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Religion and the Method of Earnings Management: Evidence from China

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Abstract

Previous studies argue that religious firms are more ethical and thus engage less in accrual earnings management. At odds with the ethical view, we use a sample of Chinese listed firms and show that firms in religious regions use more real earnings management. We postulate that besides ethics, religion also proxies for risk aversion, which motivates firms to substitute accrual earnings management with real earnings management. Consistent with this view, we show that the positive (negative) association between religiosity and real (accrual) earnings management is more pronounced for firms with lower litigation risk and for firms with less reputable auditors. In addition, we use a mediation model introduced by Baron and Kenny (J Pers Soc Psychol 51(6):1173–1182, 1986) to show that religiosity affects earnings management through the channel of risk aversion. We conclude that firms choose real earnings management over accrual-based earnings management because of risk aversion, rather than ethical reasons.

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Notes

  1. A 2017 Gallup poll reveals that about three quarters of the US population, or more than 90% of the religious population, identify as Christian. Source: http://news.gallup.com/poll/224642/2017-update-americans-religion.aspx.

  2. Source: Pew’s Global Religious Diversity (2014); http://www.pewforum.org/2014/04/04/global-religious-diversity/.

  3. Global Religious Landscape (2012); http://www.pewforum.org/2012/12/18/global-religious-landscape-exec/.

  4. For instance, accrual earnings management includes inappropriate revenue recognition and “big bath” charges; real earnings management includes changes in R&D expenses, marketing and advertising expenses, and other SG&A expenses which do not truly reflect a firm’s earnings ability.

  5. McGuire et al. (2012) suggest that risk aversion may be an alternative explanation to the association between earnings management and religiosity, but they do not offer any further investigation and do not attempt to separate ethics from risk aversion.

  6. Specifically, the individual will suffer infinite losses if God really exists, but only finite losses (time, leisure, etc.) if God does not exist.

  7. ST (or *ST) tags are given to firms which report losses for two (or three) consecutive fiscal years. ST and *ST firms will be delisted if they do not report positive earnings in subsequent years; therefore, they have particularly strong incentives to manage earnings (Cai et al. 2012).

  8. Although real earnings management is relatively safe, it faces a number of limitations and is thus costly. First, real earnings management has to occur during a fiscal year, and is thus less flexible compared to accruals management; second, real earnings management is constrained by a number of factors such as competitiveness, financial health, tax consequences, and so on (Zang 2012). Finally, real earnings management may change the magnitude of future cash flows and thus may affect long-term firm performance (Graham et al. 2005).

  9. To see this, consider a manager who needs to decide the amount of accrual earnings management and real earnings management at the same time. Let w be the portion of accrual earnings management, A be the risk-aversion coefficient, R be the payoff of real earnings management, and R’ be the payoff of accrual earnings management. Because accrual earnings management is risky, R’ is a random variable with normal distribution N(a,b), where a and b are the expected payoff and standard deviation of R’ (a > 0 and b > 0). Now with a standard CARA utility function U(z) = -exp(-Az), the manager’s problem becomes to maximize E(-exp(-A(w(R’-R) + R))). The first order condition (FOC) is that the optimal amount of accrual earnings management w* = a/Ab. According to the FOC, when litigation risk or auditing risk increases, accrual earnings management becomes more risky (b increases) which leads to less usage of accrual earnings management; however, the effect is more pronounced for managers who are less risk-averse.

  10. We drop these firms to ensure that cultural differences between provinces do not affect our results, following Chen et al. (2013). Doing so reduces our sample to firms headquartered in the 23 provinces listed in Panel B of Table 1.

  11. Cohen and Zarowin (2010) use the sum of advertising expenses, R&D expenses and SG&A expenses to proxy forthe discretionary expenditures. Because according to the Chinese Accounting Standards, the advertising expensesand R&D expenses are included into the general and administrative expenses in the current period, we use the SG&A expenses to measure the discretionary expenses.

  12. Changing the 5-year window to a 3-year window yields similar results in untabulated results.

  13. We first calculate the difference between reported earnings and analyst forecast. If the difference is equal to or larger than 0 but no larger than 0.01, then we say the earnings just meet or beat the analyst forecast. We use the most recent earnings forecast before earnings announcement as our analyst forecast following Ayers et al. (2011).

  14. In untabulated results, we also use the marketization index as the measure of litigation risk, and obtain similar results.

  15. Running regressions at the firm-year level does not affect our results.

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Acknowledgements

We thank Dhvani Badwaik, the section editor (Dr. Steven Dellaportas), and three anonymous reviewers for their insightful suggestions and valuable comments. Li Wenfei thanks the National Natural Science Foundation of China (Project No. 71702038) and the Start-up Research Grant to Talented Scholars of Guangzhou University (Project No. 69-18ZX10203); Cai Guilong thanks the National Natural Science Foundation of China (Project Nos. 71790603, 71772181).

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Authors and Affiliations

  1. Business School, Sun Yat-Sen University, Guangzhou, 510275, China

    Guilong Cai

  2. School of Economics and Statistics, Guangzhou University, Guangzhou, 510006, China

    Wenfei Li

  3. Graduate School of Management, Clark University, Worcester, MA, 01610, USA

    Zhenyang Tang

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  1. Guilong Cai
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  2. Wenfei Li
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Correspondence to Wenfei Li.

Appendix

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See Tables 9, 10, 11.

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Cai, G., Li, W. & Tang, Z. Religion and the Method of Earnings Management: Evidence from China. J Bus Ethics 161, 71–90 (2020). https://doi.org/10.1007/s10551-018-3971-6

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