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THE EFFECT OF ACCOUNTING DISCRETION ON FIRM
PERFORMANCE IN NIGERIA
TABLE
OF CONTENTS
Cover page i
Title page ii
Declaration iii
Certification iv
Acknowledgment v
Table of Contents vi
Abstract vii
List of Tables viii
CHAPTER
ONE: INTRODUCTION
1.1 overview
of the study 1
1.1.1 the case of Cadbury Nigeria PLC 3
1.2 statement
of the problem 5
1.2.1 systemic weaknesses 5
1.2.2 concealment 7
1.3 purpose
of the study 9
1.4 research
questions 9
1.5 hypotheses 10
1.6 significance
of the study 11
1.7 scope
of the study 12
1.8
definition of terms 13
CHAPTER
TWO: REVIEW OF RELATED LITERATURE
2.1 Introduction 13
2.2 accounting
discretion 14
2.3 corporate
governance in Africa 16
2.3.1 corruption 17
2.3.2 state owned enterprise 18
2.3.3 valuation of state assets for privatization 19
2.3.4 public governance 21
2.3.5 internal drives of good governance 23
2.3.6 internal control and financial audit 26
2.3.7 external
drivers of good governance 27
2.4 conceptualization
of variables 28
2.5 contributions
to literature 30
CHAPTER
THREE: RESEARCH METHODOLOGY
3.1 Introduction 34
3.2 research
design 34
3.3 description
of population 34
3.4 sampling
procedure and sample size determination 35
3.5 data
collection method 36
3.6. operational
measurement of variables 36
3.6.1
accounting discretion 37
3.6.2 smoothing measure 37
3..6.1.3 incidence of small positive earnings
surprises 37
3.6.1.4 Index of accounting discretion 38
3.6.2 economic determinants 38
3.6.2.1 leverage 38
3.6.2.2 growth opportunities 38
3.6.2.3 stakeholder claims 39
3.6.2.4 access to capital markets 39
3.6.2.5 size, risk and performance 39
3.6.2.6 industry and time dummies 40
3.6.3 governance proxies 40
3.6.3.1 shareholder rights 41
3.6.3.2 board monitoring 42
3.6.3.3 managerial ownership 43
3.6.3.4 big auditor 44
3.6.4 relationship between variables 44
3.7 data
analysis and technique 44
CHAPTER FOUR: DATA ANALYSIS PRESENTATION AND
DISCUSSION
4.1 Introduction 45
4.2 descriptive
statistics on governance variables 45
4.3 first
stage results 45
4.4 second
stage results 46
4.5 discussion 46
CHAPTER
FIVE: CONCLUSION AND RECOMMENDATIONS
5.1 Introduction 49
5.2 summary
of findings 49
5.3 conclusion 50
5.4 recommendations 51
Bibliography
Appendices
LIST
OF TABLES
Table
1: descriptive data on firm
characteristic economic determination and governance variables 56
Table
2: spearman correlation of accounting
discretion variables with economic determinant and governance variables. 57
Table
3: estimation of determinants of
accounting discretion 58
Table
4: association between predicted excess
accounting discretion and future operating each flows 59
Table
5: association between predicted excess
accounting discretion and future abnormal returns 60
Table
6: spearman correlation among economic
determinants and governance variables 61
ABSTRACT
The study examines the relationship between
accounting discretion and firm performance. The researcher gave the background
to the study and the relevance of the study to the current trends, in the
Nigeria Stock Exchange. Related literature was reviewed, pointing out earlier
studies and researches relevant to the present study. Data were obtained from
18 companies listed in the Nigeria Stock Exchange and analyzed using the
spearman rank order correlation coefficient. Prior research documents an
association between accounting discretion and firm performance and concludes
that such evidence is consistent with abuse of latitude in accounting rules. We
argue that this interpretation may be premature because, if such association is
indeed evidence of opportunism, we ought to observe loss of shareholder wealth.
Although the findings from the analysis of data show some relationship between
poor governance quality and accounting discretion, it could not be attributed
to loss in shareholders wealth. The research has come up with the conclusion
that managers do not abuse accounting discretion at the expense of the
performance of the firm. We however recommend some amendment to the Companies
and Allied Matters Act, Cap C20, laws of the federation of Nigeria 2004 to
strengthen governance structures.
CHAPTER ONE
INTRODUCTION
1.1 OVERVIEW OF THE STUDY
The
recent demises of worlCom, Enron, Tyco and Global Crossing have led investors
to ask, “How much confidence should we place on companies’ financial
statements? Prior to the recent spate of embarrassments, United States
Generally Accepted Accounting Principles (“GAAP”) was viewed as the gold
standard to which multinational corporate must conform in order to take the
greatest advantage of the efficiencies of international financial markets. Now
in light of Enoron, WorldCom and other embarrassment, the effectiveness of U.S.
GAAP and international business ethics in general are all being questioned,
with the consequent adverse effects on the price of issues on public exchanges.
In
1998 the New York Stock Exchange and the NASDAQ convened a Blue Ribbon
committee (the “BRC’) to undertake a study of corporate governance, with
particular emphasis on improving the effectiveness of corporate audit
committees. The BRC released its extensive report in February 1999. More
recently, following a number of dramatic failures, including Enron, and apparently
responding to various US congressional initiatives that will have the effect of
impinging upon the independence that public companies have traditionally
enjoyed, the New York Stock Exchange proposal on June6, 2002 detailed stricter
standards for its listing members. These standards adopted the recommendations
of BRC and expanded them in certain important respects. Clearly the efforts of
the BRC and the recent proposals of the New York Stock Exchange are moves in
the right direction.
What
neither proposal analyses in methodology detail however, are the causes of
these dramatic business failures.
Such
analysis is naturally impossible to predict whether the problem has been
properly addressed. Indeed, for example, if GAAP accounting is too antiquated for
the current stress and functionalities of modern business, putting more
responsibility on audit committee and tightening rule of corporate governance
will do little to address that fundamental problem.
Similarly,
because CEOs in huge companies cannot possibly be aware of all their firm
financial transaction, it is not realistic to endeavor to solve the problems
simply by requiring the CEO to certify that the financial are, in fact,
accurate. From historical standpoint, corporate governance emerged as a result
of the so called agency problem in which manages tend to be opportunities by
acting in their own selfish interest instead of shareholders and other
stakeholders due to information asymmetry.
Shareholders
who are normally dispersed cannot practically influence to boards of directors.
However, the monitoring cost and control is overwhelming hence the process is
highly ineffective. The period spanning from late 2001 to 2003 was
characterized by unbelievable mind boggling accounting and financial scandals
in the US and Europe. In response to these scandals the US enacted and passed
the Sarbanes Oxley Act of 2002 to help corporate governance by increasing the
monitoring and internal controls. The act was followed by the security and
Exchange Commission’s new regulations binding on all listed companies. The
European commission also followed by devising strategies to curb scandals.
1.1.1 THE CASE OF CADBURY NIGERIA PLC
The
SEC in June 2006 received a copy of Cadbury’s annual reports and accounts for
2005 which after review replied via a letter in September 2006 expressing
concern on issues bordering on declining profitability, worsening leverage
ratio, deteriorating cash flow, inadequate disclosure, non-compliance with
corporate governance code and obtaining loans for the payment of dividends of
shareholder contrary to SEC regulations. Thereafter the Chairman of Cadbury
Nigeria Plc, Rt. Hon. Uduimo Itsueli through a ltter to the SEC dated November
16, 2006 reported the engagement of an independent firm Price Waterhouse
Cooperate (PWC) to investigate the allegation of overstatement in the company’s
financial statements for the period 2003 to 30th September, 2006.
Subsequently,
the SEC constituted an in house committee which carried out a thorough
investigation on the matter and confirmed the report of a misstatement in the
account of Cadbury Nigeria Plc to the tune of N13 billion. Consequently, the
directors, some management staff of the company, its external auditor, Akintola
Williams Delloite (AWD) and the Registrars, Union Registrar Limited, were
invited before the Administrative Proceeding Committee (APC) of the commission
to explain why sanctions should not be imposed on them for violating the
provisions of the investments and securities Act 1999, the SEC rules and
regulations 2000 (as amended), Code of conduct for capital market operators and
their employees and the code of corporate governance in Nigeria.
Findings
revealed that Bunmi Oni, Chief Executive Officer, Ayo Akadiri, Chief Finance
Director, Olusegun Aina, Senior accountant/Head of accounts: Akinbode Gbolahan
sales operations and development controller and Tunde Egbeyemi, head of
internal audit, motivated by what they called “profit management desire/action”
were the masterminds of the financial malpractice perpetrated through the
falsification of sales figures, over statement of profits/assets and false
suppliers certificate to manipulate its financial records/ report.
They
also maintained and operate undocumented and undisclosed offshore account for
the company from which executive directors were paid offshore remunerations to
cushion the devaluation of their pay by soaring inflation without the approval
of the committee responsible for fixing remunerations of executive directors
and this was not recorded in the company’s financial report and account. Tunde
Egbeyemi, Cadbury’s head of internal audit, Thomas A.Ayorinde, Z.C. Enuwa, S.J.
Balogun (audit committee members) and Akinotla Williams Deloitte (AWD) were
also indicted for failing to discharge their statutory responsibilities as
specified section 359(4) and (6) of the Companies and Allied Matters Act
(CAMA).
1.2 STATEMENT OF THE PROBLEM
Lev
(2003:27) points to the widening gap between book income and tax income and the
large number of earning restatements in recent years and suggest that there are
systemic weaknesses in corporate governance systems that generate financial
information of public companies. It was the purpose of this study to
determine if a relationship exists
between accounting discretion and firm performance.
1.2.1 SYSTEMIC WEAKNESSES
Boards
of directors under the Anglo American model of corporate governance have two
primary functions which from any initial analysis, appear to be at odds with
each other. First, the board is the ultimate head of all executive decisions of
a corporate. Second, the board had ultimate responsibility for supervising
proper governance of the corporation and assuring the accountability of the
executive officers that the board has appointed to manage the day-to day
operations of the entity assets.
In
spite of such an inherent conflict, this structure works fine when a
corporation is owner operated and even when there is a small group of
investors, venture capitalists, and the like how closely monitor and are a part
of the day to day decisions of the entity. Once there is a separation of
ownership from control, however, executive no longer have the same financial
incentives, as would an operator who is also an owner to increase the future
value of the firm. (Klein 2002:380).
Historically,
this problem, as well as the inconsistency of the two obligations of the board,
this system of accountability through detailed had basic flaws which are
obvious. There is little incentive for the average shareholder effectively to
monitor the activities of any large, public corporation.
Not
only is it extremely expensive for shareholders to launch initiatives (as shown
by the exorbitant costs of hostile takeover bids and the like) but the economic
benefits inuring to such a shareholder from such monitoring function can,
because of such shareholders, relatively small percentage ownership of the
overall corporation, only marginally benefit that shareholder. Additionally,
this analysis may begin to give one the sense that the accountability of the
executive to the board is different in kind and scope than the accountability
obligations of the board to the shareholders. The general law of fiduciary duty
provides that when a corporation is insolvent, officers and directors are
required to act in the best interest of creditors, rather than of shareholders.
Finally, the goal of “shareholder” welfare is not by itself equivalent to the
concept of share price maximization.
Markets
systematically under value certain long term expenditures, particularly
expenditure that may fall into the categories of capital investment or research
and development spending. This excessive short-focus yield a form of market
myopia that may encourage, therefore, management to view its obligations to
increase the share price rather than deal with a more elusory concept of
“shareholder value”. This tendency of course if enhanced when managements own
contrasts provide bonuses based upon increases in the per share price.
1.2.2.
CONCEALMENT
There
has been a great deal written about the basic form of incentive contracts and
undoubtedly, the common type of executive contract for large, publicity traded
companies is one which provides quite significant rewards to the executive for
his reaching certain levels of earning or stock price growth. The obvious
purpose of such a contract is to endeavor to align the interest of the managers
more closely with that of shareholders. (Healy 1985:86). The basic problem
here, of course, is that because ‘value” is a complex concept, it is usually
defined in incentive contract as revenue growth, earnings per share, or share
price and the calculation of any of these three factors generally fail to
incorporate value that only is realized over time.
In
the case of share price, the most common benchmark is commonly proportional to
the price to earnings ratio of the corporations share as traded. Therefore, an
increase in earnings will yield an increase in price, if but only if, the price
to earnings ratio outset of the executive’s contracts is at least the same as
at the end of the measurement period.
Note
however, that as earnings, and therefore prices, rise there is often a
ratcheting effect which results in the application of an even higher price to
earnings ratio; thereby similarly ratcheting the bonus to which the executive
is likely to become entitled. Finally, the heavy use of stock options as
incentives skews management judgment critical heavily towards risk taking,
inasmuch as options have on downside to failure but an unlimited potential
upside. In sum what starts out as an innocent skewing of revenue leads to
realizing income sooner or deferring expenses later. (Core et al 1999:372).
Executive’s
contracts are invariably measured at least on an annual basis, over the prior
annual period, if not on a quarterly basis. The purpose of this is, of course,
to keep the “pressure” on the executive to perform. As discussed earlier,
because of general market myopia, long term with strategies, capital investment
of research and development (R&D) programs are discounted by the market,
not only because of the immediately, present value of the expenditure compared
to the distant future value of the expected return, but because the future
value must be discounted further by risk factors, change in the economic
environment, other discoveries rendering the activity obsolete in the interim,
and the like. Thus, if an executive truly believes that such expenditure is
necessary, he can defer the expenditure, re characterize the expenditure as a
capital investment, suffer lower earnings or accelerate recognizing of income.
(Demski
1998:264) Deferral is itself a misrepresentation. If indeed management does
believe that a replacement, expansion, change or development is necessary, a
failure to do so therefore is a disservice to equity. It constitutes a
misrepresentation inasmuch as the shareholders do not have the knowledge that
the executive do and may be thinking that all is well while matters may
invisibly be deterioration. On the other hand, the executive may undertake the
expense but endeavor to effect re characteristic of one sort or another in
order to conceal it. This then may preserve his ability to receive the desired
incentive bonus without revealing the truth of concealment.
1.3 PURPOSE OF THE STUDY
The
objective of this study is to ascertain if
1. Poor
corporate governance structures enhance abuses of accounting discretion.
2. Such
abuse of accounting discretion leads to loss in shareholders wealth.
3. The
use of accounting discretion is with the intent of accumulating wealth for the
managers.
4. The
use of accounting discretion is with the intent of increasing the firm
performance.
1.4 RESEARCH QUESTIONS
1. Is
there an association between poor governance and abuse of accounting
discretion?
2. Can
there be a loss in shareholder wealth as a result of the abuse of accounting
discretion?
3. Is the
abuse of accounting discretion done by manages with the intent to accumulate
wealth?
1.5 HYPOTHESES
H01:
There is no relationship between corporate governance and accounting
discretion.
H02:
There is no relationship between accounting discretion and firm performance
1.6 SIGNIFICANCE OF THE STUDY
The
importance of this topic is obvious from the considering growth in the
empirical literature on corporate governance accounting economics, finance,
management and corporate strategy literatures. Typical research studies examine
whether different governance structures impact or constrain executive behavior.
It is difficult to conceive of a situation where corporate governance is not
relevant for understanding managerial behaviour that exists between the
regulatory authorities, corporate managers and shareholders. There is a general
perception that regulatory authorities in Nigeria are not doing enough but
there has not been any scientific basis for such as conclusion. Findings of
this study will generate enough information to proffer suggestions to strengthen
the regulatory authorities thereby making it more difficult for opportunities
abuse accounting discretion. Going by everyday news the average shareholder is
tempted to believe that majority of managers are only out to make they more
comfortable without the required financial musele but again that may be
unfounded.
The
quality of governance is of absolute importance to shareholders as it provides
them with a level of assurance that the business of the company is being
conducted in a manner that adds shareholder value and safeguards its assets.
Shareholders will be better informed about the accountability of their
management and the role of the checks and balances instituted by the regulatory
authorities. Such knowledge could spur the shareholders confidence in the
system and then motivate management to act responsibly at all times.
1.7 SCOPE OF THE STUDY
This
research project like many empirical studies that rely on survey data, may not
represent all aspect of accounting discretion practices. The sample of firms
studied was not randomly selected. Even though the lists used comprised
publicly listed companies in the Nigeria stock exchange, there was a bias
towards the banking sector it was the most active of the entire sector. The
annual reports might have some shortcomings as a source for secondary data.
They are produced for commercial purposes, and the content might therefore be
coloured with an aim to attract attention from shareholders. Though, the
information gathered is not of a sensitive nature, and thus, the risk of the
company trying to create a distorted view is limited. Nevertheless, we have
been aware of the problem when analyzing the information.
1.8 DEFINITION OF TERMS
a. Accounting
discretion is the interpretation and application by the management of five
practical principle as contained in paragraph 12 of SAS No. 1 where there
exists a conflict between or among fundamental concepts in the preparation of
financial statements.
b. Corporate
governance is a combination of external and internal mechanisms in place to
ensure that the assets of the firm are used efficiently and prevent the
inappropriate distribution of the assets to managers or to other parties at the
expenses of the stakeholders.
c. Opportunities
means the unexpected managerial actions that transfer wealth to manages from
shareholders and lead to a net loss in aggregate shareholder wealth.
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