The relationship between real earnings management and forecasted earnings per share with overexploitation of net operating assets

Master's Thesis in Accounting

Abstract

This thesis studies a situation where balance sheet inflation limits the use of discretionary accruals in order to manage incremental profits. The inflated balance sheet appears due to the use of optional accrual items in the past periods and the accumulation of these items in the net operating assets of the companies. In such a situation, it is expected that, in order to avoid unexpected negative profit reporting (failure to realize profit forecasts), real profit management and profit forecast management are on their agenda. In order to test this prediction, the data of 243 companies, consisting of 2,233 company-year observations during the period of 2010-2018, and logistic regression with fixed effects were used. The obtained results show that when the net operating assets of the companies are overreported due to the use of discretionary accruals, the probability of managers using incremental real profit management to realize the predicted profit and also the downward management of profit forecasts in order to reduce investors' expectations increases, so that companies avoid reporting negative unexpected profits.

Key words: discretionary accruals; Decreasing profit forecasting management; real profit management; Negative unexpected profit. 1-1 Introduction The purpose of accounting is to provide information that helps investors and other users of accounting information to make their economic decisions using this information. The importance of accounting information in the capital market and the reaction of the participants in the market to the accounting information make the managers of companies to be very obsessive and careful about the information they provide in the form of financial statements to the market participants.

The consequences of the market reaction to the accounting information for managers can be very important. For example, management's performance evaluation may rely heavily on the company's stock price in the market after the release of financial statements. If the financial reports published by the company cause an increase in the price of securities in the capital market, this increase in the price of shares (and as a result, yield) will cause investors to evaluate the performance of the management positively. These evaluations will have a direct impact on the job security of managers and their salaries, benefits, and rewards.

Another consequence of the market's reaction to accounting information for management is its impact on the company's ability to finance and the cost of financing. The companies that the market has shown a positive reaction to their information have access to more resources to finance their capital projects. Also, usually, compared to companies whose information the market has shown a negative reaction, the cost of financing capital is lower for these companies.

The different consequences of the capital market to the information published by the companies make the managers of the companies have the motivation to use all their efforts so that the market welcomes the information published by them and if the company cannot meet the expectations in normal and real conditions, to take measures to avoid this reaction. The market should avoid or reduce its amount.

1-2 Statement of the problem

Previous studies (for example, Broan and Kyler [1], 2005; Matsumoto [2], 2002; Bartow [3] et al., 2002; Broan [4], 2001) have shown that managers tend to have the profit that the company reports at the end of the period, at least as much as the forecasts. which has been mentioned before by management or financial analysts. Since the lower of the actual profit than the predicted profit (which is called "negative unexpected profit [5]") leads to an adverse market reaction and causes unfavorable evaluation of management performance, companies often use strategies that reduce the probability of not realizing the predicted profit [6].

Accounting research literature has shown that companies may avoid negative unexpected profit in various ways. (Ho et al., 2012):

One of these methods is the use of discretionary accruals for incremental profit manipulation, which is known as accrual-based profit management[7]. The second method refers to real profit management[8], based on which managers take real economic actions to achieve the desired profit level.These actions can be things like reduction in avoidable expenses in the field of research and development (R&D), advertising and repairs and maintenance, as well as reduction in the cost of goods sold by increasing production in the current period.

One of the other methods of realizing the predicted profit [9] is managing the expectations of the market and investors by presenting their forecasts at a low level (profit reduction forecast [10]).

The main part of the research literature is three methods. Earnings management based on discretionary accruals, real earnings management, and forecasting earnings are considered complementary mechanisms that managers use simultaneously to try to avoid unexpected negative earnings (Barto et al. 2002; Matsumoto 2002; Barton and Simcoe [11] 2002; Bragstler and Ames [12] 2006).

However, Brown et al. Pinello [13] (2007) showed that in the process of realizing the predicted profit, the incremental profit management method through optional accrual items and the decreasing profit forecasting method are used as alternatives. Zhang [14] (2007) showed that real earnings management and accrual-based earnings management are used interchangeably. In general, this evidence shows that in order to avoid negative expected profit, the managers use this tool to realize the predicted profit in an alternative and complementary way.

Due to the limitation in using accruals for incremental profit management and also the reversal of managed accruals in the future period(s), managers are expected to manage real profit for more stable profit management. Especially in periods when there are more restrictions in the use of discretionary accruals for profit management, the realization of this prediction is more likely.

Using incremental profit management through discretionary accruals in the past period(s) causes net operating assets in the balance sheet to be exaggerated (inflated balance sheet). Therefore, the inflated balance sheet can be seen as a sign of profit management in the past periods and it can be used as a criterion to evaluate the limitations of using the discretionary accrual method for profit management in the current period. In such a situation, the management of the company turns to alternative solutions such as managing the actual profit and predicting a decrease in profit in order to realize the predicted profit. In this way, the topic of the upcoming research is to investigate the relationship between the exaggeration of net operating assets in the balance sheet (inflated balance sheet) with the management of real profit and the forecast of declining profit. 1-3 Importance, necessity and possible results of the research Identifying the mechanisms through which managers act to realize the forecasted profit is very important from the aspect of the usefulness of accounting information. While the goal of accounting is to provide information that investors can use to make appropriate economic decisions, it is important to identify channels that information can reflect the company's future prospects in a more favorable way. The results obtained from this research can help investors, analysts, and standard setters to better understand hidden messages in accounting information. If the results of the research can confirm the existence of a relationship between the inflated balance sheet and the management of real profit and the forecast of reduced profit, the users of the financial statements will be able to predict the management actions in a more favorable way and show an appropriate reaction to it. 1-4 Research Objectives The general purpose of this research is to investigate the alternative mechanisms of using discretionary accruals in order to realize the forecasted profit. Specifically, the objectives of this research include the following:

Investigation of the relationship between the exaggeration of net operating assets in the balance sheet (inflated balance sheet) and real profit management

Investigation of the relationship between the exaggeration of net operating assets in the balance sheet (inflation of the balance sheet) and the downward management of profit forecasting

1-5 main research questions

According to the contents raised in the statement of the problem, this research seeks to answer the following questions is:

What is the relationship between the decline in profit per share forecast and the exaggeration of net operating assets in the balance sheet?

What is the relationship between real profit management and the overstatement of net operating assets in the balance sheet?

1-6 research hypotheses

First hypothesis: There is a positive and significant relationship between the decline in the forecast of profit per share and the overstatement of net operating assets in the balance sheet. there is