Earnings Management in Polish Companies

Brzeszczynski, Janusz; Gajda, Jerzy; Schabek, Tomasz Article Earnings Management in Polish Companies Comparative Economic Research. Central and Eastern Europe Provided in Cooperation with: Institute of Economics, University of Łódź Suggested Citation: Brzeszczynski, Janusz; Gajda, Jerzy; Schabek, Tomasz (2011) : Earnings Management in Polish Companies, Comparative Economic Research. Central and Eastern Europe, ISSN 2082-6737, Łodz University Press, Łodz, Vol. 14, Iss. 3, pp. 137-150, https://doi.org/10.2478/v10103-011-0023-1 This Version is available at: https://hdl.handle.net/10419/259085 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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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. https://creativecommons.org/licenses/by-nc-nd/4.0 10.2478/v10103-011-0023-1 JANUSZ BRZESZCZYŃSKI*, JERZY GAJDKA**, TOMASZ SCHABEK*** Earnings Management in Polish Companies Abstract This paper presents results of the investigation of a phenomenon known as „earnings management” (EM) among the companies listed on the Polish stock market. The distribution of earnings per share (EPS) for the stocks around the threshold value of “zero” and the threshold of “recent performance” was analyzed in the period of years 1997-2010. Moreover, the changes of earnings for the stocks, which are suspected to manipulate their earnings, were also investigated. The results, which indicate asymmetric distribution of earnings around the zero threshold along with the relative deterioration of earnings in the year following the period when the companies were suspected to conduct earnings management practices, provide evidence that this phenomenon exists among Polish stock market companies. 1. Introduction Earnings are one of the most important items of financial reports issued by public companies. Profits of every firm are closely scrutinized by shareholders, investors, financial analysts or boards of directors in order todetermine the attractiveness of a particular stock or to reward the executives *Ph. D., University of Łódź ** Ph. D., Professor at the University of Łódź *** University of Łódź 138 Janusz Brzeszczyński, Jerzy Gajdka, Tomasz Schabek for their work and for their financial results. This is the reason why the management of a company sometimes decides to deliberately manipulate the firm’s earnings, so that the pre-determined targets can be achieved. Such strategy is often called “earnings management” (EM). 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”. It must be emphasized, however, that earnings management, as we understand it for the purpose of this study, should not be confused with illegal activities, such as financial fraud, which is at the illegal end of continuum of activities of this type, whereas earnings management is at the legal end. Earnings management may be executed by two kinds of management actions: • accounting choices which follow legally accepted rules, • operating decisions. An example of an accounting choice is adopting the depreciable life for new plant at the high end of industry norms (in order to lower depreciation expenses) or at the level lower than the high end of industry norms. An example of operating decision is a delay in the execution of normal maintenance procedures in one period in order to reduce maintenance costs in that period and to perform this procedure in the following period. This kind of earnings management practices may lead to real economic costs, if the company incurs higher operating costs caused by the lack of maintenance in the future period. However, a company may pay real economic costs also via accounting choices. For example, it may pay a higher bonus in the subsequent period due to accounting earnings management (Ziv, 1998). One of the most frequently mentioned targets of earnings management is the, so called, smoothing. Smoothing has existed over decades and there are two general views as to what motivates managers to smooth earnings (Aflatooni and Nikbaht, 2010). According to the first view, smoothing is an efficient vehicle for managers to reveal private information (Ronen and Sadan, 1981, Demski, 1998, Sankar and Subramanyam, 2001, Srinidhi, Ronen and Maindiratta, 2001, Kirshenheiter and Melumad, 2002, and Goel and Thakor, 2003, among others). In such case, it may play a similar role as dividend smoothing (see, for example, Miller and Rock, 1985). The second view of smoothing is the, so called, garbling, according to which smoothing is an action undertaken by managers in attempt to fool financial analysts and the shareholders and to enhance managerial compensation (Beidleman, 1973, Lambert, 1984, Arya, Glover and Sunder, 1998, and Demski and Frimor, 1999, among others). Earnings Management in Polish… 139 However, smoothing is not the only possible explanation for the motives behind earnings management. Since accounting numbers have no meaning unless they are compared to some benchmarks, companies have incentive to beat such benchmark as, for example, zero earnings, earnings in the corresponding periods in the past (for example quarter-to-quarter results) or analysts’ consensus forecasts (see Ronen and Yaari, 2008, Aflatooni and Nikbaht, 2010, among others). There exists evidence in the literature about earnings management aiming to exceed certain thresholds in form of a discontinuity in frequency of firms’ earnings around zero or some other threshold levels (Hayn, 1995, Burgstahler and Ditchev, 1997, Degeorge, Patel and Zeckhauser, 2005). This paper deals with the latter effect, i.e. with earnings management thresholds. Most studies focused on that problem concern economies of developed countries, but the evidence from emerging markets is limited (see, for instance, Wójtowicz, 2010). The aim of our paper is to find out whether earnings management effects exist among Polish companies and whether they are similar in nature to this phenomenon in other, developed markets. The paper is organized as follows: section 2 presents methodology of this study, section 3 describes data sample, section 4 offers discussion of empirical results and section 5 concludes. 2. Methodology According to common opinions, executives care about some threshold levels when they report earnings. Two of them are the main subject of analysis in our study, i.e.: • the objective to report the profit above zero, • the objective to achieve at least the last period’s profit (i.e. not to worsen recent performance). Our study follows the methodology of Degeorge, Patel and Zeckhauser (2005) based on the idea that execution of earnings management practices in order to reach or beat certain thresholds affects the distribution of net profits, when analyzed in a large group of companies, and can be explained on the basis of a 2-period model. In each period (t=1,2) the firm gets the random, independent and identically distributed draw of “true earnings” (T 1 and T 2 ). The “true earnings” can not be observed by outsiders who see only the reported earnings (R 1 and R 2 ). In period t=1 the executives can “manage” reported earnings by choosing an amount (M 1 ) that is added to earnings such that: R 1 = T 1 + M 1 . (1) 140 Janusz Brzeszczyński, Jerzy Gajdka, Tomasz Schabek The cost of “earnings management” is paid later in period t=2, so that: R 2 = T 2 - K(M 1 ) (2) where K(M 1 ) is the positive and increasing marginal costs of moving M 1 away from 0 and K(0) = 0. In this analysis we adopt a simplifying assumption that the discount rate is equal to 0. The general meaning of equations (1) and (2) is that earnings management in period t=1 towards increasing the net profit by 1 PLN reduces net profit in period t=2 by more than 1 PLN (in our model M 1 may be also negative; in such case the reduction in profit by 1 PLN in period t=1 would be followed by earnings increase in period t=2 by less than 1 PLN). We also assume that the company ceases to exist after period t=2 and every relevant information is revealed at this time. It is important to note that manipulation of earnings does not necessarily have to occur at any profit level. In fact, managers care only about particular values (which we call thresholds), because everyone concerned with the firm’s performance behaves the same way. In our study, we focus on two important thresholds, i.e.: • positive profit, • recent performance. Thresholds are important for several various reasons (Degeorge, Patel and Zeckhauser, 2003). Some of them are psychological in nature. First, a perception of positive and non-positive value in human mind is fundamentally different. As a result, there exists a solid division line between achieving and failing to achieve the value of earnings equal to zero. Second, earnings management across thresholds is relevant for the simplification of managers relation with shareholders and board of directors: the rewards for firms’ managers – both employment decisions and compensation benefits – often depend implicitly or explicitly on the earnings for which executives are responsible and which they generate (Healy, 1985). Moreover, banks may sometimes have the policies to grant loans only to firms that report positive earnings, which also increases the role and importance of positive earnings threshold. A certain pattern of earnings over time conveys key information to the markets about company’s financial situation and its stability. For example, a report showing that earnings have been increasing during the last 7 years is a cheap and simple way of communicating that the performance of the company is systematically good. Threshold effects may be meaningful even if only few participants react to them directly. For example, even if only banks care about thresholds, reaching Earnings Management in Polish… 141 certain level of earnings will have a positive effect also for other market participants. Our analysis is divided into the following 3 stages: 1. First, we investigate the distribution of earnings around selected thresholds, i.e. around the EPS = 0 (i.e. the positive profit threshold) and the EPS growth equal to zero (i.e. the positive earnings growth threshold), 2. Second, we check whether there is a discontinuity in the EPS around the thresholds. We apply the test of discontinuity in a univariate distribution proposed by Degeorge, Patel and Zeckhauser (2005) using the statistic τ . We examine the rank of τ at the threshold relative to the other τ ’s as well as its relative magnitude in order to assess whether discontinuity can be found at the analyzed threshold level. 3. Third, we control whether according to equations (1) and (2) earnings management causes predictable changes in the earnings in the next period. This way we can find out whether the companies suspected to practice EM towards the increase of earnings, experience the decrease of their earnings in the following year. In the next sections we describe the database used in this study and present empirical results. 3. Data sample The dataset used in this investigation consists of detailed information from income statements from 359 companies listed on the Warsaw Stock Exchange (WSE) in the period of years: 2000-2009. We selected two thresholds, i.e. positive profit and recent performance on the basis of annual and quarterly reports. The number of quarterly reports available was 7939 and the number of annual reports was 2726. The source of all data is “Notoria” database. 4. Empirical results Our analysis aims to explore the extent to which executives can manage earnings to attain two threshold levels described above. We study the density function for earnings near those thresholds. If managers do indeed manage 142 Janusz Brzeszczyński, Jerzy Gajdka, Tomasz Schabek earnings to reach certain level of them, we should expect to observe “too few” earnings reports directly below it and “too many” at or directly above it. We should also expect a discontinuity in density at the level of investigated thresholds. 4.1. Positive profit threshold The first threshold which we consider is probably the most natural one, i.e. the positive earnings. The analysis of this particular threshold level addresses the most important question for shareholders, namely whether the company is profitable at all. Figure 1 presents the histogram of EPS for the threshold “positive/zero profits” for annual earnings. The distribution shows a considerable jump between the value of -0,30 and zero, which indicates that the managers strongly desire to be able to report positive earnings. The value of τ -statistic (based on the basic test for discontinuity) confirms this pattern. At EPS = 0 we obtain a τ value of 9,8, which is the highest in the sample and confirms discontinuity at that point. Figure 2 presents the same distribution but for quarterly EPS. The findings for this frequency of data are very similar to the results from annual data. In this case, the distribution also shows a considerable jump between the value of -0,07 and zero, so it appears that managers strongly desire to be able to report positive earnings. The value of a τ -statistic (based on the same test as before) at EPS = 0 is equal to 9,5. This, again, confirms a discontinuity at that point. Earnings Management in Polish… 143 Figure 1. Histogram of annual EPS for the threshold “positive/zero profits” Source: Own calculations. Figure 2. Histogram of quarterly EPS for the threshold “positive/zero profits” Source: Own calculations. Summarizing, our results presented in this section provide evidence that the zero value net profit may be treated as a threshold for earnings management among the Polish companies listed at the WSE. 144 Janusz Brzeszczyński, Jerzy Gajdka, Tomasz Schabek 4.2. Positive profit growth threshold We now turn to the analysis of the positive growth threshold. Figure 3 presents results for annual EPS growth. The change in earnings, denoted as ∆ EPS A , is defined as annual EPS minus annual EPS from four quarters ago. In Figure 3 we can observe a jump in distribution at 0, however it is not as strong as in the case of the previously analyzed EPS threshold. It is worth mentioning, that in that case the jump is stronger at the level value of -0,24. This pattern of ∆ EPS A distribution is, therefore, not so strongly consistent with the view that executives manage earnings in order to achieve or beat the comparable figures relative to the results from four quarters ago ( τ –test value is equal to 4,5). Figure 3. Histogram of change in annual EPS for the threshold of “positive growth” Source: Own calculations.