Earnings Management: A Perspective on Methodology

In an efficient market, EM focussed on small changes and done for income smoothing should not have any effect on permanent valuation of the firm. Even if it exists it is an anomaly which should disappear if markets become efficient. In this study, by using Probit analysis and partitioning the different thresholds of EM, for India, we find that the earnings management evidence in small profits and small loss areas is rather inconclusive despite the evidence of kink. The evidence of earnings management becomes stronger for higher earnings threshold. It appears that occurrence of large number of firms with positive scaled earnings and earnings difference is largely driven by the smoothening objective rather than the earnings manipulation objectives provided the level and differences are small. As these differences get larger, the evidence of manipulation is stronger. Regulatory oversight must remain focussed on monitoring and controlling of earnings “surprises” rather than earnings management of small profits. Defining critical thresholds of earnings beyond which earnings changes will be treated as earnings surprise is also important.