The roles of internal audit quality on the relationship between narcissistic CEOs and real earnings management

This study aims to investigate the roles of internal audit quality on the effects of narcissistic Chief Executive Officers (CEOs) to earnings management through real activities manipulation. The research design is quantitative method using secondary data. The sample used in this study consisted of 116 manufacturing Companies which are listed on Indonesia Stock Exchanges for the period of 2013 to 2015. Earnings management through real activities manipulation which is also called real earnings management is proxied with three patterns: cash flow from operation (CFO), production costs, and discretionary expenses as developed by Roychowdhury (2006). The results show that narcissistic CEOs has a positive and significant effect toward real earnings management in the pattern of cash flow from operation and in the pattern of discretionary expenses. Narcissistic CEOs has no effect toward real earnings management in production costs pattern. The results of this study also provide empirical evidence that quality of internal audit can alleviate the influence of narcissistic CEOs toward real earnings management in the pattern of cash flow from operation. Meanwhile, internal audit quality can not mitigate the effects of narcissistic CEOs toward real earnings management in the patterns of production costs and discretionary expenses. Corresponding author: Jasman Jasman Email address for corresponding author: jasman@perbanas.id First submission received: 4th September 2017 Revised submission received: 11th January 2018 Accepted: 5th March 2018 Background Many researches conducted a decade ago were related to accruals earnings management (Im, 2015; Jafarpour et al, 2013; Kalgo et al, 2015; Zang, 2012; Qi, 2014). The researches have examined whether exposure media and corporate actions such as dividen policy, IPO affect accruals earnings management. Meanwhile, there is a limited research regarding earnings management through real activities manipulation which is also called real earnings management (Edinburgh, 2011; Jeong, 2014; Alarlooq, 2014; Malik, 2011). In addition, research related to incentives to involve in earnings management is not complete if only conducted on aspects of corporate governance and positive accounting theory such as financial performance or corporate action like dividend policy, IPO, and takeover protection, accounting expenses lik e cash flow operation, production cost, and discretionary expenses and R &D expenditures) and accounting conservatism, and ownership structures. Study relating to the characteristic of the person responsible for financial reporting such as the CEO is important to examine. It is because each CEO is a person who has different styles and characteristics. Research on the effect of CEO characteristics such as CEOs narcissism to earnings management is very limited. Narcissistic CEOs is triggered ideosyncratic, cultural, environmentlal, and structural factors (Ouimet, 2010). CEO narcissim is proven to limit the influence of other directors on the corporate strategy and affect the information process in strategic decision making (Zhu & Chen, 2015). Journal of Business and Retail Management Research (JBRMR), Vol. 13 Issue 1 October 2018 www.jbrmr. com A Journal of the Academy of Business and Retail Management (ABRM) 242 Fraudulent financial statements will be deterred when internal control function is implemented effectively; therefore, quality of internal control should be increased through the quality of internal auditor (Ege, 2015). Internal audit play an important role in mitigating agressive accounting behaviour of management; hence, reliable internal auditor is expected to take action on anticipating every fraudulent action which could occur in the future (Prawitt & Wood, 2009). Ege (2015) argues that high quality of internal auditor is more likely mitigate management misconduct as compared to low quality of internal auditor. Moreover, high-quality of internal auditor would be as an effective tool to prevent earnings management. Gramling & Hermanson (2009) says that the quality of internal audit is based on what inputs and processes are used to produce quality performance products; in other worlds, using the average experience of audit professionals, certification owned by professional auditors, and training provided to the internal auditors. The purpose of this study is to examine the influence of Narcissistic CEOs on real earnings management as well as the role of internal audit in moderating it. The significance of this research is to contribute to stakeholders regarding the influence of psychological aspects such as CEOs narcissism on real earnings management. This research raises variables of narcissistic CEOs who are associated with earnings management activities which have been very limited examined in Indonesia. Next section of this paper discusses literature review and hypothesis development, research method, result and discusstion, and conclusion. Literature Review and Hypothesis Development The effects of Narcissistic CEOs on Earnings Management Literatures have evolved in generating models to identify factors which motivate management to commit in earnings management practices. In addition, one of the factors which is indicated to contribute to earnings management is believed to be from a psychological aspect: narcissim. Narcissism is characterized by traits such as dominance, self-confidence, sense of entitlement, grandiosity, and low empathy that have developed evidence that such individuals often appear as Leadership (O'Reilly III et al, 2013). Narcissism has become a popular topic because it has two strong organizational relationships: counterproductive and leadership behaviors (Grijalva, 2014). Another view about the negative nature of narcissistic CEOs are sensitive to criticism, poor listener, lack of empathy, dislike mentoring, intense desire to compete; despite, there is a productive narcissistic such as self-reflection, strong point of view, and a high sense of humor (McMahon, 2009). Narcissism is a characteristic that is thought to negatively affect the company's financial results and reputation (Duchon & Drake, 2009). Theoretically, extreme narcissistic CEOs point out themselves as the companies they lead and use accounting figures to gain awe from Stakeholders and for example can also result in unfavorable behavior including accounting fraud and stock manipulation (Amernic & Crag, 2010). Chatterjee and Hambrick (2007) discuss that narcissistic CEOs often want a large aide, developing the right-fisted strategy that is related to the fluctuating performance of the company. Furthermore, Chatterjee and Hambrick (2011) add that in comparisons with CEOs who are not narciss, narcissistic CEOs are less responsive to current performance goals. Narcissistic CEOs are preferred by praise and therefore require admiration and social recognition (Judge et al, 2009). In relation to the company's financial performance, Olsen et al (2014) argues that there is a positive relationship between the narcissistic CEO and the earnings per share in the company's financial statements. His research also proved the narcissism CEO crave praise and adulation of the accounting information presented to public. Narcissistic CEOs are not only surviving the influence of other directors' experience but also strengthened by their corporate strategic strategy as opposed to what has been replaced by the experience of other directors (Zhu & Chen, 2015). Jiang et al (2010) examines the influence between CEOs and CFOs in adopting earnings management. His research finds a strong relationship between CFOs' desires for earnings management action. In contrast, the results of this study differ from the findings of Feng et al (2011) on companies in the US, which found no evidence that CFOs manipulate the company's financial statements; meanwhile, CEOs have a stronger influence within the organization (proxies with CEO position holder as Chairman of Board and often has a compensation share of top five executives) and CFOs often leave the company Journal of Business and Retail Management Research (JBRMR), Vol. 13 Issue 1 October 2018 www.jbrmr. com A Journal of the Academy of Business and Retail Management (ABRM) 243 before the period of accounting manipulation. This study concludes that CEOs who manipulate corporate financial information have substantial authority over CFOs insofar as the threat of job loss is not involved in accounting manipulation. The results of Feng et al (2011) study are supported by Rijsenbilt and Commandeur (2013) who find that Narcissistic CEOs limit the directors' influence on corporate strategy. Also, the study prove that there is a positive relationship between the psychological point of view of the CEOs who is narcissistic about the potential causes of Fraud. Based on the discussion, the hypothesis of this research is stated as follows: Hypothesis 1 (H1): Narcissistic CEOs have a positive effects on real earnings management Internal Audit Quality Roles in Moderating the Effects of Narcissistic CEOs on Real Earnings Management In the decision of Indonesia Securities Exchange Commission (called Bapepam & LK) decree number: KEP-496/BL/2008 concerning the establishment and guidance of the preparation of the charter for the internal audit unit provides a requirement for auditors of internal audit department that internal auditors should have knowledge and experience on audit technical and other relevant disciplines. Previous studies have found that narcissistic CEOs are preferred by praise and therefore require admiration and social recognition (Judge et al, 2009). In relation to the company's financial performance, Olsen et al (2014) argues that there is a positive relationship between the narcissistic CEO and the earnings per share in the company's financial statements. His research also proved the narcissism CEO crave praise and adulation of the accounting information presented