Investigating Impact of Historical Costing on Real Earnings Management: An Empirical Study

Transcription

1 Cairo University Faculty of Commerce Accounting Department Investigating Impact of Historical Costing on Real Earnings Management: An Empirical Study Thesis Submitted in Fulfilment of the Requirements of the Master Degree in Accounting Prepared by Awad Elsayed Awad Ibrahim Supervised by Prof. Mohamed Hassan Mohamed Abdel-Azim Professor of Financial Accounting 2012

2 " و اص ب ر ل ح ك م ر ب ك ف إ ن ك ب أ ع ي ن ن ا... " )القران الكريم, سورة الطور, االية ) 84 ii

3 Examination Committee Dr. Tahsin Bahgat Elshazly Professor of Financial Accounting Faculty of Commerce Cairo University (Chairman) Dr. Mohamed Hassan Mohamed Abdel-Azim (Supervisor & Member) Professor of Financial Accounting Vice Dean for Community Service & Environmental Development Faculty of Commerce Cairo University Dr. Abdel-Fattah Ahmed Ali Khalil Assistant Professor of Accounting & Auditing Faculty of Commerce Suez Canal University (Member) Supervisor Signature Dr. Mohamed Hassan Mohamed Abdel-Azim Professor of Financial Accounting iii

4 Acknowledgment All praise and thanks to Allah, who inspired me, the patience and the ability to complete this work, and who accompanied me in the mid-nights when I was alone. Further, all thanks and peace be upon the messenger "Mohamed", who provided great sacrifices to help me and others to be good people. I would like to express my sincere gratitude and warm thanks to my supervisor, Prof. Mohamed Hassan Abdel-Azim, the one who accompanied my journey, supported me, and learned me both the morals and knowledge. I am so grateful for him for granting me his time, expertise, and support. I would like to thank Prof. Tariq Hassanein Ismail, the first one who accepted and supported my research idea and tried hardly to make my research idea accepted. I would like to thank Assistant-Prof. Tariq Mohamed Abdel-Fattah, Mansoura University, for his fruitful ideas, his extreme modesty, and for providing me with required data and materials. I would like to thank Prof. Tahsin Bahgat Elshazly for accepting to be the chairman of the committee. Further, I would like to thank Assistant Prof. Abdel-Fattah Khalil for accepting to be a member of the examination committee. Great thanks to all people who guided, accompanied, encouraged, and supported me, to my dear parents who appreciate the knowledge, to my work friends, and to colleagues who granted me the advice to the right way. Finally, great thanks to everyone said to me "No", to those who refused me, and to those who told me that I would never be where I dream. iv

5 Abstract This study examines the relationship between Historical Cost Accounting (HCA) and real earnings management, in one of emerging markets, namely Egypt. Accounting literature argues that HCA provides ample room for manipulation. Since HCA creates large hidden reserves that are recognized in income report only when managers decide to sell such assets, which may induce managers to manipulate earnings. Moreover, managers have the discretion to decide which asset to sell and during which period. Therefore, managers can exploit HCA in real earnings management through interfering in structuring of assets sale transactions. This study aims to contribute to real earnings management literature and to the ongoing debate about dropping HCA and replacing it with Fair Value Accounting. Using a sample of 71 non-financial most active traded firms listed in Egyptian Stock Exchange during the period , multiple regression analysis has been employed to test two main hypotheses: income-smoothing hypothesis, and debt/equity hypothesis. Results provide evidences that managers, in Egyptian business environment, partially exploit HCA in real earnings management. Managers of firm-years with a negative earnings change found to use HCA to smooth earnings, while managers of firm-years with a positive earnings change do not. Moreover, there is no evidence on managers' use of HCA to avoid violation of debt contracts terms based on accounting data. Key Words: Historical cost accounting, Real earnings management, Income-smoothing, Asset sales. v

6 Table of Contents Title P Introduction 1 Research Problem 2 Research Importance 7 Research Objectives 8 Research Hypotheses 8 Research Methodology 10 Research Structure 10 Chapter One: Earnings Management and Historical Cost Accounting Introduction Overview of Earnings Management Earnings Management Definitions Earnings Management Incentives Market Participants' Forecasts The Desire for External Financing Contracting Motivations The Desire to Avoid Reporting Losses The Incentive to Avoid High Tax Rates Methods of Earnings Management Real Earnings Management (REM) Sales Manipulation Discretionary Expenditure Manipulation Production Costs Manipulation Stock Repurchases Accounting Earnings Management (AEM) Accruals-Based Earnings Management The differences between Accounting and Real Earnings Management Timing of Earnings Management GAAP and Earnings Management The Extent of Earnings Management 39 vi

7 1.5.4 Detection of Earnings Management Earnings Management and Cash Flow Consequences of Earnings Management Which Earnings Management Type is preferred by Managers? Historical Cost Accounting in Egyptian Accounting Standards Egyptian Accounting Standard (10) "Fixed Assets and Depreciation" Earnings Management through Sale of Fixed Assets Egyptian Accounting Standard (26) "Financial Instruments" Earnings Management through Sale of Financial Assets Egyptian Accounting Standard (34) "Investment Property" Earnings Management through Sale of Investment Property How can Managers Exploit Historical Cost Accounting in Earnings Management? Earnings Management using Asset Sales Selective Sale of Assets Timing of Asset Sales Earnings Management through the Misclassification of Income from Asset Sales Item Summary 67 Chapter Two: Literature Review Introduction The First Group: the Relationship between Historical Cost Accounting and Real Earnings Management Bartov, Herrmann et al., Poitras et al., Hillier et al., Harahap, Wang et al., Analysis of the First Group of Literature The Second Group: the Relationship between Earnings Management using Asset Sales and Earnings Management using other Methods Zang, Yang, Eldenburg et al., vii

8 2.3.4 Huang, Analysis of the Second Group of Literature The Third Group: Earnings Manipulation through Other Earnings Management Methods Roychowdhury, Hribar et al., Coulton et al., Matsuura, Sawicki and Shrestha, Analysis of the Third Group of Literature The Fourth Group: the Relationship between Accounting Standards and Earnings Management Black et al., Ewert and Wagenhofer, Zhou et al., Cohen et al., Beest, Analysis of the Fourth Group of Literature The Gap in the Literature 103 Chapter Three: An Empirical Study Introduction Hypotheses Development Income-Smoothing Hypothesis Debt-Equity Hypothesis Research Methodology Variables Measurement and Study Model Dependent Variables Independent Variables Control Variables Study Model Study Sample and Data Collection Study Sample Sample Features Data Collection 143 viii

9 3.4 Data Analysis Descriptive Statistics Descriptive Statistics for Total Sample Firms Descriptive Statistics for both Negative and Positive Sub-samples Pearson Correlation Test Pearson Correlation Test of Total Study Sample Pearson Correlation Test of the Negative Sub-sample Pearson Correlation Test of the Positive Sub-sample Multiple Regression Analysis Multiple Regression Analysis of Total Sample before Outliers Multiple Regression Analysis of Total Sample after Outliers Multiple Regression Analysis of Negative Sub-sample before Outliers Multiple Regression Analysis of Negative Sub-sample after Outliers Multiple Regression Analysis of Positive Sub-sample before Outliers Multiple Regression Analysis of Positive Sub-sample after Outliers Discussion of Results Discussion of Total Sample Results Discussion of the Negative Sub-sample Results Discussion of the Positive Sub-sample Results Overall Discussion Summary 190 Summary, Conclusions, and Recommendations 193 Summary 193 Conclusions 197 Recommendations 202 References 205 ix

10 Table Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 3.1 Table 3.2 Table 3.3 Table 3.4 Table 3.5 Table 3.6 Table 3.7 Table 3.8 Table 3.9 Table 3.10 Table 3.11 Table 3.12 Table 3.13 Table 3.14 Table 3.15 Table 3.16 List of Tables Title The First Group Studies that Examine the Relationship between Historical Cost Accounting and Earnings Management The Second Group Studies that Examine the Relationship between Earnings Management Using Asset Sales and Other Earnings Management Methods The Third Group Studies that Investigate Earnings Management Using Methods, Other than Sale of Assets The Fourth Group Studies that Investigate the Relationship between Accounting Standards and Earnings Management Definitions, Measurements, and Functions of Study Variables Variables Specification of Study and Literature Studies Sector Representation of Sample Firms Sector Representation of Study Observations per Year Firm-Year Observations of the Study Three Samples Descriptive Statistics of Total Sample Descriptive Statistics of both Negative and Positive Sub-samples Pearson Correlation Test of Total Study Sample Pearson Correlation Test of Negative Sub-sample Pearson Correlation Test of Positive Sub-sample Multiple Regression Analysis of Total Sample Before Outliers Multiple Regression Analysis of Total Sample After Outliers Multiple Regression Analysis of Negative Sub-sample Before Outliers Multiple Regression Analysis of Negative Sub-sample After Outliers Multiple Regression Analysis of Positive Sub-sample Before Outliers Multiple Regression Analysis of Positive Sub-sample After Outliers Page x

11 List of Abbreviations Abbreviation AEM APSW CR CMA DR EM EAS EGID EPS FVA GAAP HCA IAS ICDM PPE R&D REM SG&A SOX TOL USA UK VIF Stands for Accounting Earnings Management Arab Polvara Spinning & Weaving Company Current Ratio Capital Market Authority Debt/Equity Ratio Earnings Management Egyptian Accounting Standards Egypt for Information Dissemination Company Earnings Per Share Fair Value Accounting Generally Accepted Accounting Standards Historical Cost Accounting Income from Asset Sales Indonesian Capital Market Directory Property Plant & Equipment Research & Development Expenditure Real Earnings Management Selling, General & Administrative Expenses Sarbanes-Oxley Act Tolerance United Stated of America United Kingdom Variance Inflation Factor xi

12 Introduction 1

13 Research Problem One of the main objectives of accounting is to provide information that is useful to users of financial reports. Financial reporting should convey accurate, reliable, and timely information that enables present and potential users of financial reports to make right decisions. Therefore, Generally Accepted Accounting Principles (GAAP) allowing managers some discretion and judgment. This flexibility of GAAP is expected to help managers convey high quality information that enables users of such information in making more efficient decisions. However, accounting literature provides evidences and proves that managers use GAAP flexibility opportunistically, to mislead some stakeholders about real performance or to get the highest outcomes from contracts based on accounting data, in addition to meeting several incentives of earnings management. Accounting literature documents several incentives for earnings management. Managers may manipulate earnings to meet market's expectations, avoid reporting losses, raise external financing at low cost, and avoid high tax rates, in addition to other incentives. Furthermore, managers believe that income smoothing and keeping accounting data meeting expectations and contractual terms increase creditability with capital market, maintain or increase stock prices, improve reputation of management team, and assure customers, suppliers and shareholders that business is stable (Graham et al., 2005). Consequently, managers may be strongly motivated to exploit the discretion and flexibility allowed by GAAP and to use different methods of earnings management, despite the expected negative impacts of using such methods. 2

14 Nevertheless, manipulating accounting data and conveying misleading financial information can lead to large negative consequences. Providing misleading information may harm users of accounting information, inhibit the efficient allocation and pricing of capital (McVay, 2004). Moreover, earnings management may lead to collapsing of large firms, which negatively affects the capital markets and countries' economies. Researchers that investigated the last decade financial scandals (e.g., Enron, WorldCom, and Global) have concluded that one of the main reasons for collapsing of long-standing firms is earnings management. Consequently, financial reports' users have lost the confidence in capital markets and in financial reporting and carried the accounting setters the responsibility. In order to regain the lost confidence in capital markets and in financial reporting, and to avoid the negative impacts of earnings manipulation, accounting setters have been attempting to curb earnings management practices, through reducing flexibility of accounting standards. In addition, more strict financial regulations and corporate governance rules have been issued. For example, Sarbanes Oxley ACT (SOX) has been released in USA since 2002, and corporate governance has been applied in Egypt since Unfortunately, earnings management literature has found that continuous attempts of hindering earnings management practices have failed in reducing extent of earnings management, despite they have succeeded in changing nature of earnings management, i.e., managers found to direct to real earnings management (REM), instead of accounting earnings management (AEM). For example, Ewert and Wagenhofer (2005) prove that despite tightening accounting standards reduced 3

15 accounting earnings management, it increased real earnings management. Moreover, Graham et al. (2005) find that managers take real economic actions to manipulate earnings than accounting actions. Further, Cohen et al. (2008) find that accounting manipulation declined significantly and real earnings management increased significantly after the passage of SOX. Finally, Beest (2009) concludes that reducing discretion and flexibility levels of accounting standards does not eliminate earnings management, but is likely to affect the nature of earnings management. Moreover, accounting literature that investigated managers' directing to REM has documented several reasons that differentiate REM than AEM. First, REM is harder to detect, where auditors do not have a considerable expertise to discover REM, relative to AEM, and managers are more familiar with firms' activities than external parties. Second, REM does not consider a violation of GAAP. Third, REM has a broader manipulation extent, since managers can interfere in a wide range of operating, investing, or financing activities. Fourth, REM can be conducted any time during the year. Hence, the negative impacts of earnings management and accusing earnings management as one of the main reasons of last decade financial scandals have forced accounting setters and financial regulators to provide solutions and initiatives for hindering earnings management. However, most of these attempts have failed, since earnings management researchers found that managers still can achieve their earnings management objectives, through manipulating real activities. So, it is more useful to examine the relationship between accounting regulations and real earnings management, to stand upon accounting responsibility in real earnings 4

16 management. Consequently, this study examines real earnings management in one of emerging markets, namely Egypt, through investigating impact of one of accounting principles, historical cost principle, on real earnings management. Real earnings management occurs when managers perform activities that deviate from the first best available practice, or deviate from normal business practices, in order to meet certain objectives (Roychowdhury, 2006; Gunny, 2010). Examples of real earnings management include discretionary expenditure management, delaying starting a positive NPV project, sales manipulation through reducing prices or providing more easy credit terms, early retirement of debt, overproduction to reduce cost of goods sold, altering the shipping schedules, and selective sale of assets. However, this study examines the relationship between historical cost principle, and one of real earnings management methods, selective sale of assets. According to historical cost accounting (HCA), assets should be recorded at cost. Moreover, it is assumed that measuring unit is stable over time. In fact, value of assets changes over time. The difference between recorded value and current value of assets is not reported, until assets are sold. Change of value is accumulated over periods, which creates large hidden reserves. However, such reserves may motivate managers to manipulate earnings either upward or downward, through interfering in structuring of assets sale transactions. 5

17 Accounting literature argues that HCA can be exploited in achieving earnings management objectives. First, Herrmann et al. (2001) argue that following historical cost accounting provides a better avenue for earnings management, than recognition of holding income each period under current value accounting. Second, Barlev & Haddad (2003) document that financial reports based on HCA obscure real financial position, and provide ample room for manipulation. Third, Ramesh et al. (2004) argue that HCA creates opportunities for earnings management. Fourth, Laux & Leuz (2009) argue that since historical cost accounting does not recognize gains unless asset is sold, it may provide incentives for managers to sell assets that have appreciated in value. HCA enables managers to practice both types of earnings management; AEM and REM. First, AEM occurs when managers choose to continue reporting assets at cost, despite its real value has been changed significantly than reported value, in order to mislead users of financial reports about the real value of the firm and results of investments. Further, AEM occurs when managers reclassify income from asset sales as an operating income item, despite it should be classified as a non-operating income item. Second, real earnings management can be practiced through selective sale of assets or timing of assets sale transactions. However, this study investigates only whether managers exploit HCA in real earnings management through interfering in assets sale transactions. Managers can interfere in structuring of assets sale transactions through selective sale of assets or timing of assets sale transactions. Since managers have the discretion to decide which asset to sell and during which period. Moreover, managers can take advantage of HCA, under which, assets should be recorded at cost, and assumes that measuring unit is stable. 6

18 Consequently, large unrealized capital gains/losses are created, which may induce managers to achieve certain objectives through real earnings management. Despite the ongoing debate for dropping HCA and replacing it with FVA, due to several shortcomings of HCA, the measurement basis most commonly adopted by enterprises in preparing their financial statements is historical cost accounting (Elena, 2005). Moreover, it has been noticed that most financial reports of study sample firms are prepared according to HCA. In addition, it has been observed that Egyptian Accounting Standards allowing accounting treatments of most assets based on HCA. Research Importance This study aims to discover the accounting responsibility in real earnings management, especially after managers' directing to real earnings management. The importance of the research stems from several points. First, earnings management results in severe negative impacts on firms value, resources allocation, and financial reports' users, in addition to accusing earnings management as one of the main reasons of last decade financial scandals. Second, the failure of continuous attempts in curbing extent of earnings management practices. Third, managers' directing to real earnings management. The fourth point is the ongoing debate about dropping historical cost accounting and replacing it with fair value accounting. Finally, there is no study that investigates the relationship between historical cost accounting and real earnings management in Egypt. 7

19 Research Objectives The main objective of this study is to investigate the relationship between historical cost accounting and real earnings management, and whether managers, in Egyptian business environment, exploit historical cost accounting to manipulate earnings, through interfering in structuring of assets sale transactions. In order to achieve the main objective, there are two main sub-objectives: 1) Do managers, in Egyptian business environment, exploit hidden reserves, created from following historical cost accounting, in income-smoothing? 2) Do managers, in Egyptian business environment, exploit hidden reserves, created from following historical cost accounting, to avoid violation of debt contracts terms? This study should also find answers for the following questions: 1) Can HCA help managers in real earnings management? 2) How managers exploit HCA in real earnings management? 3) What is the accounting role in real earnings management? Hypotheses Development Accounting literature has documented several explanations of earnings management. However, some researchers (e.g., Bartov, 1993; Black et al. 1998; Healy & Wahlen, 1999) have indicated two common explanations of earnings management: (1) To mislead some stakeholders about real performance of the firms, and (2) To get highest outcomes from contracts based on accounting data. Based on reviewing the literature and nature of the research problem, this study proposes two hypotheses that investigate 8

20 the two common explanations of earnings management, income-smoothing hypothesis and debt/equity hypothesis. Income-Smoothing Hypothesis H01: When current period net income is about to be lower than prior period net income, managers will not realize more capital gains through sale of historical cost assets, and when current period net income is about to be higher than prior period net income, managers will not realize less capital gains from sale of historical cost assets. H1: When current period net income is about to be lower than prior period net income, managers will realize more capital gains through sale of historical cost assets, and when current period net income is about to be higher than prior period net income, managers will realize less capital gains from sale of historical cost assets. Debt/Equity Hypothesis H02: When debt/equity ratio is higher, at a beginning of a financial year, managers will not realize more capital gains through sale of historical cost assets, in order to improve such ratio. H2: When debt/equity ratio is higher, at a beginning of a financial year, managers will realize more capital gains through sale of historical cost assets, in order to improve such ratio. 9