ARTICLE IN PRESS

Journal of Accounting and Economics 45 (2008) 350–357

www.elsevier.com/locate/jae

Earnings management and earnings quality$

Kin Lo
Sauder School of Business, The University of British Columbia, 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2
Received 5 June 2007; received in revised form 14 August 2007; accepted 24 August 2007
Available online 8 October 2007

Abstract

Viewing the detection of earnings management from the perspective of a crime scene investigator sheds new light on prior
research on earnings management and its close relative, earnings quality. The works of Ball and Shivakumar [2008. Earnings
quality at initial public offerings. Journal of Accounting and Economics, in press.] and Teoh et al. [1998. Earnings
management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935–1974.] are used to
illustrate the application of seven components of a crime scene investigation to earnings management research.
Crown Copyright r 2007 Published by Elsevier B.V. All rights reserved.

JEL classification: M41; G12; G14

Keywords: Market efficiency; Earnings management; Earnings quality; Accounting fraud

1. Introduction

Among research topics in accounting and finance, none is perhaps more provocative than earnings
management. Why? I think it is because the topic explicitly involves potential wrongdoing, mischief, conflict,
cloak and dagger, and a sense of mystery. As Healy and Wahlen (1999) (and similarly Schipper, 1989) define:
‘‘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.’’ [Emphasis added.] Simply put, someone is doing something that harms someone else.1 Auditors,
regulators, investors, and researchers seek to find these wrongdoers and solve the mystery, which might turn
out to involve fraud (or a crime, to use the metaphor of solving a criminal mystery).2

$
This paper is based on discussants comments the author prepared for and presented at a concurrent session on earnings management
at the 2004 American Accounting Association Annual Meeting and the 2006 Conference of the Journal of Accounting and Economics.
Tel.: +1 604 822 8430; fax: +1 604 822 9470.
E-mail address: kin.lo@sauder.ubc.ca
1
The indirect wording here is deliberate (using ‘‘that harms’’ rather than ‘‘to harm’’). Harm can be deliberate or unintentional. For
example, managers need not have a conscious intent of causing losses for investors; nevertheless, even if they manage earnings with the
belief that they are simply ‘‘putting their best foot forward,’’ investors can still be harmed, just as manslaughter (contrasted with murder)
still involves a loss of life.
2
From this perspective, the term ‘‘earnings management’’ is an academic euphemism. Indeed, if managing is part of what business
people normally do, does not ‘‘earnings management’’ legitimize the activity it describes?

0165-4101/$ - see front matter Crown Copyright r 2007 Published by Elsevier B.V. All rights reserved.
doi:10.1016/j.jacceco.2007.08.002
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K. Lo / Journal of Accounting and Economics 45 (2008) 350–357 351

If we view earnings management as a potentially fraudulent (criminal) activity, then we can think about
its detection in terms of a murder mystery à la Sherlock Holmes, or a crime scene investigation (CSI) in
more contemporary terms. Such investigations involve considering the following seven elements: whether
a crime has been committed, suspects responsible, weapons used, victims of the crime, motives for the
crime, opportunity to carry out the act, and alternative explanations.3 Alternative explanations refer to
causes of the event other than fraudulent or criminal activity, and thus, a conclusion of fraud or crime
on the basis of observed evidence would be erroneous. I discuss the various elements of solving an
earnings-management mystery, with examples primarily drawn from Ball and Shivakumar (2008) and
Teoh et al. (1998). (These elements are clearly interrelated and some overlap in the discussion below is
unavoidable.)
Earnings management has a lot in common with earnings quality. I think most would agree that highly
managed earnings have low quality. However, the lack of earnings management is not sufficient to guarantee
high-quality earnings (or high-quality accounting numbers more generally), because other factors contribute
to the quality of earnings. For example, accountants fastidiously following a poor set of standards will
generate low-quality financial reports. Nevertheless, if we take these other contributing factors as given/
constant, then we can draw a much closer connection between earnings management and earnings quality.
While there are other interpretations of earnings quality, in the following discussion, to be consistent with Ball
and Shivakumar (2008), high-quality earnings are conservative, while low-quality earnings are upwardly
managed earnings.4

2. Did earnings management occur?

One key task of a crime scene investigator is to determine whether a crime has occurred at all, or
alternatively, whether some natural cause has produced the outcome under investigation. Was a death due to a
homicide, a suicide, or accident? Making such determinations is often difficult, and no less so in accounting
research. As Healy and Wahlen (1999, p. 370) explain, ‘‘Despite the popular wisdom that earnings
management exists, it has been remarkably difficult for researchers to convincingly document it. This problem
arises primarily because, to identify whether earnings have been managed, researchers first have to estimate
earnings before the effects of earnings management.’’ In other words, researchers need to distinguish the part
of earnings from natural causes from the part due to earnings management activities.
Research designs in prior studies on earnings management and earnings quality more generally can be
summarized into three categories: (i) time series, (ii) cross-sectional, and (iii) cross-country. Notable in the
time-series approach is Teoh et al. (1998), who use the pre-IPO financial statements included in the prospectus
as a benchmark to compare with the IPO year numbers.5 Among the many studies that use the cross-sectional
approach is Ball and Shivakumar (2005), who compare the financial statements of private and public
companies in the UK. The cross-country approach is a variation of the cross-sectional approach that exploits
international differences in institutions (see footnote 2 of Ball and Shivakumar (2008) as examples of studies in
this category). In all of these studies, the benchmark is imperfect and the measure of earning management or
earning quality is consequently noisy, often tremendously so (Dechow et al., 1995).
To their credit, Ball and Shivakumar (2008) find a sample that overcomes the ex post difficulty of detection
as described by Healy and Wahlen (1999). By examining a sample of firms undergoing initial public offerings
(IPOs) in the United Kingdom, any earnings management can be detected precisely because there are two sets
of financial statements. The first set (which I will call the ‘‘shadow financial statements’’) is the one filed with
the Companies House as required of all limited liability companies, but while the companies are still private.
The second set is the one in the IPO prospectus. It is reasonable to assume that the shadow financial
3
In investigations of alleged crime, the legal term ‘‘alibi’’ is the closest to the idea of alternative explanations. An alibi is ‘‘The plea of
having been elsewhere at the time when any alleged act took place.’’ (Oxford English Dictionary) In the context of accounting research,
this term is not exactly applicable.
4
Two alternative definitions of earnings quality come to mind. The first is the sustainability of the earnings. The second is the
unbiasedness or neutrality of the earnings and of the accounting policies and estimates used to generate those earnings. This latter
definition distinctly differs from that adopted in Ball and Shivakumar (2008).
5
Teoh et al. (1998) also provide cross-section evidence comparing IPO firms with non-issuers.
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352 K. Lo / Journal of Accounting and Economics 45 (2008) 350–357

statements are relatively free of earnings management compared to the one in the prospectus, which is subject
to incentives induced by the IPO. Thus, the shadow financial statements provide a good benchmark for non-
managed earnings, and it is possible to infer with high precision any earnings management activity using the
differences of the two sets of financial statements.
Healy and Wahlen’s focus on the technical difficulty of detection just discussed is an ex post perspective.
I think it is also important to think about this difficulty of detection ex ante. Fundamentally, the hope of
those managing earnings is that it should not be easy to detect. The more sophisticated the manager, the
less likely it is that he or she will engage in easy-to-detect earnings management, and the more elaborate
will be the plans for concealment to evade detection.6 The corollary is that if something looks too obviously
like earnings management, there is a good chance that it is not. In financial reporting, the people involved
are generally experienced, intelligent, well educated, and guided by explicit professional codes of con-
duct or implicit codes of ethics. I do not think that they are likely to engage in blatant, simple-minded earn-
ings management, and if they were to do so, I would expect them to make it not so obvious to detect. While
the ex post detection problem is solved, Ball and Shivakumar’s research context is one in which the ex
ante likelihood of detectible earnings management is virtually nil. It is unreasonable to expect that investors,
their lawyers, and regulators to not notice major differences in the financial reports, and equally unreason-
able for corporate managers to systematically fail to anticipate the negative consequences that would ensue if
they were to manage earnings in ways that would allow certain detection.7 In other words, earnings
management must be somewhat difficult to detect if it has any hope of garnering benefits for those engaged in
the activity.
Based on this discussion, I find it completely unsurprising that Ball and Shivakumar find no significant
earnings management. In fact, they find that the only significant differences in the financial statements relate
to intangibles, which their data show are written down in the IPO accounts. Such write-downs are clearly
identifiable, and in all likelihood acceptable to readers and not litigable.
I am perhaps overstating the case when I claim that earnings management can be detected with virtual
certainty for IPOs in the UK. This claim should be qualified to refer to the sample studied by Ball and
Shivakumar, which includes only firms for which the IPO financial statements are comparable to those filed
with the Companies House. In other words, the sample includes only firms where a simple and direct
comparison can be made between the line items of the financial statements. This leaves out all the firms that
increase or decrease the amount of detail, or change the categorization of various items. Such firms comprise a
substantial portion of the total: 140, 198, and 245 out of a possible 393 IPO firms in year t 1, t 2, and t 3,
respectively. If comparisons are made more difficult, would this not provide the opportunity to manage the
accounts with a lower likelihood of detection? Perhaps management deliberately made the IPO financial
statements non-comparable to the shadow financial statements in order to camouflage their earnings
management. It seems to me that the firms with non-comparable reports are the ones that could have some
chance of hiding earnings management and a sample more worthy of examination. By solving the problem of
ex post detection, Ball and Shivakumar have ‘‘thrown the baby out with the bathwater.’’
By the same token, I believe it is unreasonable to extrapolate from the UK IPO context to other
circumstances, such as IPOs in the US studied by Teoh et al. (1998). Earnings management in the US is more
difficult to detect there given that there are no publicly available financial statements prior to the IPO with
which to compare.

3. Who is responsible for earnings management?

A murder mystery is sometimes referred to as a ‘‘whodunit,’’ and the question of ‘‘who’’ is ultimately the
most important one in such stories. However, ‘‘who’’ is an under-explored question in accounting research.
While a crime scene investigator certainly tries to identify the culprit, academic research is less concerned
6
The likelihood of someone committing a crime is of course a function of the extent of policing, as is the likelihood of the perpetrator
being caught. These issues will be discussed in Section 7.
7
Earnings management under these circumstances would surely be a sign of desperation or stupidity, either of which suggest that the
stock is a bad investment.
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about identifying conclusively whether a particular firm, never mind any individual person, has managed
earnings; and more interested in finding tendencies for earnings management. Of course the difference in focus
has a lot to do with the lesser amount of information available to researchers and the consequent need to
increase statistical power by increasing sample sizes. However, even if large samples are needed, there are still
interesting questions of ‘‘who’’ that could be examined. For example, what are the effects of training and
certification on the propensity to manage earnings? Are managers less likely to manage earnings if they have
professional designations and therefore subscribe to codes of ethical conduct? Do different accounting regimes
requiring different amounts of judgment by managers result in different amounts of earnings management?
Do economic and cultural differences among managers play a part?

4. By what methods have earnings been managed?

Prior writers classify earnings management into two broad categories: real earnings management (i.e.,
affecting cash flows) and accruals management through changes in estimates and accounting policies. Prior
writers have also suggested that the cost of earnings management differs across these methods, with real
earnings management generally considered to be more costly for the firm (Roychowdhury, 2006). On the other
hand, survey evidence in Graham et al. (2005) suggests that managers are much more willing to engage in real
earnings management than accruals management: 80% would decrease discretionary spending, 55% would
delay a project, compared with only 28% who would draw down reserves and 8% who would change
accounting assumptions. Thus, the survey evidence appears inconsistent with the higher cost of real earnings
management.
A different perspective, from that of a crime scene investigator, helps to explain the survey findings.
Managers are willing to engage in real earnings management that is costly to the firm because such actions
are harder to detect; with the uncertainty inherent in business environments, there is no benchmark to
determine what should have been done under any particular situation. In law, managers and boards of
directors are protected by the ‘‘business judgment rule’’ that makes it difficult to find them liable for bad
business decisions. In contrast, accrual and other accounting manipulation are subject to examination by
auditors and potentially by forensic accountants and the courts, who have accounting standards as the
benchmark.
The evidence on the willingness of managers to engage in earnings management that is more difficult to
detect further undermines the conclusions in Ball and Shivakumar (2008). For their sample of IPO firms, only
accruals management can be identified, and any real earnings management is excluded from the analysis
because the benchmark provided by the shadow financial statements contains the same amount of real
earnings management, if any.

5. Who are the victims of earnings management?

While identifying the victims of homicide is typically a non-issue, who, if anyone, suffers from earnings
management is more ambiguous. Indeed, if it were an open-and-shut case, there would be no need for research
in this area. The potential victims of earnings management are, of course, the financial statement users;
however, whether users fall victim to the maneuver is an empirical question. These users include equity
investors, bond investors, bankers, regulators, unions, suppliers, customers, and competitors.
In the context of IPOs, the potential victims are obviously the investors who buy companies’ equity. The
question is: do investors overpay for these shares as a result of earnings management? Teoh et al. (1998)
explore this issue and find that indeed, investments in firms with high earnings management tend to perform
poorly in future periods.
This result is hard to accept for firm believers in efficient capital markets. Why do investors not anticipate
the earnings management and discount the information accordingly to discount the IPO price? One possibility
is that the IPO market does not operate in the same way as the secondary market for shares and therefore has
a different degree of efficiency. Efficiency requires a balance of buyers and sellers, and the price to adjust that
balance. In secondary markets, the existing shareholders and short-sellers provide the counter-balance to the
potentially unlimited number of buyers. (Short sale constraints are a potential imperfection, but that is not
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salient to the discussion here.) In the primary IPO market, the sellers by definition consist exclusively of
company insiders, and the IPO price is set by the investment bank(s) for underwritten issues. If there is
uncertainty about the value of the shares (and there surely is), transmission of information from the lower part
of the distribution is constrained because of the limited selling activity prior to the first trading day, i.e., IPO
subscribers are susceptible to the ‘‘winner’s curse’’ (Rock, 1986). Thus, supply and demand for IPO shares
need not be balanced, and earnings management to increase the perceived value of these shares could
potentially succeed.

6. What are the motives for earnings management?

Crime scene investigators often try to infer a motive for an alleged crime. The presumption is that people
generally do not commit crimes for no specific reason. Whether it is financial gain, revenge, self-preservation,
or some other reason, it is taken for granted that there is some personal gain or loss mitigation involved.
The importance of motive is evident in Healy and Wahlen’s (1999) definition of earnings management. The
definition refers to, and indeed requires, a motive: to mislead users or to influence contractual outcomes.
Because accounting is inherently subjective, application of judgment in a benign way without the aim of
personal gain is not considered to be earnings management.
However, compared to the everyday crime, the issue of motives for earnings management goes deeper. As
mentioned in the last section, the capital markets, and users more generally, can potentially anticipate earnings
management. Thus, earnings management could be an equilibrium outcome whereby managers report inflated
earnings because inflated earnings are expected of them. A motive for earnings management is that it satisfies
expectations.
This idea of expected behavior is related to how laws define which activities are criminal. Generally,
behavior that is expected is accepted as legal. Cultural differences therefore play a large role in defining a
country’s laws and analogously the amount and types of earnings management that are acceptable. There is a
risk in extrapolating from one country to another. The socio-economic differences between the UK and the
US are arguably small, so there is little risk using the UK environment to make inferences about the US, as
done in Ball and Shivakumar (2008). Indeed, the motive would seem to be identical whether the IPO occurs in
the UK or the US—to inflate the IPO price to benefit insiders at the expense of IPO subscribers.
On the other hand, there are frequent claims that there is a significant disparity in principles vs. rules-based
standards in the UK vs. the US, respectively. It is possible that accountants and users in the UK expect a
different amount of earning management compared with the US. In other words, there is no unique
equilibrium for earnings management; the degree of motivation and extent of earnings management depends
on the behavior that is expected in each environment.

7. Was there an opportunity to manage earnings?

Whether a crime is committed of course depends on whether there is an opportunity for it to occur.
Opportunity can be considered in a general sense or specific to a person. This section deals with general
opportunity while the next section considers specific opportunity (i.e., alternative explanations for the
particular circumstance).
Consider the opportunity for crime in the following scenario. Suppose you were transported into a foreign
land about which you have no knowledge. The first thing you observe is the prevalence of police officers
everywhere. Do you conclude that (a) you have landed in a safe place, or (b) you have landed in a high crime
zone? You might argue for (a) because a high concentration of police acts as a strong deterrent and the police
presence leaves little opportunity for crime to occur. On the other hand, (b) is plausible if the high police
presence is a response to a high opportunity for crime (e.g., security guards posted in and outside banks).
Without additional information, we cannot say which conclusion is more plausible.
The ambiguity can be explained in terms of the economics of supply and demand. Consider the following
standard diagram (ignoring boundary cases of zero or infinite elasticity). While Fig. 1 should be familiar to
every reader, I include it to provide a concrete reference for the discussion that follows.
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K. Lo / Journal of Accounting and Economics 45 (2008) 350–357 355

Price

Supply 2
D
Supply 1
B
PB
C
PC
Demand 2
A
PA

Demand 1

Quantity
QC QA QB

Fig. 1. Supply and demand of a typical good.

In terms of crime and policing, we can define the good as people’s safety (i.e., lack of crime). Suppose ‘‘A’’ is
the benchmark equilibrium with corresponding price and quantity PA and QA. Observing more policing
implies that the value to policing is higher, but we cannot say whether an equilibrium such as B or C (or even
D) will attain. If there is a stronger demand for safety (i.e., a demand shift) equilibrium B will result. If more
safety is demanded because supply shifts, equilibrium C results. Whether there is more demand for safety or
whether more safety is demand of course have clearly different implications for whether the equilibrium
quantity of safety increases to QB or reduces to QC, respectively).
Interpreting the above figure in the earnings management context, we define the good as earnings quality
(lack of earnings management). Ball and Shivakumar argue that increased attention during IPOs shifts
demand for quality information to the right. Holding supply constant, they expect the quantity of high-quality
information to increase to equilibrium B. Teoh et al. (1998) assume that the benefits of earnings manage-
ment (i.e., low-quality information) increase during IPOs, and correspondingly the costs of high-quality
information increase, shifting the supply to the left, resulting in equilibrium C. When we consider both supply
and demand changes, it is not at all clear where equilibrium D will be. Whether there is higher/lower quality
information or more/less earnings management during IPOs cannot be resolved from pure argumentation
or theory, but is ultimately an empirical question the answer to which depends on the institutions and
circumstances surrounding the IPO. Certainly, one cannot extrapolate the outcome from one set of institu-
tions to another.
In fact, it is not even clear from the language in Ball and Shivakumar whether they are thinking of supply or
demand shifts, or both. For example, page 2 indicates, ‘‘widespread and substantial earnings management by
IPO firms y would attract enhanced scrutiny at the time from market monitors y.’’ To me, this sounds like a
leftward shift in the supply of quality financial information, which does result in high scrutiny (corresponding
to high price of good financial information), but importantly, a reduction in the quantity of good financial
information as hypothesized by Teoh et al. (1998).
The story goes even more deeply than exogenous shifts to supply and demand. One should ask: Why is there
more regulatory attention for IPOs? Is it not likely because it is a governmental response to the decreased
supply of quality information? Generally speaking, observing a high amount of policing can indicate one of
two things: the additional deterrence can result in less crime or the policing reflects a high crime rate that
would be even higher with average amounts of policing. One does not have to think very hard to find examples
where an extraordinary amount of police and military power is unable to quell the amount of criminal activity.
In the figure above, I think it is most plausible that during IPOs, the supply of quality information shifts left,
and the regulatory response shifts the demand right, resulting in equilibrium D. Relative to equilibrium A, the
effect on the price of financial information is clearly upwards, but the effect on quantity is indeterminate and
ultimately an empirical question. Strong claims based on considerations of either supply or demand alone is
incomplete.
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8. What other explanations are there to explain what appears to be earnings management?

Ball and Shivakumar (2008) devote a considerable amount of effort finding alternative explanations for the
alleged earnings management found by Teoh et al. (1998). They discuss at least four such explanations. Each
will be addressed below.

8.1. Estimates of discretionary accruals are too large to be plausible

Ball and Shivakumar show statistics indicating unreasonably large estimates of discretionary accruals (see
their Table 5). This evidence is quite clear. However, the idea that discretionary accrual models have
substantial measurement error is well known (Dechow et al., 1995). More importantly, the magnitude of the
discretionary accruals is not central to Teoh et al. (1998), who use ranks of the estimated discretionary
accruals to form portfolios. In other words, the discretionary accruals are acknowledged as noisy proxies for
earnings management activity. The amount of noise is admittedly large, but the important finding in Teoh
et al. is that the earnings management proxy helps predict future returns.

8.2. Factors triggering the decision to issue an IPO also affect accruals and bias estimates of discretionary
accruals in the IPO year

Ball and Shivakumar’s argue that growing firms facing cash constraints (for example) issue shares to relieve
the constraint and to fund growth. Proceeds from the IPO are likely to be used (partly) to increase non-cash
current assets or to pay off current liabilities, which will be reflected in estimates of discretionary accruals,
which are potentially misinterpreted as earnings management. This reasoning makes sense. In effect, accruals
are endogenous with the IPO decision, and not taking the endogeneity into account results in biased estimates
of discretionary accruals after the IPO.
By the same token, the same reason suggests that endogeneity also influences accruals prior to the IPO. If
firms choosing to issue an IPO are indeed cash constrained, then pre-IPO financial statements will appear to be
conservative. For example, these firms will tend to be stretching accounts payable and trying to collect
receivables on a more timely basis, resulting in more current liabilities and fewer current assets being recorded.
Indeed, Ball and Shivakumar’s find that pre-IPO financial statements are conditionally conservative (see their
Tables 3 and 8). However, how much of this conservatism is higher quality financial reporting in response to
market and regulatory pressure as argued by Ball and Shivakumar, or simply a function of endogeneity?
In summary, Ball and Shivakumar correctly identify endogeneity of the IPO decision and accruals as an
important issue. However, the issues deserve equal consideration for both the pre- and post-IPO period.
Simply, endogeneity goes both ways.

8.3. Estimating accruals using balance sheet data induces errors and bias

Ball and Shivakumar argue that using balance sheet data for companies transitioning from private to
public status induces systematic biases in the discretionary accrual measure. The conceptual arguments are
sound; however, the empirical results suggest that the effect of this issue is minor. While Table 6 shows
significant differences in discretionary accruals estimated from cash flow statements compared with balance
sheets, the mean and median discretionary accruals still increase with the earnings management quartile
and the overall pattern of the accrual estimates do not change. Since Teoh et al. only rely on discretionary
accrual ranks to form quartile portfolios, I do not find that any error or bias induced to be large enough to be
salient.

8.4. Using pre-IPO assets as a deflator creates a small denominator problem

As in many accounting applications, ratios are problematic if the denominator approaches zero (or becomes
negative). Conservatism of accounting rules is one sources of this problem, and total assets can substantially
understate economic assets. There are no simple solutions to this problem, and Ball and Shivakumar do not
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K. Lo / Journal of Accounting and Economics 45 (2008) 350–357 357

offer any; in fact, they also use pre-IPO assets as a deflator in Table 5 Panels A and C. Arguably, their use of
lagged working capital components as deflators in their Table 5 Panel B accentuates this problem.

8.5. Summary of alternative explanations

In total, Ball and Shivakumar offer an extensive list of alternative explanations for the alleged earnings
management found in Teoh et al. All of them are conceptually interesting; however, the empirical evidence is
less certain. Nevertheless, if we were to accept Ball and Shivakumar’s critique that the discretionary accrual
proxy does not represent earnings management, then we have an interesting question: For what signal does the
estimated discretionary accruals proxy, and why does this signal predict future returns?

9. Conclusions

Earnings management research has been ongoing for almost two decades. Much has been learned, but many
interesting questions remain unanswered. I believe that taking a different but complementary perspective,
from that of a crime scene investigator, can often provide interesting insights into the topic, and help inform
research designs.
The author gratefully acknowledges the financial support of the Social Sciences and Humanities Research
Council and the KPMG Research Bureau at the Sauder School of Business.

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