The Continuum from Legitimacy to Fraud - Research Paper Example

The Continuum from Legitimacy to Fraud Earnings Management: The Continuum from Legitimacy to Fraud Based on the theoretical framework from Yaping’s (2010) work, this study seeks to assess the earnings management practices of listed companies at the New York Stock Exchange (NYSE). The framework will be used to discern the extent to which the earnings practices border on legitimacy or fraud. Given that the firms listed at the NYSE must adhere to the accounting standards and corporate laws governing them, this study assumes therefore that the laws and standards are in place. Thus, the framework will only be used to the extent of four components of earnings management namely paper earnings management (PEM), real earnings management (REM), paper earnings fraud (PEF), and real earnings fraud (REF). PEM and REM relate to earnings management practices that comply with accounting standards and corporate laws in place while REF and PEF are earnings management practices that violate the standards and laws in place. Earnings Management Measurement The type of data used in this study shall be secondary data collected from the DataStream database. Such data is usually found from the financial statements of listed companies and therefore deemed reliable. Therefore, the issues of data reliability and validity for the present study shall not arise as no tools shall be developed for the collection of primary data. A number of approaches have been used by researchers to measure earnings management (Prior, Surroca and Tribo, 2007). According to McNicols (2000), three approaches have been commonly used. These are: specific accruals, distribution of earnings, and total accruals. The present study will employ the total accruals approach which consists of both discretionary accruals and non-discretionary accruals (Dechow et al. 1995). Prior studies presented two approaches for measuring totals accruals. For instance, Kothari (2005) uses the balance sheet method while Jaggi et al. (2009) use the cash flow approach. Following Jones (1991) and Dechow et al. (1995), the current or total accruals can be defined using the balance sheet method as: TACt = ΔCAt - ΔCasht - ΔCLt + ΔDCLt – DEPt Where: ΔCAt = This denotes change in current assets in year t ΔCasht = This is change in cash and cash equivalents in year t ΔCLt = This is change in current liabilities in year t ΔDCLt = This means change in debt included in current liabilities in year t. DEPt = This is depreciation and amortization expense in year t Collins and Hriber (2002) noted that the cash flow approach was a superior method than the balance sheet approach especially for companies experiencing mergers and acquisitions. Sun and Rath (2009) argued that the discretionary accrual approach is potentially ill-specified. This study therefore uses the cash flow estimation approach. Under the cash flow method, total accruals are estimated as follows: TAC t = Income t – Cash Flow t Where: Income = Earnings before extraordinary and abnormal items in year t Cash Flow t = Operating cash flow in year t Prior et al., (2007) noted that earnings management is estimated through discretionary accruals (DA) which are computed by “detracting the expected or non-discretionary accruals (NDA) from the total accruals (TA)” (p. 34). The DA and NDA can be estimated using the Kothari et al (2005) model. The model is different from the modified Jones model proposed by Dechow et al. (1995), and includes a non-deflated term that captures performance (ROA). Consistent with most empirical studies in earnings management, the present study will adopt the modified Jones model. The argument for the adoption of this model is best described by Alghamdi (2012) as follows: “The argument of this study is that management may engage in earnings management via discretionary revenues by timing the recording of these revenues, such as recording them at the year-end when the cash has not yet been collected. In this case, any increase in receivables that are supposed to be discretionary will certainly influence the total accruals.” (p. 125). The new proxy for earnings management as Dechow et al. (1995) argued can be obtained by deducting the change in receivables from the total change in revenues when calculating the non-discretionary accruals using the Jones model (1991). This is the modified Jones model. This model has been successfully used by previous scholars such as Abdul Rhaman and Ali (2006) as well as by Xie et al (2003). The model becomes: TA t /A t-1 = ά1 (1 / A t-1) + ά2 (Δ REVt / A t-1 - Δ REC it) / TA t-1 + ά3 (PPE t / TA t-1) + ε t Total Accruals = Non- Discretionary Accruals + Discretionary Accruals Where: TAit = total accruals in year t; At it = total assets in year t-1; ARevit = revenues in year t less revenues in year t- 1; AREC it = net receivables in year t less net receivables in year t-1; PPE it = gross property plant and equipment in year t; ε it = error term in year t, and ά1,ά2,ά3 = firm-specific parameters. As earlier noted, the present study will adopt the cash flow approach to calculate the total accruals (TAC) which was noted as being more efficient than the balance sheet method. Therefore, TAC will be calculated as follows: TACit = NI it – CFO it Where: NI it = is the earnings before extraordinary items of firm i in year t, CFO it = is the net cash flow from operating activities of firm i in year t, Summary This section has presented the way in which the measures in this study will be estimated. The measure specific to this study is earnings management. The concept has been defined as shall be estimated in the study and a theoretical framework for the same explained. The approach taken to measure it and the model that will be used are presented and discussed. References Abdul Rahman, R., and Ali, F. H., (2006). Board, Audit Committee, Culture and Earnings Management. Managerial Auditing Journal, 21 (7), 783-804. Alghamdi, S.A.L (2012) Investigation into Earnings Management Practices and the Role of Corporate Governance and External Audit in Emerging Markets: Empirical Evidence from Saudi Arabia, Durham e-Theses, Durham University. Retrieved on 28 Feb. 2013 from http://etheses.dur.ac.uk/3438/1/SALIM_ALGHAMDI_(2012)PDF.pdf?DDD2 Collins, D., and Hribar, P. (2002). Errors in Estimating Accruals: Implications for Empirical Research. Journal of Accounting Research, 40 (1), 105-135. Dechow, P., Sloan, R. and Sweeney, A. (1995) Detecting Earnings Management, The Accounting Review, 70, 193-225. Jaggi, B., Leung, S., and Gul, F. (2009). Family Control, Board Independence and Earnings Management: Evidence Based on Hong Kong Firms. Journal of Accounting and Public Policy, 28, 281–300. Jones, J. (1991). Earnings Management During Import Relief Investigations. Journal of Accounting Research, 29 (2), 193-223. Kothari, S.P., Leone, A.J. and Wasley, C.E. (2005) Performance Matched Discretionary Accrual Measures, Journal of Accounting and Economics, 39, 163-197. McNichols, M. (2000). Research Design Issues in Earnings Management Studies. Journal of Accounting and Public Policy, 19, 313 – 345. Prior, D., Surroca, J., and Tribo, J.A. (2007). Earnings Management and Corporate Social Responsibility. Working Paper 06-23, University of Carlos III de Madrid. Sun, L. and Rath, S. (2009) An Empirical Analysis of Earnings Management in Australia, International Journal of Human and Social Sciences 4 (14), 1069 – 1085. Xie, B., Davidson, W.N III and DaDalt, P.J., (2003). Earnings Management and Corporate Governance: the Role of Board and Audit Committee, Corporate Finance, 9 (3), 295 – 316. Yaping, N. (2005) The Theoretical Framework of Earnings Management, Academic journal article from Canadian Social Science, 2 (2), 32 – 38. Read More