An exploratory analysis of earnings management practices in Australia and New Zealand

Pages81-114
Published date05 March 2018
DOIhttps://doi.org/10.1108/IJAIM-09-2016-0087
Date05 March 2018
AuthorLan Sun,Omar Al Farooque
Subject MatterAccounting & Finance,Accounting/accountancy,Accounting methods/systems
An exploratory analysis of
earnings management practices in
Australia and New Zealand
Lan Sun and Omar Al Farooque
UNE Business School, University of New England, Armidale, Australia
Abstract
Purpose This study aims to explore corporate earnings management practices in Australia and New
Zealand beforeand after the regulatory changes and corporategovernance reforms. The study arguesthat the
effectiveness of regulatory reforms has to be reected in constraining earnings management in post-reform
period as comparedto pre-reform period.
Design/methodology/approach Using a sample of 3,966 rm-year observations, including all ASX
and NZX listed rms for the period 2001-2006,the study examines earnings management practices in both
countriesin pre- and post-reform periods with appropriatestatistical methods.
Findings The results indicatesome interesting phenomenon: the magnitudeof earnings management did
not decline after the governancereform as a positive time trend is observed in the entire sample as well as in
Australian and New Zealand sub-samples, suggesting that earnings management has been growing over
time. Additional test indicates no structuralchange has occurred before and after the new regulations. The
shifting from decreasingearnings management to increasing earnings managementcan be interpreted as an
evidence that earnings become more informativein a more transparent disclosureregime to capture short-
run benetsfrom regulator reforms.
Research limitations/implications The shifting of earnings management behaviour from
decreasing to increasing income can be interpreted as the outcome of more informative, rather than
deliberate, earnings management in a more transparent disclosureregime to capture short-run benets of
regulatory reforms, which is worth further investigation. The ndings of the study can lead regulatory
authorities taking appropriatemeasures to promote earnings quality in corporate nancial reportingfrom a
long-run decision usefulness context. Any future reforms should be directed to protecting the interest of
stakeholdersas well as ensuring benets outweighing costs for them.
Practical implications The ndings of the studycan lead regulatory authorities in taking appropriate
measures to promote earnings quality in corporate nancial reporting from a long-run decision usefulness
context.
Originality/value The study adds value to the existing earnings management literature as well as
effectivenessof regulations for the benet of wider stakeholder groups.
Keywords Australia and New Zealand, Earnings management, Accounting disclosure,
Corporate governance reforms
Paper type Research paper
1. Introduction
The issue of corporate governance has received much attention throughout the world
since the early 2000s, when almost every country has been trying to implement good
corporate governance practices in its corporate sector. Resulting from a series of
corporate collapses, scandals and frauds in the leading Organisation for Economic Co-
operation and Development (OECD) countries in recent years, such as Enron, Tyco
International, WorldCom, Xerox (US), BCCI Bank (UK), HIH Insurance, OneTel,
Westpoint, Harris Scarfe, Centaur and Pasminco (Australia), Ansett Holdings, Air New
Analysis of
earnings
management
practices
81
Received9 September 2016
Revised5 January 2017
17February 2017
Accepted19 February 2017
InternationalJournal of
Accounting& Information
Management
Vol.26 No. 1, 2018
pp. 81-114
© Emerald Publishing Limited
1834-7649
DOI 10.1108/IJAIM-09-2016-0087
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1834-7649.htm
Zealand (NZ), Nortel, Crocus (Canada), Royal Ahold, Parmalat (EU), previous studies
have raised concerns about the weak and ineffective corporate governance structure in
rms (Elloumi and Gueyle, 2001;Shen and Chih, 2007;Cormier and Martinez, 2006;Jo
and Kim, 2007) as well as the quality of the accounting information reported and
disclosed in various company nancial statements (Agrawal and Chadha 2005;Adams,
2011). This debate prompted regulatory authorities to undertake a range of corporate
governance reforms including disclosure transparency of nancial and non-nancial
reporting (Plessis et al., 2005). Such waves of reforms developed high expectations
about an effective governance structure and disclosure regime to deter managerial self-
dealing incentives and low quality earnings and disclosure to minimise agency costs.
Corporate governance and disclosure are monitoring tools that operate within a rms
governance system and seem to be potentially useful in reducing information
asymmetry as well as agency costs (Shleifer and Vishny, 1997;Hope and Thomas, 2008;
Holm and Schøler, 2010;Arcot and Bruno, 2011).
Earnings management (both opportunistic and informative) is widely perceived as a means
of distorting or manipulating accounting earnings to benet managers at the expense of
shareholders. Earnings management is one form of agency cost (Davidson et al.,2004), which
leads to earnings being mispriced by the market players and, consequently, misrepresenting
the information in capital market. Agency theory highlights a variety of agency costs that
provide incentives for earning management to agents (managers) and controlling owners at the
cost of principals (owners) and non-controlling investors, respectively, owing to divergence of
interests between them leading to non-stewardship behaviour and asymmetric information
problems (Jensen and Meckling, 1976;Fama and Jensen, 1983b;Shleifer and Vishny, 1997). In
fact, the use of nancial information, such as reported earnings, in managerial contractual
agreements may provide incentives for earnings management (Healy and Wahlen, 1999).
Managers may tend to manipulate earnings for a number of reasons including those related to
capital market motivations, compensation and bonuses as well as debt or lending contracts that
are determined by a companys earnings performance (Gaver and Gaver, 1998;Steven, 1998;
Jaggi and Lee, 2002;Shuto, 2007;Teshima and Shuto, 2008). Fields et al. (2001) contend that
earnings management occurs when managers exercise their discretion over accounting
numbers, with or without the restrictions of the generally accepted accounting principles
(GAAP). Despite the opportunistic behaviour, managers could also exercise discretion to reveal
to investors their private expectations about the rms future cash ows (Healy and Palepu,
1993).
High quality of disclosure and earnings is of value in the corporate sector. However, the
presence of earnings management can lead to lower quality of disclosure and earnings. While
the absence of earnings management confers earnings quality, the intentional manipulation of
earnings by managers, within the requirements of GAAP, can compromise earnings
persistence and predictability, and therefore, distort the usefulness of earnings in decision-
making. To overcome this problem of earnings manipulation and to mitigate agency costs,
effective monitoring mechanisms such as corporate governance is installed within the rm
(Shleifer and Vishny, 1986). It is perceived that corporate governance mechanisms can alleviate
agency problems and restore the condence of investors in the nancial reporting practices of
companies (Leng, 2004). In a similar vein, previous studies argue that strong disclosure
transparency and corporate governance in rms creates disincentives for managers to commit
earnings management (Cormier and Martinez, 2006;Jo and Kim, 2007;Shen and Chih, 2007). To
address regulatory weaknesses and to improve their international standard during the rst half
of last decade, most of the leading countries including Australia and New Zealand streamlined
a set of corporate governance codes of best practice, international nancial reporting standards
IJAIM
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(IFRSs), Corporation Act and bank and nancial sector reforms, etc. Given the regulatory and
legislative changes and international governance trends, the importance of good governance is
continually being brought into focus in todays market, and companies are required to hold up
their governance practices for public scrutiny. This entails the expectation of more transparent
and reliable nancial information to investors by constraining earnings management and, thus,
ensures high quality earnings free from fraud or manipulating real activities and showing a
true and fair view of a companysnancial performance, which conforms to the spirit of the
regulatory bodies in protecting all partiesinterest. Companies also benet by instilling
condence in their shareholders, investors and other stakeholders. However, the case in the real
business world may be different and contrary to the expectations of reducing earnings
management and ensuring higher quality earnings.
The motivation of this paper is to examine how successful the regulatory reforms have been
in relation to a specic outcome of management discretion, as we argue that the ability and
enforcement of corporate governance to constrain earnings management as evidence of the
effectiveness of the regulatory reforms. In particular, the aim is to explore the earnings
management behaviour of Australian and New Zealands listed companies before and after the
corporate governance and disclosure reforms, and to observe any positive change in the
magnitude of earnings management in post-reform periods over the pre-reform periods, as per
the expectation of the reform agenda. Managers engage in earnings management in both
directions depending on rm-specic circumstances. Further, we review the Australian studies
of earnings management for the period 1998-2011. Evidence of earnings management has been
documented in the setting of income-smoothing (Black et al.,1998); price control and political
concerns (Lim and Matolcsy, 1999;Godfrey and Jones, 1999;Monem, 2003); takeover (Eddey
and Taylor, 1999); CEO changes (Wells, 2002;Godfrey et al., 2003); benchmark beating (Holland
and Ramsay, 2003;Coulton et al.,2005); corporate governance and institutional investor type
(Koh, 2003;Hsu and Koh, 2005;Davidson et al., 2005;Koh, 2007); economic setting of
AustraliasOldand Neweconomies (Jones and Sharma, 2001); banking industry
(Anandarajan et al.,2007); earnings restatements (Ahmed and Goodwin, 2007); and earnings
management in Australian corporations (Wilson, 2011). The review of Australian research not
only shows that research on earnings management is limited, but also reveals the gaps within
existing studies. For example, the impact of Corporate Law Economic Reform Program
(CLERP) 9 on earnings management behaviour has not yet been well examined in the
Australian context.
Corporate collapses, scandals and frauds are not uncommon in recent years in both
Australia and New Zealand, matchingexperiences in the USA and Europe, which destroyed
billions of dollars in shareholders/stakeholderscapital. In 2002, the SarbanesOxley Act
(SOX) was introduced in the wave of corporate governancefailures in the US market. Cohen
et al. (2008) investigate whether the passage of SOX has affected earnings management
practices in the US, suggesting that the practice of earningsmanagement has increased over
the sample period 1987-2005. They nd an increase in earnings management in the period
before the introduction of SOX. After the introduction of SOX the level of accrual-based
earnings management declined, however, the level of real earnings management increased
signicantly. Meeting and exceeding benchmarks continued to be important to managers,
but what has changed is that managers use more real earnings management to beat the
previous years earningsand to avoid losses and meet the consensus analystsforecasts,and
ultimately to inateexecutive equity-based compensation. In the Australian context,CLERP
9 was introduced after the collapse of the HIH Insurance Company and other high prole
accounting failures.Given that CLERP 9 is to improve nancial reporting quality, one would
Analysis of
earnings
management
practices
83

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