2.1 Earnings Management
Firms manipulate reported earnings have been documented in many studies.
(see, for example, Healy (1985), Perry and Williams (1994), and DeFond and Jiambalvo (1994)). Prior research has focused almost exclusively on understanding whether earnings management exists and why. The findings indicate that earnings management occurs for a variety of reasons, including to influence stock market perceptions, to increase management’s compensation, to reduce the likelihood of violating lending agreements, and avoid regulatory intervention (Healy and Wahlen (1999)).Park and Shin (2003) report that earnings manipulations range from earnings frauds, which violate Generally Accepted Accounting Principles (GAAP), to earnings management, which does not. Even in the absence of fraudulent reporting, firms can manipulate reported accounting earnings because GAAP allows alternative representations of accounting events. Teoh et al. (1998) documented that the sources of earnings manipulations within GAAP include the choice of accounting methods, the application of accounting methods, and the timing of asset acquisitions and dispositions. The choice of accounting methods affects the timing of when revenues and expenses are recognized in income. If input prices are falling, LIFO (last-in-first-out) costs of goods sold (based on later lower prices) are lower than FIFO (first-in-first-out) costs. For depreciable assets, straight-line depreciation charges lower depreciation expenses more than accelerated depreciation in the initial periods. Even after managers have chosen the accounting methods, there remains discretion in terms of how the accounting principles are applied. For instance, Managers has discretion in the estimates of salvage values of depreciable assets, lives of intangibles, uncollectible rate on accounts receivable, the actuarial cost basis for
pension plan and for pension accounting (Teoh et al. (1998)). The timing of asset acquisitions and dispositions can affect reported earnings. Sum up, Managers can smooth reported earnings by choosing an accounting method that advances (delays) the recognition of revenues and delays (advances) the recognition of expenses in order to increase (decrease) reported earnings. Once an accounting method is chosen, management can smooth reported earnings further by using a wide range of discretionary accruals. Finally, management can smooth reported earnings by adjusting the timing of asset acquisitions and dispositions. Obviously, earnings manipulation increases information asymmetry between insider and outsider, and it has to decrease outsiders’ wealth potentially.
Next, I will introduce some literature of detect earnings management. Jones (1991) proposes a model that relaxes the assumption that nondiscretionary accruals are constant and attempts to control for the effect of changes in a firm’s economic circumstances on nondiscretionary accruals (Dechow et. al 1995). The pitfall of Jones Model is the estimate of earnings management to be biased toward zero. Jones Model implicitly assumes that discretion is not exercised over revenue in either the estimation period or the event period. Therefore, Dechow, Sloan and Sweeny (1995) introduce a modified version of Jones Model. The modified Jones Model implicitly assumes that all change in credit sales in the event period result form earnings management. This is based on the reasoning that it easier to manage earnings by exercising discretion over the recognition of revenue on cash sales. Dechow et. al (1995) reported that if this modification is successful, then the estimate of earnings management should no longer be biased toward zero in samples where earnings management has taken place through the management of revenues. Finally, Teoh et al., (1998) use an extension of the cross-sectional Jones Model decomposed accruals into four components: discretionary and nondiscretionary current accruals, and
discretionary and nondiscretionary long-term accruals. Nondiscretionary accruals are the asset-scaled proxies for unmanipulated accruals dictated by business conditions.
Discretionary accruals are the asset-scaled proxies for manipulated earnings determined at the discretion of management. Guenther (1994) showed that entrepreneurs have more discretion over short-term than over long-term accruals.
Teoh et al. (1998) consider that discretionary current accruals (DCA) are the superior proxy for earnings management. So I follow Teoh et al. (1998) to calculate the index of earnings management in this paper.
2.2 Equity Liquidity
Equity liquidity could be measured by how long it takes optimally to trade a given amount of an asset, or be measured by the price concession for an immediate transaction (Lippman and Mccall, 1986; Demsetz, 1968). Under this view, the equity liquidity is viewed as the price of immediacy, and bid-ask spreads which determined by dealer’s order processing cost, inventory holding cost, and information asymmetric cost is one measure of market liquidity. Bid-ask spreads have been used extensively in previous research as a measure of information asymmetry between management and shareholders. Evidence of the ability of bid-ask spreads to capture the information environment of the firm is provided by Healy, Palepu, and Sweeney (1995) and Welker (1995) who report evidence of a negative relationship between bid-ask spreads and firm’s disclosure policies. When information asymmetry exists between managers and shareholders, managers consistently provide incomplete information to shareholders. The market marker increases the bid-ask spreads to offset the potential losses of trading with informed traders and gain from trading with uninformed traders.
When information asymmetry is high, it also stands for equity liquidity is low. So in this paper, I use bid-ask spread proxy for the information asymmetry between insiders
and outsiders. At the same time, bid-ask spread also stands for the equity liquidity.
When the spread is narrow, it means greater liquidity in equity market and smaller information asymmetry.
2.3 Earnings Management and Equity Liquidity
A large number of papers have indicated the relationship between earnings management and stock returns. Sloan (1996) finds that stocks with high accruals consistently underperform stocks with low accruals for three years. Teoh et al. (1998) documented that issuers with higher discretionary accruals have poorer stock returns performance in the subsequent three years. Chan et al. (2003) further show that accruals are reliably, negatively associated with future stock returns. When firms manipulate reported earnings by increasing accruals, it would lead to poor future stock returns. This paper differs from those papers in investigating the relationship between earnings management and equity liquidity.
Investors and financial analysts use accounting information to help value stocks can create an inventive for managers to manipulate reported earnings in attempt to affect short term stock price performance. This paper not only hypothesizes the magnitude of information asymmetry affects the magnitude of earnings management by managers but also hypothesizes the magnitude of earnings management affects the magnitude of information asymmetry. Therefore, I expect the positive relation between bid-ask spreads and earnings management.
Several analytical papers have extended the analysis between information asymmetry on equity liquidity and earnings management (Trueman and Titman, 1988;
Dye, 1988). However, there has been little empirical testing work to investigate this relationship. Schipper (1989) argues that this lack of empirical testing of the information environment surrounding earnings management represents a slippage
between analytical models and empirical tests of earnings management.Schipper also suggests the need for empirical work that addresses the environmental conditions surrounding the practice of earnings management. Later, Richardson (2000) only investigate the magnitude of information asymmetry affects the magnitude of earnings management by firm managers. Richardson also finds that information asymmetry affects managers manipulate reported earnings significantly. However, it still lacks of a comprehensive empirical work to discuss the relationship between earnings management and information asymmetry on equity liquidity. On other hands, Richardson’s empirical work absence of the magnitude of earnings management affects the magnitude of information asymmetry.
The purpose of this paper is to fill this gap and to provide more complete research in investigating the relationship between earnings management and equity liquidity.