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Motives of Earnings Management

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Abstract

The three main theories that explain earnings management suggest three main groups of motives for this phenomenon. According to contracting theory, contractual motives exist based on the conflicts in the contract terms between the firm and its stakeholders that are linked to firm performance. Bounded rationality theory implies the inefficiency of the market in reflecting firms’ intrinsic values and thus suggests the existence of capital market motives that influence firms’ stock values. Finally, external (third-party) motives arise from parties that have current or future interests in the firm and thus interfere in the way it communicates information to the stakeholders. The three groups of motives are not completely distinct because more than one theory may explain a specific motive. Such motives influence firm performance which, in turn, plays a mediating role in determining earnings management behaviour and thus can be identified as a distinct fourth group.

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Notes

  1. 1.

    Restricted stock grants are stocks granted to a manager with restriction on their sale. The manager can only sell this type of stocks when a specific condition is met, e.g., after a specific period of time passes or a specific goal is achieved.

  2. 2.

    Phantom stocks and stock appreciation rights link between management compensation and stock prices by rewarding managers in cash, and to a lesser extent by distributing stocks. The two types of incentives mainly differ in terms of settlement dates and dividends payments.

  3. 3.

    Performance units give a reward promise to a manager in the form of stocks if the firm achieves a specific level of performance.

  4. 4.

    According to Bamber et al. (2010), the manager fixed effect is estimated as the residual from regressing management forecast characteristics (e.g., forecast frequency, precision, and bias) on the specific determinants of voluntary disclosure (e.g., change in EPS, R&D expenditure, market to book ratio, the quality of governance, market value of equity, number of analysts, litigation risk, etc.), after excluding the firm fixed effect and time influence.

  5. 5.

    The fundamental economic value is calculated as the discounted dividends expected to be distributed by the firm in the future.

  6. 6.

    While the common laws develop based on the cases experienced in the courts of a specific country over time, code laws represent systematic legislation enforced by law.

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  1. Accounting and Finance Division, Leeds University Business School, Leeds, UK

    Malek El Diri

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El Diri, M. (2018). Motives of Earnings Management. In: Introduction to Earnings Management. Springer, Cham. https://doi.org/10.1007/978-3-319-62686-4_4

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