Does the Commercial Banking Industry of UAE Practice Earnings Management Dr. Mohammed Obeidat Introduction It is the right of external users of accounting information to be provided with more adequate information to protect their interests. Many questionable issues concerning the term of earnings management are still available.
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Auditors, accountants, financial analysts, and other concerned parties may hold the responsibility of detecting external users from the practices of earnings management. Many questionable issues are still available regarding the term of earnings management.
Some people may have no enough idea about what practices are classified under earnings management, and what practices can not be classified under this term. Users of accounting information are different but few of them have the ability to detect the practices of earnings management. Because there are different methods of practicing earnings management, detecting the practices of earnings management is one of the difficult issues. The common practice of earnings management by firms and the negative effects of these practices on external users of financial accounting information justify the investigation of this issue.
Many users may lose some of their wealth as a result of practicing this phenomenon. Many financial crises appear in our world from time to time, and some reasons of these crises are related to incorrect announced financial information. The problem of the current study will be simpler, if it is presented through the following question: How investors can detect the practices of earnings management, in order to have the ability to protect themselves from the negative effects of these practices?
The answer to this question may seem more difficult, so the current study present an example from the Commercial Banking Industry of the United Arab Emirates (UAE). Studying the phenomena of practicing earnings management is important, because this will highlight why managers may practice this phenomenon. Many incentives may be available to managers and promote them to practice earnings management. These incentives will be highlighted later on in the current study, but when investors are knowledgeable with some of these incentives, they can consider and analyze the financial information of their entities more.
Moreover, when users are aware with the methods that are followed by managers to practice earnings management, they will be more eligible to detect these practices. The current study will explore the most available methods of practicing earnings management. The importance of the current study is increased, because it highlights how investors can determine whether there is a practice of earnings management or not. The objectives this study is looking to achieve are as follows: 1. To highlight the incentives standing behind the practice of earnings management by managers. 2.
To inform users about the methods available to firms’ management to manage the earnings. 3. To determine the qualitative and quantitative available procedures that can be used to detect the practices of earnings management. 4. To determine whether the Commercial Banking Industry of UAE practices or does not practice the phenomenon of earnings management. 5. In a case of earnings management is detected, this study aims to detect whether these practices were upward or downward practices. Our study makes a unique contribution to the literature by using data from the announced financial statement of Commercial Banking Industry of UAE.
This study differs from the prior studies in its location, methods, objectives, and nature of data used in the analysis. Because the current study involves the commercial banks of ABU Dhabi, and because all of these commercial banks are listed in Abu Dhabi Stock Market, this study is unique in its location. Just few studies outside Abu Dhabi followed quantitative method to investigate whether there are practices of earnings management or not, the current study is also different from other prior researches.
This study depends on cross sectional data because a time series data will misstate the data, so it is unique in its inputs of data. This paper is organized as follows: The first section defines earnings management, and describes the incentives of its practices by commercial banks, in addition to that, it explores the methods of practice and how these practices can be defected. The second section explores the most related prior researches. The third section presents the hypotheses of the current research. The fourth section describes the followed methodology in the current study.
The fifth section presents the results, while the fifth explores the findings. Literature Review and Prior Researches Many people believe that the term of earnings management is understandable in its simple form, but most of those unable to determine whether a selected practice is an earnings management or not. Understanding what earnings management constitutes and why it takes place is important for all users of accounting information. This study highlights the different aspects of earnings management, so it identifies clearly this term, and presents the incentives standing behind its practice.
Moreover, the current study determines the methods of earnings management used by firms, and explores how these practices can be detected. Earnings management is defined as the “intentional misstatement of earnings leading to bottom line numbers that would have been different in the absence of any manipulation (Mohanram, 2003). Based on this definition, the practice of earnings management is an intentional behavior, and if this practice occurs unintentionally, it can not be classified under the practices of earnings management.
Moreover, this definition states that the practice of earnings management phenomenon leads to users’ misstatement. In other words, practitioners of earnings management have different purposes and they change some accounting numbers to affect users in order to achieve these objectives. Healy and Wahlen (1999) state that earnings management “occurs when managers use 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 reporting accounting numbers”.
This definition states that this practice is also intentional and purposeful. This definition mentions that contractual issues are incentives for managers to manage earnings.But we have to remember Some concerned people believe that earnings management mean upward manipulation. Actually, earnings management may be exercised either upward or downward. In most cases, the target of earnings determines to a large degree, whether the management of the firm practices earnings management upward or downward.
Some people also believe that the all the practice of earnings management are illegal, and no legal practice exists. Actually, there are different practices of earnings management do not violate the generally accepted accounting principles (GAAP). For example, speeding the size of sales during the last month or the fourth quarter is in agreement with the GAAP. Moreover, activating sales during the last month of the accounting period through granting discounts to customers is also in agreement with the GAAP, and is not a violation to the accounting standards.
There are different incentives to managements of firms to practice the phenomenon of earnings management. Most of these incentives are related to benchmarks of earnings. Sometimes, the previous period’s performance may be the benchmark to the firm. In other cases, the benchmark to the firm may be the expectations of financial analysts. The promised compensations to the firm’s management may be the most important incentive of the practice of earnings management. Benchmarks are necessary for the determination whether the management deserves or does not deserve the promised compensation.
Sometimes, the desire of the firm’s management to increase the stock market price may also be one among the incentives to earnings management, especially, when the management is looking for more compensation. The normal positive relation between earnings and stock market price means that as the amount of announced earnings increases, the common stock market price is also increases. Therefore, when a desire exists to the firm’s management to affect the common stock market price, the management will manage its earnings. Reducing the amount of income tax may also be one among the incentives of practicing earnings management.
In many countries, business entities are subject to high income tax rates, where different categories of expenses are deducted from the income. When these entities are looking toward reducing the amounts of taxes, they practice the phenomenon of earnings management. The practice of earnings management in this case may be through increasing the amounts of tax deductions, or through the decreasing the amounts of earnings. Sometimes, firm’s management may manage earnings to simplify the issue of receiving credits from banks and other financial issues.
In addition, firms may also manage earnings to reduce the cost of this credit, because when earnings are reasonable, the firm can receive credit smoothly without such obstacles, and at lower costs, but when the firm’s earnings are unreasonable, this firm will face many obstacles to receive credit, and it may receive credit at higher costs. These are some of incentives or reasons of the practice of earnings management, but other incentives may be available to some firms, depending on the financial conditions of the firm’s management itself.
Managements of firms can follow different methods to manage earnings. Changing the assumptions for accounting standards is one of the most common used methods in managing earnings. It is already known that the GAAP are highly flexible, so managements can employ the high degree of flexibility available in these standards. Examples of this flexibility are the inventory flow methods which managements can use one among these, and the available options to depreciate some of the firm’s assets, in addition to these; firms can review the assumed lives of these depreciable assets.
As a result a variety of options are available to management whenever a desire to manage earnings exists. Managements can manage earnings through the determination to the bad debts provisions. For example, whenever there is a need to announce earnings higher than its actual value, management can determine these bad debts at amounts lower than their actual, while it can announce lower amounts of bad debts whenever there is a need to reduce the announced income. Managing transaction is one among the available options to management when there is a desire to manage earnings.
For instance, management can grant high discounts during the last few days of the accounting period to recognize more revenue through sales under the accrual basis. One option is available to managements of firms is to activate sales or services during the last days of accounting period through the adoption to more sales on credit, and through longer period of payment are given to customers. Two approaches are available to detect the phenomenon of earnings management. The first is qualitative, while the second is quantitative approach.
Using the two approaches together when this possible leads to more certain conclusions whether a firm or a group of firms manage earnings. Several steps have to be followed when there a need exists to detect earnings management through the qualitative methods. These steps are presented below: (Mohanram, 2003). 1. Identifying the key accounting policies of the firm or industry. Regarding the industry of the current research, the issues of credit risk and interest rate risk are of crucial importance to banks. 2. Assessing the firm’s accounting flexibility.
The level of accounting flexibility may be high to some firms or industries, whereas, it may be low to other firms and industries. 3. Evaluating the firm’s accounting strategy, and determining how this strategy differs from other competitors. 4. Assessing the firm’s quality of disclosure. 5. Identifying the potential red flags. The following is an example of red flags: |Unexplained accounting changes, especially when performance is bad. | |Unexplained profit boosting transactions, such as sale of assets. | |Unusual increase in accounts receivable in relation to sales increase. |Increasing gap between net income and cash flow from operations. | |Increasing gap between net income for reporting and tax purposes. | |Unexpected large asset write-offs or write downs. | |Large fourth quarter adjustment. | |Qualified audit opinion or change in auditors. | |Large related party transactions. | 6. The final step is to undo accounting distortions by reversing out the impacts of dubious accounting wherever possible. Earnings management can be also detected analytically, based on the firm’s accruals, which can be defined as the difference between net income and cash flow operations.
In occasion, firms with high level of accruals are likely to have inflated earnings. Firms practice the phenomenon of earnings management can be determined through segregating discretionary accruals from non-discretionary accruals. In this case, Jones (1991) model can be used to segregate discretionary from non-discretionary accruals. In the current study we use this model to determine whether, or not, the Commercial Banking Industry practices the phenomenon of earnings management. This model is presented below:
Where total accruals can be computed by finding the difference between income before extraordinary items and cash from operations in year t. Revenuest is revenues in year t, while revenuest-1 is the revenues at the end of year t-1. Total assetst-1 is total assets of year t-1. Gross PPEt is gross property, plant, and equipment at the end of year t, and B1, B2, and B3 are industry and year specific parameters to be estimated. The residual value in Jones’s Model is the discretionary accruals for a firm in a given year, while the fitted value gives an estimate of the non-discretionary component of earnings.
Researchers in the accounting literature have often focused on earnings management. Many researchers studied the issue of earnings management; most of these are focused in the Western or Far East Countries. A study titled ” earnings Management: Do Large Investors Care? ” and carried out by Senteza, Njoroge, and Gill (2005), deserves to be mentioned in the current study. This study mentions that institutional investment activity and behavior is an area that has become more interesting in recent times and so much work has been done so far.
The contribution of this study in the area of earnings management can be summarized in its documentation to the effect of earnings management activity on institutional investor ownership, especially through distinguishing the ownership changes in response to the direction of earnings management efforts. This study finds that institutional investors increase ownership in firms that manage earnings upwards and decrease ownership in firms that manage earnings downward before end-of-year reporting.
Moreover, this study finds that the increases observed during an observed upwards earnings-managing activity are followed by decreases in ownership in these firms in the subsequent quarter, which may suggest resource allocation between large and small investors. In his comments at the practice of earnings management phenomenon, Simon (2005) argues that managing earnings is a wrong practice, in his paper titled “Earnings Management as A Professional Responsibility Problem”.
The author of this paper states that managers of public companies often want an increase in current reported earnings per share; though they sometimes prefer a current decrease in the earnings they would otherwise report when it will allow them to show a smoothly increasing pattern of earnings in the future. He adds, on his comments on Schwarcz’s paper, that “the ‘limits of lawyering’ are the constraints of law, but having said that, the question remains-what do we mean by law? If we take a narrow, predictive conception of law, the limits will be less restrictive than if we take a broader, purposive view. . He also states that the more ambitious conception is most compatible with the idea of lawyering as a dignified calling. Caramanis and Lennox (2007), carried out a study titled “Audit Effort and Earnings Management” in their trial to determine the effect of audit hours on the practice of earnings management by the Greece Firms. To measure earnings management, the authors use the Jones (1991) model based on the balance sheet approach rather than the cash flow statement approach because most Greek companies do not provide cash flow statements.
There are three main findings of this study. First, companies are more likely to report income-increasing abnormal accruals than income-decreasing abnormal accruals, when audit hours are lower. Second, the magnitude of income-increasing abnormal accruals is negatively related to audit hours. Third, companies are more likely to manage earnings upwards to just meet or beat the zero earnings benchmark, when auditors work fewer hours. Moreover, this study finds weak or insignificant associations between audit hours and the magnitude of negative abnormal accruals.
A study titles “Detecting Earnings Management” for the purpse of evaluating alternative accrual-based models for detecting earnings management is carried out by Dechow and Sweeney (1995). This paper evaluates the ability of alternative models to detect earnings management. Concerning this issue, the paper finds that all the models considered appear to produce reasonably well specified tests for a random sample of event-years. When the models are applied to samples of firm-years experiencing extreme financial performance, all models lead to misspecified tests.
The second finding of this paper is that the models all generate tests of low power for earnings management of economically plausible magnitudes. Moreover, this paper reveals that all models reject the null hypothesis of no earnings management at rates exceeding the specified test-levels when applied to sample of firms with extreme financial reporting. The most important finding of this paper is that a modified version of the model developed by Jones (1001) has the most power in detecting earnings management.
Kerstein and Rai (2007), carried out a study titled “Working Capital Accruals and Earnings Management”. The purpose of this study is to reexamine market reactions to large and small working capital accruals. This study involves three hypotheses. First, negative or positive large working capital accruals have no impact on the earnings response coefficient of firms reporting positive small earnings surprises. Second, Positive or negative large working capital accruals have no impact on earnings response coefficients of firms reporting small earnings declines.
Third Positive or negative large working capital accruals have no impact on earnings response coefficients of firms reporting large earnings increases or declines. The authors focus on nonlinear relations between returns and large working capital accruals and use raw returns computed as the compounded monthly returns from nine months prior to the fiscal year-end to three months after the fiscal year-end as the dependent variable. They find that the market discounts unexpected earnings when there are small increases in earnings using negative large working capital accruals or negative large working capital accruals.
They also find little or no evidence that positive or negative large working capital accruals lead to lower earnings response coefficients in the remaining six situations. In his study titles “Earnings Management, Earnings Manipulation: Evidence from Taiwanese Corporations”, (2008), Chai-hui Chen differentiates between earnings management and earnings manipulation among the Taiwanese companies. In this study, Chai examines 7 hypotheses based on a sample of 90 public firms throughout 1999-2004.
The main findings this study concludes that: (1) unlike the control group, earning manipulators face greater capital market and contract motivations to manage earnings; (2) earnings manipulators are more inclined to appoint fewer independent directors to their boards, to appoint fewer independent supervisors to their supervisory boards, and to posses considerably less managerial ownership; and (3) earnings manipulators are more likely than the control group to express aggressive attitudes and rationalizations to manage earnings changes before interests and taxes, or both.
To examine the effect of firm’s stock price sensitivity to earnings news, as measured by outstanding stock recommendation, on incentives to manage earnings, Abarbanel and Leahavy (2003) carried out a study titled “Can Stock Recommendations Predict Earnings Management and Analysts’ Earnings Forecast Errors”. This study examines hypotheses concerning (1) the effect of introducing equity-market-based earnings targets on firms’ earnings management, and (2) the effects of such earnings management actions on ensuring analysts’ forecast errors.
In this study, quarterly unexpected accruals are calculated using the modified Jones (1991) model. This study finds evidence that a firm’s stock price sensitivity to earnings news, as measured by outstanding stock recommendation, affects its incentives to manage earnings and, in turn, affects analysts’ ex post forecast errors. Moreover, this study finds a tendency for firms rated a Sell (Buy) to engage More (less) frequently in extreme, income-decreasing earnings management, indicating that they have relatively stronger (weaker) incentives to create accounting reserves.
In contrast, this study finds that firms rated a Buy (Sell) are more (less)likely to engage in earnings management that leaves reported earnings equal to or slightly higher than analysts’ forecasts. Zhang (2002) carried out his study titled, “Detecting Earnings Management – Evidence from Rounding-up in Reported EPS”, for the purpose of evaluating a comprehensive list of metrics propsed for detecting earnings management in a setting where managers manipulate earnings to round up reported earnings per share (EPS).
This study provide the evidence that adds to the debate on the abilities of accrual-based models to detect earnings management of small magnitude. The study cast doubt on the abilities of accrual-based models to catch minor offenses, which is likely to be the norm, rather than exception of various forms of earnings management. The metrics under evaluation of this study are deferred tax expense and discretionary accruals computed from DeAngelo Model, Healy Model, Jones Model, Modified Jones Model, Cross-sectional Jones Model, and Forward-looking Jones Model.
This study finds that deferred tax expense is able to detect earnings management in the rounding-up setting while discretionary accruals models are not. Moreover, this study provides the evidence that firms manipulate bad debt expense for the purpose of rounding-up reported EPS. Chan, Jegadeesh, and Sougiannis (2004) carried out a study titled “The Accrual Effect on Future Earnings” in an attempt to clarify whether current accruals affect future earnings. The authors find a strong negative relationship between accruals and the aggregate future earnings.
This study mentions that if firms manage accruals upward by $1 today while holding current earnings constant, aggregate future earnings will decline, on average, by $ 0. 096 over the following three years and $0. 202 in the long run. This study also examines the accrual effects classified by firm characteristics to test the source of the negative relationship between accruals and future earnings. The study shows that high price-earnings stocks experience an enormous accrual impact on their future earnings, with 39% of current accruals reversing in the long run.
Moreover, this study shows that firms with high market-to-book ratios also have large accrual reversals, so when this is grouped by accruals, the accrual effects are significantly stronger for high accrual firms than for low accrual firms. Among the additional important findings of this study is that Jones model significantly underperforms the CF-Jones model in explaining the cross-sectional accrual variability, with only 24% of mean adjusted –R2 for the Jones model compared to 57% for CF-Jones Model.
This result shows the CF-Jones model superiority in identifying the manipulated earnings. The most recent study concerning the detection of earnings management relates to Miller (2009) and titled “The Development of the Miller Ratio (MR): A Tool to Detect for the Possibility of Earnings Management (EM)”. In this study, Miller uses new technique to detect earnings management called “Miller Ratio”, based on net working capital (NWC) and cash flow from operations (CFO). Miller also compares between the esults reached through his own model and the results revealed based on Modified Jones Model. In this study, the author states that the large body of literature on the topic of earnings management provides discussion of total accruals, discretionary total accruals, and current accruals. The findings of this study indicate that neither the Miller Ratio nor the Modified Jones Model predicted the possibility of earnings management at a statistical acceptable level of confidence on the body of data with acknowledged earnings management. .
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