 Abhijit Barua |
If you cannot understand financial statements, you are not alone.
“Anecdotal evidence from a couple of years ago indicated that only 20 percent of the members of boards of directors can decipher them,” said Abhijit Barua, assistant professor, School of Accounting in the College of Business Administration.
Yet, these reports—whether issued quarterly or annually or both for public companies—contain indispensable information for investors, or for anyone interested in a company’s performance, from bankers to the government to employee unions.
In addition to being impenetrable for many non-accounting professionals, financial statements may not be absolutely objective, a possibility with serious implications for those who rely on them for investment decisions. Barua and two colleagues set out to research “earnings management,” which examines accrual mechanisms used by firms in the context of three earnings benchmarks: avoiding losses (reporting zero or non-negative earnings), avoiding earnings declines (meeting or beating prior-period earnings), and avoiding earnings surprises (meeting or beating analysts’ forecasts).
“During the late 1990s, academic researchers, the financial press, and regulators all observed that the propensity to use earnings management mechanisms to meet or beat benchmarks was increasing,” he said. “Earlier research—which our study extends—had found that firms reporting profits are more likely to meet or beat analysts’ predictions than those reporting losses.”
Research shows differences between profit- and loss-reporting companies.
For their study, the researchers looked at the possible role of accruals management, an accounting technique that allows corporate managers to use their discretion in various accounting estimates and thus enables them to manage earnings upward to meet or beat benchmarks.
“No one had looked at how profit-reporting firms used accrual management versus the way loss-reporting firms used it.”
—Abhijit Barua, assistant professor, School of Accounting in the College of Business Administration
“No one had looked at how profit-reporting firms used accrual management versus the way loss-reporting firms used it,” Barua said. “We focused on two of the three benchmarks—analysts’ forecasts and prior-period earnings—and conjectured that, when pre-managed earnings fall below analysts’ forecasts or prior-period earnings, it is the profitable firms that are more likely to report earnings that meet or beat the benchmarks.”
Barua and his colleagues examined how companies managed accruals by looking at quarterly data from 1992-2001. Their empirical analyses supported their conjecture that corporate behavior differs between those firms that report profits and those that report losses.
“The results, which we have published, suggest that firms with profits before accruals management are more likely than firms with losses before accruals management to have pre-managed earnings below the two benchmarks and actual earnings above it,” he said.
Using accrual management to meet benchmarks raises ethical questions.
The research has practical implications in the post-Enron period with its greater emphasis on ethics.
“When you are reporting profit, you cannot have a benchmark in mind,” Barua said. “It violates one of the necessary qualitative characteristics of accounting information–neutrality—because if you have a figure in mind, you may use accounting techniques to achieve or beat that number. Some aspects of accrual management are illegal, and others, while not illegal, are unethical. Our work can enhance policy makers’ understanding by providing further insights on earnings management mechanisms and by focusing on the differential accrual management behaviors of corporate managers to meet or beat earnings benchmarks.”
Titled “Accruals Management to Achieve Earnings Benchmarks: A Comparison of Pre-managed Profit and Loss Firms,” the article appeared in Journal of Business Finance & Accounting, one of the top journals in the accounting field.
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