Impact of Firm Size and Capital Structur PDF

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
Habib Hussain Khan

MS Scholar
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
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Copyright 2011. Academy of Knowledge Process

(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,
23

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.
24

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
25

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,
26

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 (20062010) 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 (REVtRECt/ 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.
27

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
365
Number of observation
3.85
F( 2, 362)
0.0222
Prob > F
0.0134
R-squared
.40995
Root MSE
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
Standard
Coefficient
T
p>|t|
[95% Conf. Interval]
Accrual
Error
Capital Structure
-.0026641
.0010503 -2.54
0.012
-.0047296
-.0005987
ln(T. Assets)
.0223748
.0159741
1.40
0.162
-.0090389
.0537884
Constant
-.1567622
.1221406
-1.28
0.200
-.3969565
.0834321
28

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.
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International Journal of Contemporary Business Studies

Vol: 2, No: 12. December, 2011 ISSN 2156-7506

Impact of Firm Size and Capital Structure

Habib Hussain Khan

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

RESULTS AND DISCUSSION

International Journal of Contemporary Business Studies

CONCLUSION AND RECOMMENDATIONS

International Journal of Contemporary Business Studies

International Journal of Contemporary Business Studies

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