Relationship Between Management And Shareholders Finance Essay

A lot of studies have been done in the matters of earnings management. It is because earnings management can be practice in many ways. There are several research done which covered the topic about earnings management and board characteristics(Saleh, et al,2005), board of directors and opportunistic earnings management (Sarkar et al., 2006), earnings manager and long term performance (Ho, et al 2006), earnings management in education (Misiewicz, 2006), earnings management and IPOs (Spohr, 2004) and so forth. Here in this assignment I put an interest on study of earning management and IPOs. Where I already found several related articles which cover the topic from several countries. The countries cover from the articles that I already found are IPOs in Finland, Japan as well as Malaysia.

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Before I discuss about earnings management in IPOs in depth, I also discuss about the relationship between management and shareholders. Then I discuss about definition of earnings management from different point of views. Beside that I also get to understand of earnings management through the mechanism as well as the loopholes in accounting standards the can caused the earnings management could happen. I also highlight several method of earnings management that familiarly practices. Eventually, I will discuss the issues of earnings management in IPOs that happen in Japan, Finland and Malaysia.
LITERATURE REVIEW
Relationship between management and shareholders
Financial statements can be seen as medium of information between management of particular company and shareholders. Management is considered as workforces to achieve companies’ objectives. While shareholders represented as capital’s supplier which generated the workforces in order to achieve the objective. Typically only public listed company should disclose their annual report to the shareholders or potential shareholder. The benefit gain from to be listed in any stock exchange are for additional funds, not only to finance further expansion and diversification as well as new projects as well as to reduce debts(Rahman and Abdullah, 2005). Beside that public will see the listed company typically have higher profile and greater visibility which confers greater investors’ confidence and publicity.
The relationship between managers and shareholders in the business world cannot be disputable. This relationship is interpreted under Theory Agency (Bukit and Iskandar, 2009). They are very dependent each other, even somehow there exist conflict of interest among these two parties. In example the shareholders put on trust to agency by contributing huge amount of money in terms of paid up capital, so that agency can generate business and obtain profit and increase the firm’s value as principles’ return. Meanwhile agency (managers) is dependent to the principles for remunerations and bonuses as compensation (Bukit and Iskandar, 2009). Because of the great pressure from principles (shareholders) towards the high performance of firms values, so agency commonly practice earnings management in order to be sustained in market place (Jayati et. al.,2006).
Definition of earning management
Various optional opinions obtain from literature regarding earnings management. Bukit and Iskandar (2009) defined the earnings management may involve manipulation of accounting record, intentional omission or intentional misapplication of accounting o accounting principles. While, Mohanram (2003) define earnings management as the intentional misstatement or earnings leading to bottom line numbers that would have different in the absence of any manipulation. The Baralexis, S., 2004 advocates that earnings management is the process of intentionally exploiting or violating the GAAP or the law to present financial statements according to one’s interests. The earnings management activities can break the reliability and credibility of management towards the shareholders.
Earnings management is intrinsically related to earning quality (Lopes et al,2006). Schipper (1989) define the earnings management as a deliberate intervention of external financial accounting process with the intent of obtaining some private gain. Her argument of definition is based on a observing of accounting numbers as information. Within the opportunities offered by the accounting system, managers could exercise manage earnings by selecting accounting methods within GAAP or by changes in the ways given methods or policy (Ismail and Weetman, 2008). On the other hand, Healy and Wahlen (1999) define earnings management as an activity where manager used their discretion to adjust financial report either to misled stakeholders or for self interest.
Earnings management also known as creative accounting or ‘cooked the book’ may have twofold purposes. First to stop shareholders from withdrawing capital and second, as a means of reporting favorably on stewardship and performance (Devi et al., 2004). Perhaps, the main reason why companies use earnings management is because of the pressure placed upon management to show favorable returns on their investor’s money. This idea of seeking to please shareholders is reinforced by Agency Theory (Bukit & Iskandar, 2009). Theory agency states that individuals seek to maximize their own utility, and act only in the individual best interest (Hooper et. al., 1998). So, acting in the company’s best interest, management will manage the earnings to enhance their financial reporting, and therefore protect the basis of their contract (Mathews & Perera, 1996). Pressure from management, therefore, may cause accountants and auditors to accept in producing favorable reports to shareholders using earnings management techniques to improve results (Hussey,1996).
Earnings management mechanism
The practice of earnings management occurs because of the availability of different acceptability accounting accrual choice to be applied for determinant of reporting income. There are several mechanisms of implementing earnings management.
First, is what they called as ‘big bath’. This type of earnings management is when the company could not reach their target in certain period. Normally companies’ target is based on previous performance. Then when firms are way below their target, they have an incentive to make things look even worse (Mohanram, 2003). There are several ways to make it worse such as the company will take large reconstructing charges, increase in provision for bad debt, and take other income decreasing accounting decision. This kind of practices are bound under two reasons which is firstly it is highly impossible that any amount of earning management will get them over the target and secondly the cost to make it worse are typically minimal. Therefore, any improvements in performance will perceive that managers are more credible and greater credit for turning around a firm. Some other way of perception regarding big bath is when manager takes over responsibility for a unit there is a motivation to make as much as provision that ensure any losses appear as the responsibility of the previous manager (Amat and Blake et al,1999)
Second mechanism is what they called “cookie jar” accounting. This practice of earning management is when the company relatively to achieve above target, they may again have an incentive to reduce earnings. Typically there is little benefit in going way above a benchmark. Consider a firm which expects to report an EPS of RM3.80 for a given quarter when expectations hover around RM3.00. Especially when economic boom-up. Such a firm may report an EPS of RM3.30, but it still beating expectations. The remaining 50 cents of EPS reduction may come in handy in future quarters when the firm is slightly below targets. By reducing current period income, firms implicitly save some of these excess earnings for the future when they may be more valuable. The mechanism of the earnings management can be illustrated as below:
Sources: Mohanram, 2003
Standard board point of view
Earning management also be called as creative accounting. Creative accounting enable managers to ‘cook the book’ and ‘window dress’ their company by taking advantage of the loopholes in accounting standard. Due to this activity of earning management and thus provide doubtful of information in financial statement, so such information become unreliable. Therefore the users of financial statement will make wrong decision based on manipulated accounting numbers. Unfortunately, GAAP make such a room to accountant to make a manipulation since it allow accountants to use their discretion to make decision which is needed. In addition creative accounting is not against the law, in the hands of less a scrupulous managements, it can be dangerous instrument of deception (Naser, 1993). The common methods used by changing the assumptions for accounting standard.
Methods normally applied for manage the earnings
The very common method of manage earnings that normally applied by practitioners is as below:
Changing the assumptions for accounting standards. For example Change in depreciation policy by extending depreciable lives periodically and justify it on the grounds that the change brings them in line with industry standards.
Capitalization of expenses that previously expensed, increasing the extent of capitalization, slowing down amortization of previously capitalized expenses
Reducing the provisions for bad debts. This is what people say of accrual discrepancies.
Reducing income by taking on large one-time charges. For example restructuring charges.
Managing transactions, whereby companies will create last minute sales by sending up a bundle of inventories to the customers by free charge for 3 months (let say) and recorded in a book of account receivables.
Earnings managements and IPOs-Evidence from Finland
This study had been made by Sphor (2004). His study had been used a sample companies on 56 firms that went public in the years 1994 to 2000 on Helsinki Stock exchange. The author want to prove that there is a presence of earnings management in initial public offerings (IPOs) of Finnish firms. Virtually, there is several studies have documented the presence of earnings management in IPO firm (e.g. Friedlan,1994, Teoh, Welch and Wong, 1998 and Aharony, Lee and Wong, 2000). The reason for such study is in IPO normally the earnings management practice difficult to detect from the income statement and the balance sheet, thus investors would benefit from other information that reveals the probability of earnings management. It is because managers’ and owners’ incentives to manage earnings are used to assess the likelihood that earnings management is used before IPO (Spohr, 2004). According to Aharony et al (2000), the earnings management likelihood in Chinese IPO firms varied across industries and listing location. They suggest the noted differences in opportunistic behavior to be a result of manger’s incentive to manage earnings and their possibilities to do it without detected.
IPOs are priced by discounting the company’s future cash flows and by observing the market values of similar publicly traded companies. At the time of their IPOs issuing companies seem to sell below market rates as their share prices are often underpriced, meaning that their value at the close of day one trading is higher than the initial price of the stock (Ritter, 1991). During the high IPO activity period that ended in year 2000 the initial returns were on average high. The in Finland found, the biggest initial profit was generated by F-Secure whose stock rose on its first trading day on November 5, 1999 from the initial offering price of 7.70 euros to 27.45 euros.
The initial underpricing of Initial Public Offerings(IPOs) fits poorly to the long-term return on IPO shares. Ritter (1991) shows that IPO firms on average give poorer three-year returns than other listed firms in comparable sizes and industries. He explains this weak return on IPO shares with timing. Firms time their IPOs to the periods when the market overprices the firm, its industry and IPOs in general. The weak share performance after the IPO can also be explained with earnings management. If the firm before the IPO artificially boosts its value through managing earnings, the market will sooner or later find out the true performance of the company and devalue its shares.
Compared to bad accounting or simple randomness, the distinguishing feature of earnings management is the presence of intent. Studies identifying earnings management usually make the assumption that intent is present in the circumstances where the tests are made. In research testing for earnings management in IPO firms it is assumed that it is capital market motivations that drive the firms to earnings management. The aim is to maximize the company’s equity value and through this increase the owners’ wealth and reduce the companys’ financing costs.
The most commonly used method to test for earnings management is the examination of accruals because they are easier to manipulate than cash flows. Abnormal accruals are considered as a sign of earnings management. The major problem in earnings management studies is how to determine if accruals are abnormally high or low. Most models used to estimate the normal level of accruals base their estimations on the firms’ past accruals or comparable firms’ accruals. In the literature the normal and abnormal accruals are usually called nondiscretionary and discretionary accruals.
In particular, the research based on U.S. data provides strong evidence of discretionary accruals in IPO firms. Additionally, Teoh, Welch and Wong (1998) show that discretionary accruals can be linked to companies’ long term stock market performance and thus challenge the efficient market hypothesis, as the market fails to account for the manipulation. When they grouped firms by the magnitude of discretionary accruals before the IPO, they found that firms in the quartile with the lowest discretionary accruals (negative) outperformed the market by about 4% over three years, whereas firms in the quartile with the highest discretionary accruals underperformed the market by about 25%.
To date there have been at least three studies on earnings management in Finnish IPOs which from Ora (2000), Eriksson (2001) and currently Spohr (2004). First study is to showing that earnings management has been present in Finnish IPOs, Ora (2000) investigates if there is any difference in earnings management behavior between 1980s and 1990s IPOs. Her results indicate that earnings management seems to have vanished in the later period. Applying a total accruals measure Ora’s tests are affected by the substantial changes in discretionary reserves that Finnish companies could use for managing earnings. These visible forms of earnings management vanished gradually in the 1990s due to the accounting legislation reform.
Second study done by Eriksson (2001), whereby the tests for earnings management on a similar sample to this study and uses a financial ratios model called the Beneish M-score. The higher the M-score the higher is the likelihood that earnings management has occurred. Eriksson’s M-score averages of the sample indicates that no earnings management were present in the financial year closest to the IPO.
Finally finding obtain from Spohr (2004), the firms’ ownership structure and the pre-IPO owners share of ownership decrease in the IPO were used to formed expectations about the likelihood of finding earnings management before the IPO. Earnings management was hypothesized to be present in the entrepreneur owned but not in the institutionally held firms. Furthermore, the probability of earnings management was assumed to be related to how much the entrepreneurs’ ownership decreased in the IPO. The profitability of the total sample of 56 Finnish IPO firms showed a relatively high level of profitability in the critical period for which earnings management was tested when compared to three periods before and after the critical period. The most significant change in profitability occurred in the entrepreneur firms after the IPO. To answer the question of whether high profitability was only a result of successful timing, earnings management tests were conducted on accruals. The results support the hypothesis that entrepreneurs’ manage earnings before the IPO. In contrast to expectations, earnings management behavior seemed not be affected by how much of their ownership entrepreneurs gave up in the IPO. In the institutional owned IPO firms, no evidence of upward earnings management before the IPO was found. The limitation of the study is the sample is small.
Earnings managements and IPOs under pricing -Evidence from Japan
This study had been done by unstated authors in the year 2010. The study is based on the sample of 910 firms that went public in Japanese market between 1995 and 2005. The area of the study is would like to seek whether initial public offerings (IPO) are undervalued or overvalued using comparable firm multiples, (2)whether and how earnings management affects under or overvaluation, and (3) whether and how under /over-valuation and earnings management affects IPO under pricing. The underpricing phenomenon is such of common controversy covered in previous literature on Initial public offering companies over the business world. It is well known when companies go to public, the price at which investment banker sells the stock to investors in generally below the price at which the stocks trades in the secondary market shortly thereafter, resulting in a substantial price jump on the first day o trading. The meaning of IPOs underpricing is does not mean of undervalued (Purnanadam & Swaminathan, 2004).
The case in Japan the authors had examined whether Japanese IPOs are undervalued or overvalued using comparable firms multiples, similar method as done by Purnanadam and Swaminathan (2004). Then he investigates the relation between under or overvaluation and first-day return (underpricing). Later on, they identified the way of earnings management affects under or overvaluation and underpricing.
Lastly the authors found that about 60 to 70% of Japanese IPO firms are undervalued relative to their industry peers, and most of undervalued firms have positive first day return consistent with the asymmetric information models of underpricing. On the other hand, overvalued firms consisting of 30-40 % of IPO firms also earn 7% to 12% higher first day return, and pre-IPO year abnormal accruals and the magnitude of underpricing are positively correlated when firms are overvalued. These findings suggest that IPOs are overvalued more in “hot issue” periods when investors tend to be optimistic about the future performance of the IPOs, while underwriters undervalue IPO firms in usual market condition.
Earnings managements and performance towards IPO companies – Issues in Malaysia
This IPOs issue on earnings management was revealed by Rahman and Abdullah (2003). They are trying to identify the causes of firms issuing equity produce poor returns to investors in the long run by exploring the potential opportunities for earning management during the period prior to the public listing and its correlation with initial listing and post issues performance. The study covered 187 IPO valid firms identified from Bursa Malaysia Investors digest since January 1989 upward to December 1998. There are various of industries selected including tradings and services, Consumer product, construction, Properties, Infrastructure and Project companies, plantation, industrial product and hotels.
The method used in this study is similar with previous study made by Abdul Rahman(2000), Tay (1993) and Ritter (1991), whereby this study is measuring abnormal return using a buy-and-hold returns approach. The Abnormal return are calculated based on the difference between holding period returns of sample IPOs firms and control companies.
Further the study focuses on current accrual as the source of earning management. The types of accrual is whether discretionary accrual or non discretionary accrual. This justification is based on the definition of discretionary accrual itself which is those manipulated earnings that are determined at the discretion of management (Dennis and Michel, 1996 and Teoh et al,1998). The example of discretionary accrual the changes in allowance for doubtful account because on management’s interest. According to Teoh et al (1998) the discretionary current accrual are actually superior proxy for earnings management. While in contrast the nondiscretionary accrual is the change as a result of management’s accounting decisions that are of interest to the firm (Rahman & Abdullah, 2005). As stated example, during the economic growth, one would expect accruals such as account receivables and account payable to change as sales increase without earnings management occurring.
The most interested in this issue on IPOs is whether the investment activities in such companies will benefit investors who invest in the company. There are several studies whether done in overseas or Malaysia has been shown that IPO is a wealth reducing investment to investors in the long run. The evidence have been seeking in US whereby they found that IPO as poor long run investment for investors (Ritter, 1991; Loughran and Ritter, 1995 and Teoh et al, 1998). Also have been proven this similar issues happen in Malaysia of poor post issue performance (Ku Ismail et al, 1993 and Pok et al, 2000).
The result of the study by Rahman and Abdullah (2005), found that IPO in the average have experience significant positive abnormal return relative to the non-IPO firms during the initial period if the measuring taking to consider of offering price to the end of the day listing price. However the IPO firms is obtain significant negative towards share return relative to their control firms during the first, second and third year following their initial listing on Bursa Malaysia. To solve the research question to why firms issuing equity produce poor returns to investors in the long run, the authors found that Malaysia IPO firms manage their earnings upwards in the year prior to public listing on Bursa Malaysia. Furthermore, those IPO firms that manage earnings are not significantly different between industries but are significantly different between the Main and Second board.
Subsequently, the result on their study in relation between prior earnings management and post issues share return performance after the initial public listing is no significant relationship. The result sustain with respect to IPO firms with high or low level of earnings management.
In addition according to the Rahman and Abdullah (2005) there is no evidence to suggest that the pre offerings earnings management is able to predict the abnormal returns during the initial period and over one to three years following equity offerings. This argument actually had supported from previous literature made by Ku Ismail et al. 1993 and Shivakumar, 2000), whereby they mentioned that the positive abnormal return during the initial period may be due to the underpricing by underwriters and also as a result of asymmetric information among investors during the announcement period.
The result of positive share return at the initial period is actually contradicted with the literature from Teoh et al (1998). He argues that the investors are unable to fully understand managerial earnings at the time of equity offerings and ends up a high offer price. The possible reason of negative significant post issue return one to three years after listing may be due to the unfavorable earnings revealed by media, analyst’s report and financial statement after the offering(Rahman & Abdullah 2005).
CONCLUSION
In a review of earnings management in IPOs literature, Spohr (2004) and Rahman and Abdullah (2005) are identify a range of potential significant incentives to undertake earnings management. It is including contracts written in terms of accounting numbers, capital market expectation and valuation and government actions.
Managers of an IPO company probably motivated to manage earnings in the reporting period following the IPO in order to align more closely with the prediction for the period (Ismail & Weetman, 2008). In addition, Ismail and Weetman also found that managers also motivated to manage earnings to increase their short term wealth at the expense of the long term value of the firm. According to Rahman and Abdullah (2005), IPO companies have an opportunity in manipulating offering-year discretionary current accrual and non discretionary current accrual.
I noticed here there are several opinions regarding the IPOs market return begin with when company went to public upward to three years later. Therefore the investors in particular should concern with any information announced by the firm before attempting to invest. There are some evidence mentioned that the investing in IPO is kind of short term wealth. This could be happen because there is an existence of earnings management in their operation in order to meet the requirement by Securities commission.