Accounting | Finance | Management | Marketing | Operations and Information Systems
Earnings Management and Measurement Error
Volume 1 | Issue 2 | December 2008 | www.business-research.or g | ISSN 1866 - 8 6 5 8
BuR - Business Research
Official Open Access Journal of VHB
Verband der Hochschullehrer für Betriebswirtschaft e.V.
Volume 1| Issue 2 | December 2008 | 149-163
Empirical evidence indicates that earnings man-
agement is widespread in practice.1 For example,
managers use accounting judgment and real trans-
actions to influence the expectations of capital mar-
ket participants and to increase their earnings-
based bonus awards.2,3 Frequently, earnings ma-
nipulation or window dressing is the consequence of
incentives based on poor performance evaluation
(Merchant 1980), i.e., the manager’s performance
measure does not correctly reflect firm value. Then,
conceptually, there are two ways to remedy the
earnings management problem:
a) directly, by performing accounting ad-
justments that yield a more congruent
overall performance measure;
1 Lev (2003) offers some illustrative examples.
2 Healy and Whalen (1999) discuss different incentives for earn-
3 See Healy (1985); Gaver, Gaver, and Austin (1995); Holthausen,
Larcker, and Sloan (1995); Klein (2002); and Leuz, Nanda, and
Wysocki (2003) for evidence of earnings management at the firm-
level, and Guidry, Leone, and Rock (1999) with respect to evi-
dence at the business-unit level.
b) indirectly, by collecting and evaluating
evidence to appraise whether or not the
manager used earnings management to
inflate reported earnings.
Essentially, (a) requires the release of a report on
the magnitude of earnings management, whereas
(b) comprises the release of a zero/one-signal that
indicates the existence of earnings management.
This paper’s objective is to analyze the effectiveness
of both approaches to addressing