Crime rate, real earnings management and managerial ability

• DOI: https://doi.org/10.1108/CG-02-2021-0079
• Published date: 27 September 2021
• Date: 27 September 2021
• Pages: 405-423
• Subject Matter: Strategy,Corporate governance
• Author: Alex Johanes Simamora

Crime rate, real earnings management

and managerial ability

Alex Johanes Simamora

Abstract

Purpose –This paper aims to examine the effect of managerial ability (MA) on real earnings

management and the effect of real earnings management by higher ability managers on future

profitability,at a different level of the crimerate.

Design/methodology/approach –The research sample includes864 manufacturing firms-years listed

on the Indonesian Stock Exchange. MA uses an efficiency score by data envelopment analysis. Real

earnings management is measured by abnormal activities. The crime rate is measured by logarithm

natural of the numberof crimes per 100.000 citizens in the regionwhere the firm is headquartered. Data

analysisuses fixed-effect regression.

Findings –MA increasesreal earnings management in the regionwhere the firm is headquartered witha

higher crime rate while MA will reduce real earnings management in the region where the firm is

headquarteredwith a lower crime rate. Also, real earningsmanagement by higher-ability managersgives

a signal ofbetter future profitability in the regionwhere the firm is headquarteredwith a lower crime rate.

Originality/value –This research contributes to filling the previous gap of managerial characteristics

ability-related on realearnings management by providing regional crimerate as a determinant factor of

managers’ethical behavior. This research is the first one to considersthe regional crime rate treatment to

the relationship betweenMA and real earnings management especially in Indonesia.This research also

provides new evidenceof efficient real earnings management for a lowercrime rate group of samples to

give a signalof better future profitability.

Keywords Crime rate, Real earnings management, Managerial ability

Paper type Research paper

1. Introduction

The Enron case in 2002 is one of the biggest earnings management cases by violating the

GAAP (Dibra, 2016;Downes and Russ, 2005;Madsen and Vance, 2009;Vinten, 2002;

Zandstra, 2002). As it involves one of the big five auditors, Arthur Anderson, United States

Securities and Exchange Commission develops Sarbanes Oxley Act (SOX) as a guide to

improve controlling and monitoring function, business ethic and regulatory enhancement. It

includes improving the role of auditor and regulator (Chiu et al.,2017;Landsman et al.,

2009;Millar and Bowen, 2011;Petra and Loukatos, 2009). After SOX implementation, most

firms shift earnings management from the accrual method to the real manipulation one

(Cohen et al., 2008). It happens because accrual earnings management is subject to

auditor and regulator concerns(Roychowdhury, 2006). Real earnings management involves

abnormal business activities to beat earnings targets, such as positive earnings and

previous earnings or earningsforecast by the stock analyst (Roychowdhury, 2006).

Earnings management also happens in Indonesia. In 2001, PT Kimia Farma does the

earnings mark-up until IDR 32.6bn and it is proceeded by the Indonesian Stock Exchange

Regulator (Christiani and Nugrahanti, 2014). In 2018, PT Garuda Indonesia recognizes US

$239.94m of a 15 years contract as a current revenue all in one and boosts up the firms’

Alex Johanes Simamora is

based at Universitas

Terbuka, Yogyakarta,

Indonesia.

Received 19 February 2021

Revised 13 April 2021

27 July 2021

Accepted 13 September 2021

DOI 10.1108/CG-02-2021-0079 VOL. 22 NO. 2 2022, pp. 405-423, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 405

earnings from a negative US$216.58m in 2017 to a positive US$809.85 thousand in 2018

(Uly, 2019).

Earnings are important information, especially to evaluate a manager’s performance.

Managers have an interest to manage earnings because it relates to their compensation

(Essid, 2012;Olsen et al.,2014). As managers are the main actors to manage earnings (Al-

Haddad and Whittington, 2019;Hoi and Robin, 2010;Kamel and Elbanna, 2012), the

managerial characteristic is one of the most important factors to determine real earnings

management behavior. One of the managerialcharacteristics is managerial ability (MA). MA

is a characteristic that refers to expertise, knowledge, skills and experience had by

managers (Kor, 2003). Demerjian et al. (2012) explain that managerial characteristics of

ability-related (e.g. capability, talent, reputation, and, experienceand style) are important to

determine the managerial contribution to various economics, finance, accounting and

managerial decision. The managerial characteristic can alsodetermine the decision-making

of real earnings management. Some studies find conflicting findings of managerial

characteristics of ability-related and real earnings management behavior. Alhmood et al.

(2020) find that managers’ experiences have a positive effect on real earnings

management. Li et al. (2016) find that managers’ education level also increases real

earnings management. Qi et al. (2018) find that managers’ education level and financial

expertise have a positive effect on real earnings management. On the other hand, Huang

and Sun (2017) find that MA has a negative effect on real earningsmanagement.

Although managers with higher MA can use their ability to increase earnings quality

Demerjian et al. (2013) and mitigate earnings management behavior (Huang and Sun,

2017), the MA also can be used to help managers to engage more in earnings

management (Demerjian et al.,2020). As real earnings management is used to beat

earnings targets, all managers, all else equals, have the same burden to beat earnings

targets and the same opportunity to engage in real earnings management (Huang and Sun,

2017). How managers with higher MA can mitigate or engage in real earnings management

also depends on managers’ ethicalbehavior.

Managers’ ethical behavior is affected by the culture force around the firms. Jha (2019)

explains that, as one of social capital, the cultural force in the region of the firm’s

headquarter is absorbed into the firms’ culture consequently affect the managers’ behavior

in the financial reporting process. The regional crime rate is one of the explicit forms of

social capital that can directly affect the regional social culture (Cho et al.,2020). Cho et al.

(2020) explain that managers that are frequently exposed by unethical culture and norm

tend to engage in unethical behavior such as earnings manipulation. A higher regional

crime rate leads environment with higher unethical behavior (Buonanno et al.,2009).

Hofmann and Schwaiger (2020) find that the crime rate reduces financial reporting quality.

Cho et al. (2020) also find that the regional crime rate where the firms are headquartered

increases misreporting. In this case, the regional crime rate determines the managers’

behavior to engage or mitigate real earnings management behavior. Higher ability

managers in the firms that are headquartered in the region with higher crime rates tend to

use their ability to engage more in real earnings management. They will use their higher

knowledge and expertise of firms’ business environment to deviates the normal business

activities.

Earnings management can be seen as opportunisticbehavior or efficient contracting (Scott,

2014). Opportunistic real earnings management aims to fulfill managers’ self-interest

Roychowdhury (2006) provide information distortion (Menicucci, 2020). In this case,

opportunistic real earnings management fails to predict future profitability (Bhojraj et al.,

2009;Filip et al., 2015;Leggett et al.,2015;Tabassum et al.,2015;Vorst, 2016). On the

other hand, efficient real earnings management aims to give the signal of firms’ quality

Simamora (2019) and future performance (Gunny, 2010). As a higher crime rate is an

indicator of higher unethical culture and norm, higher ability managers in the firms with

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