Number game

Written by Saikat Neogi | Updated: Oct 8 2013, 08:40am hrs
Companies often resort to earning management to meet targets, especially if it is linked to any kind of compensation. And lack of quality of financial information disseminated by companies could affect investor decision-making and lead to losses for investors.

A new study released by Securities and Exchange Board of India (Sebi) says average earning management in corporate sector (non-financial) is 2.9% of the total assets of the 2,229 listed Indian companies analysed during 2008 to 2011. The study reveals that small-sized companies in India indulge in relatively more earning management than medium- and large-sized firms. Industry-wise, companies in sectors like construction and mining indulge in relatively high levels of earning management.

While the highest magnitude of discretionary accrual or earning management was recorded in construction and mining sectors 9.4% and 3.4% of total assets, respectively the manufacturing sector had, on an average, discretionary accruals of the magnitude of 2.6% of the total assets.

The service sector also had a relatively high earning management of 3.3% of total assets, while the trade sector wholesale and retail had negative discretionary accruals. So, smaller firms are more risky and demand higher returns from investors and, hence, managers of small firms indulge in higher earning management.

The study is co-authored by D Ajit, associate professor of economics, University of Northern British Columbia, Canada; Sarat Malik, joint director, Department of Economic and Policy Analysis (DEPA), Sebi, and Vimal Kumar Verma, Officer, Research, DEPA, Sebi.

The magnitude of earning management is confidential information and known only to the managers of the company. The study underlines that in capital markets, sophisticated investors like institutional investors are capable of understanding the existence and magnitude of earning management risk. It is the unsophisticated investors like retail investors who are gullible to earning management practices.

Retail investors depend on financial reports of companies for making investment decisions and regulators have a fiduciary duty to protect them.

The study highlights that managers get a number of financial incentives to meet performance expectations and derive private gains in the form of earning-based bonuses, promotion prospects and avoiding a decline in the value of their stocks and stock appreciation.

The consequence of earning management is that the stock price of the company may get distorted and pervasive manipulation of financial information could adversely affect investor confidence, drive stock markets down and raise the cost of capital significantly, the study highlights.

It also underlines that sustained flow of foreign capital into the Indian stock market can be fulfilled only if investors are protected from accounting frauds, financial misconduct and deceptive earnings management practices.

Interestingly, with the introduction of International Financial Reporting Standards (IFRS), a study of 21 countries found that firms adopting IFRS were found to be indulging in less earning management and more timely recognition of losses compared with firms which did not adopt IFRS.

The amount of managed earnings is the difference between reported earnings and true earnings. The most common method of detecting earning management is through the accruals portion of companys financial statement. Accounting adjustments known as accruals is the difference between reporting earnings and operating cash flows. Accruals consists of a discretionary portion which is often manipulated by managers and a non-discretionary portion which is dictated by business conditions.

The study recommends enhanced surveillance, monitoring and regulatory action by the market regulator for a company or industry, which is indulged in high level of earning management. The quality of financial reports, financial restatements and instances of fraud are some mechanism through which financial reporting can be evaluated. External monitoring agencies like auditors, analysts and institutional investors can play an important role in preventing aggressive or deceptive financial reporting by companies. Also, greater improvement in accounting quality and financial information can certainly reduce asymmetry of information in the capital market and protect investors.

Research has shown that well-enforced investor protection, especially minority shareholders, can reduce earning management. And analysts play an important role in monitoring the companies as earning management is low in companies where analysts coverage is high.