Earnings Management Using Customer Loyalty Programs

The importance of customer loyalty programs (hereafter CLP) is increasing substantially with the expanding implementation of these programs across industries and firms in Korea. This study evaluates the potential earnings management practices in the CLP related accounts. Initially, we have constructed a model that can measure a discretionary provision for CLP. This model helps us to identify discretionary management in CLP accounts, and to examine whether managers attain earnings increase by primarily reversing the reserves from CLP accounts. Our empirical tests indicate that discretionary management of CLP is related to a firm's earnings growth rate, as well as its several other characteristics including operating cash flow (OCF), corporate governance, and disclosure policy. In particular, discretionary provision of CLP is used for the purpose of either income smoothing or big bath accounting. The earnings management practices vary depending on the profit/loss status of firms and its magnitude. In additional analyses, we find that a firm's disclosure policy of netting provisions and reversals of CLP-related accounts is closely associated with the size of the discretionary provisions as well as the firm size, leverage, and its corporate governance. In conclusion, we confirm the increasing significance of discretionary accounting practices of CLP in Korean industries. Information users as well as the market regulators should be alert that the insufficient accounting/disclosure rules could not only cause severe information asymmetry between producers and users but also induce managers to attempt earnings management using CLP.