The impact of earnings management on accounting conservatism

Abstract

This study attempts to explore and empirically examine the impact earnings management has on earnings conservatisms. I argue that in the practice of income-decreasing earning management, managers more likely accelerate the recognition of bad news in earnings than good news and it thus actually influences firms’ earnings conservatism by biasing the degree of firms’ earnings conservatism upwards. While in the practice of income-increasing earnings management, managers more likely speed up the recognition of good news in earnings while defer the recognition of bad news in earnings and it thus actually affects firms’ earnings conservatism by biasing the degree of firms’ earnings conservatism downwards. I also argue that the firms which engage in income-decreasing earnings management tend to be more conservative than the firms which engage in income-increasing earnings management.

In the empirical examination, I use the incremental bad news effect in Basu (1997) earnings regression model to measure the degree of earnings conservatism. Discretionary accruals is used to proxy for earnings management. I partition the full sample into income-decreasing sub sample and income-increasing sub sample according to the sign of firms’ discretionary accruals. The results show: (1) In Basu’s regression model, the negative discretionary accruals sub sample obtains the higher incremental coefficient on bad news than the full sample, while the negative discretionary accruals sub sample obtains the lower one than the full sample. (2) In the combined regression model, the estimated coefficient, which captures the incremental earnings’ response to bad news for the negative discretionary accruals sub sample firms, is significantly positive. The results therefore support my hypotheses.