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Article
Publication date: 6 May 2014

Li-Chin Jennifer Ho, Chao-Shin Liu and Xu Frank Wang

The purpose of this paper is to examine the association between audit committee characteristics and a firm’s ability to guide analysts’ forecasts downward to meet or beat earnings

Abstract

Purpose

The purpose of this paper is to examine the association between audit committee characteristics and a firm’s ability to guide analysts’ forecasts downward to meet or beat earnings benchmarks.

Design/methodology/approach

The authors expect that a more effective audit committee would be able to reduce managers’ propensity to use downward forecast guidance to avoid negative earnings surprises. Four committee characteristics are used to measure its effectiveness: independence, diligence, expertise and size.

Findings

For the pre-SOX (Sarbanes-Oxley Act) period (1996-2002), none of the four audit committee characteristics are significantly associated with managers’ propensity to use downward forecast guidance to avoid negative earnings surprises. For the post-SOX era (2003-2004), however, the likelihood of engaging in downward forecast guidance is significantly lower for firms with larger and more independent audit committees. In addition, the likelihood is significantly lower for audit committees that are more diligent and have a higher proportion of the committee members with accounting or finance-related expertise.

Research limitations/implications

Overall, the authors results suggest that, in response to the increased regulatory and listing requirements in the post-SOX era, audit committees have played a more active role in scrutinizing earnings guidance. Our results also suggest that a more effective audit committee in the post-SOX era curbs managers’ tendency to use downward forecast guidance to meet or beat quarterly earnings targets.

Originality/value

To the authors knowledge, this study is one of the first to examine the role of the audit committee in reviewing managerial earnings guidance. As earnings guidance plays an important role in the overall financial reporting process over time and given the increasing importance of downward forecast guidance in earnings surprise games in recent years, the authors believe this study addresses an important question and adds to prior literature. Also, this study contributes to their understanding of the changing nature and scope of audit committee oversight activities since the passage of SOX.

Details

Review of Accounting and Finance, vol. 13 no. 2
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 18 May 2010

Li‐Chin Jennifer Ho, Chao‐Shin Liu and Thomas Schaefer

The purpose of this paper is to examine the relation between audit tenure and how clients manage the annual earnings surprise.

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Abstract

Purpose

The purpose of this paper is to examine the relation between audit tenure and how clients manage the annual earnings surprise.

Design/methodology/approach

A sample of 5,029 firm‐year observations from 1996 to 2003 were employed to examine whether audit tenure is negatively related to the incidence of accrual‐based‐upward earnings management to avoid negative earnings surprises; and whether audit tenure is positively related to the incidence of downward forecast guidance to avoid negative earnings surprises.

Findings

Empirical results indicate a substitution of downward forecast guidance for upward earnings management as audit tenure lengthens.

Research limitations/implications

The paper provides evidence that, as the auditor‐client relationship lengthens over time, firms turn to downward forecast guidance as a substitute for upward earnings management. One possible limitation of the sample period involves the implementation of the Sarbanes‐Oxley Act (SOX) of 2002. Because of the increased financial reporting scrutiny on both management and auditors that accompanies SOX, it is likely that constraints on earnings misstatements increase after SOX. Any decrease in upward earnings management resulting from SOX would thus work against finding a relation between audit tenure and the substitution of downward forecast guidance to prevent negative earnings surprises.

Originality/value

This paper supports the notion that audit tenure affects firms' choices among various tactics in their attempts to avoid negative earnings surprises. The results also contribute to the ongoing debate on mandatory audit firm rotation by showing that audit quality increases with audit tenure.

Details

Review of Accounting and Finance, vol. 9 no. 2
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 11 May 2012

Li‐Chin Jennifer Ho, Chao‐Shin Liu and Bo Ouyang

Barton and Simko argue that the balance sheet information would serve as a constraint on accrual‐based earnings management. This paper aims to extend their argument by examining…

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Abstract

Purpose

Barton and Simko argue that the balance sheet information would serve as a constraint on accrual‐based earnings management. This paper aims to extend their argument by examining whether the balance sheet constraint increases managers' propensity to use either downward forecast guidance or real earnings management as a substitute mechanism to avoid earnings surprises.

Design/methodology/approach

Following Barton and Simko, the paper uses the beginning balance of net operating assets relative to sales as a proxy for the balance sheet constraint. The argument is that because of the articulation between the income statement and the balance sheet, previous accounting choices that increase earnings will also increase net assets and therefore the level of net assets reflects the extent of previous accrual management. Models from Matsumoto and Bartov et al. are used to measure forecast guidance. Following Rochowdhury and Cohen et al., a firm's abnormal level of production costs and discretionary expenditures are used as proxies of real earnings management. The empirical analysis is conducted based on the 1996‐2006 annual data for a sample of nonfinancial, nonregulated firms.

Findings

The paper finds that firms with higher level of beginning net operating assets relative to sales are more likely to guide analysts' earnings forecasts downward, and more likely to engage in real earnings management in terms of abnormal increases in production costs and abnormal reductions in discretionary expenditures.

Research limitations/implications

Overall, the paper's evidence suggests that managers turn to real earnings management or downward forecast guidance as a substitute mechanism to avoid negative earnings surprises when their ability to manipulate accruals upward is constrained by the extent to which net assets are already overstated in the balance sheet.

Originality/value

This study adds to prior literature that examines how managers trade off different mechanisms used to meet or beat analysts' earnings expectations. It also contributes to the extant literature by providing further insights on the role of balance sheet information in the process of managing earnings and/or earnings surprises.

Details

Review of Accounting and Finance, vol. 11 no. 2
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 15 July 2019

Elio Alfonso, Li-Zheng Brooks, Andrey Simonov and Joseph H. Zhang

The purpose of this paper is to examine the impact of career concerns on CEOs’ use of expectations management to meet or beat analysts’ quarterly earnings forecasts. The authors…

Abstract

Purpose

The purpose of this paper is to examine the impact of career concerns on CEOs’ use of expectations management to meet or beat analysts’ quarterly earnings forecasts. The authors posit that early career-stage CEOs are less (more) likely to use expectations management than are late career-stage CEOs if the market views expectations management as an opportunistic strategy (efficient process) due to reputational capital concerns.

Design/methodology/approach

The authors obtain data for CEO career stages and CEO compensation from ExecuComp, analyst earnings forecasts from the detailed I/B/E/S database, financial statement data from quarterly Compustat and stock returns from the daily CRSP database over the period 1992–2013.

Findings

The results are consistent with the opportunistic hypothesis and early-stage CEOs seeking to build reputational capital by avoiding the perception of engaging in an inefficient managerial strategy. The authors find robust evidence that late career-stage CEOs are more likely to engage in expectations management than early career-stage CEOs. Furthermore, the authors show that late career-stage CEOs tend to employ expectations management to boost the value of their equity-based compensation.

Research limitations/implications

The findings have important implications because the authors document a different implication of the “horizon problem” related to CEOs’ opportunistic forecasting behavior and the manipulation of analysts’ forecasts for CEOs who are approaching retirement.

Practical implications

The results have practical implications for analysts who provide earnings forecasts for firms whose CEOs are in early or late career stages and for investors who use such analysts’ forecasts in firm valuation models.

Originality/value

The authors contribute to the literature on expectations management by documenting how reputational incentives of CEOs affect the likelihood that managers engage in expectations management. The authors show that an important managerial incentive to engage in expectations management is CEO career concerns. Furthermore, the authors show that CEOs who are in early stages of their careers choose not to engage in expectations management due to the market’s perceived degree of opportunism pertaining to this strategy.

Details

Journal of Applied Accounting Research, vol. 20 no. 3
Type: Research Article
ISSN: 0967-5426

Keywords

Article
Publication date: 10 August 2015

Camillo Lento and Naqi Sayed

The purpose of this paper is to investigate the association between gross profit percentage, abnormal market returns, revenue surprises and earnings surprises. Gross margin is…

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Abstract

Purpose

The purpose of this paper is to investigate the association between gross profit percentage, abnormal market returns, revenue surprises and earnings surprises. Gross margin is relied upon by various market participants, as its predictive power is incremental and distinct from revenue and earnings signals; however, gross margin has received little researcher attention.

Design/methodology/approach

General regression specifications found in the prior literature are extended to assess the informational content of changes in gross margin percentage. In addition, various portfolios are created based around the nature of the signals (positive or negative), provided by each income statement metrics (revenue, gross margin and earnings). A sample of 5,582 quarterly observations of S & P 500 firms is compiled. The main regressions are exposed to three robustness tests that focus on industry sub-groupings, institutional ownership and fourth-quarter observations.

Findings

The main findings reveal that gross margin percentage changes and earnings surprises are significantly related to abnormal market returns in the short window around the earnings announcement date and persist into a wider window measured as the quarter after the earnings announcement date. The relationship between gross margin percentage changes and abnormal returns is more pronounced when positive (negative) changes in gross margin percentage are accompanied by positive (negative) revenue and earnings surprises.

Research limitations/implications

This study relies upon S & P 500 firms which are all relatively large firms. Therefore, the results may not be generalizable to smaller firms. In addition, the gross margin change is measured as the quarter-over-quarter percentage change because there is no analyst expectation for gross margin.

Originality/value

This paper extends the prior literature by developing three testable hypotheses that investigate the linkages between abnormal market returns, gross margin and revenue and earnings surprises. This is the first known study to investigate the informational content of changes in gross margin percentage.

Details

Review of Accounting and Finance, vol. 14 no. 3
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 4 April 2022

Linda H. Chen, George J. Jiang and Kevin X. Zhu

The purpose of this study is to investigate whether within the same firm, earnings risk is exacerbated in the fiscal year end (FYE) quarters relative to that of other quarters…

Abstract

Purpose

The purpose of this study is to investigate whether within the same firm, earnings risk is exacerbated in the fiscal year end (FYE) quarters relative to that of other quarters, more importantly, if this type of earnings risk is unique. Further, the authors discuss solutions to mitigate this type of information risk.

Design/methodology/approach

This study provides evidence that the information risk associated with FYE quarter earnings cannot be explained by other identified risk factors. Solutions to mitigate this risk include strong corporate governance and a more streamlined financial reporting structure.

Findings

The paper shows that there is significantly lower earnings response coefficient for FYE quarters than for non-FYE quarters (1984–2015). Furthermore, strong corporate governance and a more streamlined financial reporting structure, either by firms willingly reducing the usage of extraordinary item reporting or by FASB codification changes such as FASB 145, can help mitigate this type of information uncertainty.

Research limitations/implications

This study explains that the causes of the exacerbated information risk associated with FYE quarter earnings identified in prior literature, namely, the “integral explanation” and “manipulation explanation,” are not mutually exclusive. Therefore, the authors deem it futile to disentangle the two. Instead, the authors offer two possible solutions.

Details

Review of Accounting and Finance, vol. 21 no. 2
Type: Research Article
ISSN: 1475-7702

Keywords

Article
Publication date: 30 July 2021

Nishaal Prasad, David Hay and Li Chen

The purpose of this study is to examine the effect of internal audit function (IAF) use on earnings quality and external audit fees using empirical data collected from the New…

Abstract

Purpose

The purpose of this study is to examine the effect of internal audit function (IAF) use on earnings quality and external audit fees using empirical data collected from the New Zealand (NZ) setting.

Design/methodology/approach

Applying institutional theory as the underlying framework, this study examines an IAF’s ability to demonstrate legitimacy, which will shed light to the functions long-term survival. Using a unique data set from the NZ setting, which combines information obtained from “The Institute of Internal Auditors of New Zealand” with empirical firm data collected from publicly available sources, multivariate analysis is performed to test the prediction that IAF use is associated with earnings quality, measured using discretionary accruals, and external audit fees.

Findings

There is strong positive association between IAF use and external audit fees, which supports the complementary controls view, where better internal controls increase audit fees by increasing the demand for scope of external audit work. The authors find no significant relationship between IAF use and earnings quality, which is not entirely surprising.

Research limitations/implications

The aim is to empirically test the IAF value proposition and to delve deeper into the black box of IAF value drivers. Given the size of the NZ economy and limitations of data availability, total sample size used in this study is relatively modest. However, the analysis does yield significant results. Apart from academic contribution to knowledge, this study offers a profound list of practical contributions. Practitioners will be interested to learn about the IAF value proposition from an empirical viewpoint. Senior management (SM) will obtain value from the outcomes when contemplating IAF investment and sourcing decisions. Regulators will be inherently interested in whether IAFs should be mandated.

Originality/value

The aim is to empirically test IAF value proposition and to delve deeper into the black box of IAF value drivers. To the best of the authors’ knowledge, this is the first NZ-based academic investigation which examines the relationship between IAF use and earnings quality. Apart from academic contribution to knowledge, this study offers a profound list of practical contributions. Practitioners will be interested to learn about the IAF value proposition from an empirical viewpoint. SM will obtain value from the outcomes when contemplating IAF investment and sourcing decisions. Regulators will be inherently interested in whether IAFs should be mandated.

Details

Pacific Accounting Review, vol. 33 no. 4
Type: Research Article
ISSN: 0114-0582

Keywords

Article
Publication date: 4 April 2016

Andrew Lee, Chu Yeong Lim and Tracey Chunqi Zhang

The purpose of this paper is to investigate the audit effect hypothesis for the cross-quarter differential market reactions to earnings announcements.

Abstract

Purpose

The purpose of this paper is to investigate the audit effect hypothesis for the cross-quarter differential market reactions to earnings announcements.

Design/methodology/approach

Earnings response coefficients are focused upon as indicators of perceived earnings quality.

Findings

The evidence suggests that investors of Singapore listed companies respond more strongly to earnings announcements in the fourth quarter than other interim quarters. The findings support the notion that investors attach different degrees of reliability to interim quarter earnings relative to final quarter earnings.

Originality/value

Findings in this paper shed new light on the audit effect hypothesis and are relevant to accounting regulators and audit committee members seeking to enhance the credibility of earnings announcements.

Details

Pacific Accounting Review, vol. 28 no. 2
Type: Research Article
ISSN: 0114-0582

Keywords

Article
Publication date: 31 December 2015

Nan Liu and Jamshid Mehran

The purpose of this paper is to investigate whether firms repurchase shares to meet or just beat their dividend target as managers perceive share repurchases are more flexible…

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Abstract

Purpose

The purpose of this paper is to investigate whether firms repurchase shares to meet or just beat their dividend target as managers perceive share repurchases are more flexible than dividends and managers have a strong desire to maintain dividend levels and dividend payout ratio of the firms.

Design/methodology/approach

The authors first run a Tobit regression to examine whether firms meeting or just beating the quarterly dividend per share threshold exhibit unusually high repurchases, controlling for the factors shown to affect repurchases. The authors then calculate abnormal repurchases and compare firms that would otherwise miss the benchmark with other firms.

Findings

The authors find that firms meeting or just beating the quarterly dividend per share threshold repurchase more shares than other firms, after controlling for the substitution effect, investment opportunities and financial performance. In addition, firms otherwise missing the quarterly dividend per share threshold repurchase abnormally more shares to meet the threshold.

Originality/value

The study contributes to the payout policy literature in the following ways. First, it extends the understanding of the association between dividend payout and repurchase. Second, it contributes to the threshold literature by showing that firms manipulate repurchases in addition to earnings to meet their quarterly dividend per share threshold. Third, it provides support to the survey evidence that firms have a strong desire to maintain their dividend policies.

Details

Managerial Finance, vol. 42 no. 1
Type: Research Article
ISSN: 0307-4358

Keywords

Article
Publication date: 14 October 2020

Naser Makarem and Clare Roberts

The purpose of this study is to investigate whether earnings boosts before the year end trigger earnings management. It examines whether firms that substantially outperformed…

Abstract

Purpose

The purpose of this study is to investigate whether earnings boosts before the year end trigger earnings management. It examines whether firms that substantially outperformed their last year earnings during the first three quarters push their earnings down to avoid reporting earnings boosts.

Design/methodology/approach

Regression analysis is used to compare earnings management of firms with earnings boosts and other firms.

Findings

The results indicate that firms outperforming their last year results by the end of the third quarter manipulate their earnings downwards by means of real activities manipulation, while they do not indicate income-decreasing accruals management. It is also found that consistent with the prominent shift from accruals management to real activities manipulation, accruals management is less costly which justifies why it is used for downward manipulation.

Research limitations/implications

The results are limited to one single earnings benchmark i.e. last year earnings. Further research may individually or collectively examine other benchmarks including analysts' forecasts.

Practical implications

The findings suggest that users should be more vigilant of firms exceeding their last year interim results, as they could be involved in downward earnings management.

Originality/value

This study documents earnings management in a new setting where earnings boosts before the year end trigger downward manipulation of real activities.

Details

Journal of Applied Accounting Research, vol. 21 no. 4
Type: Research Article
ISSN: 0967-5426

Keywords

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