The main research question I would like to address in this research is that whether there is a high(er) magnitude of earnings management in Nigeria and which industry is more prevalent. Earnings management is such a huge and important topic around the globe of which series of regulatory importance and penalty is now been attached to it. Earnings management got it root from the ground breaking article of Jensen & Meckling (1976) when the theory of the firm was proposed. In the article, it was stated that the relationship between the managers and the shareholders is that of ‘Agent and Principal relationship’.
Jensen & Meckling (1976) define the agency relationship as a contract under which one party (the principal) engages another party (the agent) to perform some services on its behalf. As a result of the separation of ownership from control, the principal will delegate some decision making authorities to the agent in other to achieve the primary objective of the firm which is the maximization of shareholders wealth. Moreover, the primary objective of the firm conflicts with the interest of the managers.
The divergence of interest between the principal and the agent creates agency problem which indeed have a cost attached to it (agency cost). The agency costs as stipulated by Jensen & Meckling (1976) are: (1) ‘Monitoring costs; which are expenditures paid by the principal to measure, observe and control the agent’s behaviour. They may include cost of audits, writing executive compensation contract and ultimately the cost of firing managers’ (2) ‘Bond Cost is the cost relating to setting up structures that will see managers act in the shareholder’s best interests, or compensate them (shareholders) accordingly if managers don’t, (3) ‘Residual Loss arise because the cost of fully enforcing the principal-agent contracts would far outweigh the benefits derived from it.
Earnings to investors (shareholders) are the most important single line item in financial statements. It indicate the extent to which management of the company has engaged in value added activities for a given time line. According to the Nigerian GAAP (The Statement of Accounting Standards (SAS)) for financial reporting, managers are meant to comply with the prudency concept of accounting in reporting their earnings to the shareholders.
Prudency concept of accounting stipulate that firms should not anticipate profit (income & gains) but all known losses must be provided for in the financial statement to shareholders and other external users. Prudency concept as it were is a key accounting concept that ensures that the reported net income (earnings) and assets of the firm are not overstated and also that the liabilities and expenses of are not understated. Although with the introduction of common sets of accounting standards; the International Financial Reporting Standard (IFRS), the concept was removed in IASB’s Conceptual Framework in 2010. Hans Hoogervorst (2012) , Chairman of International Accounting Standard Board (IASB) says that ‘Despite the removal of the prudency concept from the conceptual framework of the International Accounting Standard Board (IASB) the standard setting body of the International Financial Reporting Standards (IFRS), the basic tenets of the concept remains intact and visible throughout International Financial Reporting Standards (IFRS)’.
In a bid to induce sanity into the Nigerian business environment and to guide against failure of firms, code of best governance practices was introduced in 2003 with the aim to protect the wealth of the shareholders and to establish confidence in the quality of financial statements been produced by the managers according to Hassan el al. (2012).
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