Corporate reporting quality

The divergence of ownership and control gives rise to agency conflict where agents tend to perform actions that are not in line with principals’ interests. This misalignment of interests leads to information asymmetry, such that the agents as the insiders have better access to information in relation to the firm’s present and likely future performance that is superior to those acquired by the principals. In such situations, agents may take advantage of their

unobservable actions to engage in opportunistic behaviour for personal benefit (Ho Tower and Barako, 2008).

It is viewed that the corporate governance mechanism of legal corporate reporting becomes a necessity as it is intended to reduce information asymmetry and monitor managerial behaviour. The demand for corporate reporting arises as shareholders are unable to completely observe and verify managers’ actions. Quality corporate reporting is thus essential as it acts as a tool to evaluate a firm’s performance level and serve as a guide for a firm’s value (Dechow, 1994).

The quality of corporate reporting may be impaired when managers use corporate reporting to report artificial firm performance to obscure the firm’s true financial situation. Managers might manipulate corporate reporting to increase information asymmetry in order to inhibit shareholders’ ability to supervise and incentivise them appropriately. While managers and blockholders might engage in opportunistic behaviour, agency theory highlights that not all investors do this, it is merely a possibility.

Prior literature has identified that earnings management can prevent the attainment of a high quality corporate report. It is also seen as evidence of a financial reporting process

breakdown (Cohen et al., 2004). This is possible as earnings management is commonly used

by managers to camouflage a firm’s actual financial performance for rent seeking purposes at the expense of the shareholders. In this view, managers or blockholders might engage in earnings management to intentionally boost reported profits (e.g., to portray good performance) or reduce earnings (e.g., to reduce tax payable), thus increasing the likelihood for income-decreasing or income-increasing forced restatement to take place. In view of this, earnings management is taken as a proxy in this study for opportunistic behaviour by managers and blockholders. One of the earnings management techniques used by managers is accruals-based earnings management. On the one hand, accrual-based earnings management can be used to deliver value-relevant information (Healy and Palepu, 1993; Subramanyam, 1996). Ghosh and Moon (2010), for example, found that accruals were used by managers as a tool to communicate private information about a firm’s future prospects. On the other hand, accrual-based earnings management can be used to mask a firm’s true underlying performance (Dechow and Skinner, 2000). Numerous earnings management literature document that accruals are being managed opportunistically by

2008; Dechow et al., 2011). In contrast to the non-discretionary component of accruals, which are standard accounting adjustments to operating cash flows (such as salary and rental expenses), the discretionary component of accruals are exposed to managerial discretion. This is because the GAAP allows considerable flexibility for managerial judgement and discretion (e.g., by manipulating accounting estimates or changing accounting methods); this leaves substantial leeway for managers to engage in

opportunistic management or manipulation of discretionary accruals (Marra et al., 2011).

Accruals based earnings management is typically favoured among self-interested managers

as it has relatively no direct impact on cash flow and is generally hard to detect (Peasnell et

al., 2005).

This study uses several proxies to measure accruals-based earnings management. One of the proxies used to examine discretionary accruals is the Modified Jones model (1995) (DAMJ). The DAMJ is chosen over the Jones (1991) model because the explanatory power of the Jones model is relatively low. Specifically, Jones (1991) provides evidence on the correlation between accruals and firm attributes, but found that the explanatory power only explains approximately 10 percent of the variation in accruals. The Jones model is also subject to high Type I and Type II errors (Dechow et al., 2010). Type I error refers to false positive, where accruals are classified as abnormal when in fact they represent a firm’s fundamental performance. Type II error refers to false negative, where accruals are classified as normal when in fact they represent managerial discretion. The DAMJ by Dechow et al. (1995) is derived by adjusting for credit sales growth to reduce Type II errors. Since manipulation often involves credit sales, such modification improves the explanatory power of the DAMJ at a level where the residual is uncorrelated with normal revenue accruals. In such cases, the Modified Jones model is seen to help improve the detection of revenue manipulation, which triggers the likelihood of forced restatement.

Deferred tax accrual is taken as another proxy. Using deferred tax accrual to measure earnings management is likely to be more appealing than other accruals for several reasons. First, the potential for other accruals, such as depreciation or non-operating accruals, as an earnings management instrument is rather limited because of its rigidity and visibility (Young, 1999, p. 11; Beneish, 1998, p. 5). Second, Young (1999) found that the Modified Jones model produces systematic measurement error in the estimation of abnormal accruals when depreciation is included in the accruals measure. Third, other accruals are based on historical cost and can be manipulated through the various GAAP

chosen by the managers for financial reporting. Deferred tax accrual is incrementally useful beyond other accruals as it can better measure managerial accrual discretion, because the tax law generally allows less discretion of accounting choices compared to the discretion

available under GAAP (Mills and Newberry, 2001; Phillips et al.,2003). It is expected that

managers or blockholders might want to manage earnings to achieve certain objectives (e.g., avoiding a decline in earnings) by exploiting the flexibilities under GAAP available for financial reporting purposes, vis-a-vis tax reporting. The possibility for managers to manage earnings upward, for example, may increase book income but not taxable income. Thus, managing income upward generates temporary-book-tax differences, indicating that deferred tax expense is likely to be more informative and a useful measure for detecting opportunistic accrual-based earnings management compared to other accruals measures, which increases the likelihood of forced restatement.

This study further examines working capital accruals as a proxy to measure accruals-based earnings management. It is defined as the change in non-cash current assets less change in current liabilities (excluding short-term debt and tax), deflated by average assets (Dechow

et al., 2011; Allen et al., 2013; Lobo and Zhao, 2013). The measure is restricted and focuses solely on ‘working capital’ accruals; any non-current accruals (e.g., including depreciation expenses) are excluded from the definition. As Beneish (1998) and Young (1999) have discussed, the possibility for depreciation to become an earnings management tool is limited (particularly over multiple periods) due to its rigidity, predictability and visibility. More specifically, it is not possible to change depreciation policy frequently without prompting adverse attention from the auditors, thus the limitation for depreciation as an instrument for systematic earnings management (Beneish, 1998).

Working capital accruals are more susceptible to opportunistic management and misstatement, relative to non-working capital accruals (Kreutzfeldt and Wallce, 1986; Defond and Jiambalvo, 1994; Botsari and Meeks, 2008). Manipulating working capital accruals is relatively hard to detect and appears attractive as it involves judgemental estimates (e.g., McNichols and Wilson, 1988) and does not have any direct cash flow consequences (Abdullah and Mohd-Nasir, 2004). Therefore, the overstatement or understatement of working accruals may indicate opportunistic behaviour and may lead to the likelihood for misstating firms to be issued with income-decreasing or income- increasing forced restatement.

Generally firms tend to manipulate working capital accruals, such that it increases firms’ earnings figure (reported performance) thus making firm’s growth prospect (economic performance) to appear more favourable. Based on prior studies, Burgstahler and Dichev (1997), for example, provide evidence that changes in working capital are used to achieve increased earnings. This is supported by Defond and Jiambavlo (1994) when they examined 94 firms that violated their debt covenants; they found that working capital accruals are significantly positive, hence producing favourable earnings, in the year prior to and the year

of debt violation. Based on an analysis of misstating firms, Dechow et al. (2011; 2012)

consistently show that working capital accruals are unusually high during the misstatement years, but are then reversed based on a significant decrease in the accruals after the

misstatement years. Rangan (1998) and Teoh et al. (1998) found, however, that firms with

high discretionary working capital accruals show poor future reported earnings.

From the perspective of the impact of working capital accruals management on economic performance, prior studies show mixed findings. For example, Dechow et al. (2011) discover that, in addition to reporting high working capital accruals, misstatement firms also have a high price-earnings and market-to-book ratio, suggesting that the market is optimistic about the future potential growth of the companies. Ettredge et al. (2010) further reveals a systematic increase of balance sheet “bloat”, or abnormally high working capital accounts levels among fraud restatement firms compared to non-fraud restatement firms. However, it was found that the fraud firms report a high book-to-market ratio, indicating that firms have poor growth expectation.

To a certain extent, the impact of opportunistic management or misstatement of working capital accruals on economic performance can be catastrophic; this can be seen from the example of some real cases. Transmile, an air cargo service provider in Malaysia has been managing its working capital, which included inflating its accounts receivables from RM111 million to RM381 million in 2005. This has resulted in an 80 percent increase of its revenue and doubling of its net profit. By the time forced restatement was announced in May 2007, its share price had dropped from RM13 in early May 2007 to only RM8.90 at the end of May, with an estimated total paper loss of RM3.4 billion (Abdullah et al., 2010).

Another example is Megan Media, considered to be the largest data storage product manufacturer in Malaysia. In 2007, the company was found managing and misstating both accounts receivables and accounts payable amounting to RM456 million. The company’s financial performance deteriorated and it reported a negative cash flow of RM897 and net

loss of RM1.27 billion for the financial year ending 2007. The company’s share price plunged 43 percent to only 6 cents in July 2007 when the announcement of a forced restatement was made; the company was finally delisted in April 2008.

Guenther (1994) further argues on the tendency of opportunistic management of operating accruals due to its material value and states that it is routinely incurred in daily business operations. Therefore, in addition to working capital accruals, four other operating accruals metrics are tested. This includes the proxy of non-cash net operating asset accruals.

Pryshchepa et al. (2013), who applied the non-cash net operating asset accruals measure,

document significant higher accruals for the incorrectly identified healthy firms in comparison to those correctly identified. The finding indicates that aggressive accruals management is typically engaged by incorrectly identified healthy firms to signal the firm’s future prospects to be much better than that assessed by the investors. Based on this view, it is argued that firms with a high level of non-cash operating asset accruals are more likely to engage in upward earnings management, and therefore there is the likelihood of income-decreasing forced restatement.

Further current accruals proxies include change in receivables, change in inventories, and

soft assets17. The overstatement of receivables and inventory is another way of

manipulation used to artificially boost a firm’s sales and assets value (Thomas and Zhang,

2002; Dichev et al., 2013). Receivables misstatements may improve a firm’s sales growth,

while inventory misstatements may improve a firm’s gross profit margin, both of which

metrics (sales and gross profit) are closely tracked by investors (Dechow et al., 2011).

Dechow et al. (2011) further found that a firm’s soft assets are significantly higher in the

misstating years, suggesting a build-up of assets whose values are more subject to manipulation during the misstatement period. Overall, the above findings suggest that firms that report positive changes in receivables and inventories, and have more soft assets on the balance sheet, have more discretion in opportunistically managing accruals to report higher earnings, hence the likelihood for a firm to be issued with income-deceasing forced restatement.

Another technique that can be used by managers to manage earnings is real earnings management. Unlike accrual-based earnings management that is performed by changing accounting estimates or methods used in the presentation of a transaction in a firm’s

17

A soft asset is defined as the percentage of assets on the balance sheet that are neither cash nor property, plant, and equipment (PPE); it includes examples such as accounts receivables and inventories.

financial statements, real earnings management involves managers altering the execution of real business transactions. Firms manipulate real activities by adapting the structure or timing of real transactions in order to achieve a firm’s short-term goals (e.g., to meet or beat earnings expectations or avoid a breach of debt covenants). While accruals management is confined within the flexibility of accounting practices allowed by the GAAP, no such framework exists for real business operations. Managers are thus expected to use their judgement in deciding the best possible course of action given the economic circumstances. Opportunities thus arise for managers to engage in real earnings management in addition to, or in lieu of, opportunistic accruals management in an attempt to manipulate a firm’s reported earnings. The detection of real earnings management might seem to be more challenging relative to the opportunistic practices of accruals

management (Kothari et al., 2016). Real earnings management has direct cash flow

consequences, and causes a more damaging economic impact on the firm’s long-term underlying value (Gunny, 2010). Hence, there is a possibility that professional managers might be more prepared to use real earnings management rather than long-term family owners or managerial shareholders.

Prior studies document that firms employ accruals-based and real activities management as

substitutes for managing earnings (Cohen et al., 2008; Cohen and Zarowin, 2010;

Badertscher, 2011; Zang, 2012). Prior research also shows that firms will either stop

managing earnings or substitute another type of earnings management when the ability to

manage earnings is constrained (Ettredge et al., 2010). Accordingly, Badertscher (2011)

argued that firms resort to engaging real earnings manipulation when all choices of accrual management are exhausted.

In the perspective of real earnings management, Roychowdhury (2006) and Cohen and Zarowin (2010) contend that firms that engage in managing earnings upwards will possibly have certain accounting effects including:

(i) an abnormally low level of cash flow from operations resulting from lenient

credit terms or increased price discounts in order to improve current period sales;

(ii) an abnormally low level of discretionary expenses resulting from an aggressive

cut in research and development, advertising, and administrative expenses in order to boost current period reported earnings; and

(iii) an abnormally high level of production costs to cut down the costs of goods sold, which in turn improves the current period operating margin. (According to Cohen and Zarowin (2010), a firm over produces and allocates fewer overheads to cost of goods sold but more to inventory, thereby leading to a lower cost of goods sold and higher operating margin).

In view of this, three metrics are examined as proxies for real earnings management, including abnormal cash flow from operations, abnormal production costs, and abnormal discretionary expenses.

In general, this study posits that while not all managers/blockholders are opportunistic, the possibility exists that some managers/blockholders are prone to engage in accounting manipulation to mislead outsiders, either to show that the company is performing well (e.g., to increase share price) or poorly (e.g., to reduce tax liability). In this case, managers use their discretion to manipulate accrual earnings based on the flexibilities available under GAAP. Alternatively, managers may adjust real transaction activities to distort earnings. Managers may even use accruals-based and real earnings management jointly to meet market expectations, which increases the propensity for the firms involved to be issued with income-decreasing or income-increasing forced restatement. Overall, the distortion of corporate reporting may increase the likelihood of forced restatement. In this view, the following hypothesis is developed:

H5: There is a positive relationship between the distortion of corporate reporting quality and the occurrence of forced financial restatement.