1 THE RELATIONSHIP BETWEEN FINANCIAL DERIVATIVES AND DICRETIONARY ACCRUALS AS EARNINGS MANAGEMENT INSTRUMENTS AND THEIR EFFECTS ON
THE VALUE RELEVANCE OF EARNINGS AND EQUITY Etty Murwaningsaria, Sidharta Utamab
Hilda Rossietab, Sistya Rachmawatic
a Department of Accounting, University of Trisakti, Jakarta,Indonesia
bDepartment of Accounting, University of Indonesia, Jakarta,Indonesia
cDepartment of Finance, University of Melbourne, Australia
__________________________________________________________________________
Abstract
This study aims to better understand (1) the relationship between the use of financial derivatives after the implementation of PSAK 55, which was adopted from SFAS 133, and the use of discretionary accruals and (2) the effects of derivatives and discretionary accruals as earnings management instruments on the value relevance of earnings and equity. The study was conducted over the 2001-2008 period and it used secondary data of 350 observations.
The result shows a positive or complementary relationship between financial derivatives and discretionary accruals. This implies that managers tend to intensify the use of discretionary accruals to offset higher use of derivatives. A complementary relationship test indicates that the use of derivatives is generally speculative in nature. Price and return models demonstrate negative effects of speculative derivatives on the value relevance of earnings, which weakens the relationship between accounting earnings and stock prices. However, the price and return models show no significant effects of financial derivatives on the value relevance of equity. In addition, a test of the effects of discretionary accruals on the value relevance of earnings shows mixed results negative and significant with the price model and insignificant with the return model.
Keywords: Financial derivatives, discretionary accruals, the value relevance of earnings, the value relevance of equity
Research Background
This study extends Barton (2001), which was conducted over the 1994-1996 period – a period before the implementation of Statement of Financial Accounting Standard (SFAS) 133 on Accounting for Derivative Instruments and Hedging Activities. Barton (2001) shows a negative and substitutive relationship between financial derivatives and discretionary accruals. This implies that a manager decreases the use of discretionary accruals to offset higher use of derivatives, which suggests the entity’s adoption of hedge derivatives. Barton (2001) was further verified in a study conducted in Indonesia using the 2001-2008 data – a period of SFAS 133, which was adopted by PSAK 55/1999 – with findings differed from that found in Barton (2001) since Indonesian firms mostly adopted financial derivatives for speculation purposes or ineffective hedging. In this case, the relationship between financial derivatives and discretionary
2 accruals are positive or complementary, which suggests that a manager increases the use of discretionary accruals to offset the higher use of derivatives.
While derivatives received immediate acclaim and have been widely adopted since early 1990’s, the use of speculative financial derivatives in subprime mortgage schemes in the United States in mid-2007 had the nation gripped by crisis. The bankruptcy of U.S. largest investment bank Lehman Brothers Holdings washed off investors’ confidence in financial markets, leading to sharp declines in global stock indices over the 2007-2008 period as well as confidence and financial crises among countries with large exposures to the U.S. assets. Indonesia was no exception, as many firms reported losses while several others incurred major premium costs for unwinding their derivatives contracts.
Aabo (2007) notes that the use of speculative derivatives as was the case with the subprime mortgage case proved to increase cash flow volatility and earnings that are higher than the components hedged. This would increase the probability of financial distress and debt contract violations (Asquith et al., 2005). Zhang (2009) demonstrates that financial derivatives users exercised greater caution following the implementation of SFAS 133. This suggests that the use of interest rate and foreign exchange derivatives has less impact (decrease) on the risk exposures and cash flow volatility of ineffective hedgers/speculators than on those of effective hedgers.
However, no significant change in cash flow volatility and risk exposure were discovered among effective hedgers.
Beaver (1998) suggests that accounting numbers are value-relevant when they are associated with market value of equity. Therefore, accounting information is value-relevant if stock price movement is associated with the disclosed information. This study, therefore, aims to extend the use of derivatives and discretionary accruals as variables that increase or decrease value relevance of earnings and equity, given that earnings and equity are the most heeded corporate performance parameters among investors.
Based on the research design, the study aims to shed light on (1) the relationship between financial derivatives and discretionary accruals as earnings management instruments and (2) the effects of the use of financial derivatives and discretionary accruals as earnings management instruments on the value relevance of earnings and equity.
This study is expected to contribute to these following aspects. Firstly, earnings management proxied as discretionary accruals and speculative financial derivatives proves to be complementarily associated, capable of decreasing value relevance of earnings of financial derivatives-adopting firms. Secondly, the findings of the study are expected to provide investors with insight into including the use of financial derivatives, in addition to discretionary accruals,
3 as a real earnings management attempt in measuring earnings information. Investors should note that the relationship between financial derivatives and discretionary accruals in earnings management is complementary in nature, suggesting that their adverse effects on the quality of earnings are higher than if they are used separately. Thirdly, the study is expected to provide regulators with points to consider with regard to a variety of unanticipated effects that may rise from the use of financial derivatives contracts.
Hypothesis Development
1. The Relationship between Financial Derivatives and Discretionary Accruals
Barton (2001) notes that earnings are the sum of cash flows. This suggests that an earnings variance is the function of cash flows and accrual variances, with the relationship between cash flows and accruals as follows:
Earnings variance (σL2) = Cash flow variance (σ K ) + Accrual variance(σA )
+ 2 accrual covariances, cash flow (2 ρKA σ K σA )...(1)
Managers can therefore manage earnings volatility by adjusting cash flow and accrual volatility. Barton (2001) suggests that the relationship between financial derivatives and discretionary accruals are likely to be substitutional or complementary. His argument runs as follows:
a. The relationship between financial derivatives and discretionary accruals
For example, an effective swap transaction can reduce cash flow variability by converting debt interest from variable to fixed (pay-fixed/receive-variable interest rate swap). While an entity may have already used financial derivatives to a certain extent, managers engaged in earnings management will find discretionary accruals useful to reduce interest rate exposures with value unhedged against earnings volatility. Only if financial derivatives prove to be able to reduce cash flow volatility will they be legitimate to substitute discretionary accruals. This suggests that a higher use of financial derivatives decreases discretionary accruals
b. A complementary relationship between financial derivatives and discretionary accruals.
For example, a swap, which may be generated by speculative activities, is likely to increase cash flow volatility as a whole. In their attempts to manage levels of earnings with regard to the use of financial derivatives for speculative purposes, managers are motivated to increase accruals as hitgh as their earnings targets. In such a case, the amounts of discretionary accruals and financial derivatives are to be positively correlated, or complementary. This suggests that a higher use of financial derivatives increases discretionary accruals.
4 Findings by Barton (2001), which used the pre-SFAS-113 1994-1996 data, show that a substitution relationship exists between financial derivatives and discretionary accruals. The findings find support in those of Moffitt (2001) and of Pincus and Rajgopal (2002).
In the later part of his study, Barton (2001) predicts that the implementation of SFAS 133, which was adopted by PSAK 55/1999, will increase costs of reporting, as the more transparent use of financial derivatives is likely to persuade managers to use discretionary accruals more frequently than hedge derivatives in earnings management. Barton (2001)’s prediction proved accurate as shown by the lower use of hedge derivatives among Indonesian firms following the implementation of PSAK 55/1999. This stemmed from the fact that the criteria of financial derivatives reporting for hedging purposes could not be met. The cost-inefficient criteria include adept human resources, up-to-date technology, wholeness of documents and qualified risk management. Managers step up the use of discretionary accruals to contain increasing earnings volatility on account of higher use of speculative derivatives. In this setting, the relationship between financial derivative transaction and discretionary accruals is complementary, or positively associated.
Given that financial derivatives and discretionary accruals are earnings management instruments responsible for determining earnings quality, the simultaneous use of the instruments by firms needs to be examined. It is, therefore, necessary to conduct further research in Indonesia in the period in which PSAK 55/1999 was implemented. Based on the argument above, the proposed hypothesis is as follows:
Hypothesis 1.1: the use of financial derivatives has positive effects on discretionary accruals.
2. The Effects of the Use of Financial Derivatives on the Value Relevance of Earnings and Equity
The value relevance is developed from the first hypothesis – the complementary relationship (positive) – stemming from the higher use of speculative derivatives followed by an increase in discretionary accruals. The use of financial derivatives entails market risks, such as exchange rate and interest rate risks. Market risks, also known as systematic risks or stock’s beta, are non-diversifiable risks (Djohanputro, 2008). Systematic risks are negatively associated with Earnings Response Coefficient, or ERC, or are the relationship between stock prices and earnings. This suggests that the higher (lower) the risks of an entity, the lower (higher) the value relevance of earnings (Collins and Kothari, 1989; Kothari and Zimmerman, 1995). The use of speculative derivatives, hence, decreases the value relevance of earnings.
5 Meanwhile, highly risky earnings volatility is likely to give rise to financial distress or violation of debt contracts (Asquith et al., 2005; Beatty, et al., 1994). Barth et al. (1998) notes that a financially less healthy entity or an entity with high volatility gives more importance to cash flows and lower importance to income statement. For that reason, the use of speculative derivatives that gives rise to financial distress decreases the value relevance of earnings and increases the value relevance of equity, as investors transfer to equity (Collins dan Kothari, 1989; Barth et al., 1998). The proposed hypothesis is as follows.
Hypothesis 2.1:
The use of financial derivatives has negative effects on the value relevance of earnings Hypothesis 2.2:
The use of financial derivatives has positive effects on the value relevance of equity
3. The Effects of Discretionary Accruals on the Value Relevance of Earnings and Equity Prior studies on the value relevance of earnings and equity within the earnings management context have been attempted by Whelan and McNamara (2004) and Wiedman and Marquardt (2004). Whelan and McNamara (2004) argues that earnings management as reflected by high discretionary accruals serves as an indicator of low earnings reliability (Richardson at al,, 2004). Less reliable earnings will drive the market to reduce its reliance on earnings in determining firm value and turn to equity (Berger et al., 1995 and Burgstahler and Dichev., 1997). Consequently, when an entity practices earnings management, the market is expected to reduce its reliance on earnings information in determining firm value, while giving more importance to equity in communicating stock prices.
In contrast, Subramanyam (1996) notes that earnings management is driven by motivation to efficiently communicate private information about future economic potentials which cannot be accommodated by applicable accounting standards.
The foregoing description shows that discretionary accruals of derivatives have positive or negative effects on the value relevance of earnings and equity. The proposed hypothesis, thus, is as follows:
Hypothesis 3.1: Discretionary accruals have effects on the value relevance of earnings.
Hypothesis 3.2: Discretionary accruals have effects on the value relevance of equity.
6 Research Method
Sample Selection
The research population was all firms listed at the Indonesia Stock Exchange over the 2001-2008 periods, with a total of 350 observations. However, there were 20 observations which financial statements for the period of 2002-2008 could not be found and needed to be excluded, thus reducing the observations to 330. This was further slashed to 199 as 131 derivative users had not been actively engaged in derivative transactions. The sample excluded non-bank financial institutions due to differences in the accounting practices of their specific industries and the use of financial derivatives as stipulated in a special regulation. Moreover, the model used to measure the amount of discretionary accruals in the financial industry differs from that used in other industries.
Variables and Their Measurement
(1) Stock Prices are measured by the closing price at the end of the issuing month, which is March, three months subsequent to the balance date of December 31. This approach was used to ensure that a stock price fully reflected the information contained in the annual report.
(2) Discretionary accruals are measured using the Kothari et al., (2005) model. The model was chosen because it was relatively new and similar to the Jones and Modified Jones models, it also took into account the Return-on-Assets variable that controls for the impacts of firm performance on accruals. The measurement is as follows:
Total Accrual
TACit = Niit – CFOit
DACit = TACit / TAit–1 – { α1 [1/TA it–1] + α2 [∆REVit/TA it–1 – ∆RECit/TA it1] + α3 [PPEit/TAit–1] + α3 ROAt ……….( 2 )
Notasi
TACit = Total accruals of firm i in year t.
CFO = Cash Flow from Operation.
DACit = Discretionary accruals of firm i in year t.
TAit–1 = Total aset of firm i in year t.
ΔREVit = Change of net sales of firm i in year t.
∆RECit = Change of net receivable of firm i in year t.
PPEit = Property, plant, equipment of firm i in year t.
Niit = Net Income of firm i in year t.
ROAt = Return on Asset in year t (Net income divided by TAt )
7 (3) Accounting Earnings
Accounting earnings are measured using EPS (Earnings per Share), or earnings before extraordinary items deflated by stocks outstanding (Whelan, 2004).
(4) Book Value of Equity
It is the book value of equity per share that shows a shareholder’s net assets through ownership of one share. It is measured by total equity divided by stocks outstanding
(Whelan, 2004).
(5) Derivatives
Derivatives are measured by the notional amount of foreign exchange derivative transactions scaled by lagged total assets (Barton, 2001; Moffitt, 2001; Pincus and Rajgopal, 2002). A notional amount is an amount in a unit of values, shares and/or other units stipulated in an agreement (PSAK 55/1999).
Control Variables Associated with Earnings Management a) Capital Structure/Leverage (SM)
The debt variable in this equation is measured by the total debt to total asset ratio (Watts and Zimmerman, 1986).
b). Growth Opportunity (KP)
Growth opportunity is measured by the ratio of market capitalization (closing price multiplied by stock outstanding) to book value of equity (Collins and Kothari, 1989).
c). Information Asymmetry (AI)
In this study, informaton asymmetry is proxied by bid-ask spread using an eleven-day event window – five days before (-5) and five days after (5+) an accounting earnings reporting date (Brown and Warner, 1985). A long event window is not preferred on concern over potential accumulated effects on earnings. Information asymmetry is measured using the following equation:
SPREADi,t = [(aski,t – bidi,t) / ((aski,t + bidi,t)/2)] x 100%...( 3 ) Notasi
SPREADi,t
ASKi,t BIDi,t
=
=
=
Spread between ask and bid divided by the amount of ask and bid divided by two Highest ask price of the shares of firm i on day t
Lowest bid price of the shares of firm i on day t
8 However, using bid-ask spread as the proxy of information asymmetry entails some drawbacks.
To mend them, Lee et al. (1993) suggests that the combination of bid-ask spread and market depth data can signal potential information asymmetry prior to an earnings announcement.
Therefore, the information asymmetry of firm i at day t is proxied by ADJSPREADi,t or Residual Spread (εi,t), with equation as follows:
SPREADi,t = α0 + α1PRICEi,t + α2VARi,t + α3TRANSi,t + α4DEPTHi,t + ADJSPREADi,t (εi,t)..(4) Notasi:
ASKi,t
BIDi,t
PRICEi,t
VARi,t
TRANSi,t
DEPTHi,t
ADJSPREADi,t(εi,t)
=
=
=
=
=
=
=
highest ask price of firm i’s shares on day t lowest bid price of firm i’s shares on day t closing price of firm i, day t in event windows.
Variant of a daily return level over the observation period of firm i’s shares on day t
Amount of share transactions of firm i, on day t in each event window.
An average amount of shares of firm i on all quotes (an available amount during
”ask” added by that during ”bid”divided by two) in every day t in event windows.
residual errors used as the adjusted measure of SPREAD and used as the proxy of information asymmetry for firm i on day t.
d) DACt-1
It is the absolute value of discretionary accruals in the prior-year period (Barton, 2001).
e) Dividend Payout Ratio (DPR)
Consistent with Barton (2001), a Dividend Payout Ratio is measured by the cash dividend to pre-managed earnings ratio (earnings before extraordinary items substracted by discretionary accruals) on all variables divided by lagged total assets.
f) Quality of Auditor (KA)
The quality of auditor proxy employs the measurement of a Public Accountant Office (KAP), which uses a dummy, 1 = big four, and 0 = non-big four. This measurement refers to Teoh and Wong (1994).
Control Variables Associated with the Value Relevance of Earnings and Equity a. Firm Size (UP)
It is measured by the natural logarithm total assets (Atiase, 1985).
b. Capital Structure/Leverage (SM)
It is measured by the total debt to total asset ratio (Chtourou, 2001).
9 c. Growth Opportunity (KP)
It is measured by the ratio of market capitalization (closing price times number of shares outstanding) to book value of equity (Collins dan Kothari, 1989).
Research Models
Hypothesis 1 Testing Model : The Relationship between Financial Derivatives and Discretionary Accruals showed by the following regression model:
A Sensitivity Test
A sensitivity test is mostly used to determine a robustness level in comparison to the primary test. The sensitivity test on Hypothesis 1 which is the relationship between financial derivatives and discretionary accruals is conducted by comparing the effects of financial derivatives on discretionary accruals using the dividend payout ratio (DPR) as the control variable measured with and without negative pre-managed earnings. The DPR and negative pre- managed earnings variables show that there are more discretionary accruals than cash flows in firms’ earnings. This is consistent with Sun and Rath (2010) who find that managers use earnings management to boost earnings when pre-managed earnings are below zero. Hence, to obtain a result consistent with Hypothesis 1, a test needs to be conducted on the effects of Dividend Payout Ratio measured without negative pre-managed earnings on discretionary accruals.
Note:
DACit = Absolute discretionary accruals firm i in year t DERIVit = derivatives of firm i in year t
SMit = leverage of firm i in year t
KPit = growth opportunity of firm i in year t AIit = information asymmetry of firm i in year t
DACit-1 =absolute discretionary accrual firm i in the prior-year period
DPRit = dividend payout ratio of firm i in year t
KAit = dummy of the quality of audit. 1 if a firm uses big-four auditors and 0 if not.
Dspekulasi = dummy of speculation
DACit = α0 + α1DERIVit + α2SMit + α3KPit + α4AIit + α5DACit-1 + α6DPRit + α 7KAit + εit ………….( 6) DACit = α0 + α1DERIVit + α2SMit + α3KPit + α4AIit + α5DACit-1 + α6DPRit + α 7KAit + εit ……….( 5)
10 Hypothesis 2 Testing Model : The Effects of Financial Derivatives on the Value Relevance of Earnings and Equity using the Pooled Regression Analysis model (Whelan dan McNamara, 2004).
Interaction coefficients show the strengthening and weakening effects of financial derivatives and discretionary accruals on the value relevance of earnings and equity.
A Sensitivity Test
A sensitivity test on the effects of financial derivatives and discretionary accruals on the value relevance of earnings and equity using the Cumulative Abnormal Return (CAR)
This test was conducted on the assumption that a price model may raise econometric concerns, even though the estimated slope coefficients of the price model is less biased than that of the return model. Moreover, Easton (1993), who carried out a similar observation, suggests that a return specification be adopted. It is, therefore, seen necessary to include a return model of a firms’ stock, which was measured by the spread between firms’ actual return of stock and a return expectation known as a cumulative abnormal return (CAR) over the observation period, as an additional specification. The model is as follows:
Note:
CARit = Cumulative Abnormal Return of firm i in year t ΔDACit = Absolute discretionary accruals of firm i in year t ΔDERIVit = derivatives of firm 1 in year t
ΔEPSit = Earning Per Share of firm I in year t ΔEBVit = Equity Book Value of firm i in year t ΔUPit = firm size of firm i in year t
ΔSMit = leverage of firm i in year t
ΔKPit = growth opportunity of firm i in year t
In the return model, all of the independent and control variables are scaled with each of their counterparts in the prior year (t-1) for econometric reasons.
The measurement of a Cumulative Abnormal Return (CAR) variable, which is the proxy of a stock return, aims to gauge market reaction to the reported earnings. This is conducted using an event study methodology, an approach to learn market reaction to an event with disclosed
CARit= ß0 + ß1ΔEPSit + ß2ΔEBVit + ß3ΔDERIVit + ß4ΔEPSit*ΔDERIVit
+ ß5ΔEBVit*ΔDERIVit + ß6ΔDACit +ß7ΔEPSit*ΔDACit + ß8ΔEBVit*ΔDACit
+ ß9ΔUPit + ß10ΔSMit + ß11ΔKPit ……….( 8)
Pit = γ0 + γ1EPSit + γ2EBVit + γ3DERIVit + γ4EPSit*DERIVit + γ5EBVit*DERIVit + γ6DACit + γ7EPSit*DACit + γ8EBVit*DACit + γ9UPit + γ10SMit + γ11KPit + e it ………( 7 )
11 information. The abnormal return estimated using a 12-month event window from April in year t to March in year t+1 (Ali and Zarowin, 1992) is as follows:
n
CARit = ∑ Arit ...(9) i=1
Note:
ARit
Rit
RMt (Market return) CARit
=
=
=
=
=
The level of abnormal returns of individual firm i in month t, calculated using the equation: ARit = Rit - RMt
The level of individual actual returns of firm i in month t, calculated by the closing price of firm i in month t : (Pit – Pit-) / Pit-1
The level of market returns in month t, calculated by the equation: (IHSGt – IHSGt-1)/ IHSGt-1
Cumulative Abnormal Return of firm i in month t.
Research Findings
Test Results of Hypothesis 1
The following are the Results of the Test on the Effects of Financial Derivatives on Discretionary Accruals using a Dividend Payout Ratio measured with and without Negative Pre- managed Earnings:
Table 1
DACit = α0 + α1DERIVit + α2SMit+ α3KPit + α4AIit + α5 DAC t-1 + α6DPRit + α 8KAit + εit
Variables Prediction
With Negative Pre-managed Earnings
Without Negative Pre- managed Earnings Coefficients p-value Coefficients p-value
C 0.1852 *** 0.0636 ***
DERIV + 0.2374 *** 0.0646 ***
SM + -0.0954 ** 0.0424 *
KP + -0.0003 0.0009
AI + 1.2848 *** 0.4935 **
DACt-1 + -0.2740 *** -0.0453 ***
DPR - -0.0617 *** -0.1277 ***
KA - -0.0047 0.0141
Adj R2 0.2094 0.3339
F-statistic 1.7946 9.0220
Prob(F-statistic) 0.0059 *** 0.0000 ***
Durbin Watson Stat 2.6457 2.0870
Jumlah observasi 157 113
*** Significant at a level of 1%
** Significant at a level of 5%
* Significant at a level of 10%
Note: C: Constanta, EPS: Earnings per Share, EBV: Equity Book Value, DERIV: Derivatives, DAC: Discretionary accruals, UP: Firm Size, SM: capital Structure, KP: Growth Opportunity
12 The Effects of Financial Derivatives on Discretionary Accruals Using a Dividend Payout Ratio (DPR) with Negative Pre-managed Earnings
Test results of the hypothesis 1 show that financial derivatives have effects on discretionary accruals. Firms directly recognized unrealized gains/losses of financial derivatives transactions in their income statements. However, speculative derivatives increase earnings volatility, as vividly shown in Indonesia in 2008 when the rupiah steeply depreciated against the U.S. dollar, prompting managers to increase discretionary accruals to stabilize earnings. These findings are consistent with Barton (2001) that the existence of a positive or complementary relationship between financial derivatives and discretionary accruals indicates that the higher use of speculative derivatives that drives up the use of discretionary accruals is at work.
The test on the control variables shows that Capital Structure (SM) is negatively and significantly associated. This suggests that a high level of debt has a favorable effect on decreasing managerial discretion in making earnings-affecting decisions. Therefore, a higher level of debts leads to lower discretionary accruals (Jelinek, 2007). The agency theory (Jensen and Meckling, 1976) may explain this. The theory proposes that the higher the ratio of debts the higher the risk of debt covenant violation (a debt covenant hypothesis). To contain the risk, creditors monitor managerial discretion more closely, which leads to lower discretionary accruals.
The Growth Opportunity variable yields insignificant results, which may be explained by possible business maturity of the sample firms, making growth opportunities no longer the dominant factor affecting discretionary accruals, or discretionary accruals are not their preferred means of communicating robust performances. Information Asymmetry (AI), however, yields positive and significant results. This suggests that performance assessment related information compels managers to manage earnings. Meanwhile, the prior-year discretionary accruals (|DACt- 1|) and Dividend Payout Ratio (DPR) yield negative and significant results. A negative and significant DPR suggests that firms increase their DPR by adjusting accruals (decreasing earnings). The Quality of Audit (KA) variable yields insignificant results, which suggest that hiring big-four auditors does not necessarily cut down on the aggressive use of accrual accounting.
The Effects of Financial Derivatives on Discretionary Accruals with Dividend Payout Ratio (DPR) without Negative Pre-managed Earnings
The findings show that no different results exist between dividend payout ratio and pre- managed earnings variables with negative pre-managed earnings and without negative pre- managed earnings. The effects of financial derivatives on discretionary accruals consistently
13 show a positive and significant association. The control variables show consistent results from the two samples. Similarly, the dividend payout ratio variable shows negative and significant results as predicted. This suggests that an increase or decrease in a dividend payout ratio will be followed by a decrease or increase in discretionary accruals (Barton, 2001).
Test Results of Hypothesis 2
The following are the test results of the effects of financial derivatives and discretionary accruals on the value relevance of earnings and equity with price (P) and cumulative abnormal return (CAR) variables:
Table 2
Pit = γ0 + γ1EPSit + γ2EBVit + γ3DERIVit + γ4EPSit*DERIVit + γ5EBVit*DERIVit+ γ6 DACit
+ γ7EPSit* DACit + γ8EBVit*DACit + γ9UPit+γ10SMit+ γ11KPit+e it
CAR = ß0 + ß1ΔEPSit + ß2ΔEBVit + ß3ΔDERIVit + ß4ΔEPSit*ΔDERIVit + ß5ΔEBVit*ΔDERIVit + ß6ΔDACit +ß7ΔEPSit*ΔDACit + ß6ΔEBVit*ΔDACit + ß7ΔUPit + ß8ΔSMit + ß10ΔKPit
Variables Prediction Stock Price (P) Cumulative Abnormal Return (CAR)
Koef p-value Koef p-value
C 7.4223 *** 0.0039
EPS + 0.0003 *** 0.0151 **
EBV + 0.0004 *** -0.0176 *
DERIV +/- -0.3469 0.0066
EPS*DERIV - -0.0015 ** -0.0026 **
EBV*DERIV + 0.0002 -0.0161
DAC +/- 0.5895 ** 0.0058
EPS*DAC +/- -0.0017 -0.0054 *
EBV*DAC +/- -0.0004 *** -0.0168
UP +/- -0.0471 -2.5221
SM - -0.2181 0.0064
KP + 0.3047 *** -0.0894 ***
Adjusted R2 0.8852 0.0693
F-statistic 25.8522 1.9883
Prob (F-statistic) 0.0000 *** 0.0340 ***
Durbin-Watson stat 1.9235 2.0080
Numbe of Observations 191 147
*** Significant at a level of 1%
** Significant at a level of 5%
* Significant at a level of 10%
Note: C: Constanta, EPS: Earning per Share, EBV: Equity Book Value, DERIV: Derivatives, EPS*DERIV: An interaction between EPS and DERIV, EPS*DAC: An interaction between EPS and discretionary accruals, DAC:
Discretionary accruals, EPS*DAC : An interaction between EPS and DAC, EBV*DAC: An interaction between EBV and DAC, UP: Firm Size, SM: Capital Structure, KP: Growth Opportunity
14 The effects of financial derivatives and discretionary accruals on the value relevance of earnings and equity with the stock price (P) asdependent variable
The test results of the Hypothesis 2 show negative and significant effects of financial derivatives on the value relevance of earnings as predicted. This suggests that financial derivatives weaken the relationship between accounting earnings proxied with Earnings Per Share and stock prices. The effects of a complementary relationship on the value relevance of earnings are driven by the speculative nature of a derivative use, which recognizes unrealized gains or losses of financial derivatives transactions as the current-year’s gains or losses. As Aabo (2007) notes, this leads to an earnings volatility that is higher than hedged derivatives.
Consequently, this higher earnings volatility decreases market responses to stock prices (Graham et al., 2005). Financial derivatives, hence, are negatively associated with the value relevance of earnings, which suggests that speculative derivatives lead to a weaker relationship between prices and earnings.
The effects of derivatives on the value relevance of equity show insignificant results, which are anomalous as the use of derivatives that comply with PSAK 55 (1999) should increase the value relevance of book value while the use of derivatives that do not comply with PSAK 55 (1999) should decrease the value relevance of book value.
The findings show that discretionary accruals have no effects on the value relevance of earnings, which is consistent with Whelan and McNamara (2004). This may stem from less accurate accounting practices that generate earnings of questionable quality or lower earnings reliability. Discretionary accruals, hence, have no effects that strengthen or weaken the relationship between prices and earnings.
The findings show that discretionary accruals and the value relevance of equity are negatively and significantly associated, which suggests that discretionary accruals weaken the value relevance of equity. This refers to Ohlson (1995) and Feltham and Ohlson (1995) models which proposed that earnings were part of the equity components in the balance sheet. Low earnings reliability decreases the value relevance of earnings. The more accurate book values of equity, the more unbiased the value relevance of equity. However, low earnings reliability due to opportunistic discretionary accruals will give rise to errors in normal earnings estimates. In this case, discretionary accruals weaken the value relevance of equity.
The test on the Firm Size (UP) control variable shows insignificant results. This may stem from the high availability of non-accounting information used by the market to better interpret financial statements and more accurately predict cash flows during an earnings announcement, while leaving much of earnings information unheeded. The test on the Capital Structure (SM)
15 variable shows insignificant results, which indicates that the more profits reaped by a highly indebted firm the safer creditors will feel. This is because creditors, not shareholders, are the ones who will suffer the most when a firm tumbles into financial distress. Therefore, creditors, not shareholders, pay more attention to an increase in a firm’s earnings; and a firm’s high level of debt does not affect its stock price (Dhaliwal, Lee, and Fargher, 1991).
The test on the Opportunity Growth variable shows positive and significant results, which suggests that there is an increase in the stock price of a firm with higher earnings as bankruptcy becomes less viable (Zhang, 2000).
The Earnings Per Share (EPS) variable shows positive and significant results. This suggests that the market believes that EPS is capable of providing information about a firm’s operations. The Book Value of Equity (EBV) variable is positively and significantly associated as predicted. These findings show that the market pays heed to earnings and book value of equity (Kothari and Zimmerman, 1995; Ohlson, 1995; Feltham and Ohlson, 1995).
The test on the effects of financial derivatives on stock prices shows insignificant results, driven by the fact that derivatives information associated with unrealized gains/losses is a relatively new variable in financial reporting, which renders it less relevant in accounting for dependent variables (Kothari and Zimmerman, 1995). Therefore, derivatives are yet to be used to help make decisions at the capital market, as it is earnings, and not derivatives, that count for most investors.
The effects of financial derivatives and discretionary accruals on the value relevance of earnings and equity with the Cumulative Abnormal Return (CAR) dependent variable
The test results of hypotheses 2.1, 2.2, 3.1 and 3.2 show that financial derivatives have negative and significant effects on the value relevance of earnings as predicted. This suggests that financial derivatives weaken the value relevance of earnings. When associated with test results of the first hypothesis which show that speculative derivatives are at play in a complementary relationship, the unrealized gains/losses are, thus, directly recognized in the current year’s income statement. This direct recognition from unrealized gains/losses has the potential of increasing earnings volatility, resulting in speculative derivatives decreasing the value relevance of earnings.
Derivatives show insignificant effects on the value relevance of equity, which is anomalous as the use of derivatives that is consistent (inconsistent) with PSAK 55 (1999) should result in an increase (decrease) in the value relevance of book value.
The test on the effects of discretionary accruals on the value relevance of earnings shows negative and significant results. This may stem from opportunistic discretionary accruals
16 decreasing earnings reliability. This shows that discretionary accruals can potentially decrease the value relevance of earnings.
The test on the effects of discretionary accruals on the value relevance of equity shows insignificant results. These insignificant effects of discretionary accruals on the value relevance of earnings could be explained by the likely opportunistic nature of the discretionary accruals, to which the market refuses to pay heed. This is consistent with Ohlson (1995) and Feltham and Ohlson (1995) models which proposed that earnings were part of the components of book value of equity in the balance sheet. This suggests that the more accurate the book value of equity the more unbiased the value relevance of equity. However, low earnings reliability due to opportunistic discretionary accruals could give rise to errors in normal earnings estimates, resulting in discretionary accruals having no effects on the value relevance of equity.
The test on the Firm Size (UP) control variable yields insignificant results. This may stem from the high availability of non-accounting information used by the market to better interpret financial statements and more accurately predict cash flows during an earnings announcement, while leaving much of earnings information unheeded. The test on the Capital Structure (SM) variable shows insignificant results, which indicates that the more profits reaped by a highly indebted firm, the safer creditors will feel. This is so because creditors, not shareholders, are the ones who will suffer the most when a firm tumbles into financial distress. Therefore, creditors, not shareholders, pay more attention to an increase in a firm’s earnings; and a firm’s high level of debt does not affect its stock price (Dhaliwal, Lee, and Fargher, 1991).
Growth Opportunity (ΔKP) shows a negative and significant relationship, which may be explained by the possibly mature sample firms – those which continue to earn higher returns despite slower growth. The test on the Earnings Per Share (ΔEPS) control variable shows positive and significant results, suggesting that an increase in the adjusted value of EPS will have significant effects on higher return. Book Value of Equity/Equity Book value (ΔEBV) shows a negative and significant relationship. This suggests that a higher adjusted value of EBV will result in a lower stock return.
The test on the effects of adjusted derivatives (ΔDERIV) on return shows an insignificant relationship. This may be explained by the fact that financial statement information associated with the disclosure of unrealized gains/losses and the use of financial derivatives is a relatively new component in financial reporting. Furthermore, the test on discretionary accruals yields insignificant results. The findings show that the market may find it difficult to detect whether a firm’s earnings management is efficient or opportunistic in nature, so it decides not to respond.
This study supports Feltham and Pae (2000).
17 Conclusions, Implications, Limitations and Recommendations
Conclusions
The discussion above can be concluded as follows:
1. The relationship between financial derivatives and discretionary accruals is found to be positive and significant. The findings show that a higher use of speculative derivatives will be followed by a higher use of discretionary accruals in such a complementary manner.
This suggests that financial derivatives and discretionary accruals are instruments of earnings management. A test on a complementary relationship shows that derivatives are commonly used for speculative purposes. This suggests that unrealized gains/losses are directly recognized in the current-year’s income statement. This speculative treatment of accounting increases earnings volatility and encourages managers to increase discretionary accruals to manage earnings.
2. Derivatives have negative effects on the value relevance of earnings using both price and return models. This finding is developed from the first hypothesis in which a complementary relationship in speculative derivatives weakens the relationship between accounting earnings and stock prices. This stems from accounting treatment that recognizes unrealized gains/losses from speculative derivatives in the current-year’s income statement. This gives rise to earnings volatility that is higher than hedged derivatives (Aabo, 2007). The market, which prefers low earnings volatility, pays little heed to stock prices (Graham et al., 2005).
3. The test on the effects of discretionary accruals on the value relevance of earnings yields mixed results; it is significantly negative using a return model and insignificant using a price model. Furthermore, the test on discretionary accruals using a price model shows no effects of it on the value relevance of earnings. The findings are consistent with Whelan and McNamara (2004). In addition, the test on the effects of discretionary accruals on the value relevance of earnings and equity yields mixed results; it is negative and significant using a price model and insignificant using a return model.
The Implications of These Findings for Future Research
The following are implications of these findings to future research and investor
1. This study finds that a majority of firms disclosed their derivatives activities different from what actually occurred; they used speculative derivatives but disclosed them as hedged
18 derivatives, either in compliance with PSAK 55 (1999) or not. This raises a need for future research to find driving factors behind these manipulative practices.
2. This study also finds unregulated financial derivatives practices among Indonesian firms with rupiah exposure with domestic and foreign clients. Therefore, future research is advisedly conducted in the banking sector that is subject to Bank Indonesia’s deregulation policy in the hopes of finding different results that may further enrich financial derivatives research.
3. Discretionary accruals are an earnings management instrument on which continued research needs to be conducted. This consistency is expected to enable researchers to obtain generalized results. It is recommended that future research use the recent discretionary accruals models of Gul, Fung and Jaggi (2009).
4. Future research is expected to include more financial derivatives variables in the tests, whether hedged derivatives, swaps, forwards or options.
5. The implications of these findings to investors are as follows:
Firms that use financial derivatives can use them to hedge financial risks or improve earnings. According to Nissim and Penman (2003), there is a shift in the instrument used to detect earnings management from derivatives practices to real financial transactions following the imposition of the Sarbanes-Oxley Act (SOX) (Cohen et al., 2004). This is consistent with what this study finds, namely real transactions such as derivatives transactions are value-relevant, while discretionary accruals are not. Therefore, it is advisable that investors exercise caution against a shift in earnings management activities.
Limitations
The following are limitations that this study encounters:
1. This study does not include other recent discretionary accruals models such as the Gul, Fung and Jaggi models that use the CFOt+1 variable, given that the study started in 2008 and financial statements for 2009 had yet to be issued.
2. This study shows that, descriptively, a majority of firms use speculative derivatives that are comprised of a cross-currency swap, interest rate swap, forward and option. However, this study does not test samples based on those types of financial derivatives for a lack of sufficient data. What of concern is that separating data would minimize the data proportion that may result in inadequate test results.
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