Introduction of the Corporate Law Economic Reform Program

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Recent corporate failures have raised concerns about the integrity of accounting information provided to investors and the independence of auditors (Cohen et al., 2007). The major corporate collapses such as Enron, WorldCom and HIH Insurance have sparked significant pressure on management, auditors, directors, the accounting profession and governments' oversight role to review the issue of business ethics and auditor independence (Ahmed et al., 2006). These failures have led to regulatory reforms in Australia with the introduction of the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act known as CLERP 9 to promote transparency, accountability and auditor independence (Cooper & Deo, 2005).

The literature has shown that earnings management is systematically related to the strength of the corporate governance environment and severe manipulation of earnings are generally associated with loose governance (Bhat et al., 2006). Reforms by CLERP 9 have changed corporate governance enforcement through mandatory independence requirements for auditors, the strengthening of the continuous disclosure regime and a change in enforcement powers of ASIC through the extension of the civil penalty regime to individuals who are 'involved' in the breach of continuous disclosure provision with an increased fine from $200,000 to $1million. The implementation of increased independence requirements for auditors and strengthening of the continuous disclosure regime will prompt management of firms to act more diligently and with due care in respect to shareholders' interests when reporting financial matters (Robinson, 2003).

This research review investigates the association between increasing auditor independence proposed by CLERP 9 and earnings management by firms in Australia. It investigates this association by examining two groups of listed entities, using a pre/post research design covering the financial years 2003-2006. The first group of listed entities comprises of firms in the ASX 100, which are referred to in this research review as 'compliant' firms, while the second group consists of firms in the ASX Small Ordinaries Index referred to as 'emerging' firms. The two groups are selected as they are likely to behave in different ways based on their characteristics including size, media coverage, analyst following, size of holdings by institutional investors and degree of scrutiny by regulatory bodies.

1.1 Research Question

The main research question is: "Has auditor independence imposed by CLERP 9 reduced earnings management of Australian firms?" This will be tested examining the difference in accruals behavior of Australian firms during the pre-CLERP 9 and post-CLERP 9 periods. The research question is to be tested using year-by-year cross-sectional and pooled regressions of the model developed based on prior literature and theory. The modified Jones (1991) model measures earnings management as the model has a high degree of acceptance within the earnings management literature. The cross-sectional and pooled regression models are designed jointly to test the association between earnings management and corporate governance enforced by CLERP 9, measured by auditor independence. The regression model also controls for factors that might have an impact in the tests such as firm size, CEO changes, Big-4 auditors and large shareholding.

1.2 Motivation

In a recent commentary, Justice Owen emphasized the importance of the audit function for the capital market as a whole and the reliance placed on the audit function by users of financial statements (Robinson, 2003). Justice Owen made several recommendations aimed at enhancing the audit function, including the appropriate standard of independence, the provision of non-audit services and the relationship between auditors and their clients. The series of corporate scandals in 2000-2002 eroded trust in financial reports and in auditors. One of the objectives of CLERP 9 is to strengthen independence in auditors and to restore integrity of financial reports by curbing earnings management and accounting fraud. Therefore, the extent of earnings management prior to CLERP 9 and the effect of the CLERP 9 "event" on earnings management is an important research topic. Thus, the primary motivation of this research report is to examine the change in earnings management in the period leading to CLERP 9 compared to after CLERP 9. This research is motivated by the desire to understand the effect of corporate governance enforcement by CLERP 9 on earnings management in Australian firms.

The secondary motivation is to examine whether reforms by CLERP 9 to address auditor independence have weakened the auditor's economic bond with the client, thus lowering earnings management. There are substantial amounts of research in the audit literature that suggest that audit efficiencies are gained from knowledge spillovers when non-audit services are jointly provided with an audit and thus, it becomes in the best interests of audit companies to provide both audit and non-audit services to their clients (Solomon, 1990). CLERP 9 has been introduced to control the provision of non-audit services and enhance the integrity of financial reports. Accordingly, this research examines the relation between auditor independence and earnings management in the period incorporating the introduction of CLERP 9 in an event study approach.

1.3 Contribution

The most significant contribution of this research is in investigating the effects of CLERP 9 reforms on earnings management in "compliant" and "emerging" firms. The impact of CLERP 9 on emerging firms is important to study as well since in a recent article published in Alan Kohler's Eureka Report, financial education consultant, Scott Francis analyzed the recent performance of the small cap segment of the Australian share market and stated that the recent returns have been strong with the ASX Small Ordinaries Index outperforming the ASX 100 by 18% in 2009. However, the Small Ordinaries Index underperformed the ASX 100 by 16% in 2008 (Francis, 2009).

This shows the intense competition between the two indices and also shows the potential growth of the emerging firms in the Small Caps Index. In order to maintain strong growth rates and acquire more capital in the market, these firms are also likely to engage in earnings management. Therefore, this research will provide evidence relating to the efficacy of CLERP 9 reforms in addressing auditor independence and whether increasing auditor independence constrains earnings management in these firms. By examining two different groups of firms, this study will provide an insight into earnings management of these firms in the period prior to CLERP 9 and the period after CLERP 9. This study also contributes to existing literature on auditor independence, by providing evidence in whether auditor independence constrains earnings management practices in compliant and emerging Australian firms.

The study also provides an insight into whether emerging firms react differently to compliant firms in terms of earnings management, during the study periods before and after the enactment of CLERP 9. Regulatory reforms from CLERP 9 have different implications for different types of firms and through comparison of emerging firms with complaint firms, it is expected that earnings management has declined significantly for some group of firms, whilst others have continued in managing earnings. As mentioned earlier, both the groups have different external factors affecting them, hence it will be interesting to examine the reaction of both groups after the enactment of CLERP 9.


2.1 Earnings Management

Earnings management has various definitions commonly classified as white, gray, or black. "Beneficial" (white) earnings management enhances the information value of reports by conveying private information; the "pernicious" (black) involves outright misrepresentation and fraud; the "neutral" gray is manipulation of reports within the boundaries of compliance with bright-line standards, which could be either opportunistic or efficiency enhancing (Yonen & Yaari, 2007).

The terms "private gain" (Schipper, 1989), "mislead" (Healy & Wahlen, 1999) emphasize the opportunistic characteristic of earnings management and preclude the possibility that earnings management can enhance the information content of reported earnings. Scott (1997) and Mulford & Comiskey (2002) suggest the possibility that earnings management can occur for signaling purposes as well. The implication of their definition is that reported earnings can be informative for users if the management choice of accounting policies or estimates is perceived to be credible signals of a firm's underlying performance.

To understand earnings management better, the difference between earnings management and accounting fraud needs to be distinguished. Academic literature usually defines management discretions which fall within Generally Accepted Accounting Principles (GAAP) as earnings management, whereas the Security Exchange Commission (SEC) extends its examining criteria of earnings management to outright fraudulent accounting (Yonen & Yaari, 2007). The interpretation that earnings management can occur within the GAAP is consistent between academia and regulator, but whether fraud constitutes earnings management is ambiguous in academic definitions.

Brown (1999) argues that the difference between earnings management and fraudulent reporting is often very narrow and unclear. Earnings management incorporates a bias and manipulation of fair value of reported earnings, hence regulators often view it as bad and thus tend to classify it as fraud. However, there is a clear distinction between fraud and earnings management depending on the managerial intent to deceive investors. Any presentation of reported earnings which deviates from the fair earnings of the firm but falls into the boundary of fraud can be defined as earnings management.

2.2 Two fundamental conditions of Earnings Management

There is no substantive role for financial disclosures within perfect and efficient markets since financial statements are completely relevant and reliable and therefore, managers and users of financial statements would have no conflict over accounting judgments omitting the scope for accounting manipulation (Watts & Zimmerman, 1979). Unfortunately, in our world of imperfect and incomplete markets, the ideal condition does not always prevail. Two types of market imperfections exist as a result:

2.2.1 Information Asymmetry

The two principles of financial reporting - relevance and reliability, directly reflects the role of accounting information and are aimed to resolve the fundamental problem of information asymmetry. The released information is relevant information with respect to the firm's future prospects, and is reliable information free of managerial manipulation. Where financial disclosure and judgments initially are aimed to reduce the information asymmetry between managers and outsiders, it has been increasingly argued that manager's ability in exercising discretion is likely to impose costs on the users of accounting information.

Dye (1988) and Trueman & Titman (1988) point out that the existence of information asymmetry between managers and shareholders is a necessary condition for earnings management. Schipper (1989) also highlights the condition for earnings management being the persistence of asymmetric information, but she unwinds the condition by arguing that the blocked communication can be eliminated through the enforcement of contractual arrangement. From the perspective of a positive association between the conservatism of accounting estimates and corporate disclosure, Imhoff & Thomas (1994) provide empirical evidence in supporting this line of argument. They conclude that firms who disclose more information are more likely to have conservative accounting estimates (engaging in less earnings management). Richardson (1998) uses the bid-ask spread and the dispersion in analysts' forecasts as a measure of information asymmetry and finds a positive association between earnings management and the level of information asymmetry.

2.2.2 Agency Costs

The second fundamental condition for the existence of earnings management is agency costs which is based around the theoretical framework of the agency theory. Jensen and Meckling (1976) developed the agency theory to explain the nexus between principals (shareholders) and agents (managers). Principals use contracts to motivate agents who would otherwise have conflicts of interest with principals. Although the primary function of contracting is designed to align the incentives between principals and agents (Deegan, 1996), the incompleteness and the rigidities in binding of contracts create agency concerns, which lead to manipulation of the reporting process. Watts & Zimmerman (1986) suggest that the ex-post managerial discretions are made to increase compensation or to avoid debt covenant violations. They use Positive Accounting Theory to illustrate how managers choose accounting methods to achieve desired accounting numbers and thus influence the firm's contractual arrangements.

In fact, evidence of earnings management practice to generate higher management compensation suggest that the design of contracts to align the incentives of the agents with those of the principal might not be the optimal solution in mitigating agency costs (Hart & Holmstrom, 1987). Watts & Zimmerman (1978) take the view that managers' choice of accounting methods is to maximize their own utility, where the utility is a function of the management compensation and the firm's stock price. Therefore, contracting which is designed to solve agency conflicts not only raise room for managerial self-interested behavior, but also imposes additional costs on shareholders if it is used in promoting managers' self interests rather than that of shareholders.

2.3 Two competing perspectives of Earnings Management

Earnings management arises from information asymmetry problem and agency conflicts that occur when equity ownership is separated from the day-to-day operation of the corporation and managers have a comparative information advantage over shareholders. On one hand, these market imperfections create an environment for managers to engage in accounting discretion to promote their self-interest at the expense of shareholders. On the other hand, they also create an opportunity for managers to use accounting discretion to communicate their company's performance-related information in an appropriate manner with investors (Trueman & Titman, 1988; Dye, 1988; Schipper, 1989). Earnings management literature reflects these two competing perspectives as opportunistic behavior and signaling mechanism.

2.3.1 Opportunistic behavior

The perspective of opportunistic behavior takes the view that managers use information asymmetry between outsiders and insiders to maximize their utility in dealing with compensation, debt contracts and regulations. Investors are thereby misled by the unreliable information reported. Watts & Zimmerman (1978) used opportunism approach in explaining managers' discretionary behavior over reported earnings to influence contractual outcomes. Opportunistic earnings management illustrates managers' desire to affect wealth transfer between related contracting parties and themselves. Positive Accounting Theory states that owners expect managers to exercise discretion towards their personal gain and take this into consideration when they offer managers with compensation plans.

The value of management compensation contracts drive up managerial expectation and thus increases the level of discretions itself. Scott (1997) refers to this as "unexpected" managerial discretion which results in a net loss in the aggregate shareholder wealth. In a contracting relationship, however, managers are more risk averse compared with other contracting parties. Subject to constraints of these contracts, they will attempt to maximize their personal wealth. Dye (1988) and Fudenberg & Tirole (1995) demonstrate that risk-averse managers without access to capital markets will have an incentive to engage in earnings management.

2.3.2 Signaling mechanism

The proponents of the signaling perspective argue that managers manage earnings to convey their inside information about firms' prospects and thus it serves as a signaling mechanism. Managers may be able to affect the stock price by engaging in earnings management creating a smooth and growing earnings string over time. As such, earnings management can be a signal mechanism through which inside information about the firm can be communicated from the management to investors. A number of studies have modeled some form of information asymmetry and depicted earnings management as rational equilibrium behavior (Hunt et al., 1997; Bartov et al., 2002; Lev, 2003; Dye, 1988). These studies document signaling evidence of earnings management to facilitate efficient communication between managers and information users to improve the value relevance of financial reporting and enhance investors' ability in predicting firm's performance.

Further, the signaling perspective also implies that earnings management is sometimes demanded by shareholders. Beidleman (1973) and Dye (1988) argue that shareholders will demand for earnings management for two reasons. First, managers can reduce the cost of capital through a smoother, more predictable income stream. Second, Dye (1988) states that a more stable income stream influences prospective investors' perception of firm value. Since current shareholders will sell their shares to the next generation of future shareholders, managers will act on behalf of the current shareholders and have an incentive to manage earnings to maximize the selling price received by the current shareholders (Easton & Zmijewski, 1989; Chaney & Lewis, 1995).

2.4 Motivations to engage in Earnings Management

2.4.1 Contracting Incentives

Financial information and reports of a firm play an important role in establishing and monitoring contracts between a firm and its stakeholders (Sweeney, 1994). Debt providers and creditors of firms commonly include contracts that are linked with financial statement information in order to protect their interests. Watts and Zimmerman (1978) indicate that such contracts encourage firms to manipulate earnings for the financial statements to look attractive to creditors. Under terms of the debt contract firms are required to present their financial information in a manner that is consistent with the agreement in order to avoid penalties under the contract. DeFond & Jiambalvo (1994) found evidence that firms apply income-increasing accruals as a means of avoiding the consequences of debt contract violation.

There are also other contractual incentives for managers to manage earnings, for example in a management buyout contract; managers have an incentive to understate earnings in an attempt to acquire a firm at a lower price (Wu, 1997). In takeover or merger contractual settings, Easterwood (1997) found evidence that target companies of hostile takeovers attempt to inflate earnings in the period prior to a hostile takeover attempt to dissuade their shareholders from supporting the takeover.

2.4.2 Capital Market Expectations

Capital markets use financial information to set security prices. Investors use financial information to decide whether to buy, sell or hold securities. Market efficiency is based upon the information flow to capital markets. When the information is incorrect, it may not be possible for the markets to value securities correctly (Xie et al. 2003). To this extent, earnings management obscures real performance and lessens the ability of shareholders to make informed decisions. Prior studies have examined the incentives of managers to manipulate earnings in an attempt to influence various capital market participants. Dechow et al. (1996) and Teoh et al. (1998) provide evidence that managers inflate earnings prior to seasoned equity offerings. These findings are consistent with the contention that managers seek to manage pre-issue earnings in an attempt to improve investors' expectations about future performance (Xie et al. 2003).

Managers also engage in earnings management to meet and beat earnings benchmark as failure to meet earnings benchmarks are believed to increase uncertainty about the company's future prospects and a perception among outsiders that there are deep, previously unknown problems at the company (Graham, 2006). The importance of these concerns increases with the degree of earnings guidance that the company provides. There is a common belief that everyone plays the earnings game, missing earnings targets indicate that a company has no available slack to deliver earnings. Therefore, the market assumes that missing the target means the company is potentially facing serious problems and must have already used up its 'cushions' (Graham, 2006).

2.5 Earnings Management and CEO Compensation Incentives

An integral component of firms' earnings management is the proportion of CEO compensation that is attached to company's stocks and options. Bergstresser & Philippon (2006) provide evidence that earnings management is more pronounced at firms where CEO's total compensation is closely tied with firms' stocks and options. Evidence from Bergstresser et al. (2006) indicate that companies with more incentivized CEOs have higher levels of earnings management as these CEOs appear to be more aggressive in their use of discretionary components of earnings to affect their firm's reported performance. They argue that CEOs whose total compensation consists mainly of stock and options have an incentive to manipulate earnings so that the firm can report a profit and provide favorable news to investors; leading to an increase in share price. Tying CEO compensation to company stocks may have the effect of encouraging CEOs to exploit their discretion in reporting earnings, with an eye to manipulate the share price of the company (Bergstresser & Philippon, 2006).

2.6 Earnings Management and Corporate Governance

Leuz et al. (2003) found empirical evidence that earnings management occurs less frequently where outside investors are provided more stringent protection by the country's legal governance system and occurs more frequently in countries where the legal governance system provided to outsider investors is weak. Leuz et al. (2003) argues that the presence of a governance environment that provides strong, well-enforced protection of the rights of corporate outsiders serves to limit the ability of inside management to acquire private control benefits through earnings management.

Wells (2002) provides empirical support that incoming CEO's take an 'earnings bath' in the year of the CEO change. DeAngelo (1988) provides direct evidence of earnings management subsequent to CEO change and notes that the period subsequent to CEO change, incoming managers take an 'earnings bath' from both non-cash write-offs and unexpected accruals and that they attribute this to the former management. Incoming CEO's may have considerable incentives to minimize reported income in the initial stage of their tenure. This arises as a consequence of accounting income being largely irrelevant to managerial welfare during the first financial year of tenure, which is typically a partial year (Wells, 2002).

Incoming CEO's are not held responsible for past performance and may explicitly attribute past performance to prior management. Consequently, income may be deferred to subsequent periods when it will more likely have a positive impact on compensation either through explicit contracts or implicit rewards. In this setting, the incoming CEO is typically associated with past decisions, implicit criticism of which may be embodied in downwards earnings management (Wells, 2002). Moreover, the outgoing CEO is unable to constrain such behavior and this highlights an important corporate governance issue (Godfrey et al., 2003).

Klein (2002) found evidence of a negative relation between board independence and abnormal accruals, suggesting that reduction in board independence is accompanied by large increase in abnormal accruals. In addition to Klein (2002), Xie et al. (2003) found results that suggest lower levels of earnings management is associated with greater independence on the board of directors. These findings indicate that independence of the board of directors is important in constraining the propensity of managers to engage in earnings management. Based on the literature on board independence, this research will employ a variable to control for board independence in the cross-sectional and pooled regression models.

2.7 Earnings Management and Auditor Independence

Auditors are appointed as an independent party to provide an opinion as to whether financial statements provide a 'true and fair' view (Chapple & Koh, 2007). Independence is generally understood to refer to a mental state of objectivity, lack of bias, personal interest, prior commitment to an interest, or susceptibility to undue influence or pressure. Independence is crucial in the auditing profession and this has come into light through the failures of Enron and WorldCom. Without independence, investors and stakeholder will lose confidence in audit reports, the auditor's opinion will not be credible, and also financial statements will lose credibility, hence lead to future corporate failures as was the case of Enron (Chapple & Koh, 2007). It is in management's interests to have an external audit to reduce agency costs: lack of a credible independent audit will increase cost of capital, restrict access to capital and impose severe restrictions on management's actions. The requirement of auditor independence is critical and any impairment or perceived impairment of independence will increase agency costs (Firth, 1997).

Literature has expressed concerns about the effects of auditors' provision of non-audit services on the independence of auditors. For example, Beeler & Hunton (2001) mention that the provision of non audit services arguably strengthens the auditor's economic bond with the client, thereby reducing auditor independence and increases auditor's incentive to acquiesce to client pressure, including pressure to allow earnings management. Firth (1997) suggests that any actual or perceived impairment of auditor independence will seriously affect the credibility of financial statements. One possible signal of auditor independence problems is the degree to which the audit firm is economically bonded to a client.

Providing joint services leads the auditor to concur with management's views on questionable accounting practices because disputing these practices will likely result in the loss of not only the audit fee, but also consultancy assignments (Firth, 1997). DeFond et al. (2002) also suggests that although auditors have market-based incentives to remain independent, auditor independence may be threatened when auditors provide non audit services to their clients. Increased economic bonding between auditor and its client resulting from non audit services induces the auditor to resolve disputes in the client's favour in order to maintain incumbency (Simunic, 1984). The issue of measuring the economic bond and economic importance of a client to the auditor is further addressed by Ashbaugh et al. (2003), who argue that the sum of audit and non audit fees, i.e. total fees best captures the explicit economic bond between auditor and client.

Motivated by growing public and regulatory concerns over potential deleterious effects of non-audit services, new regulations control the provision of non-audit services and enhance the integrity of financial reports (Ferguson et al., 2004). A host of empirical studies have examined the relationship between auditor independence, non-audit services and earnings management. Empirical evidence from Frankel et al. (2002) indicated that non audit fees are positively related with the magnitude of discretionary accruals, while audit fees are negatively associated with earnings management. Ferguson et al. (2004) examined the association between non audit services and earnings management activity and found evidence reporting earnings management to be significantly and positively related to non audit services. This is consistent with their argument that higher level of economic bonding between auditor and client resulting from non audit services may reduce auditors' willingness to constrain earnings management activity.

2.8 Corporate Law Economic Reform Program (CLERP 9)

Severe manipulation and fraud have been associated with loose corporate governance, lack of auditor independence and executive incentives structure conducive to opportunistic behavior (Leuz et al., 2003). Recent global corporate failures have sparked significant pressure on management, auditors, directors, the accounting profession and governments' oversight role to review the issue of business ethics and auditor independence. These corporate failures have led to formal government enquiries to investigate the reasons behind these unexpected corporate collapses.

In Australia, the failure of HIH Insurance led to the inquiry into the circumstances surrounding its failure. The report of the HIH Royal Commission indentified a number of possible breaches of the Crimes Act and the Corporations Act. It was also found that there was evidence on lack of audit oversight, transparency, accountability and auditor independence (Robinson, 2003). The report's policy recommendations on corporate governance, financial reporting and assurance were considered into the CLERP 9 amendments for the Corporations Act as these amendments changed the way the law recognized the management and governance of companies and corporate groups. On 25th June 2004, the CLERP 9 Bill gained approval of Parliament and came into effect as the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (Cth) on 1 July, 2004.

The CLERP 9 Act contains a number of schedules dealing with: audit reform, financial reporting, remuneration of directors and executives, continuous disclosure, auditor independence, expensing of options, compliance controls and encouragement of greater shareholder participation at meetings (Robinson, 2003). Since the introduction of CLERP 9, auditing standards have become statutory and not merely professional obligations. CLERP 9 embodies recommendations relating to auditor independence and audit quality. One of the most important changes CLERP 9 made was establishing the Auditing and Assurance Standards Board (AUASB) as a statutory body and creating the Financial Reporting Council (FRC) which is responsible for the oversight of the AUASB and for approving its strategic decisions.

Under the CLERP 9 Act, auditors are now required to provide to their clients a written declaration that the auditor has complied with the auditor independence requirements and any applicable codes of professional conduct (Chapple & Koh, 2007). Section 324CA of CLERP 9 enforces strict requirements of the provision of both audit and non audit services to the same client and firm as well as to the circumstances that will amount to a conflict of interest. The new liability framework is designed to encourage a 'culture of compliance' by making it an offence to breach the independence requirements and placing liability on all members of an audit firm and all directors of audit companies.

The introduction of CLERP 9 has brought many reforms in a way of strengthening the independence of auditors so investors, stakeholders and the public in general can have higher confidence in audit reports and in the long-run performance of companies. Enhancing auditor independence came through the form of subjecting Australian public companies and their external auditors to detailed provisions governing auditor independence, and strengthening existing auditor independence through (Robinson, 2003; Federal Treasury, 2003; Cooper & Deo, 2005) :

A new general standard of auditor independence

Auditor rotation

Restrictions on employment relationships between auditors and audit clients

A mandatory cooling off period before members of an audit firm can become a director or officer of the audit client

Self-review threat was addressed by CLERP 9 requiring two things: mandatory disclosure of fees paid for non audit services in certain categories and a statement from the audit committee to be included in the annual report that it is satisfied that the provision of those services is compatible with auditor independence.

In summary, the literature review presented a discussion on earnings management and various subjects in relation to earnings management such as auditor independence, CEO compensation incentives, corporate governance, etc. From earnings management literature, it is evident that capital market expectations and contracting incentives are the few of the main motivations driving managers to engage in earnings management.


3.1 Earnings Management 2003-2006

The introduction of increased regulatory reforms to enhance the corporate governance environment will provide strong, well-enforced protection of the rights of corporate outsiders and will serve to limit the ability of inside management to acquire private control benefits through earnings management (Wright et al., 2006). Prior literature has suggested that the lack of corporate governance enforcement could enable managers to more easily meet analysts' forecasts, misuse the company's funds and meet earnings targets through earnings manipulation (Hope, 2003). Australian firms are expected to follow CLERP 9 reforms quite thoroughly as any non-compliance will result in significant penalties and bad image. Compliance with requirements of auditor independence introduced by CLERP 9 will reduce the economic bond companies have with their auditors, and this is expected to result in auditors providing objective audit reports free from any bias and management pressure.

With the introduction of CLERP 9, it is interesting to examine the effect CLERP 9 has on the earnings management practices of these firms. It is expected that the compliant group of firms (ASX 100) will respond faster to CLERP 9 reforms than emerging firms (Small Ordinaries Index). First, it is expected that compliant firms have an adequate internal governance structure in place to improve transparency and to ensure the market that these firms are one step ahead of the rest of the firms. Compliant firms would have prepared for CLERP 9 prior to its introduction, and hence the effect of CLERP 9 as an 'event' in these firms will be less as compared to the effect on emerging firms. Compliant firms are also under heavy scrutiny from regulators than the emerging firms, while the firms in the compliant group are all audited by the Big-4 auditors. Therefore, it is expected that CLERP 9 will have an effect on earnings management in the post CLERP 9 period for the compliant firms.

Compliant firms have less to gain and are risk averse, whilst emerging firms would want to grow and raise capital and in order to do so, management will be inclined to 'play' with accounting numbers to attract potential investors. It is expected that CLERP 9 will enhance transparency, improve auditor independence and these are expected to influence the earnings management practices of emerging firms. As indicated by Wright et al. (2006),the introduction of increased regulatory reforms to enhance the corporate governance environment will serve to limit the ability of inside management to acquire private control benefits through earnings management. These discussions therefore lead to the following hypotheses:

Hypothesis 1: Earnings management is expected to decrease in the post CLERP 9 period for the ASX 100 "compliant" firms.

Hypothesis 2: Earnings management is expected to decrease in the post CLERP 9 period for the ASX Small Ordinaries Index "emerging" firms.

Hypothesis 3: Earnings management is expected to be low (high) when auditor independence is high (low) in ASX 100 "compliant" firms and ASX Small Ordinaries Index "emerging" firms.

Hypothesis 4: Earnings management is positively associated with CEO equity based compensation.


4.1 Sample Description

The sample for this study consists of Australian firms selected randomly from the ASX 100 and ASX Small Ordinaries Index. This will ensure that the sample from each index will be proportional to the population. The study period is between 2003 to 2006, covering four financial years. The firms will be classified in the two categories (ASX 100 and ASX Small Ordinaries Index) for each year of the study identified from the Standard & Poors (S&P) database and information from the Australian Stock Exchange (ASX). The first group of firms includes the ASX 100 index, which are the 100 largest stocks listed on the ASX and 50 firms will be picked randomly for this sample. The index is float-adjusted, with securities that are highly liquid and therefore, institutionally investable (Standard & Poors, 2007). The second group includes 50 firms also picked randomly based on the ASX Small Ordinaries which is used as an institutional benchmark for small cap Australian equity portfolios (Standard & Poors, 2007). The sample from both the indices will be grouped together in a pooled regression and a dummy variable for emerging and compliant firms will be used to determine size.

Data for the independent and control variables will also be obtained from the following sources: Connect 4 online database, Fin Analysis online database and through company annual reports. The sample selection criteria are as follows: (i) firms continuously listed on their relevant constituent list and (ii) all necessary data available for the research method adopted in this study.

4.2 Measuring Earnings Management

Prior earnings management studies have developed several tests for detecting earnings management. Healy (1985) tested earnings management through the assessment of accounting policy changes, McNichols & Wilson (1988) tested the discretionary accrual component of a single account and Jones (1991) used the estimate of the discretionary component of total accruals to test for earnings management. Earnings management can be achieved by various means such as the use of accruals and changes in accounting methods.

However, earnings management through the manipulation of accruals is believed to be the favoured instrument because accruals have no direct cash flow consequences and hence, are less likely to be 'undone' by the market (Trueman & Titman, 1988). Accrual earnings is considered superior to cash flows because it overcomes the timing and mismatching problems inherent in measuring cash flows (Dechow, 1995). In addition, accruals let managers communicate their private, inside information and hence, improve the ability of earnings to reflect the underlying economic value. At the same time, managers could abuse the flexibility permitted by GAAP by engaging in aggressive reporting of accruals that can undermine the informativeness of reported earnings.

The usual starting point for the measurement of earnings management is total accruals (Dechow et al., 1995). Total accruals are then divided into a discretionary (DA) and non-discretionary (NA) component. The discretionary portion of total accruals is used in this study to measure earnings management, as the assumption underlying the earnings management framework is that the higher the composition of discretionary accruals within total accruals, the higher the likelihood that a firm is using discretion within accrual accounting to engage in earnings management. Non-discretionary accruals are part of total accruals caused by firm's sales growth and are 'viewed as independent of managerial control' or beyond the control of the CEO (Frankel et al., 2002). The portion of total accruals unexplained by normal operating activities is labeled discretionary accruals.

A time-series approach based on the Jones (1991) model allows a comparison of earnings management activities of firms. The Jones (1991) model regresses total accruals against the change in revenues and the level of gross fixed assets. Total accruals include changes in working capital accounts that, in part, depend on changes in revenue. Changes in revenue are used to control for the economic environment and the gross property, plant and equipment (PPE) is included to control for the non-discretionary depreciation expenses. However, factors such as growth and inflation can cause the time-series of a firm's economic variables to display unequal variances over time.

To overcome this problem the Jones (1991) model uses lagged assets to scale the independent and dependent variables to reduce the possibility of heteroscedasticity (Lim et al., 1999). Dechow et al. (1995) refined the Jones (1991) model by subtracting the change in receivables from the change in revenues and therefore, the innovation leads to the modified Jones (1991) model as demonstrated in equation 1.0 below. The modified Jones (1991) model provides the most powerful test for detecting earnings management as it corrects the tendency of the Jones model to measure discretionary accruals with error when discretion is applied over revenues (Dechow et al, 1995).

While this approach is subject to criticism from Kothari et al. (2005), which has suggested that performance matched discretionary accrual measures enhances the reliability of inferences from earnings management when the hypothesis being tested does not imply that earnings management will vary with firm performance. Kothari et al. (2005) suggest that performance matching on return on assets controls for the effect of performance on measured discretionary accruals. However, due to the prevalence of the modified Jones (1991) model in earnings management literature, estimating discretionary accruals is to be conducted using the modified Jones (1991) model.

Non-discretionary Accruals: Modified Jones (1991) Model

Original Jones (1991) Model


= total non-discretionary accruals in year t for firm i

= total accruals in year t for firm i

= total assets in year t-1 for firm i

= revenues in year t less revenues in year t-1 for firm i

= gross property, plant & equipment in year t for firm i

The traditional method of computing total accruals (TA) follows the lines of prior research such as Healy (1985), Jones (1991) and Dechow et al. (1995) which have used the balance sheet approach to calculate TA. Hribar and Collins (2002) argue that using the balance sheet approach to compute total accruals is inferior in certain circumstances to a cash flow statement based approach. Austin and Bradbury (1995) concluded from their study that prior research which compares different cash flow measures is likely to be robust against errors contained in the cash flow estimates. They also mention that it is preferable to use reported cash flows from operations rather than estimating cash flows from changes in balance sheet accounts and income statement items since these contain substantial errors and thus is a deficient proxy of reported cash flow from operations (Austin & Bradbury, 1995). Hribar and Collins (2002) point out that using successive-year balance sheet variables to measure earnings management creates potential problems around 'non-articulation' dates such as mergers and acquisitions. Due to the criticisms of the balance sheet approach, the cash flow approach is to be used for measuring total accruals (TA).

Total Accruals


= Net income in year t

= Cash flow from operations in year t

= lagged total assets

Discretionary Accruals

The use of raw accrual amounts as a proxy for earnings management is a simple method to evaluate earnings quality because firms can have high accruals for legitimate business reasons, such as sales growth. A more complicated proxy can be created by attempting to categorize total accruals into non-discretionary and discretionary accruals. The non-discretionary component reflects business conditions such as growth and he length of the operating cycle that naturally create and destroy accruals, while the discretionary component identifies the management choices. Therefore, the result of pulling discretionary accrual amounts from the total accrual amount is a metric that to a certain extent reflects accruals that are due to management's choice since they are not obligatory expenses that are yet to be realized and recorded in the accounts. Hence, discretionary accruals is a better proxy for earnings management.


The research review aims to investigate whether the introduction of the Corporate Law Economic Reform Program Act (CLERP 9) has influenced earnings management practices of Australian listed companies in the ASX 100 and ASX Small Ordinaries sample groups. The research questions are to be examined beyond the context of prior literature mentioned in the review. As with all accruals-based testing of earnings management, the ability to