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This study investigates the Impact of Firm Size and Capital Structure on Earnings Management: Evidence from Pakistan. Total assets were used as proxy for firm size, gearing ratio as measure of capital structure and discretionary accruals for earnings management. Results indicate a significant negative impact of capital structure on earning management.
This study investigates the Impact of Firm Size and Capital Structure on Earnings Management: Evidence from Pakistan. Total assets were used as proxy for firm size, gearing ratio as measure of capital structure and discretionary accruals for earnings management. Results indicate a significant negative impact of capital structure on earning management.
This study investigates the Impact of Firm Size and Capital Structure on Earnings Management: Evidence from Pakistan. Total assets were used as proxy for firm size, gearing ratio as measure of capital structure and discretionary accruals for earnings management. Results indicate a significant negative impact of capital structure on earning management.
22 International Journal of Contemporary Business Studies Vol: 2, No: 12. December, 2011 ISSN 2156-7506 Available online at http://www.akpinsight.webs.com
Impact of Firm Size and Capital Structure on Earnings Management: Evidence from Pakistan
Iram Naz Ph. D Scholar at Muhammad Ali Jinnah University, Islamabad, Pakistan
Khurram Bhatti MS Scholar Muhammad Ali Jinnah University, Islamabad Pakistan
Abdul Ghafoor MS Scholar Muhammad Ali Jinnah University, Islamabad Pakistan
Habib Hussain Khan MS Scholar Muhammad Ali Jinnah University, Islamabad Pakistan ABSTRACT This study investigates the impact of firm size and capital structure on earnings management. Annual data for five years (from 2006-2010) for Seventy five companies from Cement, Sugar and Chemical sectors of Pakistan is obtained for the purpose of the study. Total assets were used as proxy for firm size, gearing ratio as measure of capital structure and discretionary accruals for earnings management. Jones Model was used for calculation of discretionary accruals. Data was checked for heteroskedasticity and robust regression was applied controlling the heteroskedasticity, taking discretionary accruals as dependent variable and gearing ratio and total assets as independent variables. The results indicate a significant negative impact of capital structure on earning management. Thus we concluded that firms with debt based capital structure have creditors acting as watchdog on its earning management practices, however results firm size were not significant.
Key words: Earnings management, firms size, capital structure, Jones Model, Karachi Stock Exchange (KSE).
INTRODUCTION
It is imperative to have a concrete understanding of earnings before plunging into detailed discussion of earnings management. In simple words, earnings are the income of a company. Share prices are in fact the present value of future cash flows; future cash flows are the dividends which of course are dependent on the earnings of the company. Share prices of the companies with higher projected earnings are higher as compared to the share prices of the companies with lower projected earnings. The concept of earnings management is very important because its plays very vital role in determining the stocks prices. According to Healy and Whalen Copyright 2011. Academy of Knowledge Process
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(1999:368), 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. This approach is most commonly used by the management to intentionally modify the earnings so that it can achieve its preset objectives. Debates on the concept of earnings management started in 1980s when it was investigated as a research topic in the studies. The focus of these early studies was to identify the factors that motivate management for this practice. It was found that the motives of earnings management included the management reward contract, management position, meeting market expectations, stabilizing share prices, tax evasion, profit smoothening, meeting certain regulations, meeting contract requirements and avoiding dividend payments, preparing companies for mergers. Healy (1984) conducted a research to investigate the impact of bonus schemes on accounting decisions and found that the administrative personals maneuver the accrued profit to achieve the dividend maximization goal; he also confirmed the accuracy of management reward contracts. For standard setters, in earlier literature, the earnings management provides great deal of insight, while it is complex puzzle to solve. To assess the frequency of earnings management it is very important for standard setters to have complete knowledge about earnings management whether it is ordinary or arise rarely, earnings management focuses on accruals and its effect on decisions of resource allocation. The focal point of earlier research on earnings management was to determine when and how earnings management existed. Many researchers developed the wider measures and models of earnings management from companies where the enthusiasm to administer earnings are projected to be lofty. Researches indicated that earning management does subsist but it happens for the diverse purposes. The main reasons include meeting the expectation of stakeholders, to increase managements compensation. Prevalence of Earnings management in Pakistani listed companies is a question yet to be answered. The companies with the poor economic growth rate of Pakistan are now highlighting the importance of corporate governance practices rather than adopting complex business environment to circumvent the earnings management. By implementation of corporate governance practices, the earnings management practices are supposed to be reduced, but in Pakistan the corporate governance cannot play its role effectively because most of the businesses are family owned thus run by the controlling shareholders. In that case the earning management is significantly high. Dilution of the ownership and induction of debt in capital structure thus can play an important role to prevent management from earnings management practices. Capital Structure can be explained as a companys specific short term debt, long term debt, and preferred equity and last but not the least common equity. Capital structure explains how a company has financed its overall operations and growth by using diverse sources of funds. The management manipulates its capital structure in such a way as to reduce cost of funds and maximize the firms value. This study has important implications for the stakeholders and regulators because the quality accounting information has become very important in current situation, thats why it is very hot issue not only in Pakistan but also in whole the world. In todays business world the size of firms, Copyright 2011. Academy of Knowledge Process
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capital structure and earnings management have become important. It is assumed that there is strong and critical relationship between size of firms, capital structure and earnings management. The aim of this research is to quantify the aspects that are used by firms to manipulate their earnings and also the characteristics of such firms in term of their size and capital structure. In emerging economies like that of Pakistan, it is observed that there is deviation in trends of earnings. So to help academicians and investors in predicting earnings management policy, this research elucidates the effect of capital structure on earning management. A comprehensive study of the topic led us to investigate what impact does the size (taken as total assets) of a firm have on earnings management and how the capital structure influence earnings management. Moreover, which of these two factors influences the earnings management most? LITERATURE REVIEW Healy and Palepu (1990) examined the effect of accounting-based dividend covenants on earnings management. They documented that companys dividend and accounting restrictions augment the tightness of dividend restrictions. Results showed that reduction in the dividends does have an impact on the companys accounting but to the extent to which decrease in dividend is proportional to the tightness of the dividend restriction. The study concludes that the companys accounting based conventions are effective tools for measuring dividend procedures and to confine the shareholders. Moreover, the results also showed that firms facing possible dividend covenant violations are more likely to reduce dividends than to make accounting changes. DeAngelo et al. (1994) investigated the accounting choice of seventy six firms with consistent losses and dividend diminution listed on New York Stock Exchange (NYSE). The results suggested that managers accounting policies defined the companys financial difficulties instead of having tried to blow up the income and that the firms facing possible dividend covenant violations were more likely to reduce dividends to shareholders than to manipulate accounting earnings.DeFond and Jiambalvo (1994) examined the sample of unusual accruals of 94 firms that accounted debt convention breach in their yearly reports. The methods used to determine the normal accruals were time-series and cross-sectional models. They showed that there had been a proof of abnormal positive working capital accruals after controlling for auditor going concern qualifications and management changes. Moreover it was found out that firms had used excessive discretionary accruals in the year preceding the reported debt convention breaches. Burgstahler and Dichev (1997) took a sample of 300 organizations examine whether the earnings management controlled the losses of the firm. The results indicated that both small and large sized firms manage earnings to circumvent the small negative or small decrease in earnings. Rangan, (1998) found a significant relationship between earnings management and performance of experienced equity offerings. He took a sample of 300 companies and applied cross sectional regression analysis, the results suggested that older and largest firms were maneuvering the current accruals to exaggerate the earnings of the experienced equity offerings .Degeorge, F., J. Patel, and R. Zeckhauser (1999) investigated the impact of behavioral earnings entrances induced on explicit kinds of earnings management considering the company magnitude. He chose a sample of 400 listed firms and used regression analysis to study the impact. The results indicated that large companies manipulated the earnings of the company to avoid the negative earnings. Copyright 2011. Academy of Knowledge Process
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Myers and Skinner (2000) examined that managers used the EPS techniques to increase the quarterly long term earning managements, either by flatting the earnings to stabilize the companys earnings or by uplifting the earnings to attain higher earnings. The researchers took the sample of 399 firms with 17 successive increase in quarterly split adjusted EPS and used different characteristics of I/B/E/S analysts earning predications. The results showed that big companies did not account the true picture of their earnings after the review of earning growth. Barton and Simko (2002) studied the balance sheets of 200 firms as an earnings management constraint for managers using statistical tools. Results indicated that big companies faced more influence to get the analysts demands to manage earnings more effectively and efficiently.Nelson et al. (2002) conducted a survey of 253 experienced auditors and asked them to identify how earnings were actually managed from their point of view. The survey showed that sometimes auditors may ignore the earnings management of big clients, in other words by large sized firms.Ching, Firth and Rui (2002) examined that whether unrestricted current accruals forecasted the returns and earnings performance. They took a sample from stock exchange fact book and securities journal from 1993 to 1998 and measured the data by cross-sectional regressions. The results indicated that larger firms were manipulating current accruals to overstate earnings than the small sized firms. Companies do earnings management to attract external financing at lower cost (Richardson, Tuna and Wu 2002). After examining a broad sample taken from (1971-2000) of companies that were enforced to reaffirm earnings, results indicated that the key point of information of accruals are operating and investing accruals that helped to maneuver the earnings to restated. Kim, Liu and Rhee (2003) examined the relationship between corporate earnings management and the firm size. They analyzed the earnings of the small, medium and large companies in relation to their size and the beginning of the market value of each year by taking a sample data of 18 years. They observed that company size had a strong impact on the earning management.Small sized companies were avoiding the addition of earnings management as compared to large companies. On the other hand the medium and large size companies were more involved in earning management as compare to small firms. Bergstresser and Philippon(2006) poved through their study that use of discretionary accruals for the earning management was a distinct tool of the companys CEO because the overall potential compensation was more closely sick to the value of option holdings and stocks. Furthermore, if company had high accruals then CEO exercise abnormal large number of options and some other insider CEOs sold huge quantity of shares. Moreover the research found out that CEO compensation impacted the propensity of firms to manage earnings.Sarker, Sarker and Sen (2006) found correlation between actions of board of directors and earnings management. They concluded that hard working board of directors would be less involved in the earning management while greater number of directors were more indulged in manipulation of earning management activity in India.. Sercu, Bauwhede and Willekens (2006) elucidated the link among capital structure and earnings management by taking a sample of 1302 Belgian non-listed firms and using exploratory models, they found out that earnings management (EM) was positively related to leverage. Moreover main empirical findings by them were that debt was heterogeneous in respect of earnings management i.e. if we were to judge it by the amount of EM it would have triggered, bank debt seemed to be perceived as more alarming than trade credit. Sun and Rath (2009) analyzed the activities of earning management in Australia by taking sample of 4844 firms over period from 2000 to 2006 using Regression model to analyze whether firms were involved in earnings management or not. Results indicated that small companies having lower profits were more indulged in earning management. The study also showed that periphery sector companies Copyright 2011. Academy of Knowledge Process
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exhibited a higher tendency for income-increasing earnings management behavior than core sector companies. Zhaoguo and Xiaoxia (2009) examined the relationship between capital structure and earnings management with reference to the Chinese capital market. They measured the impacts of debts, the proportion of controlling shareholders', executives and external large shareholders. Analyzing Chinese companies listed from 2003 to 2007, they established a link between capital structure and earnings management practices by providing evidence that the equity proportion of controlling shareholders had an inverted U shaped relationship with earnings management, and the debt ratio had a strong positive relationship with earnings management.According to Jelinek (2007) there is negative relationship between leverage and opportunistic behavior, when leverage increases opportunistic behavior decreases and earnings management that is related in this function. Primarily it is opportunity behavior that motivates the earnings management. Opportunistic managers involve in manipulation of earnings to cover their opportunistic or non value maximizing behavior (Christie and Zimmerman, 1994: Eastwood, 1997). In setting of take over firms, Christie and Zimmerman (1994) and Eastwood (1997) discovered that managers of take over firms try engage in earnings management to hide their suboptimal behavior. Christie and Zimmerman(1994) found take over firms engaged in increased income accounting method from last 11 years for takeover. The one of the most important challenge faced by researchers as well as academician is that they are unable to fine study the component of earnings management accruals (Beneish, 2001). It can be very difficult to find out and then distinguish between the fraudulent and aggressive but acceptable choice of manipulation exercise that the managers will do in their accounting decisions. (Beneish, 2001) According to Watt and Zimmerman (1986) there are so many factors like constraint of debt covenant, provision compensation plan and political cost that is require to issue equity, insider trading etc that motivate the management involve in earnings management. Most of the studies suggest that management engage in earnings management to setback the onset default (Sweeny, 1994; Defond and Jimbalvo, 1994), but others studies do not find such relationship (Beneish and Press. 1993; DeAngelo, DeAngelo and Skinner, 1994). Some of studies by Healy (1985), Graver et al. (1995) and Holthausen, Laker and Sloan (1995) found evidence that managers engage themselves in earnings management to increase their compensation. Razzaque, Rahman and Salat (2006) investigated earnings management in textile sector of Bangladesh. They found that discretionary accruals are significant in most of the firms. The size of firm has positive relation with earnings management. The first is, size of firm basically relate with internal control system. The larger companies have complex internal control system then smaller one. Efficient internal control system may help the company to disclose inaccurate information to the public. The one of the most important factor that mitigates earnings management and improves the quality of financial report is corporate governance (Warfield, et al., 1995). According to Beasley, et al (2000) most of the deceitful companies in health care, financial service had less internal audit support that were accompanied by weak corporate governance mechanism. The second, the large firms are audited by big 5 Certified Public Accounting firms, these firms have experienced auditor so the chances of earnings management is less. According to Gore, et al. (2001) the non big 5 CPA auditors allow more earnings management then big 5 auditors. In addition, the firms that are audited by big 5 report lower level of discretionary accruals (Becker, Copyright 2011. Academy of Knowledge Process
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et al., 1998; Francis, et al., 1999; and Payne and Robb, 2000). Lennox (1999) find that audir reports issued by large auditors are more accurate and informative then the report issue by small auditors. The review of related literature showed some evidence of the causal relationships among firm size, capital structure and earnings management. These relationships led us to hypothesize as firm size (taken as total assets) has an impact on earnings management and the capital structure of the firms has an impact on earnings management. METHODOLOGY
This study uses the descriptive research methods to identify the impact of size of the firm and the capital structure on earnings management of the companies. The major purpose of the descriptive research is description of the state of affair, as it exists at present. Descriptive research specifies the objective and the techniques for collecting the information from the company and the data collected is processed and analyze using tables and statistical tools.
Population and Sample All private firms in Pakistan constitute the population of this study. Convenient sampling technique was used to decide the sample size. Seventy four companies from three sectors namely Sugar, Cement and Chemical Sectors were chosen as sample for analysis.
Data collection Data related to our variables is extracted from the State Banks Financial Review report (2006- 2010) of the sampled companies. The dependent variable, (earnings management) was measured by discretionary accruals. Jones Model was used to calculate the discretionary accruals. Jones model based on paper by Jones (1991) is very common model use for measuring earnings management. The model runs multiple regression with total accruals as dependent variable. The model can be implemented on time series as well as on cross section. The residual values from this regression model give the value of discretionary accruals.
Total accuralst/ total assetst-1 = 1 (1/total assetst-1) +2 (PPEt/ total assetst-1) + 3 (REVt- RECt/ total assetst-1)
Value of total assets and gearing ratio were taken for the independent variables, Firm size and capital structure respectively.
Gearing ratio = Long Term Debt Shareholders equity
Analysis Tool Data was tested for heteroskedasticity by applying Breusch-Pagan / Cook-Weisberg test for heteroskedasticity in STATA. Null hypothesis under this test was a constant variance. The test results were insignificant with chi square value of 3.40 and Probability of chi2 0.0653, thus presence of heteroskedasticity in the data was supported. A robust regression was run by controlling the heteroskedasticity.
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DATA ANALYSIS Development of Regression Model
Y = + 1X1 + 2X2 +
Whereas = Intercept Y = Earnings Management X1 = Capital Structure X2 = Size of Firm = Coefficient of X1 2 = Coefficient of X2 = Error
RESULTS AND DISCUSSION
Table 1 shows the model summary. The F value is 3.85 with probability of 0.0222 this shows the significance of model. R squared value of 0.0134 shows that 13.4% variation in earning management (Dependant Variable) is explained by Firm Size and Capital Structure (Independent Variables).
Table 1: Model Summary Linear regression Number of observation 365 F( 2, 362) 3.85 Prob > F 0.0222 R-squared 0.0134 Root MSE .40995
Table 2 shows the results of regression analysis. The estimate of the slope coefficient for capital structure is -0.0026641 with p value less than .05. Hence a significant negative impact of capital structure on earning management. This is consistent with earlier findings. The rationale for negative relation is supported by fact that capital structure is measured through leverage, as leverage increases the creditors interest in companies activities increases, they act as free watchdogs and look after the companies practices related to earning management. Thus our first hypothesis that firms capital structure has an impact on earnings management is supported. However result did not support our second hypothesis that is firm size has an impact on earnings management. The coefficient for firm size is 0.0223748 with p value greater than .05, thus these results are insignificant. Table 2: Coefficient Discretionary Accrual Coefficient Standard Error T p>|t| [95% Conf. Interval] Capital Structure
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CONCLUSION AND RECOMMENDATIONS This analysis is only used in Jones model because it is more efficient at modeling the panel data process engendering non discretionary accruals and undergo less from misspecifications caused by gone astray variables of non discretionary accruals (Dechow etal., 1995), Even though other models were used by the different researchers. Our findings suggest the tentative facts of earning management since we have applied the Jones model in measuring the discretionary accruals, gearing ratio to measure the capital structure and to measure the size of firm we take figure of total assets of firms. The negative impact of capital structure on earning management as suggested by our results implicates the use of debt in capital structure as a tool to encounter the problem of earning management. This may also suggest the nomination of a creditors director on the firms board to ensure that practice of earning management is discouraged. Earnings management is term which cover up a large range of valid and illicit actions that affect the earnings of an entity. Here are some recommendations for the firms who do earnings management. Earnings management may involve intentionally recognizing or measuring transactions and other events and circumstances in the wrong accounting period or recording fictitious transactions both of which constitute fraud. Firms should avoid this. There is an opportunity for researcher to conduct the research on this topic in Pakistani environment, furthermore, future researcher can be carried out to examine the relationship among the earning management and various incentives like enhance managerial compensation of increase capital. The results from this study could be worthy of being generalized if a more variables are taken to study this impact because the r squared value suggests the presence of more variables that may have a significant impact on earnings management. REFERENCE Barton, J. and Simko. P. 2002. The balance sheet as an earnings management constraint. Accounting Review, 77, pp. 1-27.
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