Question

It has been suggested that not all accounting choices are made by management in the best interest of fair and consistent financial reporting.

What are motivations can you think of for management's choice of accounting methods?

Answer 1

1 Earnings Management
From a broad perspective, accounting is all about the measurement and communication of economic information
to the users of financial information. Depending on the type of the users of the information be it creditors, lenders,
regulators or public at large, accounting is divided into internal and external accounting. While internal accounting
is used for decision making within the firm such as project and profitability evaluation, external accounting is used
to assist stakeholders in decisions concerning their relationship with the firm. Thus, external accounting should
deliver useful information for investors, creditors, regulators, customers, suppliers and employees in their respective
decisions regarding future investments, taxes, whom doing business and with whom to work for (Watts &
Zimmerman, 1986; Spohr, 2005).The responsibility for preparing and publishing external accounting information lies with the firm’s managers.
As an insider, managers apply their inside knowledge of the firm’s current state and business circumstances to
prepare the information, hence providing a true and fair view of the firm’s financial state and performance. In order
for the accounting information to be useful for decision making, it needs to be both relevant and reliable (Spohr,
2005). However, given the existence of information asymmetry between managers and external users of accounting
information, it gives an opportunity for the managers to use their discretion in preparing and reporting accounting
information for their own benefit. The use of discretion in preparing and reporting accounting information is what
we called earnings management.
There are no specific or clear definitions of earnings management. Prior studies have provided a lot of definition
for earnings management Schipper (1989) is among the first who give the definitions on earnings management.
Schipper (1989) defined it as:
“Purposeful intervention in the external financial reporting process, with the intent of obtaining some private
gain”.
Healy & Wahlen (1999) provide a more extensive definition of earnings management. According to their definition:
“Earnings management occurs when managers use judgment in financial reporting and in structuring
transactions to alter financial reports to either mislead some stakeholders about the underlying economic
performance of the company or to influence contractual outcome that depend on reported accounting numbers”.
On the other hand, Leuz, Nanda & Wysocki (2003) defined earnings management as the alteration in firms’
reported economic performance by insiders to either mislead some stakeholders or to influence contractual outcome.
Whatever the definition of earnings management, it agreed on the point that managerial intention is a prerequisite of
earnings management; however, whether this intention should be opportunistic in nature is not totally clear. Some
presentations on earnings management also use the term in connection with managerial discretion not opportunistic
(e.g. Dechow & Skinner, 2000; Scott, 2003). Earnings management could be legitimate or illegitimate. Illegitimate
earnings management would naturally result in fraudulent financial reporting, which in turn could mislead the users
of financial reports.
This fraudulent financial reporting once revealed could cause severe punishment from regulators and could cause
the company to be wound up and cease to exist as what had happened in the case of Enron. However, in the case of
deciding whether earnings management is legitimate or illegitimate, this can be best referred to generally accepted
accounting principles (GAAP). If the practices are within the GAAP, then it will be classified as legitimate earnings
management. However, if the practices go beyond the GAAP boundary, it will result in illegitimate earnings
management (Al Khabash & Al Thuneibat, 2009).
Yaping (2005) stated in his study that the employment of earnings management required the management
judgment to change the accounting estimation and accounting policies. The ability of the managers to use their own
judgment and discretion in accounting gives them the power to choose any allowable accounting method and any
estimate in accounting method (Dechow & Skinner, 2000). One of the ways of managing earnings is through the use
of accruals. Though, total accruals are closely related to earnings management, it should be noted that not all the
portion of total accruals is related to earnings management. In the total accrual, it will be distinguished into two
portions. The first portion is what we called non-discretionary accrual which also known as normal accrual based on
the management estimation according to the economic performance of the companies (Abd. Rahman & Mohamed.
Ali, 2006).
Meanwhile, the other portion of total accrual is discretionary accruals which are the part of the total accruals that
has been managed by the management, within the constraint of accounting principles (Amman et al., 2006). Thus,
the discretionary accrual will be used to determine the earnings management. Becker, Defond, Jiambalvo &
Subramanyam (1998); Frankel, Johnson & Nelson (2002); Mohd.Saleh, Mohd. Iskandar & Hassan (2005) and
Abd.Rahman & Mohamed Ali (2006) are the examples of studies that have been used discretionary accruals as a
proxy for earnings management. Instead of using accruals, earnings also could be managed by using other various
known techniques. Ratsula (2010) suggests that there are four techniques of managing the earnings. The first
technique is known as taking a bath. By using this technique, management tends to report more loss in order to
enhance the probability of future reported profit, especially during the situation of high organization stress or
reorganization.

Opportunistic Behaviors
The opportunist managers may manage the accounting numbers to camouflage the negative performance and
reported it as a highly performed company. In this study, the opportunistic behaviors of the manager are discussed in
terms of free cash flow and the profitability of the company. High free cash flow may create an opportunity for
managers to manage earnings and create an agency problem. Initially, free cash flow is a surplus cash flow, which is
readily available to be used to finance any project that can give positive net present value (Jensen, 1986). Agency
problem will happen if free cash flow of a company is wrongly invested or expense in a way that the manager
disregard to maximize the shareholders’ wealth (Jensen, 1986). In other words, the manager can choose either to
invest in a profitable investment or low-return investment. If the manager chooses to invest in an unprofitable
investment or low-return investment, the company may be in the state of low growth position. Previous literature
provides that when the surplus free cash flow is high, the manager will obtain their personal benefits (Ross, 1973;
Jensen & Meckling, 1976; Jensen, 1986; Gul, 2001).
Normally, earnings management that occurred in the companies with surplus free flow can be connected to
discretionary accruals (DAC). This is supported by the study of Bukit & Iskandar (2009) who argued that surplus
free cash flow may create an incentive for the manager to engage in income-increasing management, financial
flexibility signal. In other words, firms with high free cash flow and have a low growth opportunity is associated
with the agency problem and the manager tend to use income increasing to boost the reported earnings (Gul & Tsui,
1998; Chung et al., 2005). Additionally, Stulz (1990) noted that the deficit free cash flow as the reason why
company are more likely to issue debt as external fund. By having this free cash flow, the manager is expected to
invest in profitable project and rather than left it unexploited. The presence of effective and efficient monitoring and
disciplinary actions by institutional shareholders, lenders, board of directors, audit committee and others could
restrain managers of firms with free cash flow and low growth opportunity to invest in wasteful investments (Gul,
2001).
Most of the times, the managers provided inflate reported earnings to enhance expectation of the investors
regarding the future performance of the company and to increase the offer price (Rahman & Abdullah, 2005).
Besides that, the managers of the company which having declined profitability are motivated to smooth earnings
(White, 1970). Additionally, severe fluctuated income and declined profitability in a company is one of the strong
incentives that would be engaged by the managers in smoothing the company’s earnings (Ashaari, Koh, Tan &
Wong, 1994). According to Dennis and Michel (1996), there are three objectives of earnings management, which
are; to reduce political cost, the firm’s financial cost and to maximize manager wealth and well being. Thus,
earnings management employed by the managers should at least satisfy one of those objectives.

Monitoring Mechanism
Monitoring mechanisms can be divided into internal monitoring and also external monitoring. Internal
monitoring consists of parties within the corporation such as board of directors and the internal audit committee,
which ensure the effectiveness of internal control in order to reduce the opportunistic behaviors of the management
and earnings management itself. According to Van de Poel & Vanstraelen (2007), Dutch listed companies have a
lower level of abnormal accruals resulting from adequate and effective internal control. On the other hand, external
monitoring is a part of monitoring mechanism which is from outside the corporation such as lenders’ monitoring and
institutional monitoring.
Leverage referred to the amount of debt used to finance a company’s asset and business operation other than
equity. Leverage can be utilized as an efficient control mechanism to avoid the practice of excessive earnings
management that would eventually harm the corporation. According to Andrade & Kaplan (1998), high leverage
companies would have higher financial risks such as financial distress, default on debt payments and bankruptcy
risk. In addition, Jensen (1991) argued that the establishment of new regulation and economy downturn crisis may
give significant impact on high leverage companies. Hence, these high leverage companies are worsened off. The
company might consider having a high leverage if the value of debt is more than the debt optimal value (Shubita &
Alsawalhah, 2012). Thus, that the higher the debt ratio, the greater the risk, and thus the higher the interest rate will
be (Shubita & Alsawalhah, 2012).
The management’s ability to use the company’s asset for personal benefits and to exploit the company’s asset
can be constrained by the existence of external lenders (Bilimoria, 1997). As they are concerned on the debt
repayment ability of the company, lenders will ensure that the management will fully use of the cash available in the
profitable investment. In other words, the monitoring activities will be carried out by the lenders in order to make
sure that the company materializes the debt repayment. The lenders will eventually monitor the management’s
action because it is the main factors determining repayment (Leng 2008). Previous studies found that less long term
emoluments are paid to the Chief Executive Officer (CEO) of the highly leveraged firm. That means, there is no
room for the management to expropriate company’s cash flow if there is presence of lender’s monitoring. According
to Cable (1985) and Nibler (1995) monitoring by lenders contribute to the profitability and growth of the company.
While, Chirinko and Elson (1996) found an insignificant relationship between monitoring by lenders and the
company’s earnings.
Prior research has provided evidence that defaulting companies prefer to make more accounting changes as
compared to the non-defaulting companies. Similarly, the study conducted by Sweeney (1994); Dichev & Skinner
(2002) and Beatty & Weber (2003), reported that managers make an accounting choices in order to avoid debt
covenant violations by applying income increasing motive. This is supported by Christie (1990) as leverage is one of
the explanatory power in choices of accounting method. On the other hand, the lenders will demand and scrutinize
several measures if high leverage companies wish to take out a new loan and this will put a lot of pressure to the
manager to manage the earnings (Zagers-mamedova, 2009). Since the management is permitted to choose any
allowable accounting method and estimates, the manager will use this opportunity to manage the earnings because
the manipulation of accounting practice is difficult to measure (Dechow & Skinner, 2000).
There are mixed opinions on whether leverage may influence the potential of manager to exercise earnings
management. A study of Aman et al. (2006) argued that the leverage has no influence on earnings management as
refer to the period after the 1997 economic crisis. This is because the corporate sector in Malaysia heavily dependent
on commercial bank financing in order to get external funds. Hence, the financial difficulties faced by companies
might transpire managers to improve upon their performance through earnings management. In contrast, some
literature claimed that the debt may discourage or restraining earnings management as monitoring mechanism.
Having a debt, would disciplined the management in debt repayment in order to avoid debt covenant default and
being sued by the lenders (Stulz, 1990). Similarly, a study from Balsam, Bartov, & Marquardt (2002) and Siregar &
Utama (2008) claimed that lenders have more access to relevant and timely information that enable them to detect
earnings management done by unethical managers.