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Evidence of Debt Covenant Hypothesis in Indonesia Public Firms

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Evidence of Debt Covenant Hypothesis in Indonesia Public Firms Vision 2025: Education Excellence and Management of Innovations through Sustainable Economic Competitive Advantage Do High Leverage Motivate Managers to Manage Earnings? Evidence of Debt Covenant Hypothesis in Indonesia Public Firms Idil Rakhmat SUSANTO Universitas Muhammadiyah Makassar, Makassar, Indonesia [email protected] Ika PERMATASARI Universitas Negeri Surabaya, Surabaya, Indonesia [email protected] Abstract The aim of this paper is to examine the effect of increasing leverage on Earnings Management in firms listed on the Indonesia Stock Exchange. This study also aims to prove the Positive Accounting Theory about Debt Covenant Hypothesis. We used nonfinancial firms as our sample which have increasing leverage from 2007 to 2018 and obtained 571 firm-years observations. We observed Earnings Management into Accrual Earnings Management (which is measured by modified Jones model) and Real Earnings Management (which is measured by Roychowdury model). Leverage is measured using the Debt to Asset Ratio. Our result showed that leverage has a positive effect on Earnings Management, both through Accrual Earnings Management and Real Earnings Management, which means that if a firm is faced with high leverage, it tends to do high earnings management as well. This finding implies that managers can use the two forms of earnings management if their companies has high leverage and tend to increase over time. Keywords : leverage, accruals earnings management, real earnings management, debt covenant hypothesis Introduction Earnings Management is an opportunistic behavior carried out by managers because of certain objectives to be achieved and not necessarily in line with the principal's interests. Positive Accounting Theory (Watts & Zimmerman, 1990) explains that one of the motivations of management to do earnings management is the existence of debt contracts with creditors. There were many studies that examine earnings management, but still, in practice there are many phenomena that show corporate behavior related to earnings management. Recently, Garuda Indonesia (the biggest airline company in Indonesia) had 2018 financial report scandal which occurred in April 2019. Two Garuda Indonesia’s board of directors considered the 2018 financial statements were not in accordance with Indonesia’s generally accepted accounting principles. Garuda Indonesia included a profit from one of its customers who also had a debt to Garuda Indonesia, even at the end of 2018 it had not received payment for the receivables, which in turn had an impact on reporting a huge profit. The function of the board of commissioners as a monitoring board has been carried out but the management is still carrying out opportunistic practices, causing problems in the preparation of financial statements. Shu, et al (2015) explained that the existence of board monitoring, especially independent directors is able to reduce the level of earnings management. The case experienced by Garuda Indonesia is interesting for further investigation, raising questions about the motivation of managers to take income increasing actions. This study attempts to relate earnings management with firm’s financial leverage. Based on observations of Garuda Indonesia, it was found that there was a high and increasing level of debt owned by the airline. Figure 1 showed that Garuda Indonesia has a higher debt to equity ratio and higher level of debt that could result in default risk in the future. Therefore, this study attempts to investigate firms that have high levels of debt with the behavior of managers in conducting earnings management. 10287 Vision 2025: Education Excellence and Management of Innovations through Sustainable Economic Competitive Advantage Debt-to-Equity Ratio Garuda Indonesia 4.00 3.00 2.00 1.00 0.00 2010 2011 2012 2013 2014 2015 2016 2017 2018 Fig. 1: Debt-to-Equity Ratio Garuda Indonesia Basically, earnings management is divided into two categories, i.e. accrual-based earnings management and real earnings management. Accrual-based earnings management is earnings management which is carried through manipulating components related to earnings and does not affect cash directly. Real earnings management is earnings management carried out by utilizing normal operating practices with the aim that stakeholders believe that the operating activities carried out by the company are in accordance with the rules (Schipper, 1989; Chen, 2016). Previous research has focused more on the use of one earnings management strategy, which is only accrual-based earnings management or real- based earnings management, so that it still cannot explain all earnings management activities and can produce inaccurate conclusions. There is limited research that draws both earnings management strategies (Hamza & Kortas, 2019). Research on the relationship of debt levels with earnings management has been done a lot but still has not explored earnings management practices in companies with high debt levels and tends to increase over time. On this basis this study aims to observe the relationship between high levels of corporate debt with both earnings management strategies. High levels of debt can be observed from the amount of debt that exceeds its equity in terms of funding, and the sample used is the company whose debt tends to increase during the observation period. Indonesia provides an interesting context for research. Indonesia is a developing country with a low level of transparency that results in poor governance, unfair competition, weak investor protection, corruption and high moral hazard. This institutional setting encouraged this research to observe earnings management practices in Indonesian public firms with high debt levels and tend to increase during the observation period. Furthermore, based on our knowledge, there is no empirical evidence about how managers in these firms use earnings management strategy, both accrual-based and real earnings management. Previous studies have examined the relationship between earnings management and debt levels but still use earnings management strategies separately in their studies. Ge & Kim (2013) examined the relationship of real earnings management with bonds and provided evidence that excessive production could threatened credit ratings, thereby triggering sales manipulation and impacting higher bond yields. Campa (2019) found that earnings manipulation that aims to increase earnings figures through real activity shown by firms that are experiencing financial difficulties, rather than increasing earnings figures through discretionary accruals. His/her research supports the hypothesis of "opportunistic behavior" regarding the earnings management behavior of firms listed on the stock exchange, especially for firms that depend heavily on external debt. Meanwhile, An, et al (2016) found that high financial leverage is related to high earnings management. However, this positive relationship is weakened by a strong institutional environment. In this case, if the company's high debt is accompanied by an institutional environment as a control mechanism it will be able to reduce agency costs and will be cheaper to depend on the institutional environment than debt. Increased leverage also occurs in accrual-based earnings management practices (Lazzem & Jilani, 2018). He proved that financial leverage affects the opportunistic behavior of managers. His results are 10288 Vision 2025: Education Excellence and Management of Innovations through Sustainable Economic Competitive Advantage consistent with the debt covenant hypothesis, which is corporate leverage has a positive effect on the earnings management in France. Thus increasing leverage can provide incentives for managers to manipulate earnings. This is also in line with Jaggi & Lee (2002) who found that firms that experience financial difficulties tend to do income increasing management with the aim of getting relief when a debt contract violation occurs. From the above empirical evidences, several studies of earnings management investigate two types of earnings management mentioned earlier. Jie, et al (2017) examined the behavior of managers who choose between real activities and accrual-based earnings management. The results showed that the level of real earnings management was higher for firms under low government intervention, firms with higher financial leverage, and firms with low corporate governance. Whereas firms that are in a less strict legal environment, firms with dual listings, and firms with higher growth prospects tend to do accrual-based earnings management. Based on this phenomenon and empirical evidence, this study attempts to examine the relationship between financial leverage and earnings management and prove the opportunistic behavior of managers associated with the existence of a debt covenant hypothesis. In this regard, we raise question whether firms that have high level of debt and tend to have increasing leverage, have a tendency to do real earnings management or accrual-based earnings management. This study is different from previous research in terms of: 1)Samples are firms that have high levels of debt and tend to increase over time, i.e. the composition of total debt that is greater than shareholders’ equity in the firms’ capital structure; and 2) This study uses two earnings management variables, i.e. accrual-based earnings management and real earnings management. Both of these variables are considered important to be examined, to describe overall earnings management.
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