Why do firms manage their earnings?

Zeeshan Ahmed, Institute of Business Administration, Karachi, Pakistan

Abstract

The topic of corporate earnings management has not only generated a great deal of media attention but it also has become a source of serious concern to regulators and policymakers. In the wake of the events that shook investors’ confidence in the American financial reporting system in late 2001 and early 2002, the earnings management practices of firms have come under fire by shareholders groups, institutional investors and the financial press alike. To some extent, regulators have responded by proposing and enacting new rules and regulations1. Likewise, accounting and financial researchers are increasingly probing into this topic. Prior studies identify several such incentives, which can be broadly classified as: capital market incentives, contracting incentives, and regulation-related incentives. This article covers a brief explanation of the sources and nature of these incentives along with summary of related research findings. But before we begin on incentives, we briefly present definition and nature of earnings management.