Board Composition and Earnings Management an Empirical Evidence Form Pakistani Listed Companies

Transcription

1 Middle Eastern Finance and Economics ISSN: Issue 3 (2009) EuroJournals Publishing, Inc Board Composition and Earnings Management an Empirical Evidence Form Pakistani Listed Companies Syed Zulfiqar Ali Shah ACMA, MBA, MS(Finance), Ph.D (Contd.) Mohammad Ali Jinnah University Assistant Professor International Islamic University Nousheen Zafar PhD scholar, Mohammad Ali Jinnah University Islamabad Tahir Khan Durrani HOD, Departement of Economics and Finance Mohammad Ali Jinnah University, Islamabad Abstract The study examines the relationship between Board Composition and Earnings Management. A set of listed Companies have been investigated to analyze the relationship for the year 2003 to Board Composition has been measured by Board independence, and Institutional ownership. Whereas earnings management has been quantified by discretionary accruals. Modified Cross Sectional Jones Model (1995) has been used to determine the Earnings management. Common effect model indicates the presence of negative relationship between institutional ownership and earnings management while we did not get statistically significant relationship between Board independence and earnings management. Keywords: Board Composition, Earnings Management, Introduction Financial Reporting standards binds the directors to present (to shareholders) an audited profit and loss statement, an audited balance sheet, a director s report, a statement of changes in financial position and notes to the accounts for the specific period. The integrity of these financial reports has always been an important issue for regulators and practitioners. Managers sometimes intentionally provide wrong information to stakeholders about the economic performance of their company by presenting financial statements that do not supply a true and fair value of the company. Quality of financial reports heavily depends upon choice of accounting treatment. Accounting method and estimates helps managers to determine net income of a company to be used in the contract between managers and shareholders. This is the reason that managers are expected to manipulate income level intentionally in order to benefit them (Watts and Zimmerman, 1986). Information asymmetry between mangers and shareholders empower the managers to use discretionary behavior while reporting earnings of a company to increase their own utility function. Theoretically present value of future cash flows is considered as value of the company. Thus any

2 Middle Eastern Finance and Economics - Issue 3 (2009) 29 increase in earnings depicts the increase in overall value of company and vice versa (Lev, 1989). Especially in case of losses to company, earnings are managed to show favorable situation (Hayn, 1995). This presents the idea of earnings management that is use of accounting choices to amend reported earnings for the sake of managers benefits. Or earnings management can be defined as reasonable as well as legal decision making and reporting of financial results, by managers, with the intention to achieve stability in earnings. Healy and Wahlen (1998) define earnings management comprehensively as an action taking place..when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers. Incentives for earnings management for managers could be bonus plans, debt contracts, meeting analyst s expectations or raising funds on more favorable terms. Research on earnings management suggests that it is a pervasive phenomenon. According to an estimate 8-12 percent firms with small pre-managed earning decreases manipulate their earnings to give impression of earning increases and percent firms with small pre-managed losses manipulate earnings to show positive earnings (Burgstahler, 1997). Opportunity of earnings management is provided to the firms by GAAP allowing them the use of accrual accounting. According to FASB (1985) accrual accounting attempts to record the financial effects on an entity of transactions and other events and circumstances that have cash consequences for the entity in the periods in which those transactions, events, and consequences occur rather than only in the period in which cash is received or paid by the entity. This holds that by use of accrual accounting mangers can control the timing of expense and timing of revenue recognition and thus can manipulate the actual earnings of a firm for a given period. Since this manipulation does not erode the bounds of accounting treatments, it can not be considered illegal. In this situation it becomes the duty of board of directors to check out that correct accounting treatment has been selected, compliance with the standards is made and correct value of firm has been reported to stakeholders. It is widely been held that company s board of directors influence earnings manipulation and the quality of financial statements to large extent and the degree of this influence depends on board characteristics. Board Characteristics and EM Corporate governance practices have their main focus on improving the quality of financial reporting as well as on creating effective boards. Several studies conducted in UK and US show that company board is a great source to control earnings manipulation and quality of financial statements but the extent to which this control can be exerted depends on board characteristics. Best practices of corporate governance have pointed out five major characteristics of board of directors. This includes board composition, board size, directors ownership, number of directorships and chairman/ceo duality. Validity of financial reports depends upon board effectiveness and independence. How much these characteristics effect the earnings manipulation is still debatable question. Other than board characteristics, Institutional ownership is also considered as an important factor which helps in mitigating problem of earnings management. Active and attentive boards relate to the lower earnings manipulation and boards with large number of multiple directors show higher earnings management (Sarkar et al, 2006). Dechow et al. (1996) found that factors contributing to lower earnings manipulation are higher percentage of independent directors, small size of boards, and existence of audit committee. Board of directors play a vital role in controlling agency problem between shareholders and managers arise due to earnings management. This study is concerned with how much overall board composition and institutional ownership helps in controlling earnings manipulation by managers. In case of presence of non executive directors in board, and institutional ownership, managers will get less chance to expropriate the figures in their favor because outside directors and institutional owners

3 30 Middle Eastern Finance and Economics - Issue 3 (2009) both can serve as good inspectors for them. Both of these factors help in mitigating agency problems between managers and share holders. Literature Review Number of previous studies has examined the relationship of earnings quality and corporate governance practices. Most of the emphasis remains upon board practices and its characteristics. Main focus of this study is earnings management and its relation with board composition and institutional ownership. However rest of the corporate governance practices and board characteristics are also highlighted through literature. EM and CG Corporate governance codes all over the world chalk out the procedures for improving the quality and accuracy of financial statements. Role of board of directors, in this regard, has given special importance specially to restrict the opportunistic earnings manipulation and conveying true information about firm operations as result (Young, 2000). Leuz et al (2003) studied the relationship of outside investor protection and earnings management in 31 countries. Their results were that the accuracy of financial reporting increases with higher degree of legal protection to outside investors Independence of board of directors and audit committee has been emphasized a lot for good CG practices. Earnings management is negatively related to board and audit committee independence and this negative relation is stronger when the audit committee is more active (Ebrahim, 2007). Studies found no association among the existence of independent audit committee and earnings management (Osma and Belen, 2007; Peasnell, 2005) however Klein (2002) supported the idea that independent audit committee leads to reduced earnings management. For a board to be effective in controlling earnings management, independence of board members and its subsidiary committees has given much importance. Epps and Ismail (2009) formulate three groups of US firms based on relatively high negative, relatively high positive and low levels of discretionary accruals. Their results indicate that more negative discretionary accruals occur at firms with annually elected boards, small size boards, 100% independent nominating committees and 100% independent compensation committees. However, firms with 75% to 90% independent board or firms with a board size of between 9 to 12 have higher positive discretionary accruals. Results of Mashayekhi (2008) confirm for Iranian firms that expansion of board along with CEO duality leads to increased level of earnings management. However presence of more nonexecutive and institutional directors on the board reduces the level of earnings management. Holding more board meetings and presence of an audit committee does not significantly influence the earnings management. Another main variable considered in corporate governance is CEO duality. Various studies have revealed a strong positive association between CEO duality and earnings management (Kam,2007; Sarkar,2006) EM and Board Composition Boards compose of executive and non-executive directors. For effective working of board, at least one third non executive directors are preferred. Executive directors bring insider knowledge along with them which is not available to outside directors and so they can exploit this edge for transferring wealth to themselves on cost of other stockholders (Beasly, 1996). To avoid this problem, presence of independent directors on board is necessary because they are perceived to be unbiased monitors. Less chances of committing fraud are there for the firms having higher percentage of independent directors on board (Beasly, 1996).

4 Middle Eastern Finance and Economics - Issue 3 (2009) 31 Board independence is negatively related to abnormal accruals (Klein, 2002). Chances of committing earnings management are less for the companies with boards having more independent outside directors and also the directors with corporate experience (Xie et al,2003). Peasnell et al (2000) states that independent non-executive directors, being senior executive managers of other firms and being aware with financial reporting issues, have the potential to detect earnings management. This leads to reduced level of earnings management in their presence on board. Another study conducted by Peasnell et al (1998) particularly tested association between earnings management and board composition. Using Discretionary accruals as proxy for earnings management, they found significantly negative relationship between income increasing accruals and proportion of outside board members. Osma and Belen (2007) tested role of board composition and the existence of board monitoring committees in constraining earnings management for a Spanish sample of quoted companies for the period Results show that earnings manipulation is significantly determined by board composition However, the main role in confining these practices is played by institutional directors rather than by independent directors. Park and Shin (2004) examined effectiveness of board composition on the earnings management in Canada. Results found that unlike outside directors, earnings management practice is first reduced by directors from financial intermediaries and then further reduced by board representation of active institutional shareholders. Klein (2002) showed that increase in the number of insiders on boards or audit committees leads to greater earnings management. However independent boards and independent audit committee help reducing the earnings manipulations by managers. No significant association between the proportion of independent non-executive directors on the board and earnings management has been found by Kam (2007). However he suggested that presence of independent non-executive directors in board can be effective in reducing the managerial practice of earnings management in CEO duality firms. Peasnell (2005) examined the relationship of frequency of earnings management, by UK firms, with board monitoring. Two aspects of board monitoring he considers is the role of outside board members and the audit committee. Findings were that likelihood of reporting income increasing abnormal accruals (by managers) is negatively related to the proportion of outsiders on the board. Moreover outside directors hardly affects the income decreasing abnormal accruals when pre managed earnings are high. Also they found that presence of an audit committee does not directly affect the extent of income increasing manipulations. Neither do audit committees have a direct effect on the degree of downward manipulation of earnings. Role of independent outside directors as better monitors has also been criticized on the grounds that they do not have real independence, sufficient time and knowledge to accomplish their role (Gilson & Kraakman, 1991). Firms with overstated profits usually are expected to have more insider directors in the board. However Warfield et al (1995) stated that earnings management in the firms, who have high managerial ownership, remains low due to more close alignment of owner s and management s interest. Blue Ribbon Panel, an independent private sector group that look after the self-regulatory programs of the SEC Practice Section of the American Institute of Certified Public Accountants, recommends that greater representation of independent outside directors on board lowers the earnings management because outside directors normally possess experience of some other corporation or investment bank which increases their financial know how and thus helps in effective monitoring function (Xie et al,2001).

5 32 Middle Eastern Finance and Economics - Issue 3 (2009) EM and Institutional Ownership Institutional ownership is defined as share ownership by financial institutions (both banks and nonbank financial companies) and non-financial corporations. These include both the public owned as well as privately owned institutions. Institutional ownership is considered good for overall governance practices. An important role is played by institutional ownership in the firm's corporate governance structure (Dorothy et al, 2003). Since institutional investors are more encouraged and have more resources to control managers as compared to small individual investors, they are more effective for the good board performance. They play an active role in monitoring and disciplining managerial discretion, and also improve information efficiency in the capital market (Bushee, 1998 and Wahal and McConnell, 2000). Wong (2006) selected sample of 613 firms from construction, industrial products and consumer products sectors, in Malaysia, for the period to check out the role of outside directors and institutional shareholders in restricting the earnings management activities. His results showed that there exist no relationship between degree of earnings management and institutional ownership. Hsu and Koh (2005) examined the same relationship and found that long-term oriented institutions can control aggressive earnings management. However they concluded that association between institutional ownership and earnings management is totally context dependent among the firms. Koh (2003) examined the relationship of institutional ownership and income increasing discretionary accruals. His results found a positive association between lower institutional ownership region and earnings management and a negative association in a higher institutional ownership region. These results are consistent with the view that long-term oriented institutional investor mitigate managers aggressive earnings management. Institutional investors who invest in firms with the intention of holding their shares for a long time period are generally perceived to have motivation to monitor those firms. This view is supported by the studies who found institutional ownership associated with less income-increasing discretionary accruals (Rajgopal and Venkatachalam, 1998; Cheng and Reitenga, 2000) Frank Yu (2006) divided governance variables into two categories i-e internal and external. Internal variables comprise of ownership concentration and board structure while external variables identified are institutional ownership and take over pressure. His study found that that firms with stronger internal governance variables practices earnings management more than the firms with stronger external governance variables. The conclusion drawn is that earnings management is mainly driven by the conflict between insiders and outsiders. Methodology Sample To analyze the relationship between earnings management and Board Composition, our population was 654 listed companies in Karachi Stock Exchange. The sample comprises of 120 listed companies from different sectors. We excluded the firms on the basis of following criteria: - 8. Financial companies (because their capital structure and profits are different) 9. Companies for which the data could not be found Sources of data collection are State Bank of Pakistan Balance Sheet Analysis, Annual reports of the companies, web sites of companies and direct contacts as well. Hypothesis H 1 = Board Composition has a negative relation with earnings management H 2 = Institutional ownership has a negative impact on earnings management

6 Middle Eastern Finance and Economics - Issue 3 (2009) 33 Calculation of Earnings Management Majority of the researchers have used accruals as the proxy of earnings management. In literature two major methods are found to calculate the total accruals. Balance sheet approach Cash flow statement approach Balance Sheet Approach Healey (1985) and Jones (1991) used the following formula to calculate the total accruals according to balance sheet approach: - TAt =ΔCAt ΔCasht Δ CLt +ΔDCLt DEPt Where: ΔCA t is change in current assets in year t ΔCash t is the change in cash and cash equivalents in year t ΔCL t is the change in current liabilities in year t ΔDCL t is the change in debt included in the current liabilities in year t DEP t is depreciation and amortization expense in year t Cash Flows Statement Approach The other approach named as cash flow approach is simple to understand and easy to calculate. TA t = N.I t - CFO t Where: TA t is total accruals in year t N.I t is Net Income in year t CFO t is cash flows from operating activities in year t Following Collins and Hriber (1999) who argued that balance sheet approach is inferior in some circumstances to a cash flow statement approach we have used cash flow approach in this study. Total accruals are not earnings management. Earnings management is created where management has the discretion to manipulate the earnings. So, there are two types of accruals, 1- discretionary accruals and 2- non discretionary accruals. From the total accruals, first non discretionary accruals are calculated and difference of total and non discretionary accruals is known as discretionary accruals. Measurement of Discretionary Accruals Numerous methods have been used by researchers to calculate the discretionary accruals like The De Angelo Model (1986), The Healy Model (1985), The Jones Model (1991) and modified Jones model (1995). The latest model is Modified Cross Sectional Jones Model (1995). Discretionary accruals are difference between total accruals and non discretionary accruals so, in order to find discretionary accruals we calculated first of all non discretionary accruals as follows: - 1 ΔREVt ΔREC t ΔPPE t NDAt = α1 + α2 + α3 ( III ) At 1 At 1 At 1 Where: Δ REV t is revenues in year t less revenue in year t-1 ΔPPE t is gross property plant and equipment at the end of year t ΔREC t is net receivables in year t less net receivable in year t-1. A t-1 is total assets at the end of year t-1 α1,α2,α3 are firm specific parameters ε is the residuals

7 34 Middle Eastern Finance and Economics - Issue 3 (2009) DAt = TAt NDAt Where: NDA t is non discretionary accruals, DA t is discretionary component of accruals To measure the Board composition we opted two variables i.e. Board independence (Total No. of Non executive Directors/ Total No. of Board Directors), Institutional ownership (Total No. of shares held by institutional owners/ Total no. of outstanding shares). Return on Equity (Profit after tax/ share holders equity) and size of firm (Ln of total assets) have been used as control variables. Common Effect Model To test the hypothesis common effect model in panel data analysis has been used. DA = α + β1 (BC) + β2 (IO) + β3 (ROE) + β4 (size F) + µ Where: BC = board composition IO = Institutional ownership ROE = Return on equity DA = Discretionary accruals Empirical Analysis In order to test the data we first of all check the data type by descriptive statistics, results of which are presented in the following table: - Descriptive Statistics Descriptive stat below shows the mean values, median and minimum and maximum values of the series of dependent and independent data Table I: Descriptive statistics for Discretionary accruals, board composition and institutional ownership along with size and return on equity of a firm DA Size ROE BC IO Mean Median Minimum 6.12E Maximum Correlation Matrix After descriptive statistics, correlation analysis has been performed to check the relationship between independent and dependant variables and amongst independent as well so that problem of multicollinearity can be checked. Table II: Correlation analysis for Discretionary accruals, board composition and institutional ownership along with size and return on equity of a firm DA Size ROE BS B.I IO DA 1 Size ROE B.I IO

8 Middle Eastern Finance and Economics - Issue 3 (2009) 35 As mentioned in the above table, no other independent variable is significantly correlated with dependant variable other then Institutional ownership which has a negative relationship with dependent variable DA. Results of the common effect model are presented as follows: - Common Effect Model Table III below shows the results of common effect model applied to find out the impacts of board composition and Institutional ownership on earnings management. Table III: Regression analysis for Discretionary accruals, board composition and institutional ownership along with size and return on equity of a firm Earnings Management Variable Description Coefficient T statistics Intercept Size ROE B.I (Board Independence) IO (Institutional Ownership) * F Statistics E-19 R Square Adjusted R Square Note: *significant at 90% level of confidence Above table shows that size of the firm, ROE and institutional ownership have negative relation ship with earnings management. As per our results there is positive relationship between earnings management and board independence however this relationship is statistically insignificant which enables us to reject our H 1. This result of positive relationship between EM and board independence is contradictory to other studies held world wide which showed that board independence is negatively related to abnormal accruals (Klein, 2002; Xie et al, 2003). However Kam (2007) found no significant association between the proportion of independent non-executive directors on the board and earnings management. It is really alarming that Board Independence has no impact on earnings management. May be this is due to the reason that board independence in Pakistan is not actually independence. Board independence has been calculated by dividing number of non executive directors with total number of directors, in Pakistan there is not any definition of Independent non executive directors and non executive directors are actually representative of some shareholders. So they are not really independent Our results show that except institutional ownership no other variable has any impact on earnings management (being only significant value in results). Institutional ownership is negatively related with earnings management that is as much institutional ownership would be there earnings management would be reduced. Thus we accept our H 2. This result is in accordance with the generally accepted phenomenon that firms with strong institutional ownership practices less earnings management (Frank Yu, 2006). As it is also found that long term institutional ownership is negatively related to earnings management (Rajgopal and Venkatachalam, 1998; Cheng and Reitenga, 2000; Koh 2003) we can say that companies in Pakistan included in our sample also enjoys long term institutional ownership. R square for our study is very low i-e around 10% but as the data consists of time series and cross section data so; it may be an acceptable range. Significant F statistics i-e confirms the validity of the model. Conclusion After having the detailed econometric analysis we have come to the conclusion that

9 36 Middle Eastern Finance and Economics - Issue 3 (2009) 1. Institutional ownership has negative relationship with discretionary accruals. 2. Board independence doesn t have any relationship with discretionary accruals. 3. Our control variables, size of the firm and Return on equity also don t have any impact on earnings management. In Pakistan with an increased emphasis on corporate governance in companies, role of institutional owners has also expanded as they are perceived to be an important agent of improvement in corporate governance. A study by Mehmood and Sharif pertaining to the data of year 2001 showed that 45% of companies have more than 20% institutional holding. This means that stakes of institutional owners are high and thus they are more motivated for monitoring boards and thus prove shareholder activism. Our results conclude same trend that presence of institutional investors among shareholders would not let the management to perform earnings management. They actually perform the job of watchdogs due to which it becomes difficult for the management to smoothen the earnings. This also ensures the interest of minority shareholders in Pakistan. As far as board independence is concerned, although empirical studies (Klein, 2002; Xie et al, 2003) show negative relationship of earnings management and board composition, our results negate this notion. This might be so in Pakistani context as there are no specific measures to judge the independence of non executive directors. The directors which are shown independent on board normally belong to some shareholders or are under the pressure of some other directors. Thus no one can claim their real independence. This might be the reason that our results found an insignificant positive relationship for earnings management and board composition. This study paves the ways to investigate the relationship of earnings management and other board characteristics as well. As Pakistani corporate governance environment is some what different from other countries, there is a possibility that results obtained are not in accordance with the generally believed phenomenon as in case of board composition in Pakistan. References [1] Beasley, M.S. (1996), An empirical analysis of the relation between the board of director composition and financial statement fraud, The Accounting Review, 71, [2] Burgstahler, D., I. Dichev, (1997), Earnings Management to Avoid Earnings Decreases and Losses, Journal of Accounting and Economics, 24:101. [3] Bushee, B. (1998), The Influence of Institutional Investors on Myopic R&D Investment Behavior, The Accounting Review, 73, [4] Cheng, C. A. and Reitenga, A. (2000), Institutional Investors and Discretionary Accruals, Paper presented at the 2nd AAA/BAA Globalisation Conference. Cambridge: UK. [5] Deanglo, L. (1986), "Accounting numbers as market valuation substitutes: A study of managemnet buyouts of public stock holders", The Accounting Review, vol. 61 No. 3, PP [6] Dechow, P. M., R. G. Sloan and A. P. Sweeney. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC, Contemporary Accounting Research, 13 (1): [7] Dorothy A. Feldmann, David L Schwarzkopf, (2003), The Effect of Institutional Ownership on Board and Audit Committee Composition, Review of Accounting and Finance, Vol:2, Issue:4, [8] Ebrahim, Ahmed; (2007), Earnings management and board activity: an additional evidence, Review of Accounting and Finance, Vol:6, issue:1, [9] Epps, Ruth W., Ismail, Tariq Hassaneen, (2009), Board of Directors' Governance Challenges and Earnings Management, Journal of Accounting & Organizational Change, Vol. 5, No. 3, 2009 [10] FASB 1985, SFAC No. 6, para 139.

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