Conference Agenda

In recent years, there has been a growing body of research on earnings management (EM) in the public sector. Much of this literature relies on established EM models and employs quantitative methods to examine accrual-based EM, highlighting evidence of such practices (Bisogno & Donatella, 2022).

This study examines real EM practices by local government employees in the allocation of COVID-19 grants from central to local governments. In doing so, it sheds light on the understudied phenomenon of real EM in the public sector, illustrating how financial decision-making during times of crisis can affect public sector accountability. Based on 11 interviews with employees from the financial department of a Norwegian municipality, complemented by archival research, the paper identifies discretionary actions involving cash flow adjustments and post-year-end entries.

Understanding how local government employees exercise discretion in financial reporting is essential for ensuring transparency in financial management and for effectively monitoring performance (Beck, 2018). By focusing on real EM in local governments, this study seeks to complement the literature on accrual-based EM in the public sector, thereby addressing a gap in our knowledge of financial practices within these organizations. The paper investigates potential EM activities, the scope of discretionary behavior, and the underlying incentives driving such actions. The exceptional context of the COVID-19 pandemic, alongside extraordinary reimbursements from central governments, provides a suitable setting for this exploration.

Public choice theory serves as the theoretical framework for understanding potential real EM in this study. It offers a lens through which to examine the motivations and incentive structures that may drive financial decision-makers to alter reporting practices in pursuit of specific outcomes. By focusing on individual and organizational self-interest within the public sector, the theory illuminate the strategic use of discretion in financial reporting. While alternative frameworks, such as institutional theory, could provide valuable insights into how norms, routines, and organizational culture influence financial behavior, this study argue for, and adopts, the EM perspective to explore how municipal managers may deliberately adjust financial reports to meet performance benchmarks.

The main finding of this study is that employees exercise discretion in their financial decision-making with the intent of achieving specific goals - most notably, in ways that result in actual cash flow alterations. This discretionary behavior is primarily motivated by a desire to meet financial targets and avoid the negative consequences of underperformance. While research on real EM in local governments remains limited, the findings of this study are consistent with prior research in the not-for-profit sector (Eldenburg et al., 2011; Wen et al., 2019; Habib et al., 2022).

This study underscores the importance of transparent financial management and highlights the need for nuanced and context-sensitive regulatory approaches. Its alignment with findings from private-sector research; and more notably, research on not-for-profit organizations and municipally owned entities, suggests a potential universality in the incentives that drive earnings management. These parallels offer valuable insights into the financial behavior of local governments and reinforce the relevance of applying EM frameworks in public-sector contexts.

Over the past three decades, accrual-based accounting has been adopted in the public sector (Cohen et al., 2019). Accrual-based accounting offers the advantage of more accurately assessing the governments’ fiscal performance while also potentially fostering the opportunistic behavior through discretionary timing of revenues and expense recognition.

Earning management, defined as “the discretion exercised by producers of financial reports within the accounting process to alter financial performance” (Donatella et al., 2024:269), has been extensively studied in private firms (Healy, 1985; Jones, 1991), yet there is comparatively less research on its determinants in public entities (Bisogno & Donatella, 2022), leaving public-sector characteristics underexplored.

We address this gap by examining factors influencing earning management in 398 local public enterprises before and after the adoption of K-IFRS. In doing so, we draw on multiple theoretical perspectives—the political budget cycle, performance management, and administrative traditions—alongside existing theories of agency and institutionalism. IFRS adoption has often been viewed as a key driver of earning management in private firms across various countries (Barth et al., 2008; Chen et al., 2010; Christensen et al., 2015). However, the literature provides mixed outcomes: some studies find decreased earning management after voluntary adoption (Barth et al., 2008), while others show an increase under mandatory adoption (Ahmed et al., 2013; Christensen et al., 2015). Such inconclusive results extend to differences between accrual-based (AEM) and real earning management (REM), as well as across developed (e.g., Barth et al., 2008; Chen et al., 2010) and emerging economies (Saona & Muro, 2018; Mongrut & Winkelried, 2019).

Building on agency and institutional theories, we posit that IFRS adoption in public settings may either reinforce or curb AEM and REM. In addition, we explore more this is contingent on political budget cycles and performance regimes. Using quasi-experimental methods—including a difference-in-differences design—we seek to enrich the literature on public-sector accounting and governance. Our findings will enhance understanding of how K-IFRS interacts with public-sector contexts and guide policymakers, practitioners, and scholars interested in the broader implications of IFRS adoption in local public enterprises.