Reference: Question: |
Background
The European Commission believes a transition from cash to accruals-based accounting is necessary to "avoid some of the window-dressing that is allowed by cash accounting, where a payment can be brought forward or postponed so as to be recorded in the period that the government chooses" (European Commission, 2013, Section 3).
The adoption of an accrual-based accounting system implies that cash flow dates will cease to influence the allocation of revenues and expenses. However, the Commission's view that accrual-based accounting will result in a reduction in “window dressing that is allowed by cash accounting, where a payment can be brought forward or postponed so as to be recorded in the period that the government chooses” contradicts the evidence in previous accounting literature, which shows that accrual-based accounting leads to greater subjectivity, increases managerial discretion, and hence increases the opportunity to manage earnings.
Those opposed to regulatory changes that would require public sector entities to transition to accrual-based accounting may try to argue that if SOEs are more active in managing their earnings, then they would be more likely to exploit the discretions available to them in an accrual-based accounting. Consequently, guidance on whether the transnational process advocated by the EU is associated with adverse effects and how the EU can best monitor or identify firms acting opportunistically from such changes is critical.
Against this background, the paper analyzes the accounting behavior of a large sample of state-owned enterprises (SOEs) in Italy that already use accrual-based accounting to gauge whether earnings management is a problem for European SOEs as mandated by the EU. Italian SOEs are an ideal sample to study the impact of state ownership on earnings management for a number of reasons. First, by selecting state-owned companies operating public services, we have a sample of entities that, both in terms of ownership and operation, are within the domain of the public sector. Second, such firms have to prepare their financial statements using accrual-based accounting using the same rules that exist for any other corporation. Third, Italian SOEs operating public services usually compete with privately owned entities and the impact of state ownership is better analyzed in a context where firms with different ownership structures coexist and compete. Fourth, in Italy both state-owned and private, unlisted companies are required to file their annual financial statements with the Firm Register Office at the Local Chamber of Commerce (Italian civil code art. 2435). This is the first paper addressing the earnings management issue in European unlisted SOEs.
Results
The results of the research show that there is no positive correlation between state ownership and earnings management and that public entities do not exploit the discretions available in accrual-based accounting more so than any other entity preparing its financial statements on an accrual basis. Consequently, the benefits that many New Public Management Reform promoters and the EU expect the public sector would obtain from a full and harmonized accrual accounting system cannot be denied on the basis of an increased risk of reduced earnings management. Furthermore, we find that the degree of earnings management is related to firm size and profitability. This provides insights relevant to regulators in targeting audit or other investigative efforts to improve the quality of public entities’ reported financial position and performance in an accrual-based regime.
Research Limitations/Implications
While this study is the first to examine earnings management in a public sector accrual accounting environment, for a sample of European firms, namely Italian firms, more research is needed into this issue examining public entities in other EU member states or public entities other than state-owned enterprises.
