Hypotheses development

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Where, 𝐷𝐼𝑆𝑋_𝑖𝑡 = 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):

𝑃𝑅𝑂𝐷_𝑖𝑡

𝑇𝐴_{𝑖,𝑡−1} = 𝑏₀ + 𝑏₁ 1

𝑇𝐴_{𝑖,𝑡−1}+ 𝑏₂ 𝑆𝐿_𝑖,𝑡

𝑇𝐴_{𝑖,𝑡−1}+ 𝑏₃ ∆𝑆𝐿_𝑖,𝑡

𝑇𝐴_{𝑖,𝑡−1}+ 𝑏₄∆𝑆𝐿_{𝑖,𝑡−1} 𝑇𝐴_{𝑖,𝑡−1} + 𝜀_𝑖𝑡

Where, 𝑃𝑅𝑂𝐷_𝑖𝑡 = the production cost for firm i at the period t;

∆𝑆𝐿_{𝑖,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

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motivated to perform their monitoring role effectively. Researchers have recognised the audit committee’s role as being critical in ensuring the credibility of the financial statements (Abbott et al., 2001; Rahahleh & Hamzah, 2019). Therefore, the audit committee as a monitoring mechanism is intended to reduce information asymmetries between management and stakeholders, since its essential functions are to improve the quality and accuracy of financial information by continually monitoring management's opportunistic behaviours (Li, Mangena, & Pike, 2012). Krishnan and Visvanathan (2008) indicated that RAM has increased since the introduction of SOX (2002). Their study found a negative association between RAM and characteristics of audit committees; however, certain audit committees characteristics may play a role in constraining RAM. In contrast, Carcello et al. (2006) showed either no relationship or a direct relationship between audit committee characteristics and RAM. The same applies to the studies of Bello et al. (2015) and Hassan and Ibrahim (2014), which both found a positive and significant relationship with some audit committee attributes. As there are conflicting results on the impact of various attributes of the audit committee on RAM, the following hypothesis was formed to examine this impact:

H1: Attributes of audit committee members in Nigerian listed companies has a negative effect on real activities manipulations.

This hypothesis is further subdivided into six to capture all the six dimensions of the attributes under investigation, namely, audit committee independence, audit committee financial literacy, audit committee female directorships, audit committee frequency of meetings, audit committee multiple directorships, and audit committee size. The next section reviews empirical literature on the relationship of these attributes of audit committee and RAM, and then forms the related hypotheses.

4.4.1.1 Audit committee independence (ACIND) and RAM

Audit committee independence refers to the proportion of the independent directors in the audit committee. A common prediction is that monitoring functions will increase when the audit committee is more independent (Ali & Handayani, 2018; Inaam et al., 2012). Theories postulate that when the board includes more numbers of independent directors, it will better oversee and control the executive directors’ actions and connect the company with its external environment (Ali & Handayani, 2018). Empirically, studies provide inconsistent results. For example, Inaam et al. (2012) found a significant

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negative relationship between audit committee independence and all measures of RAM which included sales manipulations and overproduction. Other studies that recorded an insignificant relationship with RAM include those of Abdullah and Wan-Hussin (2015), Bello et al. (2015), Talbi et al. (2015), Garven (2015), Hassan and Ibrahim (2014), and Emna, Trabelsi, and Matoussi (2014). The reviewed studies revealed an insignificant relationship between audit committee independence and RAM. Therefore, this study hypothesises that:

H1A: Audit committee independence has a negative effect on real activities manipulations in Nigerian listed companies.

4.4.1.2 Audit committee financial expertise (ACFLT) and RAM

An essential audit committee attribute that has gained the attention of regulators and researchers is financial expertise (Dhaliwal et al., 2010). Many professional and regulatory bodies worldwide have suggested that audit committee members should have enough financial expertise to discharge their responsibilities (Ghafran & O'Sullivan, 2013). Audit committee members with financial knowledge help in better understanding the accounting procedures and financial reporting process (Lin, Xiao, & Tang, 2008).

Therefore, directors with financial knowledge, skills, and expertise are likely to increase the monitoring role and enhance the quality of financial reporting. Empirically, studies provide mixed results, for example, Bello et al. (2015), Abdullah and Wan-Hussin (2015) and Hassan and Ibrahim (2014) find a significant negative relationship between audit committee financial expertise, whereas Susanto and Pradipta (2016) and Inaam et al. (2012) find no significant effect of audit committee financial expertise on RAM.

Given the mixed results, therefore, this study hypothesises that:

H1B: Audit committee financial literacy has a negative effect on the manipulations of real activities in Nigerian listed companies.

4.4.1.3 Audit committee meeting frequency (ACMTG) and RAM

Audit committee meeting frequency refers to the number of the audit committee meetings held during the fiscal year. An audit committee that meets infrequently is unlikely to be effective monitors of managers and focus on issues like RAM.

Empirically, Garven (2015) reported that audit committee meeting frequency effectively curbs RAM as it has a negative statistically significant relationship with RAM.

However, Abdullah and Wan-Hussin (2015) and Inaam et al. (2012) found an insignificant relationship between audit committee meeting frequency and RAM. Some

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studies found a positive statistically significant relationship between audit committee meeting frequency and RAM which implied that increasing the number of audit committee meetings will lead to a proportional increase in RAM practices (Bello et al., 2015; Hassan & Ibrahim, 2014; Susanto & Pradipta, 2016). Considering the mixed results, therefore, this study hypothesises that:

H1C: Audit committee frequency of meetings has a negative effect on the manipulations of real activities in Nigerian listed companies.

4.4.1.4 Audit committee female directorships (ACFDR) and RAM

Bordean and Borza (2017) are of the view that men are the dominant gender on most corporate boards. The issue of gender diversity is attracting more attention, and agency and stakeholder theories explained the need for gender diversity on corporate boards (Cabrera-Fernández, Martínez-Jiménez, & Hernández-Ortiz, 2016). The assumption is that female audit committee members contribute to stricter oversight functions of the audit committee and cooperate more with the external auditors (Velte, 2017). In the opinion of Gul, Srinidhi, and Ng (2011), earnings manipulation decreases if an audit committee has even one female member. Gul et al. (2011) also revealed that the tendency for male members to be less ethical than their female counterparts is high.

This latter opinion is supported by Bruns Jr and Merchant (2006) that earnings manipulation is a moral issue. Studies confirmed that women present a more ethical view than men, and they seem to be more capable of identifying unethical behaviours (Eweje & Brunton, 2010). Similarly, other studies indicated that female directors are more risk-averse in decision making and are more conservative than men (Eckel &

Grossman, 2008; Man & Wong, 2013). These two attributes (aversion and conservatism) may influence the integrity of the financial reporting process. As argued by Man and Wong (2013), earnings manipulation is associated with risk and as women present more conservative behaviours than men, this may lead to the conclusion that men are more likely to manipulate financial statements than women. Krishnan and Parsons (2008) investigated Fortune 500 companies from 1996-2000 for the association between earnings quality and the presence of women in managerial positions. They found that earnings manipulation is low and earnings quality is higher when there is at least one female director on the audit committee.

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However, in contrast, Sun et al. (2011), questioned whether a director's gender on a completely independent audit committee impinges on the committee's capacity to constrain manipulation of earnings and thereby influence their oversight function on the process of financial reporting. The study found an insignificant relationship between the ratio of female directorships and the depth of earnings manipulations, using 525 firm- year data between the years 2003 to 2005. In a similar vein, Sanjaya and Jati (2015), while considering the characteristics of the audit committee and RAM, found that audit committee gender (measured by the proportion of female members of the committee) has no significant relationship with RAM. The following hypothesis is formed:

H1D: Audit committee female directorship has a negative effect on real activities manipulations in Nigerian listed companies.

4.4.1.5 Audit committee multiple directorships (ACMDR) and RAM

Directors who have additional directorships in other companies may find that this enhances their monitoring role as they can gain greater experience from these different positions (Bédard et al., 2004; Sun et al., 2014). Another view is that directors with additional directorships may become less effective as they are busy. Due to the costs and benefits associated with multiple directorships, there are both potentially positive and negative effects of audit committee members with multiple directorships on audit committee effectiveness. An audit committee member with high multiple directorships might be overcommitted and therefore contribute less time and effort to the audit committee service. On the other hand, an audit committee member with high multiple directorships might contribute to its effective functioning as he or she might bring more experience (knowledge transfer effect) and have stronger incentives to monitor because of the higher reputational capital at stake (labour market effect). Both time commitment and expertise are important to audit committee effectiveness. Therefore, the overall effect of multiple directorships on audit committee effectiveness is uncertain. Previous studies have examined the role of audit committee member’s additional directorship and RAM. These studies provide empirical evidence that audit committee members’

additional directorships are positively associated with RAM (Garven, 2015; Sun et al., 2014), indicating that the oversight functions of the audit committee decrease with additional directorship seats (Garven, 2015). Based on these reviews, the study hypothesises thus:

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H1E: Audit committee multiple directorship has a negative effect on real activities manipulations in Nigerian listed companies.

4.4.1.6 Audit committee size (ACSZE) and RAM

The size of an audit committee may play an important role in monitoring earnings manipulations (Juhmani, 2017). Krishnan and Visvanathan (2008) have shown that the objective in determining optimal audit committee size is to have a committee small enough to be manageable but large enough to monitor effectively. Thus, to effectively monitor RAM, a committee larger than the required minimum may be needed.

However, in the reviewed studies on the audit committee attributes/characteristics and RAM, shown in Table 4.2, indicates that there is no study which provides evidence on the relationship between audit committee size and RAM except Sun et al. (2014). This suggests that audit committee size has little or no significant effect on RAM practices.

The following studies, Bello et al. (2015), Hassan and Ibrahim (2014) and Inaam et al.

(2012), all reported a significant positive relationship between the size of the audit committee and RAM. It implies that the size of an audit committee serves as a motivation for managers to manipulate real activities. Other studies, for example, Susanto and Pradipta (2016), Abdullah and Wan-Hussin (2015), Garven (2015), and Visvanathan (2008), failed to find a significant relationship with RAM. Given these findings, it is appropriate to hypothesise thus:

H1F: Audit committee size has a negative effect on the manipulation of real activities in Nigerian listed companies.