Earnings Management to Avoid Earnings Decreases and Losses: Empirical Evidence from Japan

The main purpose of this study is to investigate whether and how Japanese firms manage reported earnings. We first investigate whether Japanese firm managers engage in earnings management to avoid decreases in earnings and losses by examining earnings distribution. However, the test of earnings distribution does not capture the magnitude of earnings management and does not specify the method by which earnings are managed. Then, we estimate discretionary accruals to capture the magnitude of earnings management and investigate how Japanese firms manage reported earnings. If managers of the firms engage in earnings management, we would find that discretionary accruals of these firms are unusually higher than other firms. First, this study finds that Japanese firms manage reported earnings to avoid decreases in earnings and losses. Especially, the distribution of earnings indicates that Japanese firm managers are more likely to engage in earnings management to avoid losses than the U.S. firms. Second, we find that managers control accounting accruals with discretion to increase reported earnings when pre-managed earnings are losses or decreases. Third, our results show that the prevalence of earnings management is associated with the cost of earnings management, i.e., the firms which are able to manage earnings at lower cost are more likely to engage in earnings management to move from negative pre-managed earnings to positive post-managed earnings. Finally, we present three possible explanations for the reason why Japanese firm managers are more likely to manage earnings to avoid losses than the U.S. firms.