Does Investor Protection Prevent Earnings Management Activity Through Real Activity Manipulation?
This paper examines systematic differences in earnings management through real activity manipulation across 6 Asia countries. Contrary with Leuz (2003) finding that earnings management through accrual manipulation is lower in economies with high investor protection than in low investor protection. We predict that in economies with high investor protection, manager prefer to manage earnings through real activity manipulation rather than through accrual manipulation. Because accrual manipulation is more likely to draw auditor or regulator scrutiny than real decisions about pricing and production. Our findings are consistent with our prediction.
Keyword: earnings management, real activity manipulation, investor protection
Legal systems protect investors by conferring on them rights to discipline insiders (e.g., to replace managers), as well as by enforcing contracts designed to limit insiders’ private control benefits (e.g., La Porta et al., 1998; Nenova, 2000; Claessens et al., 2002; Dyck and Zingales, 2002).2 As a result, legal systems that effectively protect outside investors reduce insiders’ need to conceal their activities. Investor protection as a key institutional factor affecting corporate policy choices (see Shleifer and Vishny, 1997; La Porta et al., 2000), we focus on investor protection as a significant determinant of earnings management activity. Leuz (2003) find: earnings management is more pervasive in countries where the legal protection of outside investors is weak, because in these countries insiders enjoy greater private control benefits and hence have stronger incentives to manipulate firm performance. Leuz measure earnings management with accrual manipulation, but beside manage earnings through accrual management, manager also can manage earnings through other method such as real activity manipulation and classification shifting. Accrual manipulation is more likely to draw auditor scrutiny than real decision. Thus, the purpose of this study is to investigate does investor protection reduce effectively earnings management through real activity manipulation.