Firm performance and demand for external

Principals would expect that managers work towards maximising shareholder wealth. However, the principal-agent misalignment of interest results in managers pursuing self- interests at the expense of the shareholders, thus impeding them from delivering a good performance (Rachagan and Satkunasingam, 2009). Pressure may arise for the managers to meet market expectations, explaining their attempts to disguise a firm’s underlying performance to make the firm appear more profitable or less risky than it really is (Zhao and Chen, 2008).

Managers prefer reporting positive growth in earnings to exhibit good firm performance (Graham et al., 2005; Huang and Scholz, 2012). Managers do not seek earnings growth for

its own sake but rather to increase their own welfare (Badertscher, 2011). This is possible as a firm’s growth increases managers’ power due to the increase of resources under their control (Jensen, 1986). More specifically, managers are often rewarded when they report increasing earnings and keep the share price high and rising (Badertscher 2011). Firms would be penalised in the share market if they fail to meet market expectations, hence the pressure to report consistent and predictable growth (Jensen, 2004; Brown, 2011). The pressure intensifies particularly among firms in a distressed financial condition to report earnings growth for them to convince creditors and shareholders of their favourable performance (Saleh and Ahmed 2005). In such situations, there is a tendency for firms to show their ability to meet or beat earnings targets and maintain a high share price, which

further helps improve a firm’s credibility within the market (Graham et al., 2005). Overall,

firm managers might succumb to the pressure of reporting continuous strong financial results and maintaining a high firm valuation, which increases the likelihood of income- decreasing forced restatement.

The following presents findings of prior literature on firms’ reported performance (defined as firm’s earnings performance reported in their financial report), in comparison to firm’s fundamental economic performance (defined as firm’s growth performance). Findings generally show that firms tend to report positive earnings to ensure that they can maintain high stock return, thus demonstrating firm’s healthy growth prospect.

Relatively, prior research documented the reported performance of firms that strive to achieve or maintain positive earnings growth (including the impact of accounting misstatements). Myers et al. (2007), for example, found 746 US firms reporting increasing earnings between 1962 and 2004 in order to achieve their defined earnings target. From the perspective of economic performance, Myers et al. (2007) discovered that these firms benefited from significant abnormal returns. Misstatement firms were also found by Schrand and Zechman (2012) to report increasing earnings. Based on a sample of 49 SEC sanctioned firms from 1996 to 2003, they document that misstatement firms reported growth in earnings to show good firm performance. In the perspective of distressed firms, Chen et al. (2010) discovered that these firms commonly reported increasing earnings. It was further revealed that firms are penalised by the market when they show a deteriorating earnings pattern with negative abnormal returns (DeAngelo, 1996).

In extreme cases, firms’ incentives to maintain and extend positive growth can eventually lead to a destructive economic performance. WorldCom, for example, overstated its

earnings by falsely increasing outputs and sub-optimal price cutting to catch up with their superior financial performance, which resulted in potential bankruptcy impacting the entire industry. Reliance on WorldCom’s inflated earnings caused its rivals to overinvest, involving $90 billion of sub-optimal and misallocated investment (The Eastern Management Group, 2001). Another case is Enron, where the company was involved in fraudulent financial reporting to maintain its credit rating at investment rates for it to continue its business. While Enron was not making sufficient profit, they engaged in aggressive misstatements when they treated the sale and purchase of investments held for trading by including it in firm’s operating cash flow (and free cash flow). Enron managed to boost its operating and free cash flow, which looked good to the investors. In October 2001, Enron announced that the firm was actually worth $1.2 billion less than previously reported. Enron further disclosed that it made a $618 million loss for the quarter, and had overstated earnings by $586 million since 1997. A $40 billion lawsuit was filed by Enron’s shareholders, after the company’s share price plummeted 99.5 percent from its highest of $91 in 2000, to less than $1 by November 2001. However, the deal failed and Enron filed for bankruptcy in December 2001 (Benston, 2003).

For the purpose of this study, four proxies will be used as a measure for firm performance. The first proxy, change in earnings, is based on the contention by Defond and Jiambalvo

(1991) and Graham et al. (2005) that firms are inclined towards reporting high growth in

earnings; there is, therefore, an incentive for firms to produce positive earnings growth during the misstatement periods. The fact that managers report positive earnings growth to meet market expectations may increase the likelihood of income-decreasing forced restatement.

The second and third proxies are book-to-market ratio and price-earnings ratio, which measure a firm’s growth prospects. Essentially, the spread between a firm’s book value and market value is taken as a measure of a firm’s perceived ability to pay returns to its shareholders, an amount in the future in excess of the expected return (Rappaport, 1981). Managers have strong incentives to show persistent growth in order to maintain high stock valuations. Dechow et al. (2011) found that misstating firms report high price-earnings and market-to-book ratios, suggesting that managers really strive to avoid disappointing shareholders and losing firms’ high valuation. This is consistent with the findings by Skinner and Sloan (2002) that firms are heavily penalised by the market when they fail to meet targeted earnings after a period of continuous growth. Even in period of downturn, firms

experiencing rapid growth may report to show that they appear to be experiencing a stable growth (Beasler 1996). Managers of growth firms may therefore have the incentive to sustain high growth to manifest good firm performance, which may lead to the possibility of income-decreasing forced restatement to occur.

The fourth proxy is financial distress. According to Jensen and Meckling (1976), financial distress creates a condition that incentivises managers to show a favourable firm performance by reporting growth in earnings. The incentive arises due to the pressure of meeting the expectations of shareholders and analysts for firms to report positive earnings

(Habib et al., 2013). In this view, it is thus expected that managerial action of reporting

earnings growth among financially distressed firms may eventually lead to the likelihood of the firm being issued with income-decreasing forced restatement.

In addition to the four proxies of firm performance, a control variable, i.e., leverage, is included to control for the effect that the variable has on the likelihood of forced restatement. It is argued that firms with high leverage have the incentive to misstate earnings to enhance a firm’s financial performance for the purpose of raising new debt, based on favourable terms or preventing violations of covenants in the existing debt

contracts (Defond and Jiambalvo, 1994; Minton and Schrand, 1999). Ettredge et al. (2010),

for example, found that firms with higher leverage are associated with core earnings misstatement. Following Sharma and Iselin (2012), this study controls for leverage as it captures misstatement and thus restatement risk associated with a high debt level.

Certain control variables such as sales growth, profitability, and income volatility may also affect the likelihood of forced restatement (Subramanyam 1996; Sue, Chin, & Chan, 2013; Correia 2014). However, these control variables are excluded from the hypotheses testing model due to high collinearity between these variables and change in earnings. Statistically, the pairwise correlations between the control variables and change in earnings are relatively low (coefficient below 0.30). However, conceptionally, since sales growth, profitability, and income volatility are measured by sales and earnings performance which are represented in change in earnings, it is thus argued that there is a high correlation between these items. In this case, introducing the control variables, sales growth, profitability, and income volatility into the equation can gives rise to a multicollinearity problem which hinders from accurate estimations of variable coefficients and significance levels (Hamilton 1992).

Within a different perspective, the attempt to ensure growth in a firm’s performance may give rise to the demand for external finance to improve a firm’s capital base and to expand

the scale of business operation (Dechow et al., 2011). The intention to raise new capital

may exist in some firms, but they could not just proceed with raising funds due to the inability of securing favourable terms (Dechow et al., 2011). Thus, as the internal funds are near to getting exhausted, managers are more inclined towards reporting higher

profitability with the anticipation of getting access into the capital market (Erickson et al.,

2006; Lennox and Pittman, 2010). By reporting good earnings performance, the firm’s share price may increase, thus reducing the cost of issuing new equity. This explains why managers tend to report positive earnings when raising external funds that, in turn, increases the likelihood of income-decreasing forced restatement.

Prior studies revealed that managers disclose a firm’s good prospects in order to allow the managers to raise the external funds necessary for investment. Research has shown that misstatement firms frequently issue shares or bonds in the capital market (see e.g., Efendi et al., 2007). Dechow et al. (2011) found that misstatement firms actively raise funds before and during the misstating years. They suggest that the concern to obtain finance has encouraged managers of misstatement firms to report favourable earnings during the misstating years. Overall, the above research findings show that firms relying on external financing are more likely to issue forced restatement.

In measuring a firm’s demand for external finance, three metrics are used as proxies. The first is change in free cash flow. Free cash flow is “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital” (Jensen, 1986, p.323). A lesser free cash flow would mean that the ability of a firm to cover its capital expenditures by using internal funds held by the company is reduced. When free cash flow reduces, a firm has the incentive to attract external finance at low cost (Dechow et al., 1996). In such situations, there would be an incentive for managers to report and show good firm performance, allowing them access to the capital market at low cost. As such, firms having a lower free cash flow are more likely to be issued with income-decreasing forced restatement. In a similar vein, a firm’s incentive on raising new capital (FINR) is examined as the second proxy to measure the demand for external

funds. Following Dechow et al. (1996), FINR, which represents an ex-ante measure of

finance need, is measured by a firm’s free cash flow deflated by current assets. When FINR becomes more negative, i.e., less than -0.5, a firm is nearer to exhausting its own internal

funds and thereby prone to show favourable earnings, which increases the likelihood for income-decreasing forced restatement.

The third proxy is the actual issuance that represents the ex-post measure of finance need.

The actual issuance proxy helps to identify whether the firm has issued new equity or debt prior to the forced restatement event. While there is evidence that the issuance of debt and stock does not motivate earnings misstatements (Beneish, 1999), more recent research has shown that debt and equity issuance is associated with the probability of fraudulent

accounting (Efendi et al., 2007; Lennox and Pittman 2010). It is suggested that

management’s concerns regarding obtaining finance might trigger managers to report favourable earnings during the misstatement period. Efendi et al. (2007) and Dechow et al. (2011), for example, show corroborating evidence that firms are active in raising finance during their misstatement years with the incentive to keep their cost of capital to the minimum. In summary, it is contended that companies that are raising external funds have the propensity to be issued income-decreasing forced restatement.

Overall, there is tendency for managers to report favourable earnings to meet market expectations. Furthermore, in an attempt to maintain a growth trend, the need for external funds might arise to support business operations. In this situation, there is a tendency for managers to report higher profits to portray good firm performance, hence reducing the cost of issuing new capital and enabling the firm to have easy access into the capital market. Overall, the attempt of portraying firm growth and the demand for raising external funds may increase the likelihood of income-decreasing forced restatement. Hence, the following proposition is developed:

H6: There is a positive relationship between firm performance and demand for external finance and the occurrence of forced financial restatement.