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Earnings Management, Firm Performance, and the Value of Indian

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International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 116 November, 2013
http://www.internationalresearchjournaloffinanceandeconomics.com

Earnings Management, Firm Performance, and the

Value of Indian Manufacturing Firms

Amarjit Gill
The University of SaskatchewanEdwards School of Business
25 Campus DriveSaskatoon, SK, S7N-5A7, Canada
E-mail: agill02@shaw.ca
Phone: 306-966-4785; Fax: 306-966-5408

Nahum Biger
School of Business Carmel Academic Center Haifa, Israel 33031
E-mail: nahum_b@carmel.ac.il

Harvinder S. Mand
University College Ghudda (Bathinda) District Bathinda
Pin Code: 151401 East Punjab, India
E-mail: hsmand27@gmail.com
Telephone: 98554-92501

Neil Mathur
College of Management & Technology Walden University
100 Washington Avenue South, Suite 900 Minneapolis, MN, USA 55401
E-mail: neil.mathur@waldenu.edu
Tel: 781.626.3240

Abstract

The purpose of this study was to test whether the practice of earnings management
that affects and perhaps benefits management of Indian companies has an effect on a firms’
performance, and whether earnings management has an effect on other stakeholders. This
study applied a co-relational research design. A sample of 250 firms was selected from Top
500 Companies listed on the Bombay Stock Exchange (BSE) for a period of 4 years (from
2009-2012). The findings of this study indicate that the more intense the practice of
earnings management, the greater it’s adverse effect on corporate rate of return on assets in
the following year. The study also found that to some extent, the market realizes that
management acts with selfish motives and responds by lowering share prices and corporate
market value. This study contributes to the literature on the association between several
features of earnings management and firm performance, and the value of the firm. It is
confined to Indian firms where companies perform intense earnings management. The
findings may be useful for financial managers, investors, financial management
consultants, and other stakeholders.

Keywords: Earnings management, Firm performance, Market value of the firm,

Shareholders’ wealth.
International Research Journal of Finance and Economics, Issue 116 (2013) 121

1. Introduction
Earnings management is the practice of managerial actions that are reflected in a company's financial
reports either to give the impression of smooth periodic or annual earnings, to show high profits in a
given year at the 'expense' of lowering reported earnings in the future or to show low profit in a given
year so that in future years reported profits will be higher. In some cases, management uses various
accounting methods in order to convey private information to financial report readers. Management of
earnings may mislead stakeholders about the true financial performance of the company. If
management gains anything from managing earnings, one must ask whether such gains are at the
expense of anybody.
The study explores the relationship between the practice of earnings management, firm
performance, and firm's value for a sample of publicly traded Indian companies. We chose to study the
relationships for Indian companies because Indian companies have been notorious for practicing
earnings management in order to achieve several objectives. Varma, for example, states that Indian
companies regularly manipulate earnings and lists several motivations for such manipulation in India
including but not limited to personal gain of management, performance based incentives, and pressure
to achieve specified earnings targets. The prevalence of earnings management in India can be
explained by some local factors: Flexibilities provided by Indian regulatory bodies; unclear lines that
can differentiate fraud and aggressive accounting (earning manipulation); weak market competition;
information asymmetry; investors’ lack of awareness about the accounting concepts; and the high
emphasis of both managers and accountants on reported earnings (Verma, 2012, p. 539-540).
In developing countries, rules of law are weak and there are claims that corruption is high.
According to Transparency International (2012), corruption has increased in India over the last five
years. Dyreng, Hanlon, and Maydew (2011) found that firms’ earnings management is more common
in weak rule-of-law countries than in companies operating in locations where the rule of law is strong.
They also found some evidence that profitable firms with an extensive tax haven manage earnings
more than other firms and most earnings management takes place in domestic rather than foreign
income. This study then concentrates on Indian companies where rules of law are weak.
Due to the intense practice of earnings management (EM) in India, the relationship between the
intensity of the practice and firm performance and value is studies using several methods of
measurement of the intensity of EM. We apply standard regression analysis in order to examine the
extent to which there is a significant relationship between the intensity of earning management
practices and company's rate of return on total assets, and whether there is a significant relationship
between the intensity of EM and the market value of firms. We hypothesize that both relationships
should be negative.
Since the practice of earnings management is prevalent in many Indian companies, the paper is
interested in two research questions:
Does intensive use of earnings management by Indian companies adversely affect companies’
rate of return on assets?
Does intensive use of earnings management by Indian companies adversely affect corporate
market values?
This study provides insights for policy-makers as to the importance of earnings management
(FP) and firm performance in influencing shareholder wealth in Indian Top 500 Firms. The results may
be generalized to similar companies listed in Indian Top 500 Firms.

2. Literature Review
Section 2 provides a literature review to formulate hypotheses.
The study of earnings management dates back to Healy’s (1985) study titled “the effect of
bonus schemes on accounting decisions.” Since that time, different authors conducted studies on
earnings management. While some authors (Sloan, 1996; Fairfield et al., 2003; Fama and French,
122 International Research Journal of Finance and Economics, Issue 116 (2013)

2006; Cooper et al., 2008; and Chu, 2012) have tested the relationship between EM and FP, other
authors (Teoh, Welch, and Wong, 1998; Othman and Zeghal, 2006; Huddart and Louis, 2009; Li,
2010; Cohen et al., 2011; Mashadi et al., 2012; and Gholami, Nickjoo, and Nemati, 2012) have tested
the relationship between EM and firm value. Although empirical studies in developed economies have
found that EM and FP affect the market price of shares, there has not been much research conducted on
developing countries (Ogundipe, Idowu, and Ogundipe, 2012).

2.1. Earnings Management and Firm Performance

It is important to understand the methods of earnings manipulation because firm performance (e.g.,
return on assets) relies on net income and managers can manipulate net income through current assets.
For example, managers can overstate ending inventory to manipulate cost of goods sold.
Earnings management (manipulation) is done by affecting total accruals and discretionary
accruals. Richardson et al. (2006) also found that accruals are associated with earnings manipulation.
Healy and Walden (1999) define EM as the alteration of a firm's reported economic performance by
insiders in order to either mislead some stakeholders or to influence contractual outcomes. The
alteration can be done by altering transactions (e.g., ending inventory, employee wages accruals in
month-ends, etc.). Fairfield et al. (2003), by sampling US firms for a period of 1963-1992 found that
working capital accruals have a negative relation with future profitability. Working capital accruals
include current assets and current liabilities. Verma (2012, p. 540) described that some of the earning
management techniques available and duly allowed by regulatory bodies (including Indian regulatory
bodies) are: i) inventory valuation methods (e.g., first in-first out, last in-first out, and weighted
average method), ii) more expenses accrued for a future period, iii) revenue and expense recognition
techniques, iv) using more of derivatives, v) transferring goods to an inflated market to increase the
profits or buying goods from a deflated market to produce desired results, and vi) showing unexpected
gains or losses from long term assets which were shown at cost.
Earnings management such as depositing current period A/R checks in the next period can
cause abnormal cash flows from operations which can impact the reported future profit of the firm. The
findings related to the relationship between EM and FP differs between authors. Sloan (1996), used
40,679 observations from US firms and found that the accrual component of operating income is less
persistent than the cash components for explaining one-year-ahead performance measured by the rate
of return on assets (ROA). Cooper et al. (2008), sampling US firms for a period of 1963-2003, found a
negative correlation between total asset growth and subsequent firm abnormal returns. Fama and
French (2006) analyzed data of US firms and found that accruals negatively predict one-year-ahead
reported profitability. Chu (2012), analyzing a sample of 4,438 US firms for a period of 1978-2007
found that high growth firms with low accruals experience high future profitability and returns.
In summary, the literature review indicates that EM impacts firm performance. Hence, the
following hypotheses are formulated:
H1: Earnings management by Indian companies adversely impacts firm performance.

2.2. Earnings Management and the Value of the Firm

One of the motivations behind earnings management is to provide good news to corporate boards by
showing good results in a certain period. This is a problem of potential endogeneity; that is, managers
are reluctant to announce earnings below analysts’ forecasts (Cohen et al., 2011) because it may have a
negative impact on market price per share. Because market price per share impacts the value of the
firm, managers tend to manipulate the components of the income statement and balance sheet through
accruals to maintain and/or to maximize share price for the current and subsequent year. However,
earnings manipulation tends to start backfiring after some time. For example, Teoh, Welch, and Wong
(1998), sampling 1,649 US initial public offering (IPO) firms from 1985-1992 found that issuers with
unusually high accruals in the IPO year experience poor stock return performance in the three years
thereafter.
International Research Journal of Finance and Economics, Issue 116 (2013) 123

Managers also tend to manipulate earnings to surprise investors, improve share price, and lower
debt costs. DuCharme and Malatesta (2004), sampling US companies for the period of 200-2001 found that
abnormal stock returns are positively related to the earnings surprise. Othman and Zeghal (2006), using
1,674 Canadian and 1,470 French firm-year observations for a period of 1996-2000 found that contractual
debt costs cause earnings management in French firms and issuing new equity leads to earnings
management in Canadian firms. Huddart and Louis (2009), used data from US COMPUSTAT for a period
of 1984-1999 and found that earnings management positively impact market price per share and led to the
1990s stock market bubble. Li (2010) took a sample of 7,861 US firms for the period 1988-2008 and found
that real earnings management practices of managers are related to subsequent higher stock returns. Cohen
et al. (2011), using a sample of 71,848 firm-quarter observations of US firms for a period of 1998-2008
found that the information environment is a crucial determinant of the market’s response to share price.
Gholami, Nickjoo, and Nemati (2012) sampled 1,200 US IPO firms for the period of 2000-2010. The
authors found that IPO firms engaged in earnings management with high investor beliefs have an influence
on the long-run abnormal stock return performance.
In contrast to some of these studies, we believe that the practice of earnings management is in a
sense a zero sum game; if management is to gain from earnings management and if creditors are not
deceived by earnings manipulation and are not offering cheaper credit to companies that manage
earnings, then shareholders must be on the losing end. Hence, the following hypothesis is formulated:
H2: Earnings management by Indian companies adversely impacts the firm value.
We also examined the extent to which some control variables have any effect on the postulated
hypotheses.

3. Methods
This study applied a co-relational research design.

3.1. Measurement
The variables used in the analysis were:
i. Tobin’s Q represents the firm value.
ii. Rate of return on assets.
iii. Firm size.
iv. Financial leverage.
v. Current ratio.
vi. Four alternative measures of earnings management (EM) were adopted from modified
DeAngelo (1986), Jones’s (1991), and Abed, Al-Attar, and Suwaidan (2012), and Revenues
as a means of earnings management (managed revenues) was adopted from Stubben
(2010).1
Table 1 provides definitions of the dependent, independent, and control variables used in the analysis.

Table 1: Proxy Variables and their Measurements

Dependent Variables Measurement

Return on assets (ROAi,t) Net income after tax / Total assets
Tobin’s Q = (Market value of equity + Book
value of debt) / Book value of total assets
Market value (Qi,t)
Market value of equity = (Highest market value
per share + Lowest market value per shares) / 2

1
Details of the four alternative method of estimating earnings management are provided in the Appendix to the paper.
124 International Research Journal of Finance and Economics, Issue 116 (2013)
Table 1: Proxy Variables and their Measurements – (continued)

Independent Variables Measurement

Earnings Management Indicators
(a) Managed revenues (Ri,t) ΔAR i,t = C x ΔR i,t + (1 - C) x ΔDR i,t
(b) Total accruals [balance-sheet approach] (TACC-B i,t) TACC-Bi,t = ∆CAi,t - ∆Cashi,t - ∆CLi,t + ∆DCi,t - DEPi,t
(c) Total accruals [cash flow approach] (TACC-Oi,t) TACC-Oi,t = EARN ,t - CFO ,t
(d) Discretionary accruals [cash flow approach] (DACC-
DACC-Oi,t = (TACCi,t - TACCi,t-1) / TAi,t
Oi,t)
Control Variable
Firm size (FSi,t) Logarithm of total assets
Financial leverage (FLi,t) Total debt / Total assets
Current ratio - liquidity (CRi,t) Current assets / Current liabilities
µi,t = the error term
εјt = Error term for Firm j in Year t

The accruals measurement provided by Healy (1985) and Jones (1991) and other authors were
used because we examined four alternative measures or proxies of the intensity of earnings
management. We examined whether they all provided the same explanation or at lease brought about
the same sign or directional effect. Discussion of the various measures related to earnings management
is provided in Appendix A.
The basic regression equation defined the dependent variable (ROA or Q) and used either one
of the fours independent (explanatory) variables (R; TACC-B; TACC-O or DACC-O) in order to find
whether the slope coefficient was negative and statistically significant. We also added several control
variables to the regressions in order to find whether any of these variables had any significant
relationship with the dependent variables.

3.2. Data Collection

A database was built from a selection of approximately 500 financial reports from publicly traded
companies between January 1, 2007 and December 31, 2011. The selection was drawn from the
Bombay Stock Exchange (BSC) Top 500 companies (www.prowess.cmie.com) to collect a random
sample of manufacturing firms. Out of approximately 500 financial reports announced by public
companies between January 1, 2009 and December 31, 2012, only 250 financial reports were usable.
The cross sectional yearly data was used in this study. Thus, 250 financial reports resulted to 750 total
observations. Since the random sampling method was used to select companies, the sample is
considered a representative sample.
All companies from the service industry were omitted because in general these companies do
not provide all the necessary information. Some other firms for which data was unavailable were also
excluded.

3.3. Descriptive Statistics

Table 2: provides descriptive statistics of the sample.and.Descriptive Statistics

Minimum Maximum Mean SD

R10 -0.99 1.95 0.22 0.45
TACC-B10 0.01 4.90 3.01 0.91
TACC-O10 1.02 5.31 3.14 0.72
DACC-O10 -0.39 0.56 0.01 0.12
FS10 1.31 6.40 4.47 0.62
FL10 0.02 8.70 0.54 0.54
CR10 0.42 8.59 2.57 1.72
ROA10 -0.70 0.51 0.09 0.09
Q10 -6.08 17.65 3.45 2.87
R11 -0.69 1.94 0.28 0.33
TACC-B11 -13.76 14.88 1.41 3.14
International Research Journal of Finance and Economics, Issue 116 (2013) 125
Table 2: provides descriptive statistics of the sample.and.Descriptive Statistics – (continued)

TACC-O11 0.76 4.80 3.21 0.67

DACC-O11 -0.27 0.33 0.02 0.09
FS11 3.34 6.45 4.57 0.55
FL11 0.06 0.96 0.51 0.17
CR11 0.27 9.46 2.64 1.84
ROA11 -0.15 0.70 0.08 0.08
Q11 -14.52 17.86 3.46 3.51
R12 -0.99 0.91 0.17 0.28
TACC-B12 -16.38 17.85 0.79 3.78
TACC-O12 -13.28 8.88 1.36 3.18
DACC-O12 -0.35 0.47 -0.01 0.09
FS12 2.40 6.47 4.64 0.57
FL12 0.05 0.89 0.51 0.18
CR12 0.36 8.68 2.45 1.65
ROA12 -0.13 0.76 0.09 0.08
Q12 -4.71 18.63 3.23 3.42
SD = Standard deviation
R = Change in managed revenues
TACC-B = Change in total accruals (balance-sheet approach)
TACC-O = Total accruals (cash flow approach)
DACC-O = Change in discretionary accruals (cash flow approach)
FS = Firm size
FL = Financial leverage
CR = Current ratio (liquidity management)
ROA = Return on assets
Q = Market value of the firm

Appendix B provides the estimates of the Pearson pair-wise correlations between the alternative
proxies of the intensity of earnings management in the two years 2010 and 2011. Note that there is a
high correlation between the TACC-B proxies in 2010 and 2011, and between the TACC-O proxies in
2010 and 2011, indicating consistency in management practice in the two years. The two proxies were
highly correlated in 2010 but only weakly correlated in 2011.

4. Regression Analysis, Findings, Discussion, Conclusion, Limitations, and Future

Research
Pooled data and cross sections were used to conduct this study. This practice may lead to a problem of
heteroskedasticity [changing variation after a short period of time] (Raheman and Nasr, 2007, P. 292).
To counter this problem, the weighted least square regression model with a cross section weight of
three industries (consumer products manufacturing, industrials products manufacturing, and energy
production) was used. In this regression, the common intercept was calculated for all variables and
assigned a weight.
There was also the possibility of endogeneity issues because we used multiple regression
analysis. The issue of endogeneity also takes place if certain variables are omitted and there are
measurement errors (Gill and Biger, 2013). To minimize endogeneity issues, the most important
variables that impact firm performance and firm value were used and the measurements were borrowed
from the previous empirical studies. As the sample of companies only included companies that
'survived' during the study period, there might have been a survival bias in the study. We consider this
to be a minor issue as the purpose of the study was to focus on the impact of earnings management and
firm performance on the value of the firms.
Table 3 provides the regression results for firm performance (return on assets) in 2011. We
used the Change in Managed Revenue proxy of earnings management intensity and two control
variables: firm size and financial leverage to test whether any of these control variables was related to
the following year's rate of return on assets – a proxy of firm performance.
126 International Research Journal of Finance and Economics, Issue 116 (2013)
Table 3: Earning Management and Future Firm Performance (Year 2011)
Un-standardized Coefficients Standardized Coefficients c T Sig. Collinearity Statistics
B Std. Error Beta Tolerance VIF
(Constant) 0.259 0.036 7.235 0.000
R10 -0.020 0.010 -0.120 -1.997 0.047 0.996 1.004
FS10 -0.033 0.008 -0.270 -4.377 0.000 0.943 1.060
FL10 -0.035 0.009 -0.250 -4.043 0.000 0.940 1.064
R10, FS10, FL10, and ROA11
R2 = 0.122; Adjusted R2 = 0.111

For performance in 2011, change in managed revenues (a measure of the intensity of EM in the
previous year), as well as firm size and financial leverage all had statistically significant negative
coefficients, supporting our first hypothesis.
We also examined an alternative measure of the intensity of EM, and the results are presented below:

Table 4: Earning Management and Future Firm Performance (Year 2011)

Un-standardized Coefficients Standardized Coefficients c t Sig. Collinearity Statistics
B Std. Error Beta Tolerance VIF
(Constant) 0.194 0.018 10.823 0.000
TACC-B10 -0.035 0.005 -0.566 -6.593 0.000 0.938 1.066
FL10 -0.028 0.006 -0.421 -4.904 0.000 0.938 1.066
TACC-B10, FL10, and ROA11
R2 = 0.379; Adjusted R2 = 0.365

The relationship between the intensity of EM in 2010 and performance in the following year
was again negative and highly significant. We also found that high financial leverage used by firms
was also negatively related to the following year's performance.
We also examined the relationship between another proxy of EM intensity, change in total
accruals, cash flow approach (TACC-O) and firm performance in the following year. The results are
displayed in Table 5:

Table 5: Earning Management and Future Firm Performance (Year 2011)

Un-standardized Coefficients Standardized Coefficients c t Sig. Collinearity Statistics
B Std. Error Beta Tolerance VIF
(Constant) 0.260 0.036 7.249 0.000
DACC-O10 -0.074 0.040 -0.111 -1.834 0.068 0.974 1.027
FS10 -0.034 0.008 -0.275 -4.461 0.000 0.944 1.059
FL10 -0.039 0.009 -0.276 -4.421 0.000 0.920 1.087
DACC-O10, FS10, FL10, and ROA11
R2 = 0.120; Adjusted R2 = 0.109

This time, the relationship between the EM proxy and firm performance in the following year is
negative albeit only significant at p=0.068.
In contrast to the relationships between the EM proxies and firm performance in 2011, the
results for 2012 were in the opposite direction. We found that both the Change in total accruals – cash
flow approach proxy of EM (TACC-O) in 2011 and the Change in discretionary accruals – cash flow
approach (DACC-O) proxy had positive and significant relationships with the firm's performance in
2012. The results of the regressions are displayed in Tables 6 and 7.

Table 6: Earning Management and Future Firm Performance (Year 2012)

Un-standardized Coefficients Standardized Coefficients c t Sig. Collinearity Statistics

B Std. Error Beta Tolerance VIF
(Constant) 0.312 0.047 6.580 0.000
TACC-O11 0.045 0.011 0.360 4.327 0.000 0.604 1.657
International Research Journal of Finance and Economics, Issue 116 (2013) 127
Table 6: Earning Management and Future Firm Performance (Year 2012) – (continued)

FS11 -0.048 0.013 -0.323 -3.813 0.000 0.582 1.718

FL11 -0.208 0.033 -0.429 -6.306 0.000 0.901 1.110
CR11 -0.011 0.003 -0.261 -3.857 0.000 0.910 1.098
TACC-O11, FS11, FL10, CR11, and ROA12
R2 = 0.303; Adjusted R2 = 0.286

Table 7: Earning Management and Future Firm Performance (Year 2012)

Un-standardized Coefficients Standardized Coefficients c t Sig. Collinearity Statistics
B Std. Error Beta Tolerance VIF
(Constant) 0.181 0.017 10.803 0.000
DACC-O11 0.297 0.049 0.331 6.041 0.000 0.944 1.059
FL11 -0.175 0.026 -0.385 -6.787 0.000 0.880 1.136
CR11 -0.004 0.002 -0.104 -1.878 0.062 0.930 1.075
DACC-O11, FL11, CR11, and Q12
R2 = 0.304; Adjusted R2 = 0.296

The other two proxies of EM had no significant relationship with firm performance.
Note that a test for multicollinearity was performed. All the variance inflation factor (VIF)
coefficients were less than 2 and tolerance coefficients were greater than 0.50.
The practice of earnings management might have an effect on reported profitability in the year
that follows the activities that 'manage' profits. If management wishes to show high profit in a given
year, this may be done at the expense of next year (reported) profit. In order to examine this conjecture,
we ran regressions where the explanatory variables, one by one, were the alternative proxies of the
intensity of earning management, and the dependent variables were the following year rate of return on
assets. The results of these regressions were as follows:
For ROA11:
a. ROA11 = 0.091 – 0.024 R10, with t-value of -2.18 and p=0.03
b. ROA11 = 0.157 – 0.029 TACC-B10, with t-value of -4.957 and p=0.00
c. ROA11 = 1.537 – 0.49 TACC-O10, with t-value of -2.454 and p=0.015
d. ROA11 = 0.086 – 0.049 DACC-O10, but this explanatory variable was not statistically
different from zero.
The results confirm the hypothesis for 2011: in 2010 earnings management by Indian publicly
traded companies, adversely affected the rate of return on assets in the following year2.
Conversely, the following year, 2012, we found that two proxies of EM in 2011 had a positive
relationship with form performance. This result is at lease puzzling and we humbly provide no
explanation to this finding.

4.1. The Relationship between Earnings Management and the Value of Firm
The hypothesis regarding market perception of the practice of management of earnings by corporate
executives was examined for both 2011 and 2012. Regression of each one of the measures of earnings
management in 2010 on corporate value, measures by the Tobin's Q was run. As stated above, several
studies conjectured a positive relationship between the practice of earnings management and corporate
value. We hypothesize that since the practice of earnings management is usually undertaken in order to
advance top management interests, such practice is done at the expense of other stakeholders and must
therefore adversely affect the market value of the firm.
We conducted several single variable regressions. As stated, we examined each one of the
measures of earnings management as an explanatory variable of the variation of the Tobin-Q value in

2
The four alternative proxies for the intensity of earnings management in our study were not highly correlated. The only
two proxies that were found to be highly correlated in 2010 were the TACC-O10 and TACC-B10 with a correlation
coefficient of 0.48. For 2011, none of the four proxies were significantly correlated with each other.
128 International Research Journal of Finance and Economics, Issue 116 (2013)

the following year. For the year 2011 two of the earnings management proxies were found to be
significant with the following regression results:
a. Q11 = 5.324 – 0.771 (TACC-B10), with t-value of the slope coefficient 1.98, and p = 0.05
b. Q11 = 6.67 – 0.891 (TACC-O10), with t-value of the slope coefficient 2.215 and p = 0.028
The other two proxies of earning management in 2010, R10 and DACC-O10 also showed a
negative slope coefficient, but the results were not statistically significant.
Our hypothesis regarding the effect of practicing earnings management was then confirmed for
2011. Top management practice of management of reported earnings adversely affected share prices
and the value of corporations, and the more prevalent the practice, the more adverse the effects.
We then performed the same test for earnings management in 2011. This time, for all four
proxies of earnings management in 2011, the slope coefficients were negative, but none of the
regression coefficients was found to be statistically significant.
We also attempted to determine whether practicing earnings management in the two
consecutive years affects the market value of companies in the following year. We found no significant
relationship of the corporate value for the proxy DACC10 and DACC11. Similarly, no significant
relationship was found when the EM proxies were R10 and R11.
For the proxies TACC-B10 and TACC-B11, we obtained the following regression results:
Q12 = 5.33 – 8.74 (TACC-B10), with t-value of the slope coefficient 2.415, and p = 0.018
Q12 = 3.38 – 1.09 (TACC-B11), with t-value of the slope coefficient 1.582, and p = 0.115

4.2. Discussion
The main purpose of this study was to test whether the practice of earnings management has an effect
on firm performance, and whether earnings management has an effect on firm value. The study focused
on Indian firms where the practice of earnings management is reported to be very common. We found
that for Indian companies, earnings management in 2010 adversely affected the performance of the
firm in the following year. Thus, the findings of this study lend some support to the findings of Fama
and French (2006). At variance, we found that EM in 2011 had a positive relationship with firm
performance in the following year, and we cannot provide a reasonable explanation to this finding. The
term "performance" was presented by the ratio of reported annual earnings as reported by the firms
divided by the firms' total assets. This rather tentative definition of performance might have been
improper measure of true economic performance of the firms since earnings that were measured in
2012 might have been 'managed' and it is conceivable that in 2012, firms had reasons to show higher
than true accounting profits so the positive relationship between 2011 EM and the return on assets in
2012 might be spurious.
With regard to the relationship between EM and market values, we found that, at least in the
context of our sample of Indian companies traded on the Mumbai stock exchange, there are rather clear
signs that, to some extent, the market realizes that management acts for selfish motives and responds
by lowering share prices and corporate market value. In some cases, and depending on the proxy one
uses to reflect and measure the extent of earnings management, the negative impact on the value is
statistically significant. For other measures that were proposed in several academic papers, the
relationships were negative; albeit not statistically significant. In any case, for the sample of Indian
companies, we did not find a single case where earnings management practices had a positive effect on
corporate market value. In the Indian context, investors tend to penalize companies whose management
performs intensive earnings management. These findings should be taken into account by managers
and should serve as a warning. If indeed part of the reasons for practicing management of earnings is
related to market-based bonus to management in the form of stock options or other price related
bonuses, the fact that the market price is adversely affected by such practices might partially deter
management from managing earnings. It will be noted that the findings of this study lend some support
to the findings of Teoh, Welch, and Wong (1998) and Gholami, Nickjoo, and Nemati (2012) but
contradict the findings of Huddart and Louis (2009) and Li (2010).
International Research Journal of Finance and Economics, Issue 116 (2013) 129

4.3. Conclusion
The present study found that the more intense the practice of earnings management, the greater its
adverse effect on firms’ rate of return on assets in the following year. Management seems to transfer
gains from the future to the present period in order to gain from reporting relatively good results in the
present period at the expense of the future. The market however, seems to detest this practice. We
found that the more intensive the activity of earnings management, the greater the negative effect of
such actions on corporate values. If managers are at all concerned with shareholders wealth instead of
their own, they should avoid the temptation of manage reported corporate earnings. Furthermore, if
managers manage earnings in an effort to gain from current year performance, but their gain takes the
form of stock options or other future price related compensations, they should realize that their
management of earnings in a given year has an adverse effect on market prices in subsequent years and
thus they might actually be on the losing end of the scale.

4.4. Limitations
This is a co-relational study that investigated the association between i) earnings management and firm
performance and ii) earnings management and firm value. There is not necessarily a causal relationship
between the two although some conjectures were provided to the findings.
This study is limited to the sample of Indian manufacturing firms. The findings of this study
could only be generalized to firms similar to those that were included in this research. In addition,
sample size is small.

4.5. Future Research

Future research should investigate generalizations of the findings beyond the Indian firms. Important
control variables such as industry sectors from different countries should also be used.

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Appendix A: Details on Earnings Management Models

Healy (1985) model
Healy (1985) model assumed that non-discretionary accruals follow the regression of white noise,
whose average is zero. It follows that the value of expected non-discretionary accruals is zero. If the
value of total accruals (TACC), which is the sum of discretionary accruals (DACC), and non-
discretionary accruals (NDACC) is non-zero, it is the result of earnings management.
For a given firm, i,
DACCi,t = TACCi,t / TAi,t-1
where
TAi,t-1 = Total assets of firm i in period t
DACC = Discretionary accruals

DeAngelo (1986) Model

DeAngelo (1986) model assumed that non-discretionary accruals follow a random walk. For a
company in a stationary condition, the non-discretionary accrual in period t is equal to the non-
discretionary accrual in period t-1. As a result, the difference between the non-discretionary accruals in
period t and t-1 is the discretionary accrual which is related to earnings management.
DACCi,t = (TACCi,t - TACCi,t-1) / TAi,t
where
DACC = Discretionary accruals
TACC = Total accruals
TA = Total assets
DACC-Oi,t = (TACCi,t - TACCi,t-1) / TAi,t
DACC-O = Discretionary accruals under operating cash flow approach of Jones (1991)

Modified Jones (1991) Model

The cross-sectional modified version of Jones’ model (Jones, 1991; Dechow et al., 1995) was also
applied to obtain proxies total accruals. The details on Jones’s model are as follows:
Jones’s (1991) model uses the balance-sheet approach, the cash-flow approach, and the
difference between earnings before extraordinary items and cash flow from operations. The
explanation of each measurement component that was used in this study is described as follows:
Total accruals computed under the balance-sheet approach are represented by the following
equation:
TACC-Bi,t = ∆CAi,t - ∆Cashi,t - ∆CLi,t + ∆DCi,t - DEPi,t
where
TACC-Bi,t = Total accruals under the balance-sheet approach for firm i in year t
∆CAi,t = Change in current assets for firm i in year t
∆Cashi,t = Change in cash and cash equivalents for firm i in year t
∆CLi,t = Change in current liabilities for firm i in year t
132 International Research Journal of Finance and Economics, Issue 116 (2013)

∆DCi,t = Change in debt included in current liabilities for firm i in year t

DEPi,t = Depreciation and amortization expense for firm i in year t
Total accruals calculated as the difference between earnings before extraordinary items and
cash flow from operations is reflected by the following equation:
TACC-Oi,t = EARNј,t - CFOј,t
TACC-Oј,t = Total accruals under operating cash-flow approach for firm i in year t
EARNј,t = Earnings before extraordinary items for firm i in year t
CFOј,t = Cash flows from operations for firm i in year t

Revenues as a Means of Earnings Management

The model of discretionary revenues can be described as follows:
Managed revenues (R) - the sum of nondiscretionary revenues (NDR) and discretionary
revenues (DR).
R = NDRi,t + DRi,t
A fraction (C) of nondiscretionary revenues remains uncollected at year-end, and it is assumed
that there are no cash collections of discretionary revenues. Thus, accounts receivable (AR) equals the
sum of uncollected nondiscretionary revenues (NDR) and discretionary revenues (DR)
AR i,t = C x (NDRi,t + DRi,t)
Discretionary revenues increase accounts receivable and revenues by the same amount;
discretionary receivables equals discretionary revenues.
Nondiscretionary revenues are not observable; therefore, terms have been rearranged to express
ending receivables in terms of reported revenues and then, took first differences to arrive at the
following expression for the receivables accrual:
∆ARi,t = C x ∆Ri,t + (1 - C) x ∆DRi,t

Appendix B: Pearson Correlations Coefficients

Pearson Correlation coefficients
DACC-
2 3 4 5 6 7 O11
1 R10 .010 .172 .266 -.013 .017 .013 -.155
2 TACC-B10 .480 -.031 -.053 .099 .469 -.461
3 TACC-O10 .295 -.061 -.105 .673 -.382
4 DACC-O10 -.035 -.065 .025 -.320
5 R11 .114 .106 .193
6 TACC-B11 .150 .170
7 TACC-O11 .122
Bold numbers are significant at p<0.05

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