Three essays on earnings management in frontier countries
Creators: name: MARTENS, Wil
Publisher: name: RMIT University
Year: 2024
Subjects: classificationCode: 350103
subject: Financial accounting

description: Earnings management (EM) is the manipulation of a firm's financial performance and stock returns by its management (Wei &amp; Li 2020). In most EM cases identified by the Securities and Exchange Commission (SEC), the underlying motivation to manage earnings was to artificially alter financial market expectations (Cyril et al. 2020). Motivations to manage earnings may also be based on self-interest, and not that of the firm (Chen &amp; Huang 2020). EM research is often premised on the assumption that managers behave opportunistically at the expense of their shareholder (Safari et al. 2016), yet studies have identified instances where the management of earnings improves the ability to predict reported earnings and consequently firm value (Subramanyam 1996a), or as an effective way to communication private information (Louis &amp;
Robinson 2005).

By virtue of three studies, this thesis makes three distinct research contributions to the study of EM. The first study examines institutional settings and its ability to constrain accruals-based earnings management. The second study examines financial statement comparability as it relates to accrual and real earnings management. The third study examines the impact of EM on bank performance. All studies are interrelated but can be read independently.

The first of three contributions of this thesis begins with an examination of accrual-based earnings management (AEM) and institutional settings (Study One). It is hypothesised that AEM is more constrained in countries with stricter investor regulation. This study's examination uses two residual based and one non-residual based EM detection methods on data from 22 frontier countries spanning from 2000 to 2017. The results show that AEM is inversely correlated with financial disclosure, legal enforcement, and the number of analysts followings. Contrary to developed market studies and novel to this study, higher levels of societal trust failed to show statistical significance in their ability to constrain AEM practices. Additionally, firms in wealthier countries and those operating in countries with greater GDP growth exhibited
less propensity to manage earnings. Larger firms and those audited by Big-4 auditors were also less apt to manage earnings. Through multiple AEM detection models (discretionary and non-discretionary), findings from this study extend the current AEM literature, in regard to the social norm theory, as well as extending current views on the effectiveness of minority investors' rights.

Implications of this first study are fourfold. First, the social norm theory, which suggests that individuals are driven to match what they perceive to be the social norm (Festinger 1954), failed to play a role in reducing AEM. Thus, the decision to engage or abstain from AEM for fear of negative outcomes was not a motivating factor. Second, formal control monitors of management behaviour are influential in providing oversight and discipline on management, resulting in abridged AEM activity as the number of analysts following a firm increases. Third, factors that moderate AEM are not universally applicable, justifying standalone frontier market studies. Fourth, increased economic growth brings about financial development and naturally limits AEM, suggesting that the need to conceal poor economic performance is greater in times of low economic growth.

The second contribution (Study Two) begins with an examination of the comparability of financial statements. It is hypothesised that enhanced financial statement comparability constrains managers from engaging in opportunistic AEM and real earnings management (REM) behaviour. Using a large sample of 19 frontier market countries, and an accounting comparability method that maps comparability across several accounting standards, the results show that enhanced financial comparability constrains AEM. Contrary to developed markets and novel to this study, a significant relationship between financial comparability and REM was not found. For greater
robustness, AEM and REM proxies were also tested on countries that have adopted International Financial Reporting Standards (IFRS) and those that have not. The results suggest IFRS adoption constrains AEM, yet exhibited no impact on curbing REM. Additionally, the use of BigN auditors failed to show an ability to moderate EM conclusively. When combined, the results suggest that frontier markets engage in less REM than expected. It is also noted that the legal roots (civil versus common law) play a significant role in constraining EM. Common law countries exhibited lower AEM when comparability increased; this significance was not found in countries that were rooted in civil law. Findings from this study extend the growing stream of comparability research by casting more light on the relationship between comparability and EM, and by providing
evidence on the divergent impact of comparability on AEM and REM in the markets examined.

Implications of this second study are threefold. First, the conduct divergence of frontier markets from what is commonly found in developed markets suggests that values and norms differ. Findings from other markets may not be universally applicable to frontier markets. Second, convergence to a single or harmonised accounting system is an ideal to be supported, as noted by the increased comparability score across IFRS adhering countries. Third, increased comparability facilitates transnational information transfer, the result of which is stimulated enterprise competitiveness.

The third contribution (Study Three) is an examination of EM on bank performance as examined via technical efficiency using Stochastic Frontier Analysis. The study focuses on income smoothing via loan loss provision (LLP) and loan loss reserves (LLR) as a form of EM. The findings of this study confirm that efficiency is negatively correlated with EM. Also tested was efficiency disparities between large and small banks across five geographic regions, from which Americas, Europe, and the Middle East large banks exhibited greater efficiency, yet no significant relationship was found between bank size and efficiency. This suggests large banks do not gain from economies of scale. These findings are notable as this study supports prior evidence and illuminates the impact of income smoothing on a bank's technical performance. This study further contributes to the literature by deepening the understanding of EM's impact on the technical efficiency of frontier market banks. Additionally, through its examination of geographic and size differentials, new understanding is gained into the proclivity of frontier market banks to smooth earnings and its impact on efficiency.

Implications from this third study suggest that banks review the use of income smoothing and credit provisioning vehicles as they impact efficiency, and consequently, competitiveness. Efficiency and competitiveness are critical success factors and associated with the improvement of the managerial process. The prioritisation of efficiency to enhance competitiveness while working with limited resources is core to business success. Further, the adoption of a dynamic provisioning system should be considered as a capital buffer mechanism to smooth credit cycles as it increases the effectiveness of macro-prudential policies, and maintains the temerity of the financial system and financial reports.