EARNINGS MANAGEMENT AND ANALYSIS OF OPPORTUNISTIC BEHAVIOUR, MONITORING MECHANISM AND FINANCIAL DISTRESS

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EARNINGS MANAGEMENT AND ANALYSIS OF OPPORTUNISTIC BEHAVIOUR, MONITORING MECHANISM AND FINANCIAL DISTRESS

ABSTRACT

This work discusses relationship between opportunistic behaviors (free cash flow and profitability), monitoring mechanism (leverage) and pressure behaviors (financial distress) toward earnings management. There are indeed several factors that could motivate the managers to manage earnings. In this study, it is assumed that the management incline to manage earnings in order to avoid reporting losses or to avoid showing any decreases in the reported earnings. This empirical research with a sample of Nigerian public listed companies from year 2010 to 2012 shows that managers of the companies would engage in earnings management when the company is financially healthy and when the profit of the company is high. The result of this study would provide a valuable explanation on the relationship between variables, thus, would give relevant views to regulators in tightening the rules and regulation in order to promote public confidence in the reliability of financial reporting.

BACKGROUND OF THE STUDY

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” (Healy & Wahlen, 1999). Earnings information can be used by the managers to convey superior and useful information which they know about company performance to shareholders and debt holders. If this is the case, then, earnings management may not be harmful to the stockholders and the public. Nevertheless, the financial scandal at WorldCom and Enron changed the outlook of earnings management toward an opportunistic view. With regards to this view, managers manage earnings for their own private benefits rather than for the benefits of the stockholders (Watts & Zimmerman, 1986; Subramanyam, 1996; Holthausen, 1990; Healy & Palepu, 1993; Guay et al, 1996; Demski, 1998; Arya et al, 2003; Hao, 2010 & Jiraporn et al, 2008).

Unlike fraud, earnings management encompasses the selection of accounting and estimates that conforms to the generally accepted accounting principles (GAAP). This implies that companies that practice earnings management would manage their earnings within the limits of accepted accounting procedures (Rahman &Ali, 2006). However, certain monitoring mechanisms can prevent managers from inflating the earnings. The monitoring hypothesis acknowledge the impact of external monitoring (such as monitoring by creditors) on the practice of earnings management. Under constant monitoring, inflated earnings through management are likely to be detected and, therefore, unlikely to affect stock prices (Shih & Yueh, 2002).

Meanwhile, pressure from financial distress too has significant adverse effects of an economy, whereby investors and creditors could possibly suffer substantial financial loss. If the firm is in financial distress, managers would anticipate that having their bonuses cut, possibility of being replaced and suffer damage in their career, reputation (Liberty & Zimmerman, 1986; Gilson, 1989). Hence, for conservative management, managers would take opportunity to conceal such a deteriorating performance by choosing different accounting methods that increase income and could conceal the loss (Habib, Bhuiyan & Islam, 2013). Rosner (2003) reports that firms that become bankrupts ex post, but do not appear ex ante, engage in income-increasing earnings manipulation practices.

Therefore, the aim of this study is to analyze the relationship between opportunistic behaviors (free cash flow and profitability), monitoring mechanism (leverage) and pressure behaviors (financial distress) toward earnings management. The result of this study would provide a valuable explanation on the relationship between variables, thus, would give relevant views to regulators in tightening the rules and regulation in order to promote public confidence in the reliability of financial reporting. This study is also expected to provide useful information to current and potential investors as well as to regulatory authorities who are responsible in observing the quality of financial reporting of firms more closely.

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