4.3 Real activities manipulations (RAM)
4.3.2 Defining RAM
Different definitions of RAM exist in the academic literature (Carcello, Hollingsworth, Klein, & Neal, 2006; Inaam et al., 2012; Roychowdhury, 2006). Roychowdhury (2006), as indicated before, defined RAM as actions taken by management that depart from usual business operations, initiated with the primary motive of achieving specific earnings targets. Earnings management does not contravene existing regulations and IFRS. However, earnings management can be inimical to the information quality of financial statements (Beest, Braam, & Boelens, 2009). Manipulations of earnings are through accruals, real activities, and shifting of core expenses. Usually, RAM practices take place during the current period. Gunny (2010) views RAM as a purposeful action to alter reported earnings in a direction which is achievable by changing the timing or structuring of operation, investment, or financing transaction, and which has suboptimal business consequences. Xu et al. (2007) viewed RAM as a deviation from normal operational activities to affect reported earnings.
Manipulations of real activities are not as widely studied as management of earnings through accruals. Graham et al. (2005) provided evidence indicating that executives opt for RAM in place of accrual-based earnings manipulation because RAM it is hardly distinguishable from ideal business operational choices. They are more complex to uncover and the costs associated with such activities can be economically devastating to the company. Although definitions of RAM do differ, peculiar to them all is that RAM is an engagement meant to benefit the executives and not the firm’s shareholders.
Graham et al.’s (2005) survey revealed that 80% of respondents prefer to reduce discretionary expenses on research and development, advertisements and maintenance to meet a certain earnings threshold. Above half of the respondents, 55.3%, prefer to delay implementing a new plan to achieve a certain earnings threshold, not minding the consequences of such action to the firm’s worth. Policymakers, capital market participants, regulatory agencies, and academia are making efforts to curb such financial reporting abuses (Graham et al., 2005).
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In Nigeria, studies of earnings manipulations through real activities are limited. Hassan and Ibrahim (2014) and Bello et al. (2015) used only the cash flow from operations model in investigating the manipulation of real activities in listed manufacturing firms in Nigeria as reviewed earlier. Okolie (2014b) investigated the impact of the most studied three types of RAM on audit quality in firms listed on NSE. This is similar to the studies of Sanjaya and Saragih (2012) concerning Indonesia and Inaam et al. (2012) concerning Tunisia. It indicates the need for more studies in this area by researchers all over the world but more specifically in developing countries.
For this study, the RAM definition used is alterations of the usual operational processes done to satisfy management's greed, thereby misinforming and deceiving unwary stakeholders into accepting that achieving specific targets is by following the usual line of operations. These alterations are injurious to the well-being of the firm as well as the interest of all stakeholders.
Consistent with this definition, Graham et al.’s (2005) survey finds that (a) financial executives attach a high relevance to meeting earnings targets such as zero earnings, previous period's earnings, and analyst forecasts, and (b) they are willing to manipulate real activities to meet these targets even though the manipulation potentially reduces firm value. In the opinion of Roychowdhury (2006), RAM can decrease firm value since actions taken in the current period to boost earnings can harm cash flows in subsequent periods. For example, price discounts to boost sales and achieve some temporary earnings threshold can lead customers to anticipate such discounts in future periods as well. It can imply lower margins on future sales as the discounts will not be available. Overproduction generates excess inventories that must be sold in subsequent periods and imposes higher inventory holding costs on the company which will affect the flow of cash negatively as it becomes necessary to make payments for the holding costs incurred.
The practice of RAM changes the firm’s decision processes (operation, investment, and financing) to skew earnings towards managers' targets and desires (Zang, 2012). The methods of RAM considered in this study are manipulation of sales, production cost and discretionary expenses. Roychowdhury (2006) developed the following metrics to measure these three frequently investigated types of RAM.
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Sales activities manipulation refers to the decisions of managers to temporarily boost sales by lowering prices, granting price discounts and mild or weak credit terms/conditions (Roychowdhury, 2006). Manipulating earnings through this method will temporarily boost sale volumes, which leads to increased earnings and a decreased current period cash flow due to the discounts and credit sales. It becomes eroded in subsequent years since the increased sales level as a result of the discounts are likely to recede when the firm returns to the old prices (Roychowdhury, 2006; Sun et al., 2014).
Roychowdhury (2006) developed the following model to measure abnormal cash flow from operations (a proxy for sales manipulation) for each year and industry as available in the literature:
𝐶𝐹𝑂𝑖𝑡
𝑇𝐴𝑖,𝑡−1 = 𝑏0+ 𝑏1 1
𝑇𝐴𝑖,𝑡−1+ 𝑏2 𝑆𝐿𝑖𝑡
𝑇𝐴𝑖,𝑡−1+ 𝑏3 ∆𝑆𝐿𝑖𝑡 𝑇𝐴𝑖,𝑡−1+ 𝜀𝑖𝑡
Where, 𝐶𝐹𝑂𝑖𝑡 = the cash flows from operations for firm i at the period t;
𝑇𝐴𝑖,𝑡−1 = the total assets at the end of the prior period (t-1) for firm i;
𝑆𝐿𝑖𝑡t = the annual sale for firm i at the period t; and
∆𝑆𝐿𝑖𝑡 =the change in the sales for firm i in the current period.
4.3.2.2 Discretionary expenses manipulation
Discretionary expenditures such as R&D, advertisements, and selling, general and administration (SG&A) are period costs, which are usually taken into account immediately when incurred. Graham et al. (2005) showed that managers could reduce discretionary expenses when they are likely to miss their earning targets. Reducing such expenses will increase the reported earnings during the same period. If discretionary expenditures are generally in the form of cash, reducing such expenditures will also reduce cash outflows which will increase cash inflow from operations in the current period, possibly at the risk of lower cash inflow in the future (Roychowdhury, 2006).
Roychowdhury (2006) developed a model to measure abnormal discretionary expenses (DISX) for each year and industry, which is commonly used in the literature and described as follows:
𝐷𝐼𝑆𝑋𝑖𝑡
𝑇𝐴𝑖,𝑡−1 = 𝑏0+ 𝑏1 1
𝑇𝐴𝑖,𝑡−1+ 𝑏2𝑆𝐿𝑖,𝑡−1
𝑇𝐴𝑖,𝑡−1+ 𝜀𝑖𝑡
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Where, 𝐷𝐼𝑆𝑋𝑖𝑡 = the discretionary expenses for firm i at the period t 4.3.2.3 Production cost manipulation
Managers choose to increase production abnormally to bring down the cost of goods sold. This technique allows managers to spread fixed production overhead costs on more units of production which results in decreasing the cost of goods sold (Roychowdhury, 2006). Indeed, such reduced cost of goods sold leads to an increase in profit margins based on the assumption that other factors will remain fixed. According to Manowan and Lin (2013), the use of this technique by managers makes detection difficult for other users of accounting information. However, because of such practices, these companies face lower financial performance in subsequent years. The recovery of the holding and production costs of the firm on the over-produced goods through sales revenue in the same period is not usually achievable. Roychowdhury (2006) identified production costs as the sum of the cost of goods sold and changes in inventory during the year. He developed the following model, which has been employed in previous studies to detect manipulation in production costs (a proxy for overproduction):
𝑃𝑅𝑂𝐷𝑖𝑡
𝑇𝐴𝑖,𝑡−1 = 𝑏0 + 𝑏1 1
𝑇𝐴𝑖,𝑡−1+ 𝑏2 𝑆𝐿𝑖,𝑡
𝑇𝐴𝑖,𝑡−1+ 𝑏3 ∆𝑆𝐿𝑖,𝑡
𝑇𝐴𝑖,𝑡−1+ 𝑏4∆𝑆𝐿𝑖,𝑡−1 𝑇𝐴𝑖,𝑡−1 + 𝜀𝑖𝑡
Where, 𝑃𝑅𝑂𝐷𝑖𝑡 = the production cost for firm i at the period t;
∆𝑆𝐿𝑖,𝑡−1 = the change in the sales for firm i in the prior period.
The next section develops the hypotheses that investigated the construct of this study.
4.4 Hypotheses development