B. L ITERATURE
6. Earnings Management
Scholars have debated a lot on the definitions of earnings management due to different motives and ways involved to do so (Beneish, 2001).
Regardless of the differing opinions, the philosophy behind earnings management is that the managers manipulate financial information to ensure that their self-interest is served, whether in terms of fulfilling the fiduciary duties or protecting the company from inadequate and inflexible business contracts (Scott, 2012). Thus, it is quite appropriate that this study takes a more general definition of earnings management as stated by Scott (2012, p.
423) which is ―the choice by a manager of accounting policies, or real actions, affecting earnings so as to achieve some specific reported earnings objective‖.
1. Motives for Earnings Management
As stated earlier, manipulation of earnings can be driven either by the desire to protect one‘s reputation (in terms of being able to fulfil the fiduciary duties) or to protect the company from contractual problems. In that sense, earnings manipulation can be seen from opportunistic and efficiency perspectives. Under the opportunistic perspective, managers manipulate accounting numbers with malicious intent (e.g. getting overcompensated, protecting reputation). In doing so, the quality and decision-usefulness of financial information is deteriorated, which means that opportunistic earnings management is bad for the company (Jones, 2015). However, under the efficiency perspective, manipulation is done to reduce information mismatch or gap between managers and shareholders
22 or investors. This is in line with the previous discussion on earnings quality, in which managers disclose information as a way to tell the external parties about the company‘s conditions. Because this manipulation essentially put earnings figures closer to the real value, this is beneficial for the company (Godfrey et al., 2010).
Focusing on the opportunistic earnings management, there are five general motives as to why managers to engineer earnings value that departs from its real value. These are explained below.
a. Bonus Plan Motive
In some companies, executive bonuses are tied to earnings target. As such, there is an incentive for them to play around with earnings so as to meet their target bonuses (Healy, 1985). Usually this is done with short-term target in mind, thus earnings management is done to ensure higher earnings today at the expense of future earnings.
b. Debt Covenant Motive
In the eyes of creditor, they want to gain comfortable interest from lending their money to the firm and thus stipulate some earnings target or leverage ceiling for the company to adhere to. If the company want to get more lending at or below the current interest rate, the management may proceed to manipulate earnings upwards for meeting the earnings target. Consequently, higher earnings can correspond to higher asset value which will reduce leverage ratio (DeFond and Jiambalvo, 1994)
23 c. Political Cost Motive
This motive concerns the company with a degree of political visibility, such as being politically-connected or state-owned enterprises. The condition gives rise to political cost where the company is under constant public monitoring (Godfrey et al., 2010).
The management want to ensure that they stay under the radar as it continues to obtain benefits from the political exposure. This is done by ensuring the firm‘s earnings are maintained at certain acceptable level (Scott, 2012).
d. Expectation and Reputation Motive
Skinner and Sloan (2002) cited in Scott (2012) found out that companies are punished more severely if they underperform rather than them being rewarded for outperforming the market‘s expectations.
Because of that, management is incentivised to manipulate earnings highly during bearish business cycle. This incentive is intensified as the management‘s reputation is linked to the company‘s performance.
Thus, earnings management work to avoid market punishment on both the company‘s share price and managers‘ reputation
e. Initial Public Offering (IPO) Motive
For companies wishing to be listed in a stocks exchange, they must provide some financial information on their worth in the market.
The management want to obtain as much capital as possible from the IPO, which can only be done by projecting an image of healthy and
24 profitable company (Marquardt and Wiedman, 2004). That gives a reason to overstate financial data, including earnings prior to IPOs.
2. Mechanism for Earnings Management
According to Mohanram (2003) and Trueman and Titman (1988), there are various ways in which earnings management is exercised. They are:
a. Taking a bath
The management enhances current loss by writing off assets and recognizing expected future costs. In this way, they want to polish future earnings because of the present turbulence within the company (e.g. the company is under stress or restructuring).
b. Income Minimisation
While the way it is done is similar to taking a bath, the goal is to lower current earnings that are way above forecasts, which can raise public scrutiny, especially if the company is politically visible. The ways to do so include rapid write-offs of capital and intangible assets or expensing, instead of capitalising, advertising and research and development (RnD) costs.
c. Income Maximisation
This is done with the bonus plan motive in mind, as the compensation packages of company executives are tied to earnings
25 target. Conversely, the practice is used to meet the conditions required in the debt covenant.
d. Income Smoothing
The practice ensures certain trend of company‘s earnings with little or no fluctuations of earnings in place. This can be driven by both the interest of investors and managers. Sometimes, investors prefer steady performance of the company at all times and it helps them in their decision-making. Meanwhile, for risk-averse managers, it is favourable that they can be compensated at relatively predictable level while being perceived to be doing well, even though they do not really do anything for the company (Lambert, 1984).
3. Types of Earnings Management
Earnings management takes place when managers choose some accounting policies or engage in real manipulations (Jones, 2015). For accrual earnings management, it can be done by either choosing a favourable accounting policy directly or playing around discretionary accruals, such as inventory valuation and receivable provisions and write- offs (Li, 2009). Although total accruals are composed of normal and discretionary accruals, discretionary accruals are measured to identify the degree of accrual-based earnings management because the managers engage directly in its creation while for normal accruals; they are natural mechanisms to capture adjustments on company‘s performance (Dechow et al., 2010).
26 As far as accrual earnings management is concerned, once it is conducted beyond what can be managed by the company, more earnings management practices will follow in the future. If the management has raised earnings upwards, the future earnings will be lower and vice versa.
This concept is called accrual. Reverse (Allen, Larson, and Sloan, 2013;
Marquardt and Wiedman, 2004). While earnings management in itself can be used with shareholders‘ interest in mind, accrual reverse will indicate opportunistic earnings management that are detrimental for the shareholders. This is where the good corporate governance practices come into play to ensure earnings management do not fall into the accrual reverse form. Meanwhile, it also means that the presence of earnings management over the years can symbolise dishonest behaviour on managers‘ part.
In the case of real earnings management, managers engage in manipulating real business activities, such as on advertising, RandD, timing for the purchase and disposal of capital assets and overproduction practices (Cohen and Zarowin, 2010). Essentially, real earnings management is designed to deceive stakeholders on some financial reporting targets using regular operational activities which may not be beneficial for the firm‘s value (Roychowdhury, 2006). Since the manipulation occurs due to the deviation of normal practices, the impact will be two-fold: increase (decrease) of current earnings and decrease (increase) of future cash flows. For instance, overproduction in present
27 period increases current earnings but will generate higher inventory holding costs due to excesses of inventory that is directly related to cash flows from operations.
Although real earnings management presents greater long-term costs for the firm than accruals, managers believe that to depend only on accrual earnings management will incur private costs, minimally in the short run, on them (Scott, 2012). The reasons are (1) the use of accruals will more likely be detected by auditors and regulators and (2) once accruals can no longer cover the difference between true earnings figures and the desired target earnings at the reporting date, real manipulation is impossible to be conducted (Roychowdhury, 2006). This preference prevailed in politically-connected firms, where management will more likely to replace accruals with real earnings management that are not easily measured and detected. This preference is stronger when companies are in the political spotlight with intense public monitoring (Braam et al., 2015).
Aside from the fact that the two types of earnings management differ in the target of manipulation, Table 2.1 summarises other differences between accrual and real earnings management.
Table 2.1
Differences between Accrual and Real Earnings Management
Type Accrual Real
Impact on cash flows Inderect Direct
Detection risk High Low
Management motive For long-term targets, e.g. income smoothing
For short-term target, such as executive compensation target or market expectation
28
Sources: modified and adapted from Roychowdhury (2006); Achleitner, Günther, Kaserer, and Siciliano (2014); Braam et al. (2015) by the author.
In recent years, there are more studies that make use of real and accrual- based earnings management to showcase the level of earnings quality. One reason is that the management have been aware of the fact that from the past major scandals, such as Enron and WorldCom, accounting regulations have been strengthened to prevent accrual-based earnings management. In one study, with the introduction of SOX in 2002, accrual-based earnings management declined sharply while real earnings management picked up the pace (Cohen, Dey, and Lys, 2008). This showed that companies today use a combination of accrual and real earnings management with preference towards the latter, making it relevant to bring real earnings management calculation in the study of earnings manipulation.
However, it is important to acknowledge that real earnings management are relatively new in the discussion of earnings quality. Its measurement is still subject to further evaluations, as compared to a variety of measurements of accrual-based earnings management that have been robustly discussed over many studies. A recent study by Cohen, Pandit, Wasley, and Zach (2015) challenged researchers to find more robust alternative(s) for measuring real earnings management, by basing their argument on the fact that the current measurement is prone to misspecifications that could lead to validity problems in studies
29 concerning real earnings management. In order to provide more reliable interpretation on earnings quality, accruals are used as a proxy for earnings management. At the same time, they correspond well with the accrual accounting system used in all Indonesian companies (Dechow et al., 2010).
4. Accrual-based Earnings Management Model
The measurement of accrual-based earnings management usually focuses on valuing the discretionary accruals that quantitatively reflect the degree of managers‘ discretions in the financial reporting processes (Beneish, 2001). The most famous and widely used method is the Jones (1991) model. This model uses a logical premise that the changes in the firm‘s economic conditions can induce earnings management to occur, which is why it uses the changes in sales and the changes in plant, property and equipment (PPE) as the measuring variables. This model was later modified by Dechow et al. (1995) by adjusting sales figures with the value of receivables. The new model is called modified Jones model.
A new measurement of discretionary accruals was introduced in Dechow and Dichev (2002) model which focuses on the use of cash flows from three different time periods and working capital as they argued that accruals need to assume future cash flows for the company. There is also the Beneish (1997, 1999) model that uses unweighted and weighted probabilities of earnings manipulation. These two models look into the accruals quality instead of the value of the accruals itself.
30 With regards to the various methods to measure discretionary accruals, in this study, it uses Modified Jones Model (1995) model. First of all, the test on modified Jones model or Dechow et al. (1995) model showed that it was statistically significant in relations to the incidence of fraudulent activities, where earnings management will occur (Jones, Krishnan, and Melendrez, 2008). Furthermore, the modified Jones model was said to be the most relevant in the context of Malaysia and Thailand (Selahudin, Zakaria, Sanusi, and Budsaratnagoon, 2014). Given that Indonesian economy quite resembles Malaysia and Thailand where (1) family-controlled firms are prevalent, (2) political connections are common and (3) the three countries are considered as emerging economies, the same line of argument on the appropriateness of the modified Jones model should hold for Indonesia.