Plan View

In the previous chapter (Chapter 3) pre-merger earnings management was investigated for samples of acquiring and target firms in periods before and after the enactment of the Sarbanes-Oxley Act of 2002. At the root of many of large-scale corporate scandals at large corporations such as Enron, Worldcom and elsewhere in the US, corporate legislation reform embodied by SOX enforcement, was not the only consequence. As a result of these scandals, public perception has evolved so that earnings management has been portrayed as a potential tool of managerial opportunism, which managers can employ in order to alter accounting numbers for their private interests rather than for the greater good of their shareholder group (Jiraporn et al. 2008).

While the conflict of interests between managers and other stakeholders due to separation of control and corporate ownership is well known, an important aspect of managing these differing interests is the investor need to control the managers’ behaviour through monitoring and controlling mechanisms (Jensen and Meckling 1976; Watts and Zimmerman 1986).

37 _{A major part of Chapter 4 is accepted for publication in the Journal of Financial and Economic}

Practice in a forthcoming issue of 2011, under the title “Does High Leverage Impact Earnings Management?: Evidence from Non-cash Mergers and Acquisitions.” An older version of the paper was previously accepted for presentation in the Global Conference on Business and Finance, Las Vegas, USA, January 2nd_-6th_{, 2011. The author could not present due to visa issues, however, the}

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As a result, a growing area of research has emerged concentrating on the effectiveness of various internal (such as boards and audit committees) and external (such as creditors and auditors) monitoring and controlling parties in mitigating the exacerbation of opportunistic earnings management (Becker et al. 1998; Chung et al. 2002; Goncharov 2005; Peasnell et al. 2005; Jiraporn et al. 2008).

This chapter focuses on the role of leverage as a constraint of managerial opportunistic discretionary power. It addresses the research question of whether the monitoring role of creditors can inhibit management’s ability to manage earnings preceding events characterised by evident incentives for earnings management. More specifically, this chapter examines the hypothesised controlling effect of abnormally high leverage on pre-merger income-increasing earnings management by a non-cash acquirer, given that managers have the incentive to manage earnings upward, as supported by the evidence discussed in Chapter 3.

For many years now, earnings management has been of grave concern for both practitioners and regulators alike, and has resultantly received considerable attention in the accounting literature. This literature is immense and still continues to develop. Around a decade ago, it was noted that research in this field had primarily focused “almost exclusively on understanding whether earnings management exists and why (Healy and Wahlen 1999, p.380)” while recently it has tended to move towards the examination of causation factors and the consequence of such corporate activity.

Thus far, there has been a general attitude in the research that good corporate governance should result in less earnings management (see, for example, Bushman and Smith 2001;

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Chung et al. 2002; Yang and Krishnan 2005; Chang and Sun 2009; Ghosh et al. 2010). Nonetheless, the role of creditors or the leverage effect on earnings management is not adequately understood at present, with much inconsistent empirical evidence in different research settings being found (Jaggi and Picheng 2002; Zhaoyang et al. 2005; Shen and Chih 2007; Wasimullah et al. 2010).

Cheryl Gray, a lead economist at the World Bank, emphasises the crucial role of creditors in promoting corporate governance stating that “effective debt monitoring and collection play a crucial role in corporate governance in market economies and require adequate information, creditor incentives, and an appropriate legal framework (Gray 1997, p.29).” This view is consistent with an interactive system of corporate governance as introduced by Triantis and Daniels (1995). Their work tries to describe a stylised theory of the role of stakeholders, including lenders, in an effective governance system that is more able to control managerial opportunism.

The different definitions of earnings management are broad enough to embrace both opportunistic and beneficial (i.e. efficient) earnings management practices38. For example, Healy and Wahlen (1999, p.368) define earnings management by the use of “... 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 outcomes that depend on reported accounting numbers.”

38 _{The classification of managerial practices into opportunistic or beneficial is based on an agency}

theory perspective (Jiraporn et al. 2008). Therefore, managerial opportunism occurs whenever managerial practices are meant to benefit firm’s managers rather than shareholders. The beneficial type is associated with the efficiency of management.

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Despite the fact that the bottom line of an income statement (i.e. the reported accounting earnings) consists of two components - a cash component and an accrual component - it is used practically for assessing a firm’s ability to generate future cash flows in order to pay dividends and interest so that the firm’s equity value can be determined while managerial performance can also be evaluated (Ronen and Yaari 2008). However, it is important to bear in mind that a major portion of accruals is subject to managerial discretionary power, and this brings to light a management team’s ability to shift earnings between accounting periods to influence users’ perceptions.

Managers’ motivation to manage earnings is driven by various incentives. On the one hand, the underlying incentives could be opportunistic (i.e. arising as a consequence of conflict of interests between managers and shareholders), to improve the managers' position for example (Iturriaga and Hoffmann 2005), obscuring facts that stakeholders ought to know (Loomis 1999), making extra gains from management buy outs (Perry and Williams 1994) or obtaining bonuses through management compensation contracts (Schipper 1989; Dechow and Skinner 2000).

On the other hand, earnings management can benefit shareholders and affect their wealth positively in instances whereby reported earnings could either meet analysts’ forecasts and fulfil capital market expectations (Yu 2008), influence short-term share prices before equity issues in IPOs, SEO and M&A (Teoh et al. 1998; DuCharme et al. 2001; Louis 2004), or can act as a response for carrying out debt and other external contractual agreements (Dechow and Skinner 2000; Jaggi and Picheng 2002).

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Since managerial motives per se play a decisive role when exercising the discretionary power over accruals, examining the impact of leverage on earnings management should lead to a better understanding if the motive effect is neutralised for all observations. In other words, the empirical test needs to control for the experimental setting so that all firms under study have the same motive that drives their decision to manage earnings.

Controlling for the motive of premerger earnings management by holding it constant, this Chapter investigates the leverage controlling effect on earnings management of a sample of non-cash acquiring firms. It provides empirical evidence on how excess debt creation does impact managerial discretionary power, given the existence of the managerial motivation to inflate the pre-merger reported earnings.

The remainder of this chapter is organised as follows. Section 4.2 reviews the relevant literature related to leverage in earnings management studies while section 4.3 develops a theoretical foundation for the stated hypothesis that is to be tested in this study. Section 4.4 specifies the sample, discusses research methodology and defines the variables employed within this work. Section 4.5 reports the results generated while section 4.6 provides a summary of the final concluding remarks of this chapter.

4.2.

Literature Review