Earnings management in interconnected networks: a perspective

The purpose of this paper is to examine how firms manage earnings when firms are in interconnected networks, that is, when firms are interconnected to each other in a way that the survival of one firm is crucial to the survival of other firms connected to it.

The paper employs network typology to provide some insight on the earnings management behaviour of firms in regulated and unregulated networks or systems.

The author shows that firms in the inner core of interconnected networks are more likely to rely on income-smoothing behaviour as a preferred form of earnings management because it stabilises the firm’s link with other firms in the network. In regulated networks, the author proposes a negative relationship between a firm’s network centrality and the number of earnings management strategies the manager can adopt. Also, the author proposes a positive relationship between a firm’s network centrality and the propensity to smooth earnings or income when firms are concerned about their reputation or regulatory scrutiny.

This paper is a brief note on earnings management, and is the first study to provide a perspective on how earnings management can be explained using a network typology.