Importance of earnings

Corporate managers periodically report accounting information such as their company's operating results and financial conditions to shareholders, creditors, governments and other external stakeholders through documents such as financial statements. Among accounting figures, earnings are a measure that reflects a company's business performance in an aggregate manner, and has an important meaning for managers. In other words, earnings are used by investors to assess the value of a company and to evaluate the performance of managers, and the amount of earnings has an economic impact on corporations and managers. In general, high earnings tend to create favorable results for companies and managers, such as rising stock prices and increased management remuneration, while low earnings tend to create unfavorable results, such as falling stock prices, reduced management remuneration, and dismissal of managers. However, excessive earnings can also lead to unfavorable consequences such as new entry by other corporations, stricter government regulations, demand for higher wages for workers, and higher tax payments. In this way, since the economic outcome changes depending on the amount of earnings, managers have an incentive to adjust earnings.

Methods for adjusting earnings

The behavior of managers to adjust earnings within the provisions of accounting standards is known as earnings management. Earnings management is not fraudulent accounting because it is discretionary behavior performed within the scope of the provisions of accounting standards. However, care should be taken when engaging in earnings management because it may falsify accounting figures and mislead stakeholders when making decisions.

Now, how do managers adjust earnings? Normally, earnings management measures are categorized into real discretionary behavior and accounting discretionary behavior. Real discretionary behavior is behavior that adjusts earnings through manipulation of business activities, and accounting discretionary behavior is behavior that adjusts earnings through accounting manipulation (see [Table 1] for specific examples).

[Table 1] Definitions and specific examples for each earnings management

Method	Definitions	Specific examples
Real discretionary behavior	Adjusting earnings through manipulation of business activities	・Increase sales volume through temporary discount ・Adjust research and development expenses, advertising expenses, etc. ・Engage in excessive production that reduces manufacturing costs ・Sell fixed assets with unrealized gains/losses
Accounting discretionary behavior	Adjusting earnings through accounting manipulation	・Change the inventory valuation methods ・Change the method of calculating depreciation ・Adjust the estimate of allowances ・Adjust the estimate for impairment of fixed assets

Although earnings management is being actively researched in countries around the world, the majority of this research focuses on accounting discretionary behavior. Consequently, little progress has been made in clarifying real discretionary behavior. The reason for this is thought to be that accounting discretionary behavior is likely to be linked to fraudulent accounting and attracts a great deal of attention. However, in order to comprehensively understand the earnings management behavior of managers, it is necessary to clarify not only accounting discretionary behavior, but also real discretionary behavior. Furthermore, real discretionary behavior that manipulates business activities for the purpose of adjusting earnings is not optimal management decision-making. It has a serious impact on corporate value, and may even have a negative impact on the national economy. It has also been pointed out that due to stricter accounting systems in many countries around the world in recent years, accounting discretionary behavior has decreased, and real discretionary behavior has increased as an alternative, and there emerges an urgent need to clarify the behavior.

Empirical analysis of real discretionary behavior

In my research thus far, I have attempted to clarify the real discretionary behavior of Japanese corporations. Specifically, I have conducted analysis from the following three perspectives: (1) implementation status of real discretionary behavior (whether real discretionary behavior is being implemented), (2) economic consequences of real discretionary behavior (what kind of economic effects will be incurred to corporations by real discretionary behavior), and (3) factors of real discretionary behavior (what factors influence real discretionary behavior). My research method is empirical analysis using archival data, and my research style is quantitative analysis using a large amount of financial data and stock price data. The results of my analysis were as follows.

Firstly, regarding the implementation status, I found that managers of Japanese companies are implementing real discretionary behavior in order to avoid losses and earnings decreases. Such behavior has been observed in other countries as well. It seems that corporate managers, both domestically and internationally, are taking real discretionary actions to avoid losses and earnings decreases.

Secondly, regarding the economic consequences, it was found that real discretionary behavior by Japanese corporate managers has a negative impact on future business results and stock prices of their corporations. The negative economic impact of real discretionary behavior has been confirmed in previous studies in Europe and the United States, and manipulation of business activities for the purpose of adjusting earnings is highly likely to have a negative impact on future business performance and evaluations in a stock market.

Thirdly, regarding factors, I found that Japanese corporate managers are influenced by factors such as contracts, the securities market, and corporate governance. For example, I observed that larger corporations do not increase earnings through real discretionary behavior in order to avoid stricter government regulations and increasing tax payments. Additionally, I obtained the result that earnings are increased by real discretionary behavior in the fiscal year prior to issuing securities so that conditions for capital increases and bond issuances are favorable. Furthermore, I also observed results suggesting that managers increased earnings through real discretionary behavior in the year before retirement in order to increase final manager compensation. In other words, it can be said that real discretionary behavior is influenced by various factors.

Summary and future issues

I have clarified that real discretionary behavior is being implemented, that it will adversely affect future performance and stock prices, and that it is affected by various factors such as securities issuance and corporate governance. It would bring me great pleasure if the findings regarding real discretionary behavior that I have clarified so far are useful for the decision-making of managers and investors, and if they are of assistance in institutional design.

However, there are still many unexplained aspects of real discretionary behavior, and it is necessary to continue to conduct further research in the future. For example, in recent years, it has become relatively easy to use international data, and international comparative research that analyzes not one country but multiple countries is attracting attention. Through international comparative research, it is possible to clarify how different systems, cultures, etc., in each country impact real discretionary behavior of managers. Such international comparative research will be a major research topic, and will further deepen our understanding of real discretionary behavior.

Furthermore, accounting discretionary behavior has yet to be fully clarified. I am very interested in what methods and motives management uses to adjust earnings when making financial reports.

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*This article is an overview of my book Earnings Management in Japanese Firms: Empirical Analyses of Real Discretionary Behavior (Chuokeizai-Sha, 2021).

Tomoyasu Yamaguchi／Professor, Faculty of Commerce, Chuo University
Areas of Specialization: Financial Accounting and Empirical Accounting

Tomoyasu Yamaguchi was born in Chiba prefecture in 1977. He graduated from the Faculty of Economics, Fukushima University in 1999. He completed the Master’s Program and the Doctoral Program in the Graduate School of Economics and Management, Tohoku University in 2008 and 2011, respectively. He holds a Ph.D. in management. He served as a Full-Time Lecturer, Associate Professor, and Professor in the Faculty of Business Administration, Tohoku Gakuin University before assuming his current position in 2022.

His current research theme is the clarification of the earnings management behavior of corporate managers.

His major books include Earnings Management in Japanese Firms: Empirical Analyses of Real Discretionary Behavior, (Chuokeizai-Sha, 2021, sole author). He has received the 65^th Nikkei Prize for Excellent Books in Economic Science, the 81^st Ota-Kurosawa Award from the Japan Accounting Association, and the 2022 Literature Award from the Japanese Association of Management Accounting.

His major papers include “Earnings management to achieve industry-average profitability in Japan,” Asia-Pacific Journal of Accounting and Economics (2022, sole author). “A cross-country study on the relationship between financial development and earnings management,” Journal of International Financial Management and Accounting (2018, co-author), “Discontinuities in earnings and earnings change distributions after J-SOX implementation: Empirical evidence from Japan,” Journal of Accounting and Public Policy (2017, co-author), “Accrual-based and real earnings management: An international comparison for investor protection,” Journal of Contemporary Accounting and Economics (2015, co-author), and more.

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