Earnings management in local governments under a soft control regime

Abstract

Purpose This study explores whether hard regulatory control decreases the level of earnings management in local governments. The implementation of a new regulatory approach by Norwegian authorities provides the opportunity for an empirical study.

Design/methodology/approach The authors adopt a two-stage strategy to investigate the existence of earnings management, using the Jones (1991) and modified Jones (Dechow et al., 1995) models to construct a random-effects model.

Findings The authors test the hypothesis that, given decentralisation of control, there will be an increase in opportunistic financial reporting. This study's findings suggest that this is not the case, thereby indicating that a soft control regime does not diminish discipline in municipalities.

Practical implications This study has practical implications for policymaking in the public sector. Its findings suggest that municipalities do not engage in more earnings management under a soft regulatory regime. Hence, other authorities should consider adopting a soft regulatory approach to controlling local governments and their financial reporting systems.

Originality/value This study contributes to a growing body of literature regarding earnings management by local governments. The authors investigate a hypothesis previously untested in the literature by comparing the degree of earnings management under different regulatory control regimes.