Master Thesis
The influence of corporate governance on real earnings
management
Program: MSc Accountancy and Control – Accountancy track Student: Sjoerd van der Linden
Student number: 6029493
First supervisor: Dr. Réka Felleg Date: 22th of June 2013
TABLE OF CONTENT 1. Introduction 1 1.1 Background 1 1.2 Research Question 1 1.3 Motivation 2 2. Literary review 3 2.1 Earnings management 3
2.2 Relation between accrual based earnings management and real earnings management 3
2.3 Corporate governance and earnings management 4
3. Hypotheses development 5 4. Research Design 5 4.1 Sample 5 4.2 Methodology 6 5. Descriptive Statistics 7 6. Estimation Models 9 7. Empirical Findings 10 8. Conclusion 12 Reference list 14
Abstract
In this study I examine the effects of corporate governance on real earnings management. I predict that strong corporate governance is positively related to real earnings management. I examine the effect of CEO duality, board composition, board size, average tenure and busy board on abnormal CFO, abnormal production and abnormal discretionary expenses and a proxy REM that captures the above real earnings management measures. I fail to find a significant relation between corporate governance and real earnings management.
There is little prior literature on the relation between corporate governance and real earnings management. My study contributes to prior literature by filling this gap.
1. Introduction
1.1 Background
Prior literature shows that managers have various incentives to manage earnings. Managers might manipulate earning to increase their compensation and job security, to avoid violating lending contracts, or to reduce regulatory costs or to increase regulatory benefits (Healy and Wahlen, 1999). Manager can conduct two different strategies to manage earnings. They can manipulate accruals or the actual economic activities can be manipulated.
Accrual-based earnings management is the manipulation of accruals without direct effect on the cash flow. It is seen as less costly as supposed to real earnings because it doesn’t affect the real economic activities of a firm. Also manipulation of accruals implies that accruals, by their nature, eventually will be reversed. Managers also alter the real economic activities in order to manipulate earnings. For example managers might reduce investments in R&D in order to meet an earnings benchmark (Bushee, 1998). Real earnings management affects the cash flows of a firm and may have a detrimental effect on long term firm value (Roychowdhury, 2006).
Prior literature suggests that corporate governance can play a role in reducing earnings management (Cornett et al 2008). Through their monitoring role corporate governance can align the interest of managers with the interests of the firm. However prior research mainly focus on how corporate governance reduces the flexibility for managers to reduce accruals but neglect to factor in real earnings management.
How managers decide which strategy to use is the topic of various studies. Most of the studies look which factors influence the trade-off between accrual-based earnings management and real earnings management. A common theme that emerges from this literature is that the earnings management strategies act as substitutes (Zang, 2012; Cohen et al 2008; Chi et al 2011). This implies that the level of overall earnings management isn’t influenced by the two strategies but remains constant. When managers use less accrual-based earning management, they will use more real earnings management, and vice versa.
1.2 Research question
2 1.3 Motivation
The accounting scandals in the beginning of this century impaired the confidence of investors in accounting quality. SOX was implemented as a response to these scandals, with the aim to improve financial reporting quality and restore investor confidence. SOX required different changes to made in regards to corporate governance. The regulations require a majority of independent directors on corporate boards, independence of the board committees that choose new directors and compensate managers (Chhaochharia and Grinstein, 2007). SOX strengthened the role of the audit committee by requiring that all audit committee members are independent and disclosures about the financial expertise of members of the audit committee (Singhvi, 2013). These changes were deemed necessary because the pre SOX monitoring of corporate governance was insufficient (Chhaochharia and Grinstein, 2007).
Prior literature shows that the use of accrual-based earnings after the implementation of SOX have declined (Zang, 2012; Cohen et al 2008). This suggests that the passage of SOX led to more scrutiny to accounting numbers which led to a decline in accrual based earnings management. However both Zang (2012) and Cohen et al (2008) find that the use of real earnings management increased after the implementation of SOX. This is consistent with the assumptions that accrual-based and real earnings management act as substitutes.
Further, Cornett et al. (2008) and Xie et al. (2003) investigate the effect of corporate governance on accrual-based earnings management. Both find that corporate governance structures reduces managers to use accrual based earnings management (Cornett et al. 2008; Xie et al. 2003). However, both studies only focus on accrual-based earnings management and neglect the effect of corporate governance on real earnings management.
My study will help fill this gap and will examine how the structure of corporate governance influences the trade-off managers make to manipulate earnings. If accrual-based earnings management and real earnings indeed act as substitutes, an unintended effect of SOX, with its requirements on stronger corporate governance structures, leads managers to use the potential more costly earnings management strategy of real earnings manipulation. My study contributes to existing literature by adding knowledge on when and how managers make a trade-off between accrual-based earnings management and real earnings management.
The next paragraph will cover the literature review. In this section I will describe the role of corporate governance and its effect on earnings management. Further, this section gives a more detailed overview of the relation between accrual based earnings management and real earnings management. In the third the hypotheses will be developed. The fourth paragraph
3 provides the research methodology. In the is paragraph I will describe the sample and regressions to be used in this study.
2. Literature review
2.1 Earnings management
Managers have various incentives to beat pre-set targets and thus engage in earnings manipulation. Managers compensation, future promotions, and job security often depends on achieving a pre-established benchmark (Healy and Wahlen, 1999). Consequences of earnings management is that financial reports provide inaccurate information (Xie et al, 2003) or the future performance of firm can be negatively influenced (Roychowdhury, 2006).
Managers can manipulate earnings through accrual based earnings management and real earnings management. Accrual based earnings management is the manipulation of earning through accounting methods. Managers can for example change depreciation methods or the estimate for provision for doubtful accounts (Zang, 2012). Accrual based earnings management only influences the accounting numbers and has no effect on the real economic activities.
Unlike accrual based earnings management, real earnings management affect the real economic activities. Because the not only the accounting numbers but the actual real economic activities, real earnings manipulation is seen to have a higher detrimental effect on firm value. Roychowdhury (2006) describes real earnings management as actions of management “that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds”. Examples are delaying or reducing investments in R&D (Bushee, 199) or building up excess inventory to lower reported COGS (Roychowdhury, 2006). A survey study of Graham et al (2005, pp. 33) finds that ‘80% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance to meet an earnings target. More than half (55.3%) state that they would delay starting a new project to meet an earnings target, even if such a delay entailed a small sacrifice in value’.
2.2 Relation between accrual based earnings management and real earnings management Prior research suggests that accrual based earnings management and real earnings management may act as substitutes. Cohen et al (2008) examine earnings management in the pre and post SOX era. They find increasing accrual based earnings management in the pre SOX era but declining real earnings management. In the post SOX era they find the opposite. They suggest that the passage of SOX led to more scrutiny to accounting numbers which led to a decline in
4 accrual based earnings management. Managers switched to real earnings management because these methods, while more costly, are harder to detect.
Cohen and Zarowin (2010) find similar result while studying the trade-offs firms make between accrual and real earnings management during seasoned equity offerings. They find that firms are more likely to use real earnings management when the costs associated with accrual earnings management are high. These costs of accrual earnings management include the scrutiny provided by the capital markets, the potential penalty of detection, and the difficulty of achieving a given earnings target.
Zang (2012) studies how managers trade off real earnings management and accrual-based earnings management. She finds the choice of which earnings management to follow depends on the relative costs. She finds that firms use real earnings management to greater because of a higher level of scrutiny of accounting practice post-SOX. Accrual based earnings management is more used when the costs of real earnings management is high due to having a less competitive status in the industry, being in a less healthy financial condition, experiencing higher levels of monitoring from institutional investors, and incurring greater tax expenses in the current period. Overall, she finds a negative relation between the two earnings management strategies, which suggest that accrual based earnings management and real earnings management act as substitutes.
Chi et al (2011) investigate whether the effect of audit quality on earnings management. Their findings suggest that higher audit quality results are associated with higher levels of real earnings management. Higher audit quality constrains the use of accrual manipulation which leads managers to the use of real earnings management. The paper suggests that an unintended consequence of higher quality auditors constraining accrual earnings management is that clients resort to higher levels of real earnings management, which is potentially more costly to the shareholders in the long run. The findings from Chi et al (2011) contribute to the theory that accrual earnings management and real earnings management act as substitutes.
2.3 Corporate governance and earnings management
Cornett et al (2008) examine the influence of corporate governance on accrual based earnings management. They find that institutional ownership of shares, institutional representation on the board, and independent outside directors on the board decreases earnings management.
Xie et al (2003) find that earnings management is less likely to occur or occurs less often in companies whose boards include both more independent outside directors and directors with corporate experience. They also find that the audit committees consisting of members with
5 corporate or investment banking backgrounds is associated lower levels of earnings management. Klein (2002) finds that an independent audit committee is negatively related with manipulation of accruals.
3. Hypotheses development
Following prior literature (Cohen et al. 2008; Chi et al. 2011; Zang 2012) I make the assumption that accrual based earnings management and real earnings management act as substitutes. The implementation of SOX increased scrutiny on financial reporting and litigation costs. I argue that SOX reduce the possibilities for managers to manipulate accruals, which in turn will increase the use of more costly real earnings manipulation strategies.
Prior literature indeed shows that suggests that the structure of corporate governance reduces the use of discretionary accruals (Klein, 2002; Xie, 2003; Cornett et al 2008). However prior research does not take the substation effect of earnings management into account, which might defeat the purpose.
Thus, I will make the assumption, that a strong corporate governance structure reduces the use of accrual based earnings management, which will in turn lead managers to manipulate the real economic activities of the firm.
H1: Strong corporate governance is associated with higher levels of real earnings management among firms with incentives to manage earnings.
4. Research Design
4.1 Sample
I started with gathering data for the years 2007-2013 using Compustat. This resulted in 86,322 firm year observations. Following Roychowdhury (2006) I deleted firms in regulated industries and banks and financial institutions, respectively the SIC codes between 4400 and 5000 and SIC codes between 6000 and 6500, they led combined to a reduction of 18,712 firm year observations. Missing data required to calculated the real earnings management measures reduced the sample further with 36,009 firm year observations. Lastly, I merged corporate governance data from ISS (formerly RiskMetrics) with the Compustat data, which led to the final sample of 6,171 firm years.
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Table 1
Sample Selection
Firm-Years
Compustat data for 2007-2013 86332
Regulated Industries -4792
Bank and Financial Industries -13920
Missing data to calculate real earnings management measures 36,009
Missing Corporate Governance data 25,440
Final sample 6,171
4.2 Methodology
I follow Roychowdhury (2006), Chi et al. (2011) and Cohen et al. (2008) in defining my proxies for real earnings management. To determine if real earnings management has occurred, I calculate the level of abnormal Cash Flow from Operations (Abn_CFO), the abnormal level of Production (Abn_Prod) and the abnormal level of Discretionary Expenses (Abn_Disxexp).
The abnormal levels are determined by comparing the actual levels with the normal levels. The normal level of CFO is calculated with the following regression:
𝐶𝐹𝑂𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1 = 𝛼0+ 𝛼1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼2( 𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼3( ∆𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝜀𝑖𝑡 (1)
Production costs are calculated as the sum of COGS and the change in inventory. The model for COGS is:
𝐶𝑂𝐺𝑆𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1 = 𝛼0 + 𝛼1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼2( 𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝜀𝑖𝑡 (2)
The model for inventory growth is:
∆𝐼𝑛𝑣𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1 = 𝛼0 + 𝛼1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼2( ∆𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼3( ∆𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝜀𝑖𝑡 (3)
The normal level of production costs is calculated with regression model 4:
𝑃𝑟𝑜𝑑𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1 = 𝛼0+ 𝛼1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼2( 𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼3( ∆𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼4( ∆𝑆𝑎𝑙𝑒𝑠𝑖𝑡−1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝜀𝑖𝑡 (4)
7 Lastly, I calculate the normal level of discretionary expenses with regression model 5:
𝐷𝑖𝑠𝑐𝐸𝑥𝑝𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1 = 𝛼0 + 𝛼1( 1 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝛼2( 𝑆𝑎𝑙𝑒𝑠𝑖𝑡 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡−1) + 𝜀𝑖𝑡 (5)
Further, I create a proxy that combines the models (1), (4) and (5) to capture the total level of real earnings management. Following Cohen et al. (2008) and Chi et al. (2011), REM is calculated as the sum of –standardized Abn_CFO + standardized Abn_Prod - standardized Abn_Discexp. Higher values of REM indicate higher levels of real earnings management.
5. Descriptive statistics
Information on corporate governance was gathered from ISS. The sample consists of 6171 distinct firm-year observation for the period 2007-2013). The variables are defined with descriptive statistics in table 2.
Table 2
Descriptive statistics for a sample of 6171 firm from 2007-2013
Total Board Statistics Mean Range
Percentage of firms with CEO duality 0.554 -
Percentage of inside directors 0.162 0 - 0.636
Percentage of affiliated directors 0.051 0 - 0.556 Percentage of outside directors 0.787 0.143 - 1
Board size 8.951 3 - 23
Average Tenure 10.024 1 - 31
Percentage of firms with busy board 0.471 -
CEO duality
A firm has CEO duality when the CEO of the firm is also the chairman of the board. The variable CEO duality takes the value one if the CEO is also the chairman of the board and zero otherwise. The sample shows that 55.4% of the firms has CEO duality. This finding is quite lower than the 85% CEO duality that Xie et al (2003) finds.
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Board Composition
I divide the board in three groups: inside directors, affiliated directors and outside directors. Inside directors are employees of the firm. Directors are labeled affiliated when they are linked to the firm, either through a relationship with its directors or executives. Directors are deemed outsiders when they are independent to the firm, and the only relationship with the firm is through their role as directors of the board.
The sample shows that on average 16.2% of the boards consists of inside directors, 78.7% of outside directors, and the remaining 5.1% is occupied by affiliated directors. The data of inside directors corresponds largely with the findings (18%) of Xie et al (2003). However, my sample shows a substantially larger percentage of outside directors and substantially lower percentage of affiliated directors compared to Xie et al (2003). Their sample consists of 67% outside directors and 15% affiliated directors.
Board size
The average board in the sample consists of roughly 9 members. The smallest board in the sample has only three members and the largest board in the sample consists of 23 members. The size of the board and the range is small in comparison to (average board size of 12 with a range of 3-39 members) the sample of Xie et al (2003).
Average Tenure
Average tenure is calculated as the relative tenure of each individual board member divided by the size of the board. I find that the average board consists of directors with a tenure of ten years. The smallest average tenure is only 1 year and the largest average tenure is 31 years.i
Percentage of Firms with a Busy Board
I categorize a board as busy when at least one director of the board holds a position as director by at least three other major boards. The variable Busy Board takes the value of one if this is the case and zero otherwise. I find that on average 47% of the boards consists of at least one director who is busy.
9 6. Estimation Models
Table 3 represents the regression coefficients to estimate the normal levels of cash flows, production and discretionary expenses. These regression are based on the data from Compustat before merging with corporate governance data.
Table 3
Model Parameters
CFOt/At-1 Prodt/At- DiscExpt/At-1
1/Assetst-1 -0.296 1/Assetst-1 0.008 1/Assetst-1 0.741
Salest/Assetst-1 0.073 Salest/Assetst-1 0.720 Salest-1/Assetst-1 0.122
∆Salest/Assetst-1 -0.18 ∆Salest/Assetst-1 -0.026
∆Salest-1/Assetst-1 -0.011
Adj. R2 0.492 Adj. R2 0.811 Adj. R2 0.565
Table 4 reports the statistics for the abnormal levels of CFO, production and discretionary expenses and also the statistics for the proxy REM that captures the total level of real earnings management.
Table 4
Distribution of Real Earnings Management variables
Variable Mean Std. Dev. p25 Median p75
Ab_CFO -0.0004 0.1608 -0.0474 -0.0011 0.0456 Ab_Prod -0.0063 0.5749 -0.0956 0.0075 0.1042 Ab_DiscExp -0.0006 0.2171 -0.1023 -0.0112 0.0803
REM -0.0366 4.3010 -1.2140 0.1362 1.3888
Table 5 shows the pairwise Pearson correlation. * indicates significance at the 10 percent level. Ab_CFO, Ab_Prod and Ab_DiscExp are respectively negative, positive and negative correlated with REM. Ab_CFO and Ab_DiscExp are negative correlated with Ab_Prod.
10 None of the corporate governance characteristics are significantly related to REM and Ab_Prod. Tenure is positive correlated with Ab_CFO. CEO duality is negative correlated with Ab_DiscExp and Busy Board is positive correlated with Ab_DiscExp.
The correlations suggests that there is no clear link between corporate governance and real earnings management.
Table 5
Correlation Matrix
REM Ab_CFO Ab_Prod Ab_DiscExp
REM 1.0000 Ab_CFO -0.3609* 1.0000 0.0000 Ab_prod 0.9230* - 0.1441* 1.0000 0.0000 0.0000 Ab_DiscExp -0.4754* 0.0277* - 0.1869* 1.0000 0.0000 0.0296 0.0000 CEO Duality 0.0167 -0.0020 0.0101 - 0.0252* 0.1889 0.8767 0.4289 0.0479 Outsiders 0.0085 0.0104 0.0146 0.0040 0.5065 0.4129 0.2517 0.7555 Board Size 0.0051 0.0092 0.0100 0.0032 0.6882 0.4681 0.4344 0.7999 Tenure -0.0169 0.0224* -0.0200 -0.0156 0.1833 0.0781 0.1163 0.2211 Busy Board -0.0187 -0.0099 -0.0088 0.0436* 0.1422 0.4354 0.4894 0.0006 7. Empirical Findings
I performed four ordinary least square regressions to examine the effect of the board characteristics on the four real earnings management proxies. The results of the ordinary least square regressions are given in table 6. REM, Ab_CFO, Ab_prod and Ab_DiscExp are the dependent variable and the board characteristics variable are the independent variables.
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Table 6
Corporate Governance and Real Earnings Management
REM Ab_CFO Ab_Prod Ab_DiscExp Intercept -0.0108 -0.0426 -0.0312 0.0126 (-0.02) (-2.15) (-0.44) (0.47) CEO Duality 0.1490 -0.0020 0.0108 -0.0112** (1.33) (-0.48) (0.72) (-1.99) Outsiders 0.0813 0.0321 0.0393 -0.0058 (0.15) (1.55) (0.53) (-0.21) Board Size 0.0191 0.0000 0.0031 -0.0008 (0.70) (0.82) (0.85) (-0.59) Avg. Tenure -0.0236 0.0012** -0.0030 -0.0005 (-1.52) (2.10) (-1.45) (-0.58) Busy Board -0.2272 -0.0038 -0.0203 0.0200* (-1.94) (-0.87) (-1.30) (3.39) * Significant at 1% level **Significant at 5% level
As already suggested by the correlations, I don’t find an significant relation between board characteristics and real earnings manipulation. None of the board characteristics show a significant link to the total use of real earnings management. The lack of significance makes it hard to make any real assumptions from the results.
Despite the lack of significance the results do suggests a certain pattern. CEO duality, the percentage of outside directors and the size of the board show positive coefficients. This is in contrast with the coefficients Xie et al. (2003) find. Xie et al (2003) find a significant negative relation between the size of the board and percentage of outside and the use of accruals to manipulate earnings. They also find a negative but insignificant coefficient for CEO duality. This result could support the notion that managers make a trade-off based on corporate governance characteristics which earnings manipulation strategy to use.
The average tenure of the board is the only characteristic that has a significant link with abnormal CFO. The coefficient is positive but rather small. It suggests that an higher average tenure doesn’t increase the use real earnings management to increase abnormal CFO. CEO duality shows a negative but insignificant coefficient. The negative coefficient supports the notion that managers prefer to use real earnings manipulation strategies as supposed to manipulating accruals when the CEO of the firm is also the chairman of the board.
None of the characteristics are significant related to abnormal production. CEO duality and the size of the board do however show a positive coefficient. This may suggest that CEO duality and a bigger board of directors could lead to more real earnings
12 CEO duality is significant and negatively related to discretionary expenses. This underlines the notion that managers prefer to use real earnings manipulation strategies as supposed to manipulating accruals when there is CEO duality. Board size shows a negative coefficient but is insignificant. The negative coefficient is in line with the positive coefficient found for board size in relation to REM and Ab_Prod. This result may suggest that managers prefer using real earnings manipulation strategies when the size of the board is larger. Lastly, I find a positive and significant relation between busy board and Ab_DiscExp. This result could be explained by that busy directors are not as effective in performing their monitor and oversight function as compared to less busy directors. Managers might have more
opportunities to manipulate accruals when directors have additional positions on other boards and thus prefer to use the less costly variant of earnings management.
Thus, I find a positive, negative, positive and negative CEO duality coefficient respectively for REM, Ab_CFO, AB_Prod and Ab_DiscExp. And a positive, positive and negative coefficients for Board Size and Outsiders relative to REM, AB_Prod and
Ab_DiscExp. These results, supported by the findings from Xie et al (2003), and the
substitution effect that Cohen et al (2008) may suggests that corporate governance structure has the ability to increase real earnings management.
These assumptions can however not be backed up by a significance relation and thus remains speculative. Overall my conclusion is that the lack of significance suggests that there is no clear relation between board characteristics and real earnings management. There is no evidence that corporate governance either enhances nor constrain real earnings management.
8. Conclusion
The accounting scandals in the beginning of this century impaired the confidence of investors in accounting quality. SOX was implemented as a response to these scandals, with the aim to improve financial reporting quality and restore investor confidence. SOX required different changes to made in regards to corporate governance. For example SOX requires that the majority of directors on corporate boards consists of independent outside directors.
One way of improving financial reporting quality is restricting earnings management. Prior research does indeed suggests earnings management has declined after the passage of SOX and that corporate governance structures have an restricting influence on earnings management. A drawback of the existing literature between corporate governance and
13 earnings management is that the focus lies on manipulation of accruals while neglecting real earnings manipulation.
The aim of this research was to fill the gap in the literature and examine the influence of corporate governance on real earnings management. The study is relevant because prior literature suggests that real earnings management and accruals earnings management act as substitutes. An unintended effect of SOX may be that strengthening corporate governance and in turn reducing accruals earnings management may lead managers to perform the more detrimental strategy of real earnings management.
I examined the relation between corporate governance and real earnings management by comparing five board characteristics with the level of real earnings management. In this study I fail to find any evidence which suggests that stronger corporate governance has the unintended consequence of increasing real earnings management.
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