Incentives and Penalties Related to Earnings Overstatements That Violate GAAP. The Accounting Review, (4), pp.425-457. Beneish, M.D. and Press, E. (1993) Costs of technical violation of accounting-based debt covenants. The Accounting Review, 68 (April), pp.223-257. ____, and ____. (1995). The resolution of technical default. The Accounting Review, 70 (April), pp.337-353. Beneish, M.D., Press, E.G. and Vargus, M.E. (2000) An Empirical Examination of the Relation Between Incentives to Avoid Debt Covenant Default and Insider Trading. Working Paper, Indiana University. Beneish, M.D., and Vargus, M.E. (2000) Insider Trading, Accrual and Earnings Quality. Working Paper, Indiana University. Burgstahler, D., and Dichev, I. (1997) Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24(1), pp.99-126. Carlton, D., and Fischel, D. (1983) The regulation of insider trading. Stanford Law Review, 35 (May), pp.857-895. Collins, J.H., Shackelford, D.A., and Wahlen, J.M. (1995) Bank differences in the coordination of regulatory capital, earnings and taxes. Journal of Accounting Research, 33 (Autumn), pp.263-291.

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Datar, S.M., Feltham, G.A., and Hughes, J.S. (1991) The Role of Audits and Audit Quality in Valuing New Issues. Journal of Accounting and Economics, (March), pp.3-49. DeAngelo, H., DeAngelo, L., and Skinner, D.J. (1994) Accounting choice in troubled companies. Journal of Accounting and Economics, 17 (1/2), pp.113-143. DeAngelo, L. (1986) Accounting numbers as market valuation substitutes: A study of management buyouts of public stockholders. The Accounting Review, (July), pp.400420. Dechow, P.M., Sloan, R.G., and Sweeney, A.P. (1995) Detecting Earnings Management. The Accounting Review, 70(2), pp.193-225. Degeorge, F., Patel, J. and Zeckhauser, R. (1999) Earnings management to exceed thresholds. Journal of Business, 72, pp.1-33. Defond, M.L. and Jiambalvo, J. (1994) Debt Covenant Effects and the Manipulation of Accruals. Journal of Accounting and Economics, (January), pp.145-176. Dichev, I.D., Skinner, D.J. (2000) Large sample evidence on the debt covenant hypothesis. Working paper. University of Michigan. Dye, R. C) Insider trading and incentives. Journal of Business, 53 (July), pp.295-313. Erickson, M. and Wang, S. (1999) Earnings management by acquiring firms in stock for stock mergers. Journal of Accounting and Economics, pp.149-176. Gaver, J., Gaver, K., and Austin, J. (1995) Additional Evidence of Bonus Plans and Income Management. Journal of Accounting and Economics, pp.3-28. Guay, W.A., Kothari, S.P. and Watts, R.L. (1996) A market-based evaluation of discretionary-accrual models. Journal of Accounting Research, 34 (Supplement), pp.83-105. Healy, P.M. (1985) The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics, (April), pp.85-107. Healy, P.M., and Wahlen, J.M. (1999) A review of the earnings management literature and its implications for standard setting. Accounting Horizons. Holthausen, R.W., Larker, D.F., and Sloan, R.G. (1995) Annual bonus schemes and the manipulation of earnings. Journal of Accounting and Economics, 19(1), pp.29-74. Holthausen, R.W. and Leftwich, R.W. (1983) The economics consequences of accounting choice. Journal of Accounting and Economics, 5(2), pp.77-117. Hughes, P.J. (1986) Signaling by Direct Disclosures Under Asymmetric Function. Journal of Accounting and Economics, (1986), pp.119-142. Jaffe, J.F. (1974) Special information and insider trading. Journal of Business, 47 (July), pp.410-428.

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Summers, S.L., and Sweeney, J.T. (1998) Fraudulently misstated financial statements and insider trading: An empirical analysis. The Accounting Review, 73 (January), pp.131-146. Sweeney, A. (1994) Debt covenant violations and managers accounting responses. Journal of Accounting and Economics, 17, pp.281-308. Teoh, S.H., Welch, I., and Wong, T.J. (1998a) Earnings management and the long-term under performance of initial public offerings. Journal of Finance, 53 (December), pp.1935-1974. Teoh, S.H., Welch, I., and Wong, T.J. (1998b) Earnings management and the long-term under performance of initial public offerings. Journal of Finance, 53 (December), pp.1935-1974. Thomas, J., and Zhang, X.J. (2000) Identifying unexpected accruals: A comparison of current approaches. Journal of Accounting and Public Policy, (forthcoming). Titman, S., and Trueman, B. (1986) Information Quality and the Valuation of New Issues. Journal of Accounting and Economics, (June), pp.159-172. Watts, R.L., and Zimmerman, J.L. (1986) Positive accounting theory. Englewood Cliffs: Prentice Hall. Watts, R.L., and Zimmerman, J.L. (1978) Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review, (January), pp.112-134. Watts, R.L., and Zimmerman, J.L. (1990) Positive accounting theory: A ten year pespective. The Accounting Review, 65 (1), pp.131-156.