The Effects of Corporate Governance Mechanisms on Earnings Management of Listed Firms in Nigeria

Uwuigbe, Uwalomwa; Peter, Daramola Sunday; Oyeniyi, Anjolaoluwa Article The Effects of Corporate Governance Mechanisms on Earnings Management of Listed Firms in Nigeria Journal of Accounting and Management Information Systems (JAMIS) Provided in Cooperation with: The Bucharest University of Economic Studies Suggested Citation: Uwuigbe, Uwalomwa; Peter, Daramola Sunday; Oyeniyi, Anjolaoluwa (2014) : The Effects of Corporate Governance Mechanisms on Earnings Management of Listed Firms in Nigeria, Journal of Accounting and Management Information Systems (JAMIS), ISSN 2559-6004, Bucharest University of Economic Studies, Bucharest, Vol. 13, Iss. 1, pp. 159-174 This Version is available at: https://hdl.handle.net/10419/310551 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Accounting and Management Information Systems Vol. 13, No. 1, pp. 159–174, 2014 The effects of corporate governance mechanisms on earnings management of listed firms in Nigeria Uwalomwa Uwuigbe a, 1 , Daramola Sunday Peter b and Anjolaoluwa Oyeniyi aCovenantUniversity, Nigeria; bSouthwestern University, Nigeria Abstract: This study basically examined the effects of corporate governance mechanism on earnings management in Nigeria. To achieve the objectives of this study, a total of 40 listed firms in the Nigerian stock exchange market were selected and analyzed for this study using the judgmental sampling technique. The choice of the selected firms arises based on the nature and extent of corporate financial failures and scandals that has been withnessed in the industry overtime. Also, the corporate annual reports for the period 2007-2011 were used for the study. The regression analysis method was employed as a statistical technique for analysing the data collected from the annual report of the selected firms. Findings from the study revealed that while board size and board independence have a significant negative impact on earnings management (proxied by discretionary accruals); On the other hand, CEO duality had a significant positive impact on earnings management for the sampled firms in Nigeria. Hence the paper concludes that firms with larger boards and diverse knowledge are more likely to be more effective in constraining earnings management than smaller boards since they are likely to have more independent directors with more corporate or financial expertise. Keywords:corporate governance, earnings management, ceo duality, board size, discretionary accruals JEL Code: M41 1 Corresponding author: Department of Accounting, School of Business College of Development Studies Covenant University, Ogun State, Nigeria, +234-8052363513, Email address: [email protected] Accounting and Management Information Systems Vol. 13, No. 1 160 1. Introduction The integrity of financial disclosure has been an issue of constant concern among regulators, financial analyst and accounting practitioners; especially after the series of high-profile accounting scandals and frauds involving well-known firms such as Worldcom and Enron (US) and One Tel (Australia), Nortel (Canada), Parmalat (Italy) and Transmile Group Berhad (Malaysia), Oceanic bank, Intercontinental bank, Afribank and Cadbury (Nigeria). For firms in Nigeria, poor corporate governance practice have been cited as one of the causes of the corporate collapses noticed among firms in the financial sector (Adeyemi and Fagbemi, 2010). This phenomenon have waned the public confidence, most especially those in the accounting circle. It has consistently raised severe concerns about corporate governance practices in a broad-spectrum. More so, it has also brought to spotlight issues relating to quality of financial reporting and the weak internal control systems among firms (Ebrahim, 2007; Kanchanapoomi, 2005; Bello, 2011; Uwuigbe et al., 2014). The corporate failures of such large organisations in the past have highlighted the intentional misconduct of managers in a wider-spectrum. In addition, there are apprehensions about the weaknesses of corporate governance in the past, as it was not effective enough to protect investors from expropriation. The management of firms’ earnings has also been an issue of continuous concern for several years for regulatory bodies and accounting practitioners (Levitt 1998). They are seen as an important summary statistic of a firm’s financial performance and are often used in firm valuation. According to Leuz et al. (2003), earnings management is basically described as the alteration of a firms’ reported economic performance by insiders either to mislead stakeholders or to influence contractual outcomes. In essences, it basically covers the true financial results and position of businesses and obscures facts that stakeholders ought to know (Loomis, 1999). However, earnings management basically occurs when managers use personal opinion in reporting financial information and in structuring accounting transactions to alter financial reports to either mislead stakeholders on the original economic performance of the company or to manipulate contractual outcomes that depend on reported accounting numbers (Healy & Wahlen, 1999). Thus, the very nature of accounting accruals gives managers a great deal of discretion in determining the earnings a firm reports in any given period because of the information asymmetry relationship that exist between managers and owners. Managers can manipulate or influence earnings in order to maximize their own interests or to signal their private information, thus influencing the informativeness of earnings (Chung et al., 2002; Gul et al., 2003). Neverthelss, in an environment characterized by imperfect information, a variance in the interest between management and shareholders can lead to sub-optimal management decisions. Such decisions are possible because the actions of managers are largely unobservable and the goals of the managers and their The effects of corporate governance mechanisms on earnings management of listed firms in Nigeria Vol. 13, No. 1 161 shareholders are not necessarily aligned. Managers are posited to opportunistically manage earnings to maximize their utility at the expense of other stakeholders. These problems are envisaged to be much more significant in an emerging market where many market imperfections continue to persist. This is particularly the case in Nigeria where despite the publication of a new corporate governance code in 2003 and 2011; there are still cases of misappropriation of fund and falsification of reports to suit management interest. However, this problem is not only adduced to poor corporate governance practice, but also, the low quality of financial information disclosure has led to series of corporate failures and scandals. Hence, this study adds to the body of existing knowledge by investigating the effects of corporate governance mechanisms on the earning management of listed firms in Nigeria. To archieve this objective, the annual reports for the period 2007-2011 were analyzed. In addition, the study considered a total of 40 listed firms in the Nigerian stock exchange market. The choice of the selected firms arises based on the nature and extent of corporate financial failures and scandals that has been withnessed in the industry overtime. To gain more insight into this paper, the paper has been organized as follows. Section 2 presents an in-depth review of related relevant literatures and hypotheses development. While section 3 focused on the research methodology adopted for the study; section 4 and 5 discusses the findings and conclusion of study. 2. Literature review and hypotheses development Corporate governance as the term implies is a mechanism that is employed to reduce the agency cost that arises as a result of the conflict of interest between managers and shareholders. The role of corporate governance according to Solabomi, and Uwuigbe (2013) is to reduce the divergence of interests between shareholders and managers. It remains one of the most important determinants in ensuring the quality of the financial reporting process. It is a set of mechanisms that affect how a corporation is operated. It deals with the welfare and goals of all the stakeholders, including shareholders, management, board of directors, lenders, regulators, and the economy as a whole. It has been in the front burners of recent discussions due to the series of highly publicized financial reporting frauds at Enron, WorldCom, Adelphia and Parmalat in particular, and a very high level of earnings restatements. While prior research in accounting literatures has looked at the relationship between different corporate governance variables and earnings management, the vast majority of these prior literatures has basically focused on the board and audit committee as proxy for corporate governance variables (Beasley, 1996; Peasnell, et al., 2005). In addition, prior accounting research that specifically examined the impact of corporate governance on earnings management is quite limited especially in emerging markets (e.g. Nigeria). However, Klein (2002) addressed this phenomenon by focusing more on the extent than the Accounting and Management Information Systems Vol. 13, No. 1 162 direction of earnings management. Klein opined that earning management is positively related to the CEO holding a position on the board’s nominating and compensation committees. Similarly, Anderson et al. (2003) also observed that the separation between CEO and board chair positions appears to positively influence the information content of accounting earnings. In U.S, Dechow et al. (1996) examined 96 firms subject to earnings manipulation enforcement action by the Securities and Exchange Commission and observed that firms whose CEO is also chair of the board of directors are more likely to be subjected to accounting enforcement action by SEC for alleged violations of GAAP. Also, Xie et al. (2003) examined the characteristics of the board in constraining earnings management using discretionary current accruals to measure earnings management for a sample of 282 US firms for the period 1992 to 1996. They observed that earnings management is less likely to take place in firms with larger boards. More so, Bedard et al. (2004) in their study found a significant negative relationship between measures of earnings management and the allindependent audit committees. However, they found no significant relationship between earnings management and audit committee proxied by annual meetings. Cheng and Warfield (2005) investigated whether the propensity for earnings management is lower when management interest’s and owners’ interests are aligned through higher managerial ownership. Their results confirmed that earnings management is lower for firms with higher managerial ownership. Shen and Chih (2007) in a related study observed that effective corporate governance mechanism tend to conduct less earnings management practices. Similarly, Abdul Rahman and Ali (2006) and Epps and Ismail (2008) confirmed that board characteristics are major determinants of earnings management. In the UK, Peasnell et al. (2005), examined whether the association between board composition and earnings management differs between the pre and post-Cadbury periods. They found the evidence of accrual management to meet earnings targets in both periods. However, only the post Cadbury period indicates less incomeincreasing accrual management to avoid earnings losses or earnings declines when the proportion of non-executive directors is high. These results offer clear evidence of the impact of independent outside directors on constraining earnings management in the UK. More recently, Osma (2008) explores different types of earnings manipulation and analyses the effect of independent boards on constraining research and development (R&D) spending manipulation. They consisidered the entire UK nonfinancial firms and their sample consisted of 3,438 firm-years, for the period 1990 to 2002. Results from there study indicated that independent directors are capable of identifying and constraining earnings management practices. In Canada, Park and Shin (2004) investigated the effect of board composition on the level of earnings management in a sample of 539 firm-years. Using the modified Jones The effects of corporate governance mechanisms on earnings management of listed firms in Nigeria Vol. 13, No. 1 163 model as a proxy for earnings management, they observed that independent outside directors do not reduce discretionary accruals whereas outside directors from financial intermediaries and active institutional shareholders do reduce earnings management. In the U.S, Cornett et al. (2006) basically examined whether corporate governance mechanisms affects earnings management at the largest publicly traded bank holding companies in the United States. Evidence from their findings showed that the use of discretionary accruals is positively related to a bank‘s unmanaged operating performance, capital ratios, and asset size. However, in contrast, the use of discretionary accruals is negatively related to a bank‘s non-discretionary accruals and market-to-book ratios. In a related study from China, Liu and Lu (2007) examined the relationship between earnings management and corporate governance by introducing a tunneling perspective. They observed that firms with higher corporate governance levels have lower levels of earnings management. Also, Prencipe and Bar-Yosef (2009) examined the effectiveness of board independence on earnings management in family-controlled companies. Empirical results provided from their study indicated that the impact of board independence on earnings management is indeed weaker in family-controlled companies. The same result also holds for the lack of CEO/board chairman duality function. Similarly, Al-khabash and Al-Thuneibat (2009) provided empirical evidence concerning the existence of earnings management from the perspective of external and internal auditors in Jordan, and they believed that managers operated by either increasing or decreasing their earnings in order to legitimize their activities. Also, their study revealed that firms with boards and/or audit committees composed of independent directors are less likely to have larger abnormal accruals. Al-Fayoumi et al. (2010) in the Jordanian context examined the relationship between earnings management and ownership structure for the period 2001-2005. They observed that managers’ ownership is ineffective in aligning managers to take value maximizing decisions. In addition, they observed an insignificant role for bulk holders in monitoring managerial unethical behavior relating to earnings management. In Nigerian, Umorem (2010) in a related study examined the relationship between corporate governance attributes and the level of voluntary disclosures among firms in Nigeria. Using t-test and analysis of variance technique the study observed that the level of voluntary disclosure among listed firms in Nigeria was low. Similarly, Uwuigbe (2011) using the peason correlation and regression analysis method of data analysis, observed that a significant negative relationship exists between board size, board composition and financial performance of listed firms in Nigeria. In addition, Bello (2011) using the probit analysis in a related study on earnings management observed that there was a positive significant relationship between Accounting and Management Information Systems Vol. 13, No. 1 164 board size, board performance on ethical accounting practices. The study also observed that board composition has a significant negative effect on ethical accounting practices. Although the relationship between corporate governance and earnings management has been the subject of an extensive research in developed economies, the same is not true in developing economies like Nigeria where there is a relatively dearth in literature. Hence this study therefore tends to fill this gap in literature by examing the effects of corporate governance mechanisms on earnings management of listed firms in Nigeria. Drawing from the literature, the hypotheses to be tested in this study are stated below in their null forms: 1) Ho: There is no significant relationship between board size and earnings management. 2) Ho: Board independence has no significant effect on the earnings management of firms. 3) Ho: CEO duality has no significant effect on the earnings management of firms. 3. Methodology To achieve the objectives of this study, the annual report for the period 2007-2011 were analyzed. The choice of these period arises based on the fact that it recorded a large number of corporate frauds arising from firms in Nigeria due to poor corporate governance practice. However, using the judgmental sampling technique; a total of 40 listed firms were analysed. This represents 20.5% of the total population. This is consistent with the propositions of Krejcie & Morgan (1970) where a minimum of 5% of a defined population is considered as an appropriate sample size in making generalization. The choice of the selected firms’ arises based on the nature and extent of corporate failures and scandals that has bedivilled industry overtime. Nevertheless, in testing the research hypothesis, the ordinary least square (OLS) was used in the estimation of the regression equation under consideration. 3.1 Specifications of the 3conometric model 3.1.1. Dependent Variable The dependent variable in this study is earnings management. However, based on prior literatures, it was observed that the modified Jones model is the most famous and most frequently used model used to detecting earnings management. Thus it was adopted in this study in determing the discretionary component of accruals. The effects of corporate governance mechanisms on earnings management of listed firms in Nigeria Vol. 13, No. 1 165 The model was adopted because it is easier to manage earnings via credit sales than cash collections. Also, it attempts to control for the endogeniety bias in the original. More so, it is one of the most commonly used models in addressing issues relating to management discretionary behaviours. In addition, the cash flows statement approach is adopted in this study for the calculation of total accruals. TA/A (t-1) = β1[1/ At-1] + β 2[(Δ in REV-Δ in REC) /At-1) + β 3[PPE/At-1] + + ϵit (i) Where: TAit = Total accruals in year t for firm i. ΔREVit = Revenues in year t less revenues in year t-1 for firm i (change in revenue) ΔRECit = Receivables in year t less receivables in year t-1 for firm i (change in receivables) PPEit = Gross property, plant, and equipment in year t for firm i (property, plant & equipment). Ait-1 = Total assets in year t-1 for firm i (total assets for the previous year) β1, β2, β3= Represents firms specific parameters. ϵ = Residual here represents the firm specific discretionary portion off accruals. However, while the right side of the equation represents the non-discretionary accruals (NDA), the net result for the left side of the equation amounts to the total accruals (TA). Nevertheless, taking the difference between the total accruals and the non-discretionary accruals; it amounts to the discretionary accruals (DA) which is basically used in this study to represent earning management. Hence, the higher the value of discretionary accruals, the more likely the presence of earnings manipulation and vice versa as depicted in equation (2): DAi-t = TACit/Ait-1 - αt[1/Ait-1] + α1i [(∆REV- ∆REC)/Ait-1] + α2i [PPEit/Ait-1] + ϵit (ii) 3.1.2. Independent Variable The independent variable in this study is corporate governance. The corporate governance variables adopted for this study includes board size, board independence and ceoduality. On the other hand, firm size proxied by total asset is used in this study to represent the control variable. Thus introducing the constructs of the dependent and independent variables, the regression equation adapted for this study is modeled in the following functional form as: Accounting and Management Information Systems Vol. 13, No. 1 166 DAi-t = β0 + β1BSi-t + β2BCi-t + β3CEODUAL i-t + FSIZEi-t +µi-t…… (iii) Where DA = Discretionary Accruals (which is the proxy for earnings management) BSIZE = Board Size; (which represents the number of directors on the board). BDIND = Board Independence is the proportion of non-executive directors to total board composition. CEODUAL = CEO duality is captured by assigning 1 if the CEO serves also as the chairman and 0 if otherwise 0. FSIZE = Firm Size is measured by the Log of total asset (Control Variable). Β1-3 = Coefficients to be estimated or the Coefficients of slope parameters. µ = Error term; it captures other explanatory variables not clearly included in the model. i-t = Where i and t represent all the 40 companies and the 5 years time period respectively. The expected signs of the coefficients (i.e. a priori expectations) are such that β1, β2while β2< 0. Table 1. Averaged data for the selected listed firms used in the study for the period under consideration S/N FIRMS LOGDA BSIZE BIND CEODUAL FSIZE 1 Evans Medical Plc 4.70 5.00 6.00 .00 4.40 2 G S K Consumer Plc 4.65 7.20 5.60 .00 4.95 3 May and Baker Nig. Plc 4.55 6.80 6.00 .00 4.37 4 Pharma - Deko Plc 4.95 7.40 6.00 .00 3.80 5 Guinness Nigeria Plc 4.59 10.40 6.00 .00 4.33 6 Nigerian Breweries Plc 4.40 11.80 6.00 .00 9.00 7 Jos International Breweries Plc 4.66 7.20 6.00 .00 4.42 8 Champion Breweries Plc 4.44 11.00 7.80 .00 9.92 9 International Breweries Plc 4.39 10.40 8.00 .00 9.20 10 Lafarge West African Portland Cement Plc 4.53 10.40 6.00 .00 4.62 11 Chemical & Allied Products Plc 4.62 9.20 4.00 .00 5.74 12 D N Meyer Plc 4.10 12.80 5.30 .60 8.85 13 Nigerian - German Chemical Plc 4.56 8.00 6.00 .00 3.75 14 Okitipupa Oil Palm Plc 5.50 5.60 4.00 1.00 4.43 15 Presco Plc 5.61 4.40 4.40 1.00 3.92 16 Okomu Oil Palm Plc 4.09 12.60 8.20 .00 4.00 17 Ellah - Lakes Plc 4.63 9.00 4.40 .00 2.02 18 Livestock Feeds Plc 4.66 12.60 6.00 .00 2.85 The effects of corporate governance mechanisms on earnings management of listed firms in Nigeria Vol. 13, No. 1 173 Epps, R. W. & Ismail, T. H. 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