earnings quality and earnings management: an empirical

Analysis Of The Provision For Credit Loss On Trade
Receivables Amongst FTSE 350 Companies
Jonathon Butler
This dissertation is submitted in partial fulfilment of the requirements for the degree of
Master of Business in Accounting, Waterford Institute of Technology.
Research Supervisor: Mr. John Casey, FCA, MSc (Finance)
August 2012
Amidst persistent global economic uncertainty, an on-going sovereign debt crisis
across Europe and an environment of elevated and deteriorating credit risk, companies
continue to face numerous challenges. One such challenge comprises the risk of credit
loss on trade receivables, which companies provide for through a specific provision.
Prior empirical research has documented extensively the existence of earnings
management through discretionary accruals. This cross-sectional study examines the
existence and determinants of abnormal provision for credit loss on trade receivables
in the context of both earnings quality and earnings management.
While traditional determinants of earnings management including capital market,
contractual, performance, governance and auditor related variables are examined, the
capital market response to instances of extreme abnormal provision for credit loss on
trade receivables is also considered. Consistent with prior earnings management
research, correlation and regression analyses are utilised to determine the extent of
relationships between abnormal provision and these variables.
The mean level of abnormal underprovision of -9.9% provides strong evidence of
provisioning practice at sharp variance with the current credit risk environment, while
the results of regression analyses provide strong evidence supporting the debt
hypothesis of positive accounting theory.
Increasing levels of gearing and increasing gross margins are identified as
significantly explaining abnormal underprovision, while strong evidence supporting
the mitigating effects of robust corporate governance structures on abnormal
underprovision is also identified, where the board of directors is comprised of an
increasing proportion of INEDs.
underprovision experience a significantly inferior post financial year end stock price
performance relative to those companies with extreme abnormal overprovision.
This result suggests that capital markets, in identifying lower quality earnings and
discounting stocks where accounting abnormalities have been identified, may mitigate
the effects of earnings management activity.
___________________________________________________________________________
ii
ACKNOWLEDGEMENTS
The completion of this dissertation signifies the end of my formal third level
education. However, its completion and my four years at W.I.T. would not have been
possible without assistance, guidance and inspiration from so many people.
I am truly grateful to Mr. John Casey for his extensive input, forbearance, practical
advice and guidance, without which, completion of this dissertation would not have
been possible.
I extend sincere thanks to PricewaterhouseCoopers (Waterford) for their financial
support at both undergraduate level and in the completion of the MBS in Accounting
programme.
To all of the lecturing and support staff on both the MBS in Accounting and
BA (Hons) in Accounting programmes - I am forever grateful for your support, advice
and assistance in helping me during my four years at WIT.
To all of my fellow classmates – I wish to thank you for a wonderful year.
The experience has left me with great memories and I have been privileged to work
with a group of such talented and determined people.
To all who assisted in reviewing this dissertation – your efforts and support are
sincerely appreciated.
Finally, yet most importantly, I extend heartfelt thanks to my family: to Mum,
Dad and Joanne. You have remained steadfast in supporting me throughout the years,
helping me in all of my achievements to date. I will forever be grateful for your
support, guidance and prayers.
_____________________________ _____________________________
1.3 Research Questions and Research Objectives ......................................................... 4
1.4 Research Methodology and Limitations .................................................................. 5
1.5 Dissertation Structure: Diagrammatic Overview ..................................................... 6
Chapter Two: Literature Review ............................................................................... 7
2.1 Introduction .............................................................................................................. 8
2.2.1 Earnings Quality as a Concept ......................................................................... 9
2.2.2 Measures of Earnings Quality .......................................................................... 9
2.2.3 Earnings Quality and Earnings Management ................................................ 10
2.3 Introduction to Earnings Management................................................................... 11
2.3.2 Differentiation between Earnings Management and Manipulation ............... 11
2.3.3 Accounting Policy Flexibility and Earnings Management ............................ 11
2.3.4 Impact from Earnings Management Activity ................................................ 12
2.3.5 Accrual Accounting, Earnings Management and Accounting Earnings ....... 12
2.4 Earnings Management – Theoretical Perspectives ................................................ 12
2.4.1 Introduction to Theoretical Perspectives ....................................................... 12
2.4.2 Signalling Theory and Higher Quality Firms ................................................ 13
2.4.3 Signalling Theory and Lower Quality Firms ................................................ 13
___________________________________________________________________________
2.4.4 Positive Accounting Theory and Earnings Management ............................... 14
2.4.5 Agency Theory and Earnings Management .................................................. 15
2.4.6 Agent Specific Motives for Earnings Management ....................................... 15
2.5 Conclusion ............................................................................................................. 16
3.1 Introduction ............................................................................................................ 18
3.2 Earnings Management and the Financial Condition of a Firm .............................. 19
3.3 The Determinants of Earnings Management ......................................................... 19
3.3.1 Contracting Motives and Earnings Management .......................................... 20
3.3.2 Executive Level Compensation and Earnings Management ........................ 20
3.3.3 Debt Contract Motives and Earnings Management ...................................... 21
3.3.4 Earnings Expectations and Earnings Management ....................................... 22
3.3.5 Regulatory Motives and Earnings Management ........................................... 22
3.3.6 Corporate Governance Structures and Earnings Management ..................... 23
3.3.7 Audit Committee and Earnings Management ............................................... 24
3.3.8 Auditor Type, Auditor Remuneration and Earnings Management ............... 24
3.3.9 Revenue Manipulation, Deferred Revenue and Trade Receivables ............. 25
3.4 The Response of Capital Markets .......................................................................... 26
3.4.1 Earnings Quality and Stock Price Performance ............................................ 26
3.4.2 Equity Offerings, Earnings Management and Stock Price Performance ...... 27
3.4.3 Magnitude of Capital Market Based Earnings Management ........................ 27
3.5 Conclusion ............................................................................................................. 27
4.1 Introduction ............................................................................................................ 29
4.2 The Provision for Doubtful Receivables: Model Development ........................... 30
4.2.1 The Provision for Doubtful Receivables: McNichols and Wilson (1988) .... 30
4.2.2 The Provision for Doubtful Receivables: Lev and Thiagarajan (1993) ......... 30
4.2.3 Manipulation of Trade Receivables: Ricci (2011) ....................................... 31
4.3 The Provision for Doubtful Receivables – IASB Accounting Guidance ............. 31
4.3.1 IAS 39: Section 58 – 59 ................................................................................ 31
___________________________________________________________________________
4.3.2 IFRS 7: Section 7.16 and 7.37 ....................................................................... 31
4.4 Literature Review Conclusion .............................................................................. 32
Chapter Five: Research Methodology ..................................................................... 33
5.1 Introduction ............................................................................................................ 34
5.5.1 Objective One: Hypothesis ........................................................................... 36
5.5.2 Objective Two: Hypotheses .......................................................................... 37
5.5.3 Objective Three: Hypothesis ......................................................................... 41
5.6 Research Approach ................................................................................................ 41
5.7 Sample Selection Process ...................................................................................... 42
5.7.1 Sample Selection Context ............................................................................. 42
5.7.2 Sample Selection Refinement ........................................................................ 43
5.7.3 Sample Selection Refinement – Specific Elimination Procedures ................ 43
5.8 Data Sources .......................................................................................................... 44
5.9.2 Additional Variables and Measures ............................................................... 47
5.10 Data Validity and Reliability ............................................................................... 47
5.11 Testing Procedures ............................................................................................... 48
6.1 Introduction ............................................................................................................ 51
6.2 Analysis of Identified Outliers ............................................................................... 52
6.3 Magnitude of Abnormal Provision for Credit Loss on Trade Receivables ........... 52
6.3.1 Descriptive Statistics ...................................................................................... 52
___________________________________________________________________________
Chapter Six: Research Findings (Continued)
6.4 Determinants of Abnormal Provision for Credit Loss on Trade Receivables ....... 54
6.4.1 Compliance with Underlying OLS Regression Analysis Assumptions ......... 54
6.4.2 Descriptive Statistics: Independent Explanatory Variables .......................... 54
6.4.3 Univariate Analysis: Simple Linear Regression Analysis ............................ 56
6.4.4 Multivariate Analysis: Multiple Regression Analysis .................................. 58
6.4.5 H2 to H15: Summary Findings ....................................................................... 64
6.5 Stock Price Performance of Extreme Abnormal Providers .................................. 65
6.5.1 Descriptive Statistics ...................................................................................... 65
6.6 Conclusion ............................................................................................................. 67
7.1 Introduction ............................................................................................................ 69
7.2 Magnitude of Abnormal Provision for Credit Loss on Trade Receivables ........... 70
7.2.1 Provisioning Activity at Variance with Credit Risk Environment ............... 70
7.2.2 Increased Credit Delinquency: Downside Risk of Elevated Write-Offs ...... 70
7.2.3 Regulatory Considerations ............................................................................ 71
7.3 Determinants of Abnormal Provision for Credit Loss on Trade Receivables ....... 71
7.3.1 Capital Market Variables – Limited Evidence .............................................. 71
7.3.2 Contractual Variables – Significant Evidence ............................................. 72
7.3.3 Performance Variables – Significant Evidence ........................................... 73
7.3.4 Governance Variables – Significant Evidence ............................................. 74
7.3.5 Auditor Variables – Mixed Evidence ........................................................... 75
7.3.6 Non Hypothesised Factors ............................................................................ 75
7.4 Stock Price Performance of Extreme Abnormal Providers .................................. 76
7.4.1 Evidence Supporting the Efficient Market Hypothesis ................................ 76
7.4.2 Capital Markets: A Potential Instrument for Effective Regulation .............. 76
7.4.3 Non Hypothesised Factors ............................................................................ 77
7.5 Conclusion ............................................................................................................. 77
8.3 Limitations of Research ........................................................................................ 81
8.4 Recommendations for Practitioners ...................................................................... 81
8.4.1 Auditors ......................................................................................................... 81
8.4.3 Capital Market Participants ........................................................................... 82
8.5 Recommendations for Future Research ................................................................ 82
8.6 Conclusion ............................................................................................................ 83
References ................................................................................................................... 84
Appendices .................................................................................................................. 95
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Chapter Two:
2.2 Signalling Theory and Earnings Management ....................................................... 13
2.3 Positive Accounting Theory and Earnings Management ....................................... 14
2.4 Agency Theory and Earnings Management ........................................................... 15
Chapter Three:
Chapter Five:
5.2 Contractual Determinants of Earnings Management ............................................. 37
5.3 Performance Related Determinants of Earnings Management .............................. 38
5.4 Governance Specific Determinants of Earnings Management .............................. 39
5.5 Auditor Related Determinants of Earnings Management ...................................... 40
Chapter Six:
6.7 Mean Stock Price Performance Post Financial Year End ..................................... 66
Appendix C:
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D.2 Stock Price Performance Multiple Regression One Equation ........................... 114
D.3 Stock Price Performance Regression Two Equation ......................................... 115
D.4 Stock Price Performance Multiple Regression Three Equation ......................... 116
Appendix G:
___________________________________________________________________________
3.3 Auditor Type, Auditor Remuneration and Earnings Management ....................... 24
Chapter Five:
5.2 Contractual Determinants of Earnings Management ............................................ 38
5.3 Performance Related Determinants of Earnings Management ............................. 39
5.4 Governance Specific Determinants of Earnings Management ............................. 40
5.5 Auditor Related Determinants of Earnings Management ..................................... 41
5.6 Capital Market Response to Earnings Management ............................................. 41
5.7 Sample Selection Refinement Summary ............................................................... 44
5.8 Financial Year End Dates Summary Analysis ...................................................... 44
5.9 Data Sources for Data Measures ........................................................................... 45
Chapter Six:
6.2 Descriptive Statistics for Magnitude of Abnormal Provision ............................... 53
6.3 Simple Linear Regression Significance Statistics ................................................. 53
6.4 Descriptive Statistics for Categorical Independent Variables .............................. 55
6.5 Descriptive Statistics for Continuous Independent Variables .............................. 55
6.6 Simple Regression Analysis Results: Full Sample (N=204) ................................ 57
6.7 Simple Regression Analysis Results: Underproviders Only (N=138) .................. 57
6.8 Multiple Regression One Significance Statistics (N=204) ................................... 59
6.9 Multiple Regression One: Fourteen Hypotheses (N=204) ................................... 59
6.10 Multiple Regression Two Significance Statistics (N=204) ................................ 61
6.11 Multiple Regression Two: Seven Hypotheses (N=204) ..................................... 61
6.12 Multiple Regression Three Significance Statistics (N=138) .............................. 62
6.13 Multiple Regression Three: Fourteen Hypotheses (N=138) ............................... 62
6.14 Multiple Regression Four Significance Statistics (N=138) ................................ 63
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6.16 H2 to H15: Summary Findings ............................................................................. 64
6.17 Descriptive Statistics for Stock Price Performance: Underproviders ................. 65
6.18 Descriptive Statistics for Stock Price Performance: Overproviders ................... 65
Appendix D:
D.2 Alternative Multiple Regression One Significance Statistics (N=204) ............. 112
D.3 Alternative Multiple Regression One: Fifteen Hypotheses (N=204) ................. 113
D.4 Stock Price Performance Regression One Sig. Statistics (N=25) ...................... 114
D.5 Regression One: Stock Price Performance Hypotheses (N=25) ........................ 115
D.6 Stock Price Performance Regression Two Sig. Statistics (N=25) ...................... 115
D.7 Regression Two: Stock Price Performance Hypothesis (N=25) ........................ 115
D.8 Stock Price Performance Regression Three Sig. Statistics (N=25) ................... 116
D.9 Regression Three: Stock Price Performance Hypotheses (N=25) ..................... 117
Appendix G:
G.2 Test for Multicollinearity: Continuous Independent Variables ......................... 136
___________________________________________________________________________
Appendix B: IFRS 7 and IAS 39 ................................................................... 98
Appendix C: Details of Final Sample Population ....................................... 102
Appendix D: Multiple Regression Analysis Data ....................................... 110
Appendix E: Disclosure Notes: Extracts from Annual Reports .................. 118
Appendix F: Dependent Variable Dataset .................................................. 120
Appendix G: Methodology Continued: OLS Regression Assumptions ...... 128
___________________________________________________________________________
EPS - Earnings Per Share
FTSE 100 - FTSE 100 Index on the London Stock Exchange
FTSE 350 - FTSE 350 Index on the London Stock Exchange
IFRS - International Financial Reporting Standards
INEDs - Independent, Non-Executive Directors
U.S. GAAP - United States Generally Accepted Accounting Principles
U.S. GAO - United States Government Accountability Office
U.S. SEC - United States Securities and Exchange Commission
VAT - Value Added Tax
VIF - Variance Inflation Factor
1.1 Introduction
This chapter outlines the justification for this study, explores its underlying rationale
and establishes its context. Key themes and concepts that underpin this study are
discussed, while its relevance to the current business environment is also considered.
The research approach and contribution of this study are also explored, while the
chapter concludes with a diagrammatic overview of the structure of the dissertation.
Chapter 1 Introduction
1.2 Research Rationale and Context
The importance of trade credit as a method of corporate financing is widely
documented, with empirical evidence suggesting that trade receivables account for
between 5 to 30 per cent of the total assets of European companies (Van Der Wijst
and Hol, 2002). Post the 2008 financial crisis, both private and corporate credit risk
remain elevated. With the intensification of the sovereign debt crisis across Europe
during 2011 and 2012, both macroeconomic uncertainty and credit risk have increased
further. EFMA (2012) states that 79 per cent of credit risk manager respondents
anticipate a renewed recession across Europe during 2012, while restrictions in trade
credit and sharp increases in credit delinquencies are also anticipated.
Companies provide for anticipated losses on trade receivables through a specific
provision for credit loss on trade receivables (IAS 39: S.58-59), commonly referred to
as the provision for doubtful receivables or provision for bad debts. In an environment
of such elevated credit risk, any reduction in this provision or failure to augment the
provision relative to an increase in total gross trade receivables is suspect. Indeed, any
reduction or failure to augment this provision generally serves to inflate overall
earnings. This study examines such abnormal provisioning activity in the context of
both earnings quality and earnings management.
Prior empirical studies, ranging from Healy (1985), Jones (1991) to Dechow et al
(2011) have examined in great detail the existence, frequency and magnitude of
earnings management activity, primarily in the context of discretionary accruals.
While a limited number of recent studies including Chen (2006) examine earnings
management in an international context, the majority of prior research has been
conducted in a U.S. or U.S. GAAP compliant financial reporting context. McNichols
and Wilson (1988) identify the need for further research with regard to earnings
management through singular accrual measures such as the provision for bad debts.
However, excepting the research of Lev and Thiagarajan (1993) and Ricci (2011), the
researcher is not aware of additional extensive research that has examined the
manipulation of the provision for credit loss on trade receivables from an earnings
management perspective, in a European or IFRS compliant financial reporting
context.
This study complements existing earnings management research in adopting
methodology employed in prior studies, while also adding to existing earnings
management literature. In considering the response of capital markets to instances of
extreme abnormal provision for credit loss on trade receivables, this study also
examines the link between theoretical perspectives and the real world business
environment. Finally, the results provide a series of useful information for
practitioners including auditors, accounting standard setters and capital market
participants, with regard to the magnitude and determinants of abnormal provision for
credit loss on trade receivables.
1.3 Research Questions and Research Objectives
The research questions to be addressed in this study are:
RQ 1 – What is the magnitude and what are the determinants of abnormal provision
for credit loss on trade receivables amongst FTSE 350 companies?
RQ 2 – What is the capital (stock) market response to instances of extreme abnormal
provision for credit loss on trade receivables amongst FTSE 350 companies?
Utilising abnormal provision for credit loss on trade receivables as a measure of
earnings quality and as a proxy for earnings management activity, the following
research objectives support the investigation of the research questions:
1. To quantify the existence, direction and magnitude of abnormal provision for
credit loss on trade receivables amongst FTSE 350 companies.
2. To develop a multivariate OLS regression model that examines the
applicability of previously identified and alternative determinants of earnings
management activity, including capital market, contractual, performance,
governance and auditor related variables to abnormal provision for credit loss
on trade receivables amongst FTSE 350 companies.
3. To examine the individual and aggregate stock price performance of the most
extreme abnormal providers for credit loss on trade receivables (both under
and over providers) over a specified post financial year end period.
Chapter 1 Introduction
Consistent with prior earnings management research, including Frankel et al (2002)
and Chen (2006), this study identifies a core measure of earnings quality and proxy
for earnings management, subsequently utilising descriptive statistics, correlation and
regression analyses to complete the varying tests that examine the research questions.
All data is gathered directly from both the latest available annual reports and the
Thomson One Banker database. The final sample population consists of 204 FTSE
350 companies, while the primary measure of earnings quality and proxy for earnings
management comprises the relative change in the provision for credit loss on trade
receivables after controlling for the relative change in total gross trade receivables.
Limitations of this study relate to the potential omission of earnings management
through alternative abnormal provisioning or discretionary accruals. The attachment
of a single earnings inflation motive to abnormal underprovision also disregards the
possibility that overprovision may represent earnings deflation activity. This study
also assumes that the prior year provision for credit loss on trade receivables is
representative of steady state, un-managed, normal provisioning. It is possible that
provisioning activity was elevated during 2008 and 2009, amidst the core of the
financial crisis, with companies now reducing their provision for credit loss on trade
receivables in subsequent years.
1.5 Dissertation Structure: Diagrammatic Overview
This dissertation consists of eight chapters in total. The overall structure of the
dissertation and composition of each chapter is detailed in Figure 1.1 below.
Figure 1.1 – Dissertation Structure: Diagrammatic Overview
Introduction
underlying the study. The research questions
and research objectives are also introduced.
Literature
Review
prior empirical research underlying earnings
quality and earnings management activity.
Methodology
and analysis procedures, with a detailed
consideration of the limitations of the study.
Findings
correlation and regression analyses
undertaken are presented sequentially.
prior empirical research.
presented, along with recommendations for
both practitioners and future research.
Chapter 2
Literature Review:
Introduction and Theoretical Perspectives
Chapter 2 Literature Review
Introduction and Theoretical Perspectives
2.1 Introduction
The purpose of this chapter is to provide an introduction to the concepts of earnings
quality and earnings management. Initially discussing prior and current literature on
these concepts, the chapter then examines both accounting and economic theory
underlying earnings management practice, including positive accounting theory,
signalling theory and modern theory of the firm.
2.2.1 Earnings Quality as a Concept
The concept of earnings quality is documented extensively in prior literature, with
Ayres (1994) stating that earnings quality was examined as early as the 1930’s,
whereby the true or underlying value of a security could be determined through
careful analysis of an entity’s financial statements to indicate whether a company
should be trading in excess of or below its current market value. According to Ayres
(1994), a focus on the degree of permanence in reported earnings became a principal
measure of earnings quality during the early 1970’s.
Bricker et al (1995) posit that reported earnings are of the highest quality when they
are most reflective of underlying events and conditions. Moreover, Duncan (2002)
asserts that management must often undertake subjective estimates with regard to
losses on loans or trade receivables that directly impact earnings quality and that if
managers smooth or manage earnings through estimates that are either too liberal or
conservative, there is a significant risk that such earnings may be viewed as lower
quality earnings by financial statement users. In supporting Duncan (2002), Schipper
et al (2003) determine that investors consistently attach higher price multiples to
earnings patterns that are supported by high quality earnings and that the magnitude
of any earnings management activity directly impacts the quality of earnings.
2.2.2 Measures of Earnings Quality
Schipper and Vincent (2003) state that earnings quality may be measured through
indicators that include the ratio of cash from operations to income, changes in total
accruals or the direct estimation of discretionary accruals through accounting
fundamentals. Palliam and Shalhoub (2003) define earnings quality as a measure of
the predictability of future earnings while Schipper et al (2003) also posit that higher
quality earnings have a signalling effect that indicates the sustainability of an earnings
pattern. Bellovary et al (2005), in identifying the provision for doubtful receivables as
a singular measure of earnings quality, also contend that earnings quality refers to the
stability, persistence and lack of variability in reported earnings while Mohammady
(2010) supports these assertions in stating that persistence, predictive value, feedback
value and earnings smoothness can all be employed as indicators of earnings quality.
10
Figure 2.1 below, adapted from Ayres (1994) outlines the traditional income
smoothing hypothesis, where long run reported and managed or manipulated earnings
are smooth, relative to underlying, real earnings.
Figure 2.1 – Income Smoothing Hypothesis
2.2.3 Earnings Quality and Earnings Management
As a result of the relationship between earnings management activity and earnings
quality, the detection of earnings management has been the focus of multiple
empirical studies to date, with the work of Healy (1985), DeAngelo (1986), and Jones
(1991) in the development of specific models to test for the existence, frequency and
magnitude of earnings management. Subsequent empirical studies, including those of
Sweeney (1994), Dechow et al (1995), Dechow and Dichev (2002), and Dechow et al
(2011) have attempted to refine prior models in the detection of earnings management
and to identify the primary determinants of earnings management practice generally.
2.3.1 Earnings Management as a Concept
References to earnings management are not always explicit and are often described as
earnings manipulation, big bath accounting, income smoothing or creative accounting
(Stlowy and Breton, 2004). Dechow and Skinner (2000) suggest that there is a
somewhat limited degree of empirical evidence from academic studies to suggest that
earnings management has a material impact upon average reported earnings. Dechow
and Skinner (2000) also acknowledge that there is significant disparity between
academic and practitioner perspectives, whereby academics focus primarily upon
earnings management activity driven by contractual agreements, yet practitioners are
primarily concerned with capital market determinants of earnings management.
2.3.2 Differentiation between Earnings Management and Manipulation
Earnings management comprises income smoothing behaviour but also refers to the
intentional structuring of disclosure or investment decisions with the bottom line
impact in mind (Ayres, 1994). In defining earnings management, an important
distinction must be made between earnings management and earnings manipulation
more specifically. Dechow and Skinner (2000) suggest that while underprovision for
bad debts constitutes aggressive earnings management, it is fictitious inventory and
revenue inflation that constitute fraudulent earnings manipulation. Moreover, Chen
(2006) posits that expense recognition deferral, erroneous revenue recognition and
measurement abuse constitute outright earnings manipulation.
2.3.3 Accounting Policy Flexibility and Earnings Management
While acknowledging that accounting flexibility is a primary mechanism through
which earnings management takes place, Dechow and Skinner (2000) suggest that the
elimination of all accounting flexibility would render earnings useless as a
measurement of economic performance. Colson et al (2010) suggest that firms may
utilise such flexibility to provide a clearer indication of their financial performance,
rather than to mislead investors. Additionally, Srivastava (2008) determines that firms
utilise flexibility in revenue recognition rules in order to convey value relevant
information to investors and not to engage in earnings management.
Despite an apparent lack of conclusive empirical evidence within academic literature
(Healy and Wahlen, 1998), the regular occurrence of corporate earnings scandals
including those of Enron, Tyco and Global Crossing (Bitner, 2005) provides
supporting evidence that earnings management occurs in extreme forms with
significant adverse impacts on firms and their respective stakeholder groups.
Additionally, Healy and Wahlen (1998) state that there is evidence of significantly
negative stock market responses to allegations of earnings management, with a
corresponding risk of an adverse impact on resource allocation in the wider economy.
2.3.5 Accrual Accounting, Earnings Management and Accounting Earnings
Accrual accounting, which is utilised to disrupt cashflow patterns in order to
compensate for issues of both timing and recognition (Dechow and Dichev, 2002),
is most contentious in the area of earnings management. Although accounting driven
accruals are often identified as a primary mechanism through which earnings
management may take place (Dechow et al, 1995), it is argued that the use of accrual
accounting in the determination of earnings results in long run earnings patterns that
are closely correlated with returns (Degeorge et al 1999). Healy and Wahlen (1998)
also contend that current earnings, which are indicative of management judgement,
are value relevant and are better indicators of future cash flow performance than
current cash flows.
2.4. Earnings Management – Theoretical Perspectives
2.4.1 Introduction to Theoretical Perspectives
The determinants of earnings management activity can be viewed primarily within the
confines of the signalling, agency and positive accounting theoretical frameworks.
While several sources of literature contend that there are significant differences
between agency theory and signalling theory, Morris (1987) concludes that both
theories are consistent, with considerable overlap in many instances.
Figure 2.2 – Signalling Theory and Earnings Management
2.4.2 Signalling Theory and Higher Quality Firms
Spence (1973) suggests that where two parties are engaged in a transaction and there
exists the problem of asymmetric information, one party may send a signal to the
other, in order to convey value relevant information, with resultant positive
implications for the party sending the signal from a valuation perspective. Accounting
standard guidance prescribes a lower bound or minimum information disclosure
requirement level according to Morris (1987), who posits that higher quality firms
will utilise accounting information disclosure to indicate to shareholders that they are
not utilising accounting flexibility to their detriment, or that they are not utilising such
flexibility to the same extent as other firms.
2.4.3 Signalling Theory and Lower Quality Firms
Conversely, Morris (1987) also argues that lower quality firms who are determined
that accounting standard disclosure requirements do not provide fine information
signals; will engage in corporate lobbying to ensure that standards of this kind are
introduced. Morris (1987) further posits that, in the context of accounting policy
choice, higher quality firms will chose more optimal accounting policies that reveal
their superior quality when compared with lower quality firms, who will utilise
accounting methods that conceal their inferior quality. The clear inference from these
assertions is that those firms who engage in earnings management are predisposed
towards those signalling motives of inferior quality firms.
Signalling
Theory
Concealing Inferior
2.4.4 Positive Accounting Theory and Earnings Management
Developed primarily by Watts and Zimmerman (1978), positive accounting theory
provides significant grounding for the determinants of earnings management practice.
Watts and Zimmerman (1986) posit that, in the absence of manipulation by
management, earnings otherwise follow a particular process and in order to reduce the
variance of that process, management adopt or alter specific accounting procedures.
In analysing the relationship between earnings and stock prices, Watts and
Zimmerman (1986) also suggest that the method of generating reported earnings has
an important bearing upon the income smoothing hypothesis, whereby, all else being
equal, managers will smooth earnings.
Watts and Zimmerman (1986) further determine, from prior empirical evidence, that
although there is no definitive evidence of a relationship between the capital intensity
of a firm, political costs and earnings deflation, there is consistent evidence that key
variables including size, the debt to equity ratio and the existence of a management
level compensation plan impact the propensity towards earnings management within a
firm. Watts and Zimmerman (1986) also posit that there is a positive relationship
between an increasing debt to equity ratio, the existence of a management level
compensation plan and the likelihood of the adoption of earnings inflation procedures
specifically. Consequently, these variables have been subject to widespread testing in
earnings management research.
2.4.5 Agency Theory and Earnings Management
Conceptualised primarily by Jensen and Meckling (1976), agency theory defines the
relationship between the principal and agent, owner and manager of a firm. Palliam
and Shalhoub (2003) state that the risk differential between principals and agents
creates a problem in the principal - agent relationship. While the responsibility for the
management of earnings rests with the agents of a firm, the methods undertaken to
manage earnings are not equally desirable from a principal’s perspective (Palliam and
Shalhoub, 2003). The principal can limit divergence by the agent from their desired
perspectives through both incentives and monitoring costs. However, where both
parties strive for utility maximisation, divergence remains highly likely (Jensen and
Meckling, 1976).
2.4.6 Agent Specific Motives for Earnings Management
In examining revenue recognition practice in the context of an agency setting, Dutta
and Zhang (2000) determine that no performance measure based upon current
accounting information will result in optimal agent specific incentives where mark to
market accounting is utilised. Moreover, in order to comply with consensus earnings
forecasts, the desires of the principal or to project a smooth earnings path, Palliam and
Shalhoub (2003) posit that agents will manage earnings through the acceleration or
deferral of either revenue or expenses or through accounting operations.
Conflicting From
2.5 Conclusion
Clearly, the concepts of earnings quality and earnings management have been the
subject of extensive focus over several decades from both empirical and theoretical
perspectives. There is considerable cross literature consensus with regard to earnings
quality measures ranging from persistence to smoothness, along with the use of
singular measures of earnings quality relating to trade receivables as outlined by
Bellovary et al (2005). Additionally, accounting and economic theory provides strong
support for the existence and determinants of earnings management activity, with
many of these determinants examined extensively in the following chapter.
Chapter 3
Literature Review:
Varying Perspectives and the Response of
Capital Markets
Varying Perspectives and the Response of Capital Markets
3.1 Introduction
The purpose of this chapter is to discuss extensively the determinants of earnings
management practice as identified in prior empirical studies, while simultaneously
aiming to demonstrate a clear link between the prior mentioned theory and extant
earnings management practice. Where multiple authors’ findings relating to the
determinants of earnings management are discussed; summary tables are presented.
The chapter then concludes with a focus on the response of capital markets to
earnings management activity.
3.2 Earnings Management and the Financial Condition of a Firm
While earnings management more frequently takes place within firms that are
experiencing financial distress (Chen, 2006), healthy firms that have not experienced
multi-period accumulated losses also engage in earnings management
(Peltier-Rivest and Swirsky, 2000). However, the determinants of earnings
management within healthy firms are not equivalent to those of distressed firms, as
such traditional determinants, including executive level motives, would not yield
sufficient benefits in order to influence managers’ accounting choice (Peltier-Rivest
and Swirsky, 2000).
Jeffrey et al (2008) determine that where a firm has suffered significant prior period
operating losses or negative cash flows, it will be motivated to manipulate revenues
specifically rather than earnings generally, as capital market participants tend to value
such firms on the basis of the level and growth in revenue rather than earnings and
cash flows. Management within healthy firms that are engaged in union or labour
negotiations are more likely to make income decreasing total accruals that depress
total earnings (Peltier-Rivest and Swirsky, 2000). Moreover, within healthy firms,
there is limited evidence of strong earnings management incentives driven through
top level executive change or government lobbying – that is, when a firm is subject to
governmental investigation (Peltier-Rivest and Swirsky, 2000).
3.3 The Determinants of Earnings Management
In establishing the determinants of earnings management, a primary consideration
includes the extent to which such activity is driven by the exercise of managerial
judgement (Healy and Wahlen, 1998). Bitner (2005) contends that asset quality, sales
growth and depreciation contain key indicators highlighting some of the contributing
factors to earnings management, while also contending that, inter alia, the following
components contribute to earnings management activity:
Sub optimal decision making resulting from prolonged periods of prosperity with
warning signals being disregarded and contradictory evidence being rationalised.
Fear on the part of lower level executives who act in their own self-interest in the
non-disclosure of negative information to their superiors.
A deficit in longer term planning, operational viability and leadership.
Contracting motives for earnings management refer to those determinants within the
confines of the agency relationship, where covenants or provisions are utilised to
mitigate traditional agency problems (Jensen and Meckling, 1976). Healy and Wahlen
(1998) state that contracting motives arise where management compensation contracts
are utilised to align external stakeholder and management incentives or where lending
contracts are utilised to prevent against managerial level engagement in activity to the
detriment of a firm’s creditors.
3.3.2 Executive Level Compensation and Earnings Management
According to Healy and Wahlen (1998), the balance of empirical evidence suggests
that managers will utilise accounting judgement to inflate earnings where bonus plans
and contractual compensation incentives are indexed to earnings performance.
Watts and Zimmerman (1986) suggest that managers with contractual bonus plans are
more likely to adopt accounting policies that lead to the premature recognition of
future period earnings in the current accounting period. Moreover, Healy (1985)
determines that firms who specify a limit on their bonus award schemes are more
likely to report accruals resulting in the deferral of income when the bonus limit is
reached, indicating that there is an incentive to report earnings that will result in
receipt of the maximum bonus level, but not beyond such a level.
Dechow and Sloan (1991) determine that chief executive officers reduce research and
development spending during their final years in office, possibly to report more
positive short run earnings, with their final compensation contracts linked to these
earnings upon departure. However, Healy and Wahlen (1998) contend that such
changes in research and development expenditure may arise as a result of changes in
general investment policy rather than earnings management specifically.
Siagian (2002) finds no evidence of an abnormally high association between the
bonus of the chief executive officer and annual earnings amongst firms have been
subject to enforcement actions by the U.S. S.E.C. However, Balsam (1998)
determines that management engage in accounting choice in order to enhance their
level of compensation, determining that the association between the compensation of
the chief executive officer and the reported income of a firm increases with the level
of discretionary accruals.
21
Gaver and Gaver (1998) support the findings of Balsam (1998), determining that
managers are rewarded for undertaking accounting choice that positively impacts
income. Chen (2006) also asserts and finds, in a Taiwanese context, that those firms
engaged in earnings manipulation have a stronger intention to avoid reporting net
losses or depressed earnings in order to secure high levels of bonus payments, when
compared with a sample of non-manipulating firms. Clearly, the majority evidence
from these studies (Table 3.1 below) suggests that executive level compensation is a
primary determinant of earnings management activity.
Table 3.1 – Executive Level Compensation and Earnings Management
Author Subject Earnings Management R
Healy (1985) Bonus Plans Limited Earnings Mgmt. +
Healy and Wahlen (1998) Bonus Plans Earnings Inflation +
Dechow and Sloan (1991) R&D Expenditure Earnings Inflation -
Balsam (1998) Mgmt. Compensation Earnings Inflation +
Gaver and Gaver (1998) Mgmt. Compensation Earnings Inflation +
Chen (2006) Bonus Payments Earnings Inflation +
Where R indicates the relationship between the subject and earnings management activity.
3.3.3 Debt Contract Motives and Earnings Management
Prior research has also investigated the relationship between an increasing risk of
breaching debt covenants or lending contracts and earnings management activity.
Chen (2006) suggests that firms are more likely to be successful in loan or funding
applications where they have higher net incomes and gearing ratios that are well
below the industry accepted threshold of 50 per cent. Dechow et al (1996) state that a
primary determinant of earnings management is the desire to raise external financing
at a low cost and to avoid any debt covenant restrictions. In examining firms that have
violated lending contracts, DeFond and Jimbalvo (1994) determine that firms
accelerated their earnings, one year prior to the breach of debt covenants.
Additionally, Sweeney (1994) determines that debt covenant violators typically
engage in income increasing accounting policy changes; however this engagement is
generally post debt covenant violation.
3.3.4 Earnings Expectations and Earnings Management
Additional research has examined whether earnings management occurs in order to
meet or exceed the expectations of institutional investors, analysts and other capital
market participants. Payne and Robb (1997) determine that firms manage their
earnings in order to meet or comply with analysts’ forecasts. Kasznik (1999) provides
evidence consistent with the findings of Payne and Robb (1997), determining that
managers utilise positive discretionary accruals to inflate earnings when earnings
would otherwise, in the absence of inflation, fall below prior management forecasts.
Habib and Hansen (2008) state that the importance placed upon meeting analysts’
forecast benchmarks has increased in recent years. Lopez and Rees (2002) determine
via empirical analysis that 65 per cent of sample firms met or exceeded analysts’
forecasts during the years post 1992. Lopez and Rees (2002) also find that the
negative response of stock market participants to not meeting forecasts is significantly
greater, in absolute terms, than the response to beating forecasts and that meeting
analysts’ forecasts is a more powerful variable in the explanation of returns than the
annual profit or loss performance of a firm.
3.3.5 Regulatory Motives and Earnings Management
Regulatory motives refer to those within the context of either governmental regulation
(Healy and Wahlen, 1998) or self-regulation in the form of effective or defective
corporate governance mechanisms (Jouber and Fakhfakh, 2011). Jones (1991)
determines that U.S. firms seeking import duty relief generally depress earnings in the
year of application for such relief. Within the regulated U.S. banking sector and in
the context of the provision for credit loss, Healy and Wahlen (1998) state that there is
considerable evidence of excess loan loss provisioning and a subsequent
understatement of loan loss impairments to facilitate the recognition of abnormal
unrealised gains. This assertion is supported by Collins et al (1995) who determine
that profitable banks decrease their loan loss provisions when their earnings are
relatively low and increase such provisions when earnings are relatively high - this
being a clear indicator of pro-cyclical earnings management. Yun and Kim (2011)
infer that regulation can limit earnings management activity, finding that there has
been a significant decline in the proportion of discretionary accruals amongst sample
firms post implementation of the Sarbanes Oxley Act, 2002.
3.3.6 Corporate Governance Structures and Earnings Management
Empirical research has also identified a strong link between effective corporate
governance structures and a reduced level of earnings management activity,
as summarised in Table 3.2 below. Dechow et al (1996) find that poor oversight
through weak governance structures is an important determinant of earnings
manipulation. Chen (2006) determines that Taiwanese firms who are engaged in
earnings manipulation have a lower concentration of INEDs on their boards of
directors and supervisory boards, when compared with non-manipulating firms.
Peasnell et al (2005) posit that, as earnings management imposes costs upon
stockholders and capital market participants, effective corporate boards should work
towards preventing such manipulation, while also finding that the incidence of income
increasing earnings management activity decreases as the concentration of external
board members to the total board increases. Sebahattin and Harlan (2009) determine
that effective or strong corporate governance mechanisms within U.S. manufacturing
firms reduce the incidence of earnings management amongst mid-range firms. In light
of these findings, Sebahattin and Harlan (2009) also assert that creditors and equity
investors should apply greater scrutiny to the reported accruals of firms, being
mindful that robust corporate governance structures may represent an intervening
variable with regard to abnormal accruals.
Table 3.2 – Corporate Governance Structures and Earnings Management
Dechow et al (1996) Weak Governance Increased Manipulation +
Beasley (1996) (+) INEDs to Board Reduction in Fraud -
Peasnell et al (2005) (+) INEDs to Board Reduced Earnings Inflation -
Sebahattin and Harlan (2009) Strong Governance Reduced Earnings Mgmt. -
Additionally, Beasley (1996) determines that the proportion of external director
concentration to the board of directors for firms experiencing financial statement
fraud is lower when compared with non-fraud firms and that the composition of the
board, rather than audit committee presence, is a more important mechanism for
reducing the likelihood of financial statement manipulation.
3.3.7 Audit Committee and Earnings Management
The audit committee is a sub-component of the overall governance structure within a
firm. While Lin et al (2006) posit that there is a significantly negative association
between the independence of the audit committee and the incidence of earnings
restatement, along with a significantly negative association between the number of
audit committee meetings and the incidence of earnings restatement, neither of these
hypotheses is supported when subject to testing.
3.3.8 Auditor Type, Auditor Remuneration and Earnings Management
Francis and Krishnan (1999) determine that large audit firms provide higher quality
audits, exhibit reporting conservatism and are more aggressive in constraining the
earnings management activity of their clients. Krishnan (2003) determines that clients
of non-specialist auditors exhibit elevated levels of discretionary accruals when
compared with clients of specialist auditors while also suggesting that the use of a
Big 6 1 auditor with industry specialist knowledge can enhance the credibility of
accounting information.
Jordan et al (2010) determine that managers of companies audited by small audit
firms manipulate their earnings to generate EPS values consistent with user reference
points and that Big 4 audit firms are more likely to be effective in constraining the
efforts of their clients in earnings manipulation. In addition, Lin et al (2006) suggest
that higher audit fees from either audit specific or non-audit services reduce auditor
independence and therefore impair overall audit quality. In contrast, Frankel et al
(2002) find that there is a negative association between audit specific fees and
earnings management indicators. Table 3.3 below summarises these findings.
Table 3.3 – Auditor Type, Auditor Remuneration and Earnings Management
Francis and Krishnan (1999) Large Audit Firms Reduced Earnings Mgmt. -
Frankel et al (2002) (+) Audit Fees Reduced Earnings Mgmt. -
Lin et al (2006) (+) Audit Fees Increased Earnings Mgmt. +
Jordan et al (2010) Small Audit Firms Increased Earnings Mgmt. +
1 Big 6 audit firms in 2003 have subsequently reduced to Big 4 audit firms at the time of this study.
The determinants of both revenue and trade receivables manipulation are discussed in
this section, given the importance of trade receivables throughout this study. Investors
and capital market participants place significant emphasis upon reported revenue
according to Anderson and Yohn (2002), who conclude that when there are
irregularities with a firm’s financial statements, investors are more concerned with
revenue recognition than alternative reporting issues, with revenue restatements
resulting in significantly more adverse stock returns compared with alternative
accounting restatements.
Caylor (2009) determines that managers engage in accelerated revenue recognition
using the short term deferred revenue and gross trade receivable accounts where
pre-managed earnings fall slightly below analyst benchmarks. Caylor (2009) also
determines that managers prefer to exercise revenue recognition in deferred revenue
rather than trade receivables in order to avoid negative earnings surprises.
Revenues form a unique role in valuations and it is preferable for managers to
manipulate revenues when compared with alternative earnings management methods,
as alternative earnings management methods are not equivalent in monetary outcomes
according to Zhang (2006); who also determines that firms with the following
characteristics are more likely to manage or manipulate revenues:
Higher growth perspectives
Higher operating margins
Higher accounting policy flexibility in revenue recognition
Jeffrey et al (2008) determine that the greater a firm’s historical operating losses or
past and expected negative operating cash flows, the more likely it is to overstate
revenues and accounts receivable in order to induce a higher market valuation. Jeffrey
et al (2008) also determine that there is a positive relationship between the likelihood
of revenue manipulation and increasing leverage and inventory to total asset ratios.
3.4.1 Earnings Quality and Stock Price Performance
While there is broad cross literature agreement that capital markets respond
negatively to low quality earnings, the available empirical evidence remains
somewhat conflicting. Dechow et al (2007) document a negative raw stock price
performance amongst manipulating firms during the years directly post earnings
manipulation. As indicated in Figure 3.1 below, there is a pronounced decline in stock
price performance post earnings manipulation, with only a slow recovery thereafter,
highlighting the longer term capital market effects arising from such activity.
Figure 3.1 – Stock Price Performance: Post Earnings Manipulation
Annual Raw Returns Surrounding the Earnings Manipulation Years
Year Relative to Manipulation Years
Note: Adapted directly from Dechow et al (2007).
Chan et al (2001) determine that there is a reliable negative association between
elevated levels of accruals, categorised as low quality earnings, and future stock
returns; also noting that changes in accounts receivable have strong predictive power.
However, Sloan (1996), in finding that the persistence of earnings performance is
dependent on the magnitude of the cash and accrual components of earnings,
determines that stock price results are inconsistent with the traditional efficient market
hypothesis that stock prices fully reflect all publicly available information.
3.4.2 Equity Offerings, Earnings Management and Stock Price Performance
Teoh et al (1998) determine that discretionary current accruals, which are subject to
managerial judgement, are artificially high around the period of an initial public
offering when compared with non-issuers. Teoh et al (1998) also determine that
issuers with an abnormally high level of discretionary accruals experience inferior
stock returns in the three years post initial public offering, with a firm in the most
aggressive category of initial public offering earnings managers experiencing, on
average, a 15 to 30 per cent worse three year stock price performance than those firms
classified as being within the most conservative range. This result is consistent with
the findings of Holthausen et al (1995) who determine that future stock returns are
negative for firms whose current earnings include large accrual components and
conversely, that future stock returns are positive for those firms with low accrual
components to their earnings.
3.4.3 Magnitude of Capital Market Based Earnings Management
While only limited prior research has measured the significance of capital market
based earnings management, Teoh et al (1994) determine, from a sample of firms
undertaking initial public offerings; that the median level of unexpected accruals
ranges from 4 – 5 per cent of total assets. Erickson and Wang (1999) find that
accruals for firms are measured at 2 per cent of total assets during the quarter of a
stock acquisition. While quantification of these findings in the absence of a
comparison with other non-issuing firms remains difficult, Teoh et al (1994)
determine that 62 per cent of firms undertaking initial public offerings exhibit
abnormally high levels of unexpected accruals when compared with a sample of
control firms, indicating an identifiable level of earnings management activity.
3.5 Conclusion
The numerous determinants of earnings management discussed throughout this
chapter provide a clear link between the previously cited accounting and economic
theory and extant earnings management practice, particularly with regard to the
opportunistic perspectives of positive accounting theory. Subsequently, varying
models have been developed to analyse the determinants of earnings management
activity. These models are considered in detail in the following chapter.
Chapter 4
Literature Review:
Relevant Accounting Standard Guidance
4.1 Introduction
The purpose of this chapter is to provide a chronological overview of the development
of models and measures utilised in testing for earnings quality and earnings
management, focusing on the provision for credit loss on trade receivables
specifically. Moreover, the chapter also details the current IFRS accounting standard
guidance and disclosure requirements with regard to the provision for credit loss on
trade receivables.
4.2.1 The Provision for Doubtful Receivables: McNichols and Wilson (1988)
There is a significant literature gap with regard to empirical studies that examine the
level of provision for credit loss on trade receivables, amongst IFRS compliant firms,
in the context of earnings management. This is possibly explained as a result of prior
research utilising a portfolio or combination approach in examining the combined
level of total discretionary accruals. In utilising the provision for doubtful debts as a
proxy for earnings management activity and predicting the provision for doubtful
debts in the absence of earnings management, McNichols and Wilson (1988)
determine that firms manage their earnings through the choice of income decreasing
accruals when income is extreme.
Additionally, McNichols and Wilson (1988) also determine that discretion in the
provision for bad debts ranges from 1 – 4 per cent of income for firms with extreme
income and that exercising discretion over the provision for bad debts, combined with
alternative discretionary accrual measures, can facilitate the achievement of target
income where annual earnings targets are within a 10 to 15 per cent growth range.
4.2.2 The Provision for Doubtful Receivables: Lev and Thiagarajan (1993)
In developing a multivariable earnings signal framework, Lev and Thiagarajan (1993)
identify disproportionate annual changes in trade receivables relative to revenue and
disproportionate annual changes in the provision for doubtful receivables relative to
trade receivables as fundamental indicators of earnings quality, suggesting that firms
with inadequate provisions for doubtful receivables are expected to experience future
depressed earnings as a result of increased provisions.
Lev and Thiagarajan (1993) also determine that while the aforementioned receivables
and doubtful receivables signals are relatively weak in unconditioned analysis, both
signals are statistically significant and value relevant during high inflation years,
indicating the importance of contextual or conditioned analysis. Lev and Thiagarajan
(1993) also suggest that there are adverse implications arising from inadequate bad
debt provisioning for both the persistence and growth of earnings.
Ricci (2011) compares the receivables and receivables related accounts of companies
subject to U.S. SEC enforcement actions against those of a positive control group.
Utilising the Wilcoxon Signed Ranks Test, manipulating companies are paired against
non-manipulating companies within the same industry grouping. In determining that
trade receivables manipulation varies by industry type, Ricci (2011) finds that
receivables are inflated via the provision for doubtful receivables specifically; in the
Information Technology sector.
4.3.1 IAS 39: Section 58 – 59
Section 58 of IAS 39 prescribes that an entity should reduce the carrying amount of a
financial asset either directly or through the use of an allowance account where
objective evidence of impairment exists at the reporting period end. Section 59 of IAS
39 also states that, inter alia, the following constitute objective evidence of
impairment:
“A breach of contract, such as a default or delinquency in interest or principal
payments”.
“National or local economic conditions that correlate with defaults on the assets
in a group”.
4.3.2 IFRS 7: Section 7.16 and 7.37
Section 7.16 of IFRS 7 stipulates that an entity must disclose a reconciliation of the
annual changes in the allowance account for each class of financial asset. Section 7.37
of IFRS 7 also stipulates that an entity must disclose:
“An analysis of the age of financial assets that are past due as at the end of the
reporting period but not impaired’’ and “An analysis of financial assets that are
individually determined to be impaired as at the end of the reporting period”.
These disclosures facilitate the determination of increasing or decreasing credit risk
arising on trade receivables from the examination of a firm’s financial statements.
4.4 Literature Review Conclusion
Capital market participants continue to place a significant emphasis upon the reported
earnings of firms (Schipper et al, 2003). As detailed in chapter two, the quality of
earnings is fundamental, as they represent a primary mechanism by which investors
can determine the most appropriate price of a security and attach a value to a firm.
However, there have been numerous corporate earnings scandals, arising from
earnings management practice, with resultant adverse effects for corporate
stakeholders (Bitner, 2005).
Accounting and economic theory provides strong support for the existence and
determinants of earnings management activity, while empirical research provides a
clear link between theory and extant earnings management practice. The majority of
these determinants have, however, been established in the context of earnings
management practice within the United States or U.S. GAAP compliant financial
reporting, as detailed in both chapters three and four. To this extent, there is a
significant literature gap with regard to empirical research in an IFRS compliant
financial reporting context. This gap is addressed in detail in the following chapter.
Chapter 5
CHAPTER FIVE
RESEARCH METHODOLOGY
5.1 Introduction
The purpose of this chapter is to discuss the research rationale, research objectives
and research methodology underlying this study. The chapter firstly discusses the
research rationale for this study along with the research questions, before examining
the research objectives and literature driven research hypotheses. Thereafter, an
in-depth overview of the research methods undertaken in this study is provided, with
significant emphasis upon sample selection, data collection methods and the rationale
for the selection of various data measures. The chapter then concludes with an
overview of several limitations associated with this study.
Chapter 5 Research Methodology
5.2 Research Rationale
Prior empirical studies, ranging from Healy (1985), Jones (1991) to Dechow et al
(2011) have examined in great detail the existence, frequency and magnitude of
earnings management activity, primarily in the context of discretionary accruals.
While Chen (2006) examines earnings management in an international context, the
majority of prior research has been conducted in a U.S. or U.S. GAAP compliant
financial reporting context. McNichols and Wilson (1988) identify the need for
further research with regard to earnings management through singular accrual
measures such as the provision for bad debts. However, excepting the research of Lev
and Thiagarajan (1993) and Ricci (2011), no extensive research has examined the
manipulation of the provision for credit loss on trade receivables in a European or
IFRS compliant financial reporting context.
Persistent macroeconomic uncertainty, particularly across Europe, combined with an
elevated level of credit risk relative to previous years (EFMA, 2012), renders this
study possible, timely and most appropriate. Undertaken in an IFRS compliant
financial reporting context, this study complements existing earnings management
research in adopting methodology employed in prior studies, while also adding to
existing literature. Moreover, this study provides a series of useful information for
various practitioners with regard to the magnitude and determinants of abnormal
provision for credit loss on trade receivables.
5.3 Research Questions
The research questions to be addressed in this study are:
RQ 1 – What is the magnitude and what are the determinants of abnormal provision
for credit loss on trade receivables amongst FTSE 350 companies?
RQ 2 – What is the capital (stock) market response to instances of extreme abnormal
provision for credit loss on trade receivables amongst FTSE 350 companies?
The research objectives that support the investigation of the research questions are
outlined overleaf.
5.4 Research Objectives
Utilising abnormal change in the provision for credit loss on trade receivables as a
measure of earnings quality and as a proxy for earnings management activity:
1. To quantify the existence, direction and magnitude of abnormal provision for
credit loss on trade receivables amongst FTSE 350 companies.
2. To develop a multivariate OLS regression model that examines the
applicability of previously identified and alternative determinants of earnings
management activity, including capital market, contractual, performance,
governance and auditor related variables to abnormal provision for credit loss
on trade receivables amongst FTSE 350 companies.
3. To examine the individual and aggregate stock price performance of the most
extreme abnormal providers for credit loss on trade receivables (both under
and over providers) over a specified post financial year end period.
5.5 Research Hypotheses for Testing
This study, similar to previous earnings management studies, including Teoh et al
(1998), Frankel et al (2002) and Chen (2006) examines a large number of independent
explanatory variables. Research hypotheses relating to each research objective, along
with the associated independent variables and supporting literature references, where
applicable, are presented throughout.
5.5.1 – Objective One: Hypothesis
Maintaining the assertion that FTSE 350 companies are managing their earnings
through the provision for credit loss on trade receivables:
H1 – Ceteris paribus, the annual relative change in gross trade receivables does not
explain a significant extent of the variation in the annual relative change in the
Literature Source: Lev and Thiagarajan (1993) – Lit. Review – Section 4.2.2
5.5.2 – Objective Two: Hypotheses
The following hypotheses are conceptualised in the context of earnings inflation
activity, with abnormal underprovision for credit loss on trade receivables in an
environment of elevated credit risk representing earnings inflation activity.
Figure 5.1 – Capital Market Determinants of Earnings Management
H2 – Ceteris paribus, there is a negative association between analyst consensus EPS
growth forecasts and the abnormal change in provision for credit loss on trade
receivables.
H3 – Ceteris paribus, there is a negative association between a company’s earnings
(EPS) surprise and the abnormal change in provision for credit loss on trade
receivables.
Where: companies abnormally underprovide, to inflate earnings, in order to comply
with such capital market determinants.
Table 5.1 – Capital Market Determinants of Earnings Management
Literature Source: Literature Review: Section 3.3.4.
Payne and Robb (1997) - Kasznik (1999)
Lopez and Rees (2002) - Habib and Hansen (2008).
Figure 5.2 – Contractual Determinants of Earnings Management
Capital Market
38
H4 – Ceteris paribus, there is a negative association between the existence of a bonus
plan and the abnormal change in provision for credit loss on trade receivables.
H5 – Ceteris paribus, there is a negative association between the proportion of
incentive (bonus) specific executive level remuneration and the abnormal change in
H6 – Ceteris paribus, there is a negative association between the change in the level of
gearing of a firm and the abnormal change in provision for credit loss on trade
receivables.
of such contractual incentives.
Literature Source: Literature Review: Sections 3.3.1 - 3.3.2 - 3.3.3.
Healy (1985) - Watts and Zimmerman (1986)
Dechow and Sloan (1991) - DeFond and Jimbalvo (1994)
Dechow et al (1996) - Balsam (1998) - Chen (2006).
Figure 5.3 – Performance Related Determinants of Earnings Management
H7 – Ceteris paribus, there is a negative association between the change in the gross
margin of a firm and the abnormal change in provision for credit loss on trade
receivables.
H8 – Ceteris paribus, there is a negative association between the change in the net
margin of a firm and the abnormal change in provision for credit loss on trade
receivables.
Performance
Variables
39
H9 – Ceteris paribus, there is a negative association between the change in the
average trade receivables collection period of a firm and the abnormal change in
Where: companies abnormally underprovide, to inflate earnings, in order to maintain
a positive top line performance through to the final earnings performance or to detract
attention from an increasing average trade receivables collection period.
Table 5.3 – Performance Related Determinants of Earnings Management
Zhang (2006) - Jeffrey et al (2008).
Figure 5.4 – Governance Specific Determinants of Earnings Management
The final No. Of Gov. Non Compliance Issues variable has been introduced to
enhance the robustness of this study. Grant Thornton (2011) determines that only half
of all FTSE 350 companies were fully compliant with the Combined Code during
their 2011 review. As a result, the No. of Gov. Non Compliance Issues variable is
selected as a proxy for overall governance best practice within a FTSE 350 company.
Moreover, it is hypothesised that previously robust variables such as the proportion of
INEDs to the Audit Committee may no longer be robust, given the emergence of
corporate governance best practice in recent years.
Governance
Variables
40
H10 – Ceteris paribus, there is a positive association between the proportion of INEDs
to the total board of directors and the abnormal change in provision for credit loss on
trade receivables.
H11 – Ceteris paribus, there is a positive association between the proportion of INEDs
to the total audit committee and the abnormal change in provision for credit loss on
trade receivables.
H12 – Ceteris paribus, there is a positive association between the number of audit
committee meetings held during the financial year and the abnormal change in
H13 – Ceteris paribus, there is a negative association between the number of firm
specific governance non-compliance issues and the abnormal change in provision for
credit loss on trade receivables.
Where: robust corporate governance structures mitigate the propensity towards
earnings inflation activity, resulting in abnormal overprovision, categorised as prudent
activity throughout this study.
Literature Source: Literature Review: Sections 3.3.6 – 3.3.7.
Dechow et al (1996) - Beasley (1996)
Peasnell et al (2005) - Chen (2006) - Lin et al (2006).
Figure 5.5 – Auditor Related Determinants of Earnings Management
H14 – Ceteris paribus, there is a positive association between auditor type and the
abnormal change in provision for credit loss on trade receivables.
H15 – Ceteris paribus, there is a positive association between audit specific fees and
the abnormal change in provision for credit loss on trade receivables.
Auditor
Variables
41
Where: Big 4 auditors are more effective in constraining the abnormal underprovision
activity of their clients and where higher audit specific fees mitigate earning inflation
activity, resulting in abnormal overprovision.
Table 5.5 – Auditor Related Determinants of Earnings Management
Francis and Krishnan (1999) - Frankel et al (2002)
Krishnan (2003) - Lin et al (2006) - Jordan et al (2010)
5.5.3 – Objective Three: Hypothesis
In developing the following hypothesis, extreme abnormal underprovision for credit
loss on trade receivables is defined as earnings inflation activity. While extreme
abnormal overprovision may also be defined as earnings deflation activity, such
overprovision is categorised as being prudent rather than representing earnings
deflation activity in an environment of elevated credit risk.
H16 – Ceteris paribus, FTSE 350 companies with extreme abnormal underprovision
for credit loss on trade receivables (and as a result lower quality earnings) experience
an inferior stock price performance, post financial year end, relative to FTSE 350
companies with extreme abnormal overprovision for credit loss on trade receivables.
Table 5.6 – Capital Market Response to Earnings Management
Literature Source: Literature Review: Sections 3.4.1 – 3.4.3.
Holthausen et al (1995) - Teoh et al (1998)
Sloan (1996) - Chan et al (2001).
5.6 Research Approach
The research approach of this study is relatively consistent with prior earnings
management research, with the use of correlation and regression quantitative
techniques to analyse earnings management activity. Webster (1995, p.621) states that
while: “Regression determines if X and Y exhibit a positive relationship, or if the
relationship is negative in that they move in opposite directions, correlation measures
how strong the relationship is between X and Y” .
42
The breadth of this study is, however, more extensive than prior research, in
considering the magnitude and determinants of earnings management activity, along
with the response of capital markets. Prior research has generally only examined two
of these facets simultaneously. However, such studies have often had access to
evidence of earnings management, primarily through the U.S. GAO accounting
restatement database (Jeffrey et al, 2008), eliminating the need to determine the
existence of earnings management.
5.6.1 Dependent Variable: Earnings Quality and Earnings Management
Where such evidence is not available, the proxy measure utilised for earnings quality
or evidence of earnings management generally comprises a measure of accounting
choice, including discretionary accruals or a measure of earnings irregularity relative
to analyst consensus expectations. Prior research, including Ricci (2011) has
examined firms specifically subject to U.S. SEC 2 enforcement actions. As no earnings
restatement database is available in an IFRS compliant financial reporting context,
this study firstly determines the existence of abnormal provision for credit loss on
trade receivables, utilising this measure as an indicator of earnings quality and as a
proxy for earnings management activity. In conducting univariate and multivariate
regression analyses, the primary dependent variable comprises the relative change in
the provision for credit loss on trade receivables after controlling for the relative
change in gross trade receivables (Section 5.9.1) (Lev and Thiagarajan, 1993).
5.7 Sample Selection Process
5.7.1 Sample Selection Context
This study is undertaken to examine earnings quality and earnings management in a
European, IFRS compliant financial reporting context. As a result, the FTSE 350
Index, a market capitalisation weighted index incorporating all FTSE 100 and FTSE
250 companies is chosen as the initial sample population. This ensures consistency
with prev

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