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LITERATURE REVIEW
Healy and Wahlen (1999) define that earnings management/manipulation (EM) “occurs when managers
use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to influence contractual outcomes that
depend on reported accounting numbers” (p.368). EM is an intentional misrepresentation of the firm’s earnings by
its discretionary management so as to influence the decisions of other stakeholders. Earnings under EM reflect
manager’s treatments and expectations rather than the true economic value and performance by the market.
Agency problems impose the necessary conditions for EM. One of the agency problems found in research
by Beneish (1999b) is that of ineffective monitoring by both insiders (upper management and owners) and outsider
monitors (the SEC). While analysts provide information, this can be biased depending on the incentives in place.
Outside auditors are also largely considered by the market to play an important role in prevention of earnings
manipulation, but there is scant empirical evidence to support this notion. In a similar context, Richardson (2000)
considers the influence of another agency problem on EM: information asymmetry. The information asymmetry
hypothesis was originally posited by Dye (1988) and Titman and Trueman (1988). The idea here is that EM is
positively correlated to the level of firm’s asymmetric information. They provide evidence that with greater
information asymmetry regarding the firm, concerned stakeholders do not have the knowledge or ability to change
the manipulated figures.
The motivations of EM are summarized and categorized into three groups in a review by Healy and Wahlen
(1999): capital market motivations, contracting motivations, and regulatory motivations. A number of studies have
found that firms manage earnings for stock market incentives or capital market motivations (Healy & Wahlen,
1999). The behavioral threshold (benchmark) theory suggests three major criteria that the market focuses on: report
positive profit, sustain recent performance, and meet analysts’ expectations (Degeorge, Patel, & Zeckhauser, 1999).
When a firm’s earnings fall below any one of above three benchmarks, there tends be a large negative stock price
change, reflecting the reduced market confidence in the management. Firms undertake EM with the hope to
increase the stock price without being identified by auditors or SEC.
Contracts may also inspire EM because financial statements will influence resources allocation and
communications between managers and other stakeholders (Healy & Wahlen, 1999). Previous studies have mainly
explored debt contracts and compensation agreements. Debt contracts may induce EM for firms to reduce the
restrictiveness or avoid the costs associated with the covenants (Beneish, 2001). Firms may further secure cheap
external borrowing costs through EM according to the study by Dechow, Sloan, and Sweeney (1996). The bonus
hypothesis states that the management who is monitored by investors, directors, customers has strong incentives to
manage earnings on behalf of themselves and sometimes the shareholders because of their compensation benefits
(Healy, 1985; Holthausen, Larcker, & Sloan, 1995). When earnings fall under the unacceptable regions,
management tends to make up the earnings upward. On the other hand, managers are more likely to adjust earnings
downward when they are at the upper bound of the bonus contract because their extra gains are marginal and they
make the future earnings goal easier to achieve.
The regulation motivation posits that managers are induced to manage earnings to cater to the regulation to
reduce regulatory costs or increase regulatory benefits. Existing literature documents that certain industry such as
bank, insurance, as well as certain firms under special condition such as an anti-trust investigation have showed an
interest in EM to meet the various regulations (Healy & Wahlen, 1999).
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