Earnings management through loss avoidance: Does South Africa have a good story to tell?

Abstract

The purpose of this study is to determine whether South African managers manage earnings to avoid reporting small losses (small earnings decreases). The study covers all the companies listed on the Johannesburg Stock Exchange (JSE) from 2003 to 2011. In line with Burgstahler and Dichev (1997), the cross-sectional distributions of earnings and changes in earnings are examined and the distributions are shown in histograms. Previous research (using data from the United States) has shown that the distribution curve for both the earnings and the change in earnings variable had noticeably fewer observations just below zero than would normally be expected, and a significantly higher number of observations just above zero. This pattern in the distributions suggests that managers manage reported earnings to ensure that earnings do not fall below a specific threshold, this being zero or the previous year’s performance. Interestingly, and in contrast with  the previous  literature, using the Burgstahler and Dichev (1997) research model of analysis, our results show no evidence in South Africa of managers managing earnings to avoid reporting small losses or small decreases in earnings. A possible reason for this could be the relatively smaller size of the JSE (compared with stock exchanges in the United States). In addition, and more important, is the possibility that investors and analysts in South Africa may be fixated on other performance indicators, such as revenue and headline earnings per share, rather than on earnings (profits).  This study adds to the limited research on earnings management in South Africa, which is a developing economy. Furthermore, previous research shows an inverse relationship between earnings management and earnings quality. The results of this study may therefore be useful to the users and the regulators of financial reports, both are concerned with earnings for the purposes of assessing the cost of capital and how companies utilise their resources.