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The Role of Earnings Management in Equity Valuation

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Encyclopedia of Finance

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Abstract

The intrinsic value of a firm’s equity is determined by the present value of future payoffs to equity-holders. Thus, to estimate equity value, one needs to identify and process a series of information that is relevant to the present value of expected future payoffs. Among the value-relevant information, earnings pertain to a summary measure of firm performance and thus play a key role in the equity valuation. Nevertheless, it is not uncommon in practice that firm managers either intentionally or unintentionally misreport earnings, making valuation challenging for outsiders. This chapter aims to explore the role earnings management plays in equity valuation, and how market participants may detect and adjust for misreported earnings, if any, in their forecasts and valuation for a firm. The chapter is organized to comprise the following sections: (i) varied managerial incentives for earnings management; (ii) various tactics of earnings management via accruals manipulation; (iii) various tactics of earnings management via real activities manipulation; (iv) consequences and determinants of earnings management; (v) trade-off between accruals manipulation and real activities manipulation to manage earnings; (vi) how to discern and measure earnings management; (vii) introduction of various equity-valuation models; and (viii) how to adjust for the effects of accruals-based and real earnings management in equity valuation.

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Notes

  1. 1.

    Throughout this chapter, all the accounting standards and policies mentioned are based on the general accepted accounting principle (GAAP).

  2. 2.

    It is worth noting, though, that unlike GAAP, the International Financial Reporting Standards (IFRS) No. IAS 38 stipulate that research and development expenditures that meet certain specified criteria can be capitalized as an intangible asset. Further details can be found via the link: https://www.ifrs.org/issued-standards/list-of-standards/ias-38-intangible-assets/#about

  3. 3.

    Pursuant to IFRS No. IAS 2, inventories are measured at the lower of costs and net realizable value, the latter of which equals the estimated selling price minus the estimated costs of completion and the estimated costs to sell. Details can be found via the link: https://www.ifrs.org/issued-standards/list-of-standards/ias-2-inventories/. According to IFRS No. IAS 36, if the carrying value of noncurrent assets (e.g., goodwill, PPE) exceeds their recoverable value, the assets should be impaired to their recoverable value, which is the lower amount of (i) fair value less costs to sell and (ii) value in use. The impairment losses can be reversed for the assets, except for goodwill, under the guidance of IFRS, whereas the reversion is not allowed if a firm follows GAAP. Further details can be found via the link: https://www.ifrs.org/issued-standards/list-of-standards/ias-36-impairment-of-assets/

  4. 4.

    Surplus free cash flows might induce agency problems in which managers use the cash flows for self-serving purposes.

  5. 5.

    Throughout this chapter, we take operating activities as, in broad sense, including investing activities. As such, operating accruals are in themselves inclusive of investing accruals.

  6. 6.

    The parameter estimation for Model (1) (as well as the follow-up Models (2, 3, 4, 5, 6, and 7) used to estimate various types of earnings management) may incorporate a scaled intercept to mitigate potential heteroskedasticity attributed to the variation in the scaling variable (i.e., total assets) (e.g., Kothari et al. 2005; He 2016).

  7. 7.

    For example, if we speculate that the firm’s liquidity and solvency positions will plausibly deteriorate in the near future, we need to first gauge the extent to which WACC will increase in consequence, and then estimate how large the estimated equity value per share will decrease as a result of the increase in WACC. On the other hand, if we are certain that the firm’s liquidity and solvency positions will deteriorate, we should factor this into our estimation of discount rate (i.e., WACC) rather than in the sensitivity analysis.

  8. 8.

    The same rationale and approach can be applied when we assess the role of downwards accruals manipulation in our forecasting and valuation.

  9. 9.

    We may use the similar approach to assess the role the downwards real earnings management plays in the forecasting and valuation.

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Authors and Affiliations

  1. Department of Accounting, Durham University, Durham, UK

    Guanming He, April Zhichao Li & Dongxiao Shen

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  1. Guanming He
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  2. April Zhichao Li
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  1. Department of Finance & Economics, Rutgers University, Piscataway, NJ, USA

    Cheng-Few Lee

  2. Center for PBBEF Research, Phoenix, AZ, USA

    Alice C. Lee

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He, G., Li, A.Z., Shen, D. (2022). The Role of Earnings Management in Equity Valuation. In: Lee, CF., Lee, A.C. (eds) Encyclopedia of Finance. Springer, Cham. https://doi.org/10.1007/978-3-030-91231-4_90

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