What is Earning Management

An effective reporting process and disclosure reduces challenges for businesses with valuable economic reasons. The company’s management may influence the financial reports as well as disclosure, which in turn introduces an additional risk for investors and minimizes capital allocation’s effectiveness ( Braam, Nandy, Weitzel & Lodh, 2010) . Finance and accounting experts have pinpointed the significance of exploring EM from various viewpoints to create a framework possible for encountering such behaviors ( Roychowdhury, 2006) . Making an EM framework could likely establish an effective way for managers to communicate internal information to stakeholders. The disclosed information must meet certain qualitative elements, such as comprehensibility, generalizability, reliability, and relevance. 

In theory, EM is explained by two different accounting theories. Manipulating earnings may be seen as opportunistic or beneficial/ effective as per the contractual perspective of financial reporting. The effective viewpoint asserts that EM may be employed as a managerial tool for confiding internal information to outsiders and thus increasing the value of financial reporting for investors ( Jiraporn, Miller, Yoon & Kim, 2008) . The opportunistic view suggests that management utilizes EM as a tool for maximizing their utility. 

When managers use earnings management opportunistically, companies, where agency costs are more severe, must show a higher degree of earnings management. That is, the extent of EM is positively connected to the weight of agency conflicts ( Abdullah & Ku Ismail, 2012; Goel, 2012) . On the other hand, EM can be aimed at conveying private information and, therefore, improve the information content for earning, which would benefit shareholders ( Vladu, 2015) . When this is the case, it is expected that companies where agency costs are higher, must not show a higher level of EMM since managers ought to manage earnings to improve their benefits. 

The management may manipulate the financial data reported to the primary users and the market. Accruals management (AM) is an integral part of the possible management manipulation as per previous research in the EM field ( Cohen, Pandit, Wasley & Zach, 2011; Srivastava, 2019) . Accruals exist since there is no single unified definition of economic income and profit. The implications of transactions must be recorded as they happen and reported in the period which most economic activities relate to. Accruals comprise an element of uncertainty because they are not fully appreciable and observable ( Enomoto, Kimura & Yamaguchi, 2015) . This element is called the discretionary accruals. Managers may use accruals as a tool for attaining the desired earnings objective ( Cohen, Dey & Lys, 2008) . Also, managers may affect earnings directly through activities that influence operating cash flow ( Ho, Liao & Taylor, 2015) . Real activities manipulation (RAM) occurs once the actions of the management diverge from established normal business practices to attain earnings benchmark. 

Accrual-Based Earning Management and Real Earnings Management 

Earnings manipulation can occur through two EM strategies – accrual-based EM and real EM. Accrual-based EM aims at obscuring actual economic performance through altering accounting techniques or estimates within the generally accepted principles of accounting ( Al-Absy, Ismail & Chandren, 2018; Cohen & Zarowin, 2010) . Real EM changes the performance of actual business transactions. Under real EM, companies alter their operating activities to fulfill short-term earnings targets by adapting the structure or timing of real transactions. This activity has direct cash flow implications and potential long-term impacts on economic value (Braam, Nandy, Weitzel & Lodh, 2015; Kothari, Mizik & Roychowdhury, 2012) . Real EM is regarded as more challenging to notice than accrual-based EM, thus making it easier for companies to hide gains made. 

Earnings Management (EM) Measurements 

Various measurements have been used to determine earnings management. Consequently, in accordance with its aims and objectives and the research questions, this study uses the most significant and relevant found in the Literature Review. 

Starting with EM, several studies used the Jones model (1991), the Modified Jones model (1995), the Kothari model (2005), real EM and classification shifting (see Table 1) to measure EM. This study uses the Modified Jones model (1995) and the Kothari model (2005) to measure EM. 

As detailed below, the Modified Jones 1995 model is the model that is used most commonly in most developed countries to measure EM: 

However, in most developing economies this model falls short because firms tend to use current accruals for the sole reason that current accruals entail cash flow implications in the subsequent years (Yoon, Jiraporn & Miller, 2006). From examining the types of accruals used by Korean firms to increase or reduce their reported earnings, Yoon et al.’s (2006) findings show that earning-increasing firms used non-cash revenues whereas earning-reducing firms employed non-cash expenses. Overall, their findings conclude that the Modified Jones Model (1995) is ineffective in the Korean market. However, Algharaballi & Albuloushi’s (2008) findings show that Kuwaiti firms practice EM to maximise the incentive and, accordingly, EM is effective in Kuwait. According to Islam, Ali and Ahmad (2011), analysed the effectiveness of the Modified Jones model in detecting EM in the Dhaka Stock Exchange’s (DSE) initial public offerings. Their study follows on from a previous study which showed that the Modified Jones model was not totally effective in measuring EM in the Korean market. Islam, Ali and Ahmad’s (2011) findings show that the modified Jones model was ineffective in the Bangladesh market since the model’s explanatory power was only 9%. In an attempt to establish which the best model was, Chen (2010) analysed 77 Chinese stock market ST companies by using various accruals-based EM models. His conclusions show that, although the Modified Jones model needs to be improved in some areas, it is the best model and above all other EM measures of discretionary accruals. 

Similar to the Modified Jones model, as detailed below, this study used, also, the Kothari model as an EM measure of discretionary accruals: 

There have been arguments in favour of performance-matched discretionary accruals models like the Kothari model. Proponents have suggested that performance matching on ROA controls for the effect of the performance on the measured discretionary accruals. Therefore, the use of the Kothari model increases the reliability of the EM results. Empirical studies suggest that the factors, which determine EM in emerging markets, depend on the model used to estimate the discretionary accruals (Charfeddine, Raheb & Omri, 2013). This result was supported by their investigation into the Tunisian market where they used the Modified Jones model, the Dechow Model (1995) and the Kothari model. In addition, empirical studies support the use of the Kothari model because there are no fraudulent activities associated with the use of this model in measuring EM (Jones, Krishnan & Melendrez, 2007). 

A key component of the traditional accruals measure of EM is its ability to be adjusted for the accruals performance when a firm's assets and performance are matched with the ROA and the industry index. In this respect, Kothari et al. (2005) explain that the inclusion of either ROA or ROA matching accruals can improve other models. Chen, Yang & Huang (2010) agree with this assertion but conclude, also, that the addition of the life cycle to the variables further improves these models. Therefore, it is evident that, as much as the Kothari model improves certain aspect of other models, other variables still need to be included in order for these measures of EM and their results to be completely reliable. 

There are limitations with the Jones model (1991) which relates total accruals to changes in sales, plant, property and equipment. This is because sales can be subject to how managers treat earnings (Arun et. Al., 2015; Gull et al., 2018). Consequently, in light of this limitation, the Modified Jones model suggests that managers use accruals to manipulate earnings since accruals are not easily detectable by stakeholders (Jones, 1991; Dechow, Sloan, Sweeney, 1995; Kothari, Leone & Wasley, 2005; Gull et al., 2018). Furthermore, short term accruals are always simpler to manage than long-term accruals (Becker et al., 1998; Arun et al., 2015; Gull et al., 2018). 

Table 1 : Articles on Earnings Management 

Number	Author/s and year	Region	Earnings management measured
1	Gull, Nekhili, Nagati&Chtioui, (2018)	France	Modified Jones (1995)
2	Ittonen, Va¨ha¨maa, and Va¨ha¨maa (2013)	Finland and Sweden	Jones (1991), Dechow  and Dichev (2002) models
3	Peni and Va ̈ ha ̈ maa (2012)	USA	Dechow and Dichev (2002) (DD model) and McNichols (2002) (modified DD model).
4	Osma & Noguer (2007)	Spain	Jones model (1991)
5	Talab, Flayyih, & Ali (2018)	Iraq	De Angelo (1986), Healy (1989), Jones (1991), Jones Rectifier, Modified jones (1995) and Beneish M-score models
6	Kumai & Bala (2015)	Nigeria	Modified Jones, Dechow 1995
7	Park & Shin (2004)	Canada	Jones 1991, Modified Jones 1995
8	Sanda, Garba & Mikailu (2008)	Nigeria	Modified Jones 1995
9	Azutoru et al. (2017)	Nigeria	Kothari 2005, modified Jones 1995
10	Mohd, Iskandar & Rahmat (2005)	Malaysia	Kothari 2005, Jones 1995,
11	Alareeni, B. & Aljuaidi, O. (2014).	Palestine	Yoon and Miller models
12	Neill et al (1995)	Korea	Jones 1991
13	Yoon and Miller (2006)	Bangladesh	Modified Jones 1995, Dechow 1995, Kothari 2005

Earnings management 

This study used EM that represents the absolute value of discretionary accruals that is measured by the Modified Jones model (1995) (Ittonen, Va¨ha¨maa, and Va¨ha¨maa, 2013). This study collected the data from the Capital IQ database and used excel software for the following calculation. 

Where  is the total accruals of firm i; AT is the total assets at the beginning of the year, ∆ 𝑅𝐸𝑉 is the revenues in year t minus the revenues in year t-1; ∆AR 𝑡 is the net receivables in year t less the net receivables in year t-1; and 𝑃𝑃𝐸 𝑡 is the gross property, plant, and equipment in year t. The a 1 , a 2 𝑎𝑛𝑑 a 3 are obtained by estimating the equation using each year and firm in the industry. 

The second one is the Kothari model (2005) (Ittonen, Va¨ha¨maa, and Va¨ha¨maa, 2013). 

Where  is the total accruals of firm i; AT is the total assets at the beginning of the year, ∆ 𝑅𝐸𝑉 is the revenues in year t minus the revenues in year t-1, ∆AR 𝑡 is the net receivables in year t less the net receivables in year t-1, and 𝑃𝑃𝐸 𝑡 is the gross property, plant, and equipment in year t. The a 1 , a 2 𝑎𝑛𝑑 a 3 are obtained by estimating the equation using each year and firm in the industry. In addition to a 4, ROA is the return on assets. This study uses time effects and the potential industry as dummy control variables. The Modified Jones and the Kothari models were chosen because, according to previous studies, the use of a different type of measurement for EM does not change the results (Jones, 1991; Dechow, Sloan, & Sweeney, 1995; Kothari, Leone, & Wasley, 2005). 

Limitations of Discretionary Accruals as EM Measures 

According to Jackson (2018), discretionary accruals measures have their limitations. He states that, although discretionary accruals are recognized as being noisy proxies for EM, they are still broadly used in literature. Discretionary accruals are not appropriate for measuring EM because of how they are calculated. Peer companies’ decisions tend to influence regression coefficients, and thus residuals, in accruals models, which might result in false calculations regarding EM in other companies. Overall, Jackson makes presents three reasons why discretionary accruals are inappropriate to measure EM. First, discretionary accruals are necessarily impacted by the conditional means of all variables in the model. Again, discretionary accruals amounts are generally not plausibly associated with the size of earnings (ROA). Lastly, discretionary accruals as EM measures lead to EM manipulation. 

References 

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