THE EFFECT OF ACCOUNTING DISCRETION ON FIRM PERFORMANCE IN NIGERIA
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THE EFFECT OF ACCOUNTING DISCRETION ON FIRM PERFORMANCE IN NIGERIA
TABLE OF CONTENTS
Cover page i
Title page ii
Table of Contents vi
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
18.104.22.168 Index of accounting discretion 38
3.6.2 economic determinants 38
22.214.171.124 leverage 38
126.96.36.199 growth opportunities 38
188.8.131.52 stakeholder claims 39
184.108.40.206 access to capital markets 39
220.127.116.11 size, risk and performance 39
18.104.22.168 industry and time dummies 40
3.6.3 governance proxies 40
22.214.171.124 shareholder rights 41
126.96.36.199 board monitoring 42
188.8.131.52 managerial ownership 43
184.108.40.206 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
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
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.
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.
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?
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.