Earnings Management of Firms that Disclose Earnings Forecasts through Fair Disclosure
Asian Tax Journal Vol. 10 No. 3 (2009), pp. 321-348
Abstract
Prior to Regulation Fair Disclosure (Reg FD), many firms disclosed important nonpublic information to securities analysts or selected institutional investors, before making public disclosure of the same information. Where this has happened, those who were privy to the information beforehand were able to make a profit at the expense of the general public. Thus, Reg FD was introduced in 2002 to level the playing field and thereby to reduce information asymmetry among market participants. Reg FD requires that when corporate management discloses material nonpublic information to a few privileged market participants, he must make public disclosure of that information. Reg FD specifies types of material information that trigger Reg FD obligations. One of them is forward-looking information about forthcoming earnings. Prior research conducted in the US suggests that firms beating earnings benchmarks enjoy higher returns than those missing the benchmarks. Management earnings forecasts can serve as earnings benchmarks. In addition, managers may face legal actions by shareholders and lose their reputation if they miss their earnings forecasts. Thus, managers in the US have incentives to manage earnings upward to achieve their earnings forecasts. The capital market and legal environment in Korea differ from those in the US. That is, there is no evidence that investors either penalize or take any legal action against managers who miss their forecasts in Korea. Thus, it is an empirical question whether managers who issue earnings forecasts manage earnings upward to meet or beat their forecasts in Korea. This study investigates whether Korean managers who issue earnings forecasts through fair disclosures manage earnings upward to meet or beat their forecasts. The empirical results reveal that in general discretionary accruals of the forecast year are not different from those of other years. However, when pre-managed earnings fall short of management earnings forecasts, firms use income-increasing discretionary accruals. Furthermore, discretionary accruals are positively associated with the difference between management forecasts and pre-managed earnings. These results suggest that even in Korea managers manage earnings upward when pre-managed earnings fall short of their forecasts. Prior research also suggests that strong corporate governance deters managers' income－increasing accounting decisions. However, there is no significant association between corporate governance and earnings management acitivity for our sample firms.
Keywords
- Reg FD
- selective disclosure
- information asymmetry
- management earnings forecasts
- earnings management
- discretionary accruals
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