Practical Motivation
Different firms practice conservatism differently. Both the stockholders and the debt providers do not have the same interests in the corporations. The shareholders try to take a considerable amount of dividends at the expense of the creditors especially where the businesses have a big executives’ ownership structure (Boyd and Solarino 2016). Due to this structure, the managers decide to give the stockholders dividends in surplus. Therefore, the shareholders’ interest is to maximize on the dividends. On the other hand, the debt providers require that the corporations secure their monies in order to get returns in the future. Therefore, the debt providers require the companies to practice conservative financial reporting in order for them to be safe from the stockholders who transfer the earnings that the firm makes by taking too much dividends (Guay and Verrecchia 2018). According to Guay and Verrecchia (2018), conservatism decelerates the recognition of income and increases the recognition of expenses, hence, it triggers the accounting estimation. The present study is vital, since, it will assist both the stockholders and the debt providers to understand the businesses that produce the reliable financial reports in order to maximize their dividends and returns respectively in the future.
Firms’ executives get pressure when managing the earnings and through the accountants, they manipulate the corporations’ accounting practices in order to realize what they expect financially while keeping the share prices of the business up (Mao and Renneboog 2015). Most of the managers obtain bonuses depending on how the earnings perform while some might qualify for stock options, which create an income when their prices improve. Auditors do not disclose several forms of earnings’ manipulation, therefore, shareholders remain in the dark. Therefore, the executives who mind about the firms’ stockholders will find the current research helpful because they will get its findings, which will suggest the methods to reduce the pressure that they get when managing the earnings. By following the proposed ways, the firms will produce true financial statements that the shareholders will rely on when making investment decisions.
Scholars have carried out a lot of studies about the firms’ earnings management in various parts of the globe but not many have studied the relationship between the firms’ earnings management and accounting conservatism especially in Australia. Hence, the present research will concentrate on that association in Australia. According to Akdogan and Ozturk (2015), managers must explain any variation in the accounting principles to the users of the financial accounts by disclosing in the footnotes of the statements. These disclosures would ensure that there is consistency and the financial accounts become comparable, thereby, exposing any manipulation of the earnings. The current study will improve on the prevailing theory because it will demonstrate how the executives should manage the earnings of their firms in order to avoid giving misstatements and help the financial accounts’ users to make prudent investment decisions.
Theoretical Motivation
This section discusses the earnings management, agency theory, and the relationship between a firm’s earnings management and accounting conservatism.
Firm’s Earnings Management and its Relationship with Accounting Conservatism
Earnings management is a situation where the managers of a firm use the accounting methods to come up with financial accounts, which exaggerate a corporation’s commercial activities and financial position in a positive way. According to Ali and Zhang (2015), several accounting rules and principles allow business managers to make their decisions by following them. Ali and Zhang assert that the earnings management such benefits of the accounting and principles to create financial reports, which inflate the income and assets of the firms, hence, smooth out variations in earnings and show consistent returns either monthly or annually.
There is a negative relationship between the firm’s earnings management and accounting conservatism. Conservatism is a principle, which tries to create the asset and income values, hence, decelerates the recognition of revenue while accelerating the recognition of expenses. According to Lara, Osma, and Penalva (2016), conservatism slows the future cash inflows recognition and allows the accountants to report the highest liabilities’ values, and the lowest assets and revenues’ values, therefore, producing the lowest equity book values. Conservatism produces high profits, since, the principle does not allow companies to exaggerate their earnings, thus, assists the accounting information users as they present earnings and assets that they do not overstate (Guan 2014). Therefore, the organizations’ managers and accountants might require to start using accounting conservatism when calculating the values of the assets and incomes in order to enhance the revenues’ quality for the stakeholders to use when evaluating the business.
The agency theory expounds on the association that exists between a business’s principals and the agents. According to Pepper and Gore (2015), the purpose of agency theory is to resolve the challenges that arise in agency relations because of the objectives that are not aligned or when the levels of averting risk are different. Pepper and Gore assert that in finance the commonest agency association happens between the shareholders who are the principals and the corporation’s executives who are the agents. Agency problems might happen due to the principal not being aware of the agent’s activities or the lack of funds prohibit him or her from getting the information (Chari, David, Duru, and Zhao 2018). For instance, the firm’s managers might wish to grow the corporation to other marketplaces, which will take much of the current profits of the business as the executives prospect more incomes. On the other hand, the shareholders who want more growth in the current capital might not be aware of the managers’ strategies.
Literature Review
According to Eisdorfer, Giaccotto, and White (2015), Jensen and Meckling are the ones who proposed the agency theory in 1976 by defining the corporations’ managers as the “agents” and the shareholders as the “principals”. Jensen and Meckling acknowledged that shareholders are at odds with the directors because the shareholders delegate decision-making to the managers. However, the challenge is that the directors do not make decisions in the favor of the shareholders. Jensen and Meckling posited that agency theory assumes that the “agents” and the “principals” have a conflict of interest. The views of the two were that what motivates the managers is in their private interests, which conflicts with the interests of the shareholders to maximize wealth. This opinion posits that the motivations, which include rewards, contracts, political motivations, tax incentives, and changing the Chief Executive Officer (CEO), are some of the major earnings management inducements.
Nahandi, Baghbani, and Bolouri (2012) undertook a study about the earnings management and accounting conservatism with a case study of Iran. The scholars investigated, “the relationship between earnings management and accounting conservatism in Iranian firms.” Nahandi, Baghbani, and Bolouri measured the earnings management using the modified Jones model while they measured conservatism using the Basu (1997) model. The scholars studied the firms listed in Tehran Stock Exchange between 2001 and 2008, and used the systematic omission method to get the sample and the ordinary least squares (OLS) regressions to test the relationship between earnings management and accounting conservatism. Nahandi, Baghbani, and Bolouri found out that the association between the earnings management and accounting conservatism is negative. The organizations whose earnings management was at low levels appeared to possess big asymmetric timeliness coefficients while the institutions whose earnings management was at high levels had small asymmetric timeliness coefficients.
Zhang (2012), in his research about, “the empirical study of earnings management based on Chinese listed companies” used the margin return on equity (ROE) and the Jones model in the empirical examination on the selected manufacturing firms in China. From the results, Zhang found out that changing of accounting principles does not escalate the earnings management although sometimes it can go up slightly, hence, not statistically significant.
Martin and Roychowdhury (2015), in their study about, “Do financial market developments influence accounting practices? Credit default swaps and borrowers? reporting conservatism” studied how conservatism relates to both the accrual and real earnings management. The authors used a large sample of the banks from1991 to 2010. From the results, Martin and Roychowdhury found out that there is a positive relationship between conservatism and the real earnings’ management and a negative relationship between conservatism and the accruals interference’s measures.
Firm’s Earnings Management and its Relationship with Accounting Conservatism
Abbasiazadeh and Zamanpour (2016) studied about, “Investigation of the Effect of Audit Size on Earnings Management in Tehran Stock Exchange.” The authors investigated the effect of audit size on the earnings management in the 116 corporations registered with the Tehran stock market from 1387 to 1392. Abbasiazadeh and Zamanpour tested earning management using multiple regressions. The authors used a sample of 5 corporations that are listed on the stock market and utilized the Excel statistical tool for analysis. From the findings, Abbasiazadeh and Zamanpour established that the audit size and tenure are significantly correlated to the earning management.
Hosseini, Chalestori, Hi, and Ebrahimi (2016), in their study about, “the relationship between earnings management incentives and earnings response coefficient” used a sample of 100 firms listed in Tehran Stock Exchange. The authors studied the firms from 2007 to 2013 and statistically analyzed the data collected at a 95% confidence level using the coefficient of correlation. Hosseini, Chalestori, Hi, and Ebrahimi used the multivariate linear regression model to test the hypothesis of the study. From the findings, the authors established that there is no relationship between the earnings management incentives and the earnings response coefficient.
Saghafi (2016) studied about, “examining the relationship between disclosure levels, ownership structure, and earning management in the Tehran stock exchange.” The author studied 143 companies that are registered with Tehran stock market from 2005 to 2014 with an aim of examining the effect of the various disclosure levels and methods on the firms’ earnings management. From the findings, Saghafi established that there is a positive and significant effect of the ownership of organizations on earnings management. In addition, Saghafi established that there is a negative and significant effect of disclosure on the firm’s earnings management. The size of the organization also has a positive correlation with the earnings management while financial leverage has a negative effect. Therefore, from these findings, it is prudent that the investors and key shareholders take part in supervision in order to enhance the company’s performance. Their supervision will also assist in aligning their interests with those of the executives in order to reduce the agency problems.
In his research about, “the effect of accounting conservatism on earning quality”, Asri (2017), studied the corporations registered with the Indonesian stock exchange from 2010 to 2015 using the purposive sampling technique to get the representative sample of the population. Asri found out that conservatism positively affects the earning quality and, therefore, the managers positively show the accounting conservatism’s use in the firm, hence, enhancing the earnings’ quality. The investors get high values by offering high premiums on the business’s price of shares. From the literature reviewed above, it is established that there is a negative relationship between firms’ earnings management and accounting conservatism. Some studies show that there is a slight escalation in the earnings management when the firms change their accounting principles.
The accounting conservatism at the level of the organization influences the corporation’s earnings’ management.
Reference List
Abbasiazadeh, L. and Zamanpour, A., 2016. Investigation of the Effect of Audit Size on Earnings Management in Tehran Stock Exchange. International Journal of Humanities and Cultural Studies.
Akdogan, N. and Ozturk, C., 2015. A Country Specific Approach to IFRS Accounting Policy Choice in the European, Australian, and Turkish Context. EMAJ: Emerging Markets Journal, 5(1).
Boyd, B.K. and Solarino, A.M., 2016. Ownership of Corporations: A Review, Synthesis, and Research Agenda. Journal of Management, 42(5).
Ali, A. and Zhang, W., 2015. CEO Tenure and Earnings Management. Journal of Accounting and Economics, 59(1).
Asri, M., 2017. The Effect of Accounting Conservatism on Earning Quality, SSRN Electronic Journal
Chari, M.D., David, P., Duru, A. and Zhao, Y., 2018. Bowman’s Risk-Return Paradox: An Agency Theory Perspective. Journal of Business Research.
Eisdorfer, A., Giaccotto, C. and White, R., 2015. Do Corporate Managers Skimp on Shareholders’ Dividends to Protect their Own Retirement Funds? Journal of Corporate Finance, 30.
Guan, K., 2014. Corporate Growth, Audit Quality and Accounting Conservatism: Empirical Evidence from Public Companies in China. Journal of Accounting and Economics, 5(005).
Guay, W. and Verrecchia, R.E., 2018. Conservative Disclosure. Journal of Financial Reporting.
Hosseini, M., Chalestori, K.N., Hi, S.R. and Ebrahimi, E., 2016. A Study on the Relationship between Earnings Management Incentives and Earnings Response Coefficient. Procedia Economics and Finance, 36.
Lara, J.M.G., Osma, B.G. and Penalva, F., 2016. Accounting Conservatism and Firm Investment Efficiency. Journal of Accounting and Economics, 61(1).
Mao, Y. and Renneboog, L., 2015. Do Managers Manipulate Earnings Prior to Management Buyouts? Journal of Corporate Finance, 35.
Martin, X. and Roychowdhury, S., 2015. Do Financial Market Developments Influence Accounting Practices? Credit Default Swaps and Borrowers? Reporting Conservatism. Journal of Accounting and Economics, 59(1).
Nahandi, Y. B., Baghbani, S. M., and Bolouri, A., 2012. Earnings Management and Accounting Conservatism: The Case of Iran. African Journal of Business Management, 6(19).
Saghafi, S., 2016. Examining the Relationship between Disclosure Level, Ownership Structure, and Earning Management in the Tehran Stock Exchange. The Turkish Online Journal of Design, Art, and Communication.
Pepper, A. and Gore, J., 2015. Behavioral Agency Theory: New Foundations for Theorizing about Executive Compensation. Journal of Management, 41(4).
Zhang, Y., 2012. The Empirical Study of Earnings Management Based on Chinese Listed Companies. Lingnan Journal of Banking, Finance, and Economics, 3(1).
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