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CHAPTER ONE
INTRODUCTION
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).
This prompted standard setters, regulators and the academia to embark on the factors that
determine earnings management in different sectors and industries. Some of the empirical studies
considered corporate governance in terms of board of directors monitoring mechanisms as major
determinant of earnings management, while others pointed institutional ownership, performance,
audit quality and financial structure of a firm.
For instance, with regards to the financial report quality, Watts and Zimmerman (1986)
opine that audit of reported financial accounting numbers serve as monitoring mechanism which
protect and minimize information asymmetry between general stakeholder and the managers, and
assure the general stakeholders that reported accounting numbers are free from material error and
misstatements. Furthermore, audit is one of the critical determinants of earnings management
which improve the quality of accounting numbers and increase the confidence level of the
financial statements user. However, Heirany, Sadrabadi and Mehrjordi (2016) indicate that
attention given the corporate governance issues is assumed to control managers‟ irregularities
manipulation of accounting information and this consequently increases the quality and
reliability of their financial reporting. Nadia (2015) argues that institutional investors have the
opportunity, resources and capacity to monitor and influence the decisions of managers, these
investors can control the process of preparing financial statement and prevent managers from
behaving in an opportunistic manner, through an aggressive management of earnings, thus
ensuring a better quality of account information.
Similarly, a review of studies on earnings management highlights that corporate financial
structure is also among the determinants of earnings management. For example, Jelinek (2007)
and Wasimullah, Toor and Abbas (2010) provide evidence that leverage limit earnings
management; according to Jelinek (2007), increase in debt in firm‟s capital structure reduce
opportunistic earnings management for two reasons. First, leverage required debt repayment,
thus reduces cash available to management for non-optimal spending; secondly, when a firm
employs debt financing, it undergoes the scrutiny of lenders and is often subject to lender-
induced spending restriction (Jensen, 1986). Lastly, firm‟s financial performance is usually seen
as one of the main determinants of real earnings management; for instance, Roychowdhury
(2006) argues that managers exercises real earnings management such as sales manipulation and
overproduction in order to avoid reporting losses, or reporting good performance.
In addition, a survey and interviews of 400 executives of U.S. firms by Graham, Harvey
and Rajgopal (2005) found that executives‟ managers would rather take economic actions (real
earnings management) that could have long-term consequences than make accounting
adjustments (accrual-based earnings management) to hit earnings targets. Out of the total survey
participants, a total of 80% of surveyed executives stated that, in order to deliver earnings, they
would decrease research and development, advertising, and maintenance expenditures, even
though these actions damage firm value in the long run.
However, it is the debate in the earnings management literature and its determinants that
this study intends to critically evaluate determinants of real earnings management in the listed
industrial goods firms in Nigeria. Moreover, previous researches on earnings management have
concentrated on other sectors, leaving industrial goods sector receiving little attention.
The industrial goods sector of the Nigerian economy, where previous studies have not
sufficiently emphasized on. The listed industrial goods sector is of interest, since it has been
argued that industrial goods manufacturing firms are more prone to earnings manipulation and
more precisely through real activities manipulations and structuring; due to two main reasons.
One industrial goods firms have the largest volume of production and operating activities due to
the nature of their products, which is more susceptible to manipulations than firms in other
industries; two, there is wider rooms for subjective judgments managers must undertake
concerning expected production costs and discretionary expenses.
From the structuring and manipulation of operating activities perspective within the listed
industrial goods firms, the analysis of sales manipulation, overproduction and manipulation of
discretionary expenses is critical, as they impacts on the timing and amount of reported earnings.
Therefore, this presents an interesting case for examining the determinants of real earnings
management in the listed industrial goods firms.
It is against this background that the present study examines real earnings management in
relation to corporate financial structure, board monitoring, institutional shareholding,
performance and audit quality as determinants.
1.2 Statement of the Research Problem
Corporate managers do earnings management practice either good or bad as reported in
the literature. Earnings management practices according to Yero (2012) is prevalence in both
developing and developed countries, and as such corporate managers as agents should be
monitored and control to ensure that they do not manipulate accounting earnings at the expenses
of owners.
Previous researches on earnings management in Nigeria have concentrated on other
sectors, prompting a research question of whether industrial goods sector is protected to the realbased manipulation activities. Except an empirical study in Nigeria by Yero (2012) which
investigate the effect of leverage on real earnings management. Hence, the present study
examine real earnings management proxy by (sales manipulation, production cost manipulation
and discretionary expenses manipulation) in relation to some specific determinants (financial
structure, board monitoring, audit quality, institutional ownership and firm performance). This
constitutes one of the gaps in the literature that this study attempt to fill. This study highlights the
methodological gap that the study intends to address. To the best knowledge of this study, only a
few studies have examined the determinants of real earnings management in terms of the audit
quality, financial structure, firm performance, institutional ownership and board monitoring.
Furthermore, most of the studies focus one dimension the determinants of real earnings
management and provide mixed evidence. Chi et al., (2011) and Cohen and Zarowin (2010)
considered only audit quality in their studies and found significant association between audit
quality and accrual-based earnings management. Additionally, Chi et al. (2011) report that
companies that highly encourage managing earnings engage in higher level real earnings
manipulations to avoid the monitoring of accrual earnings management by big-N audit firms. On
the other hand, Norhayati, Rahayu, and Noor (2013) examine the relationship between leverage
and real-based earnings manipulations activities. The study discovered a negative and significant
relationship between leverage and real-based manipulation. The finding reveals that companies
with lower leverage have manipulate real-based earnings lower. Ge and Kim (2013) studied the
effect of board monitoring on real earnings management. They found that real-based earnings
management “(proxy by sales manipulation, abnormal declines in R&D expenses, and other
discretionary expenses)”is better with good board governance and reduce with higher takeover
protection. The overall findings of their study show that real-based earnings management is at
higher level when board monitor firm strongly and takeover protection may decrease
motivational factors for real-based earnings management. Moreover, Visvanathan (2008) found
that majority of the corporate governance proxies are not playing greater role in decreasing real
earnings management with exception of board independent; while Osma (2008) and Zhao et al.
(2012), in the United Kingdom disclosed that board independent is effectively reducing realearnings management.

One dimension of the determinants alone cannot reveal much about the strength of the
determinants in relation to real earnings management. To overcome this limitation, our study
constructs a comprehensive measure of the determinants from different dimensions (audit
quality, financial structure, corporate governance and performance. This study also considers
three divisions of real-based earnings management which are: overproduction, sales
manipulation and abnormal cut of other discretionary expenses. Therefore, the scope of this
study and the research design allows the research to consider how the major determinants affect
real earnings management in the Nigerian industrial goods firms. To test the relation between the
determinants and real earnings management, the study focuses on five mechanisms: the board
monitoring, financial structure, audit quality, institutional ownership and corporate performance.
The study intends to investigate how the selected firm characteristics will affect real-based
earnings management.
1.3 Research Questions
The following research questions are raised to guide the study.
i. How does financial leverage affect real earnings management in the listed industrial
goods firms in Nigeria?
ii. What is the effect of audit quality on real earnings management in the listed industrial
goods firms in Nigeria?
iii. What is the effect of financial performance on real earnings management in the listed
industrial goods firms in Nigeria?
iv. To what extent does institutional ownership affect real earnings management in the
listed industrial goods firms in Nigeria?
v. To what extent does board attributes (in terms of board size and board composition)
affect real earnings management in the listed industrial goods firms in Nigeria?