EARNINGS MANAGEMENT AND EARNINGS QUALITY

Table of Contents

Synopsis. 4

  1. Introduction. 5

1.1. The Problem Statement 6

1.2. Summary of Methodology, Data Sources, and Findings. 8

  1. Background. 9

2.1. Earnings Management 9

2.2. Earnings Quality. 12

2.3. Impact of Earnings Management on Companies’ Performance. 13

2.4. The Impact of Earnings Quality on Companies’ Performance. 15

  1. Hypothesis. 17
  2. Methodology. 18

4.1. The Sources of Data. 19

4.2. The Data Collection Method. 19

4.3. The Population Sampling. 20

4.4. Data Analysis. 21

4.5. The Dependent Variables. 21

4.6. Independent Variables. 22

4.7. The Control Variables. 22

  1. Results. 23

5.1. Firms without Earnings Management 23

5.2. Firms Practicing Earnings Management 24

5.3. The Calculation of Earning Persistence. 24

5.4. The Persistence of Earnings for Firms with no earnings management 25

5.5. The Persistence of earnings for firms with high earnings management 26

5.6. Test for the Hypothesis. 27

There is a relationship between the earnings management and the persistence of earnings. 27

5.6. Discussion of the Results. 33

  1. Conclusion and Recommendation. 34

Reference List 38

 

Synopsis

Earnings management and earning quality are management practices that are related to one another in various dimensions. Earnings management is a practice that is evident in many firms across different industries. The current competitive business environment makes it difficult for many firms to meet their financial objectives. As a result, many executives attempt to initiate and implement strategies that can help boost their performance in both short-term and long-term periods. The earnings management practices have an overall influence on the financial performance of companies. This research study investigates the association between earnings management and quality of earnings. The research considers one component of earnings quality which includes the persistence of earnings to determine the relationship. The study used both qualitative and quantitative research techniques. The data was collected from ten firms listed in the stock exchange market in the United States for six years. Five firms were without earnings management practices while the other five demonstrated high earnings management. The earnings for the six years were retrieved for each company and earning persistence calculated using regressions analysis. The findings of the study found that there is an inverse relationship between earnings management and earnings quality. The future studies recommend that large sample size should be used and the duration of the study increased to at least ten years.

1. Introduction

Based on the Generally Accepted Accounting Principles (GAAP), there is a provision for flexibility when preparing an organization’s financial statements. As a result, the management of companies often has the privileges to select certain alternatives and policies on accounting. Earnings management often uses the principle of flexibility when preparing the accounts statements and reports by manipulating the financial results of a firm.     Due to this, it is a global challenge for corporations when releasing information related to income.

Earnings management serves a significant purpose of determining the appropriate earnings quality that can meet the expectation of the shareholders or the requirements of the regulators (Li & Lin 2005).  In essence, earnings management is closely linked to the earnings quality which is represented by various aspects such as the earnings persistence, the accruals quality, the earnings predictability and the smoothest of earnings. Notably, the companies with the high earnings management can lead to the low-quality earnings (Li, Abeysekera & Ma 2011). This is because an artificial release by the managers regarding the financial status of the firm may cause incorrect decisions among various stakeholders such as investors, shareholders, and customers (Ahmadpour & Shahsavari 2016). However, it does not imply that lack earnings management can guarantee the high-quality earnings to the firms since other economic factors such as compensation of the administration and the capital market can influence the quality of earnings. Ideally, earnings quality in accounting is the ability of the reported income to predict the future earnings of the company (Balsam et al. 2002). It represents a portion of earnings that is attributed to the lower costs or higher sales as opposed to the artificial profits that are created by the anomalies of accounting such as the inflation of inventory (Machdar & Murwaningsari 2017). The earnings quality can be considered as poor when there is high inflation in the economy.

Earnings management and earnings quality are fundamental to the empirical and theoretical research in accounting. In earnings management, the manager observes the earnings of the firm and issues a financial report to the market (Hosseini et al. 2016). During the issuance of the report, the managers are not confined to adhere to the truthful reporting. However, the manipulation of the financial statement of a corporation can affect the current and future earnings or stocks of an organization thus prove costly to businesses. In essence, earnings management is the intentional misrepresentation or the concealing of some financial information of a given company by a manager.  The earning management can be regarded as wrongdoing, fraud, and mischief which is similar to other criminal offenses (Beyer et al. 2014). Many of the highly publicized financial scandals in companies can be attributed to the earnings management and thus there is a need for strict regulation of accounting and financial reporting. Accordingly, many empirical studies have linked the earnings management to earnings quality. Earnings management can be detrimental earnings quality. However, no or inadequate research has come up with findings to establish the direction of the association between earnings management and earnings quality.

1.1. The Problem Statement

The rampant cases of earnings management by the management of corporations trading on the stock exchange market in the United States is a concern to many people and accounting bodies. Several firms have been accused of manipulation of their financial statements thus misleading the stakeholders in making some important decisions. The problem is made worse as some companies who have engaged in the practices have either become bankrupt or collapsed. The main aim of financial reporting and accounting is to help provide specific user data and information to various stakeholders such as investors to enable them to predict the performance of an organization. The financial report and data are used by the executives, investors, and analysts to make decisions in organizations (Glover 2014). Furthermore, the earnings or income reports serves various purposes in the economy such as providing the basis for the determination of tax payment and the criteria for assessing the performance. Besides, it determines the success of a firm, the amount of the divisible earnings, the management of the distribution earnings and the control of the economic unit among others (Ewert & Wagenhofer 2013).

The executive of organizations typically engages in the earnings management to mislead the potential investors and the shareholders on the actual financial and economic performance of the company. The earnings management can be achieved through the manipulation of the accounting figures, information or real activities. Such manipulation often reduces the credibility and accuracy of the income messaging and increase the uncertainty and risks of the individuals who are outside the organization. It can also lead to asymmetry of information and reduces the efficiency of a given investment. Evidently, the earning management has the potential to hide the actual performance of the company as well as the actual process of the growth in earnings (Weil 2009). Also, it can conceal the revenue sources of companies that can be used to estimate the future growth of a corporation. Although there are many benefits of earning management to the firms, its adverse effect can play against the long-term survival of a company. Majority of the research studies focused mainly on impacts of the earnings on the performance of stocks of organizations. However, few research studies have developed a framework to identify the impacts that earnings management has on the quality of earnings (Ewert & Wagenhofer 2012). This research study, will, therefore, determine the link between the management of earnings and earnings quality. In particular, it will assess how earnings management influences the earnings quality with respects to persistent earnings. The research will shed more light on how the managers should implement earnings quality in a manner that does not affect the overall performance of companies. The findings can also be useful in making informed decisions on whether companies should implement earnings management or not.

1.2. Summary of Methodology, Data Sources, and Findings

The research study makes use of qualitative and quantitative techniques. The qualitative methods are used to determine the influence that earnings management has on the quality of income from selected corporation trading in the stock exchange in the United States. This is achieved by conducting interviews with various finance and account managers of the companies chosen. However, the emphasis will be on the quantitative data research techniques which will include the assessments of the past financial reports and information of companies that are trading in the stock exchange markets in the US.

The data will be collected from the financial reports of companies that included annual earnings and stock prices. Various financial measures will be obtained from the companies selected to participate in the study and include the cash flow information, profit, revenues, executive compensation, and accruals.  The dependent variable in the study will be the earnings quality while the independent variables will be the earnings management. Based on the reviews of the previous literature, it is expected that the findings will establish that earnings management is related to the quality of earnings. However, there is an inverse association between management of earnings and earnings quality. In essence, when there is high earnings management, the earnings quality will be low. Again, low earnings management will lead to high earnings quality in companies.

2. Background

The decisions for investors, shareholders and other stakeholders of companies depended on the reports of organizational accounts. The executives, therefore, should make decisions regarding the choice of the financial statements and reports that can offer the best procedures to provide the appropriate advisory services to the various stakeholders of the company. The organizational reported earnings are the leading financial decision-making criteria. However, whenever it occurs that the objectives of the owners and executives are not aligned, the management of the company might provide the financial statement and reports to serve his or her interest. Many users of the financial statements are not happy with the asymmetry of the accounting information. As a result, they are in need of the information to facilitate rational decision making.

2.1. Earnings Management

Earnings management is an issue that has been experienced by various firms across the United States. It is a worldwide business practice in the financial statement and reporting of firms or the release of information about annual earnings (Lennox et al. 2016). The primary intention of the earnings management is to help achieve the quality earnings that can meet requirements and anticipation of the shareholders to obtain the authorization from the industry regulators. Earnings management is closely linked to the quality earnings. The high management in organizational earnings can lead to poor-quality of earnings since the artificial and temporary information can lead to wrong decision process (Enomoto et al. 2015). Also, lack of earnings management measures cannot necessarily lead to the best-quality earnings since others factors including management compensation and capital markets affect the quality of the earnings.

Many firms in different countries engage in earnings management for various purposes such as reducing the amount of tax paid to the government, to remain profitable and convince the shareholders that the firm is profitable.

Earnings management happens when the executive of companies have an opportunity to make some of the decisions on accounting policies that can changes the income reported. Ideally, accounting for companies requires the sound judgment and estimates. Typically, Management of companies has the responsibility of estimating the sales and revenues which can lead to higher net income than the normal. When there are wide options of the reasonable estimates to manipulate the financial statement, the executives can have more options to influence the income of the company.

In the United States, many firms report cases of earnings management. The pressure on the management and other executives of the company to ensure the profitability of companies is the leading reason for manipulation of the financial statements. However, there are various incentives for earnings management in the United States. Some companies engage in this practices to meet the expectation of the analyst. The expectation of analyst and prediction of the company’s trend addresses the two high profile elements of the financial performance that include earnings and revenues. There is intense pressure to meet the revenue expectations, and this is regarded as the primary motivating factor that makes it necessary for the executives to involve in earnings management (Sayari & Omri 2017). In some instances, it is the firm that creates the pressure to meet the desired earnings. Many companies in the United States that include Coca-Cola, Gillette Co., and Intel Corp among others have a contrary strategy where they no longer report annual and quarterly estimates of earnings to analysts (Ali & Zhang 2015). The reason for such actions is to enable these companies to achieve their long-term strategies as opposed to the short-term strategies.

Several cases of earnings management occur around the period when there is a management change. The chief executive officers with poor performance record are attempted to increase the reported income through manipulation to postpone or prevent being fired. Also, the incoming chief executive officer can shift part of the income to a future date which is around the period of the performance evaluation. Notably, management of earnings is practiced by the managers to increase their income based bonus. If executives expect earnings that are lower than the minimum amount required receive a bonus, the profits can be inflated to achieve the minimum for the reward.

Several research studies have established the evidence that shows the opportunistic perspective as the motivating force for the earnings management. Enomoto et al. (2015), and Cheng et al. (2015) suggested in a research study that accruals management emphasizes on manipulating the cash or income bonus. Badolato et al.  (2014) investigated the inverse relationship that exists between the accruals and the returns on stocks before the announcement of the earnings by indicating that the market perceives the accruals as opportunities. On the contrary, other studies show that management of earnings is efficient as opposed to opportunistic.  Soliman & Ragab (2014) concluded that the accruals have a significant association with the future profitability of firms.

The agency theory can also be linked to earnings management. The agency theory defines the executives of the firms as agents while the shareholders are the principals. In many cases, the shareholders are in conflicts with the executives (Godsell et al. 2017). This means that the executives are responsible for decision making in organizations. However, the problems that arise is that the management cannot make decisions that favor the shareholders. One prominent hypothesis of the agency theory is that the agents and principals encounter with a conflict of interests, and this makes them be at odds with one another. In essence, the interest, opinions, and incentive of the management are for private purposes while shareholders are interested in maximizing the profit of the firm. Based on this, contract incentives, reward incentives, private agreements, contracts on commission, political incentives, initial public offering, tax incentives, and change of executives are some of motivating factors that encourage measures of earnings management.

With regards to earnings management, scholars have two viewpoints where on group believes that as firms grow, the executives make negative earnings management to reduce the sensitivity. The other group considers that as firms grow in size, the social and supervision effects of the financial statements and reports increase and this leads the tendency of the management to enhance the earnings management (Capkun et al. 2016). Irrespective of the two views of the scholars, the earnings management does not rely on the size of the firms. This is because in the current business environment, individuals attempt to maximize their prosperity and wealth and the managers tend also do the same. Based on this, earnings management differs with the type of industry or business sector where a company operates.

2.2. Earnings Quality

The past studies on identification of the earnings quality and its effects on the capital market are scarce. Miko & Kamardin (2015) enhance the literature reviews on the quality of earnings by assessing the relationship between equity of capital cost as well as the seven elements of earnings that include accruals quality, predictability, persistence, smoothness, conservatism, timeliness, and, and conservatism. The model predicted positive relations between the information report quality and the equity cost. They established that companies with the poor favorable values of the different types of earnings typically have the high equity cost than those with the highly favorable values of the earnings categories. Sohn (2016), also investigated the relationship between earnings quality and voluntary disclosure of the financial statements. The findings established that companies with favorable attributes of earnings have the most comprehensive disclosure than those with poor attributes of earnings.

Ben-Nasr et al. (2015) investigated the association between the ability of chief executive officers and the attributes of earnings quality by taking into account the managerial human capital dimension which was the reputation of the executives to explain the quality of earnings. Furthermore, the research also investigated the link between the quality of accrual as an attribute of quality earnings and cost of debt and equity. Furthermore, the findings indicated that the poor quality accrual is related to with high cost of equity and debt. Another finding from the study was that favorable values of the attributes of earnings quality are experienced in the countries where there is the strong protection of investors.

2.3. Impact of Earnings Management on Companies’ Performance

The research study established a significant association between management of earnings and returned on stocks in the following year (Braam et al. 2015). Essentially, the stock prices of the firms having a low amount of the operating cash flow achieve low financial performance in the following trading period. Also, the stocks of the companies with a high amount of cash flows usually perform better in the following year. Besides, shares of corporations with low cost of production often outperform within the subsequent three years whereas the stocks with high production costs will underperform with the next three years. The earnings management is not a typical business practice. It is a concept motivated by the managers to make some of the stakeholders of the organization to believe that that the company has achieved some of the desired financial performance objectives during a given trading period (Lambert et al. 2017). This implies that the earnings that are reported by the management in the firm’s financial statements are not the actual performance but are meant to alter the quality of the accounting reports.

The earnings management can be achieved in three ways and include the discretionary production, the discretionary cash flow, and the discretionary expenditure. The earnings management using discretionary cash flow involves the manipulation of sales which leads to the lenient credit or discounted prices with the purpose of boosting the volumes of transactions temporarily in the current trading period (Lennox et al. 2016). The practice eventually leads to an increase in the reported profits or earnings. Ideally, sales manipulation is the behavior of the executives to increase sales in a particular trading period. The practice can lead to cash flow a cash flow which is lower than the normal net cash flow of the company a situation which causes negative cash flow. Evidently, the low levels of the cash flow of a company imply that there is a high amount of profits or earnings of the firm. According to (Sayari & Omri 2017), the acceleration of the volumes of sales by offering lenient credit terms and price discounts have the potential to increase the earnings and sales in the current year but reduces cash flows in the same period.

Earnings management can also be achieved through a discretionary production where a company can over produce to show a low cost of sales and avoid reported losses. Firms can produce more products than the usual volume to meet the anticipated demand in the market and increase the earnings. The high levels of production usually lead to a decline in the fixed costs and enable the reported cost of goods sold to be a low and high-profit margin. The organizations that create temporary overproduction measures indicates direct and high production costs. The companies with higher costs of manufacturing will experience higher reported income or earnings.

The other strategy that firms can use in the earnings management is through the discretionary expenditures. The discretionary expenditure is achieved through a reduction of the burden associated with research and development, administrative expense and advertisement to improve the reported earnings or income of the company in the current period (Ali & Zhang 2015). It is argued that earnings management that focuses on the reduction of the research and development expenses can be detrimental to companies since it reduces the competitiveness of such firms and compromises their profitability in the future. Nevertheless, it can help increase the profit margin, current earnings, and cash flows for the organizational operations. The firms use the discretionary expenditures by reducing the expenses to help improve the earnings reported by the companies (Enomoto et al. 2015). However, such strategies can have an adverse influence on the financial performance of firms, especially in future. Ideally, the low discretionary expenditure implies that there is high reported income or earnings of the company.

2.4. The Impact of Earnings Quality on Companies’ Performance

Earnings quality is a critical indicator that is used to measure the performance of companies. A high earnings quality shows that a company has high financial performance while low earnings quality is an indication of the level financial performance of an organization. The earnings management provides the more information and data that demonstrates the performance situation of a firm (Cheng et al. 2015). These performance indicators are used by the relevant stakeholders of companies such as investors and shareholders when making major business decisions. As a result, it is an essential financial metrics that can be used by investors to make several business decisions. Ideally, the high quality of earnings represents a good financial parameter for the evaluation of the performance, assessment, and prediction of the company (Badolato et al. 2014). There are various components of earnings quality that can be used to assess the performance of a firm and can include the income smoothing effect, the accrual component, persistence, and predictability.

The income smoothing refers to the international action that is carried out by the executives or managers by implementing certain accounting policies in an attempt to reduce the earnings fluctuations. Income smoothing is the magnitude of earnings that are disclosed in the conditions that they are evenly reported over a period during the normal operation of the firm. Soliman & Ragab (2014) show that income smoothing is an important measure that determines the return on stocks for a given company. Specifically, the income smoothing is argued to have a positive impact on returns on stocks.

The accrual part of the earnings quality is often subjected to the market uncertainty as opposed to the cash flow component. This is because the accruals component is a product of estimates, judgments, and allocation. On the other hand, the cash flow components are not estimated but realized (Godsell et al. 2017).  The management of an organization is allowed to use the recognition of the accrual accounting to enable the increase or decrease of the accruals impact on the ability of the executives to use the earnings as a determinant of the performance of the firm. As a result, the management can use private information or manipulate the financial statements and revenues using the accruals. With a low quality of accruals then it implies that the disclosed earnings quality of a firm is good. Accrual quality can also reduce the cash flow fluctuations, and this can create earnings figures to become more useful (Capkun et al., 2016).

3. Hypothesis

Earnings quality is closely linked to the earnings management in the evaluation of an organization’s financial performance. Earnings management has an impact on the integrity of the financial statements. Furthermore, earnings management also significantly influence the allocation of resources in a firm. There exist two types of earning management which include the efficient and opportunistic (Miko & Kamardin 2015). Earnings management is argued to be efficient if the executives use discretion to pass the information concerning the income of the company which is unavailable in the previous cost-based income or earnings. In many cases, earnings management has been measured regarding the discretionary accruals. The researchers often determine the discretionary accruals as the residuals from the specific expectation of the firm (Sohn 2016).

The accruals have the potential to determine or signal the future financial performance of the company such as profitability. The research studies will test many elements such as whether the accruals have a significant impact on the future income of an organization. This is achieved through the identification of the opportunistic and efficient earnings management among the firms in the United States. The efficient earnings management can ensure that the discretionary accruals the United States have a positive impact on the future profitability (Ben-Nasr et al. 2015). On the other hand, if it is opportunistic, the accruals show a negative association or the insignificant relations with the future profitability of a business entity.

In this research, the financial statements of the company who are almost bankrupt are likely to produce reports that suggest material overstatements of the earnings. This is because such companies are often motivated by the desire to conceal some of the financial signs of distress as opposed to the ones which are not bankrupt. The assumption in this analysis is that firms which are bankrupt manipulate their earnings than the ones which are not in financial distress. The research will consider both the firms practicing earnings management and those with lacking earnings management to determine the relationship between the two cases.

With regards to earnings quality, the study will consider only one aspect of earnings quality which is the persistence of earnings. The persistence of earnings measures the consistency of the income of a company over a specified period such as within some years (Braam et al. 2015). The persistence of earnings, in this case, will be the primary dependent variable in the study. Only one component of earnings quality is considered for the study for simplicity and accuracy purposes.

Based on the matters mentioned above on the subject, the main idea behind the research was to determine the association between the earnings management and the earnings quality in the companies listed in the United States’s stock exchange markets. The research, therefore, came with the following hypothesis to help accomplish the objectives of the study. The hypotheses for the research are as follows.

  • There is a relationship between earnings management and earnings quality
  • There is a relationship between the earnings management and the persistence of earnings
  • The earnings management and persistence earnings are directly related

4. Methodology

Research methodology provides the procedures and processes that are followed by the researchers to investigate a given phenomenon. It is the research methodology that will determine the effectiveness of the result of the study. The chosen method for the research study should consider various factors such as the variables under investigation, the nature of the study, that availability of the data and the sample size among others.

The research is an applied study with regards to the objective and approach used which is typically descriptive. Since the study aims to establish the significant association between the variables, it is correlational study. The variables under investigation in the study include earnings management and earnings quality which are independent and dependent variable respectively. The statistical model that is applied in this study is the simple regression model. The information and data required to accomplish the objectives of the study are obtained from the financial statements of companies operating in the United States’ stock exchange market.

4.1. The Sources of Data

The source of the data and information to be used in research proves an essential factor for this research study. Ideally, the area of the earnings management and earnings quality has attracted few research studies and thus needs an appropriate collection of data from reliable sources. In this study to determine the link between earnings management and earnings quality, various sources of data were used such as primary and secondary data. However, the emphasis was on the secondary sources of data where information was collected from the previous literature on the topic and the financial statements of the selected firms.

4.2. The Data Collection Method

The research considered two types of data that include the qualitative and quantitative data. The research study used the mixed data collection method to increase the reliability of the study. The quantitative data collection method was used by the researchers when obtaining information such as the financial statements of companies and other accounting reports. Also, the data from the stock exchange market over the given period of the study was collected through qualitative method. On the other hand, the qualitative technique was used to obtain the information such as manager’s analysis and reports on the performance of companies.  Furthermore, the perception of investors and other stakeholders of the companies were gathered through the use of qualitative data collection methods. It can be argued that the use of the two ways to collect the data and information increased the scope of the study and thus was critical towards improving its validity and reliability.

4.3. The Population Sampling

The population sampling is involved with the methods that are used to select the appropriate participants for the study. The sample should be selected from the targeted population and should be a representative of the entire population.

In this study sample, the researcher worked with ten firms listed in the stock exchange market in the United States. The companies were trading on a stock exchange, and the selection depended on several factors and criteria discussed below.

The financial statement and information of the company are available during the period of the study. This criterion aimed at making sure that relevant data and statistics that can facilitate the research is obtained. Some of the vital information of the study was only accessed from the financial reports of the company as well as other reports available in the stock exchange markets.

The other criteria used to select the sample companies in this study was the end of the trading period of the selected firms. For comparability purposes, the trading period was chosen to end by the end of March for all the companies chosen to participate in the study.  The choice of the similar trading period was to ensure that the period and seasons of trade are identical and thus avoid any biases in the business environment.

It was also a condition to choose companies that are not banks or any financial institutions such as financial brokers, investment companies, leasing and holding companies. The reason for selecting non-financial organization is because they have a different structure of the financial statements as compared with firms from other sectors of the economy.

The firms selected were group into two categories that include those practicing earning management and those not practicing earnings management as shown below.

Those without Earnings management

Companies
AES Corporation
FMC Corporation
Norvatis
Accenture
AECOM
Tyson

Those With Earnings management

Energy Future Holdings Corp
NII Holdings, Inc.
Genco Shipping & Trading Limited
USEC, Inc
Eagle Bulk Shipping Inc.

 

4.4. Data Analysis

As indicated before the purpose of the research was to assess the association between the earnings management and earnings quality in the firms trading at the stock exchange in the United States. The study considered one aspect of earnings for simplicity. The primary factor of earning merit was the presence of profits over a period specified in the study. However, earnings management was determined by identifying the companies that were close to bankrupt and those who were performing well during the period of the study. The non-bankrupt companies were used as a control group in this study. In essence, they were used to shows the differences in earnings quality between the companies which are bankrupt and those which are not bankrupt at the time of the study.

4.5. The Dependent Variables

In this research study, the dependent variable was the earnings quality.

In this study, one component of earning quality was used as the dependent variables. The persistence of earnings was the main component of dependent variable used to identify the link between the earnings management and earnings quality. The persistent of earnings was considered as the best estimates of earning quality since it gives an idea of the company to be able to generate profits over an extended period. In essence, the profits of two consecutive years were regressed against each other to determine the earnings persistent of the firms selected for the study.

4.6. Independent Variables

The study also came up with the independent variable to help investigate the relation between the two variables. Ideally, the independent variable was the earnings management. In essence, earnings management was the main factor that was deemed to affect the quality of earnings in companies (Lambert et al. 2017). The earnings management can be evaluated using several factors that include financial incentives, debt limit and the reduction of performance of executive (Ahmadpour & Shahsavari 2016). One primary goal of the executives is the financial incentives, through compensation and the amount paid to the donor share. The debt limit is the primary goal of the executives to manipulate the figures and earnings using the lowest interest rates. In this study, the research considered the compensation of the executives as the leading independent variable to represents the earnings management.

4.7. The Control Variables

It was essential to come up with control variables to ensure the validity of the study. The control group consisted of the five firms which have enjoyed higher profits over a long duration and have not been in any financial distress. The result from the control group was compared to the one obtained from the banks which were manipulating their financial statements. Since the selected sample consisted of ten companies, the control, and the main group were made of five firms each. The reason for using the control group was to determine if there is any significant difference with regards to the relation between the earnings management and earnings quality for the two groups of companies that include near-bankrupt and with no bankrupt records.

5. Results

The results predicted the association between the earnings management and earnings quality. Firms with different earnings management were compared and years earnings persistence determined over a period of five years. The results section shows the findings that were obtained from the study. Ideally, the report considers two types of companies that include the ones with evidence of financial distress or near bankruptcy. This category was chosen based on the level of debts on the financial statements. The other group includes the firms that were performing well in the market. This group of firms constituted the ones with low debts or credit.

5.1. Firms without Earnings Management

The firms without earnings management were made of those who were not engaged in the manipulation of the financial statements. The firms with no evidence of financial distress are not likely to participate in the earnings management. As a result, they will not manipulate their earnings to conceal their financial performance to the relevant stakeholders. The financial performance of the five companies for five years is shown in the table below. The reported earnings are in billion US dollars.

Companies Net profit in millions
AES Corporation 2010 2011 2012 2013 2014 2015
FMC Corporation 579.36 590.72 621.96 727.04 718.52 761.12
Norvatis 536.76 585.04 579.36 653.2 698.64 766.8
Accenture 443.04 428.84 475.7 497 585.04 653.2
AECOM 309.56 352.16 369.2 417.48 454.4 511.12
Tyson 474.28 505.52 553.8 619.12 701.48 724.2

 

Data retrieved from Sec.gov. (2018)

5.2. Firms Practicing Earnings Management

The other group of companies selected for the study was made up of the firms with high earnings management. The selection of these firms relied on the assumptions that organizations in financial distress are likely to manipulate their financial statement to conceive the stakeholders that they are performing well in the industry. The selection of these companies depended on their creditworthiness and debt levels. The table below shows a list of the banks with high earning management and the profits for five consecutive years.

Income in Millions
Companies 2010 2011 2012 2013 2014 2015
Energy Future Holdings Corp 247.08 448.72 312.4 295.36 264.12 261.28
NII Holdings, Inc. 184.6 259 264.12 252.72 298.2 312.4
Genco Shipping & Trading Limited 445.88 524.4 289.68 284 318.08 340.8
USEC, Inc 355 391.92 275.48 269.8 309.56 312.4
Eagle Bulk Shipping Inc. 386.24 403.28 301.04 252.72 232.88 227.2

 

Data retrieved from Sec.gov. (2018)

5.3. The Calculation of Earning Persistence

The research calculated earnings persistence for the two groups of firms to determine the connection between the earnings management and earnings quality. The calculation of earnings persistence was made for the five year period for each group of firms that include those with the high earnings management and the group with low earnings management. The earnings persistence was determined by regressing the present earnings on the earnings of the previous years to determine the coefficient estimates of the earnings persistence.  The study used the following equation to determine the persistence of earnings for the two groups of companies.

Earn j, t/Total Assets j, t-1 = α +β * Earn j, t-1/Total Assets j, t-1 + Vj,t 

Where

Earn j, t is the net income of the firm before the extraordinary items in the year t

Earn j, t-1 is the net income of the firm before the extraordinary items in year t-1

For each of the firm-year, the study estimated the earnings persistence for the five years. The measurement that includes the earnings persistence is determined by the value of the coefficient estimate which in the model above is β. The values of β which are close to one or more than 1 is an indication that the earnings are highly persistent while the values that are close to zero imply that the earnings are transitory. In essence, the persistence earning is the earnings with high quality. On the other hand, the irregular earning is the earnings of low quality.

5.4. The Persistence of Earnings for Firms with no earnings management

The following shows the results of the presence of earnings after the regressions.

Year 2011 2012 2013 2014 2015
Persistence of Earnings/Coefficient 0.959439 0.939505 1.234014 0.830158 0.981077

 

Table 3: Shows Persistence of earnings for the firms with low earnings management

From the table, the values of the persistence of earnings are close to 1. All the values are more than 0.5 and thus are close to one as opposed to zero. Since the high values of the persistence of earnings indicate high-quality earnings, the firms with low management earnings are associated with high earning quality.

5.5. The Persistence of earnings for firms with high earnings management

The persistence of earnings for the companies with high earnings management was also determined using regression analysis to determine the coefficients. From the regression analysis, the persistence of earnings was established to be as follows.

Year 2011 2012 2013 2014 2015
Coefficient/Persistence of earnings 0.688968 0.129961 0.555395 -0.39242 1.274245

 

From the findings, it is evident that the values reflecting the persistence of earnings are not stable and varies between -0.39 to 1.27. Although there are some values close to one, it is not appropriate to conclude that the earnings are of high quality. Some earnings with the coefficient values close to 1 can be due to the misrepresentations of the profits at those particular periods to mislead the stakeholders such as the customers. It is not adequate to state that the company has consistent earnings in all the subsequent years. The coefficients of the earnings keep on changing and this is an indication of low-quality earnings. It is important to note that the earnings that are having higher coefficients can reflect a situation where the management had to conceal some information to mislead the stakeholders on the performance of the companies. This might have led to temporary high earnings which resulted in such high coefficient of profits.

5.6. Test for the Hypothesis

The hypothesis testing for the research considered the P values of the results of the regression analysis. The regression analysis was done for each of the five years based on the equations which follow.

Earn j, t/Total Assets j, t-1 = α +β * Earn j, t-1/Total Assets j, t-1 + Vj,t 

In essence, it was achieved by regressing the current earnings on the last year earnings to determine the coefficient value estimates of the earnings persistence.

There is a relationship between the earnings management and the persistence of earnings

The test for the relationship between earnings management and persistence of earnings considers the regression analysis to determine the coefficient of earnings which is a measure of the persistence of earnings. The following are the results from the firms with low earnings management.

Regression for 2011 Persistence of Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 40.95924 81.20296 0.504406 0.66406 -308.429 390.3474 -308.429 390.3474
X Variable 1 0.959439 0.1697 5.653731 0.029889 0.229278 1.6896 0.229278 1.6896

 

The coefficient of the regression is 0.959439 which is close to 1. This suggests there is persistence in earnings. The first regression shows that the level of significance P-value is 0.02988 which is less than 0.05.  This means the findings are reliable and accurate.

Regressions for 2012 persistence of Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 51.95832 63.19438 0.822198 0.497388 -219.945 323.8618 -219.945 323.8618
X Variable 1 0.939505 0.126443 7.430269 0.017635 0.395465 1.483546 0.395465 1.483546

 

The regression for 2012 persistence of earnings shows that the coefficient is close to 1 and thus there is a high persistence of earnings. Also, the significance level, P-value is less than 0.05, and this is a suggestion that the finding is significant and reliable.

Regression for 2013 Persistence Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -57.586 78.48971 -0.73368 0.539495 -395.3 280.1279 -395.3 280.1279
X Variable 1 1.234014 0.150699 8.188616 0.014588 0.58561 1.882418 0.58561 1.882418

 

The regression for 2013 earnings shows that the coefficient is more than 1 and this is an indication of the earnings persistence. The significance level is P-value is less than 0.05, and this shows that the finding of the study is significant.

Regression for 2014 Persistence of Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 137.9048 92.13444 1.496778 0.27313 -258.518 534.3273 -258.518 534.3273
X Variable 1 0.830158 0.157056 5.28574 0.033978 0.1544 1.505917 0.1544 1.505917

 

The results of 2014 earnings show that the coefficient is 0.83 which is close to 1 and thus there is high earnings persistence. The significance level of the result is P-value is 0.03397 which is less than 0.05, and this indicates that the result is significant.

The Regression for 2015 Persistence of Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 70.53146 43.16136 1.634135 0.243845 -115.177 256.2398 -115.177 256.2398
X Variable 1 0.981077 0.069266 14.16383 0.004948 0.683048 1.279106 0.683048 1.279106

 

The regression for 2015 earnings indicates a coefficient which is close to 1, and this shows the high persistence of earnings. The significance level P-value is 0.04948 which is less than 0.005, and these suggest that the result is significant.

From the results of the four regression analysis for companies with low earnings management, it is evident that there is a high persistence of earnings since the coefficient in all the analysis are close or more than 1. Also, in all cases, the significance level is less than 0.05 which suggest that the results are significant. Based on this, it can be concluded that the low earnings management is associated with the persistence of earnings. The hypothesis that earnings management is associated with persistence of earnings is, therefore, accepted.

Hypothesis Test for Firms with high Earnings management

Just like the firms with low earning management, the persistence of earnings was tested for the companies with high earnings management for the four years. The results of the regression analysis are shown in the tables that follow.

The Regression to test 2011 Earnings Persistence

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 182.4037 117.105 1.557608 0.217202 -190.277 555.0841 -190.277 555.0841
X Variable 1 0.688968 0.347097 1.984945 0.141376 -0.41565 1.793585 -0.41565 1.793585

 

The table shows the results of regression to test the earnings persistence for 2011. As evident in the table, the coefficient value is more than 0.5 which is an indication of high earning persistence. The significance level is P-value is 0.1413 which is more than 0.05, and this suggests that the result is insignificant. As a result, the hypothesis that high earning management is related to earning persistence is rejected.

Regression to test for 2012 earning Persistence

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 235.8495 36.13037 6.527735 0.007306 120.8665 350.8325 120.8665 350.8325
X Variable 1 0.129961 0.087135 1.491487 0.232637 -0.14734 0.407264 -0.14734 0.407264

 

The regression 2012 to test earning persistence for the high earnings management firms indicates the value of coefficient to be 0.13 which is close to zero, and this shows that there is no earning persistence. Besides, the significance level, P-value is 0.087 which is more than 0.05, and this indicates that the result is insignificant. Therefore, it can be concluded that high earning management is associated with low persistence level.

Regression to test for 2013 earnings persistence

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 110.6641 134.5805 0.822289 0.471178 -317.631 538.9593 -317.631 538.9593
X Variable 1 0.555395 0.465578 1.192916 0.318649 -0.92628 2.037071 -0.92628 2.037071

 

The result above shows that the coefficient is 0.555395 which is slightly above 0.5 and an indication of the high persistence in earnings. The significant level of the findings is 0.0.46557 which is more than 0.05. This shows that the result is insignificant thus indicates that high earnings management is not attributed to the persistence of earnings.

Regression to test 2014 Persistence of Earnings

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 15.79651 19.5238 0.80909 0.463841 -38.4102 70.00325 -38.4102 70.00325
X Variable 1 -0.39242 0.022746 43.63089 1.65E-06 0.929264 1.055569 0.929264 1.055569

 

The result of this regression shows a negative value of the coefficient, and this suggests that the earnings are not persistence. Besides, the significance level, P-value is 0.56 which is more than 0.05, and this indicates that the finding is insignificant. This shows that high earnings management is no associated with persistence in earnings.

Regression to Test for 2014 Earning Persistence

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 3.309723 2.056926 1.609063 0.205975 -3.23633 9.855779 -3.23633 9.855779
Profit 2014 0.933016 0.091339 10.21491 0.002 0.642336 1.223696 0.642336 1.223696

 

The result of this regression shows that the coefficient is close to 1 and this shows persistence earnings. Also, the significance level is P-value is 0.002 which is less than 0.05 a suggestion that the result is significant. This can imply that high earnings management leads to persistence in earnings which is contradictory based on the previous test. The test is influenced by the manager’s intention to conceal some financial information and deceive the stakeholders to make uninformed decisions.

Regression to Test for 2015 Earning Persistence

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept -71.7934 32.42365 -2.21423 0.113652 -174.98 31.39309 -174.98 31.39309
X Variable 1 1.274245 0.11324 11.25264 0.001505 0.913866 1.634624 0.913866 1.634624

 

The regression to determine the coefficient shows that the coefficient is 1.274245 which is an indication of earning persistence. The P-value for the regression is 0.00150 which shows that the result is significant. However, since the other hypothesis is correct, the single hypothesis that is correct can be argued to have been influenced by other factors such as inflation of the profits by the organizations or the improved business environment during the period.

Based on the hypothesis test for the five firms with high earnings management, high earnings management is not associated with persistence in earnings. Although two regression results were significant and suggested that high earnings management can lead to the persistence in earnings, the situation is only temporary since the investors are deceived and thus likely to make wrong decisions. However, in the long run, the investors will be aware of the condition of the company and makes informed decisions.

5.6. Discussion of the Results

The study to examine the connection between earnings management and earnings quality came with different findings based on the hypothesis developed to achieve the objective of the research. Notably, it was established that there is a connection between the earnings management and earnings quality. In the study, it was found that firms without earnings management can realize the high-quality earnings. The result of the research is supported by many previous studies such as Balsam et al. (2002), Ewert and Wagenhofer (2012) and Glover (2014). Li et al. (2011) who found that low earnings management ensures that there are quality earnings in companies.

The other finding of the study was that there is a connection between the earnings persistence and earnings management. In essence, the low earnings management ensures that there is persistence in earnings. On the other hand, the firms with high earnings management were found to have poor earnings persistence (Li & Lin (2005). The findings can indicate that in high earnings management, the investors and other stakeholders of the organizations are deceived with false financial information to gain their trust and short-term benefits (Machdar et al. 2017). However, such organizations cannot enjoy long-term economic benefits since the stakeholders will be aware of their manipulation and make informed decisions. The firms with low earnings management often provide accurate estimates of their financial statements and thus they stakeholders will gain trust in such companies and develop a long-term relationship. This can lead to persistence in earnings for firms who discontinue from the financial manipulation.

6. Conclusion and Recommendation

Since the previous research studies indicate that quality of the accounting data and information can cause a significant economic and financial consequence in companies, the determination of the quality of data and information is considered necessary by many stakeholders.  The most valuable determinants of earnings quality are the executive reporting decisions. The study assessed the connection that exists between the earnings management and earnings quality. The result of the hypothesis developed for the study shows a significant link between earnings management and earnings quality. In this study, only one element of earnings quality was used to determine the relationship between the two variables. The study used the persistence of income to assess the association between the variables.

The assessment of how the earnings management affects the persistence of earnings shows two types of relations. In the first relation, the study tested how low earnings management can affect earnings quality concerning the persistence of earnings. The findings established that the firms with low earnings management usually record high-quality earnings. These firms can enjoy consistent earning for a long time. Many factors can contribute to such high-quality earnings for companies with low earnings management. One reason is that the stakeholders such as investors will gain confidence in the firm and this will boost its performance in the market. Many studies show that low earnings management can help increase the stock prices of companies (WeiL 2009). The findings demonstrate the ability of the firms to attract the potential investors and improve its capital base over the years.

With regards to firms with high earnings management, the research established that such firms’ records low earnings quality. It shows that there is an inverse relationship between the firms with earnings management and earnings quality for the organization that manipulate their financial statement to conceal some information to the stakeholders. Many studies also support these findings. Ewert & Wagenhofer (2012) in the study to investigate the association between earnings quality and earnings management found that high earnings management lowers the confidence that the shareholders have on the companies. Because of low confidence, the investors will be unwilling to invest in such companies, and this can expose such firms to liquidity problems. In many cases, the firms can experience a decrease in the stock prices. Many firms with high earnings management end up collapsing due to lack of capital, weak sales or bankruptcy. The findings show that many companies in the United States engage in practices that include manipulation of the financial statements to conceal some information from the shareholders. In some cases, the managers of these firms are interested in receiving commissions based on the financial performance. As a result, they adjust the profits of the company using various means to ensure that they qualify for the commissions.

6.1. Recommendations

Although the study was successful, many limitations affected its outcome. One major limitation of the study was lack of adequate time to enable the gathering of sufficient data to support the study. The limited time for the study implies that the research was not able to follow all the appropriate process that can help come up with adequate data for the research. The other limitation that impacted on the results of the study was lack of sufficient resources to fund the study. Due to the inadequate resources, the study neglected some critical process that could have improved its reliability and validity.

As a result of these shortcomings of the study, several recommendations can enhance the reliability of future studies. One suggestion for the study is to increase the sample size for the future studies. The next research study should emphasize on large sample size to help improve its reliability. Large sample size can provide a good representation of the entire population. In this study, lack of adequate resource made it impossible to come up with a large sample. In essence, the study considered only ten companies listed on the stock exchange market.  Furthermore, the period of study should also be increased to at least ten trading period to enable the collection of adequate data and information from the company.

Another recommendation is to include several measurements of earnings quality. The current study used only one measure of the earnings quality due to the limitation of resources and time. It considered just the persistence of earnings when determining the link between earnings quality and earnings management. However, there are many other useful measurements of earnings quality that can be used to determine the association between the variables of the study and can include predictability of earnings and accruals among others. The future studies should consider many components of earnings quality to determine the relationship. The inclusion of several elements of earnings quality can ensure that the results are verified, and thus its outcome important.

 

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