Investigating The Impact Of Historical Costing On Real Earnings Management: An Empirical Study

Abstract

The current study examines the relationship between Historical Cost Accounting (HCA) and real earnings management. Accounting literature argues that HCA provides a chance for manipulation. HCA creates large unrealized capital gains/losses that are recognized in income statements only when managers decide to sell such assets. This may induce managers to manipulate earnings. Moreover, managers are able to decide which assets to sell and during which period. Therefore, managers can exploit HCA in real earnings management by interfering in the structuring of asset sale transactions.

The current study aims to contribute to the ongoing debate over dropping HCA and replacing it with Fair Value Accounting (FVA). Using a sample of the 71 most actively traded non-financial firms listed on the Egyptian Stock Exchange during 2004–2010, multiple regression analysis is employed to test two main hypotheses: the income-smoothing hypothesis and the debt/equity hypothesis.

The results provide evidence that managers in the Egyptian business environment exploit HCA in real earnings management to some extent. Managers with negative earnings changes tend to use HCA to smooth earnings, while managers with earnings changes do not. Moreover, there is no evidence for managers’ use of HCA to avoid violating debt contract terms based on accounting numbers.