Earnings management detection over earnings cycles: the financial intelligence in Indian corporate

It is largely believed that stock pricing is influenced by disclosure of earnings. This motivates the corporate to exercise earnings management practices. This paper aims to analyse and detect the earnings management practices of Indian firms over earnings cycles. The earnings behaviour of the firms has been analysed at three levels of earnings cycles for the pricing effect: complete, incomplete and prospective. In India, the corporate ownership model is promoter-dominated shareholders’model (PDSHM) which highlights the relevance of the study for earnings-management motivation. This paper contributes by examining earnings management of the units at three levels of earnings cycle with regard to stock pricing. Earnings cycles have been decomposed into three components: complete, incomplete and prospective. While earnings management has been studied extensively, virtually all studies have focused on firm-specific effects. This study relates earnings management to the cycle of the earnings for stock-price effect.

The cash-flow model has been used for the computation of accruals (Collins and Hribar, 1999), and D’Angelo model (for calculating discretionary accruals) has been used for detecting earnings management in the present study, being comprehensive in nature and detailed in approach. The results of the “complete earnings cycle”are measured by net income. The results of the “incomplete earnings cycle” are measured by the ratio of gross margin over sales multiplied by inventory. It yields an approximate measure of the unrealized holding gains and losses. The “prospective earnings cycle” stems from the management decision to choose a rate of income growth. Statistical tools have been used for testing the results. These include regression analysis and descriptive statistics like arithmetic mean, median and standard deviation.

An examination of the units shows that firms report more discretionary accruals (DACC) at complete cycle, i.e. when financial markets are more certain about their future prospects which influence their securities’ pricing. It verified that unrealized income and growth prospects have very little role to play in determining returns. The results indicated that each of the components of the earnings cycle has a relevance factor for returns. In complete earnings cycle, DACC had the highest significance on returns than operating cash flows (OCF) and non-discretionary accruals (NDACC). Its determination content is the highest. So, the firms report more negative DACC when financial markets are less certain about their future prospects. Stock-price responses to earnings surprises are moderated when firm-level uncertainty is high, consistent with performance being attributed more to chance rather than performance.

The present study could be confined to only top 12 profit-making corporate enterprises in the private sector in India, leaving all other enterprises due to data non-availability. Of 25 enterprises, there were public sector undertakings too which had to be excluded. The period in the study is of five years (from 2003-2004 to 2007-2008) to highlight earnings management motivation. This period is best suited to identify the effects of global recession on the practice of earnings management in India. Researchers may like to select a different time-period based on their perspective.

It is hoped that the study would improve the understanding of the manner in which the capital markets process the publicly available earnings and its components for global firms. The findings of this study are significant not only for organisations that function in India but also for other companies that are based in economies with relatively mature corporate governance mechanisms. So, the authors’ findings have important policy implications for the Western world, as the sample companies are multinationals and operate globally. Similar efforts in other countries would be rewarding in controlling the management of reported earnings and enhance the reliability and transparency of reported earnings to promote economic efficiency.

Evidence on this issue could bring a new dimension to how the capital markets interpret these reported earnings and its components (cash flows, DACC and NDACC) at different levels of earnings cycles for minority shareholders in particular. Further, the evidence could also provide insights into the economic incentives for discretionary accounting choice and disclosure of the results of these earnings cycles.

It is an original paper which highlights the earnings behaviour and its motivation in Indian corporate enterprises for earnings cycles with regard to stock pricing.