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A summary of a firm's business activities over a period of time is reported in the financial statements. They form "the basis for understanding the financial position of a business and to assess its historical and future financial performance" (Fraser & Ormiston, 2007p.1). The responsibility of preparing the financial statements of any company rests on the directors, who act on behalf of the shareholders and represent their interests. However, in the course of carrying out this function, both parties' interests may collide causing some problems.
Earnings are regarded as the most important item in any financial statement because they serve as a measure of the firm's worth, which is used to make informed business decision by its users. It is no wonder that these earnings may often be manipulated to misrepresent the actual earnings of the company, overstating them or otherwise.
This essay argues out the concept of earnings management, attempts to trace an origin and understand the extent to which its application is influenced. To achieve this, we will first understand the process of earnings management, drawing conclusions from various theoretical and empirical literatures and analyse the relationship between earnings management, debt financing and other firm characteristics with a view to find out the extent of their impact.
THE AGENCY THEORY
According to Dalton et al (2007), as cited in Nyberg et al (2010), they perceive this theory as a situation where 'managerial mischief' is likely to occur as a result of the divergence in owner's interests and manager's interests.
Mallin (2007, p.12) defines it as "a theory that identifies the relationship where one party (principal) delegates work to another party (agent)".
Eisenhardt (1989, p.58) sees it as the problems that begin when "the goals of the principal and agent conflict and it is difficult and costly for the principal to verify what the agent is actually doing".
Thus, the agency theory tries to explain the problems that occur when the interests of those running the firm (managers or agents) and those who own it (principal) are in conflict. This conflict leads to various problems and the costs incurred in monitoring managers (monitoring costs) and managing these conflicts (bonding costs) is referred to as agency costs. The agency problem has been traced to trigger earnings management that resulted in several big accounting scandals like the large energy company, Enron who omitted the activities of its special purpose entities from its financial statement in order to report greater earnings; WorldCom, with claims of fraudulent accounting practices and Arthur Anderson, in their audit practices.
Leuz et al, (2003) finds that these agents are motivated to manage earnings by reporting a false performance in a bid to hide their self-interests from investors and reduce the effect of their contribution to the firm e.g. by concealing losses or creating reserves by understating earnings in good years. Identified causes of the agency problem include:
Information asymmetry, where the managers have access to more detailed information about the business than the owners and use it to their personal benefit. Its existence is a required condition for manipulating earnings.
Opportunism or self interest suggests that the agents will not act in the best interest of the owner, as a result of their differences in preferences and tastes.
Most researches that discuss the relationship between earnings management and corporate governance use the agency theory as a basis to analyse the role of the board in affecting a firm's participation in managing earnings. (Xie et al. (2003), Frankel et al (2002), Davidson et al, 2007). It can then be said that agency theory could be suggestive for earnings management and that effective corporate governance practice should in turn reduce earnings management.
UNDERSTANDING THE EARNINGS MANAGEMENT PHENOMENA
Empirical facts suggest that earnings management (and agency theory) have widely been researched on by several academics in the past, and is still being discussed in the corporate and academic world. Some varying perspectives of the concept include:
It is defined as "a strategy of generating accounting earnings, accomplished through managerial discretion over accounting choices and operating cash flows" (Phillips et al, 2003-p.493 cited in Ronen & Yaari, 2008).
Sugata (2006 p.337), sees earnings management in the light of real activities manipulation and defines it as "departures from normal operational practices, motivated by managers' desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations".
Schipper, (1989, p.92) cited in Ronen & Yaari (2008) views earnings management as "disclosure management, which is a purposeful intervention in the external financial reporting process, with the intention of obtaining some private gain".
Creative accounting is "a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business". (Amat et al, 1999 p.2)
Earnings management is "the choice by a manager of accounting policies so as to achieve specific objectives" (Scott 2003, p.369 in Ronen & Yaari, 2008).
Naser (1993) cited in Amat et al (1999 p.3) defines creative accounting is "the transformation of financial accounting figures from what they actually are to what preparer's desire by taking advantage of the existing rules and/or ignoring some or all of them".
Healy and Wahlen (1999), as cited in Kin (2007 p.350) define earnings management "as a situation that occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers''.
The last definition seems to be the most inclusive; nevertheless, Ronen & Yaari (2008) disagree with their opinion, offering an alternative definition that "earnings management is a collection of managerial decisions resulting from not reporting the true short-term, value-maximizing earnings known to management, which could be beneficial, pernicious or neutral". This results from 'taking investment actions before earnings are realised or making accounting choices that affect earnings after they have been realised'. They attempt to divide given definitions into "white (to enhance transparency of reports), grey (manipulation within compliance levels to enhance efficiency) and black (outright misrepresentation for fraud)".
Table 1: Alternative definitions of Earnings Management.
"taking advantage of the flexibility in the choice of accounting treatment to signal the manager's private information on future cash flows"
"choosing an accounting treatment that is either opportunistic (maximizing the utility of management only) or economically efficient"
"the practice of using tricks to misrepresent or reduce transparency of the financial reports"
(Source: Reproduced from Ronen & Yaari 2008, Chapter 2.)
Following the above definitions, we can say that earnings management occurs as a result of the agency problem and the need for reporting an increased accounting profit and to meet up with earnings expectations. However, not all earnings management is considered as a fraud. As observed by Ronen & Yaari (2008), it could be a very useful tool in bridging information asymmetry about the firm's future expectations/value and is considered bad only when corporate governance is hindered to distort the truth.
Earnings management, sometimes referred to as 'creative accounting' or 'cooking the books of account', is used to explain the processes organizations undertake to manage their profits/earnings. It has been defined in many ways by many academics as 'smoothing the profits' of the firm to show a steady trend and using creative accounting principles to manage income in the favour of those who have prepared it. It can be implemented successfully through accounting methods for income recognition, stock evaluation, depreciation, amortisation of goodwill and intangibles and off-balance sheet financing, with the obvious intention of increasing reported profits and reducing reported losses.
EARNINGS MANAGEMENT AND LEVERAGE
Leverage is often defined as the amount of borrowed funds invested in a company. It is the extent to which a business employs borrowed funds in its operations and can also be referred to as 'gearing' or 'debt financing'. Leverage could be classed into operating leverage (based on its operating costs) or financial leverage (based on its capital structure), and is usually calculated as a proportion of total assets.
Leverage = Funds from third parties
(Shareholders fund + Fund from third parties)
Source: Ray Proctor (2009), p.45
The impact of debt financing on earnings management is a contentious empirical issue that has a positive and negative effect and even though past research have shown a positive relationship that a higher leverage increases earnings management through income-increasing accounting procedures, Jelinek (2007) argues otherwise. She uses managers' opportunistic behaviour to measure leverage and earnings management and shows that different levels of debt have diverse effects on actions of earnings management, concluding that an increased amount of leverage reduces earnings management.
Ahmed et al (1999), studying banks and loan loss provisions conclude that earnings management is not an important determinant in providing for loan loss, even though their acknowledged previous researches show a mixed relationship between them. They however document a change in capital regulations to which banks that fail to comply face a high cost of default as the major reason for earnings manipulation.
Murya (2010, p.181) suggests that if "understating liabilities and overstating assets is used to avoid debt covenant violations, leverage is positively related to earnings management". He considers a control using variables that measure leverage.
Watts & Zimmerman (1986, 1990) agree that leverage is a tool for earnings management. In their opinion, firms' with higher leverage are likely to employ accounting measures that seek to increase current income.
Jiang et al (2008) in Murya (2010) find that changes in leverage tend to have varying levels of impact on earnings management. This could be true as managers of highly levered firms may want to present earnings that will conceal a wrong signal and prevent any default fees.
Saleh and Ahmed (2005) in their study of distressed firms that had their debts re-negotiated in Malaysia argue that these firms were more likely to adopt an income-reducing accrual. Even more alarming is the fact that users of these statements are not likely to detect this manipulation when not clearly disclosed.
However, Becker et al. (1998) find that leverage is negatively associated with the absolute value of discretionary accruals. These studies indicate that increased leverage may provide an incentive that fosters earnings management noting that most literature on corporate governance and earnings management use leverage as a control variable.
Following the empirical debates, we cannot assume a positive or negative impact of leverage on earnings. Both sides of the argument have been supported by theory and facts in their favour, with neither side rendering a definite answer. We can however say that, depending on the financial circumstance of the firm and the position it wishes to portray, leverage could be a motive for influencing accruals with a view to manage earnings. An examination of leverage should be of importance when examining a case of earnings management.
EARNINGS MANAGEMENT AND OTHER FIRM CHARACTERISTICS
These include, but not limited to a company's fundamental variables and its corporate governance characteristics. Some of them include:
Board Size and Composition
This is directly related to the effect the size of a company's board has on its performance. It is generally agreed that a smaller board size result in more effective decisions and reasonable costs incurred in passing across information. Some empirical evidence finds no direct relationship between a firm's board size and earnings management. However, they argue that the more efficient a board is, they should be a positive relationship between size and earnings and vice versa, since larger board sizes indicate a larger proportion of independent directors. (Ronen & Yaari, 2008). In other words, the size and complexity of a large firm can make the relationship between board and earnings management doubtful.
Board of Directors/Audit Committee
In his research about earnings management and corporate governance, Xie et al (2003) find that the structure and composition of any company's directors have a role to play in the earnings management phenomena. They hypothesize that earnings management is greatly reduced when the percentage of independent directors on the board is higher than that of executive directors and when the board has a higher level of independence. Frequent board meetings also serve as a check against earnings management. The quality of the members and the effectiveness of the audit committee also help to reduce incidence of earnings management to a large extent.
Traditionally, earnings manipulation is blamed on the actions and/or inactions of auditors. Early research fail to provide sufficient relationship between audit fees paid to auditors and the firm's earnings, but recent researches have argued that fees from non-audit related services may encourage earnings management. Frankel et al (2002) find a significant relationship between firms rendering non-audit services and earnings management but a not so significant relationship between the total audit fees and earnings management arguing that audit and non-audit services have different effects on firms' earnings.
However, Larker and Richardson (2004) find little relationship between these two, saying that the relationship between audit fees and earnings restatement is dependent on the measures used to analyse the different levels of auditor independence.
A clear case of audit fees is the case Arthur Anderson, an accounting firm that received a larger amount in fees from rendering non-audit services to its client - Enron. Independence was hampered which eventually led to a collapse of the firm.
Executive Age and Career horizon
The 'horizon problem' occurs when executives nearing retirement age are less concerned with the long-run goal of the firms and are more interested in current performance. For most of these executives, the horizon problem pushes them to take decisions that show an increase in the earnings of the firm in the years before they leave, which in turn translates to increased incentive pay/bonuses for them. This results to agency costs, as the decisions taken are not for the benefit of shareholders (Davidson et al, 2007). "As executives approach retirement, career concerns become irrelevant in guiding executive behaviour and incentives from current compensation become stronger" (Gibbons and Murphy 1992, cited in Davidson et al p.48).
Holthausen et al (1995 p.31) supports this argument saying that senior executives "manipulate earnings to maximise their compensation but only in certain regions of the contract". To fight this, remuneration packages for this group of employees should be the strongest.
Research and Development costs (R&D)
As a follow up to the horizon problem, many researchers, as reported in the work of Davidson et al (2007) have found that most about-to-retire executives manage earnings and boost profitability by reducing their capital expenditure and amount spent on R&D. If according to (Yew et al 2006, p.852) findings that "R&D investment has a positive impact on firms' growth opportunities", then the impact of this is that earnings are reduced almost immediately after the executives leave the company.
Lately, compensation strategy to CEOs has been by means of stock and option holdings. This is linked to the companies reported profit and share price. Bergstresser and Phillipon (2006) suggest that insider access to the company's shares and a large option package available to exercise is enough incentive for CEOs to manipulate earnings, while Cheng & Warfield (2005, p.441) "hypothesize that managers with high equity incentives are more likely to sell shares in the future, this motivates them to engage in earnings management to increase the value of their shares to be sold", making managers with very high equity incentive are more likely to avoid reporting large positive earnings surprises. In contrast, Laux & Laux (2009) say that an increase in equity compensation doesn't necessarily increase earnings manipulation.
Generally, firms with larger size tend to have more avenues from which to manipulate their total earnings when compared with small sized firms. Many of the accounting scandals as a result of earnings management e.g. the cases of Enron, Arthur Andersen & Co, WorldCom, have been reported on firm's with very huge economic activities, large capitalizations and a larger proportion of shareholders and outside investors. This is not to say that small companies do not engage in some form of earnings management for growth purposes.
A few empirical studies have related a company's industry to its earnings management ability. Shen & Chih (2005) try to understand this relationship by studying the banking industry and earnings management across 48countries. They find that, apart from their huge capitalization and asset base, most bank face possible illiquidity crises which expose them to losses from the risk of intermediation. Banks also are very highly levered and may alter earnings to disguise 'asset substitution behaviour'; also the industry is highly regulated, making earnings management to come in as a handy tool to avoid violations.
Very strong accounting disclosure requirement, like requirements of the Sarbanes Oxley Act, is suggested to reduce these activities.
We have seen that earnings management is an untrue representation of the financial statement done for different purposes. The level of debt and several other firm characteristics impact greatly on the extent to which a firm's income is misrepresented by the executive officers, who are usually held responsible for this misappropriation.
Effective implementation and monitoring of existing accounting regulations aimed at enforcing corporate governance and bridging the gap between all the users of/parties to the financial statement is recommended.
Limitations of this paper include that the term earnings management is a general term that is difficult to coin in one single definition. Exact definitions given may be misleading and insufficient to understand the term. Also, as Jelinek (2007) pointed out, it is not easy to measure managers' opportunistic behaviours to see if an increased leverage reduces opportunism. Further research into the field of earnings management and the impact of leverage is highly recommended for a further understanding of the topic.