205
increase earnings in a later period and smooth income according to the circumstances that a company faces. DeFond and Park 1997 showed that management who tries to report
stable income flow reduces or increases profit through downward or upward earnings management when the current year‘s income is high or low.
Healy 1985 found that managers try to lower accounting income if reported earnings exceed a certain threshold at which their bonuses can be paid at the maximum.
Managers may also lower reported earnings when it does not reach a minimum threshold to deposit current earnings for future bonuses Healy 1985. The direction of earnings
management may correspond to managers‘ income smoothing incentives. However, Gaver et al. 1995, re-verifying the results of Healy 1985, reported that companies
experience upward earnings management when profit is less than the minimum incentive level.
24
To summarize prior studies, earnings management incentives move in different directions according to the level of earnings. Frank and Rego 2006 showed that earnings
management incentives differ according to the circumstances of the company. They investigated how management uses the valuation allowance of deferred corporate taxes
for earnings management. In particular, they divided earnings management incentive into three brackets: 1 profit before earnings management slightly smaller than zero, 2 profit
before earnings management much larger than zero, and 3 profit before earnings management much less than zero. They also demonstrated that earnings management
moves in different directions according to earnings management incentives.
24
Two studies examined situations with low reported earnings: Gaver et al. 1995 reported results identical to incentives for nominal zero earnings, while Healy 1985 supported the big bath argument. The results
from prior studies on the two incentives are generally mixed.
206
III. HYPOTHESES DEVELOPMENT
Earlier studies have shown that majority shareholders sometimes act against the
interests of minority shareholders, and that this behavior changes according to the
corporate ownership structure. The convergence-of-interests hypothesis claims that majority shareholders will not pursue activities that reduce the value of a company
because they have a vested interest as shareholders in its success, even more so as their proportion of ownership increases. However, the expropriation-of-minority-shareholders
hypothesis, which emphasizes information asymmetry between majority and minority shareholders, argues that companies tend to act in detriment to the wealth of minority
shareholders as the proportion of majority shareholders grows. These two opposite hypotheses can be applied only to accruals-based earnings
management. That is, majority shareholders may use discretion in their accruals to overstate short term performance and deceive minority shareholders with information
asymmetry between them. On the other hand, if the proportion of majority shareholders ownership increases, they pay more attention to the effectiveness of the business to
improve longer term performance. Klassen 1997 also suggested that the more shares majority shareholders hold, the more interested in cash flows rather than reported income.
However, referring to real earnings management, it is irrational for majority shareholders to allow real activity manipulation to raise current period net income,
because it will eventually impair their own wealth as well. After upward real earnings management, majority shareholders may suffer from a bigger loss in their own wealth than
minority shareholders. Therefore, we expect that real earnings management will decrease when the proportion of ownership held by majority shareholders is higher. Thus, our first
hypothesis, stated in an alternative form, is as follows:
207
Hypothesis 1: Companies with higher proportions of majority shareholder ownership reduce real earnings management.
Since Kahneman and Tversky 1979 many researchers have explained investors‘ behavior with the prospect theory. Shefrin and Statman 1985, for example, found that
investors tend to hold the stock when price declines while they sell the stock early when return is positive. They defined this asymmetric phenomenon as a disposition effect and
argued that it came from investors‘ greater tendency to avoid losses than to realize profits. This tendency implies an increase in disutility from experiencing wealth decline is greater
than that in utility from earnings profits. This asymmetric phenomenon is commonly described as the prospect theory.
The prospect theory can be applied to majority shareholders‘ behavior toward real earnings management. Real earnings management can be divided into upward and
downward earnings management. Prior studies have reported that upward real earnings management results in downturns in future performance. In contrast, downward real
earnings management does not impair long term operating performance and may in fact improve future performance while sacrificing reported earnings in the short-run. Gunny
2005 found that abnormal business decisions have adverse effects on operating performance. Mizik and Jacobson 2007 found that companies using upward real
earnings management showed significant decreases in stock price after they raised funds. Majority shareholders would be more interested in the long-term value of a
company since their wealth is more affected by firm value than minority shareholders. Thus, consistent with the prospect theory, majority shareholders with larger ownership
would be more sensitive to upward real earnings management resulting in worse operating performance in later periods. On the other hand, although there is an income smoothing
incentive that might lead to downward earnings management, the majority shareholders
208
with larger ownership are expected to be less interested in it. This is because downward real earnings management is likely to result in a greater operating performance in the long-
run. We, therefore, hypothesize that avoidance of upward real earnings management will be stronger than that of downward real earnings management when majority shareholders
have higher levels of ownership. Insert FIGURE 1 about here
This study utilizes three earnings management incentive brackets Frank and Rego, 2006, as shown in FIGURE 1: 1 upward earnings management, 2 downward earnings
management, and 3 ambiguous earnings management. Following Burgstahler and Dichev 1997 and Phillips et al. 2003, we first assume that companies with reported
earnings slightly greater than zero have a great incentive toward upward adjustment to avoid a deficit, and therefore classify these companies in the upward earnings
management bracket. Second, companies with earnings much greater than zero have a motivation for income smoothing, and are therefore classified as being in the downward
earnings management bracket. Third, companies with earnings much less than zero might be tempted not only to implement a big bath, which reserves earnings to improve future,
but also to reduce loss. Therefore, these companies are classified as being in the ambiguous earnings management bracket, with mixed upward and downward earnings
management incentives. Among these three brackets, in the upward earnings management incentive bracket majority shareholders monitor managers‘ opportunistic
activities more closely to protect their own wealth as the proportion of ownership rises.
Hypothesis 2a: In the upward earnings management incentive bracket, real earnings management is smaller when the majority shareholder
209
ownership is high compared to low majority shareholder ownership.
Hypothesis 2b: In the downward earnings management incentive bracket, real
earnings management is indifferent between high majority shareholder ownership and low majority shareholder ownership.
Hypothesis 2c: In the ambiguous earnings management incentive bracket, real earnings management is indifferent between high majority
shareholder ownership and low majority shareholder ownership.
IV. RESEARCH DESIGN AND DATA COLLECTION 4.1 Real Earnings Management Estimation Model
Real earnings management can be divided into three categories: 1 sales, 2 production, and 3 expenses. First, from a sales perspective, management can execute
abnormal promotional events and discounts and can ease credit policy to increase the accruals-based accounting profit of the current period. However, although offering
discounts will increase the accounting profit of the current period, it may damage long-term brand power and increase bad debt in the future. Second, from a production perspective,
management can increase production to lower fixed overhead costs per unit, which in turn will decrease the cost of goods sold. Although this can increase accruals-based
accounting earnings in the short term, the value of the company will decrease due to inventory maintenance costs and deterioration. Third, discretionary expenses are directly
connected to profit and loss. Therefore, management can reduce the current period‘s advertising expenses, RD expenses, education and training expenses, and fringe benefit.
Although this might i mprove the current term‘s profit, it will reduce long-term brand
awareness and quality of product and result in the drain of talents, thereby decreasing the quality of employees.
These changes in management activity can be measured by three variables: 1 cash flow from operations CFO, 2 production costs PC, and 3 discretionary
210
expenses DE. CFO is affected by changes in all three categories mentioned above. Discounts and increased credit sales will reduce cash flow compared to sales with regular
prices and credit policies. Moreover, increased production will increase labor costs, material costs, and cash expenses, which in turn will reduce cash flow from operations.
Although cost reduction reduces cash expenses, which is expected to increase cash flow, cost reductions in sales management or research and development can also reduce sales
in the current term. Therefore, increased cash flow from reduced costs leads to decreased cash flow due to a reduction in sales. From a sales and production points of view, CFO will
be reduced per regular sales. From a cost reduction standpoint, CFO will not increase or will increase only slightly. Therefore, even though cash flow could increase or decrease, it
is rational to expect a general decrease in cash flow because the effect from sales and production is great.
PC can be divided into two categories: cost of goods sold COGS and inventory. COGS will be reduced because of reduced fixed costs. However, it can increase as sales
decrease. Moreover, management can increase production until the cost of inventory does not exceed the amount of decreased COGS if attempting earnings management. In
addition, DE will decrease as research and development expenses and advertisement expenses decrease.
We adopted the Roychowdhury 2006 model to estimate real earnings management: abnormal cash flow from operations ACFO, abnormal production costs
APC, and abnormal discretionary expenses ADE. The abnormal portion of each variable is calculated by subtracting the estimated value from the actual value. Equations
1 to 3 are used as estimation models, and were introduced by Roychowdhury 2006 based on Dechow et al. 1998. Moreover, each model was estimated through cross-
211
sectional analysis according to industry and year to reflect the characteristics of each industry and year.
t t
t t
t t
t t
A S
A S
A A
CFO
1 3
1 2
1 1
1
1
1
t t
t t
t t
t t
t t
A S
A S
A S
A A
PC
1 1
4 1
3 1
2 1
1 1
1
2
t t
t t
t t
A S
A A
DE
1 1
2 1
1 1
1
3 where CFO
Cash flow from operations; DE
RD + Advertising + Selling, general, and administrative SG A expenses;
PC Cost of goods sold + Change in inventory;
A Total assets; and
S Sales.
In the estimation model, upward earnings management will result in decreased CFO, increased PC, and decreased DE. In order to align the direction of metrics of real activity
manipulation with the same direction in equations 4-6, we multiply ACFO and ADE by negative one. After this operational manipulation, all the metrics representing real earnings
management, namely ACFO, APC, and ADE, are positively related with upward real earnings management. In addition, to capture the effects of real earnings management for
all three variables in a single comprehensive measure, we compute a single variable by combining the three individual real earnings management variables. Specifically, we
compute REM as the sum of the individual variables, ACFO, APC, and ADE Cohen and Zarowin, 2008; Cohen et al., 2008.
1
t
ACFO
Residual from the estimation model of equation 1 4
t
APC
Residual from the estimation model of equation 2 5
1
t
ADE
Residual from the estimation model of equation 3 6
t t
t t
ADE APC
ACFO REM
7
4.2 Classification of earnings management
212
Upward earnings management can worsen the future performance of a company, while downward earnings management can improve it. Burgstahler and Dichev 1997,
who reported an extraordinarily high frequency of companies with earnings slightly greater than zero, interpreted this phenomenon as a result of upward earnings management in
companies trying to avoid reporting losses. This finding may reflect investors‘ tendency of being more sensitive to bad news as suggested in Shefrin and Statman 1985.
Insert FIGURE 2 about here We measured earnings level by dividing the net income NI of a total of 6,440
firm-year samples by total assets at the beginning of the period from 1991 to 2007 and then classified these observations by their earnings levels in terms of increments of 0.005
to derive their distribution. As shown in Figure 2, a great asymmetry exists between the companies with earnings slightly greater than zero and those with earnings slightly below
zero. There were 69 companies in the earnings bracket of -0.01 to -0.005 and 74 in the bracket of -0.005 to zero, which is considerably lower than the number at the slightly
higher earnings level than zero. Specifically, 462 companies were in the bracket of 0 to 0.005, and 485 fell into the bracket of 0.005 to 0.01. This indicates that the two groups of
companies divided using the criterion of zero earnings level have considerable differences in the number of group members. Thus, consistent with Burgstahler and Dichev 1997
and Phillips et al. 2003, this supports the idea that companies with NI slightly less than zero report a surplus by using upward earnings management.
We assigned the companies that use upward earnings management to avoid reporting loss to bracket EM1, where the value of NI divided by total assets at the
beginning of the current period is slightly greater than zero. More specifically, we defined a
