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Earnings management has been a debatable topic to researchers, regulators, standard setters, and investors in the 21st century. It raised a great concern among the stakeholders because of some accounting practices that threaten the quality of corporate financial reporting and erode public confidence in the reported earnings. Managers have a tendency to avoid the release of bad earnings news at times of earnings announcements and as such managers can manipulate earnings through discretionary accounting choices (accrual-based earnings management) or by structuring real transactions and/or changing their timing (real earnings management). A vast financial reporting literature examined accrual-based earnings management with little attention to real earnings management. This study examined the determinants of real earnings management through real activities in the listed industrial goods firms in Nigeria. The study covers a sample of 10 industrial goods firms for a period of 7 years (2009-2015). The study employed correlational research design and panel regression technique of data analysis. The study found after controlling for firm size that firm leverage, ROA, board size and board composition have significant statistical negative effect on real earnings management in the sample industrial goods firms. The findings also revealed that institutional ownership have an insignificant positive effect on real earnings management during the period covered by the study. The study also found that audit quality (proxy by auditor-type, Big4 and Non-Big4) has an insignificant positive effect on real earnings management of the listed industrial goods firms in Nigeria. The study recommends that the regulators and policy makers in Nigeria should consider real earnings management when making policy to minimize managerial opportunistic practices in corporate reporting. The study also recommends that the Securities and Exchange Commission and NSE should review the code of corporate governance by increasing the composition of the board of directors of listed companies. This could improve the corporate governance quality and its ability to constrain earnings management in all its forms.
TABLE OF CONTENTS
Table of contents vii
List of Tables ix
CHAPTER ONE: INTRODUCTION
1.1 Background to the Study 1
1.2 Statement of the Research Problem 6
1.3 Research Questions 8
1.4 Objectives of the Study 9
1.5 Research Hypotheses 9
1.6 Significance of the Study 10
1.7 Scope of the Study 12
CHAPTER TWO: LITERATURE REVIEW
2.1 Introductions 13
2.2 The Concept of Earnings Management 13
2.3 Determinants of Real Earnings Management 21
2.4 Review of Empirical Studies on the Determinants of Real Earnings Management 30
2.5 Theoretical Framework of the Study 35
CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction 40
3.2 Research Design 40
3.3 Population of the Study 40
3.4 Sample Size of the Study 42
3.5 Sources and Method of Data Collection 42
3.6 Techniques of Data Analysis 42
3.7 Variables Measurements and Models Specification 43
CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS
4.1 Introduction 47
4.2 Descriptive Statistics 47
4.3 Analysis of Inferential Statistics 54
4.4 Discussion of Major Findings 72
4.5 Policy Implications of the Findings 74
CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATION
5.1 Summary 75
5.2 Conclusion 76
5.3 Recommendation 77
5.4 Limitations and Area of Further Research 78
1.1 Background to the study
Accounting information has been the major input in capital allocation decisions of investors and lenders in the capital markets. Specifically, accounting earnings remain the strategic financial statement variable for assessing firm‟s viability and future prospects. For accounting earnings to be useful and relevance to investors and lenders it has to be of higher quality, that is, free from errors and material misstatements. Accounting information particularly the “earnings” indicate firm‟s direction, reduces information asymmetry and ensures efficient capital allocation. This is achievable only if the managers did not interfere with the financial reporting process. The incidences of corporate failures that are related to creative accounting practices has raised concerns and remain a topical to researchers, regulators, standard setters, and investors in the 21st century and during the last two decades in particular. This rising concern among the stakeholders is not unrelated to some accounting practices that threaten the quality of corporate financial reporting and erode public confidence in the accounting profession. It also raised concerns about the reliability and credibility of financial reporting globally (Ge & Kim, 2013).
Corporate financial reporting is the management‟s responsibility, through which the managers communicate their stewardship performance to the owners and other stakeholders. Several researches on Capital Market are of the view that stock market responds favorably to earnings news when reported earnings meet or beat earnings expectations, while it reacts unfavorably when reported earnings fall short of earnings benchmarks. To avoid unfavorable reactions, managers have a tendency to avoid the release of bad earnings news at times of
earnings announcements (Ge & Kim, 2013). As such managers can manipulate earnings through discretionary accounting choices (accrual-based earnings management) or by structuring real transactions and/or changing their timing (real earnings management). Earnings management is known in increasing information asymmetry between managers and outsiders and hide firm‟s unmanaged economic performance, thereby eroding financial reporting reliability and credibility. Bello (2011) argues that earnings management in whatever form is misrepresentation of true fact and figures of accounts which lead to a number of recent corporate collapses that erode shareholders confidence on the reported companies‟ financials. Moreover, Yero (2012) posits that, management report managed earnings to manipulate information asymmetry and misguide ill-equipped users.
There are many advantages attached for managing accounting earnings by corporate managers; for instance, managers might concentrate their efforts in tax planning to manage earnings and attempt to minimize the tax effects over time. Essentially, the conflict of interest between shareholders‟ and managers could encourage managers to use a certain degree of flexibility provided by accounting standards to manage earnings, and create distortions in the earning figures reported in the financial statements. This is in the corporate managers‟ efforts to influence short-term share price performance; or minimize earnings fluctuations in order to show better or more stable financial results.
The prevalence of corporate accounting scandals has changed the public perception of earnings management, as well as, the objective of corporate governance, which stop corporate managers from engaging in improper accounting activities for their own benefits. Financial reporting quality literature have documented a variety of accounting activities that manager‟s use whenever they engage in activities to manipulate earnings.
According to Gunny (2010) these activities include actions that managers may undertake to change the timing or structuring of an operation, investment and financial transactions. Specifically, Roychowdhury (2006) with regards real earnings management enumerated the management of sales, reduction of discretionary expenses, overproduction and reduction of R&D expenses. Though researchers especially in Nigeria ignored real earnings management, Kim and Sohn (2012) reveals that real-based earnings management has more damage than accrual-based earnings management, furthermore, it has both direct and indirect consequences on current and future cash flows of the business. They added that real earnings management activities are more difficult to be detected than accruals-based earnings management and are normally less subject to external monitoring and scrutiny. They also argue that real earnings management are more difficult for average investors to understand that make them into believing that business has achieved the targeted normal business goals.
Majority of the earnings management literature investigated how management used discretionary accruals to achieved desire earnings in a desired period. Therefore, the present study is motivated by the present research trend which less attention is giving toward investigating real earnings management. And also recent stakeholders concern about earnings management which is accepted by standard setters, practitioners and regulators, that earnings management can be detriment to corporate entities. As such, regulators and standard setters around the world have considered the extensiveness of earnings management to be a major concern for the reliability of published financial statements (Jiraporn, Young & Mathur 2008). This prompted standard setters, regulators and the academia to embark on the factors that determine earnings management in different sectors and industries. Some of the empirical studies considered corporate governance in terms of board of directors monitoring mechanisms as major
determinant of earnings management, while others pointed institutional ownership, performance, audit quality and financial structure of a firm.
For instance, with regards to the financial report quality, Watts and Zimmerman (1986) opine that audit of reported financial accounting numbers serve as monitoring mechanism which protect and minimize information asymmetry between general stakeholder and the managers, and assure the general stakeholders that reported accounting numbers are free from material error and misstatements. Furthermore, audit is one of the critical determinants of earnings management which improve the quality of accounting numbers and increase the confidence level of the financial statements user. However, Heirany, Sadrabadi and Mehrjordi (2016) indicate that attention given the corporate governance issues is assumed to control managers‟ irregularities manipulation of accounting information and this consequently increases the quality and reliability of their financial reporting. Nadia (2015) argues that institutional investors have the opportunity, resources and capacity to monitor and influence the decisions of managers, these investors can control the process of preparing financial statement and prevent managers from behaving in an opportunistic manner, through an aggressive management of earnings, thus ensuring a better quality of account information.
Similarly, a review of studies on earnings management highlights that corporate financial structure is also among the determinants of earnings management. For example, Jelinek (2007) and Wasimullah, Toor and Abbas (2010) provide evidence that leverage limit earnings management; according to Jelinek (2007), increase in debt in firm‟s capital structure reduce opportunistic earnings management for two reasons. First, leverage required debt repayment, thus reduces cash available to management for non-optimal spending; secondly, when a firm employs debt financing, it undergoes the scrutiny of lenders and is often subject to lender-
induced spending restriction (Jensen, 1986). Lastly, firm‟s financial performance is usually seen as one of the main determinants of real earnings management; for instance, Roychowdhury (2006) argues that managers exercises real earnings management such as sales manipulation and overproduction in order to avoid reporting losses, or reporting good performance.
In addition, a survey and interviews of 400 executives of U.S. firms by Graham, Harvey and Rajgopal (2005) found that executives‟ managers would rather take economic actions (real earnings management) that could have long-term consequences than make accounting adjustments (accrual-based earnings management) to hit earnings targets. Out of the total survey participants, a total of 80% of surveyed executives stated that, in order to deliver earnings, they would decrease research and development, advertising, and maintenance expenditures, even though these actions damage firm value in the long run.
However, it is the debate in the earnings management literature and its determinants that this study intends to critically evaluate determinants of real earnings management in the listed industrial goods firms in Nigeria. Moreover, previous researches on earnings management have concentrated on other sectors, leaving industrial goods sector receiving little attention.
The industrial goods sector of the Nigerian economy, where previous studies have not sufficiently emphasized on. The listed industrial goods sector is of interest, since it has been argued that industrial goods manufacturing firms are more prone to earnings manipulation and more precisely through real activities manipulations and structuring; due to two main reasons. One industrial goods firms have the largest volume of production and operating activities due to the nature of their products, which is more susceptible to manipulations than firms in other industries; two, there is wider rooms for subjective judgments managers must undertake concerning expected production costs and discretionary expenses.
From the structuring and manipulation of operating activities perspective within the listed industrial goods firms, the analysis of sales manipulation, overproduction and manipulation of discretionary expenses is critical, as they impacts on the timing and amount of reported earnings. Therefore, this presents an interesting case for examining the determinants of real earnings management in the listed industrial goods firms.
It is against this background that the present study examines real earnings management in relation to corporate financial structure, board monitoring, institutional shareholding, performance and audit quality as determinants.
1.2 Statement of the Research Problem
Corporate managers do earnings management practice either good or bad as reported in the literature. Earnings management practices according to Yero (2012) is prevalence in both developing and developed countries, and as such corporate managers as agents should be monitored and control to ensure that they do not manipulate accounting earnings at the expenses of owners.
Previous researches on earnings management in Nigeria have concentrated on other sectors, prompting a research question of whether industrial goods sector is protected to the real-based manipulation activities. Except an empirical study in Nigeria by Yero (2012) which investigate the effect of leverage on real earnings management. Hence, the present study examine real earnings management proxy by (sales manipulation, production cost manipulation and discretionary expenses manipulation) in relation to some specific determinants (financial structure, board monitoring, audit quality, institutional ownership and firm performance). This constitutes one of the gaps in the literature that this study attempt to fill. This study highlights the
methodological gap that the study intends to address. To the best knowledge of this study, only a few studies have examined the determinants of real earnings management in terms of the audit quality, financial structure, firm performance, institutional ownership and board monitoring.
Furthermore, most of the studies focus one dimension the determinants of real earnings management and provide mixed evidence. Chi et al., (2011) and Cohen and Zarowin (2010) considered only audit quality in their studies and found significant association between audit quality and accrual-based earnings management. Additionally, Chi et al. (2011) report that companies that highly encourage managing earnings engage in higher level real earnings manipulations to avoid the monitoring of accrual earnings management by big-N audit firms. On the other hand, Norhayati, Rahayu, and Noor (2013) examine the relationship between leverage and real-based earnings manipulations activities. The study discovered a negative and significant relationship between leverage and real-based manipulation. The finding reveals that companies with lower leverage have manipulate real-based earnings lower. Ge and Kim (2013) studied the effect of board monitoring on real earnings management. They found that real-based earnings management “(proxy by sales manipulation, abnormal declines in R&D expenses, and other discretionary expenses)”is better with good board governance and reduce with higher takeover protection. The overall findings of their study show that real-based earnings management is at higher level when board monitor firm strongly and takeover protection may decrease motivational factors for real-based earnings management. Moreover, Visvanathan (2008) found that majority of the corporate governance proxies are not playing greater role in decreasing real earnings management with exception of board independent; while Osma (2008) and Zhao et al. (2012), in the United Kingdom disclosed that board independent is effectively reducing real-earnings management.
One dimension of the determinants alone cannot reveal much about the strength of the determinants in relation to real earnings management. To overcome this limitation, our study constructs a comprehensive measure of the determinants from different dimensions (audit quality, financial structure, corporate governance and performance. This study also considers three divisions of real-based earnings management which are: overproduction, sales manipulation and abnormal cut of other discretionary expenses. Therefore, the scope of this study and the research design allows the research to consider how the major determinants affect real earnings management in the Nigerian industrial goods firms. To test the relation between the determinants and real earnings management, the study focuses on five mechanisms: the board monitoring, financial structure, audit quality, institutional ownership and corporate performance. The study intends to investigate how the selected firm characteristics will affect real-based earnings management.
1.3 Research Questions
The following research questions are raised to guide the study.
i. How does financial leverage affect real earnings management in the listed industrial goods firms in Nigeria?
ii. What is the effect of audit quality on real earnings management in the listed industrial goods firms in Nigeria?
iii. What is the effect of financial performance on real earnings management in the listed industrial goods firms in Nigeria?
iv. To what extent does institutional ownership affect real earnings management in the listed industrial goods firms in Nigeria?
v. To what extent does board attributes (in terms of board size and board composition) affect real earnings management in the listed industrial goods firms in Nigeria?
1.4 Objectives of the Study
The main objective of the study is to examine the effects of firms Characteristics on real earnings management in the listed industrial goods firms in Nigeria. The specific objectives of the study are to:
i. evaluate the effect of financial leverage on real earnings management in the listed industrial goods firms in Nigeria.
ii. examine the effect of audit quality on real earnings management in the listed industrial goods firms in Nigeria.
iii. examine the effect of financial performance on real earnings management in the listed industrial goods firms in Nigeria.
iv. determine the effect of institutional ownership on real earnings management in the listed industrial goods firms in Nigeria; and
v. assess the effect of board attributes on real earnings management in the listed industrial goods firms in Nigeria.
1.5 Research Hypotheses
The following null hypotheses are raised to guide the study:
H01: Financial leverage has no significant effect on real earnings management in the listed industrial goods firms in Nigeria.
H02: Audit quality has no significant effect on real earnings management in the listed industrial goods firms in Nigeria.
H03: Financial performance has no significant effect on real earnings management in the listed industrial goods firms in Nigeria.
H04: Institutional Ownership has no significant effect on real earnings management in the listed industrial goods firms in Nigeria.
H05: Board attributes has no significant effect on real earnings management in the listed industrial goods firms in Nigeria.
1.6 Significance of the Study
The study contributes to the literature on earnings management by presenting evidence on the management of real activities, which has received little attention in Nigeria. Furthermore, empirical evidence shows that some determinants are related to less accrual-based earnings management and a lower likelihood of expectation management, it is important to understand whether and how the determinants affects real earnings management.
One of the major significance of conducting the study on the determinants of real earnings management in the listed industrial goods firms in Nigeria is that, several studies (like Cohen & Zarowin 2010; Zang 2012) find that real earnings management has negative consequences, such as lower future abnormal returns on assets, abnormal operating cash flows, and Tobin‟s Q, and higher costs of equity capital. Wang and D‟Souza (2006) and Zang (2012) further lamented that real earnings management deviates from optimal business operations, hides a firm‟s unbiased earnings, and jeopardizes its competitive advantage in the long run.
Some of these empirical studies include examined corporate financial structure in relation to real earnings management in the world. However, there is limited and mixed evidence on the effect of certain determinants of real earnings management among these studies. By using more comprehensive measures of the strength of board governance, this study adds a lot to the
growing literature that examines the determinants of real earnings management. Moreover, this study differentiates from the above-mentioned studies in several ways. For instance, Osam (2008) focuses on U.K. firms, whereas this study focuses on listed industrial firms in Nigeria. The significant differences in accounting and institutional environments between these two countries suggest that the U.K. results do not necessarily hold for Nigerian firms.
The findings from this research have policy implications for regulators, standard setters, auditors, managers, investors, shareholders, students and researchers. For instance, recently, regulators have attempted to improve financial reporting quality by strengthening corporate governance, audit and corporate financial structures. On the other hand, investors and shareholder activists also call for reducing fraudulent reporting in order to enhance firm value. Hence, the findings from this study are an effort towards factors affecting fraudulent financial reporting in terms of real earnings management.
Management groups are strongly against reducing fraudulent and opportunistic practices, which is usually is in their favor. Thus, argue that these reforms may distract and disrupt management; therefore, findings from this research will provide evidence that may suggest that strengthening the determinants may have unintended adverse consequences such as opportunistic real earnings management or otherwise. Lastly, students may find this research as a source of knowledge and reference point; while researchers will find this study as a valuable source of further research and a guide for conducting empirical studies in the field of earnings management.
1.7 Scope of the Study
The following three real earnings management measures are considered: abnormal cash flow from operations (proxy for sales manipulation), abnormal production cost (proxy for overproduction), and the abnormal reduction of discretionary expenses (R&D is outside the scope of discretionary expenses in this study). On the other hand, five major determinants of real earnings management are considered in this research; BIG4 auditor type (proxy for audit quality), Board of directors‟ composition/independence and insider ownership (proxy for board monitoring), institutional ownership, financial leverage and returns on assets (proxy for corporate financial performance). These five factors are considered because they are most frequently pronounced in the industrial goods companies in Nigeria. Similarly, there was a series of reform and regulatory intervention with respect to board monitoring and audit recently in the listed companies in Nigeria, which prompted the need to examine its effect on the real earnings management. Moreover, industrial goods firms are characterized by huge capital needs due to their large nature of operations, which make them use debts; hence the need for the study of financial structure and real activities manipulations.
The study period covers seven years (2009-2015). Furthermore, the present study is limited to the listed industrial goods on the floor of the Nigerian Stock Exchange (NSE) as at 31st December, 2015. This period is chosen because it is a period immediately after the reform in the 2011 code of best practices on corporate governance in Nigeria. This has affected the monitoring of boards and the structure of corporations in Nigeria.