Mind mapping the topic of earnings management (EM)
Joseph Kim-keung Ho
Independent
Trainer
Hong
Kong, China
Abstract: The topic of earnings
management (EM) is a main one in Accounting and Finance. This article makes use
of the mind mapping-based literature review (MMBLR) approach to render an image
on the knowledge structure of earnings management. The finding of the review
exercise is that its knowledge structure comprises four main themes, i.e., (a) Descriptions
of basic concepts and information (b) Major underlying theories and thinking,
(c) Main research topics and issues, and (d) Major trends and issues related to
practices. There is also a set of key concepts identified from
the EM literature review. The article offers some academic and
pedagogical values on the topics of EM, literature review and the mind
mapping-based literature review (MMBLR) approach.
Key words: Earnings management
(EM), literature review, mind map, the mind mapping-based literature review
(MMBLR) approach
Introduction
Earnings management
(EM) is a main topic in Accounting and Finance. It is of
academic and pedagogical interest to the writer who has been a lecturer on Accounting
and Finance for some tertiary education centres in Hong Kong. In this article,
the writer presents his literature review findings on EM using the mind
mapping-based literature review (MMBLR) approach. This approach was proposed by
this writer in 2016 and has been employed to review the literature on a number
of topics, such as supply chain management, strategic management accounting and
customer relationship management (Ho, 2016). The MMBLR approach itself is not
particularly novel since mind mapping has been employed in literature review
since its inception. The overall aims of this exercise are to:
1.
Render an image of the knowledge structure of
earnings management (EM) via the
application of the MMBLR approach;
2.
Illustrate how the MMBLR approach can be
applied in literature review on an academic topic, such as EM.
The findings from this literature review
exercise offer academic and pedagogical values to those who are interested in
the topics of EM, literature review and the MMBLR approach. Other than that,
this exercise facilitates this writer’s intellectual learning on these three
topics. The next section makes a brief introduction on the MMBLR approach.
After that, an account of how it is applied to study EM is presented.
On mind
mapping-based literature review
The mind mapping-based literature review
(MMBLR) approach was developed by this writer in 2016 (Ho, 2016). It makes use
of mind mapping as a complementary literature review exercise (see the Literature on mind mapping Facebook page
and the Literature on literature review
Facebook page). The approach is made up of two steps. Step 1 is a thematic
analysis on the literature of the topic chosen for study. Step 2 makes use of
the findings from step 1 to produce a complementary mind map. The MMBLR
approach is a relatively straightforward and brief exercise. The approach is
not particularly original since the idea of using mind maps in literature
review has been well recognized in the mind mapping literature. The MMBLR
approach is also an interpretive exercise in the sense that different reviewers
with different research interest and intellectual background inevitably will
select different ideas, facts and findings in their thematic analysis (i.e.,
step 1 of the MMBLR approach). Also, to conduct the approach, the reviewer needs
to perform a literature search beforehand. Apparently, what a reviewer gathers
from a literature search depends on what library facility, including e-library,
is available to the reviewer. The next section presents the findings from the
MMBLR approach step 1; afterward, a companion mind map is provided based on the
MMBLR approach step 1 findings.
Mind
mapping-based literature review on earnings management (EM): step 1 findings
Step 1 of the MMBLR approach is a thematic analysis on
the literature of the topic under investigation (Ho, 2016). In our case, this
is the EM topic. The writer gathers some academic articles from some
universities’ e-libraries as well as via the Google Scholar. With the academic
articles collected, the writer conducted a literature review on them to
assemble a set of ideas, viewpoints, concepts and findings (called points
here). The points from the EM literature are then grouped into four themes
here. The key words in the quotations are bolded in order to highlight the key
concepts involved.
Theme
1: Descriptions of basic concepts and information
Point 1.1.
“The
earnings management studies state that managers use their discretionary power
to select alternative accounting techniques to manipulate actual financial
statement. Earnings management has
been defined as an intentional intrusion coupled with the purpose of deriving
some private gain in the external financial reporting process” (Kumari and Pattanayak, 2014);
Point 1.2.
“Discretionary
accruals can be
described as management choices for non-obligatory accruals. These are
non-mandatory expenses/assets recorded within the accounting system which are
yet to be realized, e.g., write-off of preliminary expenses, creating provision
for bad debts, alternative methods of
recording depreciation, credit sales, etc. Discretionary accruals are choices
given to the management by GAAP and other accounting laws through the provision
of alternative accounting practices and alternative financial reporting
techniques” (Kumari and
Pattanayak, 2014);
Point 1.3.
“Whenever
financial decisions are based on intentional
judgment applied for transaction structuring and financial reporting with
the sole purpose of meaningful deceit, concealment or data spinning, it gives
rise to earnings management. This is done in order to mislead the investors and stakeholders and influence favorable
outcomes from business contracts through manipulated accounting figures” (Baig
and Khan, 2016);
Point 1.4.
“…real
earnings management
manifests through sales manipulation, reduction of discretionary expenditures,
or overproduction” (Visvanathan,
2008);
Point 1.5.
“Earnings management can be
classified into two categories: accruals
management and real activities
manipulation (RM). Accruals management involves within generally accepted
accounting principles (GAAP) accounting choices that try to ‘‘obscure’’ or
‘‘mask’’ true economic performance …. RM
occurs when managers undertake actions that change the timing or structuring of
an operation, investment, and ⁄ or financing transaction in an effort
to influence the output of the accounting system” (Gunny,
2010);
Point 1.6.
“Roychowdhury … defines real activities manipulation as
“departures from normal operational practices, motivated by managers’ desire to
mislead at least some stakeholders into believing certain financial goals have
been met in the normal course of operations. These departures do not
necessarily contribute to firm value even though they enable managers to meet
reporting goals.”…” (Visvanathan,
2008);
Point 1.7.
“Examples of RM [real activities manipulation] include overproduction to decrease
cost of goods sold (COGS) expense and cutting desirable research and development
(R&D) investments to boost current period earnings” (Gunny,
2010);
Theme 2: Major underlying theories
and thinking
Point 2.1.
“…earnings management is more pervasive in countries where investor protection is weak than in
countries where investor protection is strong” (Karim
and Sarkar, 2016);
Point 2.2.
“Companies
manipulate earnings not only by accruals but also by taking or postponing
production or operating actions that adjusts the earnings towards the desired target. The latter type is
labeled as “real” earnings management. In contrast to accruals management, real
earnings management is likely to lead to value
reduction by misallocation of appropriate corporate activities” (Visvanathan, 2008);
Point 2.3.
“Ronen and Yaari … classified earnings
management activities as ‘‘black,’’ ‘‘white,’’ or ‘‘gray’’ in terms of their perceived transparency and intended
purposes” (Johnson, Fleischman, Valentine and Walker, 2012);
Point 2.4.
“The effect of a listing on an international capital market can be
twofold. A foreign exchange listing might
result in additional regulatory requirements reducing national opportunities
for earnings management. However, international capital market pressures might
also give additional incentives for increasing the level of earnings
management. The net effect of these opposing forces is, a priori, unclear” (Maijoor and Vanstralen, 2006);
Point 2.5.
“The incentive to manage earnings around a debt-covenant violation originates from the manager’s compensation
contract. This contract is designed to have the lowest possible agency cost and
to address the conflict between the bondholders and the shareholders. Usually,
the firm first chooses the optimal compensation contract based on accounting
numbers to minimize agency costs arising from the separation of ownership
(shareholders) and control (managers). In addition, the managers may have
further obligations to maintain reported values such as the ratio of earnings
to total debt above a contractual threshold. These restrictions, commonly
called debt-covenants, are set by the firm’s lenders to reduce the cost of
monitoring” (Jha,
2013);
Point 2.6.
“…. the managers have some discretion on how to report their
earnings. They are given this discretion partly because it is impossible to
write a contract that eliminates such discretion, and partly because it might
be optimal for shareholders to allow managers some discretion …. Consequently,
managers manage earnings. The reasons
for the earnings management can be many, but often the reasons are
opportunistic” (Jha,
2013);
Point 2.7.
“…managers
are likely to engage in three main types
of earnings management practices in order to meet the unrealistic
performance expectations incorporated in an overvalued stock price. ….. (1)
Real Transactions Management (RTM), (2) within-GAAP Accruals Management (AM),
and (3) Non-GAAP earnings management (NonGAAP)” (Badertscher, 2011);
Point 2.8.
“…managers may prefer accruals management to RM [real activities manipulation]
because accruals management can take place after the fiscal year end when the
need for earnings management is the most certain, whereas RM decisions must be
made prior to fiscal year end” (Gunny, 2010);
Point 2.9.
“…recent
studies suggest that managers inflate earnings to sell their shares subsequently,
at inflated prices (‘‘pump
and dump’’)” (Beneish,
Press and Vargus, 2012);
Point 2.10.
“A
firm performing poorly in interim quarters may attempt to increase earnings of
the fourth quarter to achieve a desired
level of annual earnings, whereas a firm performing well in interim
quarters may attempt to decrease earnings of the fourth quarter to build "reserves" for the
future” (Das, Shroff
and Zhang, 2009);
Point 2.11.
“Announcement of misconduct by
other firms,
and the consequences they face, is likely to enable peer firms to learn about
(1) the details of the misconduct (for instance, the use of early revenue
recognition or the nature of the restating firm), and (2) the costs of engaging
in questionable accounting practices. If the target restating firm, upon
discovery of misrepresentation, faces little or no regulatory enforcement, then
a peer firm is likely to conclude that the costs of managing earnings are low”
(Kedia, Koh and Rajgopal, 2015);
Point 2.12.
“Family owners are often active
managers in the firms …, and hence, may
enjoy greater latitude in altering regular operational and investment
activities. Such actions are less likely to be contested by the professional
managers since they serve the family interests … Accordingly, the REMs,
achieved through alteration of regular operational and investment decisions,
may turn out to be a more convenient option for family firms” (Razzaque,
Ali and Mather, 2016);
Point 2.13.
“Managers may want to engage in RM [real
activities manipulation] versus using accruals management for several reasons.
First, ex post aggressive accounting choices with respect to accruals are at
higher risk for Securities and Exchange Commission (SEC) scrutiny and class
action litigation. Second, the firm may have limited flexibility to manage accruals. …. Further, accruals
management must take place at the end of the fiscal year or quarter, and
managers face uncertainty as to which accounting treatments the auditor will
allow at that time” (Gunny, 2010);
Point 2.14.
“REM
[real earnings management] increases noise
or errors in earnings and decreases investor expectations of future cash
flow levels” (Liu, 2016);
Point 2.15.
“REM
[real earnings management] is typically seldom subject to external monitoring or scrutiny and is difficult to detect using
internal monitors such as a board or audit committee” (Liu, 2016);
Point 2.16.
“Reported
net income is an important determinant
of credit ratings, and ratings are highly correlated with bond yields.
Therefore, firms may conduct EM [earnings management] in order to improve the
terms of a bond offering” (Caton, Chiyachantana, Chua and Goh, 2011);
Point 2.17.
“The poor legal protection for investors has been found to be positively
related to poor quality reported earnings …
Insiders are more likely to acquire private benefits in such environment and this
in turn induces them to manage earnings to conceal their activities” (Razzaque, Ali and Mather, 2016);
Point 2.18.
“Whereas a manager in his
last period in office brings forward earnings to the period in which he
will leave, the incoming manager has an incentive to shift earnings away from
the first period of his tenure as these will to some extent be attributed to
the ability of his predecessor” (Liu,
2016);
Theme 3: Main research topics and
issues
Point 3.1.
“…it is often difficult and time-consuming to identify earnings management,
especially in generic settings where an obvious incentive to manage earnings is
absent” (Jansen, Ramnath and Yohn, 2012);
Point 3.2.
“In
Pakistan difference of opinions exists on whether IFRS adoption makes for more transparent and comparable financial
statements or not and the positive or negative impact on earnings
management. This has not been empirically tested before” (Baig and Khan, 2016);
Point 3.3.
“Jensen …. posits that, when a firm’s stock becomes overvalued, managers
engage in a variety of earnings management choices to sustain overvaluation” (Badertscher,
2011);
Point 3.4.
“More recently,
researchers have also investigated how earnings management practice varies
across countries with different legal environments, levels of investor
protection and capital market developments” (Karim
and Sarkar, 2016);
Point 3.5.
“On the one hand, earnings management undertaken
solely to enhance personal goals (e.g., a positive performance evaluation,
increased pay, or bonuses) is generally viewed as unethical … On the other
hand, conclusions about the ethics of
managing earnings for business related goals (e.g., to meet budget targets)
are mixed, with some studies reporting acceptance of such practices as ethical
…, and others concluding that they are unethical” (Johnson, Fleischman,
Valentine and Walker, 2012);
Point 3.6.
“…managers might bias reported earnings to maximize their own
bonus payments. This so-called bonus-plan
hypothesis was first investigated by Healy…” (Liu, 2016);
Point 3.7.
“…there is a paucity of research on family firms' engagement in REMs [real earnings management] despite the fact that family firms offer an interesting experimental setting for the
investigation of REMs engagement. On the one hand, it may be argued that the
activities that result in REMs are more easily facilitated in family firms. On the other hand, the potential adverse effect of deviating
from regular operational and investment” (Razzaque, Ali and Mather, 2016);
Point 3.8.
“Although
several studies document that litigation is more likely against firms whose
managers sell their stock and manage earnings …., there is disagreement about
the impact of litigation risk in
studies of managers’ trading patterns and accounting choices” (Beneish, Press and Vargus, 2012);
Point 3.9.
“Early
studies examining earnings management surrounding capital market transactions find evidence that managers manipulate
earnings through accruals to influence short-term stock
price performance in
the capital markets surrounding these major corporate transactions” (Karim and Sarkar, 2016);
Point 3.10.
“In the
last few decades, the corporate world has witnessed a series of accounting
frauds and financial scandals...… This phenomenon attracted the attention of
regulators and academics all over the world in identifying the degree to which
the reported financial information misrepresents the financial performance of a
reporting entity. The present condition renews the interest about earnings
management practice and corporate
governance as control mechanism” (Kumari and Pattanayak, 2014);
Point 3.11.
“Several
research studies prior to and after Sarbanes-Oxley Act have examined the role of board of directors in
constraining earnings management … Much of the attention focuses on accrual
type earnings management such as aggressive revenue recognition and
misstatement of inventories or accounts receivable etc.” (Visvanathan, 2008);
Point 3.12.
“The effect of earnings management on the
value of the firm and the related issues of financial-based incentives for
managing earnings has been widely examined in the accounting literature”
(Johnson, Fleischman, Valentine and Walker, 2012);
Point 3.13.
“The
inherent difficulty in modelling
accruals leads to model misspecification and low power tests resulting in
serious inference problems” (Das,
Shroff and Zhang, 2009);
Point 3.14.
“The role of corporate governance in financial reporting has received
significant attention in recent years. In particular, researchers have examined
whether certain governance factors restrain earnings management practices at
companies” (Visvanathan,
2008);
Point 3.15.
“There
is limited empirical evidence on the relation between the duration of
overvaluation and management’s choice of
alternative earnings management mechanisms” (Badertscher,
2011);
Point 3.16.
“While academic research has used numerous proxies for (or diagnostics of) earnings
management, most recent studies use accruals models to decompose total
accruals into a normal, economics-driven component and an abnormal, earnings
management component” (Jansen, Ramnath and Yohn, 2012);
Theme 4: Major trends and issues
related to practices
Point 4.1.
“Common-law
countries are
characterised by: transactions at ‘arms-length'; a diverse
base of investors; and a relatively high
risk of litigation. In code-law
countries, capital markets are less active. Companies are more financed by
banks, other financial institutions and the government, which results in less
need for public disclosure. ….
discontinuities in the distribution of earnings are more pronounced in code-law countries ….
compared to the US and the UK. Hence, earnings management and loss avoidance
practices appear to be more prevalent in companies from code-law countries
compared to companies from common-law countries” (Maijoor and Vanstralen, 2006);
Point 4.2.
“Evidence has been provided in the US and the UK that Big Four audit
firms constitute a constraint on
earnings management .… nonfraudulent clients of Big Four auditors are less
likely to have errors or irregularities, which are considered to be proxies for
earnings management” (Maijoor and Vanstralen, 2006);
Point 4.3.
“In past many big or well reputed companies in all over the
world created sophisticated methods for accounting manipulations by abusing
accounting and shaking the confidence of
the investors and general public too, which hurt the economic activity
around the world” (Baig and Khan, 2016);
Point 4.4.
“Prior research provides evidence that the reporting regulatory environment faced by non-U.S. firms using
international financial reporting standards (IFRS) gives rise to more accruals
earnings management than the environment faced by U.S. firms using U.S.
generally accepted accounting principles (GAAP)” (Evans, Houston, Petes and Pratt, 2015);
Point 4.5.
“Erickson and Wang …. find evidence that
acquiring firms manage earnings in
the quarter prior to the deal announcement and in the quarters between the
announcement and agreement dates, as the unexpected accruals in these quarters
are significantly higher by 2% to
3%. They also find that the degree of
earnings management is significantly positively
related to the size of the deal as
large deal provide stronger incentives to so do” (Karim
and Sarkar, 2016);
Point 4.6.
“Louis …. finds that acquiring firms manage earnings in the quarters preceding stock based
acquisitions. In post-merger period, stock-based acquirers' underperformance is
partly due to the pre-merger earnings
management and its subsequent post-merger reversal” (Karim and Sarkar, 2016);
Point 4.7.
“Zhang
and He …. determined that managers of firms with medium accounting performance
and at the borders of profit targets typically engage in earnings management through real research and development
(R&D) transactions” (Liu, 2016);
Each of the four themes has a set of
associated points (i.e., idea, viewpoints, concepts and findings). Together
they provide an organized way to comprehend the knowledge structure of the earnings
management (EM) topic. The bolded key words in the quotation reveal, based on
the writer’s intellectual judgement, the key concepts examined in the EM
literature. The referencing indicated on the points identified informs the
readers where to find the academic articles to learn more about the details on
these points. The process of conducting the thematic analysis is an exploratory
as well as synthetic learning endeavour on the topic’s literature. Once the
structure of the themes, sub-themes[1]
and their associated points are finalized, the reviewer is in a position to
move forward to step 2 of the MMBLR approach. The MMBLR approach step 2
finding, i.e., a companion mind map on EM, is presented in the next section.
Mind
mapping-based literature review on EM: step 2 (mind mapping) output
By adopting the findings from the MMBLR
approach step 1 on earnings management (EM), the writer constructs a companion
mind map shown as Figure 1.
Referring to the mind map on EM, the topic
label is shown right at the centre of the map as a large blob. Four main
branches are attached to it, corresponding to the four themes identified in the
thematic analysis. The links and ending nodes with key phrases represent the
points from the thematic analysis. The key phrases have also been bolded in the
quotations provided in the thematic analysis. As a whole, the mind map renders
an image of the knowledge structure on EM based on the thematic analysis
findings. Constructing the mind map is part of the learning process on
literature review. The mind mapping process is speedy and entertaining. The
resultant mind map also serves as a useful presentation and teaching material.
This mind mapping experience confirms the writer’s previous experience using on
the MMBLR approach (Ho, 2016). Readers are also referred to the Literature on literature review Facebook
page and the Literature on mind
mapping Facebook page for additional information on these two topics.
Concluding
remarks
The MMBLR approach to study EM provided here
is mainly for its practice illustration as its procedures have been refined via
a number of its employment on an array of topics (Ho, 2016). No major
additional MMBLR steps nor notions have been introduced in this article. In
this respect, the exercise reported here primarily offers some pedagogical value
as well as some systematic and stimulated learning on earnings management (EM)
in Accounting and Finance. Nevertheless, the thematic findings and the image of
the knowledge structure on EM in the form of a mind map should also be of
academic value to those who research on this topic.
Bibliography
1. Badertscher, B.A. 2011.
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2. Baig, M. and S.A. Khan. 2016.
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Pakistan” Procedia – Social and
Behavioral Sciences, Elsevier: 343-350.
3.
Beneish,
M.D., E. Press and M.E. Vargus. 2012.
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Caton,
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