Meeting and Beating Earnings Benchmarks: Evidence of Earnings Management in the form of Real Earnings Management (REM) and Accrual Earnings Management (AEM)

Extant research indicates that managers engage in earnings manipulation to manage reported earnings and value of the firm to maximize specific private benefits and to mislead some of firm’s investors. This study examines whether the managers of Australian firms engage in earnings manipulation in the form of real earnings management (REM) and accrual earnings management (AEM) across the years they are meeting and/or beating earnings benchmarks in the form of earnings per share (EPS) and in the form of small changes in earnings per share (changes in EPS). These research questions are particularly relevant to Australia as a result of introduction of regulatory reform in Australia, which is Corporate Law Economic Reform Program (CLERP 9) to protect investors’ interest after a series of high profile corporate collapses in Australia. Using a 4287 firm-year observations (excluding Financial and Utility Industry Sectors) over the 9 years from 2002 to 2010, cross-sectional REM models developed by Dechow et al. (1998) and implemented by Roychowdhury (2006) are used to estimate the proxies for REM (abnormal cash flow from operations, abnormal production costs, and abnormal discretionary expenses) and the modified Jones (1991) model is used to measure the proxy for AEM (abnormal accruals). Controlling for other determinants of REM and AEM activities, this study reveals that meeting and beating earnings benchmarks is associated with both REM and AEM activities.