Assessing earnings management flexibility

Hiu Lam Choy

Review of Accounting and Finance, 2012, vol. 11, issue 4, 340-376

Abstract: Purpose - The purpose of this paper is to propose a new measure of earnings management flexibility based on the limits of the allowable set of accruals, prior discretionary accruals used, and the reversal rate of these accruals. Design/methodology/approach - Quarterly financial data from Compustat for the period 1990‐2009 were used to construct the flexibility measure. Then the author examined how well this measure captures flexibility by investigating its effect on a firm's probability of meeting analysts' forecasts. Findings - The results show that this flexibility measure better captures the firm‐specific flexibility than that of Barton and Simko which captures mainly the difference in flexibility across industries. Further, the positive effect of their measure on a firm's probability of meeting/beating analysts' forecasts is not observed in the extended sample period. Practical implications - The flexibility measure proposed here can assist investors, analysts, or researchers to compare earnings management flexibility across firms in the same industry, which is useful in evaluating the quality of a firm's financial reports, stock picking or credit granting decisions. Originality/value - This paper contributes to the earnings management literature by incorporating both the variation in flexibility used and that in flexibility limits. Second, evidence in this paper suggests that while financial benefits motivate managers to undertake earnings management, flexibility determines the extent of earnings management they can undertake. Third, this study points out that the unreversed discretionary accruals impose a constraint on the level of discretionary accruals a manager can incur in the current period, and hence have an indirect influence on current reported earnings.

Keywords: Earnings; Financial flexibility; Stock markets; Financial markets; Earnings management; Flexibility; Accruals; Analysts' forecasts (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eme:rafpps:v:11:y:2012:i:4:p:340-376

DOI: 10.1108/14757701211279169

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