On the Relation between Real Earnings Management and Accounting Earnings Management: Income Smoothing Perspective

INTRODUCTION The purpose of this paper is to investigate a relation between real earnings management and accounting earnings management to smooth income in Japan. We generally can divide earnings management into accounting earnings management and real earnings management. Accounting earnings management contains a choice from menu of treatments that are accepted under Generally Accepted Accounting Principles (hereafter, GAAP), such as LIFO versus FIFO for inventory valuation and depreciation. Real earnings management consists of real production and investment decisions, such as reducing research and development expenditures and affecting selling and administrative expenses. Current accounting system has some discretion that allows managers to manage earnings. Managers generally can use the discretion in reporting earnings to achieve their goal. Note that as long as managers use their discretion within the limits of GAAP, both earnings management are not illegal. Managers have some discretion in determining how aggressive or conservative their financial reporting should be. Real earnings management and accounting earnings management are useful tools to manage earnings. Burgstahler and Dichev (1997) show evidences that managers manage earnings to avoid loss and profit decline by using real earnings management and/or accounting earnings management. Managers may engage in a variety of earnings management patterns. One of earnings management patterns is income smoothing. Income smoothing is a very popular strategy among earnings management (Scott, 2006). Prior research has argued that income smoothing can occur as rational activities (Lambert, 1984; Trueman and Titman, 1988). From contracting perspective, risk-averse managers prefer a less variable bonus stream, other things equal. Consequently, managers may smooth reported earnings over time so as to receive relatively constant compensation. Efficient compensation contracting may exploit this effect, and condone some income smoothing as a low cost way to attain the managers' reservation utility. To illustrate this, suppose the agent is risk averse and his utility function is additively separable over time. Further assume that his compensation depends only on the reported profits of each period and that the "unmanaged" profits are independently distributed over time. In this case, if the agent's compensation is linear or concave, he will want to adjust first-period outcomes that are extremely high (low) downward (upward). This behavior corresponds to "income smoothing". Moreover, firms may smooth reported net income for external reporting purposes. Income smoothing can convey private information to the outside by enabling the firm to communicate its expected persistent earnings power. A smooth car ride is not only comfortable, but it also reassures the passenger about the driver's expertise. Graham et al. (2005) report that 78% of managers would sacrifice a small, moderate, or large amount of value to achieve a smoother earnings path. I examine Japanese manager's income smoothing activity through real earnings management and/or accounting earnings management. In this paper, I examine manager's use of real and accounting earnings management to smooth earnings. A real earnings management has been considered as good device for earnings management. Even though Accounting Standards Board of Japanese (hereafter, ASBJ), which is Japanese accounting standards setter, has set new standards to reduce accounting earnings management, such as "Impairment" and "Financial instrument" accounting standard, current accounting standards has much discretion in financial reporting. In Japanese GAAP, accounting standard for financial instrument requires managers to evaluate marketable securities with market price. Also the accounting standard for impaired asset forces managers revaluates tangible fixed asset and intangible asset which decrease value largely. …