A Diagnostic for Earnings Management by Using Changes in Asset Turnover and Profit Margin

IntroductionIdentifying earnings management is important to the users of financial statements for evaluating present economic performance, predicting future profitability, and determining corporate value. However, identifying earnings management is time-consuming and difficult, especially when there is no clear motivation for earnings management. While, in academic settings, different indexes have been used for earnings management, some recent studies have used non-discretionary accruals as a measure for earnings management. For example, Field et al. (2001) have suggested that using extant discretionary accruals may create serious inferential problems. Accordingly, this study follows a simple diagnostic of earnings management, based on Joan DuPont 's analysis in which a firm's return on assets is decomposed into asset turnover (ATO,the ratio of sales to net operating assets) and profit margin (PM, the ratio of operating income to sales). Sale is a fundamental driver of net operating assets in the balance sheet and the main drive of net operating income in the income statement. In fact, main books of financial statements' analysis are advocates of predicting accruals of income statement and balance sheet based on sale predictions. For example, Penman (2007) offers a framework for forecasting, suggesting that sale prediction is a starting point. This view which uses Joan DuPont analysis implies that there should be a constant correlation between operating sale and income in income statement and between sale and net operating assets in the balance sheet. The basis of this observation is in the articulation of the income statement and balance sheet, which ensures the effect of earnings management on operating income and net operating assets as a result of which ATO and PM move in the opposite directions. As an illustration, at a sale level, if a company has an upward earnings management because of the expense of bad debts, both net income compared with sale and net receivable value of receivable accounts compared to sale will increase.This increase in net income compared with sale leads to PM increase while an increase in net received accounts compared to sale induces ATO decrease. Also, if a company doesn't register the costs of its bad debts in a period for earnings management but faces an increase in the expenses of itsbad debts in the next period, probably for the changes in ATO and PM in the opposite direction in the next period, identifying ATO? PM leads to an increase of PM in first period as an evidence of upward earnings management and decrease of ATO in the second period as an evidence of downward earnings management (Jansen et al. 2012). According to mentioned points, changes in opposite direction of ATO and PM in the company can be a sign of potential earnings management. Specially, simultaneous increase (decrease) in PM and decrease (increase) in ATO as a diagnostic of upward (downward) earnings management will be examined in this study. Then, according to mentioned points, the following hypotheses were stated:H1a. Simultaneous increase of PM and decrease of ATO is a sign of upward earnings management.H1b. Simultaneous decrease of PM and increase of ATO is a sign of downward earnings management.Identifying earnings management through ATO ? PMis similar to non-discretionary accruals, leading to determining the growth of non-discretionary accruals of balance sheets. However, diagnosing ATO ? PM is via using an accounting model for creating more understanding about earnings management, resulted from the model of non-discretionary accruals.For example, consider the investment of a company in current operating assets in predicting sale growth in future. In this case, non-discretionary accruals are more likely positive, even when earnings management is upward; because, more investment on current capital is not necessarily along with sale growth.From the other hand, ATO? PM diagnostic is not upward earnings management. …