International Journal of Economy, Management and Social Sciences, 2(7) July 2013, Pages: 533-538

TI Journals

International Journal of Economy, Management and Social Sciences

ISSN
2306-7276

www.tijournals.com

Effect of Accounting Conservatism Level, Debt Contracts and

Profitability on the Earnings Management of Companies:
Evidence from Tehran Stock Exchange
Seyedeh Maryam Babanejad Bagheri *1, Milad Emamgholipour 2, Meysam Bagheri 3,
Esmail Abedi Rekabdarkolaei 4
1

Department of Accounting, Babol Branch, Islamic Azad University, Babol, Iran.

Young Researchers Club, Babol Branch, Islamic Azad University, Babol, Iran.
3
Department of Accounting, Gomishan Branch, Islamic Azad University, Gomishan, Iran.
4
Department of Public Administration, Qaemshahr Branch, Islamic Azad University, Qaemshahr, Iran.
2

AR TIC LE INF O

AB STR AC T

Keywords:

The main objective of this study is to investigate the effect of accounting conservatism level, debt
contracts and profitability on the earnings management of listed companies in Tehran Stock
Exchange. For this purpose, a sample of 700 firm-years during the time span of 2006 to 2010 was
chosen to test the research hypotheses. The research results indicate that the variables of
accounting conservatism level and return on equity have positive and significant relationship with
earnings management of studied companies and indicate that companies that have higher levels of
conservatism and earnings management, their earnings management is more. In addition, the
results showed that there is a significant and negative relationship between debt contracts and
earnings management and also, firm size and audit firm size have no effect on earnings
management.

Earnings management
Accounting conservatism level
Debt contracts
Return on equity

2013 Int. j. econ. manag. soc. sci. All rights reserved for TI Journals.

1.

Introduction

One of the most restrictive covenants of financial statements which implies on exercise of caution in the recognition and measurement of
income and assets is conservatism. Conservatism is one of sensible characteristics of financial reporting which is mixing with the theory
and practice of accounting long ago [10]. There are several definitions from conservatism in accounting literature. Givoly and Hayn (2000)
suggest that conservatism is choosing an accounting technique under uncertainty conditions that finally lead to presentation of minimum
assets and incomes and has minimum positive effect on equity [5]. Watts and Zimmerman (1986) define conservatism as follows:
conservatism means that the accountant among possible values should report the lowest value for assets and the highest value for liabilities.
Revenues are recognized later rather than sooner and costs must be identified sooner no later [15]. Conservatism is an effective mechanism
to reduce the costs of conflict of interests between managers and owners, and in uncertainty conditions will increase the company's value.
In fact, the main goal of conservatism is to prevent incorrect decisions by investors, creditors and other users of financial statements.
Companies and managers to fund their required financial resources refer to two main groups of creditors and investors. The main objective
of creditors is to receive the principal and interest of their granted loans and also the main objective of investors is to increase the wealth
and earning good returns. Therefore, existence of high debt contracts and low profitability for companies will cause that investors and
creditors give up from supply financial resources required for the company. Since investors and creditors for making their optimal decisions
rely on the financial information contained in the financial statements of economic units particularly reported earnings, it is possible that
managers of companies with high debt contracts to comply with the terms of the financing contracts, showing desirable situation of
performance and profitability trend of company, reduce investment risk in company and consequently reduce the interest rate of receiving
credit began to earnings management in the framework of accounting principles and procedures.
Healey and Wahlen (1999) define earnings management as a type of purposeful intervention of manager in the financial reporting process
to the people outside of economic enterprise in order to earn the personal interest which occurs through the manipulation of information in
the current fiscal period [6]. However, Scott (1997) points out earnings management as company option in selecting accounting policies for
the achievement of some specific objectives of manager [14] and Kellogg and Kellogg (1991) indicate that two main motivations for
earnings management are persuasion of investors to buy shares of company and increase the company's market value [9].
The results of several studies about the level of conservatism in financial reporting indicate that conservative reporting can be used as a tool
for earnings management [4]. While Watts [16] know conservatism as an effective mechanism in the contracts between the company and
creditors and investors that protect creditors and investors against management opportunism. Also, Lobo and Zhou [12] in their research
* Corresponding author.
Email address: nezhad_1354@yahoo.com

Seyedeh Maryam Babanejad Bagheri et al.

534

Inter nat ional Journal of Economy, Mana ge ment and Social Scie nc es , 2(7) July 2013

found, companies that provide conservative financial reporting, can have more earnings management behaviors. In contrast, Zhou [17] in
their study found that companies that provide conservative financial reporting, they pay to earnings management less.
According to the mentioned theoretical bases, the main objective of this study is to answer this question: whether amount of accounting
conservatism, debt contracts and profitability effect on the earnings management of listed companies in Tehran stock exchange?

2.

Literature review

Kazemi et al. [8] the relation between accounting conservatism and earnings characteristics of the listed companies in Tehran stock
exchange were examined. In this study, 145 companies during the years 2004 to 2008 were chosen. Also, the ratio of market value to book
value as a measure of conservatism and stability variables, Predictability, timeliness and relevance of the features of interest are used.
Results showed that between accounting conservatism and stability features, and the predictability of earnings, there is a significant positive
relationship. However, the relationship between conservatism and timeliness properties is not significant.
Abed et al. [1] in their study examined the level of conservatism in accounting policies and their effect on earnings management of 259
Jordanian companies during the period 2006 to 2009. In this study, the ratio of book value to market value has been used as an indicator of
accounting conservatism level. The research results indicate that there is significant and negative relationship between variables of
accounting conservatism level, return on equity and firm size with earnings management. However, significant relationship is not observed
between the variables of financial leverage and audit firm size with earnings management.
Zhou and Chen [18] in their study found that there is a significant and positive relationship between audit firm size and discretionary
accruals. In addition, the research results of Krishnan [11] showed that there is negative and significant relationship between firm size and
discretionary accruals. But there is no significant relationship between the variables of financial leverage and market value to book value
ratio with discretionary accruals.
Badavar Nahandi et al. [2] studied the relationship between accounting conservatism and earnings management in a sample of 480 firmyears during the time span from 2001 to 2008 on the listed companies in the Tehran Stock Exchange. They had used Basu model as a
measure of accounting conservatism. The research results showed that there is positive and significant relationship between earnings
management and accounting conservatism.
Rusmin [13] studied the relationship between earnings management and audit quality in 301Singaporean companies in 2003. The results
showed that there is no significant relationship between the variables of firm size and financial leverage with earnings management. But
there is negative and significant relationship between audit firms, which at least examine 20% of companies in an industry, with earnings
management.

3.

Research methodology

3.1 Research Hypotheses

To investigate the effect of accounting conservatism level, debt contracts and profitability on earnings management of the listed companies
in Tehran Stock Exchange and according to the mentioned theoretical bases, the following hypotheses are designed to test:
H1: There is significant relationship between accounting conservatism level and earnings management.
H2: There is significant relationship between debt contracts and earnings management.
H3: There is significant relationship between the return on equity and earnings management.
H4: The firm size has an impact on earnings management.
H5: The audit firm size has an impact on earnings management.
3.2 Statistical Population and Sample
All companies listed in Tehran Stock Exchange constitute the statistical population of present study. The time period of this study is five
years from 2006 to 2010. To select the statistical sample, the following conditions are considered:
1.
2.
3.
4.
5.

In order to increase comparability, the end of their fiscal year lead up to December 31.
In order to information homogeneity, activity of companies should be manufacturing.
Companies are listed in stock before the year 2006.
Their financial period has not changed during the studied fiscal year.
Needed financial information is available.

Thus, considering the above conditions, 140 companies are selected to test the research hypotheses.
The data used in this study are the actual data from the site that has been extracted from the site of the Tehran Stock Exchange (Note 1) and
CDs of financial information of companies listed in Tehran Stock Exchange.
3.3 Methods of Data Analysis and Hypotheses Testing
The present study is application research in terms of purpose, and is descriptive in terms of nature. To test the hypotheses is used
multivariate regression model. To determine the significance of the regression model is used F Fisher statistic and to explain the variability
of dependent variable by independent variables is used the adjusted R 2. To evaluate the significance of the coefficients of independent
variables is used t-student statistic and to evaluate the lack of autocorrelation problem between sentences of Error Model has been used
Durbin-Watson test (DW).

Effect of Accounting Conservatism Level, Debt Contracts and Profitability on the Earnings Management of Companies

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Internat ional Jour nal of Economy, Mana ge ment and Social Sciences , 2(7) Jul y 2013

3.4 Research Variables and how they are calculated

In this study, the variables of book value to market value of equity ratio (BTM), financial leverage (LEV), return on equity (ROE), firm size
(SIZE) and audit firm size (AUDITSIZE) are used as explanatory variables that how each of them are calculated are presented in Table
(1). However, the variable of discretionary accruals (DACC) is used as the dependent variable and an indicator for earnings management.
Dechow et al. [3] in their study evaluated the relative performance of Healy, Deangelo, Jones, Modified Jones and industry models for
earnings management knowledge and concluded that Modified Jones model is more appropriate and stronger test for investigation of
earnings management. Thus, in the present study is used modified Jones model to estimate discretionary accruals. In this way, first the total
accruals are calculated as follows:
(1)
TACC it NI it OCF it
Where:
TACC = total accruals.
NI = net income.
OCF = operating cash flows.
After calculating total accruals using the following equation, we estimate used coefficients:

TACC it
1
REVit RECit
PPE it
1 (
) 2 (
) 3(
) it
Ait 1
Ait 1
Ait 1
Ait 1

(2)

Which in this equation:

TACC it = total accruals of firm i in year t.
Ait-1 = total assets of firm i in year t-1.
REV it = change in revenue of firm i in year t.
REC it = Change in accounts and notes receivable of firm i in year t.
PPEit = gross value of property, machinery and equipment of firm i in year t.
it = Error of model for firm i in year t.

1 , 2

And 3 = estimated coefficients of modified Jones model.

After estimating the coefficients of the model (2), we put them to the following equation to calculate non-discretionary accruals (NDACC):

NDACC it
1
REVit RECit
PPEit
1 (
) 2(
) 3 (
)
Ait 1
Ait 1
Ait 1
Ait 1

(3)

And finally, discretionary accrual (DACC) is calculated by the following equation:

DACC it TACC it NDACC it

(4)

Table 1. Explanatory Variables and how they are calculated

Variables Name

Symbol

How to Calculate

Independent variables
Book Value to Market Value Ratio
(Accounting Conservatism Level)
Financial Leverage (Debt Contracts)

BTM

Return on Equity (Profitability Index)

Book value of equity to market value of equity ratio

LEV

Total debt to total assets ratio

ROE

Net profit to total equity ratio

SIZE

Natural logarithm of total assets of company

Control variables
Firm Size
Audit Firm Size

AUDITSIZE

If the audit firm is auditing organization (large audit firm), is used artificial variable
of one and if, audit firm is member of certified public accountants (small audit firm),
is used zero.

3.5 The Model used to test the Research Hypotheses

In this study to test the hypotheses, the following model is used:

DACC it 0 1 BTM it 2 LEV it 3 ROE it 4 SIZE it 5 AUDITSIZE

Which in this model:
DACCit = discretionary accruals of firm i in year t.
BTMit = accounting conservatism level of firm i in year t.
LEVit = debt contracts of firm i in year t.
ROEit = return on equity of firm i in year t.
SIZE it = firm size of i in year t.
AUDITSIZE it =Audit firm size of firm i in year t.

it = Error of model component.

0 = constant coefficient and 1

to

5 = coefficients of independent and control variables.

it

it

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Inter nat ional Journal of Economy, Mana ge ment and Social Scie nc es , 2(7) July 2013

4.

Research findings

4.1 Descriptive statistics

Table (2) shows the descriptive statistics of the main variables of study. As can be seen mean of discretionary accruals (DACC) is equal to
0.0012 and indicate that studied companies averagely have 0.12% of discretionary accruals which its range is between 0.5116 and -0.6179.
Accounting conservatism Level index which is the book value to market value ratio (BTM), has a mean equal to 0.77. Jain and Rezaee [7]
stated that the book value to market value ratio less than one represents a reasonable level of accounting conservatism in financial
reporting.
The mean of debt contracts index (LEV) is equal to 0.6495 and indicates that on average 65% of the required funds of investigated
companies provide from the debts. Also, the return on equity (ROE) shows that on average 26% of the earned profit is from the resources
that common shareholders place at disposal of company. Finally, the average amount of the audit firm size (AUDITSIZE) shows that 23%
of the financial statements of studied companies have been investigated by large audit firms (auditing organization).
Table 2. Descriptive Statistics
Variables

Mean

Median

Max

Min

Std. Dev

DACC

0.0012

-0.0047

0.6179

-0.5116

0.1329

BTM

0.7653

0.6936

4.0792

-7.0502

0.8227

LEV

0.6495

0.6448

2.3713

0.0795

0.2278

ROE

0.2600

0.2532

3.9666

-9.1716

0.6537

SIZE

13.0374

12.8178

19.7806

9.8215

1.4128

AUDITSIZE

0.2255

0.0000

1.0000

0.0000

0.4182

4.2 Correlation Analysis

Pearson correlation test results are presented in Table (3). As can be seen, there is no multicollinearity between research variables. Because
obtained correlation coefficients are less than 33 percent. In addition, research results show that indexes of accounting conservatism level
(BTM) and profitability (ROE) have significant and positive correlation at the 99% confidence level with earnings management index
(DACC). The results also indicate that there is significant and negative correlation between financial leverage (LEV) and discretionary
accruals (DACC) at the 99% confidence level. But variables of firm size (SIZE) and the audit firm size (AUDITSIZE) are not significantly
correlated with the earnings management. Among the independent variables, there is significant and positive correlation between firm size
and the audit firm size and shows that the larger companies use large audit firms to examine their financial statements.
Table 3. Pearson Correlation Test
Variables

DACC

DACC

1.000

BTM

LEV

ROE

SIZE

BTM

0.129**

1.000

LEV

-0.242**

-0.332**

1.000

ROE

0.174**

-0.098*

-0.054

1.000

SIZE

0.045

0.089*

0.076*

0.072

1.000

AUDITSIZE

0.027

0.060

0.033

-0.001

0.278**

AUDITSIZE

1.000

** Correlation is significant at the 1% level, * Correlation is significant at the 5% level.

4.3 Results of Hypothesis Testing

The results from the research hypotheses test are presented in Table (4). The first research hypothesis states that there is significant
relationship between the accounting conservatism level (BTM) and earnings management (DACC). As can be seen in Table (4), results
indicate that there is significant and positive relationship between accounting conservatism level and earnings management statistically at
90% confidence level. Consequently, the first hypothesis of research is confirmed.
The second hypothesis investigates the significant relationship between debt contracts (LEV) and earnings management (DACC). The
results indicate that there is significant and negative relationship between debt contracts and earnings management statistically at 99%
confidence level. Thus, the second research hypothesis also is confirmed.
The third hypothesis tests the significant relationship between return on equity (ROE) and earnings management (DACC). As the results
show, there is significant and positive relationship between return on equity and earnings management at 99% confidence level.
Consequently, the third research hypothesis also is confirmed.
The fourth and fifth research hypothesis state that firm size (SIZE) and audit firm size of client company (AUDITSIZE) effect on the
earnings management of the company (DACC). Test results show that the firm size and the size of audit firm which examine the financial
statements of studied companies have no impact on earnings management of company. So the fourth and fifth research hypothesis cannot
be confirmed.

Effect of Accounting Conservatism Level, Debt Contracts and Profitability on the Earnings Management of Companies

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Internat ional Jour nal of Economy, Mana ge ment and Social Sciences , 2(7) Jul y 2013

Table 4. Regression Results

Variables

Coefficient

t-statistics

Sign.

Constant

0.017

0.354

0.724

BTM

0.011

1.757

0.079

LEV

-0.125

-5.437

0.000

ROE

0.034

4.477

0.000

SIZE

0.004

0.981

0.327

AUDITSIZE

0.006

0.505

0.614

R2

0.092

Adjusted R2

0.085

F-Statistics

13.677

Prob(F-statistic)

0.000

Durbin-Watson

1.572

As it is evident from the Table (4), the amount of adjusted R2 is equal to 0.085 which indicates that explanatory variables of model only
explain 8.5% of changes in dependant variables (earnings management). F statistic value is equal to 13.677 and its significance level is
0.000 and indicates that the model generally is significant. Since the Durbin-Watson statistic value is equal to 1.572 and this value is
between 1.5 and 2.5, can be concluded that there is no Autocorrelation problem in the remaining component of model.

5.

Conclusion

The present study investigates the effect of conservatism accounting level, debt contracts and profitability on the earnings management of
listed companies in Tehran stock exchange. For this purpose, a sample of 140 companies during the period of 2006-2010 was chosen to test
the research hypotheses.
Results from first hypothesis testing showed that there is positive and significant relationship between earnings management and
accounting conservatism and indicates that companies which have a high level of conservative financial reporting may have more earnings
management behaviors. The results are consistent with the research results of Abed et al. [1], Badavar Nahandi et al. [2] and Lobo and
Zhou [12]. But they are contrary to the research results of Zhou and Chen [18], Krishnan [11] and Zhou [17].
The results from second hypothesis indicate that there is negative and significant relationship between debt contracts and earnings
management. It means that companies that have a higher ratio of debt or debt contracts, have less earnings management that is not
consistent with the research results of Abed et al. [1], Krishnan [11] and Rusmin [13]. The results from third hypothesis testing indicate that
companies which have high profit from the resources that shareholders place at disposal of company, have more opportunistic behaviors
that is contrary to the research results of Abed et al. [1]. The results from fourth and fifth hypotheses test showed that there is no significant
relationship between firm size and audit firm size with earnings management. Which it is consistent with the research results of Rusmin
[13], but it is contrary to the research results of Abed et al. [1], Zhou and Chen [18] and Krishnan [11].

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Notes
Note 1. www.irbourse.com.