Earnings management and financial reports’ readability: moderating role of audit quality, cash holding, and ownership pattern

Abstract

The present study investigates how earnings management (EM) influences the readability of financial reports (readability) of top Indian firms. This study also examines whether cash holdings, audit quality, and ownership patterns moderate the relationship between EM and readability. To model this relationship, the study employs generalized methods of moments using 2184 management discussion and analysis (MDA) reports from 2017 to 2022. The paper examined earnings management under two different approaches: accrual-based [using Raman and Shahrur (Account Rev 83(4):1041–1081, 2008)] and real activity-based [using Lo et al. (J Account Econ 63:1–25, 2017)]. The study used the Gunning fog index to measure the readability of financial reports and the Smog index for robustness checks. The findings reveal that Indian firms that manage earnings publish complex MDA reports. Additionally, cash holdings, audit quality, and ownership patterns significantly moderate the relationship between EM and readability. Finally, findings show that COVID-19 pandemic has adversely affected the readability of financial reports. This study contributes to the limited number of studies in the global context, focusing on narrative accounting disclosures. On one hand, this study is the first of its kind performed in the Indian context, and on the other side, it contributes to the limited number of the literature in the global context focusing on the linguistic complexity of disclosures and its linkage with other relevant variables, especially ownership pattern, audit quality, and earnings management indicators.