An investigation of earnings management practices in Australian firms

Abstract

Earnings management is an area in which managers are able to exercise discretion over financial reporting to achieve various objectives. Researchers have been investigating the pervasiveness of earnings management and incentives that induce earnings management. However, the evidence is mixed and studies of using Australian data are scarce. This thesis is an empirical investigation of earnings management in the Australian context addressing if and why Australian firms engage in earnings management.Based on a sample covering all ASX listed firms during the period of 2000 to 2006, this study examines the overall breadth and scope of earnings management behaviour in a broad context across Australian industry sectors and individual firms’ characteristics. The result suggests that Australian firms engage in earnings management. The level of earnings management practices in some specific industries and the association of these practices with firms’ characteristics may help the assessment and improvement of the overall quality of financial reporting.Based on a sub-sample, this study also examines whether the practices of earnings management is induced by executive compensation incentives. It extends prior research by using more relevant, recent, and large-scale compensation data to capture the dynamic relations between earnings management and different forms of executive pay. Such dynamic relations may be of interest to compensation committees in designing compensation structures that balance the incentives to improve firms’ performances with the incentive to earnings manipulation.This study also examines whether earnings management is induced by benchmark beating incentives. It extends prior research by examining under what circumstance managers are more likely to beat benchmarks. The results suggest that managers beat two earnings benchmarks: reporting profits and sustaining prior year’s earnings. More importantly, managers are more likely to exercise positive discretionary accruals to inflate earnings to beat ex post benchmarks when the true earnings are below relevant benchmarks. This will be of interest to regulators as an effective way to detect earnings management may be pronounced when the ex ante condition under which firms seek to manipulate earnings is identified.