Ownership structure and Earnings Management in Emerging Markets: the Case of Jordan

ByNedal Al-Fayoumi

Department of FinanceFaculty of BusinessUniversity of Jordan

e-mail: nfayoumi@ju.edu.jo

Bana Abuzayed Talal Abu-Ghazaleh Collage of Business

German Jordanian Universitye-mail: bana.abuzayed@gju.edu.jo

David AlexanderBirmingham Business SchoolUniversity of Birmingham, UK

e-mail: d.j.a.alexander@bham.ac.uk

Abstract

This study examines the relationship between earnings management and

ownership structure for a sample of Jordanian industrial firms during the

period 2001-2005. Earnings management is measured by discretionary accruals.

The three types of ownership studied are insiders, institutions and block-holders.

Using the Generalized Method of Moment (GMM), the results indicate that

insider ownership is significant and positively affect earnings management. This

result is consistent with the entrenchment hypothesis which states that insider

ownership can become ineffective in aligning insiders to take value-maximizing

decisions.

Further analysis shows insignificant role of institutions and block-holder

in monitoring managerial behaviour earnings management. Our findings have

important policy implications since they support the encouraging for applying

corporate governance principles in order to motivate institutions and block-

holders to provide effective monitoring of managers in Jordanian firms. As a

result, the reliability and transparency of reported earnings may be enhanced.

Key Words: Earnings management, Discretionary Accruals, Ownership Structure,

Size.

1. Introduction

The global markets crisis of 2008 has claims a vast body of research on

financial information quality and corporate control. In corporations, finance and

management are usually separated. However, this separation action poses two

conflicts. First, fund suppliers face collective action problems preventing them to

monitor and discipline managers of the company they are investors of (see

Macey, 1998). Second, managers need to convince market participants (current

and potential) of the firm performance, in order to be able to allocate enough

funds for the firm investments. Since the value of these investments is tied to the

firm, this value depends on the future prospects of the business relationship

between the firm and its suppliers. Consequently, the perception of these

stakeholders about the firm’s future prospects affects their incentive to

undertake such investments. From this point of view, researchers suggest that

managers may engage to earnings management to influence stakeholders

(Graham et al., 2005).

There is no consensus on the definition of earnings management (Beneish,

2001). For example, Davidson et al., (1989) cited in Schipper (1989, p. 92) defined

earnings management as “the process of taking deliberate steps within the

constraints of Generally Accepted Accounting Principles to bring about a

desired level of reported income”. Healy and Wahlen (1999) state that "earnings

management occurs when managers use judgment in financial reporting in

structuring transactions to alter financial reports, to either mislead some

stakeholders about the underlying economic performance of the company, or to

influence contractual outcomes that depends on reported accounting".

Earnings management occurs in three ways: (1) via the structuring of

certain revenue and/or expense transactions; (2) via changes in accounting

procedures; and/or (3) via accruals management (McNichols and Wilson 1988,

and Schipper 1989). Of the above mentioned earnings management techniques,

accruals management is the most damaging to the usefulness of accounting

reports because investors are unaware of the extent of such accruals (Mitra and

Rodrigue , 2002). Accrual is defined as the difference between the earnings and

cash flow from operating activities. Accruals can be further classified into non-

discretionary accruals and discretionary accruals. While non-discretionary

accruals are accounting adjustments to the firm’s cash flows mandated by the

accounting standard-setting bodies, discretionary accruals are adjustments to

cash flows selected by the managers (see Rao and Dandale, 2008)

A number of previous studies attempt to examine whether earnings

management exist in firms reports (Healy, 1985; Burgstahler and Dichev, 1997;

and DeAngelo et al., 1994), endeavor to determine the types of earnings

management (Sirgar and Utama, 2008; and Beneish, 2001), or questioned the

motives behind earnings management (Healy and Wahen, 1999). Factors like

management compensation contract incentives (Guidry et al., 1999, and Dechow

and Solan 1991), regulatory motivations (Key, 1997), capital market motivations

(Teoh et al., 1998), and external contract incentives (Watts and Zimmerman,

1986) have been examined to interpret managers behavior towards earnings

management.

In this paper, we are turning our focus on the relationship between

ownership structure and earnings management practices among firms operating

in an emerging market. With globalalization of business and financial markets,

there has been strong demand for quality of information from firms across

countries so that investors can conduct comparative evaluation of risk and

return of firms in different countries (Jaggi and Leung, 2007). Consequently,

regulators in several countries outside the USA also started paying attention to

corporate governance and especially ownership structure components (e.g.,

insider managers, institutional investors, and block-holders) to improve the

quality of reported accounting information.

There is a public perception that earnings management is utilized

opportunistically by firm managers for their own private rather than for the

benefits of the stockholders. This misalignment of managers' and shareholders'

incentives could induce managers to use the flexibility provided by the

accounting standards to manage income opportunistically, thereby creating

distortions in the reported earnings (Jiraporn, 2008). However, a number of

academic studies have argued that earnings management may be beneficial

because it potentially enhances the information value of earnings. Managers may

exercise discretion over earnings to communicate private information to

stockholders and the public (e.g., Arya et al., 2003; Demski, 1998; Guay et al.,

1996).

The ability of managers to opportunistically manage reported earnings is

constrained by the effectiveness of external monitoring by stakeholders such as

institutional and external block-holders. These investors have the opportunity,

resources, and ability to monitor, discipline, and influence managers of firms

(Monks and Minow, 1995). Whether they use these powers is partially a function

of the size of their individual or collective shareholdings (Chung et al., 2002).

And this implies less opportunity for accruals management or earnings

manipulation (see Yeo et al. (2002) and De Bos and Donker, 2004). This will be

especially the case when major stakeholders know managers’ incentives for

earnings management. If managers have no self-serving incentives to use

discretionary accounting accruals, these stakeholders will be less inclined to

monitor discretionary accounting choices (Chung et al, 2002).

Yet many argue that institutions do not monitor effectively because they

either lack expertise or suffer from free rider problems among themselves

(Admat et al., 1999), or strategically ally with the management (Pound, 1988). A

similar argument can be made for the individual block-holders (Jung and Kwon,

2002).

This study contributes to the literature in the following ways. First, from

the previous literature it appears that there is no general agreement regarding

the effect of ownership structure on earnings management. Therefore, this study

investigates the determinants of earnings management activities and extends the

very limited research on the association between ownership structure and

earnings management. Unlike most existing research, which usually studies just

one aspect of ownership structure, we focus on three ownership categories:

insiders, institutions, and block-holders.

Second, it represents the first known study, to the best of our knowledge

that examines the relationship between ownership structure and earnings

management in Jordan. Jordan has been selected in the current study because

recently it has displayed a significant interest in consolidating the pillars of

corporate governance. Additionally, we use Jordanian data because they

generally reflect an institutional setting similar to many emerging countries,

where a high share of insider ownership, weak investor rights and less mature

block-shareholders are prevalent. Fundamental stakeholders in the Jordanian

corporations include families, banks, social security institution, and individual

investors. Thus, this study provides empirical evidence to assess the merits of

calls for different types of investors to play a greater role in corporate

governance practices.

Third, it provides further evidence on the possibility of coexistence of the

opportunistic and informative managerial ownership in addition to active and

myopic institutional and block-holders ownership and their differential

associations with earnings management. Understanding the nature of these

associations is important for portfolio managers and decisions makers because

they may convey information about the quality for financial information and

firm value.

The paper is structured as follows: Section 2 gives a brief overview of

accounting system in Jordan. Section 3 presents the theoretical background.

Section 4 summarizes earnings management literature. Section 5 discusses the

data and methodology, while section 6 reports the main results. Finally, section 7

summarize and concludes this paper.

2. The Accounting System in Jordan

Jordan has a political stability in a very volatile region, a liberal economy,

and relatively advanced stock market. However, the Jordanian economy is

private sector oriented; the state ownership is relatively small. Recently, a series

of privatization initiatives have been implemented to reduce public shares in the

productive sectors.

All registered firms in Jordan are subjected to the obligation of

certification and publishing their accounts. Since 1987, a body is in charge of

checking the quality of the accounting information called the Jordanian

Association of Certified Public Accountants (JACPA). The certification and the

control of accounts in Jordan refer to the recommendations from the JACPA

which adopt International Accounting Standards. Only the auditors who have

received this certification are authorized to certify annual reports. In addition,

there are a number of internationally recognized accounting and auditing firms

in the kingdom. In general, government's accounting and auditing regulations

are regarded as being compatible with international standards.

Public shareholding companies were set up and their shares were traded

in, long before the setting up of the Jordanian Securities Market. In the early

thirties, the Jordanian public already subscribed to and traded in shares1.

However, the Amman Financial Market (AFM) was established in 1978.

However, the passage of Securities Law No. 23 in 1997 was indeed a landmark

and a turning point for the Jordanian capital market. Three institutions

emerged: the Jordan Securities Commission (JSC), the Amman Stock Exchange

(ASE), and the Securities Depository Center (SDC)) out of what has been the

Amman Financial Market till 1997. The ASE is one of the largest stock markets

in the region that permits foreign investment (in year 2008, Market

Capitalization to GDP was about 226.3 per cent). Securities listed in ASE are

electronically traded.

According to the Jordanian Securities Commission (JSC) Law (23/1997)

and Directives of disclosures, auditing, and accounting standards (1/1998), all

entities subject to JSC’s supervision are required to apply International

Financial Reporting Standards (IFRS)2. These Directives specify the information

required public shareholding companies to be disclosed and filed with the

Commission for the purpose of enhancing transparency. Public shareholding

1Where the Arab Bank was the first public shareholding company to be established in Jordan in 1930, the first corporate bonds were issued in the early sixties. See the Jordan Security Commission web site at http://www.jsc.gov.jo/2 IFRS refers to all International Accounting Standards (IAS) and related interpretations issued by the former International Accounting Standards Committee (IASC), and the International Financial Reporting Standards (IFRS) and related interpretations issued by IASC’s successor body, International Accounting Standards Board (IASB).

companies are required to apply the International Auditing and Accounting

Standards under the supervision of the Jordan Security Commission (JSC)3.

Firms operating in Jordan are required to submit annual reports and

announce yearly statements within a period not exceeding 3 months after end of

its fiscal year and to announce its half yearly statement within a period not

exceeding one month after the end of the mid-year. Additionally, these directives

contain chapter on insider trading and how they are obliged to submit to the

JSC material information related to the dealings. In 2002, a new Securities Law

number 76 has been issued, which authorized setting up other stock exchanges

and allowed forming an independent investor protection fund, stricter ethical

and professional codes, and a more stringent observance of the rule of law (ASE,

2009). By December 2008, the exchange recorded 5,442.3 million shares traded4.

The Accountancy Profession Law (APL) 73/2003 was issued in 2003.

Important features of the APL include establishment of a “High Council for

Accounting and Auditing” headed by the Minister of Industries and Trade, and

the creation of an improved JACPA. However, Rahman and Waly (2004)

claimed for more clarification and refinement in the law in addition to upgrade

its contents with the new global developments5. Given that more robust auditing

should capture any earnings management practices, this study tries to bring

evidence that the level of earnings management and though the quality of

reported financial information are influenced by firms ownership structure.

3The Jordan Securities Commission is the regulator of the capital market. Its mission is reforming and developing legislation and regulations, emphasizing transparency and disclosure, revitalization Jordan’s investment culture, encouraging and protecting investors and most importantly enforcing the rule-of-law.4 See ASE website at: www.ase.com.jo/5 They state "the term “practicing professional” needs to be better defined; the provision on auditor rotation gives rise to ambiguity about rotation of partners or firms; and it appears to be impractical to implement the provision on composition of the Board of High Council having ministers without the same right of proxy as members of the High Council Board. While the Law focuses primarily and in great depth on JACPA regulations and by law 4, it overlooks important elements that could strengthen the auditing regulatory framework in Jordan, particularly auditors’ independence. It does not include provisions specifically focusing on monitoring and enforcement mechanisms for ensuring compliance with the applicable auditing standards and code of ethics, not only in appearance but also in substance. .

3. Theoretical Background

Mainly focusing on the effect of ownership structure on earnings

management (discretionary accruals), we account for the complexity of interests

represented in a given company, by consider the main dimensions of ownership

structure – insiders, institutions and external block-holders .

The effect of managerial ownership (insiders) on incentives to act in the

interests of shareholders is inarticulate in the previous literature. The traditional

agency theory suggests that shareholdings held by managers help align their

interests with those of shareholders (Jensen and Meckling, 1976). This incentive,

alignment effect, is anticipated to have more impact as managerial ownership

increases, suggesting that as managerial ownership increases, efficient earnings

management may exist to improve earnings informativeness in communicating

of value-relevant information (Siregar and Utama, 2008). Thus, under the

convergence-of-interest hypothesis, insider ownership can be seen as a

mechanism to constrain the opportunistic behavior of managers and, therefore,

the discretionary accruals (a proxy of earnings management) is predicted to be

negatively associated with insider ownership (Warfield et al., 1995).

In contrast, when there is narrow separation between owners and

managers, managers face less pressure from financial markets to signal the firm

value to the market and they pay less consideration to the short-term financial

report (Jensen, 1986; Klassen, 1997); therefore, highly managerial ownership are

more likely to manipulate earnings, since this lack of market discipline may lead

insiders to make accounting choices that reflect personal motives rather than

firm economics (Sanchez-Ballesta and Garsa-Meca, 2007). In this context, Morck

et al., (1988) argue as managerial ownership increases, the managerial labour

market and the market for corporate control become less effective in aligning

managers to take value maximizing decisions. This is because high ownership by

management implies sufficient voting power to guarantee future employment.

Additionally, these managers have incentives to pursue self-interest non-

value maximizing actions at the expense of shareholder wealth. This managerial

behavior is consistent with the entrenchment hypothesis which states that high

levels of insider ownership can become ineffective in aligning insiders to take

value-maximizing decisions. Hence, this entrenchment effect potentially

confounds the agency theory predictions. As managerial ownership increases,

earnings management may increase (see Yeo et al., 2007,).

Warfield et al., (1995) indicate that this positive relationship is expected if

either accounting-based constraints mitigate managers' accounting choices or

higher ownership results from difficulties in accounting numbers measuring

performance as reflected in increased accruals variability.

The effect of institutional ownership on earnings management behavior

have been examined before (e.g. Velury and Jenkins, 2006; Balsam et al., 2002;

and Siregar and Utama 2008). It is possible to explain this effect based on an

active monitoring hypothesis and passive hands-off hypothesis (see Koh, 2003).

Under an active monitoring hypothesis (Bushee, 1998 and Majumdar and

Nagarajan, 1997), institutional investors influence the monitoring mechanism a

firm uses, including the monitoring of earnings management activity. Academic

researchers believed that institutional investors who have large magnitude of

investments are more sophisticated investors. They are, on average, better

informed than individual investors due to their large-scale development and

analysis of private pre-disclosure information about firms. So, systematic

differences exist in the amount and precision of private information in the hands

of institutional and individual investors.

The higher level of informness of institutional investors also implies that

with the increase in institutional investor shareholdings in a firm, the

information asymmetry between shareholders and managers will decline thereby

making it more difficult for managers to manipulate earnings. Thus, earnings

management and institutional ownership is supposed to be negatively correlated

(Mitra, 2002). Under the passive hand hypothesis (Bhide, 1993 and Portter,

1992), the institutional investors are inherently short-term oriented. Such

investors are often referred to as myopic investors who focus mainly on current

earnings rather than long-term earnings.

This orientation deters institutional investors from incurring monitoring

costs and to concentrate on current earnings news, and that managers have

incentives to manage earnings aggressively (Koh, 2003).

The monitoring by substantial external bock-shareholders is similar to the

effect of institutional ownership on earnings management (Yeo, 2007).Two

competing views exist. First, outside block-holders require a higher return from

their investment and pose a bigger threat of intervention to the firm's

management. Thus, they might not be as inclined to encourage management to

report high quality earnings (Velury and Jenkine, 2006 and Zhong et al., 2007).

Second, outside block-holders, with higher motivation and ability to monitor

managers' actions than small shareholders, might reduce earnings management

through their closer monitoring (Dechow et al., 1996).

4. Literature Review

Previous studies bring evidence that ownership structure influences the

monitoring mechanism a company uses including the monitoring of earnings

management activities. Wang (2006) states that ownership structure has

important effect on reported earnings. However, the influence of insiders,

institutional investors, block-holders and on the ability of managers to

manipulate earnings remains a controversial issue.

The literature discriminates between inside and outside holders (e.g.

Dempsey et al., 1993; and Warfield et al., 1995). Dempsey et al., (1993)

distinguish between owner-managed firms, in which managers own substantial

blocks of the firms' outstanding stocks, and external-controlled-firms, in which

one or more external block-holders own a substantial block of the firm's stocks

while the managers do not substantially own the firm's stocks. The study

suggests that large ownership by management is the underlying factor that

reduces earnings management where the existence of external block-holders does

not seem to significantly affect earnings management. In addition, Warfield et al.

(1995) provide evidence that managerial ownership is negatively related to the

magnitude of earnings management. Warfield et al. (1995) also find evidence

that the inverse relationship between managerial ownership and absolute

abnormal accruals becomes moderated in case of regulated firms. They suggest

that regulation provides monitoring on managers’ choice of making accrual

adjustment to manage earnings.

Sanchez-Ballesta and Garsa-Meca (2007) examine the relationship

between ownership structure and discretionary accruals for a sample of Spanish

non-financial companies. Their results support the hypothesis that insider

ownership contributes to the constraining earnings management when the

proportion of shares held by insiders is not too high. When insiders own a large

percentage of shares, however, they are entrenched and the relation between

insider ownership, discretionary accruals reverses. Morck et al., (1988) argue

that greater ownership would provide managers with deeper entrenchment and,

therefore, greater scope for opportunistic behavior (act in the interests of

shareholders). Gabrielsen et al. (2002) find a positive but non-significant relation

between managerial ownership and discretionary accruals in a sample of Danish

firms, which they attribute to the different institutional settings between the US

and Denmark.

The manner in which earnings management is associated with

institutional ownership is an empirical issue. Extant literature posits two

competing views on institutional investors. One group of the literature such as

El-Gazzar, 1998; Wahal and McConnell, 2000; Velury and Jenkins, 2006 among

many others, provide evidence indicating institutions are playing an active role

in monitoring and disciplining managerial discretion. On the other hand, the

second group of studies (e,g Porter 1992 and Bushee, 1998) alleges that frequent

trading and fragmented ownership discourage institutional from becoming

actively involved in the corporate governance of their portfolio firms (Grace et

al., 2005).

Chung et al., (2002) find evidence supporting that the presence of large

institutional shareholdings inhibit managers from increasing or decreasing

reported profits towards the managers’ desired level or range of profits. This

evidence is consistent with institutional investors monitoring and constraining

the self-serving behavior of corporate managers. Koh (2003) examines the

association between institutional ownership and income increasing discretionary

accruals and finds a concave association where (a) a positive association is found

at a lower institutional ownership region and (b) a negative association at a

higher institutional ownership region.

In a recent study, Koh (2007) extend the literature by classifying

institutional investors into transient or long-term by their investment horizons to

examine the association between institutional investor type and firms’

discretionary earnings management strategies in two mutually exclusive settings

– firms that (do not) use accruals to meet/beat earnings targets. The results

support the view that long-term institutional investors constrain accruals

management among firms that manage earnings to meet/beat earnings

benchmarks. This suggests long-term institutional investors can mitigate

aggressive earnings management among these firms. Transient institutional

ownership is not systematically associated with aggressive earnings management

and is evident only among firms that manage earnings to meet/beat their

earnings benchmarks.

On the other hand, external block-holders, are considered to be an

important external mechanism to influence earnings management. Jensen and

Meckling (1976) is one of the earliest studies that suggest monitoring by block-

holders can be a way to reduce agency costs. Many subsequent studies have

suggested that external block-holders could effectively monitor management of

firms (Koch 1981, Mikkelson and Ruback 1985, Shleifer and Vishny 1986, and

Barclay and Holderness 1991).

The higher incentive of outside block-holders in monitoring managers'

actions potentially reduces earnings management by restricting managers'

discretion with financial reporting and/or mitigating their incentive to manage

earnings.

Dechow et al. (1996) suggests that outside block-holders are effective

monitors of managers' earnings overstatements that violate GAAP. Yeo et al.,

(2003) show a strong positive relationship between external unrelated block-

holdings and earnings informativeness. However, McEachern (1975), Shleifer

and Vishny (1986), Holderness and Sheehan (1988), and Barclay and Holderness

(1991) among some others argue that outside block-holders may create extra

pressure for their firms' managers to engage in income-increasing earnings

management. Zhong et al., (2007) study the association between outside block-

holder ownership and earnings management for NYSE firms. Their results

indicate that outside block-holder ownership is positively associated with

discretionary accruals for firms that face declining pre-managed earnings. Thus,

the evidence, consistent with the second view, suggests that outside block-holders

are not effective monitors of income-increasing earnings management that is

generally within the bounds of GAAP.

Although extent literature examined the determinants of earning

management, the evidences are mixed, and what are the determinants of firms'

earnings management remains an empirical issue. Therefore, this study

contributes to the literature by examining the effect of ownership structure on

earnings management behavior in an emerging market. This paper is examining

an important issue among research topics in accounting and finance. The

importance behind examining the determinants of earnings management is to

minimize potential wrongdoing, conflict, and a sense of mystery in accounting

information used by financial managers because, as argued by Lo (2007), highly

managed earnings have low quality.

5. Research Design

In this section we will develop the study hypotheses, describe the main

models used in this paper, clarify the operational definition of the variables used,

and explain the procedures of sample selection.

5.1 Hypotheses and Research Models

The aim of this study is to test the association between ownership

structure and earnings management and to examine if this association differs

between small and large firms.

The standard assumption is that each of the ownership categories has

different objectives with implications for corporate strategy and performance

(Edwards and Nibler 2000; Morck et al. 2000; Thomsen and Pedersen 2000) .

Therefore, each ownership category is expected to influence earnings

management differently.

We examine whether each of the ownership structure categories (insiders,

external block-holders, and institutional investors) is associated with earnings

management after controlling for factors that are likely to impact earnings

management such as size, the level of debt, firm growth, and profitability. Our

primary hypotheses (stated in null form) are as follows:

H1: Earnings management is not associated with the level of insiders'

ownership.

H2: Earnings management is not associated with the level of institutional

ownership.

H3: Earnings management is not associated with the level of external block-

holders' ownership.

We employ Models 1to 4 to examine the above mentioned hypotheses:

(1)

(2)

(3)

(4)

Where, EMit is earnings management measured by discretionary accruals

for firm i at time t, INSIit is insiders (managerial) ownership variable, INSTit is

institutional ownership variable for firm i at time t, and EBHit is external block-

holders' ownership variable for firm i time t, and. Contit stands for control

variables and εit is the error term.

Finally, we examined the interaction between the significant ownership

category and size to check whether the association between earnings

management and ownership structure differs among large and small firms. The

following hypothesis in its null form can be stated as follows:

H4: The association between earnings management and ownership structure is

not differ among firms of different size.

The above formulated hypothesis is examined using the following model:

(5)

Where, OSit stands for one or more significant ownership categories for

firm i at time t and SIZEit is firm i size at time t.

To examine the above mentioned tests, Ordinary Least Squares (OLS)

estimation may be used in this study. However, Hsiao (1985) shows that in the

presence of firm specific effects, OLS coefficients are biased assuming that co-

variances between the independent variables and the firm specific variable and

the disturbance terms are nonzero. If variables are endogenous, using OLS

estimates may lead to inconsistency. Therefore, we employ a dynamic panel, the

Generalized Method of Moment (GMM) estimator proposed by Arellano and

Bond (1991).

Under GMM, the consistency of the estimator depends on the validity of

the instruments and the assumption that the differenced error terms do not

exhibit second order serial correlation. To test these assumptions, Arellano and

Bond proposed a Sargan test of overidentifying restrictions, which tested the

overall validity of the instruments by analyzing the sample analog of the moment

conditions used in the estimation procedure (Liu and Hsu, 2006). Besides, they

also tested the assumption of no second-order serial correlation. Failure to reject

the null hypotheses of both tests gives support to our estimation procedure6. All

regressors are treated as strictly exogenous except the lagged dependent

variables. Therefore, we conduct the analyses with lagged independent variables

dated t−2 and earlier together with the lagged changes of endogenous variables,

and exogenous variables used as instruments variables.

5.2 Definition of Variables

5.2.1 Measuring Earnings Management

In this study, we use accounting accruals approach to measure earnings

management. Accruals includes a wide range of earnings management

techniques available to managers when preparing financial statements, such as,

inter alia, accounting policy choices, and accounting estimates (Grace et al.,

2005; and Fields et al., 2001)7.

In general, accounting accruals, which is the difference between earnings

and cash flows from operating activities, have been used in different terms in the

previous literature. While Healy (1995) used total accruals to measure earnings

management, subsequent studies attempt to separate them into components,

discretionary and non discretionary accruals. Discretionary accruals are

extensively used to demonstrate that managers transfer their accounting

earnings from one period to another. In other words, managers exercise their

discretion over an opportunity set of accrual choices within GAAP, for example,

choosing the depreciation method of fixed assets (Healy, 1995). Additionally,

total accruals include non-discretionary accruals which reflect none manipulated

accounting accruals items because they are out of managers’ control.

6 See also the discussion in Baltagi (2008).7 As stated by Aljifiri (2007, p.77), “accounting accruals changes may be less costly when compared to accounting methods changes as a mean to transferred earnings between periods and maybe more difficult to detect by auditors”. The two main components of accounting accruals (discretionary and non discretionary accruals) are not directly observed. Therefore, all studies have used an indirect estimation of discretionary accruals.

Consistent with the previous literature on earnings management (Jones,

1991; and Subramanyam, 1996), we used discretionary accruals to measure the

extent of earnings management. Following recent literature (e.g. Jaggi and

Leung 2007), this study uses the cross sectional variation of the modified Jones

model (Jones, 1991; and Dechow et al., 1995) to obtain a proxy for discretionary

accruals. Dechow et al., 1995; Guay et al., 1996 among some others argue that

modified Jones model is the most powerful model for estimating discretionary

accruals among the existing models. Furthermore, Bartove et al., (2000) indicate

that the cross sectional model outperforms its time- series counterpart in

detecting accruals management.

The dependent variable in our model, earnings management, is measured

as discretionary accruals using a cross-sectional version of the modified Jones

model (Dechow et al. 1995) as follows:

First, total accruals (TACC) is defined in this study as the difference

between net income before extraordinary items (NI) and cash flow from

operating activities (OCF):-

(6)

Equation 2 below is estimated for each firm and fiscal year combination

(7)

Where, TACC is the total accrual, ∆REV it the changes in operating

revenues, ∆REC is the change in net receivables, PPE is gross property, plants

and equipments, t and t-1 are time subscripts and i is the firm subscript.

Changes in revenues is included to control for the economic circumstances

of a firm; whilst gross property, plant and equipment are included to control for

the portion of total accruals related to non-discretionary depreciation expenses

(Jones, 1991). Dechow et al., (1995) modified the Jones (1991) model by removing

the discretionary components of revenues through changes in accounts

receivable. Firms are considered to have engaged in income increasing

(decreasing) discretionary accruals if they have positive (negative) estimated

discretionary accruals. Earning is the reported earnings before interest and tax

and before extraordinary items Earnings target is the prior year earnings level

(Degeorge et al., 1999). Non-discretionary earning (NDE) is earnings less

discretionary accruals (DACC). To estimate the coefficient values, an Ordinary

Least Squares (OLS) regression with no intercept is employed.

The Difference between total accruals and the non-discretionary components of

accruals is considered as discretionary accruals (DACC) as stated below:

(8)

All variables are scaled by prior year total assets A t-1 to control for

heteroscedastisity.

5.2.2 Measuring Ownership Structure and Firm Size

Insider ownership (INSI), external block-holders ownership (EBH) and

institutional ownership (INST) were collected from the annual reports of the

sampled firms in the Amman Stock Exchange (ASE) data base8. INSI was

defined as the percentage of shares held by officers or directors within the firm

and their families (see Karathanssis and Drakos, 2004).

EBH was measured as the percent of shares held by the individual block-

holders9. For each party, we only consider the ownership percentage that

represents 5% or more of firm's equity share capital. INST was measured as the

percent of shares held by the institutions, which includes shares owned through

social security and other funds. Consistent with Koh (2003), the following

organizations are classified as institutional investors: insurance companies (life

and non-life), pension funds, investment companies, and financial institutions

including banks.

8 Government ownership have been excluded because The Jordanian economy is private sector oriented, the state ownership is relatively small.9 Individual external block-holders exclude managerial owners.

Additionally, firms' accruals management decisions are likely to be

influenced by firms' size. The size hypothesis (Watts and Zimmerman, 1986)

posits that large firms are more politically visible and are more likely to manage

earnings to reduce their political visibility (Moses, 1987; Hsu and Koh 2005).

However, Ashari et al., (1994, p. 293) has an opposite view and argues that more

information is available about larger firms, which are closely scrutinized by

analysts and investors Smoothed income signals from larger firms add little

value; accordingly, they have less incentive to smooth income (Atik, 2008). Thus,

there is no specific prediction on the association between firm size and

discretionary accruals. This study uses natural logarithm of total assets as a

proxy for firm size (SIZE).

5.2.3Measuring Other Variables

Given that firms' accruals management decisions are likely to be

influenced by factors other than the three ownership categories (INSI, EBH,

INST) or the size of the firm, several control variables are introduced to capture

the incentives that have been found to influence managers' discretionary

accounting choices. The control variables included in this study are firm

financial leverage (LEV), profitability (ROE), and growth (GROW).

Firms financial Leverage, measured as the ratio of debt to assets, is

included, as a proxy for risk, because managers are more likely to exercise their

accounting discretion granted by GAAP when they are closer to default on debt

covenants (Press and Weintrop, 1990). Trueman and Titman (1988, p. 128)

argue that managing earnings enables managers to reduce estimates of various

claimants of the firm about the volatility of its earnings process and so lowers

their assessment of the probability of bankruptcy. Consequently, as discussed

by Atik (2008), this provides an opportunity to borrow at lower interest rates

and decreases cost of capital. Consistent with this debt hypothesis, we expect that

managers in more leveraged firms are more likely to adopt aggressive earnings

management techniques to prevent violation of debt covenants (Watts and

Zeimmerman, 1986).

Since accruals could also related to growth opportunity, this variable

(Grow), measured as year-over-year sales changes is considered in our

estimation. This variable will be used as a control for demand conditions and

product-cycle effects on profitability. As argued by Chan et al., (2001) and Lui

(2004), firms with the highest growth opportunities usually have higher

valuation ratio and higher growth because the market uses the dividend discount

models to value the firm equity (Lee et al., 2005). Firms with the highest growth

opportunities are likely to have more private information about these prospects,

which would exacerbate the problems of asymmetric information. Therefore,

insiders try to reveal this relevant information through financial statements in

which earnings have been managed to signal the profitable projects available to

the firm (Heay and Palepu, 2003). Our prediction is, consistent with the before

mentioned discussion, firms with higher growth rate have higher discretionary

accruals.

Finally, profitability, measured by return on equity, is included to control

the relationship between earnings management and ownership structure.

Orlitzky et al., (2003, p. 408), argues that “ indicators such as Return on Assets

(ROA) and Return on Equity (ROE) are subject to managers’ discretionary

allocations of funds to different projects and policy choices, and thus reflect

internal decision making capabilities and managerial performance rather than

external market responses to organizational actions”. Thus, in this study ROE is

included as a proxy for profitability. As examined by Chen et al., (2006), listed

firms with lower profitability have higher behavior of earnings management.

Therefore, we expect a negative relation between earnings management and

profitability10.

Table 1 summarizes the definitions and interpretations of the study variables.

5.3 Sample Selection

The sample used in this study comprises the listed industrial firms in

Amman stock exchange between 2001 and 2005. The industrial sector in Jordan

is very important to the economy, as a source of employment and economic

growth. Therefore, understanding the characteristics of earnings management

this sector is vital to enhance the reliability and transparency of reported

earnings, and therefore improve the ability of investors to determine the fair

value.

Data are collected manually from Jordanian shareholding companies

guide issued by Amman Stock Exchange and annual reports of Jordanian

shareholding companies. The firms selected are well settled companies in the

Jordanian economy; they are the major players in the Jordanian industrial

sector. At least for the time of the study these companies have continued to work

progressively, they have a high trading volume and no merging or acquisition

were announced for any of the sample companies.

Additionally, firms with insufficient data for ownership and firms with

inadequate financial data are excluded from the sample. After applying these

conditions, 39 were included in the analysis, which represents around 64% of

Jordanian Industrial firms. The final sample consists of 195 firm-year

10 Some literature uses other factors like research & development outlays and advertising expenditures, unfortunately in this thesis will not be included due to the absence of reliable data and are available for limited number of firms.

observations for accrual estimation and empirical analysis. Of these, 94(101)

firms have positive (negative) discretionary accruals.

6. Results

6.1 Descriptive Statistics

Table 2 reports the descriptive statistics for the dependent and explanatory

variables.

While the discretionary accruals, DACC, ranges between about 34 per

cent and -39 percent, the mean and standard deviation for it are about 0.12%,

10%, respectively. On average, the sample firms have positive discretionary

accruals. This may indicate that Jordanian firms in our sample are managing

their earnings upwardly. Most prominent result is the high standard deviation of

growth (about 53%) relative to the standard deviation of the other variables

included into our models (which range between 10% and 26%). This high

standard deviation of growth may indicate that our sample firms are of different

size and maturity. This is supported by the high standard deviation of size (1.23),

and this justified the inclusion of size and growth in our models.

On the other hand, insider investors, on average, hold around 35 per cent

of total shares outstanding of the sample firms. Comparing this ownership

category with the other categories, we find about 20 per cent on average are

external block-holders. The level of external block-holders is far from what Hso

and Koh (2005) is reported for the period from to 1993 to 1997 within Australian

firms (about 12 per cent). However, Institutional investors represent 23 per cent

of shareholders on average. Again this is quite less than the average institutional

ownership level reported by Koh (2003, 2007) of 47-48 per cent between 1993

and 1997 inclusive, and Stapledon (1998) of around 49 per cent on 1997 for more

developed countries. These statistics are not surprising due to the nature of

emerging markets investing. Most of the listed firms are owned and controlled

by individuals rather than institutional. This is supported by the reported

institutional investors in Indonesian firms, which account for only 7% of total

shareholding for the period from 1994 to 2002 (see Siregar and Utama, 2008).

The average leverage ratio for the sample firms is about 38%. While this

average leverage ratio was far from what is found by Hso and Koh (2005),

around 54 per cent, it is near to the average leverage found in China for the

period in 1994, about 34 percent (see Wei and Verela, 2003).

Pearson correlations between the explanatory variables are documented in Table 3.

DACC has a positive (negative) and significant correlation with insider

(institutional) investors, which is consistent with the nature of managers.

Managers seems to engage more (less) in manipulating their accounting

information and smoothing their income the more are the insiders (institutional)

holding of stocks. On the other hand, external block-holders, growth and

leverage seem to be not correlated with the earnings management behavior of

managers. Size (SIZE) is positively associated with leverage (LEV), consistent

with Cotter's (1998) finding that larger firms have higher leverage constraint

levels. A negative correlation between profitability (ROE) and DACC indicates

that more profitable firms are less likely to witness earnings management.

Negative and significant correlation between EBH and ROE signify that the

more the concentrated the ownership the less the profitability. However, larger

firms seem to be more profitable firms (positive and significant correlation

between SIZE and ROE).

6.2 Ownership Structure and Earnings Management

The results of the regression models, which test the relation between

ownership structure and earnings management, are presented in Table 4.

The first three models are examined to test the relation between each

ownership structure category (INSI, INST, and EBH) and earnings management

measured by DACC. Then models 4 and 5 look at the effect of the three

ownership categories collectively. We control for a number of factors that may

affect earnings management, like SIZE, LEV, ROE and GROW.

The hypothesised concave association between DACC and INSI is found

and is statitically significant. The coefficient of INSI in models 1 is positive and

equals to 0.0554 (see row 3 in Table 4). We interpret the results as support for

Morck et al., (1988) hypothesis that management entrenchment could occure

when insider holdings are high. This suggest that the managerial ownership has

a determinantal effect on earnings management. This result approved the agency

problem that appears between managers and shareholders in Jordanian firms.

Managers have weak incentives to act in shareholders interest. Managers use

their discrition to maximize their utility, thereby grabing earnings (see

Subramanyam, 1996). Based on these results, we can reject the first null

hypothesis.

Looking at the relation btween institutional ownership and discritionary

accruals, in model 2, a negtive relation emerged. However, it has not been

supported statistically. This insignificant association indicates that institutional

investors are not a magor cosideration in managers' aggressive earnings

management strategy. This result is not serprising. In Jordan, most institutional

owners of social security institutions (government pention funds) and other small

investment and financial firms. There is no existence of developed mutual funds

or investment companies. As a result, institutional investors in Jordan are not

effective in constraning managerial behaviour of earnings management.

Consistent with the argument that institutional investors in Jordan are

short-term oriented and create incentives for managers of their portfolio firms to

manage earnings aggressively. As these institutional investors focus excessively

on current earnings performance (see Koh, 2003). The result of non influencial

effect of institutional investors on earnings management found in this study is

not consistent with what Velury and Jenkins (2006) found in a sample of US

based firms. However, similar evidence found by Siregar and Utama (2008) for

Indonisian firms. The same result is evident regarding the relationship between

ernings management and external block-holders. The negative coefficient value

of the EBH variable in model 3 of -0.046 is not statistially significant. Therefore,

the propotion of external block-holders has no influence on management of

earnings. Based on the above mentioned results, our second and third

hypothesis cann't be rejected.

In addition, model 4 brings togather the three ownership categories. All

sighnes remain the same to confirm the previos results. While the level of insider

investors continued to be influential factor on earnings management, the other

wonership categories (INST and EBH) continued to be not important variables,

and have no effect on the level of earnings management within the Jordanian

firms.

Regarding the other variables, included as controle variables, we found

that firms growth (GROW) and leverage (LEV) are not significantly affecting

the quality of accounting information. Managers in Jordanian firms with higher

sales growth and high financial leverage have no more (less) incentives to

manage their income. On the other side, the association between earnings

management and profitability within the Jordanian firms are different than

what we expect. Firms with higher profitability measured by ROE are ingaged

more with earnings managemet (positive and significant coefficients of ROE in 3

out of 5 models, Table 4). This positive relation is not strange and consistent with

Chen and Yuan (2004) findings.

One of the explanation for this positive relation is that Amman Stock

Exchange (ASE) required firms to achieve a minimum profitability to continue

to be listed or apply for permission to issue additional shares (Directives for

Listing Securities on the Amman Stock Exchange, 2004)11

.

Size appears to affect earnings management significantly (significant SIZE

coeffecients in models 1 to 4). However, we find that larger Jordanian firms

have less earnings quality since they engage more in earnings management.

Furthermore, the size effect is further examined by introducing one

interaction variable in model 5. The only influencial ownership category, insider

investors, is multiples by firm size (INSI*SIZE) to develope the interaction

variable. The coefficient is positive and statitically significant. This result is

quanitavely the same as the main finding of models 1 to 4. It confirms that

larger firms are engaging more in earnings manipulation. Based on these results,

we can reject the fourth null hypothesis.

Finally, in order to check the accuracy of our models, we apply

autocorrelation and Sargan tests. In all models, autocorrelation 1 test brings

evidence for negative first order serial correlation. However, autocorrelation 2

test suggests that second order serial correlation is not supported. These results

11 See the web site of ASE at http:// www. exchange.jo

are not violating the assumptions of GMM estimation because as mentioned by

Arellano and Bond (1991), the first order residuals autocorrelation need not to

be zero, but the consistency of the GMM estimators relied heavily on the

assumption that the second order residuals autocorrelation should equal zero.

The Wald test of the joint significance of the regressors is satisfied suggesting

that aggregate factors exert a significant influence on DACC levels in the firms

reported information in all models. The Sargan test also indicates that the

instruments used in the GMM estimation are valid in all models. This is

consistent with the assumption that the instruments used are not correlated with

the error term.

7. Conclusions

In this paper, we use Generalized Method of Moment (GMM)

methodology to examine the relationship between ownership structure and

earnings management (discretionary accruals) for a sample of Jordanian

industrial companies listed on Amman Stock Exchange during the period 2000–

2005. In our first analysis we find a positive and significant relationship between

insiders' ownership and earnings management, which supports Morck et al.,

(1988) who argue that greater ownership would provide managers with deeper

entrenchment and, therefore, greater scope for opportunistic behavior. This

finding indicates that Jordanian insiders tend to make discretionary accounting

choices. In this case, we expect earnings quality and earnings informativeness to

decrease. This result is not surprising since the owner–largest shareholder in

Jordan, typically a founder or his immediate family, usually participates in firm

management directly or indirectly, and influences most of the management

decisions.

We then examine the role of institutions and block-holders, proposing two

opposing hypotheses- an active monitoring role and a passive hand hypothesis.

We find insignificant relationship between each of these two variables and

earnings management. These results suggest that institutions and block-holders

generally play a myopic role in Jordanian companies. They don't not monitor

effectively because they may either lack expertise or suffer from free rider

problems among themselves (Admat et al., 1994), or strategically ally with the

management (Pound, 1988).

Regarding the controle variables, we found that firms growth and

leverage are not significantly affecting the quality of accounting information.

However, ther is no conclusive results for profitabiliy. Size appears to affect

earnings management significantly and larger firms are engaging more in

earnings manipulation.

Our findings have important policy implications since they support the

encouraging for applying corporate governance principles in order to motivate

institutions and block-holders to provide effective monitoring of earnings

management in Jordanian firms, especially those with a large size. These firms

operate in the business environment of insider ownership domination and

control, where managers have greater motivation to manage earnings to

maximize their private benefits. This suggests that similar efforts in other

countries in the region would be rewarding in controlling the management of

reported earnings and enhance the reliability and transparency of reported

earnings in order to promote economic efficiency.

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Table 1

Variables Definitions

Variable Definition Interpretation A- Dependent Variable DACC Discretionary Accruals

measured using modified Jones model.

Measures the managers' ability to transfer their accounting earnings from one period to another (see Jones, 1991; and Subramanyam, 1996, and Jaggi and Leung 2007.

B- Independent variables1- Test variables

INSI Insider ownership defined as the percentage of shares held by officers or directors within the firm and their families.

Based on convergence of interest hypothesis (alignment effect), discretionary accruals is predicted to be negatively associated with insider ownership (see Warfiled et al., 1995). In contrast, entrenchment hypothesis implies that high level of insider ownership can become ineffective in aligning insiders to take value maximizing decisions. Therefore, a positive relationship between earnings management and managerial ownership may exist. Yeo et al., (2007).

INST Institutional investors' ownership measured as the percent of shares held by the institutions.

The relationship between earnings management and the level of institutional ownership is ambiguous. Under an active monitoring hypothesis (Bushee, 1998 and Majumdar and Nagarajam, 1997), the higher the level of institutional investors the lower the earnings management. On the other hand, passive hand hypothesis supports the positive relationship between earnings management and institutional ownership (see Bhid, 1993, and Portter, 1992).

EBH External block-holders measured as the percent of shares held by the individual block-holders (excluding managers). Who ones 5% or more of firm's equity share

Negative or Positive relationship between EBH and DACC may exist. External owners with higher motivation and ability to monitor managers' actions might reduce DACC through their closer monitoring (Dechow et al., 1996). On the other side, EBH require returns from their investment. Thus they

capital. might encourage managers to increase DACC (Velury and Jenkine2006 and Zhong et al., 2007).

2- Control Variables

SIZE Firms size measured by the natural logarithm of total assets.

Large firms are likely to manage earnings to reduce their political visibility (Moses, 1987; Hsu, and Koh 2005). However, Ashari et al., (1994, p. 293) has an opposite view and argue that larger firms have less incentive to earnings management (Atik, 2008).

ROE Firm profitability measured as Return on Equity.

The lower profitability the lower the behavior of earnings management. Therefore, we expect a negative relation between earnings management and profitability (see Jiang Yihong, 1999; and Chen et al., 2000).

GROW Growth opportunity measured as year-over-year sales changes.

Firms with higher growth rate are expected to have higher discretionary accruals (see Heay and Palepu, 2003).

LEV Firms financial Leverage, measured as the ratio of debt to total assets.

Managers in more leveraged firms are more likely to adopt aggressive earnings management techniques to prevent violation of debt covenants (Watts and Zeimmerman, 1986).

Table 2

Descriptive Statistics

Variable Mean Standard

Deviation

Minimum Maximum

DACC 0.117% 10.098% -38.700% 34.400%

INSI 38.053% 24.497% 6.330% 97.290%

EBH 20.301% 22.046% 2.14% 77.240%

INST 23.101% 25.935% 0 97.24%

ROE 6.1521% 10.573% -55.960% 32.423%

SIZE 16.340 1.231 13.971 19.829

GROW 16.468% 52.745% -85.329% 454.46%

LEV 35.667% 18.837% 5.302% 84.422%

DACC= discretionary accruals, DINSI= Insider ownership measured

as percentage of shares owned by board of directors their wives and children

and influential executives, EBH= External block holders measured as the sum of

shares that exceeds 5% for every individual share holder. INST= Institutional

block holder measured as the sum of shares that exceeds 5% for every

institutional share holder. SIZE= the size of the firm approximated by total

assets. GROW = Growth of the company approximated by percentage change in

sales. LEV= Leverage ratio calculated by total liabilities over total assets.

Table 3Correlation Matrix

Variable

DACC INSI EBH INST ROE SIZE GROW

DACC

INSI 0.146**

EBH 0.007 0.4692***

INST -0.136**

0.265***

-0.516***

ROE -0.182**

0.125* -0.199** 0.259***

SIZE -0.499***

0.095 0.280***

0.295***

0.307***

GROW

-0.074 -0.012 0.105 -0.099 0.107 -0.016

LEV -0.076 -0.197**

0.135** 0.020 -0.218***

0.306***

0.144**

See Table 1 for variables definitions.

Each value in this table represents Pearson product moment correlation

coefficient between each pair of the variables listed in column 1.

Stands for 10%, 5%, and 1% significance levels respectively.

Table 4 Ownership Structure and Earnings Management Model 1:

Model 2: Model 3: Model 4: Model 5: Model

(1) (2) (3) (4) (5)

Intercept -0.249**(0.124)

-1.491**(0.724)

-1.587**(0.748)

-0.441**(0.146)

-0.473(0.442)

L1 -.320***(0.021)

-.245***(0.068)

-0.247 ***(0.063)

-.331(0.018)

-0.346***(0.023)

INSI .0554**(0.025)

0.144***(0.045)

1.664**(0.754)

EBH -0.046(0.122)

-0.003(0.028)

-0.183(0.124)

INST -0.001(0.145)

0.041(0.03)

0.004(0.048)

SIZE 0.017**(0.008)

0.090**(0.044)

0.095**(0.044)

0.023***(0.008)

0.029**(0.029)

LEV 0.007(0.030)

0.078(0.100)

0.089(0.982)

0.023(0.025)

0.084***(0.026)

ROE 0.001***(0.000)

0.000(0.001)

0.0002(0.001)

0.001*(0.000)

0.002***(0.000)

GROW -0.006(0.006)

0.018(0.111)

0.0172(0.012)

-0.008(0.005)

0.003(0.009)

INSI*SIZE 0.102**(0.047)

Autocorrelation(1) -3.4964*** -3.3244*** -3.375*** -2.874***

-3.042***

Autocorrelation(2) -1.2395 1.160 -1.096 -1.212 -1.706SarganTest (df) 7.094(5) 7.792(5)* 8.792(5) 8.753(5) 7.434(5)Wald (df) 24.87(6)*** 26.160(6)*** 26.60(6)*** 27.81

(8)***39.74(9)***

The dependent variable Earnings Management (EM) is measured by

Discretionary Accruals (DACC). DINSI is the insider ownership measured as

percentage of shares owned by board of directors their wives and children and

influential executives. EBH is the external block holders measured as the sum of

shares that exceeds 5% for every individual share holder. INST is the

institutional block holder measured as the sum of shares that exceeds 5% for

every institutional share holder. SIZE is the size of the firm approximated by the

natural logarithm of total assets. GROW is the growth of the company

approximated by percentage change in sales. LEV is the leverage ratio calculated

by total liabilities over total assets. In all the reported Models DACC is regressed

on the aforementioned independent variables.

Models 1 to 3 each of the ownership measures are included individually

in addition to the control variables. In Model 4 the entire ownership structure

variables are included at ones. In Model 5 the interaction effect of size and the

portion of insider ownership are examined wither the relation between earnings

management and insiders differ among different firms size. All models are

examined using GMM estimation. Four test statistics are reported: (1) and (2)

first and second order autocorrelation of residuals respectively, which are

asymptotically distributed as standard normal N (0, 1) under the null of no serial

correlation. Wald is the Wald test of joint significance of the estimated

coefficients which is asymptotically distributed as Chi-square under the null of

no relationship. Sargan test of overidentifying restrictions which is

asymptotically distributed as chi-square under the null of instruments validity.

All estimations were carried out using the Stata program. ***,**, and * indicate

coefficient is significant at the 1, 5, 10% levels, respectively.