Downward Real Earnings Management around Operating Activities: Evidence from the UK

Abstract

This thesis builds on agency theory and income smoothing hypothesis to link two lines of earnings management research, which are: (i) downward earnings management, and (ii) real earnings management (REM). Although earnings management is a well-researched area in the literature, downward REM around operating activities is widely overlooked.

Based on that, and using a large sample of UK listed firms over the period of 2010-2019, this thesis aims at investigating four main research questions, being: (i) to what extent do suspect UK listed firms engage in downward REM techniques around operating activities? (RQ1); (ii) what is the timing during the financial year in which downward REM techniques take place? (RQ2); (iii) what is the nature of the relationship between REM and accrual earnings management (AEM) in context of this thesis? (RQ3); and (iv) what is the impact of audit quality on these downward REM attempts? (RQ4).

To address these research questions, an ex-ante approach based on the theoretical framework adopted in the current thesis has been used in identifying suspect observations. That is, firms that out-perform in the first half of their financial years are considered as suspect observations. This is identified based on the percentage of change in the first half-year earnings of two consecutive years.

The results around the aforementioned research questions have been reported in two empirical chapters. While the first empirical chapter addresses the first two research questions, the second empirical chapter addresses the last two research questions

The findings of the first empirical chapter revealed that downward REM existed around suspect firms in the context of this thesis. In detail, the findings indicate that suspect firms engaged in managing production levels by under-producing and managing cash flow from operations (CFO) to pull their earnings down. However, this was less evident around discretionary expenses as a downward REM tool (RQ1). Additionally, the findings of this chapter also provided evidence of the timing of earnings management techniques being attempted towards the year end, namely in the second half of the financial year (RQ2).

Moreover, the findings of the second empirical chapter provided a new evidence based on a UK-based income-decreasing context of the substitutive relationship between real and accrual earnings management (RQ3). The findings of this chapter also indicted that high-quality audit is not effective in constraining all forms of earnings management tools in the context of this thesis (RQ4).

Finally, these findings proved to be robust to a number of robustness and sensitivity tests.

Date of Award	2022
Original language	English
Sponsors	British Council
Supervisor	Gizella Marton (Supervisor), Theresa Dunne (Supervisor) & Stavros Kourtzidis (Supervisor)