1.1 Background to the study
Accounting information has been the major input in capital allocation decisions of investors and lenders in the capital markets. Specifically, accounting earnings remain the strategic financial statement variable for assessing firm‟s viability and future prospects. For accounting earnings to be useful and relevance to investors and lenders it has to be of higher quality, that is, free from errors and material misstatements. Accounting information particularly the “earnings” indicate firm‟s direction, reduces information asymmetry and ensures efficient capital allocation. This is achievable only if the managers did not interfere with the financial reporting process. The incidences of corporate failures that are related to creative accounting practices has raised concerns and remain a topical to researchers, regulators, standard setters, and investors in the 21st century and during the last two decades in particular. This rising concern among the stakeholders is not unrelated to some accounting practices that threaten the quality of corporate financial reporting and erode public confidence in the accounting profession. It also raised concerns about the reliability and credibility of financial reporting globally (Ge & Kim, 2013).
Corporate financial reporting is the management‟s responsibility, through which the managers communicate their stewardship performance to the owners and other stakeholders. Several researches on Capital Market are of the view that stock market responds favorably to earnings news when reported earnings meet or beat earnings expectations, while it reacts unfavorably when reported earnings fall short of earnings benchmarks. To avoid unfavorable reactions, managers have a tendency to avoid the release of bad earnings news at times of earnings announcements (Ge & Kim, 2013). As such managers can manipulate earnings through discretionary accounting choices (accrual-based earnings management) or by structuring real transactions and/or changing their timing (real earnings management). Earnings management is known in increasing information asymmetry between managers and outsiders and hide firm‟s unmanaged economic performance, thereby eroding financial reporting reliability and credibility. Bello (2011) argues that earnings management in whatever form is misrepresentation of true fact and figures of accounts which lead to a number of recent corporate collapses that erode shareholders confidence on the reported companies‟ financials. Moreover, Yero (2012) posits that, management report managed earnings to manipulate information asymmetry and misguide ill-equipped users.
There are many advantages attached for managing accounting earnings by corporate managers; for instance, managers might concentrate their efforts in tax planning to manage earnings and attempt to minimize the tax effects over time. Essentially, the conflict of interest between shareholders‟ and managers could encourage managers to use a certain degree of flexibility provided by accounting standards to manage earnings, and create distortions in the earning figures reported in the financial statements. This is in the corporate managers‟ efforts to influence short-term share price performance; or minimize earnings fluctuations in order to show better or more stable financial results.
The prevalence of corporate accounting scandals has changed the public perception of earnings management, as well as, the objective of corporate governance, which stop corporate managers from engaging in improper accounting activities for their own benefits. Financial reporting quality literature have documented a variety of accounting activities that manager‟s use whenever they engage in activities to manipulate earnings.
According to Gunny (2010) these activities include actions that managers may undertake to change the timing or structuring of an operation, investment and financial transactions. Specifically, Roychowdhury (2006) with regards real earnings management enumerated the management of sales, reduction of discretionary expenses, overproduction and reduction of R&D expenses. Though researchers especially in Nigeria ignored real earnings management, Kim and Sohn (2012) reveals that real-based earnings management has more damage than accrual-based earnings management, furthermore, it has both direct and indirect consequences on current and future cash flows of the business. They added that real earnings management activities are more difficult to be detected than accruals-based earnings management and are normally less subject to external monitoring and scrutiny. They also argue that real earnings management are more difficult for average investors to understand that make them into believing that business has achieved the targeted normal business goals.
Majority of the earnings management literature investigated how management used discretionary accruals to achieved desire earnings in a desired period. Therefore, the present study is motivated by the present research trend which less attention is giving toward investigating real earnings management. And also recent stakeholders concern about earnings management which is accepted by standard setters, practitioners and regulators, that earnings management can be detriment to corporate entities. As such, regulators and standard setters around the world have considered the extensiveness of earnings management to be a major concern for the reliability of published financial statements (Jiraporn, Young & Mathur 2008).