CHAPTER I INTRODUCTION

Transcription

1 CHAPTER I INTRODUCTION 1.1 Background Earnings figure, notwithstanding its several definitions, has been widely considered as one of the most referred to figures in companies financial statements. Sadka (2007) asserted that shareholders put more emphasis on earnings than they do on free cash flows. Earnings are regarded as closely associated with firms profitability; and thus, representing their performances even better than cash flows do under certain circumstances (Dechow, 1994). Through their capacity to signify the firms future stream of cash flows (Barth, Cram, & Nelson, 2001; Dechow & Dichev, 2002), earnings are believed to provide a glimpse on companies underlying value and to a greater extent, to facilitate assessment of firms long-term performance and sustainability. Essentially, earnings act as a powerful means of relaying and signaling information on firms performances to the relevant stakeholders; they sum up the performance of the firm in one single figure (Dechow, 1994) earnings denote the bottom-line of firms. Earnings figure supports investors and creditors in determining their resource allocation decisions by facilitating firm valuation (Lev, 2003), risk and credit eligibility assessment, as well as ongoing performance measurement and monitoring (Dechow, 1994). It contributes to the maintenance of agency relationship through being a base figure for managers compensation plans and 1

2 2 debt covenants (Dechow, 1994; Lev, 2003). Lastly, earnings further serve a role in companies income tax determination as well as internal performance assessment and evaluation (Lev, 2003). Despite the existence of accounting standards that set forth how economic transactions should be accounted for and financial statements prepared, the nature of accounting principle always provides room for a certain degree of discretion, estimates, and judgment. This translates into room for errors and loopholes for earnings management that may result in financial figures not reflecting the fundamentals: the true economic state of a firm. As this is not an exception for the figures that compose earnings, the quality of earnings figure is susceptible to this risk as well. Fundamentally, earnings quality refers to the extent to which the earnings figure represents the true economic state of the firm which; as Dechow, Ge, & Schrand (2010) asserted; is unobservable. High quality of earnings is portrayed as encompassing informative messages that are instrumental to the decision making process of stakeholders (Dechow et al., 2010); and being of value relevance (Ewert & Wagenhover, 2010; Lev, 1989; Lev & Zarowin, 1999). Earnings quality has also been construed as the degree of earnings persistence or sustainability, with higher persistence suggesting higher earnings quality (Francis, LaFond, Olsson, & Schipper, 2004; Penman & Zhang, 2002). Closely related to this, Lipe (1990) and Penman and Zhang (2002) implicitly defined earnings quality as the predictive power that earnings hold over future earnings. Considering the presence of accrual component in earnings figure, earnings quality is also measured through quality of the accrual: represented mostly by

3 3 how well the accruals reflect and relate to lagged, current, and future cash flows (Dechow & Dichev, 2002); accrual persistence (Givoly, Hayn, & Katz, 2010; Sloan, 1996); total accrual (Richardson, Sloan, Soliman, & Tuna, 2001); as well as the level of discretionary or abnormal accrual (Dechow, Sloan, & Sweeney, 1995; Jones, 1991; Kaznik, 1999; Kothari, Leone, & Wasley, 2005). Moreover, high earnings quality is characterized by low pervasiveness of earnings management (Givoly et al., 2010). Arguably, earnings quality is also attributed by the timely recognition of loss and conservatism (Ball & Shivakumar, 2005, 2008; Setiabudi, 2011). Using external measures, earnings restatement and regulatory enforcement related to the presentation of financial figures are other potential indicators of firms earnings quality (Bradshaw, Richardson, & Sloan, 2001; Dechow, Sloan, & Sweeney, 1996; DeFond, 2010; Livnat & Tan, 2004). Considering the significance of earnings, in which it affects the decision making processes of numerous parties, earnings quality consequently holds even more influential substance. Low quality earnings, which fail to capture the true economic state of the firm, risk misleading stakeholders in their decision making, especially concerning their resource allocations. Accordingly, this will result in sub-optimal resource allocation decisions. The effect could potentially extend to disruption in the stability, or worse: diminishing public confidence, of financial market in general and capital market in particular for public firms. Even worse, low earnings quality could lead to the loss of trust in financial reporting. The quality of earnings of a firm is driven by a lot of different forces and mechanisms that characterize, surround, and affect that firm. The same applies

4 4 to both private and public firms. Considering the different characteristics of these firms, complemented with generally distinctive market and regulatory environment in which each of them operates; one would expect to observe different earnings quality in private and public firms. Surrounding both private and public firms, there are idiosyncratic incentives and controls that would result in either higher or lower earnings quality relative to each other. Public firms have their own motivations to produce lower quality earnings such as to inflate their stock prices (Fan, 2007; Teoh, Wong, & Rao, 1998); stronger need to meet various earnings targets (Burgstahler & Dichev, 1997; Degeorge, Patel, & Zeckhauser, 1999; Hamdi & Zarai, 2012; Kaznik, 1999; Schøler, 2005); to maximize managers stock-based compensation value (Bergstresser & Philippon, 2006; Cheng & Warfield, 2005; Ronen, Tzur, & Yaari, 2006); and less direct monitoring or involvement of shareholders as they also have their own incentives to deliver higher quality earnings figures: stronger demand for high earnings quality from capital market participants (Ball & Shivakumar, 2005), more extensive public scrutiny and external monitoring, higher litigation risk (Givoly et al., 2010), more extensive regulation, and cost of capital consideration (Bhattacharya, Daouk, & Welker, 2003; Francis et al., 2004). Likewise, private firms reside in circumstances that are affected by forces resulting in motivation to produce higher quality earnings such as less exposure to capital market forces (motivation to increase stock prices, surpass analysts earnings projection, or reap benefits from stock-based bonus plan) and shareholders direct involvement and supervision and motivation to generate lower quality earnings; such as to reduce taxes, increase managers earningsbased bonuses (Guidry, Leone, & Rock, 1999), to avoid violation of debt

5 5 covenants (DeFond, 1994; Jaggi & Lee, 2002; Jha, 2013), or due to lower public scrutiny, less extensive regulation, and less exposure to legal action risk (Givoly et al., 2010). Considering the above interacting forces, current literatures on the earnings quality of private and public firms have been generating mixed results. Burgstahler, Hail, and Leuz (2006) as well as Ball and Shivakumar (2005), despite focusing on different facets of earnings quality, are amongst the studies that conclude that earnings figures reported by private companies are of lower quality compared to the ones reported by public firms. Conversely; Givoly et al. (2010) suggested that earnings quality of public firms is lower than that of private firms. Still, Sundgren (2007) focusing on earnings management level as one aspect of earnings quality purported that no significant difference exists between the earnings quality of private firms and public firms in Finland. Arnedo, Lizarraga, and Sanchez (2007) further found that there is no significant difference in earnings smoothing and income increasing activities indication of earnings management, thus lower quality of earnings of private and public firms, but signified that income decreasing activities are more prevalent in private firms. Due to these conflicting and inconclusive findings across different studies, debate continues on whether public firms exhibit higher quality of earnings compared to private firms, or the other way around. Further to note in this matter is that the above researches do not specifically focus on the changes in earnings quality of firms that transition from private to public firms, because they basically studied one set of private firms and another set of public firms at the same point of time. The private firms and public firms

6 6 observed are essentially two different sets of entities. Correspondingly, the above researches do not study the earnings quality around Initial Public Offerings (IPOs). Earnings quality around IPOs is an interesting issue, because when private firms go public, the earnings quality drivers associated with private firms will change and shift to the drivers that belong to public firms. Motivations to produce high quality earnings in the private firms change to the one of public firms. The same applies to incentives for generating low quality earnings. Briefly, their motivation behind the reporting of earnings as well as the circumstances and controls that affect their earnings quality change, and that will influence their earnings quality. When private firms go through the initial public offerings process and become public, especially in Indonesian context, they have to comply with the whole additional regulations and requirements imposed on public firms by the authority, such as the Capital Market and Financial Institutions Supervisory Agency (Badan Pengawas Pasar Modal dan Lembaga Keuangan/BAPEPAM- LK). Among these regulations are the ones that would directly and indirectly affect the earnings quality of the firms. Once the firms become public, they are required to enhance the transparency of their financials; not only by submitting their financial statements to the Capital Market and Financial Institutions Supervisory Agency; but also to investors, financial analysts, and to public in general. This is consistent with and is in fact enhanced by the notion of political costs, which suggests that larger firms generally garner more attention and public scrutiny than smaller ones (Deegan,

7 7 2009, p. 295). These tighter regulations and increased public attention were not there at least not with the same intensity when the firms were still private. Ball and Shivakumar (2008) delivered an insightful approach to understanding the effect that going public has on firms earnings quality. Analyzing the financial statements of private firms and the restated financial statements of the same firms for the same year as published in their prospectuses when they are going public, Ball and Shivakumar (2008) controlled for different firms characteristics and examined in isolation whether the changed market and regulatory environment once firms conduct their IPOs affect the quality of their reported earnings. To the best of the author s knowledge, in Indonesia itself, studies on earnings quality are relatively limited. Even more limited are the studies on differences in earnings quality of Indonesian private and public firms; let alone studies on the changes of earnings quality of firms that transform their status from private to public. Some of the Indonesian earnings quality studies investigate the determinants of earnings quality. Hermawan and Adinda (2012), studying the relationship between corporate governance and earnings quality in Indonesian state-owned enterprises, represents one of those studies. The same applies to Murhadi (2009), who examined how good corporate governance practices affect earnings management behavior in Indonesian public firms. Sanjaya (2011) contributed to this body of literature by investigating the causal relationship between control rights or cash flow rights of ultimate shareholders and the incidence of earnings management in Indonesian public companies. Nonetheless, the focus of the

8 8 abovementioned studies is limited to state-owned enterprises or to public companies; and on how the corporate governance, such as board composition, or shareholding characteristics affect the quality of earnings, which is mostly in the context of earnings management. Those studies did not discuss on the different attributes of earnings quality of Indonesian private and public firms; or how the characteristics of these attributes change when a firm undergoes transition from private to public. Most of other Indonesian studies still focus on earnings management as one dimension of earnings quality. Siregar and Utama (2008) highlighted that there exist earnings management practices among Indonesian publicly listed firms, although the motivation is efficient. Notwithstanding the efficiency earnings management, the result of this study pinpointed that there is something about the earnings quality of Indonesian firms. It is further noteworthy that Siregar and Utama (2008) only studied the publicly listed firms in Indonesia; their study did not extend to private firms; or to firms transitioning from private to public in their status firms around their Initial Public Offerings (IPOs). Concerning earnings quality of firms around IPOs; Warganegara and Indriastari (2009), utilizing abnormal accruals as a proxy for earnings management, shortened the gap and arrived at a conclusion that no earnings management activity is apparent in Indonesian firms one year before their IPOs. Complementing this research, Setiabudi (2011) studied earnings quality of Indonesian firms one year before and after their IPOs; finding the absence of conservatism in firms reporting before IPOs and reported an even decreasing

9 9 conservatism degree after IPOs. However, her study focused only on the conservatism aspect, and did not extend to other features of earnings quality. Once again, the motivation and results of both of these researches signify that there is something on the quality of earnings of Indonesian firms transitioning from private to public that is worth further analysis. Considering the leads laid by previous researches, this study aims to investigate this matter further by examining the changes in earnings quality of Indonesian firms before and after their Initial Public Offerings (IPO). Weighing on the importance of earnings and their quality, and the effects that going public and its corresponding legal requirements potentially impose on public firms earnings quality; this study attempts to corroborate the above evidences and fill in the gap in Indonesian literature by answering the following research question: Does earnings quality of Indonesian firms improve subsequent to their Initial Public Offerings (IPOs)? 1.2 Scope This research focuses on three facets of earnings quality: accrual quality, earnings persistence, and earnings predictability. The sample would include all firms in Indonesia that conducted their stock IPOs within the observation period of this paper: year 2009 to year 2011; and are listed in Indonesia Stock Exchange (IDX) accordingly excluding firms from finance industry as well as property, real estate, and building construction industry. 1.3 Research Objectives The objective of this research is to examine the changes in earnings quality of Indonesian firms that transition from private companies to public companies. In

10 10 particular, this research aims to determine whether the earnings quality of Indonesian firms improves after they become public (subsequent to the IPOs). 1.4 Research Benefits The author believes that this research delivers benefits at least to the following parties Indonesian Authority Body and Capital Market Participants This study will answer the research question of whether earnings quality of Indonesian firms actually improves subsequent to their IPOs. As such, the results of this study could be utilized by relevant authority bodies such as the Capital Market and Financial Institutions Supervisory Agency (Badan Pengawas Pasar Modal dan Lembaga Keuangan/BAPEPAM-LK), or Financial Services Authority (Otoritas Jasa Keuangan/OJK) now to assess the sufficiency and quality of existing measures implemented to mitigate companies incentives to produce lower quality earnings. This study accordingly facilitates the authority bodies to perform appropriate improvements on the regulatory controls to ensure the quality of financial reporting of not only public companies, but also private companies in Indonesia. The following discussion will briefly discuss why it is important for the authority bodies to conduct the aforementioned improvements on firms earnings quality, and what the benefits to capital market participants are. Defond, Hung, and Trezevant (2007) suggested that the information content of earnings increases along with the increase in earnings quality. Boulton, Smart, and Zutter (2011) further noted that the degree and

11 11 intensity of information asymmetry are affected by earnings quality. Considering these factors, further effects of improvements conducted by the authority bodies in enhancing earnings quality are expected to result in increased value relevance of earnings as well as reduced information asymmetry among various stakeholders. This would lead to a better functioning financial market for private firms and capital market for public firms. Expectantly, this will improve the stock trading and investing mechanism to reach more representative market equilibrium. Related to the information asymmetry, Francis et al. (2004) as well as Bhattacharya et al. (2003) found that lower earnings quality results in higher cost of capital. Bhattacharya et al. (2003) also suggests that lower earnings quality gives rise to declining stock trading. Realizing the need to and understanding which aspects of earnings quality to improve accordingly contribute to the stabilization of investors required return and enhancement of trading activity conduciveness. Thus, the resulting expectantly higher quality of earnings will benefit capital market participants, other stakeholders, as well as the companies themselves by providing better investor protection, reduced information asymmetry, increased value relevance of earnings, required rate of return stabilization, and better functioning financial and capital market Financial Statement Users Along the analysis and results discussion, this study will provide insights on several aspects of the quality of reported earnings of Indonesian firms during their private as well as public status. This will help caution

12 12 the financial statement users to be more vigilant in referring to and utilizing firms reported earnings for decision making Academicians and Researchers This research contributes to the earnings quality body of literature, particularly in Indonesian context, where limited studies exist on this research area; and when they do, they mostly focus on earnings management. By analyzing different facets of earnings quality accrual quality, earnings persistence, and earnings predictability and through highlighting how these attributes change over the transition of firms from private to public, this research intends to fill in the current gap in Indonesia literature and shed some light on a different perspective of viewing earnings quality. This research is also expected to lay the foundation for further potential researches that will explore this research area deeper in the future. 1.5 Research Methodology This study takes the form of an empirical research. According to the classification suggested by Saunders, Lewis, and Thornhill (2009, p ), the purpose of this study is explanatory as it attempts to explain the causal relationship between going public and firms earnings quality. Responding to this purpose, this study employs a deductive approach it shifts from the theoretical conception on how going public affects earnings quality to the data, which will be utilized to test the formulated hypotheses; and is consistent with its explanatory purpose, which is deductive in nature. This study represents a longitudinal study, considering its need to reconnoiter the change of firms earnings quality over time: before and after they become public. The sampling

13 13 technique utilized in this study is purposive sampling method, in which all Indonesian companies conducting IPOs within the observation period; excluding those from finance industry and property, real estate, and building construction industry; are included in the sample and analyzed accordingly. Further into the methodology, this study resorts to the documentary secondary data collection method and quantitative data analysis technique. Detailed discussion on the research methodology will be revisited in Chapter Thesis Structure The structure of this study is arranged as follows. CHAPTER 1: INTRODUCTION The first chapter of this study sets forth the context of underlying problems that trigger and motivate the conduct of the research. The core of this study is developed based on this foundation. Chapter 1 also briefly highlights the scope, objective, benefits, methodology, and structure of the research CHAPTER 2: THEORETICAL FOUNDATION This chapter presents the platform for understanding the current state of literature development in earnings quality field, particularly in relation to private and public companies, by discussing various contributing studies and literatures in this area. This chapter also establishes the theoretical framework that develops the logical reasoning for conceptual hypotheses formulation. CHAPTER 3: RESEARCH METHODOLOGY Chapter 3 of this research explains the design and methodology of the research; including the research purpose, research approach and strategy, research choice, sampling technique, data collection method, and data analysis technique employed.

14 14 CHAPTER 4: FINDINGS AND DISCUSSIONS This chapter elaborates the findings obtained during the research, particularly through the data analysis. Findings are analyzed and the results are utilized to justify whether to accept or reject the hypotheses. CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS This chapter concludes the research by providing answers to the initially developed research question. Limitations of research, along with its implications and recommended avenue for future researches, are also discussed in this chapter.