The Continuum from Legitimacy to Fraud Research Paper

The Continuum from Legitimacy to Fraud - Research Paper Example Thus, the framework will only be used to the extent of four components of earnings management namely paper earnings management (PEM), real earnings management (REM), paper earnings fraud (PEF), and real earnings fraud (REF). PEM and REM relate to earnings management practices that comply with accounting standards and corporate laws in place while REF and PEF are earnings management practices that violate the standards and laws in place. Earnings Management Measurement The type of data used in this study shall be secondary data collected from the DataStream database. Such data is usually found from the financial statements of listed companies and therefore deemed reliable. Therefore, the issues of data reliability and validity for the present study shall not arise as no tools shall be developed for the collection of primary data. A number of approaches have been used by researchers to measure earnings management (Prior, Surroca and Tribo, 2007). According to McNicols (2000), three app roaches have been commonly used. These are: specific accruals, distribution of earnings, and total accruals. The present study will employ the total accruals approach which consists of both discretionary accruals and non-discretionary accruals (Dechow et al. 1995). Prior studies presented two approaches for measuring totals accruals. For instance, Kothari (2005) uses the balance sheet method while Jaggi et al. (2009) use the cash flow approach. Following Jones (1991) and Dechow et al. (1995), the current or total accruals can be defined using the balance sheet method as: TACt = ?CAt - ?Cash-?CLT + ?DCL – DEPt Where:?CAt = This denotes change in current assets in year t ? Cash = This is a change in cash and cash equivalents in year t?CLT = This is a change in current liabilities in year t?DCL = This means a change in debt included in current liabilities in year t. DEPt = This is depreciation and amortization expense in year t Collins and Hriber (2002) noted that the cash flow approach was a superior method than the balance sheet approach especially for companies experiencing mergers and acquisitions. Sun and Rath (2009) argued that the discretionary accrual approach is potentially ill-specified. This study therefore uses the cash flow estimation approach. Under the cash flow method, total accruals are estimated as follows: TAC t = Income t – Cash Flow t Where: Income = Earnings before extraordinary and abnormal items in year t Cash Flow t = Operating cash flow in year t Prior et al., (2007) noted that earnings management is estimated through discretionary accruals (DA) which are computed by â€Å"detracting the expected or non-discretionary accruals (NDA) from the total accruals (TA)† (p. 34). The DA and NDA can be estimated using the Kothari et al (2005) model. The model is different from the modified Jones model proposed by Dechow et al. (1995), and includes a non-deflated term that captures performance (ROA). Consistent with most empiric al studies in earnings management, the present study will adopt the modified Jones model. The argument for the adoption of this model is best described by Alghamdi (2012) as follows: â€Å"The argument of this study is that management may engage in earnings management via discretionary revenues by timing the recording of these revenues, such as recording them at the year-end when the cash has not yet been collected.