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

• Pages: 81-114
• Published date: 05 March 2018
• DOI: https://doi.org/10.1108/IJAIM-09-2016-0087
• Date: 05 March 2018
• Author: Lan Sun,Omar Al Farooque
• Subject Matter: Accounting & 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 ref‌lected in constraining earnings management in post-reform

period as comparedto pre-reform period.

Design/methodology/approach –Using a sample of 3,966 f‌irm-year observations, including all ASX

and NZX listed f‌irms 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 ‘informative’in a more transparent disclosureregime to capture short-

run benef‌itsfrom 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 benef‌its of

regulatory reforms, which is worth further investigation. The f‌indings of the study can lead regulatory

authorities taking appropriatemeasures to promote earnings quality in corporate f‌inancial reportingfrom a

long-run decision usefulness context. Any future reforms should be directed to protecting the interest of

stakeholdersas well as ensuring benef‌its outweighing costs for them.

Practical implications –The f‌indings of the studycan lead regulatory authorities in taking appropriate

measures to promote earnings quality in corporate f‌inancial 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 benef‌it 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

f‌irms (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 f‌inancial statements (Agrawal and Chadha 2005;Adams,

2011). This debate prompted regulatory authorities to undertake a range of corporate

governance reforms including disclosure transparency of f‌inancial and non-f‌inancial

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 f‌irm’s

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 benef‌it 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 f‌inancial 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 company’s 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 f‌irm’s future cash f‌lows (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 f‌irm

(Shleifer and Vishny, 1986). It is perceived that corporate governance mechanisms can alleviate

agency problems and restore the conf‌idence of investors in the f‌inancial reporting practices of

companies (Leng, 2004). In a similar vein, previous studies argue that strong disclosure

transparency and corporate governance in f‌irms 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 f‌irst 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 f‌inancial reporting standards

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(IFRSs), Corporation Act and bank and f‌inancial 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 today’s market, and companies are required to hold up

their governance practices for public scrutiny. This entails the expectation of more transparent

and reliable f‌inancial 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 company’sf‌inancial performance, which conforms to the spirit of the

regulatory bodies in protecting all parties’interest. Companies also benef‌it by instilling

conf‌idence 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 specif‌ic 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 Zealand’s 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 f‌irm-specif‌ic 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

Australia’s“Old”and “New”economies (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’/stakeholders’capital. In 2002, the Sarbanes–Oxley 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 f‌ind 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

signif‌icantly. 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 year’s earningsand to avoid losses and meet the consensus analysts’forecasts,and

ultimately to inf‌lateexecutive equity-based compensation. In the Australian context,CLERP

9 was introduced after the collapse of the HIH Insurance Company and other high prof‌ile

accounting failures.Given that CLERP 9 is to improve f‌inancial reporting quality, one would

Analysis of

earnings

management

practices

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