Method‐Shifting in Aggressive Earnings Reporting: The Case of the US Software Industry's Response to New US Regulation

Abstract

Under rationality, firms should shift to alternative earnings management methods to achieve their earnings management goals whenever the alternatives provide greater benefit. New accounting regulation can alter the net benefit derivable from existing earnings management methods and thus may provide the impetus for method-shifting. This study investigates whether firms circumvent regulatory-imposed restrictions on their use of specific methods for accelerating earnings by shifting to alternative methods. Specifically, the study examines whether the US's adoption of a reporting standard that placed restrictions on the recognition of software revenue prompted US software-firm managers to method-shift to expense components for accelerated earnings reporting. A comparison of discretionary revenue and expense accruals and discretionary R&D expenses before and after the adoption of the standard confirmed a reduction of accelerated revenue recognition after the adoption and supported the hypothesized method-shift to expense components for accelerated earnings reporting. Copyright (c) 2010 Blackwell Publishing Ltd.

The impact of director blockholders on abnormal accruals and inventory

“…Our paper adds to the literature regarding both blockholders and the board of directors' role in providing corporate governance, suggesting that director blockholders are helpful in preventing agency problems in a firm. Previous studies have shown that outside blockholders cannot prevent earnings management and may increase the number of abnormal accruals reported by a firm (Guthrie & Sokolowsky 2010;Zhong et al, 2007). This study shows that, unlike outside blockholders, director blockholders can limit earnings management.…”

“…While one would expect that outside blockholders could limit these accruals due to their role as a corporate governance mechanism, research has shown that outside blockholders typically have little to no impact on lowering abnormal accruals. Zhong et al (2007) assert that firms with declining financial performance tend to manage earnings upward, and pressure to perform for outside blockholders tends to increase this earnings management. Guthrie and Sokolowsky (2010) support this finding by showing that firms with outside blockholders tend to increase abnormal accruals during an SEO more than firms without large outside blockholders.…”

Accrual management as an indication of money laundering through legally registered Mafia firms in Italy

“…In confirmation of this, in a following study, Stubben (2010) finds that revenue accrual models are more likely than aggregate accrual models to detect a combination of revenue and expense manipulation within a sample of firms subject to SEC enforcement actions. On the other hand, Zhong et al (2010) show that US software firms' method shift from revenue accrual management to expense accrual management in response to the issuance in 1997 of a new reporting standard (SOP 97-2) that places restrictions on the recognition of software revenue. Hence, following previous research (Caylor, 2010;Stubben, 2010;Zhong et al, 2010;Capalbo et al, 2014), this study measures accrual management by estimating discretionary revenue accruals (DREVAC), discretionary expense accruals (DEXPAC) as well as discretionary aggregate accruals (DACC).…”

“…On the other hand, Zhong et al (2010) show that US software firms' method shift from revenue accrual management to expense accrual management in response to the issuance in 1997 of a new reporting standard (SOP 97-2) that places restrictions on the recognition of software revenue. Hence, following previous research (Caylor, 2010;Stubben, 2010;Zhong et al, 2010;Capalbo et al, 2014), this study measures accrual management by estimating discretionary revenue accruals (DREVAC), discretionary expense accruals (DEXPAC) as well as discretionary aggregate accruals (DACC). In essence, the authors consider that LMFs may resort to a combination of revenue and expense manipulation, for example, through fictitious transactions, in order to achieve their illicit purposes.…”

“…It is noteworthy that the definition of total expense accruals, included as dependent variable in Equation ( 4), is in line with that adopted in the aforementioned study of Zhong et al (2010). However, Zhong et al (2010) remove the non-discretionary component of expense accruals by adding specific control variables in the final regression model estimated to test differences in accrual management between software firms and non-software control firms. In contrast, this study first isolates the discretionary component of expense accruals (DEXPAC) by computing the residuals of the Equation (4) model.…”