Did Firms Manage Earnings more Aggressively during the Financial Crisis?

• DOI: http://doi.org/10.1111/irfi.12135
• Author: Pornsit Jiraporn,Pandej Chintrakarn,Young S. Kim
• Date: 01 September 2018
• Published date: 01 September 2018

Did Firms Manage Earnings more

Aggressively during the Financial

Crisis?*

PANDEJ CHINTRAKARN

†

,PORNSIT JIRAPORN

‡

AND YOUNG S. KIM

§

†

Business Administration Division, Mahidol University International College (MUIC),

Nakhon Pratom, Thailand,

‡

Great Valley School of Graduate Professional Studies, Pennsylvania State University,

Malvern, PA, USA and

§

Department of Economics and Finance, Northern Kentucky University, Highland

Heights, KY, USA

ABSTRACT

We investigate the extent of earnings management during the financial crisis

of 2008 (The Great Recession). Based on a large sample of 14,000 observations

across 15 years, our results show that firms managed earnings less aggressively

during the crisis. We also show a severe decline in firm value and profitability

during the crisis. Our results are consistent with the notion that, during the

crisis, firm performance was so far below the target that no amount of earnings

management would have been sufficient to reverse the poor earnings picture.

As a result, managers were less motivated to manage earnings. Furthermore,

the crisis serves as a convenient excuse for poor performance, lessening the

motivation and necessity for managers to manage earnings. Additional

analysis including fixed-effects regressions, propensity score matching, and

GMM dynamic panel data estimation shows that our results are robust and

are not driven by unobserved heterogeneity. Further analysis documents

similar findings for the Dot-com crisis in 2001 and the Asian Financial Crisis

in 1997–1998.

JEL Codes: G30; M41

I. INTRODUCTION

It has been documented in the literature that firms manage earnings when they

have incentives to do so. For instance, firms have been found to manage earnings

prior to seasoned equity offerings (Teoh et al. 1998a), initial public offerings

(Teoh et al. 1998b; Teoh et al. 1998c), and stock-financed acquisitions (Erickson

and Wang 1999). The literature also documents evidence of earnings

management for the purpose of meeting the expectations of financial analysts

* Part of this research was carried out while Pornsit Jiraporn served as Visiting Scholar at The National

Institute of Development Administration (NIDA).

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12135

International Review of Finance, 18:3, 2018: pp. 477–494

DOI:10.1111/irfi.12135

© 2017 International Review of Finance Ltd. 2017

or management (Abarbanell and Lehavy 2003; Burgstahler and Eames 2006). The

above studies investigate earnings management in the context of firm-specific

events such as IPOs and SEOs. However, much less investigated are the incentives

to manage earnings when firms are subject to market-wide severe economic

shocks. Our study fills this void in the literature and examines the extent of

earnings management during the Great Recession of 2008. Since the Great

Depression of the 1930s, the crisis of 2008 has been the most severe and had

far-reaching impacts on the USA as well as on the global economy.

As far as earnings management, how should firms respond to the negative

shocks brought about by the financial crisis? We advance two hypotheses. The

first hypothesis argues that firms have incentives to manage earnings more

aggressively during the financial crisis. During the crisis, the vast majority of

firms had poor earnings. In order to alleviate the negative effects of the poor

earnings, firms were motivated to resort to earnings management. If this is the

case, there should be a higher degree of earnings management during the

financial crisis. On the contrary,however, it can be argued that firms may manage

earnings to a lesser extent during the crisis. The financial crisis of 2008 had

strongly adverse effects on earnings. Earnings were so poor that no amount of

earnings management would be sufficient to reverse the poor earnings picture.

Earnings were so far below the expectations that, no matter how hard firms tried

to management earnings, they would not be able to meet the expectations.

Because it would not be fruitful to manage earnings during such a severe

economic crisis, managers were less likely to exercise earnings management,

resulting in a lower degree of earnings management.

Based on a large sample of over 14,000 observations across 15 years, our results

show a substantial drop in the extent of earnings management during the

financial crisis. Our measure of earnings management is the absolute value of

the discretionary current accruals (DCA), estimated by the modified Jones’

(1991) model. We also show that firm value and firm profitability declined

precipitously during the crisis. Our evidence appears to be consistent with the

notion that firms did not have incentives to manage earnings when facing such

a serious economic shock because doing so would not be enough to move their

earnings to a satisfactory level. In addition, having poor earnings when nearly

everybody else shows poor earnings as well does not hurt the firm that much.

The crisis serves as a convenient excuse for any poor performance, lessening

the incentives to manage earnings. Managers can attribute the poor earnings to

the crisis, not to their managerial skills.

Finally, we investigate whether the significant decline in earnings

management is unique to the Great Recession. In particular, we perform

additional analysis using the Dot-com crisis in 2001 and the Asian Financial

Crisis in 1997–1998. All the three crises are similar in the sense that each of them

can be classified as an economic shock. In that sense, what is found in the Great

Recession should be found in each of the other two crises as well. By contrast, it

could be argued that the Great Recession was unique as it was far more

devastating than the other two crises, thus providing different incentives than

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