Measurement of EM (Dependent Variable)

The review of EM literature reveals that three alternative approaches are currently used in the literature to measure EM. These approaches are total-accruals, specific- accruals, and frequency distribution approaches (see Section 2.5 of Chapter 2). In spite of the advantages of using the specific-accruals approach to estimate EM, it is insufficiently flexible to investigate additional variables such as corporate governance and CSR (McNichols 2000). In addition, the frequency distribution approach has also been criticised because it does not enable researchers to assess the extent of EM or to differentiate between discretionary accruals and non- discretionary accruals (McNichols 2000). On the other hand, the total-accruals approach allows researchers to control for additional variables and distinguish between non-discretionary and discretionary accruals. Therefore, the aggregate- accruals approach is preferred to the other two approaches in recent EM studies (Choi et al. 2013; Pyo and Lee 2013; Kim et al. 2012; Hong and Andersen 2011; Yip et

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Whatever the name of the corporate social responsibility report, be it the corporate responsibility report, the environmental report, social and environmental citizenship report, the corporate sustainability report, etc.

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al. 2011; Mohamad et al. 2010; Sun et al. 2010). Following the previous studies, the present study applies total-accruals to measure discretionary accruals. According to this approach, there are three steps to measure discretionary accruals. The first step is to calculate total accruals, the second is to estimate non-discretionary accruals, and the third is to predict discretionary accruals. Each of these three steps is discussed as follows.

4.5.1.1 Estimating Total Accruals

To calculate total accruals, there are two approaches have been used in the literature. These approaches are traditional balance sheet approach (Dechow et al. 1995; Jones 1991; Healy 1985) and cash flow approach (Kim et al. 2012; Hong and Andersen 2011; Sun et al. 2010; Kothari et al. 2005; Klein 2002; Becker et al. 1998; Subramanyam 1996; DeFond and Jiambalvo 1994). Under the traditional balance sheet approach, total accruals are calculated as follows:

Equation 4-1: Total accruals (balance sheet approach)

Where:

: Total accruals in year t

: Change in current assets in year t

: Change in cash and cash equivalents in year t : Change in current liabilities in year t

: Change in debt included in current liabilities in year t : Depreciation and amortization expense in year t

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Equation 4-2: Total accruals (cash flow approach)

Where:

: Total accruals in year t

: Earnings before extraordinary and abnormal items in year t : Operating cash flow in year t

Although the balance sheet and cash flow approaches have been used in the literature, Hribar and Collins (2002) indicate that the cash flow approach produces fewer measurement errors compared to the balance sheet approach to estimating accruals. In line with this argument, a significant number of recent studies have preferred to apply cash flow to estimate accruals (Pyo and Lee 2013; Kim et al. 2012; Hong and Andersen 2011; Sun et al. 2010; Chih et al. 2008; Gong et al. 2008; Gunawan 2007; Kothari et al. 2005). The present study follows the previous studies and calculates total accruals in accordance with the cash flow approach. Therefore, total accruals are defined as the difference between earnings before extraordinary and abnormal items and operating cash flow.

4.5.1.2 Estimating Discretionary Accruals

Although EM literature has suggested a number of discretionary models (see Section 2.5.1 of Chapter 2), the discretionary accruals models most commonly used in empirical EM research are the Jones, modified Jones, and performance-matched models (Choi et al. 2013; Jiang et al. 2013; Pyo and Lee 2013; Sun and Rath 2010; Kothari et al. 2005; Bartov et al. 2001; Kothari 2001; Thomas and Zhang 2000; Beneish 1997; Subramanyam 1996; Dechow et al. 1995; DeFond and Jiambalvo 1994; Jones 1991).

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4.5.1.2.1 Jones (1991) Model

Jones (1991) argues that a firm’s economic circumstances have an influence on accounting accruals and attempts to control for such effects. The study uses the change in revenues as a proxy to control for firm’s economic circumstances and the level of property, plant, and equipment as a proxy to control for the effect of the depreciation.

According to the cross-sectional Jones (1991) model, discretionary accruals are estimated in two steps. The first step is to predict non-discretionary accruals for each year and industry, and all the variables are scaled by total assets at the beginning of the year (Jones 1991). The Jones model is presented in equation 4.3 as follows:

Equation 4-3: Non-discretionary accruals Jones (1991) model

⁄ ⁄ ⁄ ⁄

where

TA : Total accruals ∆REV : Change in revenues

PPT : Gross property, plant and equipment A : Total assets

j : Firm j; 1 …………N i : Industry i; 1 ………N t : Year; 1 ………..N e : Error term

At the second stage, discretionary accruals for each firm j were calculated by deducting non-dictionary accruals from total accruals (TA) as illustrated in equation 4.1.

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Equation 4-4: Discretionary accruals Jones (1991) model

⁄ ́ ⁄ ́ ⁄ ́ ⁄

where

DA : Discretionary accruals j : Firm j; 1 …………N

́ , ́ , and ́ are the predicted coefficients from equation 4.3.

4.5.1.2.2 Modified Jones (Dechow et al. 1995) Model

Dechow et al. (1995) developed the original Jones model by adjusting the change in receivables (debtors) from the change in revenues (see Section 2.5.1.5 of Chapter 2).

As in the process of measuring discretionary accruals in accordance with the Jones model, two steps are conducted to estimate discretionary accruals, as suggested by Dechow et al. (1995). Firstly, non-discretionary accruals are estimated for each year and each industry group as presented in equation 4.5 as follows:

Equation 4-5: Non-discretionary accruals modified Jones (Dechow et al. 1995) model

⁄ ⁄ ⁄ ⁄

where

TA : Total accruals ∆REV : Change in revenues

∆RCE : Change in receivables (debtors) PPT : Gross property, plant and equipment A : Total assets

j : Firm j; 1 …………N i : Industry i; 1 ………N t : Year; 1 ………..N e : Error term

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Equation 4-6: Discretionary accruals modified Jones (Dechow et al. 1995) model

⁄ ́ ⁄ ́ ⁄ ́ ⁄

where

DA : Discretionary accruals j : f rm j; …………

́ , ́ , and ́ are the predicted coefficients from equation 4.5.

Consistent with the previous studies of Pyo and Lee (2013); Kim et al. (2012); Gargouri et al. (2010); Sun et al. (2010); Chih et al. (2008); and Prior et al. (2008), the present study uses the residuals from equations 4.3 and 4.5 of the Jones and the modified Jones models as discretionary accruals.

Although, the original Jones and modified Jones models are applied in a discretionary-accruals time-series approach, a significant number of recent academic studies (Cohen and Zarowin 2010; Sun and Rath 2010; Iqbala et al. 2009; Chen et al. 2008; Abdul Rashidah and Ali 2006; Bergstresser and Philippon 2006; Xie et al. 2003; Kothari 2001; Teoh et al. 1998a; Teoh et al. 1998b) prefer the cross-sectional discretionary-accruals approach to the time-series approach (see Section 2.5 of Chapter 2). Following the previous studies, the present study uses the cross-sectional Jones and modified Jones models to predict discretionary accruals.

4.5.1.2.3 Performance-Matched (Kothari et al. 2005) Model

Kothari et al. (2005) argue that firms’ financial performance has an impact on accounting accruals and that both the Jones and modified Jones models may result in measurement errors because of the misspecification issue in estimating discretionary accruals. Therefore, they add the firms’ financial performance to the

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modified Jones model to control for the impact of financial performance on accounting accruals. Their study uses a lagged value of return on assets (ROA) as a proxy for firm financial performance to reduce the problem of heteroscedasticity and to avoid the problem of misspecification measurement.

Two steps were performed to measure dictionary accruals according to the performance-matched (Kothari et al. 2005) model. The first was to predict non- discretionary accruals as follows:

Equation 4-7: Non-discretionary accruals Performance-Matched (Kothari et al. 2005) model

⁄ ⁄ ⁄ ⁄

where

TA = Total accruals REV = Change in revenues

RCE = Change in receivables (debtors) PPT = Gross property, plant and equipment ROA = Return on assets

A = Total assets j = F rm j; ………… i = I us ry ; ……… t = Y r; ……….. e = Error term

The second was to calculate discretionary accruals as presented in equation 4.7 below.

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Equation 4-8: Discretionary accruals Performance-Matched (Kothari et al. 2005) model

⁄ ́ ⁄ ́ ⁄ ́ ⁄

where

DA = Discretionary accruals j = f rm j; …………

́ , ́ , and ́ are the predicted coefficients from equation 4.7. The residuals of equation 4.7 were used as discretionary accruals.