DISCRETIONARY ACCRUALS AND EARNINGS MANAGEMENT BY OIL COMPANIES IN INDIA

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1 Indian Journal of Accounting (IJA) 32 ISSN : (Print) (Online) Vol. XLVIII (2), December, 2016, pp DISCRETIONARY ACCRUALS AND EARNINGS MANAGEMENT BY OIL COMPANIES IN INDIA Gnyana Ranjan Bal ABSTRACT The study attempts to analyze the earnings management practices by select oil companies in India. Further the study tries to test whether the reason behind consistent hike in oil prices by oil companies in India is due to earnings management. Specifically by taking 18 oil companies including exploration and marketing companies during the period from 2003 to 2012, the study analyses the magnitude of use discretionary accruals though estimation of modified Jones model. The paper concludes that oil companies in India are using income decreasing accruals to manage their earnings in order avoid implication of new policies, taxes and political pressure to claim for less subsidies. KEYWORDS: Earnings Management, Political Cost, Modified Jones Model, Oil Companies. JEL classification: M41, M48, M49. Introduction Since a decade hike in oil price and government subsidies to oil companies has been a major issue in India. The considerable increase in oil prices has made the life of average person vulnerable for the reason that all other economic variables are associated with it. This rise in oil prices and the clamor of oil companies to lift the subsidies in regulated economies have raised a question among the stakeholders about the genuineness of the claims made by oil companies. The claims of loss made by oil companies and the increase in petrol prices which do not commensurate with the change in crude oil prices has often come under sharp criticism from rulers as well as academic community. This raises some serious concerns whether oil companies are managing earnings to increase the price of petroleum products. The quality of earnings had suffered a major setback in nineties with many firms showing signs of earnings management. According to Chen et al., (2010) the frequency of earnings management is higher when firms try to meet analysts forecast. Further, empirical evidence shows that more firms manage earnings to decrease their earning rather than to avoid negative earnings. In addition, evidences of fraudulent practices by companies like Satyam, Sunbeam, Mcdata, Open wave systems and many others have forced both analysts and academicians to focus the issue on quality of earnings. Companies are increasingly resorting to clever gimmicks to show their earnings are matching with analyst s expectation. Studies conducted by Byerd, (2007), Watt and Zimmerman, (1986), Rodríguez- Assistant Professor, Department of Commerce, Guru Ghasidas Vishwavidyalaya, Bilaspur, (C.G.), Koni, Chhattisgarh.

2 Gnyana Ranjan Bal : Discretionary Accruals and Earnings Management by Oil Companies Pérez and Hemmen, (2010) have established a relationship between the political cost hypothesis, agency cost theory, and debt covenant hypothesis with the earnings management by companies. Further Iatridis and Kadorinis (2009) investigated the motivation behind the firms that engage in earnings management. The findings of the study have shown that firms with low profitability and high leverage are likely to adopt earnings management practices. Moreover, firms in need of more equity or debt finance also try to increase firm s financial numbers in order to attract more investors. Firms that chose to debt covenants also resort to earnings management to avoid financial distress and lenders disappointment. Byard (2007) argues that political costs have increased after implementation of Sarbenes and Oxley Act. Oil companies were engaged in earnings management to escape from political pressure and imposition of new taxes like wind fall tax. Using time series for earnings management estimation the study finds earnings management by US based oil companies immediately after impact of Katrina and Rita. Further big oil companies use more income decreasing accruals as compared to smaller oil companies. In similar line, Han (1998) studied political cost and earnings management by oil companies during Persian Gulf crisis. Watt and Zimmerman (1986) argues that during the period of unusual product price increases the reported earnings bring political attraction for scrutiny, so firms engage in earnings management to show lower earnings. Literature shows that models like Healy (1985), Jones (1991) and Jones (1995) are there to identify the earnings management by firms. Among this Modified Jones model (1995) is one of the powerful model used for detection of earnings management. Prior to Jones model non discretionary accruals was used as a measure of earnings management and discretionary accruals were assumed to be constant. A company can manage its earning through various ways like change of accounting policies, change of capital structure and use of accruals (Jones1991). Nevertheless, the companies are engaging in earnings management through changes in their accounting policies. Change of capital structure may not be always a better idea as in either way it will attract high leverage or debt covenant hypothesis. From a regulator point of view, it may not be possible to scrutiny the accounting changes of all companies, for which only accruals is a measure of earnings management. Therefore, the accrual models assume that the companies are using only accruals for earnings management. Hence it is a non-trivial exercise to test whether only changes in current accruals affect it or the changes in past also can affect the current earnings. Companies can manipulate its income through change in the policy of capitalization of expenditure. In a similar line, the change in total assets can detect the changes in income due to the change for depreciation. Further, the increase in accounts receivable may increase the EM or vice versa. Through changing revenue recognition policy, companies can manage the position of account receivables. Companies that recognize all future earnings in current period will show less earnings in future. The cookie jar reserves maintained by the companies might have both positive and negative impact. This will help regulator, analyst and investor to know actual effect due to earnings management. The main objective of the paper is to analyze the use of discretionary accruals for earnings management by oil companies in India. By using modified Jones model I have estimated discretionary accruals to analyze earnings management practice by oil companies in India. Data and Methodology Data pertaining to earnings management (EM) from 18 oil companies as per availability of data, which consist of both exploration and marketing, are from Centre for Monitoring Indian Economy database (CMIE). The period of the study ranges from 2003 to 2012during which considerable fluctuation in oil price occurred. The variables of the study include total accruals (TA), calculated as net profit before extra-ordinary item, minus cash flow from operation. Other variables are change in revenue minus change in account receivables (REV-AR) and plant property and equipment (PPE). As use of discretionary accruals cannot be observed directly from company s financial statement, so we have to use some model for it. Here I have applied modified Jones model to identify use of abnormal accruals by the

3 34 Indian Journal of Accounting (IJA) Vol. XLVIII (2), December, 2016 companies. The model estimation includes three steps; first is to calculate total accrual which is calculated by deducting cash flow from operation from net profit. The second step to estimate parameters through regression using panel data and calculate non-discretionary accruals. The third is to calculate the discretionary accruals as a proxy of earnings management, which is total accrual minus non-discretionary (NDA) accruals. Modified Jones Model (Dechow et al. 1995) TAit= β1 ( REVit - ARit) + β2ppeit+ it (1) TAit = Annual current accruals = earnings before extraordinary items - cash from operations; ARit = Accounts receivable; REVit =Annual revenues; PPEit =property, plant, and equipment By applying regression to equation (1) we have calculated the parameters, and then nondiscretionary accruals have been calculated by putting the parameters in equation (2). NDAit= β1 ( REVit - ARit) + β2ppeit+ it (2) Here NDAit means non-discretionary accruals and in above equation (1) and (2) all the variables are scaled by total assets in t-1 period. After estimation of NDA, Discretionary accruals (DA) have been calculated as below in equation (3). DAit = TAit - NDAit (3) Results The table: 1 shows the descriptive statistics of the different variables for sample companies. Here mean of total accruals is and median is which indicates there is presence of accruals. In all cases the variables are statistically significant. Also by taking TA as dependent and other variables as independent we found the R square is and S.E of regression is , which gives evidence of presence of discretionary accruals. It means the companies are using abnormal accruals to manage their earnings. Table 1: Descriptive Statistics TA REV-AR PPE Mean Median Maximum Minimum Std. Dev Skewness Kurtosis Jarque-Bera Probability Sum Sum Sq. Dev Observations Source: Computed by the author Figure 1: Discretionary Accruals for the Period From 2003 to 2012

4 Gnyana Ranjan Bal : Discretionary Accruals and Earnings Management by Oil Companies The figure 1shows the average discretionary or abnormal of sample companies for the period from 2003 to We can observe the DA is negative in case of all companies. It means the sample companies have engaged in downward earnings manipulation and same also conformed in Table.2. Table 2: Mean and Standard Deviation of total Accruals, Non-Discretionary Accruals and Discretionary Accruals of Sample Companies Company Name Mean Mean Mean SD SD SD NDA TA NDA DA TA DA Bharat Petroleum Corpn. Ltd Castrol India Ltd Chennai Petroleum Corpn. Ltd Essar Oil Ltd Goa Carbon Ltd Gulf Oil Corpn. Ltd Hindustan Petroleum Corpn. Ltd India Carbon Ltd Indian Oil Corpn. Ltd Mangalore Refinery & Petrochemicals Ltd Numaligarh Refinery Ltd Panama Petrochem Ltd Reliance Industries Ltd Sah Petroleums Ltd Savita Oil Technologies Ltd Savita Polymers Ltd Southern Refineries Ltd Tide Water Oil Co. (India) Ltd Source: Computed by the Author The Table 2 shows the mean and standard deviation of discretionary accruals, non-discretionary accruals and total accruals. Here the discretionary accruals have been taken as a measure for earnings management. If it is positive then it indicates use of income increasing accruals and in case of negative it indicates income decreasing accruals. From the table no: 2 it is very clear that the average abnormal accruals is negative in case of all the companies. It means the companies are using income decreasing accruals. The companies have engaged in downward manipulation of the earnings. We can see that DA is high in case of Essar Oil i.e and low in case of Castrol India Ltd. i.e Also the variation is high in case of Essar Oil and low in case of Reliance Industries Ltd. While though in case of Castrol India Ltd. the mean DA is low but variation is more. Out of 18 companies 10 companies have abnormal accruals of more than -1. This may be because the earlier studies say that the company s higher profit attracts political scrutiny and leads to imposition of new tax etc. So to avoid political scrutiny and imposition of new costs, the companies are showing lesser earnings. In other words, the oil companies are showing less profit and managing earnings so that the prices of the oil products are increased accordingly. This may be due to the political cost hypothesis where oil companies always come under the scrutiny of government policy decisions. Conclusion In an emerging economy, it is very highly desirable to watch out corporate actions and their performance, especially in case when the product of firms affects the development of society. Taking into consideration the current scenario of oil prices and political conditions, we studied the earnings management by oil companies in India. At this point of time when the fiscal deficits are high, there exists a need think about subsidies and its requirement. In other words, we need to test whether oil firms are really in need of subsidies. Using modified Jones model I have examined the earnings manipulation by oil companies in India. The results of the study show that the sample companies have been engaged in income decreasing accruals to understate their earnings. Out of 18 companies the mean discretionary accruals is negative for all the companies. Findings of our study revealed that oil companies are indeed

5 36 Indian Journal of Accounting (IJA) Vol. XLVIII (2), December, 2016 managing earnings so that the price of oil is enhanced correspondingly. The findings of this study have several dimensions. It will help the policy makers in making important decisions regarding the hike in oil prices. It further raises questions to the regulatory authority on the adequacy of the standards that help oil companies in managing the earnings. Finally, if expropriation risk by the rulers is mitigated average person will be less vulnerable to oil price hike. References Baginski, S.P., Hassell, J.M. & Wieland, M.M., An examination of the effects of management earnings forecast form and explanations on financial analyst forecast revisions. Advances in Accounting, 27(1), pp Byard, D., Hossain, M. &Mitra, S., US oil companies earnings management in response to hurricanes Katrina and Rita. Journal of Accounting and Public Policy, 26(6), pp Chen, T., Analysis on accrual-based models in detecting earnings management Analysis on Accrual-Based Models in Detecting. Lingnan Journal of Banking, Finance and Economics, 2(1), pp Chi, J. (Daniel) & Gupta, M., Overvaluation and earnings management. Journal of Banking & Finance, 33(9), pp Chung, R., Firth, M. & Kim, J.-B., Earnings management, surplus free cash flow, and external monitoring. Journal of Business Research, 58(6), pp Ghosh, S., Firm ownership type, earnings management and auditor relationships: evidence from India. Managerial Auditing Journal, 26(4), pp Iatridis, G. & Kadorinis, G., Earnings management and firm financial motives: A financial investigation of UK listed firms. International Review of Financial Analysis, 18(4), pp J. Han, S.W., Political Costs During the and Oil Earnings Companies Management of Persian Gulf Crisis. The Accounting Review, 73(1), pp Jensen, M., Agency costs of free cash flow, corporate finance, and takeovers. The American Economic Review, 76(2), pp Jones, J., Earnings management during import relief investigations. Journal of accounting research, 29(2), pp Madalla, G. S Introduction to econometrics. New Delhi: Wiley India Pvt. Ltd. Rodríguez-Pérez, G. & Van Hemmen, S., Debt, diversification and earnings management. Journal of Accounting and Public Policy, 29(2), pp Stubben, S.R., Discretionary Revenues as a Measure of Earnings Management. The Accounting Review, 85(2), pp Watts, R. and Zimmerman, J Positive Accounting Theory. Englewood Cliffs, NJ: Prentice-Hall.