Int. J. Accounting, Auditing and Performance Evaluation, Vol. 18, Nos.

3/4, 2022 227

Earnings management and environmental

performance in political cost perspective:
an Indonesian case *

Alex Johanes Simamora

Accounting Program,
Universitas Tidar,
Jalan Kapten Suparman 39, Potrobangsan,
Magelang, Central Java, 56116, Indonesia
Email: alexjohanessimamora@untidar.ac.id

Abstract: This study aims to examine the moderating role of industry

sensitivity, profitability, and size of companies on the effect of environmental
performance on earnings management. The samples are manufacturing
companies listed on the Indonesian Stock Exchange and PROPER assessment
2015–2019. Based on the year-fixed effect regression, companies with lower
environmental performance are more likely to manage earnings downward if
companies are included in an environmentally sensitive industry and have
higher profitability. This indicates that to avoid the political cost of lower
environmental performance, companies in the environmentally sensitive
industry and having higher profitability tend to manage earnings downward to
reduce societal, regulators, and environmental activist attention and pressure.
Surprisingly, companies with lower environmental performance are more likely
to manage earnings downward for smaller companies than the bigger ones.
This indicates that smaller companies with lower environmental performance
have less market pressure to fulfil earnings targets and tend to manage earnings
downward.

Keywords: earnings management; environmental performance; company’s

size; industry sensitivity; political cost; profitability.

Reference to this paper should be made as follows: Simamora, A.J. (2022)

‘Earnings management and environmental performance in political cost
perspective: an Indonesian case’, Int. J. Accounting, Auditing and Performance
Evaluation, Vol. 18, Nos. 3/4, pp.227–252.

Biographical notes: Alex Johanes Simamora is graduated from Master of

Accounting Program Universitas Gadjah Mada, Yogyakarta, Indonesia.
Currently, he works as Lecturer in Universitas Tidar. His subjects of lecturing
are theory of portfolio and investment analysis, research method, financial
analysis, and financial accounting. His research interests are in financial
accounting, financial reporting, and corporate governance.

* This research is funded by Universitas Tidar

Copyright © 2022 Inderscience Enterprises Ltd.

228 A.J. Simamora

1 Introduction

Environmental performance refers to the quality of companies’ environmental

responsibility (Schultze and Trommer, 2012). Environmental responsibility is one of the
areas of corporate social responsibility undertaken by companies to maintain and recover
the environment to pay back their negative impact on the environment (Li et al., 2017;
Wong et al., 2018). Environmental responsibility has become an important issue and has
received global attention. In the context of business, environmental impacts are the most
pressing questions of time for companies (Homroy and Slechten, 2017). Thus, companies
must ensure that their business activities are clean of environmental problems. As result,
in Indonesia, ‘green companies’ assessed by the Environmental and Forestry Ministry are
increased about 54% from 2016 to 2017 that can push cost efficiency up to IDR 53
trillion (Secretariat of PROPER, 2018).
However, there are still environmental problems in Indonesia. Environmental damage
cases of the PT. Freeport Indonesia and PT. Lapindo Brantas shows that environmental
responsibility in Indonesia is still not fully implemented (Agustina et al., 2015). The case
of PT Freeport Indonesia relates to business operation waste that has been dumped into
forests, rivers, and estuaries in Papua. The waste causes US$ 12.95 billion as state losses
(News Desk, 2018). PT Freeport Indonesia also utilises 4,536 protected forests, which is
found to be a direct violation of Law nos. 19/2004 on Forestry (News Desk, 2018). The
case of PT Lapindo Brantas relates to a missing drill that causes the eruption of hot and
noxious mud to the environment in East Java (Fitrianto, 2012). The report of the Law
Enforcement General Directorate of Environment and Forestry Ministry of Indonesia also
records 462 companies engaged in environmental cases, such as 1544 cases of
environmental approval, 61 companies’ cases of waste management, and 65 criminal
cases with nine cases have proceeded to the law court (Head of Public Relation of
Environment and Forestry Ministry of Indonesia, 2018).
Public awareness of environmental ethics gives pressure on companies to be more
transparent (Sarumpaet, 2012) because some investors also experience losses as an
impact of environmental scandals (Litt et al., 2014). In the context of ethics, companies
take environmental responsibility as an ethical obligation (Phillips et al., 2003). As
guiding moral principles, environmental responsibility leads companies to give
simultaneous attention to all stakeholders’ interests (Kim et al., 2012). This indicates that
companies with high environmental performance reduce unethical behaviours, otherwise,
low environmental performance increases unethical behaviours.
Regarding financial reporting, one of the unethical behaviours is earnings
management. Companies with low environmental performance are more likely to engage
in earnings management. Previous research has proven that environmental performance
affects earnings management. In the context of corporate social responsibility activities,
Kim et al. (2012) find that corporate social responsibility negatively affects earnings
management. Litt et al. (2014) also find that environmental initiatives increase financial
performance without engaging in earnings management.
Since previous research has found that low environmental performance increases
earnings management, it is important to examine the extent to which earnings
management is done. Litt et al. (2014) find that companies with low environmental
performance engage in upward earnings management. On the other hand, Sarumpaet
(2012) finds that worse environmental performance has a positive effect on downward
earnings management. Kim et al. (2012) find that companies with low environmental
 Earnings management and environmental performance 229

performance tend to engage in both upward and downward earnings management. There
is a conflict between previous findings to capture the direction of earnings management
by companies with low environmental performance.
Kim et al. (2012) and Litt et al. (2014) argue that companies with worse
environmental responsibilities increase earnings by earnings management without
explaining the motivation that relates to environmental issues. Sarumpaet (2012) provides
the finding of downward earnings management behaviour by companies with worse
environmental responsibilities from a political cost perspective, but Sarumpaet (2012)
does not consider the political cost factor that makes companies become political targets.
The inconsistency of previous results comes from the lack of earnings management
motivation related to environmental responsibility, such as political costs. The political
cost perspective explains that companies tend to engage in earnings management,
especially to decrease earnings numbers, to avoid political costs (Watts and Zimmerman,
1990) because such companies have characteristics that become political targets (Sutton,
1988; Wong, 1988). In the context of environmental responsibility, companies with
worse environmental performance become political targets that tend to get pressure from
regulators, communities, or society, to spend more cost on recovering environmental
damage. To avoid regulators, communities, or society’s attention, low environmental
performance companies decrease their earnings by downward earnings management
rather than engage in upward ones (Sarumpaet, 2012).
In the context of political cost, previous research provides findings of the relationship
between environmental performance and earnings management (Cahan et al., 1997;
Sarumpaet, 2012). Cahan et al. (1997) find that companies in a sensitive industry, such as
the chemical industry, tend to manage earnings to respond to political costs from
environmental legislation. Sarumpaet (2012) finds that companies with worse
environmental performance tend to engage in downward earnings management.
Companies’ characteristics that determine whether companies become political
targets can be seen in terms of industry sensitivity, profitability, or size of companies.
Industry sensitivity refers to the impacts and consequences of a company’s business risks
on the environment (Adams et al., 2005), so each industry has different impacts and
consequences on the environment (Solikhah, 2016). The industry that has more potential
for environmental destruction receives more attention from society, environment
activists, and regulators than less potential ones (Solikhah, 2016). Companies with low
environmental performance tend to engage in downward earnings management,
especially when companies are in a sensitive industry.
High-profitability companies are also political targets, especially when these
companies enjoy high profits and low environmental performance. This indicates that
companies achieve high profitability without recovering from the environmental
destruction caused by business activities. High-profitability companies with low
environmental performance tend to engage in downward earnings management in
response to public pressure.
Size is another characteristic that determines companies as political targets. Watts and
Zimmerman (1990) state that political costs and government attention are higher for
bigger companies and more engaged in downward earnings management. When big
companies experience low environmental performance, society and regulators can notice
more than small companies. To avoid more political costs, big companies with low
environmental performance engage in downward earnings management.
230 A.J. Simamora

This study examines whether industry sensitivity, profitability, and size of companies
moderate the effect of environmental performance on earnings management. The novelty
of this research is to answer the inconsistency of previous findings of upward (Kim et al.,
2012; Litt et al., 2014) and downward (Sarumpaet, 2012) earnings management by low
environmental performance companies, by providing factors that determine companies to
become political targets. This research provides new evidence that companies in the
sensitive industry with higher profitability become political targets, which motivates
companies to engage in downward earnings management when they achieve worse
environmental performance.

2 Literature review

2.1 Earnings management

Earnings management has been widely examined. In Indonesia, significant research on
earnings management contributes 18% of all accounting and finance research in the
National Symposium of Accounting as well as 45.7% of all published research in the big
five Indonesian accounting journals between 2000–2009 (Suhardianto and Harymawan,
2011). Earnings management is the accounting decision choices taken by managers to
manage earnings numbers for bonuses, debt contracts, or political cost motivation (Scott,
2014). Earnings can be managed upward (income-increasing) or downward (income-
decreasing), depending on manager motivation. When managers face bonuses and debt
contract motivation, they tend to manage earnings upward, on the other hand, if managers
face political costs, they tend to manage earnings downward.

2.2 Political cost

In positive accounting theory, Watts and Zimmerman (1990) explain that managers’
behaviour, include in earnings management, is affected by bonuses, debt contracts, or
political cost motivation. This study focuses on the perspective of political costs. Since
environmental issues are monitored by regulators, society, and environmental activists,
companies will be political targets related to business consequences on the environment.
The political cost perspective explains that companies tend to engage in earnings
management, especially to decrease earnings numbers, to avoid political costs (Watts and
Zimmerman, 1990). Watts and Zimmerman (1978) state that potential unethical business
government-sanctioned affect companies’ accounting decisions. Since it will be costly for
companies and politicians to equate high income with monopoly profits, Watts and
Zimmerman (1978) expect that companies with high political reduce reported earnings,
known as the political cost hypothesis. Some previous research proves that companies
manage discretionary accruals negatively in periods of high political attention (Cahan,
1992; Han and Wang, 1998; Jones, 1991), as a response to potential political costs,
including anti-trust, monopoly, capital requirements, and import relief issues.
Political costs also imply an agency relationship between managers and shareholders.
In the context of agency theory, conflicts of interest between managers and shareholders
lead to managers’ opportunistic behaviour (Jensen and Meckling, 1976). Political cost
motivation leads managers to engage in downward earnings management to fulfil
managers’ interests but ignore shareholders’ interests. For example, in the regulated
 Earnings management and environmental performance 231

industry, companies’ managers try to avoid regulator attention by managing earnings

downward so that they can pay lower regulation costs (Chen et al., 2011; Grace and
Leverty, 2010; Key, 1997). Cost reduction leads a manager to be an efficient manager
(Akeem, 2017). Companies’ managers also engage in downward earnings management to
reduce tax payments (Marques et al., 2011). This leads to higher after-taxed earnings.
Higher after-taxed earnings are considered better managers’ performance (Khuong et al.,
2020) and lead to higher managers’ compensation (Phillips, 2003). On the other hand,
downward earnings management can harm shareholders’ interests in wealth
maximisation, such as reducing the dividend payment threshold in the following year
(Smith and Pennathur, 2019) or decreasing the current stock price (McAnally et al.,
2008).
In the context of responsibility issues, a political cost perspective explains the
responsible use of companies’ business power in the political arena, such as building
relationships and the responsibility to society (Kim et al., 2012). The political perspective
suggests that companies need to involve a society in which companies do business and
formalise their willingness to improve society, including the environment (Kim et al.,
2012). In this study, industry sensitivity, profitability, and size are used as pictures of
business power that make companies in positions where they have to improve their
environmental conditions. If companies that have such business power, on the contrary,
harm the environment, companies must be ready to pay the potential political cost of
environmental destruction.

2.3 Theories of environmental responsibility

Some theories explain why companies do environmental responsibility, such as
legitimacy theory, stakeholder theory, and ethical theory. Legitimacy theory is based on
the idea of a ‘social contract’ (Patten, 2002) that explains sustainability and growth of
business companies depends on the fulfilment of some social goals to society and
distribution of economic, social, and political benefits to society (Cho and Patten, 2007).
This shows that companies’ environmental responsibility is a form of legitimacy from
society to achieve business sustainability and growth. Stakeholder theory explains that
companies have social and environmental responsibility that makes companies consider
all stakeholders’ interests (Branco and Rodrigues, 2007), not only the interests of
shareholders (Madhani, 2017). The ethical theory explains that environmental
responsibility is the behaviour of companies to make a profit by obeying the law and
ethics, including the support of worthy social factors (Carroll, 1979). These theories
indicate that companies with worse environmental responsibility have no alignment
values between companies and society, ignore social and environmental interests, and
make a profit without obeying the law and ethics. In such a condition, companies tend to
engage in unethical behaviour, such as earnings management.

2.4 Environmental responsibility in Indonesia

Environmental responsibility is regulated generally in Act no. 40 2007 about the Limited
Company (President of Republic of Indonesia, 2007) and specifically in Government
Regulation no. 47 2012 about Social and Environmental Responsibility of Limited
Company (President of Republic of Indonesia, 2012). It says that companies, that have
232 A.J. Simamora

business risks related to natural resources or contribute to giving waste to the

environment, have to do social and environmental responsibility.
In Indonesia, the first nationwide corporate environmental performance assessment
was the PROPER (Performance Rating Assessment of Environmental Program) program
by BAPEDAL (Agency of Environmental Impacts Management) which was initiated in
1995. Two important components of environmental performance assessment by PROPER
are regulatory compliance and compliance beyond regulation (Minister of Environment
and Forestry, 2013). Assessment of compliance consists of documents or permission for
environmental, water contamination, air contamination, and dangerous and toxic waste
management, while assessment of beyond compliance consists of the environmental
management system, resource management, society empowerment, and environmental
performance reporting (Minister of Environment and Forestry, 2013). Finally, PROPER
issues rating by five colours:
1 Black (company contributes to environmental destruction)
2 Red (the company does not fully comply with regulation)
3 Blue (the company does fully comply with regulation)
4 Green (the company does beyond compliance of regulation)
5 Gold (the company does beyond compliance of regulation consistently by achieving
a Green rating three times in a row) (Minister of Environment and Forestry, 2013).

2.5 Environmental performance and earnings management

Carroll (1979) states that environmentally responsible companies take the business in
legal and ethical ways. Kim et al. (2012) suggest that companies have an incentive, to be
honest, trustworthy, and ethical in their business processes. In such behaviour, companies
with high environmental responsibility tend to constrain unethical behaviour, including in
the earnings information reporting area.
On one hand, earnings management is used for an efficiency purpose as a signalling
tool. Subramanyam (1996) and Lipe (1990) suggest that earnings management for
efficiency purposes is as a managerial accrual discretion to improves the ability of
earnings to reflect the economic value and predict future performance. Some previous
findings show the existence of earnings management for efficiency purposes to reflect the
economic value and predict future performance (Al-Attar et al., 2008; Liu, 2016; Rezaei
and Roshani, 2012; Simamora, 2019; Siregar and Utama, 2009; Tangjitprom, 2013).
On the other hand, earnings management is considered widely as an opportunistic
behaviour by managers to gain benefits (Healy and Wahlen, 1999; Schipper, 1989), such
as bonuses, debt covenants, and political costs (Scott, 2014).
In the context of environmental responsibility, earnings management is more likely to
engage in opportunistic behaviour. There are some arguments as to why the relationship
between environmental responsibility and earnings management is opportunistic. First,
some studies put environmental responsibility as ethical behaviour (for example, Branco
and Rodrigues, 2007; Carroll, 1979; Cho and Patten, 2007; Madhani, 2017; Patten, 2002).
This means that there is a big possibility that earnings management is done under the
condition of low environmental responsibility based on unethical behaviour. Second,
Scott (2014) argues that political cost motivates managers to gain benefits, such as cost
 Earnings management and environmental performance 233

efficiency and higher after-taxed performance and compensation (Khuong et al., 2020;
Marques et al., 2011; Phillips, 2003). Since gaining personal benefits is a factor in
determining opportunistic behaviour (Healy and Wahlen, 1999; Schipper, 1989),
the relationship between earnings management and environmental responsibility in the
context of political cost is considered to be opportunistic behaviour. Third, opportunistic
earnings management is usually done to cover up bad situations or performance
(Simamora, 2018, 2019), for example, in the case of Enron, which does the earnings
mark up to hide financial problems and losses (Shirur, 2011). In the context of
environmental responsibility, earnings management aims to cover up the worse
environmental performance. This study considers earnings management as an
opportunistic behaviour. However, since auditor quality can determine earnings
management for efficiency or opportunistic purposes (Simamora, 2019), this research still
controls the efficiency or opportunistic purposes by using Big Four auditors as a control
variable.
Environmental responsibility has been examined in the earnings information. Lassaad
(2013) examines the effect of environmental reporting on income smoothing as a proxy
for earnings quality. The results show that companies with a high level of environmental
responsibility are less likely to have smooth earnings. In the context of corporate social
responsibility, Kim et al. (2012) find that environmental responsibility increases earnings
quality by reducing accrual and real earnings management. Litt (2014) tests
environmental initiatives on earnings management and finds that environmental
initiatives exhibit lower earnings management. In Indonesia, Sarumpaet (2012) finds that
worse environmental performance tends to engage in earnings management.
Based on previous research, companies with low environmental performance tend to
manage earnings. The problem is the extent to which earnings management is extended
by companies with low environmental performance. It can be either upward or
downward.
Upward earnings management is performed because companies with low
environmental performance have competitive advantage losses. High environmental
performance provides a competitive advantage, such as cost reduction, efficiency, brand,
and reputation image (Kumar et al., 2012), and gain new customers (Liu et al., 2018) to
increase profitability. In Indonesia, Secretariat-of-PROPER (2018) reports that ‘green
companies’ can cut costs out to IDR 53 trillion from waste management and efficiency.
de Burgos-Jimenez et al. (2013) also find that environmental responsibility increases
financial performance. Low environmental performance companies cannot enjoy these
competitive advantages and have lost opportunities to increase their earnings. Low
environmental performance companies tend to engage in upward earnings management to
compensate for lost opportunities to increase reported earnings.
Downward earnings management is done because companies with low environmental
performance tend to avoid the political cost of environmental issues. Political costs may
include penalties and stricter regulations (Sarumpaet, 2012), environmental destruction
recovery, and other activities related to significant environmental destruction
consequences. By decreasing earnings, regulators or environmental activists have less
attention to low environmental performance companies that engage in downward
earnings management. Cahan et al. (1997) and Sarumpaet (2012)find that companies
engage in downward earnings management in response to political costs.
Since environmental performance provides competitive advantages to increase
profitability (de Burgos-Jimenez et al., 2013; Kumar et al., 2012; Liu et al., 2018),
234 A.J. Simamora

companies with low environmental performance have no competitive advantages; further,

they will increase profitability by upward earnings management. On the other hand, low
environmental performance indicates that companies harm the environment in their
business process, and they engage in downward earnings management to get less
attention from the public, especially environmental stakeholders. Conflicting results of
upward and downward earnings management by low-environmental performance
companies can be solved by considering factors that determine whether companies are
political targets in environmental issues. Companies that are in an environmentally
sensitive industry, have higher profits and have bigger sizes tend to be political targets in
environmental issues. Such companies are required to have higher environmental
performance because they receive more attention from regulators, society, and
environmental activists.

2.6 Hypotheses
The environmentally sensitive industry refers to companies in an industry where
contributes a significant business risk impact on the environment (Adams et al., 2005).
Each industry has a different level of business risk impact on the environment. Industry
activities that have a significant impact on environmental destruction are categorised as
environmentally sensitive industries and receive more attention from the public
(Solikhah, 2016). In Indonesia, the mining industry is a sensitive industry that has a direct
impact on a natural resource (Widyadmono, 2014) as well as manufacture companies in
the chemical sector that contributes industry waste to the environment (Sarumpaet, 2012),
while non-sensitive industry such as construction and property, banking, medical
suppliers, a textile company, and household manufacturer (Widyadmono, 2014).
Companies in a sensitive industry get more pressure from society and environmental
activists to improve environmental performance (Sari, 2012). If sensitive industry
companies have lower environmental performance, companies will pay more political
costs to the environment. In the context of legitimacy theory, the political cost comes
from the lower environmental responsibility where the companies fail to fulfil the social
goals based on the ‘social contract’. In the context of stakeholder theory, lower
environmental performance shows that companies do not consider the interests of society
and environmental activists as companies’ stakeholders. To avoid such political costs,
sensitive industry companies with lower environmental performance are more likely to
engage in downward earnings management than upward ones. Downward earnings
management makes sensitive industry companies receive less attention from social and
environmental activists. Cahan et al. (1997) find that chemical companies use downward
earnings management to avoid political costs.
H1: The positive effect of environmental performance on earnings management is
moderated by environmentally sensitive industries.
High profitability makes public notice about the existence of companies. Sutton (1988)
suggests that UK companies with high profitability are particularly vulnerable to
government-imposed price control regulations. Han and Wang (1998) find that instead of
being good news, rapid earnings growth in the oil industry will make companies face
more political costs in the crisis period. This indicates that, in a specific situation, higher
profitability companies will attract more attention to monitoring by some parties than
enjoy the benefits of becoming profitable companies.
 Earnings management and environmental performance 235

According to environmental issues, higher profitability will receive more attention

from regulators, society, and environmental activists. Higher profitability is followed by
higher environmental performance. If higher profitability is followed by lower
environmental performance, then it is assumed that companies achieve high earnings
without considering their business risk impact on environmental destruction. As in ethical
theory, unethical companies refer to profitable companies that have lower environmental
responsibility. Companies make a profit while ignoring business ethics, including
ignoring the environmental damage that comes from companies’ activities (Carroll,
1979). In such a situation, companies are more likely to engage in downward earnings
management than upward ones, to generate less attention from regulators, society, and
environmental activists.
H2: The positive effect of environmental performance on earnings management is
moderated by profitability.
Bigger companies will be noticed more by the public and have more potential political
costs than smaller companies. An early test of the political cost perspective conducted by
Watts and Zimmerman (1978) uses companies’ size as a proxy for expected political
costs. Watts and Zimmerman (1978) expect that companies with high political costs
reduce reported earnings, well known as the political cost hypothesis. Some previous
research confirms the relationship between size and political cost (for example, Belz
et al., 2019; Dyreng et al., 2016; Graham et al., 2014).
According to environmental issues, bigger companies will receive more attention
from regulators, society, and environmental activists. In the context of legitimacy theory,
bigger companies are more likely to be forced to engage in environmental responsibility
to legitimise their business (Stubbs et al., 2013) because bigger companies’ operational
activities involve the lives of many people (Scott, 2014). If bigger companies have lower
environmental performance, they can directly notice that bigger companies do not
consider their business risk impact on environmental destruction. In such a situation,
bigger companies are more likely to engage in downward earnings management.
H3: The positive effect of environmental performance on earnings management is
moderated by company size.

3 Research method

3.1 Sample
The research samples are manufacturing companies listed on the Indonesian Stock
Exchange and PROPER (environmental assessment program in Indonesia) period of
2015–2019.This research has a limitation of data availability where the oldest data can
only be accessed at www.idx.co.id from 2015. This research chooses manufacturing
companies as a sample because manufacturing companies experience high earnings
volatility (Ahmed and Azim, 2015) and tend to engage in earnings management
(Rasmussen, 2013); at the same time, manufacturing companies contribute significant
waste and pollution. The research sample is presented in Table 1.
236 A.J. Simamora

Table 1 Research sample

Panel A: Sample selection

Year
Criteria 2015 2016 2017 2018 2019 Company-year
Manufacture companies listed in IDX 138 143 142 143 152 718
Does not participate in PROPER (77) (86) (80) (80) (92) (415)
Incomplete data – – – (2) (1) (3)
Change the financial reporting period (2) (1) (2) – – (5)
Total 59 56 60 61 59 295

Panel B: Sample based on industry

Industry Company-year Percentage (%)
Cement 20 7
Ceramics 14 5
Metal 26 9
Chemical 16 5
Animal feed 15 5
Woods 5 2
Pulp and paper 22 7
Automotive 20 7
Textile 34 12
Wire 19 6
Electronics 4 1
Food and beverage 41 14
Tobacco 13 4
Pharmaceutical 20 7
Cosmetics 18 6
Household 8 3
Total 295 100

3.2 Research variables and operational definitions

The dependent variable is earnings management. Earnings management is measured
using discretionary accruals. The consideration of uses discretionary accruals as earnings
management measures because (1) discretionary accruals are widely used and have been
validated as an earnings management proxy (Litt et al., 2014); (2) it is a more suitable
measurement related to environmental issues because many environmental
responsibilities require significant resources that result in material capital expenditures,
such as property, plant, and equipment (PPE), which are included in discretionary
accruals estimation (Litt et al., 2014); and (3) abnormal activities (referring to real
earnings management) are more costly than discretionary accruals (referring to accrual
 Earnings management and environmental performance 237

earnings management) to engage in downward earnings management because real

earnings management has direct consequences on cash flow, so real earnings
management is less used by companies (Francis et al., 2016). Discretionary accruals
estimated by Jones modified as follows (Dechow et al., 1995).
TACt 1 ΔSalest PPEt
= β 0 + β1 + β2 + β2 +e (1)
TAt −1 TAt −1 TAt −1 TAt −1

m + βl 1 + β
NDACt = β m ΔSalest − ΔReceivablet + β
m PPEt (2)
0 1 2 2
TAt −1 TAt −1 TAt −1

TACt
DACt = − NDACt (3)
TAt −1

where,
TACt = Earnings after taxt − Operation cash flowt (4)

TACt is total accruals period t, TAt–1 is total assets period t – 1, ∆Salest is sales change
period t, ∆Receivablet is receivable change period t, PPEt is property plant equipment
period t, NDACt is non-discretionary accruals period t, DACt is discretionary accruals
period t. The higher and the positive discretionary accruals the higher the earnings
management to increase earnings, while the lower and negative discretionary accruals,
the higher the earnings management to decrease earnings. Discretionary accruals close to
zero indicate that companies have lower earnings management.
The independent variable is environmental performance. The environmental
performance uses an interval scale measured by PROPERrating. Companies that get
‘Black Rank’ scored 1, ‘Red Rank’ scored 2, ‘Blue Rank’ scored 3, ‘Green Rank’
scored 4, and ‘Gold Rank’ scored 5. The lower the rating, the lower is the environmental
performance.
The moderating variables are industry sensitivity, profitability, and size. This research
categorises industries that are sensitive to environmental issues based on Regulation of
Environmental Minister no. 5 2012 about business and activities obligate to have
environmental impact analysis, which is the industry of cement, chemicals, wood, and
pulp and paper (Indonesian Minister of Environment, 2012). Industry sensitivity is
measured by a dummy variable, 1 if companies are included in a sensitive industry, and 0
otherwise. Based on Das et al.’s (2009) finding that end-year earnings management is
driven by the first three quarters’ profitability pattern, this study measures profitability by
the average of return on assets (ROA) in the first three quarters. The ROA for each
quarter is calculated as earnings after tax divided by total assets. Size is measured as the
logarithm of the total assets.
The control variables are leverage, and Big Four auditors. Leverage captures debt
covenant motivation for earnings management, which shows that companies with higher
leverage tend to engage more in upward earnings management (Watts and Zimmerman,
1990). Leverage is measured by the debt-to-assets ratio (DAR), calculated as total
liabilities divided by total assets. The Big Four auditors have a higher quality to constrain
earnings management than non-Big four auditors (Krishnan, 2003). A Big Four auditor is
238 A.J. Simamora

measured by a dummy variable, score 1 if companies’ auditor is affiliated to big-four

auditor, and 0 otherwise.

3.3 Analysis model

This study uses a year fixed-effect regression as the hypothesis test. The year-fixed effect
is used to control the adjustment of an environmental assessment by PROPER to the
dynamic current year situation (Minister of Environment and Forestry, 2013). The
regression model is as follows.
DAC = a0 + a1 ENV + a2 ENVxINDUSTRY + a3 INDUSTRY
(5)
+ a4 DAR + a5 BIG _ 4 + a6 ∑ year

DAC = a0 + a1 ENV + a2 ENVxROA + a3 ROA + a4 DAR + a5 BIG _ 4 + a6 ∑ year (6)

DAC = a0 + a1 ENV + a2 ENVxSIZE + a3 SIZE + a4 DAR + a5 BIG _ 4 + a6 ∑ year (7)

DAC = a0 + a1 ENV + a2 ENVxINDUSTRY + a3 ENVxROA + a4 ENVxSIZE

+ a5 INDUSTRY + a6 ROA + a7 SIZE + a8 DAR (8)
+ a9 BIG _ 4 + a10 ∑ year

Equations (5)–(7) examine the moderating effects of industry sensitivity, return on assets,
and size separately. Equation (8) examines the moderating effect of industry sensitivity,
return on assets, and size all at once. ENV is environmental performance, INDUSTRY is
industry sensitivity, ROA is the return on assets, SIZE is companies’ size, DAR is debt to
assets ratio, BIG_4 is a big-four auditor. H1 is accepted if the coefficients of a2 in
equations (5) and (8) are positive and significant. H2 is accepted if the coefficients of a2
in equation (6) and a3 in equation (8) are positive and significant. H3 is accepted if the
coefficients of a2 in equation (7) and a4 in equation (8) are positive and significant.

4 Results and discussions

4.1 Descriptive statistics

Based on Table 2, panel A shows that the average value of discretionary accruals for the
total sample is 0.001, for companies in an environmentally sensitive industry is 0.005,
while for companies in a non-environmentally sensitive industry is –0.000. This indicates
that in Indonesia, average manufacturing companies tend to engage in upward earnings
management (the positive sign of discretionary accruals), while companies in the
environmentally sensitive industry tend to engage in upward earnings management (the
positive sign of discretionary accruals), and companies in the non-environmentally
sensitive industry tend to engage in downward earnings management (the negative sign
of discretionary accruals).
 Earnings management and environmental performance 239

Table 2 Descriptive statistics

240 A.J. Simamora

Table 2 Descriptive statistics (continued)

 Earnings management and environmental performance 241

The mean difference test shows that there is no significant difference in discretionary
accruals between environmentally sensitive and non-environmentally sensitive industries.
On the other hand, there is a significant difference in environmental performance
between environmentally sensitive and non-environmentally sensitive industries,
indicating that an environmentally sensitive industry has better environmental
responsibility.
Panel B in Table 2 shows that there is a positive correlation between environmental
performance, ROA, and size on discretionary accruals, while industry sensitivity has no
significant correlation with discretionary accruals. As expected, as moderating variables,
industry sensitivity, ROA, and size are correlated.

4.2 Validity test

This study also performed a feasibility test to estimate the non-bias regression model.
Because the year-fixed effect is used in the regression analysis, the autocorrelation
problem should not exist. Correlation between independent variables should also not
exist, which is ensured by a multicollinearity test.

Table 3 Validity test

Test Result Notes

Breusch-Godfrey serial Sig. value = 0.1848 Free of autocorrelation
correlation LM test problem
Variance inflation factors • VIF of DAR and BIG_4 are • Free of a
(VIF) below 10 multicollinearity problem
• VIF of ENV, INDUSTRY, • Free of multicollinearity
ROA, SIZE and its interactions problem*
are above 10*
*VIF value above 10 indicates there is multicollinearity problem, however, Hartono
(2014) states that correlation between independent variable and interaction variable of
independent and moderating variables happens in moderating regression analysis, but it
will not be a problem since the coefficient of the independent variable is not sensitive to
the coefficient of interaction variable.

Table 3 shows that the significant value of the Breusch-Godfrey Serial Correlation LM
Test is 0.1848 (insignificant), indicating that there is no autocorrelation problem.
The VIF test shows that the VIF value is below 10 for the control variables, while the
VIF of the independent and moderating variables is above 10. Even though conditions for
free of multicollinearity problems occur when VIF is below 10, this research is defined as
no multicollinearity problem according to Hartono (2014).

4.3 Hypothesis test and discussions

Table 4, for non-moderated analysis, shows that environmental performance has a
coefficient value of 0.045 with t-statistics of 4.101 (significant in 0.01). Environmental
performance has a positive effect on discretionary accruals. This indicates that Indonesian
manufacturing companies with lower environmental performance are more likely to
engage in downward earnings management than upward ones.
242 A.J. Simamora

Table 4 Hypothesis test

 Earnings management and environmental performance 243

For moderated analysis of industry sensitivity, the interaction variable between

environmental performance and sensitive industry has a coefficient value of 0.050 with
t-statistics of 2.173 (significant in 0.05). For the moderated analysis of profitability, the
interaction variable between environmental performance and ROA has a coefficient
value of 0.062 with t-statistics of 1.723 (significant in 0.10). For moderated analysis of
companies’ size, the interaction variable between environmental performance and size
has a coefficient value of –0.051 with t-statistics of –2.180 (significant in 0.10).
For moderated analysis with all moderating variables, the interaction variable
between environmental performance and sensitive industry has a coefficient value of
0.033 with t-statistics of 3.041 (significant in 0.01). H1 is accepted, which is the positive
effect of environmental performance on earnings management is moderated by
environmentally sensitive industry. The better environmental performance will be
followed by higher earnings management to maximise earnings, especially for companies
in an environmentally sensitive industry. On the opposite side, it can be seen as the worse
environmental performance will be followed by the higher earnings management to
minimise earnings, especially for companies in an environmentally sensitive industry.
This result is consistent with Cahan et al. (1997) who find that companies in a sensitive
industry take downward earnings management to avoid political costs. Companies in
sensitive industries receive more attention and pressure from society, regulators,
and activists, especially when companies have lower environmental performance.
In such conditions, companies will face the potential cost of the environment, such as the
costs of environmental destruction recovery or breaking the law. To avoid these costs,
companies tend to manage earnings downward, so the attention and pressure will be
decreased.
The interaction variable between environmental performance and ROA has a
coefficient value of 0.064 with t-statistics of 1.694 (significant in 0.10). H2 is accepted,
which is the positive effect of environmental performance on earnings management is
moderated by profitability. The better environmental performance will be followed by
higher earnings management to maximise earnings, especially for profitable companies.
On the opposite side, it can be seen as worse environmental performance will be followed
by higher earnings management to minimise earnings, especially for profitable
companies. This is consistent with Han and Wang (1998) and Sutton (1988) who find that
profitability is a picture of political cost, especially for companies with lower
environmental performance. Higher profitability with lower environmental performance
indicates that companies’ businesses only maximise economic performance and ignore
the consequences of environmental destruction caused by the business. In this condition,
public pressures will come, and companies will face the political cost of environmental as
well. To avoid such conditions, companies manage earnings downward.
The interaction variable between environmental performance and size has a
coefficient value of –0.021with t-statistics of –2.400 (significant in 0.05). H3 is rejected.
Surprisingly, the positive effect of environmental companies with lower environmental
performance manages earnings to minimise earnings more by smaller companies than the
bigger ones. The better environmental performance will be followed by higher earnings
management to maximise earnings, especially for smaller companies. On the opposite
side, it can be seen as the worse environmental performance will be followed by the
higher earnings management to minimise earnings, especially for smaller companies.
244 A.J. Simamora

This is not consistent with Watts and Zimmerman (1978) who state that bigger
companies describe expected political costs as a motivation to manage earnings
downward. The result is more consistent with Richardson (2000) who states that bigger
companies tend to engage in upward earnings management because they get market
pressure to fulfil earnings targets. It indicates that the cost of earnings target missing is
overweight on the political cost of environmental problems, so bigger companies keep on
manage earnings upward even also they have lower environmental performance. On the
other hand, smaller companies with lower environmental performance have less market
pressure to fulfil earnings targets and tend to manage earnings downward to avoid the
political cost of the environment.

4.4 Robustness test

By nature, political costs motivate more downward earnings management than upward
ones. There is a possibility that firms with higher political costs are less likely to engage
in upward earnings management, so political cost factors cannot fully explain the effect
of environmental performance on upward earnings management. This study uses an
alternative test to examine whether the effect of political cost factors of industry
sensitivity, profitability, and size occur more on downward earnings management than on
upward earnings management. The alternative test aims to examine whether the main
result of this research is sensitive when it is analysed into different groups of downward
and upward earnings management. To obtain a robust result, this study also examines
a group of downward and upward earnings management individually. A group of
downward earnings management is a group of companies that have negative
discretionary accruals, while a group of upward earnings management is a group of
companies that have positive discretionary accruals.
Based on Table 5, a group of downward earnings management consists of 159
companies-years, while a group of upward earnings management consists of 136
companies-years. In a group of downward earnings management, the interaction variable
between environmental performance and sensitive industry has a coefficient value of
0.045 with t-statistics of 2.692 (significant in 0.01). In a group of upward earnings
management, the interaction variable between environmental performance and sensitive
industry has a coefficient value of 0.016 with t-statistics of 1.276 (insignificant).
According to the main analysis of H1, the result for a group of downward earnings
management is consistent with the main analysis, while the result for a group of upward
earnings management is not consistent with the main analysis. This indicates that
the political cost of the environmentally sensitive industry for companies with lower
environmental performance can explain more about increasing downward earnings
management than reducing upward earnings management. Industry categorisation is
sensitive to upward and downward earnings management behaviours.
In a group of downward earnings management, the interaction variable between
environmental performance and ROA has a coefficient value of 0.076 with t-statistics
0.604 (insignificant). In a group of upward earnings management, the interaction variable
between environmental performance and ROA has a coefficient value of 0.058 with
t-statistics of 1.186 (insignificant). According to the main analysis of H2, the results for
either group of downward earnings management or group of upward earnings
 Earnings management and environmental performance 245

management are not consistent with the main analysis. This indicates that the political
cost of higher profitability for companies with lower environmental performance can
explain only when these groups of earnings managements are in one group. Profitability
is sensitive to earnings management as one behaviour compared to when earnings
management behaviour is split up into the separated direction of earnings management.

Table 5 Robustness test

Downward earnings Upward earnings

management (N = 159) management (N = 136)
Variable Coefficient t-statistic Coefficient t-statistic
ENV 0.238 1.621 0.251 1.831*
ENVxINDUSTRY 0.045 2.692*** 0.016 1.276
ENVxROA 0.076 0.604 0.058 1.186
ENVxSIZE –0.020 –1.675* –0.020 –1.839*
INDUSTRY –0.109 –2.202** –0.014 –0.336
ROA 0.461 1.288 0.744 4.349*
SIZE 0.061 1.711* 0.040 1.206
DAR –0.001 –0.082 0.044 3.811***
BIG_4 –0.003 –0.371 0.003 0.365
Dependent variable Negative DAC Positive DAC
Adjusted R-squared 0.582 0.873
F-statistic 17.889*** 72.152*
Year-effect Yes Yes
*Significant in 0.10.
**Significant in 0.05.
***Significant in 0.01.

In a group of downward earnings management, the interaction variable between

environmental performance and size has a coefficient value of –0.020 with t-statistics of
–1.675 (significant in 0.10). In a group of upward earnings management, the interaction
variable between environmental performance and size has a coefficient value of –0.020
with t-statistics of –1.839 (significant in 0.10). According to the main analysis of H3, the
results for either group of downward earnings management or group of upward earnings
management are consistent with the main analysis.
This study uses another discretionary accrual estimation method as an alternative
measurement method. Since this study uses profitability as a political target proxy,
discretionary accruals are adjusted by profitability. Profitability-adjusted discretionary
accrual is developed by Kothari et al. (2005), as shown in equation (9). Profitability-
adjusted discretionary accruals are estimated as the value of e in equation (9).
TACt 1 ΔSalest PPEt Earnings After Taxt
= β 0 + β1 + β2 + β2 + β3 +e (9)
TAt −1 TAt −1 TAt −1 TAt −1 TAt −1
246 A.J. Simamora

Table 6 Alternative test

 Earnings management and environmental performance 247

This research also runs an alternative test using capital market-based measurements.
Return on assets and total assets as profitability and companies’ size proxies are
influenced by accounting estimations and policy, so this study also examines whether the
main results are consistent if profitability and size are measured by capital market-based
proxies. Capital market-based measurement captures how stock market participants,
especially investors, see the profitability and size of companies. Market-based
profitability is measured by the market value of the equity to assets ratio (MVA), which
reflects the investor perception of companies’ performance and prospects (Salinger,
1984). The market value of the equity to assets ratio is calculated by dividing the stock
market price by the total assets per share at the end of the period. Market-based size is
measured by the natural logarithm of market capitalisation (MC), which reflects how big
companies are in the stock market (Friedman, 2019). Market capitalisation is calculated
by the stock price multiplied by total outstanding shares at the end of the period. The
alternative test results are shown in Table 6.
In Table 6, where alternative 1 provides earnings management estimation of
profitability-adjusted discretionary accruals, the interaction variable between
environmental performance and sensitive industry, interaction variable between
environmental performance and ROA, and interaction variable between environmental
performance and size respectively have coefficient values of 0.028, 0.081, and –0.021
with t-statistics of 2.528 (significant in 0.05), 2.047 (significant in 0.10), and –2.246
(significant in 0.05). The alternative results are consistent with those of the main analysis.
The main results are not sensitive to whether earnings management is measured by
profitability-adjusted discretionary accruals.
In Table 4, the interaction variable between environmental performance and market
value of equity to assets ratio (MVA) in alternatives 2 and 4 have coefficient values of
0.001 and 0.003, respectively, with t-statistics of 0.379 (insignificant) and 1.071
(insignificant). The alternative results are not consistent with those of the main analysis.
The main results are sensitive if profitability changes from accounting-based
measurement to market-based measurement. This might be due to the nature of
discretionary accruals that relate to accounting estimation and method utilisation so that
it can be determined more by accounting-based profitability than market-based
profitability.
In Table 4, the interaction variable between environmental performance and
logarithm natural of market capitalisation (MC) in alternatives 3 and 4 respectively have
coefficient values of –0.018 and –0.022 with t-statistics of –2.511 (significant in 0.05)
and –2.041 (significant in 0.05). The alternative results are consistent with those of the
main analysis. The main results are not sensitive if companies’ sizes are measured by
both accounting and market-based measurements.

5 Conclusion

This study examines the moderating roles of industry sensitivity, profitability, and size of
companies on the effect of environmental performance on earnings management from a
political cost perspective. The results show that companies with lower environmental
performance are more likely to manage earnings downward when they are included in an
environmentally sensitive industry and have higher profitability. This indicates that
to avoid the political cost of lower environmental performance, companies in the
248 A.J. Simamora

environmentally sensitive industry and have higher profitability tend to manage earnings
downward, so the attention and pressures by society, regulators, and environmental
activists will decrease.
Surprisingly, companies with lower environmental performance are more likely to
manage earnings downward for smaller companies than bigger ones. This indicates that
smaller companies with lower environmental performance have less market pressure to
fulfil earnings targets and tend to manage earnings downward to avoid the political cost
of the environment.
This study has some limitations. Since market pressure to fulfil earnings targets can
outweigh the political cost of the environment for bigger companies, this research lacks
consideration of using market pressure factors to explain companies’ size as expected
political cost. This research also only uses companies in the PROPER assessment, so the
results cannot be generalised to companies that do not participate in the PROPER
assessment. Future research should consider the factors of market pressure and use a
wider manufacturing sample outside PROPER participants.
This research implies that companies are expected to implement effective internal
control and monitoring, especially for financial reporting and environmental
responsibilities, to reduce the opportunistic behaviour of earnings management and
increase environmental performance. This research also implies that stock market
stakeholders, such as investors, market regulators, analysts, and social and environmental
stakeholders, such as environmental regulators and activists are expected to play a
monitoring role in companies to achieve better environmental responsibilities.

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