ownership structure and earnings management in emerging markets

Consequently, regulators in several countries outside the USA also started paying attention to corporate governance and especially ownership structure components e.g., insider managers,

ISSN 1450-2887 Issue 38 (2010)

© EuroJournals Publishing, Inc 2010

http://www.eurojournals.com/finance.htm

Ownership Structure and Earnings Management in

Emerging Markets: The Case of Jordan

Nedal Al-Fayoumi

Department of Finance, Faculty of Business, University of Jordan

E-mail: nfayoumi@ju.edu.jo

Bana Abuzayed

Talal Abu-Ghazaleh College of Business, German Jordanian University

E-mail: bana.abuzayed@gju.edu.jo

David Alexander

Birmingham Business School, University of Birmingham, UK

E-mail: d.j.a.alexander@bham.ac.uk

Abstract

This study examines the relationship between earnings management and ownership

structure for a sample of Jordanian industrial firms during the period 2001-2005 Earnings management is measured by discretionary accruals The three types of ownership studied are insiders, institutions and block-holders Using the Generalized Method of Moment (GMM), the results indicate that insiders' ownership is significant and positively affect earnings management This result is consistent with the entrenchment hypothesis which states that insiders' ownership can become ineffective in aligning insiders to take

value-maximizing decisions Further analysis shows insignificant role for institutions and

block-holders in monitoring managerial behaviour earnings management Our findings have important policy implications since they support encouraging applying corporate governance principles in order to motivate institutions and block-holders to provide effective monitoring of managers in Jordanian firms As a result, the reliability and transparency of reported earnings may be enhanced

Keywords: Earnings management, Discretionary Accruals, Ownership Structure, Size

1 Introduction

The global markets crisis of 2008 has stimulated a vast body of research on financial information quality and corporate control In corporations, finance and management are usually separated However, this separation action poses two conflicts First, fund suppliers face collective action problems preventing them to monitor and discipline managers of the company they are investors of (see Macey, 1998) Second, managers need to convince market participants (current and potential) of the firm performance, in order to be able to allocate enough funds for the firm investments Since the value of these investments is tied to the firm, this value depends on the future prospects of the business relationship between the firm and its suppliers Consequently, the perception of these stakeholders about the firm’s future prospects affects their incentive to undertake such investments From this point

of view, researchers suggest that managers may engage in earnings management to influence stakeholders (Graham et al., 2005)

There is no consensus on the definition of earnings management (Beneish, 2001) For example, Davidson et al., (1989) cited in Schipper (1989, p 92) defined earnings management as “the process of taking deliberate steps within the constraints of Generally Accepted Accounting Principles to bring about a desired level of reported income” Healy and Wahlen (1999) state that "earnings management occurs when managers use judgment in financial reporting in structuring transactions to alter financial reports, to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting"

Earnings management occurs in three ways: (1) via the structuring of certain revenue and/or expense transactions; (2) via changes in accounting procedures; and/or (3) via accruals management (McNichols and Wilson 1988, and Schipper 1989) Of the above mentioned earnings management techniques, accruals management is the most damaging to the usefulness of accounting reports because investors are unaware of the extent of such accruals (Mitra and Rodrigue , 2002) Accrual is defined as the difference between the earnings and cash flow from operating activities Accruals can be further classified into non-discretionary accruals and discretionary accruals While non-discretionary accruals are accounting adjustments to the firm’s cash flows mandated by the accounting standard-setting bodies, discretionary accruals are adjustments to cash flows selected by the managers (see Rao and Dandale, 2008)

A number of previous studies attempt to examine whether earnings management exist in firms reports (Healy, 1985; Burgstahler and Dichev, 1997; and DeAngelo et al., 1994), endeavor to determine the types of earnings management (Sirgar and Utama, 2008; and Beneish, 2001), or question the motives behind earnings management (Healy and Wahen, 1999) Factors like management compensation contract incentives (Guidry et al., 1999, and Dechow and Solan 1991), regulatory motivations (Key, 1997), capital market motivations (Teoh et al., 1998), and external contract incentives (Watts and Zimmerman, 1986) have been examined to interpret managers behavior towards earnings management

In this paper, we are turning our focus on the relationship between ownership structure and earnings management practices among firms operating in an emerging market With globalalization of business and financial markets, there has been strong demand for quality of information from firms across countries so that investors can conduct comparative evaluation of risk and return of firms in different countries (Jaggi and Leung, 2007) Consequently, regulators in several countries outside the USA also started paying attention to corporate governance and especially ownership structure components (e.g., insider managers, institutional investors, and block-holders) to improve the quality

of reported accounting information

There is a public perception that earnings management is utilized opportunistically by firm managers for their own private gain rather than for the benefit of the stockholders This misalignment of managers' and shareholders' incentives could induce managers to use the flexibility provided by the accounting standards to manage income opportunistically, thereby creating distortions in the reported earnings (Jiraporn, 2008) However, a number of academic studies have argued that earnings management may be beneficial because it potentially enhances the information value of earnings Managers may exercise discretion over earnings to communicate private information to stockholders and the public (e.g., Arya et al., 2003; Demski, 1998; Guay et al., 1996)

The ability of managers to opportunistically manage reported earnings is constrained by the effectiveness of external monitoring by stakeholders such as institutional and external block-holders These investors have the opportunity, resources, and ability to monitor, discipline, and influence managers of firms (Monks and Minow, 1995) Whether they use these powers is partially a function of the size of their individual or collective shareholdings (Chung et al., 2002) And this implies less

opportunity for accruals management or earnings manipulation (see Yeo et al (2002) and De Bos and

Donker, 2004) This will be especially the case when major stakeholders know managers’ incentives for earnings management If managers have no self-serving incentives to use discretionary accounting

accruals, these stakeholders will be less inclined to monitor discretionary accounting choices (Chung et

al, 2002) Yet many argue that institutions do not monitor effectively because they either lack expertise

or suffer from free rider problems among themselves (Admat et al., 1999), or strategically ally with the management (Pound, 1988) A similar argument can be made for the individual block-holders (Jung and Kwon, 2002)

This study contributes to the literature in the following ways First, from the previous literature

it appears that there is no general agreement regarding the effect of ownership structure on earnings management Therefore, this study investigates the determinants of earnings management activities and extends the very limited research on the association between ownership structure and earnings management Unlike most existing research, which usually studies just one aspect of ownership structure, we focus on three ownership categories: insiders, institutions, and block-holders

Second, it represents the first known study, to the best of our knowledge that examines the relationship between ownership structure and earnings management in Jordan Jordan has been selected in the current study because recently it has displayed a significant interest in consolidating the pillars of corporate governance Additionally, we use Jordanian data because they generally reflect an institutional setting similar to many emerging countries, where a high share of insider ownership, weak investor rights and less mature block-shareholders are prevalent Our analysis and results are therefore likely to be generalisable across many emerging economies and we would encourage empirical work in other settings to investigate this proposition Fundamental stakeholders in the Jordanian corporations include families, banks, social security institution, and individual investors Thus, this study provides empirical evidence to assess the merits of calls for different types of investors to play a greater role in corporate governance practices

Third, it provides further evidence on the possibility of coexistence of the opportunistic and informative managerial ownership in addition to active and myopic institutional and block-holders ownership and their differential associations with earnings management Understanding the nature of these associations is important for portfolio managers and decisions makers because they may convey information about the quality of financial information and firm value

The paper is structured as follows: Section 2 gives a brief overview of the accounting system in Jordan Section 3 presents the theoretical background Section 4 summarizes earnings management literature Section 5 discusses the data and methodology, while section 6 reports the main results Finally, section 7 summarize and concludes this paper

2 The Accounting System in Jordan

Jordan has a political stability in a very volatile region, a liberal economy, and relatively advanced stock market However, the Jordanian economy is private sector oriented; the state ownership is relatively small Recently, a series of privatization initiatives has been implemented to reduce public

shares in the productive sectors

All registered firms in Jordan are subjected to the obligation of certification and publishing their accounts Since 1987, a body is in charge of checking the quality of the accounting information called the Jordanian Association of Certified Public Accountants (JACPA) The certification and the control of accounts in Jordan refer to the recommendations from the JACPA which adopt International Accounting Standards Only the auditors who have received this certification are authorized to certify annual reports In addition, there are a number of internationally recognized accounting and auditing firms in the kingdom In general, government's accounting and auditing regulations are regarded as being compatible with international standards

Public shareholding companies were set up and their shares were traded in, long before the setting up of the Jordanian Securities Market In the early thirties, the Jordanian public already

subscribed to and traded in shares1 The Amman Financial Market (AFM) was established in 1978 However, the passage of Securities Law No 23 in 1997 was indeed a landmark and a turning point for the Jordanian capital market Three institutions emerged: the Jordan Securities Commission (JSC), the Amman Stock Exchange (ASE), and the Securities Depository Center (SDC)) out of what has been the Amman Financial Market till 1997 The ASE is one of the largest stock markets in the region that permits foreign investment (in year 2008, Market Capitalization to GDP was about 226.3 per cent) Securities listed in ASE are electronically traded

According to the Jordanian Securities Commission (JSC) Law (23/1997) and Directives of disclosures, auditing, and accounting standards (1/1998), all entities subject to JSC’s supervision are required to apply International Financial Reporting Standards (IFRS)2 These Directives specify the information required by public shareholding companies to be disclosed and filed with the Commission for the purpose of enhancing transparency Public shareholding companies are required to apply the International Auditing and Accounting Standards under the supervision of the Jordan Security Commission (JSC)3 Firms operating in Jordan are required to submit annual reports and announce yearly statements within a period not exceeding 3 months after the end of their fiscal year and to announce a half yearly statement within a period not exceeding one month after the end of the mid-year Additionally, these directives contain chapters on insider trading and how firms are obliged to submit to the JSC material information related to the dealings In 2002, a new Securities Law number

76 has been issued, which authorized setting up other stock exchanges and allowed forming an independent investor protection fund, stricter ethical and professional codes, and a more stringent observance of the rule of law (ASE, 2009) By December 2008, the exchange recorded 5,442.3 million shares traded4

The Accountancy Profession Law (APL) 73/2003 was issued in 2003 Important features of the APL include the establishment of a “High Council for Accounting and Auditing” headed by the Minister of Industries and Trade, and the creation of an improved JACPA However, Rahman and Waly (2004) argued, for more clarification and refinement in the law in addition to upgrade its contents with the new global developments5 Given that more robust auditing should capture any earnings management practices, this study tries to bring evidence that the level of earnings management and thus the quality of reported financial information are influenced by firms ownership structure

3 Theoretical Background

Mainly focusing on the effect of ownership structure on earnings management (discretionary accruals),

we account for the complexity of interests represented in a given company, by consider the main dimensions of ownership structure – insiders, institutions and external block-holders

1 Where the Arab Bank was the first public shareholding company to be established in Jordan in 1930, the first corporate bonds were issued in the early sixties See the Jordan Security Commission web site at http://www.jsc.gov.jo/

2 IFRS refers to all International Accounting Standards (IAS) and related interpretations issued by the former International Accounting Standards Committee (IASC), and the International Financial Reporting Standards (IFRS) and related interpretations issued by IASC’s successor body, International Accounting Standards Board (IASB)

3 The Jordan Securities Commission is the regulator of the capital market Its mission is reforming and developing legislation and regulations, emphasizing transparency and disclosure, revitalization Jordan’s investment culture, encouraging and protecting investors and most importantly enforcing the rule-of-law

4 See ASE website at: www.ase.com.jo

5 Rahman and Waly (2004) state "the term “practicing professional” needs to be better defined; the provision on auditor rotation gives rise to ambiguity about rotation of partners or firms; and it appears to be impractical to implement the provision on composition of the Board of High Council having ministers without the same right of proxy as members of the High Council Board While the Law focuses primarily and in great depth on JACPA regulations and by law 4, it overlooks important elements that could strengthen the auditing regulatory framework in Jordan, particularly auditors’ independence It does not include provisions specifically focusing on monitoring and enforcement mechanisms for ensuring compliance with the applicable auditing standards and code of ethics, not only in appearance but also in substance"

The effect of managerial ownership (insiders) on incentives to act in the interests of shareholders is inarticulate in the previous literature The traditional agency theory suggests that shareholdings held by managers help align their interests with those of shareholders (Jensen and Meckling, 1976) This incentive, alignment effect, is anticipated to have more impact as managerial ownership increases, suggesting that as managerial ownership increases, efficient earnings management may exist to improve earnings informativeness in communicating of value-relevant information (Siregar and Utama, 2008) Thus, under the convergence-of-interest hypothesis, insider ownership can be seen as a mechanism to constrain the opportunistic behavior of managers and, therefore, the discretionary accruals (a proxy of earnings management) is predicted to be negatively associated with insider ownership (Warfield et al., 1995)

In contrast, when there is narrow separation between owners and managers, managers face less pressure from financial markets to signal the firm value to the market and they pay less consideration

to the short-term financial report (Jensen, 1986; Klassen, 1997); therefore, highly managerial ownership are more likely to manipulate earnings, since this lack of market discipline may lead insiders to make accounting choices that reflect personal motives rather than firm economics (Sanchez-Ballesta and Garsa-Meca, 2007) In this context, Morck et al., (1988) argue as managerial ownership increases, the managerial labour market and the market for corporate control become less effective in aligning managers to take value maximizing decisions This is because high ownership by management implies sufficient voting power to guarantee future employment

Additionally, these managers have incentives to pursue self-interest non-value maximizing actions at the expense of shareholder wealth This managerial behavior is consistent with the entrenchment hypothesis which states that high levels of insider ownership can become ineffective in aligning insiders to take value-maximizing decisions Hence, this entrenchment effect potentially confounds the agency theory predictions As managerial ownership increases, earnings management may increase (see Yeo et al., 2007,) Warfield et al., (1995) indicate that this positive relationship is expected if either accounting-based constraints mitigate managers' accounting choices or higher ownership results from difficulties in accounting numbers measuring performance as reflected in increased accruals variability

The effect of institutional ownership on earnings management behavior has been examined before (e.g Velury and Jenkins, 2006; Balsam et al., 2002; and Siregar and Utama 2008) It is possible

to explain this effect based on an active monitoring hypothesis and passive hands-off hypothesis (see Koh, 2003) Under an active monitoring hypothesis (Bushee, 1998 and Majumdar and Nagarajan, 1997), institutional investors influence the monitoring mechanism a firm uses, including the monitoring of earnings management activity Academic researchers believed that institutional investors who have large magnitude of investments are more sophisticated investors They are, on average, better informed than individual investors due to their large-scale development and analysis of private pre-disclosure information about firms So, systematic differences exist in the amount and precision of private information in the hands of institutional and individual investors

The higher level of understanding of institutional investors also implies that with the increase in institutional investor shareholdings in a firm, the information asymmetry between shareholders and managers will decline thereby making it more difficult for managers to manipulate earnings Thus, earnings management and institutional ownership is supposed to be negatively correlated (Mitra, 2002) Under the passive hand hypothesis (Bhide, 1993 and Portter, 1992), the institutional investors are inherently short-term oriented Such investors are often referred to as myopic investors who focus mainly on current earnings rather than long-term earnings This orientation deters institutional investors from incurring monitoring costs and they will tend to concentrate on current earnings news Therefore, managers have incentives to manage earnings aggressively (Koh, 2003)

The monitoring by substantial external block-shareholders is similar to the effect of institutional ownership on earnings management (Yeo, 2007).Two competing views exist First, outside block-holders require a higher return from their investment and pose a bigger threat of intervention to the firm's management Thus, they might not be as inclined to encourage management to report high quality earnings (Velury and Jenkine, 2006 and Zhong et al., 2007) Second, outside block-holders,

with higher motivation and ability to monitor managers' actions than small shareholders, might reduce earnings management through their closer monitoring (Dechow et al., 1996)

4 Literature Review

Previous studies bring evidence that ownership structure influences the monitoring mechanism a company uses including the monitoring of earnings management activities Wang (2006) states that ownership structure has important effects on reported earnings However, the influence of insiders, institutional investors, and block-holders on the ability of managers to manipulate earnings remains a controversial issue

The literature discriminates between inside and outside holders (e.g Dempsey et al., 1993; and Warfield et al., 1995) Dempsey et al., (1993) distinguish between owner-managed firms, in which managers own substantial blocks of the firms' outstanding stocks, and external-controlled-firms, in which one or more external block-holders own a substantial block of the firm's stocks while the managers do not substantially own the firm's stocks The study suggests that large ownership by management is the underlying factor that reduces earnings management whereas the existence of external block-holders does not seem to significantly affect earnings management In addition, Warfield et al (1995) provide evidence that managerial ownership is negatively related to the magnitude of earnings management Warfield et al (1995) also find evidence that the inverse relationship between managerial ownership and absolute abnormal accruals becomes moderated in the case of regulated firms They suggest that regulation provides monitoring on managers’ choice of making accrual adjustment to manage earnings

Sanchez-Ballesta and Garsa-Meca (2007) examine the relationship between ownership structure and discretionary accruals for a sample of Spanish non-financial companies Their results support the hypothesis that insider ownership contributes to the constraining of earnings management when the proportion of shares held by insiders is not too high When insiders own a large percentage of shares, however, they are entrenched and the relation between insider ownership, discretionary accruals reverses Morck et al., (1988) argue that greater ownership would provide managers with deeper

entrenchment and, therefore, greater scope for opportunistic behavior Gabrielsen et al (2002) find a

positive but non-significant relation between managerial ownership and discretionary accruals in a sample of Danish firms, which they attribute to the different institutional settings between the US and Denmark

The manner in which earnings management is associated with institutional ownership is an empirical issue Extant literature posits two competing views on institutional investors One group of the literature such as El-Gazzar, 1998; Wahal and McConnell, 2000; Velury and Jenkins, 2006 among many others, provide evidence indicating institutions are playing an active role in monitoring and disciplining managerial discretion On the other hand, the second group of studies (e,g Porter 1992 and Bushee, 1998) alleges that frequent trading and fragmented ownership discourage institutions from becoming actively involved in the corporate governance of their portfolio firms (Grace et al., 2005)

Chung et al., (2002) find evidence supporting that the presence of large institutional shareholdings inhibit managers from increasing or decreasing reported profits towards the managers’ desired level or range of profits This evidence is consistent with institutional investors monitoring and constraining the self-serving behavior of corporate managers Koh (2003) examines the association between institutional ownership and income increasing discretionary accruals and finds a concave association where (a) a positive association is found at a lower institutional ownership region and (b) a negative association at a higher institutional ownership region In a more recent study, Koh (2007) extends the literature by classifying institutional investors into transient or long-term by their investment horizons to examine the association between institutional investor type and firms’ discretionary earnings management strategies in two mutually exclusive settings – firms that (do not) use accruals to meet/beat earnings targets The results support the view that long-term institutional investors constrain accruals management among firms that manage earnings to meet/beat earnings

benchmarks This suggests long-term institutional investors can mitigate aggressive earnings management among these firms Transient institutional ownership is not systematically associated with aggressive earnings management and is evident only among firms that manage earnings to meet/beat their earnings benchmarks

On the other hand, external block-holders are considered to be an important external mechanism to influence earnings management Jensen and Meckling (1976) is one of the earliest studies that suggest monitoring by block-holders can be a way to reduce agency costs Many subsequent studies have suggested that external block-holders could effectively monitor management

of firms (Koch 1981, Mikkelson and Ruback 1985, Shleifer and Vishny 1986, and Barclay and Holderness 1991) The higher incentive of outside block-holders in monitoring managers' actions potentially reduces earnings management by restricting managers' discretion with financial reporting and/or mitigating their incentive to manage earnings

Dechow et al (1996) suggest that outside block-holders are effective monitors of managers' earnings overstatements that violate GAAP Yeo et al (2003) show a strong positive relationship between external unrelated block-holdings and earnings informativeness However, McEachern (1975), Shleifer and Vishny (1986), Holderness and Sheehan (1988), and Barclay and Holderness (1991) among some others argue that outside block-holders may create extra pressure for their firms' managers

to engage in income-increasing earnings management Zhong et al., (2007) study the association between outside block-holder ownership and earnings management for NYSE firms Their results indicate that outside block-holder ownership is positively associated with discretionary accruals for firms that face declining pre-managed earnings Thus, the evidence, consistent with the second view, suggests that outside block-holders are not effective monitors of income-increasing earnings management that is generally within the bounds of GAAP

Although extant literature examined the determinants of earning management, the evidences are mixed, and what are the determinants of firms' earnings management remains an empirical issue Therefore, this study contributes to the literature by examining the effect of ownership structure on earnings management behavior in an emerging market This paper is examining an important issue among research topics in accounting and finance The importance behind examining the determinants

of earnings management is to minimize potential wrongdoing, conflict, and a sense of mystery in accounting information used by financial managers because, as argued by Lo (2007), highly managed earnings have low quality

5 Research Design

In this section we will develop the study hypotheses, describe the main models used in this paper, clarify the operational definition of the variables used, and explain the procedures of sample selection

5.1 Hypotheses and Research Models

The aim of this study is to test the association between ownership structure and earnings management and to examine if this association differs between small and large firms

The standard assumption is that each of the ownership categories has different objectives with implications for corporate strategy and performance (Edwards and Nibler 2000; Morck et al 2000;

Thomsen and Pedersen 2000) Therefore, each ownership category is expected to influence earnings

management differently

We examine whether each of the ownership structure categories (insiders, external block-holders, and institutional investors) is associated with earnings management after controlling for factors that are likely to impact earnings management such as size, the level of debt, firm growth, and profitability Our primary hypotheses (stated in null form) are as follows:

H 1: Earnings management is not associated with the level of insiders' ownership

H 2: Earnings management is not associated with the level of institutional ownership

H 3: Earnings management is not associated with the level of external block-holders'

ownership

We employ Models 1to 4 to examine the above mentioned hypotheses:

it it it

it it it

it it it

it it it

it it

Where, EMit is earnings management measured by discretionary accruals for firm i at time t,

INSIit is insiders (managerial) ownership variable, INSTit is institutional ownership variable for firm i

at time t, and EBHit is external block-holders' ownership variable for firm i time t, and Contit stands for

control variables and εit is the error term

Finally, we examine the interaction between the significant ownership category and size to

check whether the association between earnings management and ownership structure differs among

large and small firms The following hypothesis in its null form can be stated as follows:

H 4 : The association between earnings management and ownership structure does not differ

among firms of different size

The above formulated hypothesis is examined using the following model:

it it it

it it

it it

Where, OSit stands for one or more significant ownership categories for firm i at time t and

SIZE it is firm i size at time t

To examine the above mentioned tests, Ordinary Least Squares (OLS) estimation may be used

in this study However, Hsiao (1985) shows that in the presence of firm specific effects, OLS

coefficients are biased assuming that co-variances between the independent variables and the firm

specific variable and the disturbance termsε are nonzero If variables are endogenous, using OLS it

estimates may lead to inconsistency Therefore, we employ a dynamic panel, the Generalized Method

of Moment (GMM) estimator proposed by Arellano and Bond (1991)

Under GMM, the consistency of the estimator depends on the validity of the instruments and

the assumption that the difference error terms do not exhibit second order serial correlation To test

these assumptions, Arellano and Bond proposed a Sargan test of overidentifying restrictions, which

tested the overall validity of the instruments by analyzing the sample analog of the moment conditions

used in the estimation procedure (Liu and Hsu, 2006) Besides, they also tested the assumption of no

second-order serial correlation Failure to reject the null hypotheses of both tests gives support to our

estimation procedure6 All regressors are treated as strictly exogenous except the lagged dependent

variables Therefore, we conduct the analyses with lagged independent variables dated t−2 and earlier

together with the lagged changes of endogenous variables, and exogenous variables used as instrument

variables

5.2 Definition of Variables

5.2.1 Measuring Earnings Management

In this study, we use accounting accruals approach to measure earnings management Accruals

includes a wide range of earnings management techniques available to managers when preparing

financial statements, such as, inter alia, accounting policy choices, and accounting estimates (Grace et

al., 2005; and Fields et al., 2001)7

6 See also the discussion in Baltagi (2008)

7 As stated by Aljifiri (2007, p.77), “accounting accruals changes may be less costly when compared to accounting

methods changes as a mean to transferred earnings between periods and maybe more difficult to detect by auditors” The

two main components of accounting accruals (discretionary and non discretionary accruals) are not directly observed

Therefore, all studies have used an indirect estimation of discretionary accruals

In general, accounting accruals, which is the difference between earnings and cash flows from

operating activities, have been used in different terms in the previous literature While Healy (1995)

used total accruals to measure earnings management, subsequent studies attempt to separate them into

components, discretionary and non discretionary accruals Discretionary accruals are extensively used

to demonstrate that managers transfer their accounting earnings from one period to another In other

words, managers exercise their discretion over an opportunity set of accrual choices within GAAP, for

example, choosing the depreciation method of fixed assets (Healy, 1995) Additionally, total accruals

include non-discretionary accruals which reflect non-manipulated accounting accruals items because

they are out of managers’ control

Consistent with the previous literature on earnings management (Jones, 1991; and

Subramanyam, 1996), we used discretionary accruals to measure the extent of earnings management

Following recent literature (e.g Jaggi and Leung 2007), this study uses the cross sectional variation of

the modified Jones model (Jones, 1991; and Dechow et al., 1995) to obtain a proxy for discretionary

accruals Dechow et al., 1995; Guay et al., 1996 among some others argue that the modified Jones

model is the most powerful model for estimating discretionary accruals among the existing models

Furthermore, Bartove et al., (2000) indicate that the cross sectional model outperforms its time- series

counterpart in detecting accruals management

The dependent variable in our model, earnings management, is measured as discretionary

accruals using a cross-sectional version of the modified Jones model (Dechow et al 1995) as follows:

First, total accruals (TACC) is defined in this study as the difference between net income before

extraordinary items (NI) and cash flow from operating activities (OCF):-

OCF NI

Equation 2 below is estimated for each firm and fiscal year combination

it it it i it it it

i it t it

Where, TACC is the total accrual, ∆REV is the change in operating revenues, ∆REC is the

change in net receivables, PPE is gross property, plant and equipment, t and t-1 are time subscripts and

i is the firm subscript Changes in revenues is included to control for the economic circumstances of a

firm; whilst gross property, plant and equipment are included to control for the portion of total accruals

related to non-discretionary depreciation expenses (Jones, 1991) Dechow et al., (1995) modified the

Jones (1991) model by removing the discretionary components of revenues through changes in

accounts receivable Firms are considered to have engaged in income increasing (decreasing)

discretionary accruals if they have positive (negative) estimated discretionary accruals Earnings means

the reported earnings before interest and tax and before extraordinary items Earnings target is the prior

year earnings level (Degeorge et al., 1999) Non-discretionary earnings (NDE) are earnings less

discretionary accruals (DACC) To estimate the coefficient values, an Ordinary Least Squares (OLS)

regression with no intercept is employed

The Difference between total accruals and the non-discretionary components of accruals is

considered as discretionary accruals (DACC) as stated below8:

] / [ ˆ ] / ) [(

ˆ )]

/ 1 ( ˆ

All variables are scaled by prior year total assets At-1 to control for heteroscedastisity

8 Since any accrual effect is included in net income, it is therefore also included in discretionary accruals (if it was

'non-discretionary' then it cannot be outside GAAP) Therefore our working definition of DACC makes no distinction between

GAAP and non-GAAP accruals

5.2.2 Measuring Ownership Structure and Firm Size

Insider ownership (INSI), external block-holders ownership (EBH) and institutional ownership (INST) were collected from the annual reports of the sampled firms in the Amman Stock Exchange (ASE) data base9 INSI was defined as the percentage of shares held by officers or directors within the firm and their families (see Karathanssis and Drakos, 2004) EBH was measured as the percent of shares held by the individual block-holders10 For each party, we only consider the ownership percentage that represents 5% or more of firm's equity share capital INST was measured as the percent of shares held

by institutions, which includes shares owned through social security and other funds Consistent with Koh (2003), the following organizations are classified as institutional investors: insurance companies (life and non-life), pension funds, investment companies, and financial institutions including banks

Additionally, firms' accruals management decisions are likely to be influenced by firms' size The size hypothesis (Watts and Zimmerman, 1986) posits that large firms are more politically visible and are more likely to manage earnings to reduce their political visibility (Moses, 1987; Hsu and Koh 2005) However, Ashari et al., (1994, p 293) has an opposite view and argues that more information is available about larger firms, which are closely scrutinized by analysts and investors Smoothed income signals from larger firms add little value; accordingly, they have less incentive to smooth income (Atik, 2008) Thus, there is no specific prediction on the association between firm size and discretionary accruals This study uses the natural logarithm of total assets as a proxy for firm size (SIZE)

5.2.3 Measuring Other Variables

Given that firms' accruals management decisions are likely to be influenced by factors other than the three ownership categories (INSI, EBH, INST) or the size of the firm, several control variables are introduced to capture the incentives that have been found to influence managers' discretionary accounting choices The control variables included in this study are firm financial leverage (LEV), profitability (ROE), and growth (GROW)

Firm financial leverage, measured as the ratio of debt to assets, is included, as a proxy for risk, because managers are more likely to exercise their accounting discretion granted by GAAP when they are closer to default on debt covenants (Press and Weintrop, 1990) Trueman and Titman (1988, p 128) argue that managing earnings enables managers to reduce estimates of various claimants of the firm about the volatility of its earnings process and so lowers their assessment of the probability of bankruptcy Consequently, as discussed by Atik (2008), this provides an opportunity to borrow at lower interest rates and decreases cost of capital Consistent with this debt hypothesis, we expect that managers in more leveraged firms are more likely to adopt aggressive earnings management techniques

to prevent violation of debt covenants (Watts and Zeimmerman, 1986)

Since accruals could also relate to growth opportunity, this variable (Grow), measured as year-over-year sales changes is considered in our estimation This variable will be used as a control for demand conditions and product-cycle effects on profitability As argued by Chan et al (2001) and Lui (2004), firms with the highest growth opportunities usually have higher valuation ratio and higher growth because the market uses the dividend discount models to value the firm equity (Lee et al., 2005) Firms with the highest growth opportunities are likely to have more private information about these prospects, which would exacerbate the problems of asymmetric information Therefore, insiders try to reveal this relevant information through financial statements in which earnings have been managed to signal the profitable projects available to the firm (Healy and Palepu, 2003) Our prediction is, consistent with the before mentioned discussion, firms with higher growth rate have higher discretionary accruals

Finally, profitability, measured by return on equity, is included to control the relationship between earnings management and ownership structure Orlitzky et al (2003, p 408), argue that “

9 Government ownership has been excluded Because the Jordanian economy is private sector oriented, the state ownership

is relatively small

10 Individual external block-holders exclude managerial owners