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«ijcrb.webs.com JANUARY 2012 VOL 3, NO 9 INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS Efficient or opportunistic earnings management ...»

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ijcrb.webs.com JANUARY 2012

VOL 3, NO 9


Efficient or opportunistic earnings management with regards to the role of

firm size and corporate governance practices

Farzin Rezaei* (Corresponding author) 

Assistant Professor of Accounting and Management faculty, Qazvin Branch, Islamic Azad University, Qazvin, Iran.

Maryam Roshani M.A. Student of Financial Management, Qazvin Branch, Islamic Azad University, Qazvin, Iran.

Abstract The purpose of this study is to examine the type of earnings management in Iran and to investigate it, the effect of discretionary accruals, as a proxy for earnings management, on future profitability has been examined. Also we consider the effect of firm size, ownership structure, audit quality and the proportion of independent board members on it. In this research, a sample of 167 firms in a 6 year financial period from 2004 to 2009 has been analyzed and fixed effect regression method is applied. The results show that managers tends to use efficient earnings management in Iran and firm size, ownership structure, audit quality and the proportion of independent board members can influence on the type of earnings management.

Key words: Efficient earnings management, opportunistic earnings management, discretionary accruals, corporate governance practices, firm size  

1. Introduction  Financial reporting is so important to all users of financial statements in making decisions, that the study of EM(Earnings Management) is expected to be very useful to them (Al-khabash & Al-Thuneibat, 2009). According to public perception, earnings management occurs “when managers use judgment in financial-reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy & Wahlen, 1999).

Managers can use earnings management to deliver some useful and superior information which they know about firm performance to shareholders and debt holders. If this is the case, then, earnings management may not be harmful to the stockholders and the public. On the other hand, the financial scandals at Enron and WorldCom changed the nature of earnings management toward an opportunistic view. With regards to this view, managers manage earnings for their own private benefits rather than for the benefits of the stockholders (watts and Zimmerman, 1986; Subramanyam, 1996; Holthausen, 1990; Healy and Palepu, 1993; Guay, Kothari, and Watts, 1996; Demski, 1998; Arya, Glover, and Sunder, 2003; Hao, 2010 & jiraporn, 2008).

Firm size can influence on the type of earnings management. Generally large companies have developed internal control systems, audited by audit firms with long history and also take into consideration the reputation costs when they engage in earnings management (Kim et al. 2003). With reference to these reasons we expect that large sized firms are tend to apply opportunistic earnings management less than those in smaller firms.

Institutional investors have the opportunity, resources and ability to monitor, discipline and influence a manager’s decision in the firm (Chung et al. 2002; Monks and Minow, 1995). So they are more able of detecting opportunistic earnings management than non-institutional investors.

Independent directors are supposed to monitor management activities in favor of shareholders. The findings of Dechow et al. (1996) and Beasley (1996) show that higher proportion of independent directors, more confidence in the firm’s financial reporting system.

High quality auditors are more likely and able to detect questionable accounting practices, and report material errors and irregularities than low quality auditors. Because high quality auditors have the expertise, resources, and incentives to separate the information component from noise, they can enhance the informativeness of discretionary accruals by constraining aggressive and opportunistic reporting of accruals by managers (Krishnan, 2003).

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Findings of Prior Researches  2.

2.1. Prior research on type of earnings management   The findings  of  Siregar and  Utama  (2008)  imply that earnings  management  tends  toward  efficient  in  Jakarta.  Also they find that firms with a high proportion of family ownership and non‐business groups are more inclined to  choose efficient earnings management than other types of firms.  Subramanyam (1996) examines if current-period discretionary accruals help predict future cash flows, earnings, and dividends. It is expected that accruals should help predict cash flow if discretionary accruals increase the information content for current earnings-related future performance. He finds evidence consistent with this hypothesis, suggesting that discretionary accruals do add informational content to earnings.

Jiraporn et al. (2008) offer agency theory as a tool to distinguish between the opportunistic and beneficial uses of earnings management. The empirical evidence suggests that firms where earnings management occurs to a larger (less) extent suffer less (more) agency costs. Moreover, a positive relation is documented between firm value and the extent of earnings management. Taken together, the results reveal that earnings management is, on average, not detrimental.

2.2. Prior research on earnings management and firm size  Kim et al. (2003) find that small firms engage in more earnings management than large or medium-sized firms to avoid reporting losses. On the other hand, large and medium-sized firms exhibit more aggressive earnings management to avoid reporting earnings decreases than small sized firms.

Lee and Choi (2002) also find that small companies tend to more frequently manage earnings to avoid losses than do large companies. But, Moses (1987) finds evidence that large firms have more incentive to smooth earnings than small firms.

2.3. Prior research on earnings management and corporate governance  Chung et al., (2002) find evidence supporting that the presence of large institutional shareholdings inhibit managers from increasing or decreasing reported profits towards the managers’ desired level or range of profits.

This evidence is consistent with institutional investors monitoring and constraining the self-serving behavior of corporate managers.

Rajgopal, Venkatachalam, and Jiambalvo, (2002), Jiraporn and Gleason (2007), Koh (2005) and Mashayekhi (2008) argued that institutional share ownership may have implications for earnings management as they are able to influence the company’s management. The results indicate that institutions with large shareholdings play an active role in monitoring managerial opportunism in managing the reported earnings.

The findings of Dechow et al. (1996) and Beasley (1996) imply that higher proportion of outside directors in the Board Committee is associated with greater confidence in the firm’s financial reporting system.

Klein (2002) examines whether board attributes are related to earnings management among S&P 500 firms for the period 1992-1993. She finds a significant and negative association between the incidence of abnormal accruals and (a) the percentage of independent directors on the board and (b) the fact that outsiders account for the majority of board members.

Jaggi et al. (2009) find that independent corporate boards of Hong Kong firms provide effective monitoring of earnings management, which suggests that despite differences in institutional environments, corporate board independence is important to ensure high-quality financial reporting.

Norman et al. (2005) and Kam (2007) find that outside directors do not reduce the incidence of earnings management.

Osma & Noguer (2005) investigated whether corporate governance mechanisms are effective in constraining earnings manipulation for Spanish companies during the period 1999-2001. They analyzed the association between earnings management and two key aspects of corporate governance: board composition and the existence of board monitoring committees. The results show that board composition significantly determines earnings manipulation practices. However, the main role in constraining such practices is not played by independent directors, as UK and COPY RIGHT © 2012 Institute of Interdisciplinary Business Research ijcrb.webs.com JANUARY 2012 VOL 3, NO 9


US based research suggests, but by institutional directors. The study found no correlation between the existence of an independent audit committee and earnings management measures.

The results of Al-Abbas et al. (2009) provide no evidence that corporate governance factors mitigate against earnings management in the Saudi environment. However, auditing firm’s size negatively relates to abnormal accruals, which indicates that auditing firm’s size is an important factor with regard to the extent of earnings management.

DeAngelo (1981) argues that auditor size is a proxy for auditor reputation and audit quality. She reasons that brand-name auditors (i.e., Big 5 auditors) are better able to detect material misstatements in financial statements and more willing to report what they find than are other auditors (i.e., non-Big 5 auditors).

Zhou and Elder (2003) and Chen et al (2005) find that Big 4 auditors associate with less earnings management in the firms.

3. Literature review and hypotheses development 

3.1. The type of earnings management  There is a public perception that earnings management is utilized opportunistically by firm managers for their own private gain rather than for the benefit of the stockholders. This misalignment of managers' and shareholders' incentives could induce managers to use the flexibility provided by the accounting standards to manage income opportunistically, thereby creating distortions in the reported earnings. However, a number of academic studies have argued that earnings management may be beneficial because it potentially enhances the information value of earnings. Managers may exercise discretion over earnings to communicate private information to stockholders and the public (Al Fayoumi et al, 2010).

Therefore, we test whether earnings management is efficient or opportunistic by examining the effect of discretionary accruals on future profitability. If the effect of discretionary accruals on future profitability is positive, then the type of earnings management will be efficient. If the effect of discretionary accruals on future profitability is negative or they don't have any significant relationship, then the type of earnings management will be opportunistic.

Hypothesis 1. There is a relationship between discretionary accruals and future profitability.

3.2. The effect of company size on the type of EM  The firm size may have an effective role in constraining opportunistic earnings management. First, the size of a firm is related to the internal control system. Larger companies may have more sophisticated internal control systems and have more expert internal auditors in comparison to smaller companies.

Second, large firms are usually audited by large sized audit firms (big 5 CPA firms). Large CPA firms tend to have more experienced auditors that in turn could help prevent earnings misrepresentation.

Third, large firms take into consideration the reputation costs when engaging in earnings management. Large firms have usually grown up with a long history during which they may have better appreciation of market environment, better control over their operations and better understanding of their businesses relative to small firms.

Therefore, their concern about reputations may prevent large firms from manipulating earnings (Kim et al. 2003).

According to above reasons we expect that large companies are more likely to manage earnings efficiently than opportunistically, and so there will be a positive relationship between discretionary accruals and future profitability.

Hypothesis 2. Earnings management tends toward efficient in large firms.

3.3. The effect of corporate governance practices on the type of EM  Relying on Earnings numbers are more when management’s opportunistic behaviour is controlled (Wild, 1996;

Dechow et al., 1996; Klein, 2002; Peasnell et al., 2000 & Bugshan, 2005).

Large shareholders are often considered as sophisticated investors (Balsam et al., 2002; Jiambalvo et al., 2002 & Collins et al., 2003). they have the ability to play a more active role in monitoring and disciplining management than small shareholders, which might alleviate earnings management (Rifi, 2010).

Therefore, we test the following hypothesis.

Hypothesis 3. Earnings management tends toward efficient in firms with high proportion of institutional ownership.

Board of directors play an important role in monitoring management to protect shareholders’ interest. The Board Committee consists of executive directors and independent non-executive directors. The role of independent nonexecutive directors is to bring independent judgment to the Board (Yang, 2009). As outside members do not play a COPY RIGHT © 2012 Institute of Interdisciplinary Business Research ijcrb.webs.com JANUARY 2012 VOL 3, NO 9


direct role in the management of the company, their existence may provide an effective monitoring tool to the board and thus produce higher quality financial reports (Hashim & Devi, 2008).

With reference to above reasons, we expect that firms with high independent board members are more likely to manage earnings efficiently than opportunistically, and so there will be a positive relationship between discretionary accruals and future profitability.

Hypothesis 4. Earnings management tends toward efficient in firms with high proportion of independent board members.

The most commonly used audit quality proxy is auditor size (e.g., Tendeloo and Vanstraelen 2008; Piot and Janin, 2006; Krishnan, 2003; Vander Bauwhede et al., 2000; Becker et al., 1998). Big-4 auditors have reputation and they are more experienced (Krishnan, 2003) and more conservative in their opinion (Piot and Janin, 2006), they are more likely to constrain earnings management.

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