Real earnings management and financial statement fraud: evidence from Malaysia

• Pages: 508-526
• Date: 01 October 2018
• Published date: 01 October 2018
• DOI: https://doi.org/10.1108/IJAIM-03-2017-0039
• Author: Noorul Azwin binti Md Nasir,Muhammad Jahangir Ali,Rushdi M.R. Razzaque,Kamran Ahmed
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Real earnings management and

f‌inancial statement fraud:

evidence from Malaysia

Noorul Azwin binti Md Nasir

Faculty of Entrepreneurship and Business, Universiti Malaysia Kelantan,

Pengkalan Chepa, Malaysia

Muhammad Jahangir Ali

Department of Accounting, La Trobe University, Melbourne, Australia

Rushdi M.R. Razzaque

Department of Accounting, Independent University, Dhaka, Bangladesh, and

Kamran Ahmed

Department Accounting, La Trobe University, Melbourne, Australia

Abstract

Purpose –We examine whether the fraud f‌irms are engaged in real earnings management and accrual

earningsmanagement prior to the fraud year in the Malaysian context.

Design/methodology/approach –Our sample comprises of 65 f‌inancial statement fraud and 65 non-

fraud f‌irmsover a period of eight yearsfrom 2001 to 2008.

Findings –Using the abnormal cash f‌low from operations (CFO) and abnormal production costs as the

proxies for real earnings management,we f‌ind that f‌inancial statement fraud f‌irms engage in manipulating

production costs during preceding two years of the fraud event. However, our results show that f‌inancial

fraud f‌irms engage in manipulating CFO prior to the fraud event. Additionally, we f‌ind that f‌inancial

statement fraudf‌irms prefer to manipulate earnings using accruals relative to real earnings priorto the fraud

year.

Originality/value –Our results demonstrate that real earnings management is more aggressive in

f‌inancialstatement fraud f‌irms compared to the non-fraud f‌irms in the four years prior to fraud.

Keywords Malaysia, Earnings management, Financial statement fraud, Accrual manipulation,

Real activity manipulation

Paper type Research paper

1. Introduction

The rising number of cases involving f‌inancial statement fraud have received considerable

attention following the collapse of a number of f‌irms in Malaysia (Malaysian Institute of

Accountants, 2012)[1]. In 2009, KPMG Malaysia estimated that f‌inancial statement fraud

valued RM63.5 million eachyear. Financial statement fraud is a type of fraudulent f‌inancial

reporting. We examine f‌irms that are convicted for fraudulentf‌inancial reporting primarily

resulted from delays in disclosing information, failure in disclosing information, and

The author would like to acknowledge helpful comments and suggestions from seminar participants

of the Department of Accounting, La Trobe University. Any remaining errors are ours.

IJAIM

26,4

508

Received22 March 2017

Revised24 July 2017

Accepted20 August 2017

InternationalJournal of

Accounting& Information

Management

Vol.26 No. 4, 2018

pp. 508-526

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-03-2017-0039

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

fabrication of accounting details.In addition to the direct impact on the f‌inancial statement

fraud f‌irms, Perols and Lougee (2011)state that f‌inancial statement fraud affects employees,

creditors, and investors. The incidence of f‌inancial statement fraud also weakens the

reliability of corporate f‌inancial statements and conf‌idence in f‌inancial markets. The

severity of f‌inancial statementfraud in manipulating accounting information has inf‌luenced

the ability of f‌inancial statement users in decision making processes. These concerns have

generated social attention andeconomic concern in the country. Hence, this paper attempts

to examine the incidenceof real earnings management around the f‌inancial statementfrauds

in Malaysian context.

Akers, Giacomino, and Bellovary, (2007) argue that f‌inancial statement fraud has

implications for earnings management. A f‌irm’s earnings management practices can be

considered as unethical (Dugan and Gary, 2016). Previously, studies on earnings

management have used accounting accruals as the proxy for earnings management. For

example, Liu and O’Farrell, (2011) provide evidence that the magnitude of accruals have

decreased in China since 2007 after the introduction of new set of accounting standards.

Perols and Lougee (2011) investigate relationship between earnings management in fraud

f‌irms in the US. Our paper is different from this study because wetest whether fraud f‌irms

manipulate real activitiesin developing countries, particularly,Malaysia where institutional

arrangements governingcorporate reporting different from those in the US.

Recently, Liu et al. (2014) f‌ind signif‌icantly higher earnings management for the IAS/

IFRS f‌irms. Lee and Choi (2015) observe that f‌irms manage bad debtexpense downward to

avoid Losses. Zarzedi (2016) f‌inds that greater volatility of sales, cash f‌low, accruals and

earnings provide a lower accrual quality. Xu and Ji (2016) document that the top Chinese

f‌irms engage in earningsmanagement in the pre-post GFC. Lau and Ooi (2014)show that the

motives of fraudulent f‌inancial reporting for f‌irms to manipulate their f‌inancial statements

include capital raising exercises,closeness to defaulting on debt repayments and sustaining

equity overvaluations. However, existing literature provides evidence that it is more

favourable for f‌irms to manipulatetheir real activities (Ball and Shivakumar, 2005;Graham,

Harvey and Rajgopal, 2005;Hashemi and Rabiee, 2011;Joosten, 2012). Further, Zang (2011)

and Pincus and Rajgopal (2002) highlight that real earnings management activities occur

prior to accruals earnings management.Real earnings management includes the alterations

of activities through adjusting the timing and scale of underlying real business activities

(Xu, Taylor and Dugan, 2007). Examples of real earnings management include providing

excessive sales discounts, offering too lenient credit terms and increasing production to

manipulate the value of currentearnings. Given these conditions, real earnings management

is more diff‌icult for outsidersto detect compared to accruals earnings management (Ball and

Shivakumar, 2005;Graham et al., 2005;Schipper, 1989) and hence, may turn out to be the

preferred form of earnings management. As far as we know, to date no studies have

examined the practice of real earnings management of fraud f‌irms prior to the f‌inancial

statement fraud yearin emerging economies, especially,Malaysia.

The justif‌ication for choosing f‌irms in Malaysia as the context for this study is due to

several reasons. Malaysia is one of the prominent growing economies in the world.

Malaysia’s GDP has risen about 6 per cent per year, which is higher than the US, UK and

Europe (Department of Statistics Malaysia, 2013). Malaysia’s total trade has also increased

from RM685 billion in 2000 to RM1,168billion in 2010. Moreover, its capital market has also

grown rapidly in the last decade,[2] the governmenthas shown awareness by appointing a

number of agencies to address the subject related to f‌inancial reporting quality such as the

Companies Commission of Malaysia (CCM), Securities Commission of Malaysia (SCM),

Bursa Malaysia and Malaysian Institute of Accountants (MIA). These agencies are formed

Real earnings

management

509