Effects of Ownership Structure and Company Conditions on

Earnings Management

Cynthia Jane and Friska Firnanti

Trisakti School of Management, Kyai Tapa No. 20, 11440, Jakarta, Indonesia

Keywords: Earnings Management, Ownership, ROA, Leverage, Operating Cash Flow, and Growth.

Abstract: This research aims to obtain empirical evidences about effects of ownership structure, return on asset, size,

leverage, operating cash flow and sales growth on earnings management. The samples used in this research

was secondary data from annual report of non-financial company listed in Indonesia Stock Exchange from

2013-2015. The samples of this research are 285 data using purposive sampling method. The result of this

research shows that institutional ownership, return on asset, leverage, operating cash flow and sales growth

had effect on earnings management, while managerial ownership, board of director size and firm size had

no effect on earnings management.

1 INTRODUCTION

In globalization era and dynamic economic growth,

competition in business area becomes very real.

Each company is trying to be the best to win over

the competition and keep its survival (Scott, 2015).

Management tried to fill the desire of its

shareholders by showing the company’s

performance through the result of financial

statement (Bassiouny, 2016). However, the question

is if the result of financial statement can be reflected

as the real condition faced by the company. The

financial statement can be used for investor and

stakeholders to consider their investment in a

company. However, sometimes, investor and

stakeholders have no further consideration about the

truth behind its financial statement. Management is

the authorized part who published and made its

financial statement. It is possible for them to make

or arrange the financial statement based on their will

which give them the best result for themselves or

other advantages. This can be called as earnings

management practice (Yogi and Damayanthi, 2014).

Earnings management is an intentional act of

management in order to choose accounting policies

used in the firm for several reason or to make benefit

for themself (Fishcher dan Rosenzweirg, 1995).

Management always aims to keep the resources or

fund needed in the company to keep it working well

so external parties cannot intervene them. Several

cases in the world, such as Enron, Xerox, and World

Com, has witnessed that some of management

actions are intentional acts to manage the amount

that showed in financial report for some certain

benefit or another reason (Bassiouny, 2016).

Generally, investor will trust the financial report and

asses the company by the number that showed in

financial statement. So, the number that showed in

financial statement is really important. Both investor

and shareholder will seek management

responsibilities in the company (Ngamchom, 2014).

Earnings management is a signal and can be seen

as an opportunistic behaviour to achieve the targets.

Ownership structure and board of director are

important aspect in corporate governance to lessen

earnings management practice (Liu and Tsai, 2015).

There are different results in previous studies, where

managerial and institutional ownership theoretically

reduces earnings management (Alves, 2012; Alzoubi

and Selamat, 2012). But on the other hand,

managerial ownership and the board of directors are

the decision makers in the company. In addition,

institutional ownership usually has a great strength

in the company, so that it can encourage earnings

management (Al-Fayoumi et al., 2010; Cheng and

Warfield, 2005)

Jane, C. and Firnanti, F.

Effects of Ownership Structure and Company Conditions on Earnings Management.

DOI: 10.5220/0008488700930098

In Proceedings of the 7th International Conference on Entrepreneurship and Business Management (ICEBM Untar 2018), pages 93-98

ISBN: 978-989-758-363-6

2 LITERATURE REVIEW

2.1 Agency Theory

Agency Theory by Jensen and Meckling (1976) is a

theory that underlies current business practice. This

theory is about contractual relationship between

agent and principal. Where there are two parties that

have an interest towards each other called agent and

principal. Agent is the one who was given the job

and responsibilities from principal to do principal’s

job and act like principal for making some decisions

in the company. Agent should also meet principal’s

desires such as maximum principal wealth. Principal

is a person who owned the firm that run by Agent.

Agent also has a self- interest for its own self and

trying to do the work to gain some benefit for itself

besides principal’s benefit.

Earnings management activity is done by

management to fulfill principal’s will by presenting

a financial report according to principal expectations

(Bassiouny, 2016). Management can choose

methods that are used in financial statement which

expected to maintain fluctuation of company’s

income in current period as management will. If

company does not work as well as principal wants, ]

management will try to hide bad condition from

principal. It can be called asymmetry information

which is the condition which principal’s knowledge

is just as far as Agent’s reports to principal.

Principal will give some rewards to management

who has a good performance (Subramanyam, 2014).

Agent also can do earnings management activity for

attracting public and raising funds from the public.

Agents are required to meet principal’s desire and

caused earnings management activities (Scott,

2015).

This research focuses on accrual based earnings

management. This study aims to see whether

managerial ownership and institutional ownership

play an active role in helping company to suppress

earnings management.

2.2 Managerial Ownership and

Earnings Management

Managerial ownership is amount of shares that are

owned by company’s management, who does

operational activity in the company (Tarigan and

Yulius, 2007). Management that owned shares in a

company will have bigger the control of the

company. The management should be engaged to

the company so they will give the best contribution

to the company. When the company makes profit

and achieves its goals, it also gives advantages to

management (Aygun et al., 2014). Thus, managerial

ownership encourages management to make

earnings management. Based on the explanation

above, the following hypothesis will be tested:

H1: Managerial ownership has an effect on earnings

management.

2.3 Institutional Ownership and

Earnings Management

Institutional Ownership is a shared ownership that

owned by institution (Llukani, 2013). Institutional

ownership could give impact to management’s

activity if compared with shares that are owned by

individual (Bukit and Nasution, 2015). It has power

or tools to direct management’s activity and tends to

increase earnings management. Based on the

explanation above, the following hypothesis will be

tested:

H2: Institutional ownership has an effect on earnings

management.

2.4 Board of Director and Earnings

Management

Board of directors is people that have great impact in

a company and they can decide policies that have to

be implemented by a company (Ngamchom, 2015).

The quantity of board of directors can possibly

decrease activity of management earnings in a

company. The more board of director, the stricter the

control to management, so they can work better and

give reliable financial report (Aygun et al., 2014).

The larger the number of board of director can

increase knowledge and capability to prevent

earnings management. Based on the explanation

above, the following hypothesis will be tested:

H3: Board of director has an effect on earnings

management.

2.5 Return on Assets and Earnings

Management

Return on assets is the ability of asset to produce net

income. Company that has high return on assets is a

company that has good performance. It means that

the management has done their job well, so the

possibility of earnings management will be reduced.

If a manager has satisfied with the result of the

performance, they will create financial report with

the real data (Aygun et al., 2014). Based on the

explanation above, the following hypothesis will be

ICEBM Untar 2018 - International Conference on Entrepreneurship and Business Management (ICEBM) Untar

tested:

H4: Return on assets has an effect on earnings

management.

2.6 Firm Size and Earnings

Management

Firm Size can be seen from how many assets that a

company has. The larger the company, management

has responsibility to protect company’s name and

reputation. It will reduce earnings management

because it will affect the reputation that company

has built for years. A big company also has good

internal control. Thus, management has to be more

careful and it reduces earnings management

(Bassiouny, 2016). Based on the explanation above,

the following hypothesis will be tested:

H5: Firm size has an effect on earnings

management.

2.7 Leverage and Earnings

Management

Leverage is the ratio of total debt to total asset.

Higher leverage means higher debt. Company with

high leverage has credit covenant that must be

fulfilled so creditor can trust that the company will

pay off the debt (Gitman and Zutter, 2015). Higher

leverage will make strict control from creditor and it

means management will be harder to do earnings

management (Bassiouny, 2016). Based on the

explanation above, the following hypothesis will be

tested:

H6: Leverage has an effect on earnings

management.

2.8 Operating Cash Flow and Earnings

Management

Operating cash flow is a tool to measure the

operational activity of a company that shows

whether the company can produce cash flow to

maintain for operational activity and pays short-term

debt. The flow from operational cash flow can be

used as determinants of a profit quality of a

company because cash flow can be more permanent

than the accrual component (Subramanyam, 2014).

The ratio of high cash flow shows the quality level

of income. Management that has done operational

activity well, do not have to initiative to do earnings

management because the performance of

management has been acknowledged by the investor

(Yuliana and Trisnawati, 2015). Based on the

explanation above, the following hypothesis will be

tested:

H7: Operating cash flow has an effect on earnings

management.

2.9 Sales Growth and Earnings

Management

Sales growth is the increase of sales from previous

year to the current year. When there is an increase of

sales, it can be assumed that the company has a good

growth and a fulfilling development. High sales

growth makes management does not have to do

earnings management because they already

performed well (Gonzalez and Meca, 2014). Based

on the explanation above, the following hypothesis

will be tested:

H8: Sales growth has an effect on earnings

management.

3 METHODS

The populations used in this research are non-

financial companies listed in Indonesian Stock

Exchange (IDX). The samples of this study were

selected by purposive sampling method with several

criteria such as the company should be constantly

listed on IDX since 2013-2015, reports financial

statement using IDR as its currency, has December

31 as its closing period, and has managerial

ownership and institutional ownership. Samples

which meet the criteria above are 95 companies with

295 data.

Earnings management in this study is measured

by discretionary accruals (modified Jones model).

Discretionary accrual is the accrual component that

is chosen by management to report or the component

that management can intervene for financial

statement. Discretionary accrual is measured by the

following regression (Aygun et al., 2014):

TAt = NIt

–

CFO

(1)

TA = DA + NDA ; NDAt = β1j [1/At-1] +

β2j [ΔREVt- ΔARt/At-1] + β3j [PPEt/At-1]

(2)

TACt/At-1 = β1j [1/At-1] + β2j [(ΔREVt –

ΔARt)]/ A

-1 + β3

[PPEt/ A

-1] +ε

(3)

DAjt = TACjt/Ajt-1 – NDAjt (4)

Where:

TAt: Total Accrual in year t; NIt: Net Income in

year t ; CFOt: Cash flow from operating activities in

year t ; TA: Total accruals ; DA: Discretionary

Effects of Ownership Structure and Company Conditions on Earnings Management

Accruals NDA: Non – Discretionary Accruals ;

NDAt: Non-discretionary accruals in year t ; At-1:

Total asset in prior years ; ΔREVt: change in income

in year t ; ΔARt: change in receivable in year t;

PPEt: gross PPE in year t ; β1j, β2j, β3j: specific

parameter.

Managerial Ownership is percentage of share

that owned by management, measured by ratio scale

and calculated by percentage of share that is owned

by management (Aygun et al., 2014). Institutional

ownership is percentage of share that is owned by

institutional such as bank, insurance company,

investment company, and other institutional

companies. Institutional ownership measured by

ratio scale and calculated by percentage of shares

that owned by institutional shareholders (Aygun et

al., 2014).

Board of director is a person that has so many

impacts on the company, the one who has a part of

making decision and deciding other policies in the

company. Board of director measured by ratio scale

and calculated by number of board of directors in the

company (Aygun et al., 2014). Return on Asset is

the ratio which divided net income and total assets.

ROA is measured by ratio scale and calculated by

net income to total asset (Aygun et al., 2014).

Firm Size is the size of company which can be

seen from total asset, average of sales, and market

price of share in the company. Firm size in this study

measured by ratio scale and calculated by natural

logarithm of total asset (Aygun et al., 2014).

Leverage is an analysis of credit in company and

used to assess amount of debt to finance its asset in

order to do their operations beyond the resources of

capital and equity. Leverage measured by ratio scale

and calculated by total debt to total asset (Aygun et

al., 2014).

Operating Cash flow is measured by ratio scale

and calculated by cash flow from operating activities

to total asset (Yuliana dan Trisnawati, 2015). Sales

growth is an increasing of total sales in compare

with sales prior year. Growth is measured by ratio

scale and calculated by percentage change of sales

(Gonzalez and Meca, 2014).

4 RESEARCH RESULT

The result of the statistical test can be seen in

hypothesis result shown in table 1 below:

Table 1: Hypothesis Result.

Model

Sig.

(Constant) 0.318 0.751

Managerial Ownership 1.828 0.069

Institutional Ownership 2.748 0.006

Board of Directo

-1.223 0.222

ROA 31.098 0.000

Firm Size -0.479 0.633

Leverage -2.586 0.010

CFO -46.584 0.000

Sales Growth -3.110 0.002

Table 1 shows that managerial ownership has no

effect on earnings management activities. Shares

that owned by management are only a small fraction

of total shares outstanding so it has no effect on

management acts and decisions. The result of this

research is consistent with Yogi and Damayanthi

(2016), Susanto (2013), Destriana and Arifin (2016),

and Agustia (2013). Institutional ownership has an

effect on earnings management activities. Company

with a large number of shares that are owned by an

institution makes the institution can control the

existing activity in the company directly or

indirectly. The possibility of earnings management

activity for institutional purposes will be higher than

personal ownership. The result of this study is

consistent with Destriana and Arifin (2016).

Return on Asset has an effect on earnings

management activities. It means when the

performance of company is in poor or good

condition, management will intend to do

opportunistic activity, such as increasing or

decreasing company’s income according to real

condition that is faced by the company. The result of

this study is consistent with Usman and Yero (2012).

Leverage has an effect on earnings management

activities. It shows low leverage levels in a company

made the management tried to do some activities to

keep showing good circumstances to its shareholders

and stakeholders. The result of this study is

consistent with Yuliana and Trisnawati (2015), and

Kusumaningtyas (2012).

Cash flow from operation has an effect on

earnings management activities. When operating

cash flow increases, the income of the company will

decrease, thus cash inflow is getting smaller and it

encourages management intention to do earnings

management activities to show the good state of

company. The result of this research is consistent

with Christiani and Nugrahanti (2014), Yuliana and

Trisnawati (2015).

Sales Growth has an effect on earnings

management activities. Company with great number

of sales and growth of sales from year to year shows

good circumstances and improvements of the

company, so it suppressed management intention to

do earnings management. The result if this study is

consistent with Llukani (2013).

ICEBM Untar 2018 - International Conference on Entrepreneurship and Business Management (ICEBM) Untar

On the other hand, board size and firm size have

no effect on earnings management activities. It

shows that the number of board of directors has no

effect on the board’s optimal function to detect

earnings management and no matter how big or

small the company, management does not make it as

a consideration to do earnings management

activities.

5 CONCLUSIONS

The result of this research shows that institutional

ownership, return on asset, leverage, operating cash

flow, and sales growth have effect on earnings

management and on the other hand, managerial

ownership, board size, and firm size have no effect

on earnings management activities. Institutional

ownership as a shareholder who has a large portion

of the company can play a role in earnings

management practices. While managerial ownership

in non-financial companies in Indonesia has a

relatively small portion of shares, it does not have

the power as much as institutional ownership. This

research has some limitations. The research only

used samples three years period from 2013-2015,

and the samples were only non-financial companies

listed in IDX. Another research should add period of

the research of the samples, and compare conditions

in different countries. Further research may add

another variable such as audit quality.

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