Earnings managment:

quantitative methods
Alessandro Mura
Dipartimento di Scienze Economiche e Aziendali

University of Cagliari

Scuola di Dottorato in Scienze Economiche e Aziendali, 24 November 2016

Earnings quality (EQ) (1)

• Earnings quality – Dechow et al. (2010):
“Higher quality earnings provide more information about the features
of a firm’s financial performance that are relevant to a specific decision made
by a specific decision-maker”

Three main features:

• EQ – depends on the context of a specific decision model

• Which users?

• EQ – depends on whether it is informative about the firm’s financial

performance (which is partially unobservable)

• EQ jointly determined by relevance of underlying financial performance

to the decision AND by ability of the accounting system to measure
performance

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Earnings quality (EQ) (2)
• EQ is a multi-dimensional concept

“the choice of an earnings quality measure depends on the research

question posed (which dimension of earnings quality is implied by the
research question) and the availability of data and estimation models
(wich measure can be estimated)” Francis et al. (2006)

Role of financial reporting

• Financial reporting should provide information about an enterprise’s

financial performance during a period.“

• Reported earnings ≡ f(X)

• X = financial performance during a period

• f(·) = acc. system, converts unobservable X into observable earnings

• (note: reported earnings ≠ financial performance)

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Implementation of an accounting system

• Implementation of f(·): An accounting system that measures an

unobservable construct (Financial performance) (X) inherently
involves estimations and judgment … has the potential for
unintentional errors and intentional bias (i.e., earnings management).

• Critical challenge is how to adequately distinguish the impact of

fundamental performance on EQ from the impact of the
measurement system.

Earnings management (EM)

• Managers have discretion in reported earnings

– Discretion can be used opportunistically (if conditions allow – Fields

et al., 2001)

– EM reduces informativeness of earnings

– EM does not automatically imply fraud

Earnings management may erode earnings quality

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Central role of accruals

• Simple (but complete) definition:

E = OCF + Accruals

• Accounting choices and manipulations manifest through accruals

(e.g., Ramsay, 2003; Roychowdhury, 2006)

• Accruals are based on estimates about future CFs and subjective

allocations of past CFs

• Accruals have different properties than CFs (Dechow, Kothari &

Watts, 1998)

Proxies for earnings quality

(Properties of earnings)

• Earnings persistence

• Abnormal accruals

• Earnings smoothness

• Asymmetric timeliness and timely loss recognition

• Target beating

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Empirical proxy: Earnings persistence
Simplest model

• Earningst + 1 = 𝛼 + 𝛽Earningst + 𝜀t
𝛽 measures persistence

• Logic
Firms with more persistent earnings have a more ‘‘sustainable’’
earnings/cash flow stream that will make it a more useful input into
DCF-based equity valuations

Empirical proxy: Earnings persistence (2)

• Extensions of the model
• Earningst+1 = 𝛼 + 𝛽1 CF + 𝛽2Accrualst + 𝜀t

• Earningst+1 = 𝛼 + 𝛿 1 Earningst + 𝛿 2Financial statements componentst + 𝛿3

Other information + 𝜀t

• Pros: Fits well with the view of earnings as a summary metric of

expected cash flows useful for equity valuation.
• Cons: Persistence depends both on the firm’s fundamental performance
as well as the accounting measurement system.

Disentangling the role of each is problematic. Persistence may be achieved

in the short run by engaging in earnings management

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Empirical proxy: Abnormal accruals
General procedure:
1) step: Models that estimate normal levels of accruals.
2) step: Residuals from the models are used as a measure of ‘‘abnormal”
accruals

• Jones (1991) model

Acct = 𝛼 + 𝛽1 𝛥Revt+ 𝛽2PPEt+𝜀t

• Logic
Accruals are a function of revenue growth and depreciation is a function
of PPE. All variables are scaled by total assets

• Modified Jones model (Dechow et al., 1995)

• Acct= 𝛼 + 𝛽1 (𝛥Revt - 𝛥Rect) +𝛽2PPEt+ 𝜀 t

Empirical proxy: Abnormal accruals (2)

• Performance matched (Kothari et al., 2005)
DisAcct - Matched firm’s DisAcct

• Logic
Matches firm-year observation with another from the same industry and
year with the closest ROA. Discretionary accruals are from the Jones
model (or Modified Jones model)

• Dechow and Dichev (2002) approach

𝛥WC =𝛼 + 𝛽1CFOt-1+𝛽2CFOt+𝛽2CFOt+1+𝜀t

• Logic
Accruals are modeled as a function of past, present, and future cash flows
given their purpose to alter the timing of cash flow recognition in earnings

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 Empirical proxy: Earnings smoothing (2)
• Measured as: σ(earnings)/σ(cash flow)

A lower ratio indicates more smoothing of the earnings stream relative to cash
flows

• OK: earnings smooth fluctuations in the timing of cash payments and

receipts, making earnings more informative about performance than cash
flows
• BUT: When managers have accounting choices that can influence
smoothness, do they make choices that result in greater earnings
smoothness?

• Real challenge: disentangling natural smoothing from artificial smoothing

Earnings smoothing in public firms

• Early evidence – Burgstahler & Dichev (1997), Degeorge et al.
(1999) for publicly-quoted firms:
• To avoid losses
• To avoid earnings decreases
• To meet or beat analysts forecasts

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Earnings smoothing in private firms
• Garrod, Ratej Pirkovic & Valentincic (2007, WP):

• Not a normal distribution!

Earnings proxy: timely loss recognition (TLR)

• Timely loss recognition (TLR)

Earningst+1=𝛼0+a1Dt+𝛽0Rett+𝛽1DtRett+et
• where Dt=1 if Rett< 0.

A higher 𝛽1 implies more timely recognition of the incurred losses in

earnings.

• Logic
There is a demand for TLR to combat management’s natural optimism.
TLR represents high quality earnings

Ability of accounting to capture losses

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 • Ball & Shivakumar (2006) - 2 roles of accruals are:
• (-): Timely recognition of gains and losses through accruals as based
in part on revisions of future CF expectations, made before their
actual realization
• (+): Revisions in current-period CF are likely to be positively
correlated with revisions in its expected future cash flows.

Mura, Piras, Valentincic, 2016, When accruals exchange their roles: the case of
write ups and write-offs? WP

Research Question
Investigate whether upward (write ups) and downward revaluations (write offs
are able to predict future profitability of private firms.

Institutional Framework
• Accounting system based on historical cost model

• High alignment between tax and financial reporting

• Special laws allow discretionary upward assets revaluations in specific years (a

substitute tax was often required)

• Downward revaluation below assets cost are compulsory in case of impairment

losses and are not deductible for tax purposes
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 Mura, Piras, Valentincic, 2016, When accruals exchange their roles: the case of write-
ups and write-offs? WP
Research Question
Investigate whether upward (write ups) revaluations are able to predict future
performance of Italian private firms.
Motivation
Examining write-ups (and write-offs) in the Italian setting offers the chance to
enhance our understanding on how financial reporting and tax accounting
interact and how they impact the quality of accounting properties in the
context of private firms:

• both treatments aim at adjusting asset values originally recorded in the

financial statements at historical cost

• both treatments require critical accounting estimates: their (lack of)

reliability depends on the uncertainty inherent in forecasting future
economic conditions but also on opportunistic behaviour to cope with that

• Write-ups are discretionary; Write-offs are compulsory Alessandro Mura

Università di Cagliari

Extant literature
• Mainly related to public firms offers conflicting findings (Whittered & Chan
1992; Barth & Clinch 1998; Aboody et al. 1999; Lopes & Walker, 2012)

• Barlev et al. (2007) analyse motivations for and effects of write-ups across
35 countries. Main finding: they are not uniform and conclusions from
previous studies are not applicable to countries with different institutional
features

• Two studies relate to write-ups in private firms. Main finding: a high

proportion of financial debts and weak solvency conditions make this
accounting choice more likely (Gaeremynck & Veugelers, 1999; Piras &
Mura, 2015)

• A few studies on write-offs in private firms (Garrod, Kosi & Valentincic,

2008; Kosi & Valentincic, 2013; Szczesny & Valentincic, 2013)

• no existing studies investigate jointly the effects of write ups and write-offs
Alessandro Mura
Università di Cagliari

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 Institutional setting and conceptual framework
• Accounting system based on historical cost model

• High alignment between tax and financial reporting

• Special laws allow discretionary write-ups in specific years (a substitute tax

is often required)

• Great differences between the revaluation laws issued in 2003 and 2005
and the revaluation law issued in 2008.

Alessandro Mura
Università di Cagliari

Institutional setting and conceputal framework

Theory: Attaching a cost to a voluntary reporting choice can enhance

signal credibility (Gigler JAR 1994)

Italian Tax system creates interesting variation in (net) cost of signal:

Variation in tax cost of revaluation
2003 and 2005 high substitute tax
vs.
2008 low substitute tax or revaluing with no tax implications

2003 2005 2008

Corporate Income Tax Rate (%) 34 33 27,5
Substitute Tax for Revaluation (%) 19 12 3
Undiscounted Net Tax Benefit (%) 15 21 24,5

• Write-offs are compulsory in case of impairment losses and are not

deductible for tax purposes
Alessandro Mura
Università di Cagliari

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 Hypothesis development
Firms that will have taxable earnings in future reporting periods that are
sufficiently high to absorb the fiscal deduction of the depreciation in the
following years will be able to fully exploit this net tax benefit.
Reliably forecasting the firm’s future profitability when the revalued asset is
depreciated is essential for gaining the tax relief.

H1a: write-ups of fixed assets in private firms reliably predict positive

future operating performance when the reporting choice is expensive

H1b write-ups of fixed assets in private firms do not predict positive

future operating performance when the reporting choice is cheap or free

The non-tax cost of appearing worse off to outside parties due to write-offs
combines with their fiscal neutrality as they are not recognised for tax purposes
in Italy. Unlikely their use to admit the presence of imminent losses

H2: write-offs of fixed assets in private firms do not predict negative

future operating performance
Alessandro Mura
Università di Cagliari

Research design
• Sample: around 14.000 Italian private firms selected using AIDA database.
• All firms conforming to Local GAAP (Civile Code and OIC)
• Only Non financial firms
• Firms that file an abridged version of financial accounts removed from the
sample
• Year: 2003-2005-2008 split into two sub-periods (2003-2005; 2008)

Model: Persistence of earnings components; adaptation of Ball and Shivakumar

(2006) Asymmetric Timely loss and gain recognition

Main Model

𝑂𝐼)*+ , 𝑂𝐶𝐹)*+ = (𝛽1 + 𝛽3 𝑅𝐸𝑉𝐴𝐿) + 𝛽9 𝑊𝑂) + 𝛽; 𝑂𝐶𝐹) + 𝛽< 𝐴𝐶𝐶𝑂𝑇𝐻) ) @

𝐷𝑂𝐶𝐹) + 𝛽31 𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑠) + 𝜖)

Alessandro Mura
Università di Cagliari

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 Dependent variables
𝑶𝑰𝒕*𝒏 : Operating income in year t + n

𝑶𝑪𝑭𝒕*𝒏 : Operating cash flows of firm i in year t + n

Main independent variable

REVALit: dummy variable equals 1 if the firm i revaluate in year t

Control variables
WOit: dummy variable equals 1 if the firm i write-off in year t

ACCOTHit: ΔInventory + ΔDebtors + ΔOther current assets – ΔCreditors – ΔOther

current liabilities – Depreciation – Provisions, deflated by total assets at the
beginning of year t

OCFit: Operating cash flows of firm i in year t

DOCFt: dummy variable proxy for bad news equals 1 if CF0<0

Alessandro Mura
Università di Cagliari

Other control Variables

ACCOTHit-1: lagged ACCOTH, deflated by total assets at the beginning of year t

OCFit-1: lagged OCF, deflated by total assets at the beginning of year t

QRit: ratio between current assets – inventories and current liabilities

LEVit: total debts deflated by total assets at the beginning of year t

DIMit: logarithm of sales

SECTit: vector of dummy variables for industry control

REGit: vector of dummy variables for geographical control

YEARit: vector of dummy variables for time control

Alessandro Mura
Università di Cagliari

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 Sample composition (2003, 2005, 2008)

Italian Private Firms

Year Non writing-up firms Writing-up firms Total Writing-up Percentage

2003 7,997 896 8,893 10.08%
2005 8,979 781 9,760 8.00%
2008 9,174 3,729 12,903 28.90%
Year Non writing-off firms Writing-off firms Total Writing-off Percentage
2003 8,702 191 8,893 2.15%
2005 9,588 172 9,760 1.77%
2008 12,639 264 12,903 2.05%

Alessandro Mura
Università di Cagliari

Results for sub-sample 2003-2005

Dependent variable
VARIABLES OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt.3

Earnings components
REVAL 0.0103*** 0.0097*** 0.0058 0.0164*** 0.0170*** 0.0160***
(3.27) (2.90) (1.47) (8.57) (6.85) (5.26)
WO -0.0084 0.0154** 0.0001 0.0069* 0.0026 0.0011
(-1.27) (2.14) (0.01) (1.69) (0.56) (0.21)
ACCOTHt 0.4889*** 0.5096*** 0.4607*** 0.9335*** 0.9182*** 0.9217***
(13.79) (13.05) (10.82) (29.58) (20.85) (18.88)
OCFt 0.5793*** 0.7358*** 0.6954*** 1.1379*** 1.1447*** 1.1703***
(16.12) (18.24) (15.96) (35.70) (25.88) (23.48)
Bad news timeliness recognition
DOCF -0.0013 0.0071* 0.0026 0.0077*** 0.0094*** 0.0095***
(-0.37) (1.91) (0.64) (3.54) (3.54) (3.03)
DOCF ACCOTHt -0.0191 -0.2039*** -0.1194* -0.3865*** -0.4236*** -0.4788***
(-0.35) (-3.01) (-1.79) (-8.62) (-7.81) (-8.20)
DOCF OCFt -0.3303*** -0.5101*** -0.5052*** -0.6881*** -0.7672*** -0.9139***
(-5.45) (-6.83) (-6.68) (-14.81) (-13.42) (-13.40)
Control variables
ACCOTHt-1 0.1517*** 0.0365 0.1265*** 0.1679*** 0.1651*** 0.1504***
(4.35) (0.97) (3.05) (6.28) (4.71) (3.52)
OCFt-1 0.2134*** 0.1073*** 0.1927*** 0.2408*** 0.2341*** 0.2112***
(6.27) (2.90) (4.73) (9.16) (6.76) (5.04)
QR -0.0001 -0.0007* -0.0003 -0.0003 -0.0003 -0.0001
(-0.26) (-1.81) (-0.78) (-1.22) (-1.05) (-0.32)
LEV -0.0378*** -0.0263*** -0.0207*** -0.0414*** -0.0354*** -0.0182***
(-6.53) (-4.27) (-2.94) (-11.67) (-7.87) (-3.35)
DIM -0.0054*** -0.0084*** -0.0125*** -0.0055*** -0.0102*** -0.0152***
(-4.78) (-6.95) (-8.73) (-7.63) (-11.34) (-12.96)
GROUP -0.0031 -0.0028 0.0016 0.0023 0.0005 0.0025
(-1.32) (-1.09) (0.52) (1.53) (0.25) (1.03)
Time Dummies Yes Yes Yes Yes Yes Yes
Sector Dummies Yes Yes Yes Yes Yes Yes
Geographic dummies Yes Yes Yes Yes Yes Yes
Constant 0.1670*** 0.1995*** 0.3164*** 0.1563*** 0.2418*** 0.3113***
(7.28) (7.21) (9.73) (10.32) (11.38) (13.40)

Observations 18,653 18,653 18,653 18,653 18,653 18,653

R-squared 0.1103 0.1119 0.1007 0.4945 0.3758 0.2962
levels of significance: *** p<0.01, ** p<0.05, * p<0.1. Boldfaced estimates significant at 5% or better.

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 Results for sub sample 2008
Dependent variable
VARIABLES OCFt+1 OCF(t+1)+(t+2) OCF(t+1)+(t+2)+(t+3) OIt+1 OI t+1)+(t+2) OI(t+1)+(t+2)+(t+3)

Earnings components
REVAL -0.0017 -0.0076** -0.0134*** -0.0068*** -0.0162*** -0.0283***
(-0.85) (-2.46) (-3.23) (-5.33) (-6.58) (-7.60)
WO 0.0065 0.0279** 0.0509*** 0.0155*** 0.0352*** 0.0575***
(0.98) (2.30) (2.91) (3.23) (3.56) (3.75)
ACCOTHt 0.4834*** 0.9980*** 1.5143*** 0.8531*** 1.6081*** 2.3285***
(13.24) (16.44) (18.06) (31.18) (29.18) (27.26)
OCFt 0.5833*** 1.2656*** 1.9343*** 1.0111*** 1.9717*** 2.9073***
(15.43) (20.44) (22.50) (36.76) (35.58) (33.76)
Bad news timeliness recognition
DOCF 0.0018 0.0039 0.0012 0.0055** 0.0122** 0.0225***
(0.43) (0.62) (0.14) (2.33) (2.58) (3.07)
DOCF ACCOTHt 0.0513 -0.0775 -0.1854 -0.2019*** -0.4802*** -0.7516***
(0.72) (-0.73) (-1.25) (-4.16) (-5.09) (-5.26)
DOCF OCFt -0.2326*** -0.5929*** -0.9694*** -0.3703*** -0.9227*** -1.4759***
(-3.17) (-5.14) (-6.06) (-7.49) (-9.60) (-10.29)
Control variables
ACCOTHt-1 0.1249*** 0.1212* 0.1690* 0.0249 0.1325** 0.3282***
(3.19) (1.86) (1.84) (0.85) (2.26) (3.77)
OCFt-1 0.1741*** 0.2448*** 0.3455*** 0.1178*** 0.3215*** 0.6151***
(4.54) (3.83) (3.79) (4.14) (5.62) (7.18)
QR -0.0005 -0.0012** -0.0006 -0.0001 -0.0003 -0.0003
(-1.64) (-2.15) (-1.12) (-0.63) (-0.73) (-0.44)
LEV -0.0398*** -0.0711*** -0.0774*** -0.0197*** -0.0453*** -0.0659***
(-7.16) (-7.91) (-6.23) (-5.61) (-6.37) (-5.97)
DIM -0.0036*** -0.0151*** -0.0273*** -0.0045*** -0.0146*** -0.0303***
(-3.01) (-7.46) (-9.60) (-5.86) (-8.90) (-11.47)
GROUP 0.0012 0.0035 0.0048 0.0019 0.0032 0.0029
(0.47) (0.84) (0.85) (1.08) (0.95) (0.56)
Sector Dummies Yes Yes Yes Yes Yes Yes
Geographic Dummies Yes Yes Yes Yes Yes Yes
Constant 0.1502*** 0.4009*** 0.6421*** 0.1320*** 0.3505*** 0.6936***
(5.97) (9.42) (9.97) (8.26) (10.34) (11.47)
Observations 12,903 12,903 12,903 12,903 12,903 12,903
R-squared 0.1429 0.2099 0.2394 0.4453 0.4497 0.4400
levels of significance: *** p<0.01, ** p<0.05, * p<0.1. Boldfaced estimates significant at 5% or better.

Results for sub-sample 2008 split by low/high profitability

High bottom-line profitability (>5%) Low bottom-line profitability (<5%)
VARIABLES OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt+3 OCFt+1 OCFt+2 OCFt+3 OIt+1 OIt+2 OIt+3

REVAL 0.0073 -0.0100* 0.0022 -0.0017 -0.0086* -0.0143*** -0.0037* -0.0049** -0.0060** -0.0037*** -0.0054*** -0.0082***
(1.22) (-1.66) (0.35) (-0.40) (-1.84) (-2.92) (-1.89) (-2.15) (-2.58) (-3.09) (-4.01) (-5.28)
WO 0.0340 -0.0071 0.0336 0.0196 -0.0033 -0.0015 -0.0004 0.0188** 0.0138 0.0140*** 0.0220*** 0.0242***
(1.64) (-0.31) (1.59) (1.31) (-0.24) (-0.09) (-0.06) (2.11) (1.49) (2.99) (3.55) (3.77)
ACCOTHt 0.6109*** 0.5445*** 0.6156*** 0.8615*** 0.7983*** 0.8430*** 0.4496*** 0.3681*** 0.3374*** 0.6076*** 0.4756*** 0.4689***
(11.52) (9.66) (10.12) (22.74) (17.27) (15.65) (11.72) (8.58) (7.85) (25.64) (17.91) (15.84)
OCFt 0.6174*** 0.6808*** 0.7504*** 1.0138*** 1.0038*** 1.0388*** 0.5208*** 0.5061*** 0.4566*** 0.7225*** 0.6131*** 0.6218***
(13.14) (12.97) (13.76) (29.95) (23.81) (21.58) (13.49) (11.80) (10.67) (30.79) (23.27) (21.23)
QR -0.0004 -0.0009 0.0020 0.0003 -0.0005 0.0005 -0.0006** -0.0007** 0.0003 -0.0002 -0.0004 -0.0002
(-0.22) (-0.62) (1.54) (0.26) (-0.50) (0.45) (-2.26) (-2.11) (0.67) (-1.61) (-1.64) (-1.20)
LEV -0.0320** -0.0249 0.0266 0.0145 -0.0088 -0.0078 -0.0411*** -0.0257*** -0.0105 -0.0056 -0.0090** -0.0055
(-2.07) (-1.48) (1.43) (1.27) (-0.69) (-0.54) (-6.61) (-3.63) (-1.37) (-1.53) (-1.98) (-1.07)
Observations 3,001 3,001 3,001 3,001 3,001 3,001 9,902 9,902 9,902 9,902 9,902 9,902
R-squared 0.1169 0.1433 0.1239 0.3582 0.3035 0.2781 0.0568 0.0633 0.0404 0.2065 0.1507 0.1393
levels of significance: *** p<0.01, ** p<0.05, * p<0.1. Boldfaced estimates significant at 5% or better.

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 Conclusions
Italian private firms weigh tax costs against expected future tax benefits to
decide whether to revalue their fixed assets.

- where current tax costs are relatively high, firms will revalue assets if future
net tax benefits are positive: current revaluations are positively related to
future profitability.

- If current tax costs are relatively low (or zero), revaluation choice will be
followed for opportunistic reasons.

- finding is consistent with Gigler’s theory: a voluntary signal is effective when it

is costly. As soon as the signal is “cheap”, it does not work.

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- Main implications:

• the interaction of financial and tax accounting creates a trade-off that

can improve the signal quality of reported numbers

• Book-tax-conformity can enhance credibility of financial reporting

- Write-offs are positively related to future profitability. This is not

consistent with accounting standards, but is consistent with firms
obtaining economic benefits other than maximizing firm value
(including smoothing).

• Many thanks for your attention

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