The effect of earnings co-movement on the probability of earnings manipulation: by considering product market competition

Document Type : Research Paper

Author

Accounting Department, Faculty of Administrative Sciences and Economics, University of Isfahan, Iran

Abstract

1- Introduction
Due to the separation of ownership from management and conflict of interests, asymmetry of information between managers and owners, debt contracts and managers' rewards, there is a probability of distortion and manipulation of earnings by management. In this regard, the information environment of the firms plays a central role in the investors' reaction to the financial reports. There are various sources of information to obtain information, include reports published by the firm or information published by peer firms in the same industry. The ability of managers to manipulate earnings or not, depends on the amount of information that can be obtained from other sources of information such as financial statements of other firms. The intra-industry information transfer and the earnings co-movement can affect the involvement of managers with earnings manipulation activities.
When there is earnings co-movement, capital market’s members can obtain information from the earnings of peer firms about the real and correct earnings of the firm, and as a result, they can better identify bias in financial information and reports. The knowledge of the capital market participants about the true earnings of the firm, the expected benefits of earnings manipulation are reduced. Based on this, the aim of this study is to investigate the effect of earnings co-movement on the probability of earnings manipulation and also to investigate this relationship under the conditions of product market competition.
 
2- Hypothesis
According to the literature, the research hypotheses include:

In firms with higher earnings co-movement, the probability of earnings manipulation will be less.
In firms with low product market competition, compared to high competition, the relationship between earnings co-movement and the probability of earnings manipulation will be stronger.

 
3- Methods
In this study, in order to calculate the variables and test the hypotheses, required data has been collected from the annual and quarterly financial statements and its footnotes of listed companies in the Tehran Stock Exchange and the existing databases including “Rahavard Novin” and “Codal”. The sample of this study consists of 134 listed companies in Tehran Stock Exchange during 2009 to 2020. To test hypotheses, logit regression and panel data methods have been used.
 
 
4- Results
The results of the first hypothesis test showed that earnings co-movement has a negative and significant effect on the probability of earnings manipulation. That is, in firm with higher earnings co-movement, the probability of earnings manipulation is less.
The results of testing the second hypothesis also showed that in firms with low product market competition, there is a negative relationship between earnings co-movement and the probability of earnings manipulation, but there is no significant relationship in firms with high product market competition. Therefore, in firms with low competition, compared to high competition, the relationship between earnings co-movement and the probability of earnings manipulation is stronger.
Based on the sensitivity analysis test, the relationship between earnings co-movement and probability of earnings manipulation is stronger in companies with old age, compared to young ones.
 
5- Discussion and Conclusion
According to the accounting literature, the intra-industry information transfer and the earnings co-movement can affect the level of involvement of managers with earnings manipulation activities. Based on this, in the current study, the impact of earnings co-movement on the probability of earnings manipulation was investigated, as well as the investigation of this relationship under the conditions of product market competition.
According to the first hypothesis, it was expected that the probability of earnings manipulation would be lower in firms with higher earnings co-movement. The results of the test of this hypothesis showed that the coefficient of earnings co-movement variable is significant and negative at the confidence level of 95%, and the first hypothesis of the research is not rejected. This means that when the firm’s earnings moves with the earnings of other companies in the industry and this co-movement is more, investors can estimate the expected profit of the firms based on the earning’s’ information of other firms in the industry. In this situation, managers will be less able to manipulate earnings, as a result, the probability of earnings manipulation will decrease.
In the second hypothesis, the relationship between earnings co-movement and the probability of earnings manipulation in high and low competitive environment was investigated. When product market competition is higher, competition acts as a disciplinary mechanism and limits the biased behavior of managers. Therefore, it was expected that in firms with low product market competition, the relationship between earnings co-movement and the probability of earnings manipulation will be stronger than in high competition. The results showed that in firms with high product market competition, earnings co-movement has no significant effect on the probability of earnings manipulation, but in firms with low product market competition, earnings co-movement has a negative and significant effect on the probability of earnings manipulation. That is, the high competition in the product market is a deterrent and a limiting factor for managers' biased behavior.
Based on accounting literature, managers' motivations and their bonus contracts are different based on the firm’ age. Hence, the relationship between earnings co-movement and the probability of earnings manipulation was also investigated by considering the age of firms.
The results showed that in older firms, earnings co-movement has a negative and significant effect on the probability of earnings manipulation, but no significant effect was observed in younger firms. This may indicate that old firms are the focus of attention of capital market activists and shareholders. Therefore, in old companies, the earnings co-movement reduces the probability of biased activities of managers and earnings manipulation.
 
Keywords: Earnings Co-movement, Earnings Manipulation, Intra-industry Information Transfer, Product Market Competition.

Keywords

References

 
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History

  • Receive Date: 21 August 2022
  • Revise Date: 15 November 2022
  • Accept Date: 15 November 2022

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