CHAPTER II THEORETICAL BACKGROUND AND THE HYPOTHESIS
DEVELOPMENT
2.1 Earnings Management 2.1.1
Definition and Motivations of Earnings Management
Earnings management is defined as the choice of managers over accounting policies, or real actions, affecting earnings to achieve some
specific earnings objectives Scott 2012, page 423. Based on earnings management motivation, earnings management can be divided into two
categories; good earnings management and bad earnings management Scott 2012, page 422.
A. Good earnings management informational earnings management Good earnings management stems from the idea that earnings
management is useful to communicate information within firms to external parties Wardani and Kusuma 2011. Managers as agents usually obtain
specialized information within firms, to informed every detail information to principal, it will costly Scott 2012, page 436. Principals do not know
everything about firms, so it is easier for them to understand the general picture of firms’ performance. According to Demski and Sappington 1990,
managers typically have inside information related to firms’ future performance, it conveys in operating cash flows or even earnings. The inside
information can be the new firms’ strategies, changes in firms’ characteristics or changes in market condition. Because the complexity to communicate
2.1 Earnings M Management
2.1.1 De
Definition and Mot t
iv i
at a
io io
ns ns
o o
f f
Ea Ea
rn r
ings Managem ment
Earnings s
ma ma
na na
gement is defined d
as as
t the
he c choice of m
m an
an agers over
accoun un
ti ti
ng ng
p policie
e s,
s, o
r re al act
io ns, affe
ct t
in in
g g
earnin ngs
gs t to
o achiev ve
e some
sp sp
ec ec
if if
ic ic
ear ar
n ni
ng s
objectives Sc ot
t 2012, page 4 23
3. .
Based d
on on
earni nings
ma ma
nage ge
me nt motiv
atio n, earning
s manage
ment can be
di d
vide e
d d
in in
to tw wo
cate e
g go
ries; good earning s
manage me
nt and b
ad earnings ma na
a ge
g me
me nt
nt Sc
S ott
t 20
12 , page 4
22 .
A A.
Good earnings m anag
em ent inf
or mati
on al
earnings mana g
gement t
Go od
ear ar
ni ni
ng ng
s s
ma ma
nagement ste e
ms ms
f f
ro ro
m m
th e
id ea
t ha
hat t earnin
n gs
gs management is useful to comm
m un
un ic
ic a
ate information within firms to exte tern
rn a
al pa
pa rties Wardani and Kusuma 2011. Managers as agents usua
ua ll
lly y
ob ob
ta tain
spec i
ia li
li ze
ze d
d i
in fo
form rm
at atio
ion wi i
th th
in in f
fir ir
ms ms
, ,
to to
i informe
med d
ev ev
ery de
de t
ta il
il i
infor r
ma ma
ti ti
on to pr
pr in
in ci
i pa
l, l, it
t wi
wi ll
costly Sco cott 2012,
2, page 436. Pr
Pr in
in cipa
p l
ls d d
o o not know
everything about firms, so it is easier
r for them to understand the general picture of firms’ performanc
c e.
e Accordi
ding to Demski and Sappington 1990, managers typically have in
n si
s de
information related to firms’ future performance, it conveys in operati
ti ng cash flows or even earnings. The inside
overall information directly to the investors, the choice and disclosure over discretionary accruals are viewed as options to reveal the information Scott,
2012. B.
Bad earnings management opportunistic earnings management Bad motivation can lead managers to do earnings management
opportunistically Scott 2012, page 442. The motivation can be various, some motivation stem from the positive accounting theory.
1. The bonus plan hypothesis
According to Watts and Zimmerman 1986, managers’ firms with bonus plan, tend to choose accounting procedures that shift reported earnings
from future period to current period. This act is based on theory that, when the given bonus planremuneration, at least in part, depends on the reported
net income, managers who want high bonus planremuneration
1
, will response with the increased current reporting earnings. Healey 1985 also
argue that managers would manage to maximize the net income in order to maximize their bonuses under firms’ bonus plan.
2. The debt covenant hypothesis
According to Watts and Zimmerman 1986, the closer firms towards violation of debt-covenants, the more likely managers will choose accounting
procedures that shift reported earnings from future period to current period. Most debt agreements contain covenants that borrowers must comply with.
For instances, during the term of agreement, borrowers have to maintain If managers have the risk-averse nature, they tend to smooth reported earnings since a
less variable bonus stream has higher expected utility than a volatile one B.
Bad earnings man n
ag ag
e ement oppor
or tu
tu nistic earnings management
Bad mo o
ti tivation can lead managers to
do do
earnings management opportun
un i
istically Scott 201 2,
2, p
p ag
g e
e 44
44 2.
. The motivatio
on n
can be various, so
o m
me motivation n
st st
em em
from th
e positive acc cc
ou ount
nt in
ing g theory.
1. 1.
The e
b bo
nus plan hypothesis A
Ac cording to
W atts and
Z im
merman 19
86, man ag
agers’ ’
f f
ir ir
ms wit th
h bonu
u s plan, tend to choo
se accou
nt ing proc
ed ures that shift re
po ported
d e
e ar
ar ni
n ngs
fro om
future pe ri
od to curr
en t
pe riod
. Th is
act is ba sed
on the or
y y that, when
en th
h e
given bonus planr emun
er ation, at
le ast in
part, depends on t
the repo ported
d ne
ne t
t in
come, ma
a na
na ge
ge rs
rs w
w ho want high
gh b
b on
on us
us p
p lan
remune ra
a ti
tio on
1
, wi wi
ll ll
response with the increased cu cu
r rren
n t
t reporting earnings. Healey 1985 al
al s
so ar
ar gu
gu e that managers would manage to maximize the net income
e in
in o o
r rd
er er
to maxi
i i
mi ze
ze t
t he
he ir
ir b
bon onus
us es
und nd
er er f
f ir
irms ms
’ ’ bo
bon nus pl
l an
an .
2 2.
T The de
de bt
bt covenant hy y
p pothesis
According to Watts a and Zimme
erm r
an 1986, the closer firms towards violation of debt-covenants,
t the more li
likely managers will choose accounting procedures that shift reported e
earnin ngs from future period to current period.
Most debt agreements contain cov o
enants that borrowers must comply with.
specified levels of interest coverage, debt-to-equity, working capital, or even shareholders’ equity. If the covenant is violated, in consequence, there will be
penalties, such as constraints on dividends or constraints to additional borrowing. Those penalties subsequently can restrain managers to manage
firms. Managers who want to prevent the penalties will choose accounting procedures to raise current earnings. DeFond and Jiambalvo 1994, provide
the evidence about the using of income increasing discretionary accruals in the year prior and to lesser extent in the year of covenant violation.
2
3. The political cost hypothesis
According to Watts and Zimmerman 1986, the greater the political costs that are faced by firms, the more likely managers will choose
accounting procedures that shift reported earnings from current to future period. The larger the firm’s are the more profitable the firms are, the higher
the political costs will be imposed. Because the firms attract media and consumer attention, in consequence, it attracts the politician to publish new
taxes or other regulations. Another factor, a competition with foreign company, will also make
managers to choose the accounting procedures to decrease the current reported income. The goal is to convince the government that firms’ profit
suffers and the grant about import protection can be applied. 4.
Seasoned-equity Offerings Marquardt and Wiedman 2004 Motivation to manage earnings also comes from managers who own
stocks and can sell them due to seasoned equity offerings Marquardt and Not all managers want to increase current earnings, because it means increase the
volatility of earnings, thus, increase the probability of future covenant violation borrowing. Those penalti
ti es
es s ub
sequen n
tl tl
y y
can restrain managers to manage firms. Manager
r s
s who want to prevent the penalt t
ie ie
s s
will choose accounting procedur
ur e
es to raise current t
ea a
rn rn
in i
gs gs.
. De
De Fo
o nd and Jiambal
alvo v
1994, provide the
e evidence abo
bo ut
ut the
he using of income
i inc
nc re
reas as
in ing
g discretionar
r y
y accruals in the ye
e ar
ar p pri
ri or
o and t
t o
o le
le sser extent
in the year
of of c
c ov
o enan
nt t
vi vi
ol ol
at a
ion.
2
3. 3.
The e
p po
litica l
cost hypothe sis
A Ac
cording to W
atts and Z im
merman 19
86, the g re
eater t t
he he
politic al
a cost
t s
s that are faced
by firm
s, the mor
e likely manager
s s
wi i
l ll c
c ho
ho ose
ac c
co unting
p ro
ce du
res th at
s hift
r ep
or te
d earnin gs
f ro
m curr e
ent to futur ure
e pe
e riod. The larger the
firm’ s
ar e the m
or e prof
it ab
le the firms a re
e, the hi highe
er th
th e
e po
li ti
ca l
co st
st s
s wi
wi ll
ll b
b e
e imposed. Bec
ec au
au se
se t
t he
he fir
ms attra ct
t m
media a a
nd nd
consumer attention, in consequ u
e ence
ce ,
it attracts the politician to publish
h ne
ne w
w ta
ta xe
x s or other regulations.
An An
ot ot
h he
r r
fa fa
ct ctor
or, a co o
mp mpet
etit it
io io
n n wi
wi h
th f f
or r
ei ei
gn gn c
c om
pa pa
ny ny,
i will a
a ls
ls o
o m
make ma
managers t t
o o choose the ac
ccounting g procedures
t t
o o
de d
crease e
t t
he he current
reported income. The goal i
is to convin ince the government that firms’ profit
suffers and the grant about im mport prote
tection can be applied. 4.
Seasoned-equity Offering ngs M
Marquardt and Wiedman 2004 Motivation to manage ear
r n
nings also comes from managers who own
Wiedman 2004. Managers can use their position to influence the firms’ financial reporting, giving them opportunity to manage earnings Marquardt
and Wiedman 2004. The objective is to sell managers’ stocks at higher price in seasoned equity offerings.
2.1.2 MethodsMechanism of Earnings Management
Earnings management can be managed either through accounting accrual or real activities.
1. Accruals earnings management
The measurement of accruals earnings management itself, originally, is through total accruals. It is because accruals earnings management focuses
on the choice of accounting policies. A particular model is then assumed to generate the non-discretionary component of total accruals, thus, it allows
total accruals to be divided into non-discretionary accruals and discretionary accruals Dechow et al. 1995.
Healey 1985 and DeAngelo 1986 model fit well for an assumption that non-discretionary accruals is constant over time. However, Kaplan
1985 argues that non-discretionary accruals is not constant over time, it changes to response the changes in economic circumstances. As a result,
there is a need to propose a new non-discretionary accruals model, and the Jones model set in place.
Jones 1991 model attempts to control the effect of changes in firms’ economic circumstances on non-discretionary model. The Jones model for
non-discretionary accruals can be seen below. NDA
߬ = ߙ
1
1A ߬
– 1
+ ߙ
2
ᇞREV߬+ ߙ
3
PPE ߬
in seasoned equity offerin n
gs gs.
2.1.2 Method
d s
s M
Mechanism of Earnings Manage geme
m nt
Ea Earnings managem
me ent
t ca
c n
n be
be man
an aged either
th th
ro r
ugh accounting ac
c cr
crual or real ac c
ti t
vi vi
ti i
e es.
1. Ac
Ac cr
cr u
uals ear ar
ni ni
ng s
ma nagement
The e
m me
asur em
ent of acc rual
s earnings m an
ag em
ment i
itse se
lf lf
, ,
or o
igin n
al a
ly, is
is t
throu u
gh total accru al
s. It is bec au
se accrual s
earnings m an
nagem men
en t
t focuse es
on t t
h he
c hoice of accou
nt ing poli
cies . A p
ar ticular model is
the hen as
as su
su me
me d to
ge e
n ne
rate the n on
-discretio na
ry c
om po
nent of to
tal ac
cruals, th u
us, it allow ws
s to
o ta
l accruals to be div ided
i nt
o non-di sc
reti on
ary accruals and d
discretio onary
ry ac
ac cr
c ua
ls Dech
ow w
e e
t t
al al.
19 19
95 9
. Healey 1985 and DeAn
An ge
ge lo
lo 1986 model fit well for an assump
mp ti
tion on
th th
at non-discretionary accruals is constant over time. Howev v
er er, Ka
Kapl pl
an 1
98 98
5 5
a a
rg rg
ue ues
th th
at at
n non-d
d i
is cr
cr et
etio iona
nary ry a
accrual l
s s
is is
n n
ot ot
c on
on st
st an
t t over
er t
t im
im e, it
ch ch
an an
ge g
s to r r
es esponse the ch
h an
anges in e economic circum
umstances. A As a result,
there is a need to propose a a new non-
-discretionary accruals model, and the Jones model set in place.
Jones 1991 model attem empts
s to control the effect of changes in firms’
economic circumstances on non- d
discretionary model. The Jones model for
Explanation: A
߬
– 1
: total assets at ߬
– 1
ᇞREV߬ : revenue in year ߬ minus revenue in year ߬
– 1
scaled by total assets at
߬
– 1
PPE ߬
: gross property, plant, and equipment in year ߬ scaled by
total assets at ߬
– 1
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms specific parameters
The assumption used is that revenue is part of non-discretionary accruals. However, some part of revenue is established by managers’ discretion. There
is probability that managers accrue revenues when cash is not yet received at the year-end, thus it will be questionable whether revenues have been earned
or not Dechow et al. 1995. If revenues is accrued, but not yet earned, the revenues amount and total accruals receivables are more likely to be
increased Dechow et al. 1995. To adjust with the assumption that not all revenues are non-
discretionary accruals, the modified Jones completed the model. NDA
߬ = ן
1
1 A ߬
– 1
+ ן
2
οREV߬- οREC߬ + ן
3
PPE ߬
Explanation: A
߬
– 1
: total assets at ߬
– 1
ᇞREV߬ : revenue in year ߬ minus revenue in year ߬
– 1
scaled by total assets at
߬
– 1
οREC߬ : net receivables in year ߬ minus net receivables in year ߬
– 1
scaled by total assets at ߬
– 1
PPE ߬
: gross property, plant, and equipment in year ߬ scaled by
total assets at ߬
– 1
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms specific parameters
The assumption prevails is all changes in credit sales results from earnings management Dechow et al. 1995. It is easier to manage earnings through
g p p
y y
, p ,
q p y
y total
l as
as se
ts at ߬
– 1 –
ߙ
1
ǡ ߙ
2
ǡ ߙ ߙ
3 3
: :
f firms specific parameters
The assu su
mp tion used is tha
ha t re
e ve
ve nu
nu e
e is
i p
p art of non-discr
cret e
ionary accruals. Ho
Ho we
ver, some pa
part rt
o o
f revenue is establi h
sh ed
ed b
b y
y ma
m nagers’ disc
c re
re tion. There
is proba babi
bili i
ty ty
that m ma
na gers accru
e revenu
es w w
he he
n cash h i
is s
no not
t yet rece
ceived at th
th e
e ye ye
a ar-end
nd ,
th us i
t will be questi
on able wheth
er rev
en n
ue u
s ha ha
ve ve b
bee ee
n ea a
r rned
or not De
chow et al
. 1995. If
re venues is
ac crued, but n
ot ot yet
t e
ear arned, th
he reve
e nu
es amount and to
tal ac cr
ua ls re
ce iv
ables are mor e
like ke
ly ly
t t
o o be
in c
cr eased D
ec how
et al. 1 99
5 .
To adjust wi th
the assumpt io
n th at not all revenue
s s are
non n-
di di
s sc
re ti
onary ac
c cr
cr ua
ua ls
ls, th
th e
e mo
m dified Jones
es c
c om
om pl
pl et
et ed
ed t
he m
od el.
NDA ߬ = ן
1
1 A ߬
– 1
1 –
+ +
ן ן
2
οREV߬- οREC߬ + ן
3
PPE ߬
Explanation: A
A ߬
– –
1 1
– –
: :
t t
ot al ass
et et
s s
at at
߬ ߬
– –
1 1
– –
ᇞ ᇞRE
REV V
߬ ߬
: : revenu
u e
e in y
y e
ear ߬ mi
minus reve ve
nu n
e in
in y
y ea
ea r
r ߬
߬
– 1
–
sc scaled by
total asse e
ts t
at ߬
– 1
1 –
οREC߬ : net recei i
v vables in
ye y
ar ߬ minus net receivables in year ߬
– 1
scaled by total ass
sets at ߬
– 1 –
PPE ߬
: gross pr roperty, pl
a ant, and equipment in year
߬ scaled by total asse
ets at ߬
– 1 1
–
ߙ
1
ǡ ߙ
2
ǡ ߙ
3
: firms spe ecific p
p a
arameters
The assumption prevails is all changes in credit sales results from earnings
discretion over revenue recognition on credit sales than cash sales Dechow et al. 1995.
2. Real earnings management
Real earnings management uses real activities manipulation to manage earnings. Roychowdhury 2006 defines real activities manipulation
as departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial
reporting goals have been met in the normal course of operations. It usually results in abnormal cash flow from operation, discretionary expenses, and
production costs. There are three manipulation methods that raise the abnormal value;
sales manipulation, reduction of discretionary expenses, and overproduction Roychowdhury 2006.
A. Sales manipulation
Sales manipulation is an attempt by managers to increase sales temporarily through price discount offer or more lenient credit terms
Roychowdhury 2006. The price discount offer will likely to retain higher current sales because higher current sales volume. However, the increased
sales volume will disappear, as the old price is re-established Roychowdhury 2006. The consequence, it will make the lower future cash flows because
customers expectation regard future discount price Wardani and Kusuma 2011. The higher the sales volume, the lower the margins, thus it will make
the production costs relative to sales to be abnormally high. Real earnings ma
ma n
nagement u u
se se
s s
real activities manipulation to manage earning
ng s
s. Roychowdhury 2006 defines r r
ea ea
l activities manipulation as depar
ar tu
tures from norma a
l l
op o
er e
at at
io io
na na
l l
pr pr
actices, motiv at
at ed by managers’
de e
si sire to mislea
a d
d at at
l l
e east some stakeh
h l
ol de
de r
rs i int
nto o
b believing cert
rtai a
n financial report
t in
ing g go
go a
als have ve
b b
een met in the
norma l
l co
cour u
se of f op
op er
er at
a ions. It
It usually re
e su
sult lts
s in a
a bn
bn orma
l cash flow
fr om
operation, disc re
ti ti
onary y
ex ex
pe pe
ns n
es, and
pr pr
o oduc
c ti
ti on
costs. Th
ere are three ma
nipula tion
metho ds
that raise the ab
b no
n rm
m al
al v
v al
a ue;
sa l
le s manipu
la ti
on , reduct
ion of
dis cr
et io
nary exp en
se s, and o
ve erpro
d ductio
on n
R R
oychowdhury 2006 .
A. A.
Sa le
s ma ni
ni pu
pu la
la ti
ti on
on Sales manipulation is
a an
a a
t ttempt by managers to increase
s s
al al
e es
te te
mp m
orarily through price discount offer or more lenient c c
re re
d dit
t te erm
rms R
oy h
ch ow
ow dh
dhury y 20
20 06
06 . T
he he
p pri
rice ce
d dis
isco count
of of
fe fe
r r
wi wi
ll ll
l l
ik ik
el el
y t
to retai ai
n n
hi higher
cu cu
rr rr
ent sale le
s s
be because higher
r current
s sales volume.
H H
ow ow
ever, th th
e e increased
sales volume will disappear, as the old p
price is re-established Roychowdhury 2006. The consequence, it
w w
ill make e the lower future cash flows because
customers expectation regard f
f utur
r e
e discount price Wardani and Kusuma 2011. The higher the sales volume
m , the lower the margins, thus it will make
Another method to boost sales is through more lenient credit terms. The more lenient credit terms, the lower cash inflow regards with the future
receivable collectability Wardani and Kusuma 2011. It can be concluded that sales manipulation results higher production cost and lower current
period CFO than the normal level Roychowdhury 2006. B.
Reduction of discretionary expenses Managers will reduce the discretionary expenses RD, advertising,
and SGA expenses because they do not generate immediately revenue and income. It will result in unusually low discretionary expenses, and if it is in
the form of cash, it leads to lower cash outflows Roychowdhury 2006. In the end, it gives positive effect on abnormal cash flow from operation in the
current period Roychowdhury 2006. C.
Overproduction Overproduction means lower fixed costs per unit, hence, reduction in
total cost per unit. In the income statement, it will affect the cost of goods sold number; it becomes lower and firms report higher operating margins.
The incremental marginal costs incurred in producing more inventories, results in higher annual production costs relative to sales Roychowdhury
2006.
2.1.3 Patterns of Earnings Management
Earnings management doing creates some patterns. Those patterns are listed below.
A. Taking a bath
that sales manipulation re re
s su
lt s high
h er
r p
p roduction cost and lower current
period CFO tha a
n n
t the normal level Roychowdhury
2 2
00 6.
B. Re
Reduction of discret t
io i
na na
ry ry
e e
xp xp
en en
se e
s s
Managers rs
w w
il i
l l
reduce the discr et
io i
na n
ry ry
e e
xp xpenses RD
D ,
advertising, and SG
G A
A e expense
se s
s b
bec ause the
y do not g
en n
er er
at a
e imme me
di di
at at
ely reve enu
n e and
in in
co co
me me
. It w
w il
l re su
lt in unusuall y
low discretion ar
y ex
xpe p
nses ,
, an and
d if it
is i
in th
th e
e form rm
of cash, it lea
ds to lowe r
cash out fl
ow s Roych
ow wdhur
ry y 20
2 06. I
I n
n th
e e en
d, it gives positive effect on
abnorma l
cash flow from o
p perati
ti on
on i
i n
n the cu
u r
rr ent period
Ro ychowd
hu ry
2 00
6 .
C .
Overproduction Ov
erpr od
d uc
uc ti
ti on
on m
m ea
e ns lower fixed
ed c
c os
os ts
ts p
p er
e u
nit, h ence,
re red
duction n
in in
total cost per unit. In the inco o
m me s
s ta
tatement, it will affect the cost of g goo
oo d
ds so
so ld number; it becomes lower and firms report higher operatin
n g
g ma marg
rgin ins.
The i
in cr
cr em
emen ta
ta l
l ma ma
rg in
al l
c c
os osts
ts i inc
ncur urre
d i
in p
p ro
ro du
du i
ci ng
ng more in n
ve ve
nt nt
o ories,
re re
su su
lts i
in h h
ig ig
he her annual pro
o du
d ction
c costs relative
t t
o o
sa sa
les R
Roy oy
ch chowdhury
2006.
2.1.3 Patterns of Earnings s Managem
ement
Earnings management do doing
g creates some patterns. Those patterns are
listed below.
When firms have to report loss, it is most likely that managers will report a large amount of loss. Managers do this to enhance the probability of
future reported profits, because of the accruals reversal. Accruals reversal means that when managers report greater amount of loss in current period, the
subsequent period will force the future earnings upwards Scott 2012, page 425.
B. Income minimization
Managers will do income minimization during the period of high profitability. Managers do not want to report the high income for some
reasons; income tax is one of the reasons Scott 2012, page 425. C.
Income maximization Managers will do income maximization for bonuses purposes and to
hinder from the violation of debt covenant Scott 2012, page 425. D.
Income smoothing Income smoothing makes the less volatility less variable of income
numbers Fudenberg and Tirole 1995 in Bao and Bao 2004. However, not all smoothed income results from earnings management. Albrecht and
Richardson 1990 in Bao and Bao 2004 classify two types on income smoothing; natural and intentional smoothing. Natural smoothing is natural
result from income-generating process no manipulation. Meanwhile, intentional smoothing refers to real smoothing managers’ change of the
economic event and artificial smoothing managers’ change of the timing of accounting entries. It can be concluded that the intentional smoothing results
from earnings management. means that when manage
g rs
rs r
r ep
ort grea te
te r
r am
a ount of loss in current period, the
subsequent per r
io io
d d will force the future earnings u
u pw
pw ards Scott 2012, page
425. B.
. Income m
m in
in im
im i
ization Ma
Ma na
na gers w
w il
il l
l do
income minimiza ti
ti on
on durin
ng g th
th e
e period
o o
f high pr
pr of
ofit itab
ab ility.
y. M
an ag
ers do not w an
t to report th
e hi
high g
incom om
e e
fo f
r so some
re re
a asons
s; income tax
is one of the
re asons Sco
tt 2
012, page 42
425. C.
In come maximiz
at ion
Manage rs
will do i
nc om
e ma
xi mi
za tion for
b onuses p
ur p
poses and to to
hi i
nd er from the violat
io n of
d ebt covena
nt Sc
ott 2012, page 425
. D.
D. In
come s
mo mo
ot ot
hi hi
ng ng
Income smoothing mak akes
es t t
he he
less volatility less variable of inc ncom
ome nu
nu mbers Fudenberg and Tirole 1995 in Bao and Bao 2004. How
w ev
ever r
, ,
no no
t al
l smoo
th th
ed ed
i inc
om ome
e result
lt s
s fr
fr om
om e
ear ar
i nings
ma mana
na ge
ge me
me nt
nt. A
Albr r
ec echt
ht and
Ri Ri
ch ch
ar d
dson 19
1990 in Bao a a
nd n
Bao 2004 classi
i fy
fy t
t wo
w typ
p es
es o
on income smoothing; natural and inte
entional smo oothing. Natural smoothing is natural
result from income-generat ating proc
cess no manipulation. Meanwhile, intentional smoothing refers t
t o
o rea
al smoothing managers’ change of the economic event and artificial sm
m o
oothing managers’ change of the timing of
Income smoothing feature attracts many users to utilize it. Managers that are risk averse, tend to smooth earnings to get constant
bonuscompensation Scott 2012. Not only managers, but also investors also prefer less variability of income numbers because it is less risky McInnis
2010. In this context, the earnings management method used is accruals
earnings management. Previous research documented the mean of accruals earnings management in Indonesia and Philippines are higher compare to
Malaysia, Singapore, and Thailand Wardani and Kusuma 2011. It can be interpreted that accruals earnings management is mostly used in Indonesia
Wardani and Kusuma 2011. According to Leuz 2003, when the investor protection in certain
country is weak, it will result into high probability of private benefit control phenomenon. In turn, the frequency of earnings management happens will be
high. Looking at Indonesia country, Indonesia can be classified as weak
investor protection country
3
. Furthermore, the characteristic of concentrated ownership makes Indonesia vulnerable to private benefit control
phenomenon
4
. As a result, the chance of doing earnings management in Indonesia is quite open wide.
Leus 2003 implicitly indicates that Indonesia is classified as weak investor protection country
Benos and Weisbach 2003 in Hwang 2004 define private benefit control as “benefits that accrue to managersshareholders that have control over firms, but not to minority
shareholders”. It prevails in the firms with concentrated ownership. prefer less variability of
f i
i nc
ncome numb mber
er s
s because it is less risky McInnis
2010. In
In this context, the
e e
e ar
ar ni
n ng
ng s
s ma
m na
na gement metho
d d
used is accruals ea
a rn
rnings manag g
em emen
en t.
t Previous research
h d
doc oc
um um
en ented the mean
n of accruals earnin
n gs
gs m
m an
a agem
m en
en t
t in
Indonesia and P hi
i li
li pp
pp ines a
are re h
h ig
ig her comp
mpare to Ma
Mala lays
ys ia, Si
Si ng
ap or
e, and Thail an
d Wardani and K us
s um
u a
20 2011
11 .
. I
I t ca
n n be
in in
te terpre
re te
d that acc
rual s earnings managemen
t is mostly
us used
i i
n n In
In donesi
sia W
ar ar
da ni
and Kusuma 2011. Acco
rd in
g to Leu z
2 00
3, wh
en the inv
es to
r protecti o
on in certai ain
n co
o un
try is weak, it wi
ll res ul
t into hig h
probab il
ity of private b en
nefit con ontro
ol ph
ph en
omenon. In
t t
ur ur
n n,
t t
he he
f f
requency of ea a
rn rn
in in
gs gs
m m
an a
ag ement
ha pp
ppe ens will
l b
be e
high. Looking at Indonesia country, Indonesia can be classifie
ie d
d as as w
we eak
inve t
stor p
p ro
ro t
te ct
ct io
io n
n co country
3 3
. Fu Furt
rt he
herm rm
o ore, t
he he
c c
ha ha
ra ra
t ct
er er
is is
ti tic
f of con
n ce
cent nt
rated ow
owners h
hip p
m ma
ke s Indone
si si
a vuln n
e erable to pr
r iv
iv at
at e
b bene
ne fi
fi t
t control phenomenon
4
. As a result, ,
the chanc ce of doing earnings management in
Indonesia is quite open wide.
It is quite relevant that earnings management happen in Indonesia because the listed factors. However, if the question address to which is
dominant, opportunistic or informational earnings management, it is still quite mixed. Siregar and Utama 2008 found that earnings management in
Indonesia tends to be informationalefficient because of a high proportion of family ownership. Another finding, earnings management is present around
initial public offering IPO and the operating performance and stock returns subsequently underperformed Saiful, 2004. It implicitly indicates the
opportunistic earnings management. In this research, the opportunistic earnings management is the lead.
2.2 Value Relevance of Earnings 2.2.1
Financial Statement and Financial Reporting
SFAC number 1 paragraph 6 and 7 stated the description of financial statement and financial reporting as follows.
Financial statements are a central feature of financial reporting. They are principal means of communicating accounting information to those outside
an enterprise.
Financial reporting includes not only financial statements but also other means of communicating information that relates, directly or indirectly, to
the information provided by the accounting system-that is, information about an enterprise’s resources, obligations, earnings, etc. Management may
communicate information to those outside an enterprise by means of financial reporting other than formal financial statements either because the
information is required to be disclosed by authoritative pronouncement, regulatory rule, or custom or because management considers it useful to
those outside the enterprise and discloses it voluntarily. quite mixed. Siregar and
d U
U ta
tama 2008 08
fo fo
und that earnings management in Indonesia tends
s to
to be informationalefficient becaus use of a high proportion of
family o o
w wnership. Another
r fi
i nd
nd in
i g,
g, e
e ar
ar ning
n s management
nt is present around init
it i
ial public off ffe
erin in
g g
IPO and the operatin in
g g
pe pe
rf rfo
ormance and d
st s
ock returns subseq
q ue
ue nt
nt ly
ly under
er p
perf ormed Saiful,
200 4
4 .
It imp mp
li li
ci ci
tl tl
y y
indica ates the
op op
po po
rt rt
u unisti
ti c
c earnings managem
en t. In this
r es
ea rc
ch, h
t t
h he
o opp
pp or
o tuni
nistic ea
ea r
rning gs
managemen t
is the lead.
2.2 2
Value R elev
ance of Ea rn
in gs
2. .
2. 1
Financial Stat em
en t
an d Fina
nc ia
l Re porting
SF AC
n um
um be
be r
r 1
1 pa
pa ragraph 6 and
d 7
7 st
st at
at ed
ed t
t he d
escr ip
ti on
n o
o f
f financ c
ia al
l statement and financial reportin
in g
g as s
f follows.
Fi Fi
nancial statements are a central feature of financial reportin n
g. g.
T The
hey y
a are
pr prin
in cipa
p l l means
of of c
c om
om mu
mu ni
ni ca
c ting acc
cc ou
ou nt
nt in
ing g in
in fo
form t
at i
ion to t t
ho ho
se se
o out
ut s
side an e
t nterpr
pr is
is e.
Fi Fi
na na
ncial re re
po porting includes
es not onl
nl y
y financial stat atem
em ents but
ut a
also other means of communicating inf
f o
ormation n that relates, directly or indirectly, to
the information provided by y
the accoun nting system-that is, information about
an enterprise’s resources, obligation
ns, earnings, etc. Management may communicate information to
t t
hose outs side an enterprise by means of financial
reporting other than forma al fina
a n
ncial statements either because the information is required to be
e disc
closed by authoritative pronouncement, regulatory rule, or custom or
be be
c cause management considers it useful to
those outside the enterprise and d di
iscloses it voluntarily.
Both financial statement and financial reporting have the function as a communication tool towards firms’ outsider. The objective of financial
reporting SFAC number 1; bullet 5, point 1 is stated as follow. Financial reporting should provide information that is useful to present and
potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be
comprehensible to those who have a reasonable understanding of business and economic activity and are willing to study information with reasonable
diligence
To achieve the objective, the financial reporting has to have several qualitative characteristics within. SFAC number 2 provides the guidelines
about those qualitative characteristics. In general, the qualitative characteristics are split into two perspectives, the users’ perspective and the
financial statementreporting itself. For the users’ perspective, the users of financial statementreporting
are obliged to have understanding of the information content of financial statementreporting. It is written in SFAC number 2; paragraph 7 as follow.
Information cannot be useful to decision makers who cannot understand it, even though it may otherwise be relevant to a decision and be reliable.
Meanwhile, from the financial statementreporting itself, it has to contain the inherent qualitative characteristics. It is termed as the primary decision
specific qualities. The primary decision specific qualities consist of relevance and reliability. The definition of relevance and reliability according to SFAC
number 2 can be describes below. x
Relevance To be relevant, accounting information must have predictive
valuefeedback value and must be timely. It is capable of making difference Financial reporting shou
u ld
ld p
provide inf nf
or orma
m tion that is useful to present and
potential investors s
a and creditors and othe
her r
users in making rational investment, cr
r ed
ed it
, and similar decisions. The he information should be
comprehens s
ib ib
le to those wh
w o have a reasonable unde
ders r
tanding of business and econ
on om
ic activity and d
ar r
e e
wi wi
ll ll
in in
g g
to s s
tudy informati i
on on with reasonable
dilige ge
n nce
To o
a ach
c ieve
ve the obj
bj ec
ec ti
ti ve
ve ,
th th
e e
fi fi
na na
ncial repo p
rtin n
g g ha
ha s to hav
ave several qual
al it
it at
at iv
iv e
e char
ar a
acte ristics within
. SFAC number
2 2
pr p
ov id
ides s
t the
h guide
delines ab
ab ou
ou t th
th os
e qual it
ative char ac
teristics. I n
genera l,
l, the
he q
qua u
litati tive
ch c
arac ac
teristics are spli t
into two p
er spective
s, the users’ pe
rs s
pe p
ct t
iv ive
e an and th
e e
fina a
ncial st
at em
entreport in
g itse
lf. For the us
er s’
per sp
ecti ve
, th
e us er
s of
fin ancial state
me e
ntreporti ting
g ar
r e
obliged to h ave
un de
rs tanding of the
infor ma
ti on
content o
of fi fi
n nancia
al l
statemen t
re re
po po
rt rt
in in
g g.
I I
t t
is is
w w
ri r
tt t
en e
in SF F
AC AC n
n um
um be
be r
r 2;
2; p
p ar
ar ag
agra ph
7 as follow w
. Information cannot be useful to de
d cision makers who cannot underst
stan nd
d i
it, ev
ev en though it may otherwise be relevant to a decision and be reliab
ab l
le. .
Mean wh
wh il
il e
e, f
f ro
rom m th
th e
e fi
financ c
ia ial
l st
stat at
em em
en en
t trepo
rt rt
in ing
g it
itse lf
lf, it
it h
has t
o co o
nt nt
ai ai
n the in
in he
he rent q
q ua
ua li
li t
tative charact t
er eristics. It
It is termed a s
s th
th e pr
im im
ar ar
y y decision
specific qualities. The prima ary decision
n specific qualities consist of relevance
and reliability. The definition n of relev
a ance and reliability according to SFAC
number 2 can be describes belo o
w. w
x Relevance
in users’ decisions by helping them to predict about the outcomes of past, present, and future events or to confirm or correct prior expectations.
Information can make a difference decision by improving decisions maker capacities to predict the results of similar future actions. Meanwhile,
timeliness means having information available to decision makers before it loses its capacity to influence decision. If information is not available in the
time when it is needed or becomes available quite awhile after the reported events that it has no value for future action, it is interpreted as lack relevance
and is of little or no use. x
Reliability To be reliable, information must have representational faithfulness
and it must be verifiable and neutral. The reliability of a measure rests on the faithfulness with which it represents what it purports to represent, coupled
with an assurance for the users that it has that representational quality. Aside from the primary decision specific qualities, there is also the
secondary quality that interacts with relevance and reliability, that is comparability include consistency. Financial reporting financial statement
has to be comparable among firms and consistent in the method application over time.
To be concluded, the accounting information is useful when the users of financial statementreporting able to understand the content and when the
financial statementreporting has the major characteristics of relevance and reliability.
capacities to predict th h
e e results of
f s
s im
im ilar future actions. Meanwhile,
timeliness mea a
ns ns having information available to
d d
ecision makers before it loses its
s c
capacity to influenc n
e e
de de
ci i
si si
on on
. .
If f
i i
nformation is no not available in the
tim me when it is
n need
ed ed
e or becomes availa
l bl
bl e
e qu qu
it ite
e awhile after
r t t
he reported events
s t
t ha
ha t it
it has no
o v
va lu
e for futu re
action, i
i t
t is
is interpr
ret et
ed ed
a as lack r
el el
evance an
n d
d is
is o
of litt tt
le le
or no use. x
R Re
liability To
be reliable, in
format ion
must h
ave representation a
al fai ai
th th
fu fu
ln l
ess an
n d
d it must be
ver if
iable an d
neut ra
l. T he
r eliability
of a measur
e e
rests on t t
he he
fa a
it hfulness with whic
h it r ep
resents wh
at it purports to repres
e ent, cou
oupled d
wi wi
th t
an assura nc
c e
e fo
fo r
r th
th e
e us
us ers that it has
s th
th at
at r
r ep
ep re
re se
s ntatio
nal qu al
alit ity.
Aside from the primary y
dec ec
is ision specific qualities, there is als
s o
o th
th e
se seco
c ndary quality that interacts with relevance and reliabil
l it
it y
y, t t
ha hat
t is
compar b
ab il
il i
ity i
inc nc
lu lude
de con si
si st
st en
en cy
cy .
. F Fin
inancial l
r r
ep epor
or ti
ting fi
fi na
ncial st st
at at
em ement
ha ha
s s
to be co co
m mparable among
g firms and
nd consistent in t
t he
he m
et ho
hod d
a application
over time. To be concluded, the
accountin ng information is useful when the users
of financial statementreporting g
able e to understand the content and when the
financial statementreporting has the major characteristics of relevance and
2.2.2 Elements of Financial Statement
The elements of financial statements that most frequently provided are statement of financial position, income statement, statement of changes in
equity, statement of cash flow, and financial statements’ notes PSAK 1 2009 revision, SFAC number 1. The explanation of financial statements’ elements
is listed as follow. A.
Statement of Financial Position In general, statement of financial position provides information about
firms’ assets, liabilities, and firms’ equities. B.
Income Statement It captures the information about the revenues and costs that firms
generated. In the end, earnings information is on the focus because it is important as indicator of firms’ performance.
C. Statement of Changes in Equity
It reflects the changing of equity from the beginning of accounting period till the end of accounting period. The changing of equity is affected by
income of the year and dividends. D.
Statement of Cash Flow It reflects the cash inflow and cash outflow of the firms. Statement of
cash flow consists of cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities.
E. Notes
It is a summary of significant accounting policies and other explanatory notes. It provides more detail information about statement of
equity, statement of cash fl fl
o ow, and fina
a nc
ncia i
l statements’ notes PSAK 1 2009 revision, SFAC
C n
number 1. The explanation of finan ancial statements’ elements
is listed a
as follow. A.
. Statemen
nt t
of of
F F
in i
anci al
Position In
In g
g en
en eral, st
st at
at em
ent of fin an
cial p os
it it
io io
n n
provid id
es s
i i
nf nf
ormation on about
fi fi
rm rm
s’ s’ a
asset t
s s,
l iabili
ti es, and firms’ equities.
B B.
I In
come Statement It
captures the in
fo rmatio
n about
th e revenues and
c o
osts t tha
hat t
fi f
rms ge
e n
ne rated. I
n th
e end, ear ni
ngs in
form at
ion is on th
e focus b
because it is
s im
m portant as indicator o
f firms’ perform an
ce .
C. C.
St at
em en
t t
of of
C C
ha ha
ng ng
es in Equity It reflects the changing
g o
o f eq
eq ui
ty from the beginning of accou u
nt nt
in in
g pe
pe riod till the end of accounting period. The changing of equity is
s af
af fe
fect cted
d by
income o
o f
f th
the ye
year ar a
a nd
nd d
iv id
id en
ends ds
. .
D D.
S Statem
em e
ent of Cash Flow ow
It reflects the cash in nflow and ca
ash outflow of the firms. Statement of cash flow consists of cash
f f
low from m operating activities, cash flow from
investing activities, and cash flo ow fr
r o
om financing activities. E.
Notes
financial position, income statement, statement of changes in equity, and statement of cash flow.
2.2.3 Earnings
Earnings is the end result of the income statement. It comes into many financial statementreporting users because it provides a measure about how
well firms currently deployed it resources to generate profit Burgstahler and Dichev 1997. In Sitanggang 2006, earnings is described as follow.
1. Earnings is used as the basis of income taxes and the wealth return of
investors. 2.
Earnings is considered as the benchmark of dividend policy and retained earnings.
3. Earnings is viewed as significant predictor of future earnings and cash
flow. 4.
Earnings is used as efficiency measurement. It is a measurement of management stewardship over the firms’ resources and how to
manage it well.
2.2.4 Earnings and the Qualitative Characteristics of Financial Reporting
According to Barth et al. 2001, when accounting information has the quality of relevant and reliable, then accounting information can be termed as
having value relevance.
5
In another words, value relevance is a measurement of decision usefulness of earnings Gaio and Raposo 2011. Value relevance
also defined as the association between accounting information and equity
Value relevance is an empirical operationalization of relevance and reliability Barth et al. 2001
Earnings is the en n
d d
re result of th
h e
in in
co c
me statement. It comes into many financial statem
m e
entreporting users because it pro vi
vi de
d s a measure about how
well firm ms currently deploye
ye d
d it
t r
r es
es ou
ou rc
rc es t
t o generate pro
fi fi
t t
Burgstahler and Di
i ch
chev 1997. In n
S S
it itan
n ggang 2006, earn
in in
gs gs i
i s
s de
de s
scribed as fol l
lo lo
w. 1.
Ea Ea
rn rni
ings is us us
d ed
a s
the basi s
of inc om
e e
ta ta
xes an nd
d th the
e we
w alth r
ret e
urn of inve
e st
st or
s. 2
2. E
Ea rnings is
co nsidered a
s the benchmark of d
iv id
idend po
po l
licy and nd
re tained earning
s. 3.
. Earnin
gs is
viewed as
sign if
ican t pr
edicto r
of f
ut ure earn
in ngs and cas
ash h
flow. 4
4. Ea
rn in
gs g
i i
s s
us us
ed ed
a a
s s
efficiency m m
ea ea
su su
re re
me me
nt n
. It i
s a me as
asu urement
t of
of management stewardsh
sh ip
ip o ov
ver the firms’ resources and how ow t
t o
o manage it well.
2.2. 4
4 Ea
Ea r
rn i
ings gs
a a
nd nd t
he he Q
Qua ua
li lita
tati tive
C C
ha ha
ra ra
ct cter
is is
ti ti
cs o
f Fi
Fina na
nc ial
Repo po
rt rt
i ing
According to Barth e e
t al. 2001
, when accounting information has the quality of relevant and reliab
b le
l , then ac
ccounting information can be termed as having value relevance.
5
In ano other w
words, value relevance is a measurement of decision usefulness of earnings
s Gaio and Raposo 2011. Value relevance
market valuesreturns Francis and Schipper 1999, Barth et al. 2001, Himma 2013. In particular, earnings is termed as value relevance if it can explain the
variance of stock pricesstock returns Gaio and Raposo 2011. To be concluded, value relevance is a measurement of decision usefulness of
earnings, thus, this will reflect in stock pricesreturns. Several studies documented the relation between earnings and stock
pricesreturns. Whelan and McNamara 2004 and Himma 2013 documented that earnings is related with the movement of stock prices.
Another researchers, Collins and Kothari 1989 documented the change of stock prices associated with given unexpected earnings change.
2.3 Previous Research
