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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.
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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
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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.
Real earnings management is measured using the Roychowdhury (2006) model with three approaches, i.e. cash flow from operations, production costs, and discretionary expenditures, then the results of the three approaches are combined to obtain the value of real earnings earnings management. Meanwhile, the measurement of accrual-based earnings management is carried out using the modified Jones model introduced by Dechow, et al (1995) with a discretionary accruals approach. The results of this study have several implications. For investors, this finding can be used as information in making the right investment decisions, that firms with high debt levels and tend to increase apply earnings management activities in two strategies. For researchers, this finding can provide insight into future research to make observations on both forms of earnings management. The remainder of this paper is organized as follows: The next section presents the literature review and hypothesis development. Section 3 outlines research method, Section 4 outlines results and discussion, and the last section provides concluding remarks. Literature Review And Hypothesis Development Positive accounting theory was first introduced by Watts and Zimmerman since 1978. This theory emerged based on factors that motivated managers' behavior to take advantage of the flexibility of using accounting standards so that they could influence the results of the financial statements according to the opportunistic goals of managers. Watts & Zimmerman (1978) stated that the factors underlying opportunistic behavior of managers are related to tax regulations, management compensation plan, expenses, debt contracts, and political costs.
This study is based on positive accounting theory related to debt contracts. Basically, companies that want to get a debt contract will certainly provide good financial information such as cash flow and earnings. Even though the firm’s conditions does not support to operate, but the flexibility of accounting standards can be used by managers to manipulate earnings to obtain a debt contract without considering the negative impact, this behavior is conducted using earnings management.
This study attempts to analyze the effect of high level of leverage on earnings management practices, both real earnings management and accrual-based earnings management. Positive accounting theory states several manager incentives to conduct earnings management, i.e. debt contracts, management compensation contracts, and political costs. In relation to debt contracts, it is possible that debt policy
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is related to the opportunistic attitude of managers to manipulate earnings or earnings management. Companies that experience increased leverage will provide incentives for managers to manipulate earnings through accrual-based earnings management practices (Lazzem & Jilani, 2018; Takhtaei, et al, 2013; Jaggi & Lee, 2002). Meanwhile Campa (2019); Anagnostopoulou & Tsekrekos (2017); and Jie, et al (2017) found that companies with severe financial problems (very high levels of debt dependency) would show earnings manipulation that tends to increase profits through real activities rather than through discretionary accruals.
In contrast, Jensen (1986) proposed a control hypothesis and the benefits of debt to companies. When a company has a lot of debt, the company has pressure in its settlement. With this pressure, companies are motivated to be consistently in debt settlement without having to do earnings management. Income- increasing earnings actions will actually be more risky when there is a default on debt. Although managers do earnings management, it will tend to do income-decreasing earnings compared to income- increasing earnings. Meanwhile, Alsharairi & Salama (2012)found that there was a negative relationship between leverage and earnings management. The existence of debt will reduce the manager's opportunistic behavior, where high leverage will limit the ability of managers to manipulate income-increasing accruals. Likewise Zamri, et al (2013) found that levered firms have a low level of real earnings management, thus supporting the assumption that the existence of leverage can limit managers to conduct real earnings management activities, which in turn can affect the quality of accounting earnings. Based on the above explaination, we proposed the following hypothesis:
H1 : Firms that have high and increasing leverage will be motivated to do accrual-based earnings management.
H2 : Firms that have high and increasing leverage will be motivated to do real earnings management.
Methodology Sample and Data Collection We used firms listed on the Indonesia Stock Exchange during 2007-2018 as our sample. Purposive sampling is used to select non-financial firms that have a high level of leverage and tend to increase from year to year. Thus a total of 571 years of firm observation were obtained.
The independent variable used in this study is financial leverage, which is measured by debt-to-asset ratio (DAR). Meanwhile, the dependent variable in this study is earnings management which is divided into real earnings management (REM) and accrual-based earnings management (DA). REM is measured using the Roychowdhury (2006) model in three approaches, i.e. cash flow from operations, production costs, and discretionary expenditures. Furthermore, the results of the three approaches are combined to obtain the value of real earnings management. Accrual-based earnings management measurements are carried out using the modified Jones model introduced by Dechow et al (1995) with a discretionary accruals approach. Measurements Accrual-Based Earnings Management Modified Jones model Dechow et al (1995) is used to calculate accrual-based earnings management which involves several equations as follows:
TA it = NI it – CFO it (1) where TA it = Total accruals firm i in year t NI it = Net income firm i in year t CFO it = Cashflow from operation firm i in year t
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Furthermore, total accruals are used as dependent variables in the following model (2) and are estimated every year using all firm-year observations: