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
