Healy, P. M. and J. M. Wahlen. 1999.

A
review of the earnings management
literature and its implications for standard
setting. Accounting Horizons (December):
365-383.
Summary by Lisa Anderson
Master of Accountancy Program
University of South Florida, Summer 2003
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The purpose of this paper is to summarize the findings of earnings management

research and the overall integrity of financial reporting. This article also identifies
areas for future research in the area of earnings management.
Earnings management literature provides only slight insight for standard setters.
Much of the literature provides little evidence on some of the most important
questions asked by standards setters, including whether earnings management is
commonplace or occurs infrequently, which accruals are the focus of earnings
management and what are the effects on resource allocation decisions. This
information is necessary to assess the pervasiveness of earnings management and
the overall integrity of financial reports.
The focus of earnings management research of the past has been mainly on
detecting whether earnings management exists and when. Researchers have
examined broad measures of earnings management and samples from firms where
the motivations to manage earnings are expected to be high. Studies have shown
that earnings management does exist and it occurs for different reasons. These
reasons include influencing capital market expectations and valuation, to increase
managements compensation, to avoid violating contracts written in terms of
accounting numbers, and to reduce regulatory costs.
Earnings Management is said to have occurred 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.1

The review is focused around four questions:

What motives drive earnings management?
Which accruals appear to be managed?
What is the magnitude and frequency of earnings management?
What are the economic consequences of earnings management?
By answering these questions, standard setters will be able to assess the effects of
accounting standards that require management judgment. If there are areas where
earnings management is common and has had significant effects, standard setters
will be able to refine the existing standards and expand disclosure requirements to
enhance the reliability of the financial reports.
For regulators and standard setters, research has confirmed their suspicions that
earnings management is a problem that needs attention. But before these regulators
can attempt to remedy the situation, they will need to do extensive research to
determine which accounting standards are being managed, the frequency and effect
of earnings management, and what factors limit earnings management.
The majority of studies that have been done on earnings management do not help
standard setters to be able to answer these questions. The research that has been
done documents that earnings have been managed but it doesnt document the
extent and magnitude of earnings management. This does not help regulators to
know if current accounting standards are effectively facilitating communication
with investors or whether they encourage earnings management. Most of the
studies that have been done examined unexpected accruals for earnings
management. Although this research does provide some very useful information, it
does not show which accounting standards are effective in facilitating
communication with investors and which are not. Lastly, most of these studies
examine research settings where earnings management is likely to be observed,
increasing the likelihood for detection. This makes it difficult to determine the
frequency of earnings management in our economy.
Although it is known that earnings management exists, it is difficult to document
it. The main reason being that to prove that earnings have been managed
researchers must first determine what earnings should have been before the effects
of earnings management. One approach that has been used is to identify conditions
in which managers incentives to manage earnings are high. The next step would
be to test whether patterns of unexpected accruals are consistent with these
incentives.

Researchers have examined different incentives for earnings management

including capital market expectations and valuation, contracts written in terms of
accounting numbers and anti-trust or governmental regulation. The use of
accounting information by financial analysts and investors to value stocks has
created an incentive for managers to manipulate earnings to influence the shortterm performance of the stock. The evidence gathered by researchers shows that
some firms manage earnings for stock market reasons. The frequency of this
occurrence has not yet been determined. Sometimes, contracts can give incentives
for managers to manipulate earnings. Some studies show that compensation and
lending contracts give an incentive for firms to manage earnings to increase
bonuses, improve job security and mitigate potential violation of debt covenants.
Earnings management due to regulatory motivation is another area where
researchers have begun to discover evidence. Studies suggest that regulatory
considerations can induce firms to manage earnings. There is very little evidence,
though, on the frequency of this behavior and the effect on regulators or investors.
After this review it is clear that earnings management is still a very new topic that
it is only beginning to be researched. Future research will not focus merely on
whether or not earnings management exists, but will broaden the questions to
include the magnitude and frequency of the earnings management and the effect
that earnings management has on stock prices and resource allocation.
_________________________________________
1

Schipper, K. 1989. Commentary: Earnings Management.Accounting

Horizons (December): 91-102.
Related Summaries:
Collingwood, H. 2001. The earnings game: Everyone plays, nobody wins. Harvard
Business Review (June): 65-74. (Summary).
Dechow, P. M. and D. J. Skinner. 2000. Earnings management: Reconciling the
views of accounting academics, practitioners, and regulators. Accounting
Horizons(June): 235-250. (Summary).
Healy, P. M. and K. G. Palepu. 2003. How the quest for efficiency corroded the
market. Harvard Business Review (July): 76-85. (Summary).
Romney, M. B., W. S. Albrecht and D. J. Cherrington. 1980. Red-flagging the
white collar criminal. Management Accounting (March): 51-54, 57. (Note and list
of Red Flags).
Waddock, S. 2005. Hollow men and women at the helm ... Hollow accounting
ethics? Issues in Accounting Education (May): 145-150. (Summary).