Kaniz Sakina

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An investor put her money in a company with an obvious expectation of return. The return is expected in forms of payouts, or in simpler term profits sharing and capital gain from the company she has invested in. These gains are possible when the company is performing well enough to generate earnings that satisfy the shareholder’s expectations. A company leaves no stones unturned when it comes to generating enough profits. Often times, it adopts legal, yet unethical practices such as earnings manipulation to deliver favorable earnings to its shareholders. Various techniques are being used for years to curve accounting rules which help to smooth or inflate earnings for companies. Techniques include changing accounting principles to raise earnings within short time and/or to capitalize costs rather than showing as expenses. Earnings manipulation keeps listed companies seemingly profitable and as a derivative, it wrongfully helps those companies stay afloat among uninformed investors.

Many researches have been conducted in Bangladesh, where authors have tried to discover whether or not Bangladeshi listed companies are likely to practice earnings management. Beneish Model calculating M-score helped determine the likelihood of earnings management. A study with 105 manufacturing companies belonging to pharmaceuticals, food & allied, cement, engineering and many others found most of the sample size practicing manipulation in their earnings (Parvin, 2020).

Bangladesh’s neighbor India, a fast-growing economy, has its fair share of earnings management practices. A study consisting sample size of 2,229 companies reveals that smaller companies have more tendency to inflate their earnings compared to middle or larger companies. Industrial companies, to be specific, business in construction and mining are said to have more tendency towards earnings manipulation (Ajit, Malik, Verma, 2013). In India, a study found that discretionary accruals are used as a shadow mechanism to inflate earnings in financial statements (Mishra and Malhotra, 2016). This practice is found similarly in Bangladeshi listed companies, who have used corporate accruals as a medium to engage in this mechanism. Not only this, Bangladeshi companies are said to have reported earnings earlier, unstated expenses, overstated inventories, used inappropriate accounting terms and avoided full-disclosure of events (Hasan, Hossain, and Rahman, 2014). Another study revealed that the manipulated areas are specific to receivables and cash flows (Sakib, 2019). Corporate governance is also said to be closely related to earnings manipulation. This is proven by another paper that found corporate governance variable of CEO duality and audit committee having noteworthy relationship with earnings management (Mukit and Keyamoni, 2019).

While previous literature identifies the possible areas of manipulation, they lacked to identify exactly through which element companies manipulate their reported earnings. This study worked on a sample of 42 listed companies belonging to different manufacturing industries. Data was extracted for a 5-year timeline from 2016 to 2020, from their respective annual reports. These 42 companies were selected based on their high performance in their own industries. Also, they have full disclosures regarding their financial statements compared to other listed companies.

The analysis utilizes Beneish M-score model that makes use of 8 indicators to identify whether the companies have a tendency to manipulate earnings. The 8 indicators of the Beneish Model that suggest earnings management practices are:

 

Days’ Sales in Receivables Index

DSRI

Gross Margin Index

GMI

Asset Quality Index

AQI

Sales Growth Index

SGI

Depreciation Index

DEPI

Sales, General and Administrative Expenses Index

SGAI

Total Accruals to Total Assets

TATA

Leverage Index

LVGI

 

Despite being high performers in Dhaka stock market, out of 42 companies, 32 of them showed to have possibly manipulated their earnings through the use of different components in the financial statements in at least one of the five years. The number of companies that manipulated earnings in at least one year of the five-year timeline through certain components are demonstrated with the graph below:

The graph clearly reveals the maximum components that were exploited were through Gross Margin, Asset Quality, Total Accruals to Total Assets and Leverage Index. Most of the companies misused their leverage, cost of goods sold, operating income, operating cash flows, current assets, PPE and securities data to curve their earnings and make it favorable. Most companies were unlikely to manipulate sales revenue, operating expenses and depreciation reporting directly. Besides these, half of the companies were found to have the tendency to manipulate receivables data which reflected through DSRI.

While data extraction, it was noticeable that some companies changed their reported non-current liabilities abruptly from one year to the next. This may be one technique they used to manipulate their earnings and thus reflected in the Leverage Index. Another trick is to delay revenue recognition, with a tendency to reduce tax obligations. This practice helps reduce revenue for current year and holds off cost of goods sold simultaneously. Thus, impacting Days Sales in Receivables and Gross Margin Index in a favorable manner. There was also inconsistency in reporting operating income and operating net cash flows from year to year that may have led to higher index values for Total Accruals to Total Assets Index.

While doing this analysis, annual reports of 2020 of three very high performing companies were still not published yet. Around halfway into the next fiscal year, the previous year’s annual reports are yet to be published due to Covid-19 pandemic’s effect on them. This slightly distorted data consistency. Moreover, during analysis, disclosure of depreciation amount in consecutive years were found to be inconsistent. One year a certain company have listed the depreciation in the manufacturing overheads section and the next year, they listed in the administrative expenses section. This conflicts with consistency rule of accounting.

An article in Forbes magazine reveals the motives of higher management behind this practice. Executives in higher authority said they engage into it because their own bonuses depend on it. They are not questioned or accountable for their reported earnings. And most interestingly, this exercise allures them because everyone else is also doing it! (Trainer, 2015).

From regulatory perspective, Ajit, Malik and Verma suggests that it is crucial to enhance better surveillance and monitoring system so that the integrity of the capital market is not compromised. Symmetric information should be top priority for companies, and to make sure it is, auditors play significant roles (Ajit, Malik, Verma, 2013). The author of this study urges top management to be more accountable for their reported earnings and develop a sense of honesty to make the capital market optimally profitable and transparent.

 

Disclaimer: This research report is for educational purposes incorporating researcher’s own opinion. BBS Research Center does not bear liability, however arising, for error, inaccuracy, incompleteness of fact, or any losses or damages which may arise from use of this research report.

For inquiries, please contact BBS Capital Market Research and Professional Development Centers, Capital Market Research Center (email: kaniz.sakina@bracu.ac.bd)

References

Ajit, D., Malik, S., & Verma, V. K. (2013). Earnings Management in India. Retrieved from http://www.corporatelawreporter.com/wp-content/uploads/2013/10/Earnings-Management-in-India.pdf

Hasan, D. S., Rahman, D. R., & Hossain, D. S. (2014). Corporate accruals practices of listed companies in Bangladesh. European Journal of Economics and Management, 1(1), 17-46. Retrieved from https://www.researchgate.net/publication/267334026

Mishra, M., & Malhotra, A. K. (2016). Earnings Management Practices in Indian Companies: A Cross-Sectional Analysis. Journal of Modern Accounting and Auditing, 12(6), 295-305. doi:10.17265/1548-6583/2016.06.001

Muktadir-Al-Mukit, D., & Keyamoni, T. J. (2019). Corporate Governance and Earnings Management practices among Listed firms: a Study on post Stock market crisis period in Bangladesh. Journal of Asian Business Strategy, 9(1), 1-9. doi:10.18488/journal.1006.2019.91.1.9

Parvin, R. (2020). Earnings Management Practice in Bangladesh. International Journal of Business and Management Future, 4(1). Retrieved from www.cribfb.com/journal/index.php/ijbmf

Sakib, I. A. (2019, August). Detection of Earnings Manipulation Practices in Bangladesh. International Journal of Management, Accounting and Economics, 6(8), 616-631.

Trainer, D. (2015). Four Reasons Executives Manipulate Earnings. Forbes. Retrieved from https://www.forbes.com/sites/greatspeculations/2015/12/07/four-reasons-executives-manipulate-earnings/?sh=7416d54df9ee