Corruption and earnings management in developed and emerging countries

• Pages: 35-51
• Date: 05 February 2018
• Published date: 05 February 2018
• DOI: https://doi.org/10.1108/CG-12-2016-0226
• Author: Isabel Costa Lourenço,Alex Rathke,Verônica Santana,Manuel Castelo Branco
• Subject Matter: Strategy,Corporate governance

Corruption and earnings management in

developed and emerging countries

Isabel Costa Lourenço, Alex Rathke, Verônica Santana and Manuel Castelo Branco

Abstract

Purpose –The purpose of this studyis to examine whether firms from countries presentinghigher levels

of corruption are more likelyto have higher levels of earnings management than their counterparts from

countries with lower levels of corruption. It also explicitly examines how this relationship compares

betweenemerging and developed economies.

Design/methodology/approach –Using multiple regression analysis, this study tests the

hypothesis of positive association between the countries’ leve l of corruption and the level of

earnings management using a sample of foreign firms with American Depositary Receipts in the US

market.

Findings –Findings indicatethat higher corruption perception is related to higherincentives for firms to

manipulate earnings in the case of emerging countries. Such results are not identified in developed

countries where the level of minority investors’ protection is higher. Findings also indicate that in

developed countries earningsmanagement is negatively related to investor protection,which is not the

case for emergingcountries.

Originality value –As far as the authors are aware, this study is the first to examine the effects of

corruptionon earnings management on the basis of accountingfirm-level data.

Keywords Earnings management, Corruption, Developed countries, Emerging countries

Paper type Research paper

1. Introduction

A broad definition of corruption depicts it as “the abuse of entrusted power for private gain”

(Cuervo-Cazurra, 2016, p. 36). The wide-ranging negative effects of corruption are legion. They

include constrained economic growth, decreased trust in government and reduced legitimacy

of market economy and democracy (Branco and Delgado, 2012). Given its detrimental effects,

corruption is considered by many as a cancer on society (Everett et al., 2007).

A little over 10 years ago, Riahi-Belkaoui (2004) expressed his dismay regarding the

lack of interest evidenced by the economic and accounting literature on the impact of

corruption on accounting quality. This consequence has remained largely unexplored

in that literature (Riahi-Belkaoui, 2004;Riahi-Belkaoui and AlNajjar, 2006). Motivated by

this scarcity, we analyse the relationship between country-level and firm-level

characteristics and the level of earnings management of foreign firms with American

Depositary Receipts (ADR) in the US market, highlighting the role of corruption as a

determinant of earnings management (a measure of accounting quality).

Earnings management is related to managers’ judgement in financial reporting and the

structuration of transactions with a view to altering financial information to either misguide

some stakeholders regarding the underlying economic reality or to influence the outcomes

of contracts that are dependent upon such information (Healy and Wahlen, 1999). It may

occur for a variety of reasons, including influencing the perceptions of stock market

participants, enhancing management compensation, reducing the likelihood of violation of

Isabel Costa Lourenc¸ois

Associate Professor at

Instituto Universita

´rio de

Lisboa (ISCTE-IUL),

Lisbon, Portugal and

Researcher at Business

Research Unit (BRU-IUL),

Lisbon, Portugal.

Alex Rathke is Research

Scientist at the

Universidade de Sao Paulo,

Sao Paulo, Brazil.

Vero

ˆnica Santana is based

at the Universidade de Sao

Paulo, Sao Paulo, Brazil.

Manuel Castelo Branco is

Assistant Professor at

Faculty of Economics,

University of Porto, Porto,

Portugal and Researcher at

CEF.UP and OBEGEF,

University of Porto, Porto,

Portugal.

Received 14 December 2016

Revised 3 July 2017

16 July 2017

Accepted 17 July 2017

This article was supported by

FCT – research project UID/

GES/00315/2013.

DOI 10.1108/CG-12-2016-0226 VOL. 18 NO. 1, 2018, pp. 35-51, © Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 35

lending agreements and avoiding intervention from regulatory agencies (Healy and Wahlen,

1999). Dichev et al. (2013) reported evidence suggesting that roughly 20 per cent of public

firms engage in earnings management, and that the usual management borders on 10 per

cent of the earnings per share.

Many consider that higher levels of earnings management are tantamount to unethical

practices (Elias, 2002;Kaplan, 2001;Martin et al.,2016). A moral judgement is

unquestionably involved in earnings management (Martin et al., 2016). Despite this and the

long history of research on earnings management (Healy and Wahlen, 1999;Dechow and

Skinner, 2000;Walker, 2013), accounting researchers have left almost untouched the

relationship between earnings management and corruption, undoubtedly one of the most

conspicuous and damaging unethical behaviours of our times; this happened even though

corruption is considered a serious problem and accounting is deemed as useful in the fight

against it (Everett et al.,2007).

Few studies have explored the relationship between the level of corruption and accounting

quality (Kimbro, 2002;Riahi-Belkaoui, 2004;Wu, 2005;Riahi-Belkaoui and AlNajjar, 2006;

Malaguen

˜oet al.,2010;Houqe and Monem, 2016). Of these studies, only Riahi-Belkaoui

(2004) and Riahi-Belkaoui and AlNajjar (2006) examine the impact of corruption on

accounting quality, albeit basedon accounting country-level data and without guaranteeing

that the study is conducted in a settingof relatively stable accounting environment.

We add to this literature by analysing the effect of countries’ corruption levels on earnings

management. More specifically,we examine whether firms from countries presenting higher

levels of corruption are more likely to have higher levels of earnings management than their

counterparts from countries with lower levels of corruption. As far as we are aware, our

study is the first to do this on the basis of accounting firm-level data. Similar to Riahi-

Belkaoui (2004) and Riahi-Belkaoui and AlNajjar (2006), we posit that a high level of

corruption creates a climate that encourages low levels of accounting quality. Hence, the

premise of this study is that in low-corruptionenvironments, firms are less likely to engage in

earnings management practices.

In particular, this paper brings new insights to the topic by explicitly examining how this

relationship compares between emerging and developed economies. Although corruption

is a worldwide blight, it is particularly worrisome in emerging countries such as Brazil,

China, India and Russia, in which the level of development of the governance mechanisms

required to deal adequately with this phenomenon may not be in place (Kaymak and

Bektas, 2015). Based on the argument that in emerging economies the level of institutional

development may not be sufficient to effectively attenuate the diffusion and impacts of

corruption, we posit that in these countries the positive impacts of corruption on the level of

earnings management tend to be strongerthan in their developed counterparts.

The empirical study relies on foreign firms with ADR in the US market that apply

International Financial Reporting Standards (IFRS). We thus guarantee the homogeneity of

the sample, which is based on firms with greater incentives to transparency that apply a set

of high-quality accounting standards. Hence, contrary to Riahi-Belkaoui (2004) and Riahi-

Belkaoui and AlNajjar (2006), our study is conducted in a setting of relatively stable

accounting environment, with firms providing high-quality financial information somewhat

comparable with that reported by US firms.

Our sample comprises 1,281 firm-year observations, regarding427 firms from 33 countries.

About 68 per cent of these observations are from developed countries, and the remaining

are from emerging countries. Weuse data from 2011 to 2013. The research design relies on

a model that regresses the level of earnings management (the magnitude of absolute

discretionary accruals) on a set of independent firm-level and country-level variables. The

main independent variable is theTransparency International’s Corruption Perceptions Index

[CPI], which is a leading measure of perceptions regarding corruption that ranks countries

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