Earning Management, Audit Quality and Over-Investment: Empirical Evidence from Companies Listed in Tehran Stock Exchange

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1 : Earning Management, Audit Quality and Over-Investment: Empirical Evidence from Companies Listed in Tehran Stock Exchange Mohammad Reza Ola Faculty Member, Department of Accounting, Mashhad Branch, Islamic Azad University, Mashhad, Iran. Javad Mohebi Hosein Abad M.A. Student of Accounting, Department of Accounting, Mashhad Branch, Islamic Azad University, Mashhad, Iran. Abstract This paper examines how earnings quality affects the investment decisions of companies listed in Tehran Stock Exchange who do not employ Audit Organization of Iran (as the biggest audit firm in Iran). The sample of this study, includes 88 companies listed in the Tehran Stock Exchange during the period 2007 to 2011 and for processing and testing hypotheses, regression method is used. We find that Manipulation of earnings will contribute to underinvestment by Iranian companies, and Iranian companies with lower audit quality are more likely to have underinvestment. Also, lower audit quality decreases positive impact of earning quality on the overinvestment. Keywords: Earning Management, Earning Quality, Audit Quality, Over- Investment, Tehran Stock Exchange 1.Introduction Previously, researchers have studied companies use of discretionary accruals as a way to smooth income and affect earnings informativeness (Aboody and Kasznik, 2000; Bartov and Mohanran, 2004; Dechow and Dichew, 2002; Geiger and North, 2006; Jones, 1991; Tucker and Zarowin, 2006). While firms that manipulate earnings may indicate a favorable outcome for investors, such misrepresentations could affect internal decision making and lead to suboptimal or inefficient investment decisions (McNichols and Stubben, 2008). McNichols and Stubben (2008) have studied whether earnings management affects firms investment decisions by examining fixed asset investments for a sample of firms that were investigated for accounting irregularities. The company s auditor may also influence the extent of earnings management. A higher quality audit may result in the company adopting a more conservative approach to financial reporting (McNichols and Stubben, 2008). This paper examines how earnings quality affects the investment decisions of companies listed in Tehran Stock Exchange who do not employ Audit Organization of Iran (as the biggest audit firm in Iran). 2.Earning Quality Earning Management Earnings, sometimes called the bottom line or net income, are the single most important item in financial statements. They indicate the extent to which a company has engaged in value-added activities. They are a signal that helps direct resource allocation in capital markets. In fact, the theoretical value of a company s stock is the present of its future earnings. Increased earnings represent an increase in company value, while decreased earnings signal a decrease in that value (Lev, 1989). The definition of earning management was given by Schipper (1989) who defined it as purposeful intervention in the external financial reporting external process with intent to obtain some private gain. In accordance to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence the contractual outcomes that heavily depend on reported accounting numbers. Earnings management is the choice by a manager of accounting policies, or real actions that affect earnings, so as to achieve some specific reported earnings objective. Earnings 477

2 management involves the artificial increase (or decrease) of revenues, profits, or earnings per share figures through aggressive accounting tactics on all earnings. Aggressive earnings management is a form of fraud which differs from reporting error. Most of this happen is when management of the companies needs to present and show the earnings at a certain level or certain loopholes in financial reporting standards. Practically, the management will alter the numbers to achieve desired aims or to satisfy projections by financial analysts or in other words attempts by management to influence or manipulate reported earnings by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings. These are fraudulent reporting due to not fulfilling the accounting practice principles with the techniques of revenue recognition, accounting policy change, timing adoption of new standards, write-off, asset sales, provisions, accruals (discretionary) and direct charges to retained earnings. All this probable actions is due to downturn in business (Soon and Wee, 2011). In addition, the term earnings quality has also been defined in different ways (Hejazi et. al., 2012): 1. Based on earnings stability: The more sustainable the earnings, the higher the quality of earnings (Tapia and Fernández, 2007). 2. Based on the level of accruals: We can define the earnings quality based on the degree of the closeness of a company s earnings to the amount of cash flow. In other words, the less the level of accruals, the more the quality of earnings (Bao and Bao, 2004). 3. Based on information content: Kirschenheiter and Melumad (2004) recognized an earnings quality as earnings that are closer to the value of a company over a long-term period and that include more information. The focus of this research is on the second definition. 4. By considering all these definitions, we should expect to have various approaches regarding earnings quality resulting in different assessments (Abdelghany, 1995). 3.Earnings Management and Investment Decisions Though our study is the first we are aware of to test whether earnings management leads to overinvestment or underinvestment decisions by providing distorted information to decision makers, other studies have posited and tested theories relating to the link between earnings management and firms investment decisions. Dechow et al. (1996) study firms targeted by SEC enforcement actions and concludes that a desire to attract external financing at low cost is an important motivation for earnings manipulation. Presumably, these funds are then used for capital investment. Managers considering profitable investment projects but facing financing constraints might manipulate earnings in order to obtain financing for investment. However, it is not clear why these managers would over-invest rather than invest optimally with the funds obtained. Our prediction of overinvestment relies on distorted information being used by investment decision makers, rather than just a desire to raise additional capital. A theoretical paper by Bar-Gill and Bebchuk (2003) predicts that inefficient investment projects will more likely be undertaken by companies that misreported prior to undertaking the project because firms overstating their financial results will be able to obtain cheaper financing. Evidence in support of this hypothesis is found by Wang (2006). Wang (2006) finds that misreporting firms are more likely to over-invest in R&D and stock-financed mergers and acquisitions. A concurrent study by Kedia and Philippon (2009) predicts that firms overstating their financial results pool with better performing firms to avoid detection. These firms over-invest to mimic firms truthfully reporting stronger results (McNichols and Stubben, 2008). 4.Earnings Quality and Investment Decisions Our study relates to the emerging literature on the role financial statement information plays in investing decisions. For example, Biddle and Hilary (2006) and Verdi (2006) predict and find that better accounting information reduces information asymmetry between managers and outside suppliers of capital, allowing for more efficient investment. Biddle and Hilary (2006) find that measures of accounting quality are negatively related to investment-cash-flow sensitivities, indicating that the effect of financing constraints on investment is lower for firms with higher accounting quality. Verdi (2006) finds accruals quality is significantly negatively associated with both over-investment and under-investment. Bushman et al. (2006) argue that timely accounting recognition of economic losses makes managers less likely to engage in ex ante negative net present value investment projects. They find that more timely accounting recognition of economic losses curbs over- 478

3 investment by managers faced with declining investment opportunities the investment response to declining investment opportunities decreases when loss recognition is timelier. However, these studies do not address whether intentional distortions in accounting numbers affect investment (McNichols and Stubben, 2008). 5.Audit Quality - Audit Firm Size as a Proxy for Audit Quality DeAngelo (1981) has theoretically analyzed the relation between audit quality and auditor s size. She argued that large auditors will have more clients and their total fees will be allocated among those clients. Defining the auditor s independence by the conditional probability that the auditor will disclose any misstatement in financial statements given that this misstatement was already discovered, DeAngelo (1981) argued that large auditors will be more independent and, therefore, will provide higher quality of audit. The results of some empirical papers have provided additional support for the use of auditor size as a proxy for audit quality. Davidson (1993) used an indirect method to support the argument that size is a good proxy for auditing quality. He argued that managers have incentives to manipulate the reported earnings to meet the analysts forecasts. Therefore, if large auditing firms provide higher-quality audits than small auditing firms, we may expect the forecast errors of big auditing firms clients to be larger. Using data for Canadian firms, his results support that expectation indicating that the auditor size is a good proxy for auditing quality. Lennox (1999) looked at the two explanations of the hypothesized positive relation between audit quality and auditor size: the reputation hypothesis suggested by DeAngelo (1981) who argues that large auditors have more incentives to be accurate because they have more client-specific rents to lose if their reports are not accurate, and the deep pockets hypothesis used by Dye (1993) who argued that large auditors will be more accurate because they have greater wealth that is exposed to risk in case of any litigation. Lennox (1999) examined the relation between auditor size and litigation and found greater support to the deep pocket hypothesis than reputation hypothesis. Finally, Colbert (1998) focused on small CPA firms and the peer review activities between such firms and found some evidence that the auditor quality is positively associated with firm size (Ebrahim, 2001). 6.Audit Quality and Earning Management Some prior papers have looked at the relation between earnings management and audit quality and examined the effect of auditor quality on management incentives to manipulate the reported earnings. For example, Hirst (1994) used an experimental design to test the effect of auditors belief that managers may have incentives to manage reported earnings on their expectation of material misstatements in financial statements. His results show that auditors assessed probability that material misstatements exist is higher if auditors think that managers have incentives to manage reported earnings whether upward or downward. Defond (1993) has reported that firms that changed the auditor after a client-auditor disagreement are highly leveraged and more likely to have debt covenant violation. These firms also are more likely to have a decline in reported earnings. His results also show that if the questionable accounting procedures were applied, this would result in smoothed earnings numbers or flat earnings growth. The study used a sample of matched pairs of firms that changed auditors because of client-auditor disagreement and other firms that simply changed the auditor. These results show that auditors usually disagree on earnings management activities and lead to hypothesize that higher audit quality will be associated with less magnitude of earnings management. Burilovich (1997) looked at specific incentives to mange reported earnings in the case of alternative minimum tax. She used a sample of 72 regulated life insurance firms during the period and found that income decreasing discretionary accruals differ significantly across the companies audited by big auditing firms. She also argued that auditing firms with the greatest market share appear to allow greater discretion to the client in determining accruals. To explain these results, she argued that auditing firms with higher market share will have more experience in the industry and, therefore, they can allow more discretion to their clients. In this study, Burilovich (1997) didn t use any model to measure the discretionary accruals but used the items that may affect the difference between taxable income and reported income in this special case of AMT considering the regulations of life insurance industry. On the other hand, it is difficult to accept the argument that big auditing firms that usually have larger market share will allow their clients more discretion in accounting reporting. Becker et al. (1998) used the cross-sectional version of Jones model (Jones 1991) for estimating discretionary accruals and found that income increasing discretionary accruals for the clients of non-big auditing firms are higher than big auditing firms. Their paper also looked at the variation in discretionary accruals in addition to its sign and magnitude and found 479

4 that the variation was lower for big auditing firms clients and higher for non-big auditing firms clients. In their study, Becker et al. (1998) focused on the income-increasing discretionary accruals and excluded firms that changed the auditor during their test period ( ) from the analysis. Therefore, they didn t examine the auditor s tenure effect. Francis, et al. (1999) applied the cross-sectional Jones model using a sample of NASDAQ companies and found evidence that the clients of big auditing firms have lower amounts of estimated discretionary accruals (Ebrahim, 2001). 7.Earnings Quality, Audit Quality, and Investment Decisions Previous research has studied the relation between audit quality and external investors. Boone et al. (2008) measured the equity risk premium or the cost of equity capital over the risk-free interest rate, in order to gauge the confidence of investors. They found that the equity risk premium decreased in the early years of the auditor s tenure but increased with additional years of tenure. Mansi et al. (2004) and Ghosh and Moon (2005) studied perceptions of investors regarding auditor quality and auditor tenure and found that investors perceive auditor tenure as improving audit quality, and that audit quality and auditor tenure are negatively related to the cost of debt financing. In examining internal decision making, Biddle and Hilary (2006) and Biddle et al. (2009) studied accruals and found that higher quality accounting enhances investment efficiency, while measures of accounting quality are negatively related to investment for firms prone to over-investment. The findings of McNichols and Stubben (2008) indicated that earnings management can influence internal decisions in addition to targeting external parties. The authors found that the manipulation of financial information, as measured by the value of fixed asset investments, results in suboptimal investment decisions (Lenard and Yu, 2012). Using models based on the method of McNichols and Stubben (2008) and Lenard and Yu (2012), our paper examines the relationship between earning quality, audit quality and internal investment decisions for a sample of Iranian companies. 8.Hypotheses In this study, we examine the internal decision-making of Iranian companies based on manipulation of earnings as influenced by audit quality. When considering investment decisions, company management will have expectations about the return provided by the investment, but they will also have expectations of future growth of the company based on information about revenues and earnings (McNichols and Stubben, 2008). If information about growth is misreported, due to management of earnings, then the company may over-invest or under-invest. Consistent with McNichols and Stubben (2008), we identify excess investment as investment that differs from the amount that would be predicted given the firm s investment opportunities (Lenard and Yu, 2012). Therefore, for our first hypothesis, we consider how companies that aggressively manage earnings might contribute to over-investment. H1: Manipulation of earnings (Earning quality) will contribute to overinvestment (underinvestment) by Iranian companies. Because earnings may be aggressively managed through the use of discretionary accruals in order to enhance firm performance, and firm performance reflects the company s ability to invest, we examine discretionary accruals as a factor in over-investment. Discretionary accruals have also been studied for their effect on earnings quality represented by accounting conservatism. As previous authors have found that accounting conservatism is influenced by audit quality (Jenkins and Velury, 2008; Li, 2010; Lenard and Yu, 2011; Lenard and Yu, 2012), we therefore seek to determine how audit quality affects over-investment, by considering the effect of audit quality on the quality of reported earnings. This leads to our second hypothesis: H2: Iranian companies with lower audit quality are more likely to have overinvestment. 9.Research Methodology 9.1.Sample Our sample includes the collected data from 88 nonfinancial companies listed on the Tehran Stock Exchange from 2007 to Each company had to meet specific criteria to be included in the sample: 480

5 1. They must close their fiscal year in mid-march (end of Persian calendar year). 2. They must have full financial data for the whole period of investigation. 3. They must list on the Tehran Stock Exchange before Data Collection Methodology The data needed for analysis are gathered from audited financial statements and decisions taken in annual general meetings. This enables the main part of the data to be collected from the database that belongs to the Islamic Research Management Center of the Tehran Exchange Market, and the remaining data are gathered from the second version of Tadbir Pardaz software. 10.Variables 10.1.Independent Variables: -Earning Management Earning Quality We calculate discretionary accruals following procedures as proposed in Kothari et al. (2005) and used by Ashbaugh et al. (2003), and Fung and Goodwin (2013). In the first step we estimate the following model for all of the companies: CA t = α 1 (ASSETS t-1 ) + α 2 SALES t + α 3 ROA t-1 + α t4 (1) Where CA is the current accruals divided by beginning of year total assets, where current accruals are measured as net income before extraordinary items plus amortization and depreciation minus operating cash flows divided by beginning-of-fiscal-year total assets; ASSETS t-1 is the total assets at the start of the fiscal year; SALES is the net sales revenue in year t less net sales revenue in year t-1 divided by beginning-of-fiscal-year total assets and ROA t-1 is the return on assets for the prior fiscal year. The parameter estimates from Eq. (1) are used to predict the firm s expected current accruals (ECA) as follows: ECA t = α 1 (1/ASSETS t-1 ) + α 2 SALES t - AR t ) + α 3 ROA t-1 (2) Where AR is the accounts receivable in year t less accounts receivable in year t-1 divided by beginning-offiscal-year total assets. Earning Management is measured as the absolute value of CA minus expected accruals ECA from Eq. (2) (Fung and Goodwin, 2013). We use the absolute value of discretionary accruals multiplied by -1 to calculate earning quality. -Lower Audit Quality It is a dummy variable. It is equal zero if Audit firm is Audit Organization of Iran (as the biggest audit firm in Iran) and 1 otherwise Dependent Variable: Over-Investment Deviations from the model, as reflected in the error term of the investment model, represent the investment inefficiency (Gomariz and Ballesta, 2013): Investment i,t = b 0 + b 1 SalesGrowth i,t-1 + ԑ I,t (3) Where Investment i,t is the total investment of firm i in year t, defined as the capital expenditures scaled by total assets. SalesGrowth i,t-1 is the rate of change in sales of firm i from t-2 to t-1. We estimate the investment model for all of the data. The residuals from the regression model reflect the deviation from the expected investment level, and we use these residuals as a firm-specific proxy for investment inefficiency. A positive residual means that the firm is making investments at a higher rate than expected according to the sales growth, so it will overinvest. In contrast, a negative residual assumes that real investment is less than that expected, representing an underinvestment scenario (Gomariz and Ballesta, 2013). 481

6 10.3.Control Variables -Size Applied mathematics in Engineering, Management and Technology 2 (2) 2014 We measure firm size as the logarithm of total assets. -Leverage It is measured as total debts divided by total assets. OverInvestment t = α + β 1 EarningQuality i,t + β 2 LowerAuditQuality i,t + β 3 Size i,t + β 4 Leverage i,t + β i,t (4) OverInvestment t = α + β 1 EarningQuality i,t + β 2 LowerAuditQuality i,t + β 3 Size i,t + β 4 Leverage i,t + β 1 EarningQuality*AuditQuality i,t + β i,t (5) 11.Results Table 1 presents the estimation results of Model (4). According to the results in Table 1, coefficient for the earning quality is , indicating that earning quality has a positive effect on over-investment. The calculated value of t statistic for the coefficient of earning quality is greater than critical value of t statistics in error 0.05 and likelihood for earning quality is that represents a significant coefficient obtained for earning quality. So hypothesis one will be rejected. Table1: Analysis the hypothesis one Variable Coefficient Std. Error t-statistic Prob. EarningQuality SIZE Leverage LowerAuditQuality C AR(1) Weighted Statistics R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Sum squared resid F-statistic Durbin-Watson stat Prob(F-statistic) Table 2 presents the estimation results of Model (5). According to the results in Table 2, coefficient for the lower audit quality is , indicating that lower audit quality has a negative effect on overinvestment. The calculated value of t statistic for the coefficient of lower audit quality is greater than critical value of t statistics in error 0.05 and likelihood for lower audit quality is that represents a significant coefficient obtained for lower audit quality. Also, coefficient for the EarningQuality*LowerAuditQuality is , indicating that EarningQuality*LowerAuditQuality has a negative effect on overinvestment. The calculated value of t statistic for the coefficient of EarningQuality*LowerAuditQuality is greater than critical value of t statistics in error 0.05 and likelihood for EarningQuality*LowerAuditQuality is that represents a significant coefficient obtained for EarningQuality*LowerAuditQuality. So hypothesis two will be rejected. 482

7 Table2: Analysis the hypothesis two Variable Coefficient Std. Error t-statistic Prob. EarningQuality SIZE Leverage LowerAuditQuality EarningQuality* LowerAuditQuality C AR(1) Weighted Statistics R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Sum squared resid F-statistic Durbin-Watson stat Prob(F-statistic) Conclusion The definition of earning management was given by Schipper (1989) who defined it as purposeful intervention in the external financial reporting external process with intent to obtain some private gain. In accordance to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or influence the contractual outcomes that heavily depend on reported accounting numbers. In this study, we examine the internal decision-making of Iranian companies based on manipulation of earnings as influenced by audit quality. When considering investment decisions, company management will have expectations about the return provided by the investment, but they will also have expectations of future growth of the company based on information about revenues and earnings (McNichols and Stubben, 2008). If information about growth is misreported, due to management of earnings, then the company may over-invest or under-invest. Consistent with McNichols and Stubben (2008), we identify excess investment as investment that differs from the amount that would be predicted given the firm s investment opportunities (Lenard and Yu, 2012). Therefore, for our first hypothesis, we consider how companies that aggressively manage earnings might contribute to overinvestment. Because earnings may be aggressively managed through the use of discretionary accruals in order to enhance firm performance, and firm performance reflects the company s ability to invest, we examine discretionary accruals as a factor in overinvestment. Discretionary accruals have also been studied for their effect on earnings quality represented by accounting conservatism. As previous authors have found that accounting conservatism is influenced by audit quality (Jenkins and Velury, 2008; Li, 2010; Lenard and Yu, 2011; Lenard and Yu, 2012), we therefore seek to determine how audit quality affects over-investment, by considering the effect of audit quality on the quality of reported earnings. This leads to our second hypothesis. Study results show that Manipulation of earnings will contribute to underinvestment by Iranian companies, and Iranian companies with lower audit quality are more likely to have underinvestment. Also, lower audit quality decreases positive impact of earning quality on the overinvestment. References Abdelghany, Kh. (2005). Measuring the Quality of Earnings. Managerial Auditing Journal, Vol. 20, No. 9, pp Aboody, D., & R. Kasznik. (2000). CEO stock option awards and the timing of corporate voluntary disclosures. Journal of Accounting and Economics, 29, Ashbaugh, H., LaFond, R., Mayhew, B., Do nonaudit services compromise auditor independence? Further evidence. The Accounting Review 78, Bao, B.; and D. Bao (2004). Income Smoothing, Earnings Quality and Firm Valuation, Journal of Business, Finance &Accounting, 31(9) & (10), pp

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