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RELATED PARTY TRANSACTIONS AND EARNINGS MANAGEMENT Linvani Kuan Curtin University, Perth, Australia Greg Tower Curtin University, Perth, Australia e-mail: g.tower@.curtin.edu.au Rusmin Curtin University, Perth, Australia e-mail: Rusmin@cbs.curtin.edu.au J-L.W. Mitchell Van der Zahn Curtin University, Perth, Australia e-mail:mitchell.vanderzhan@cbs.curtin.edu.au Abstract This study examines the association between related party transactions and earnings management, based on a sample of 50 Indones
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    RELATED PARTY TRANSACTIONS AND EARNINGS MANAGEMENT Linvani Kuan Curtin University, Perth, Australia Greg Tower Curtin University, Perth, Australiae-mail: g.tower@.curtin.edu.au Rusmin Curtin University, Perth, Australiae-mail: Rusmin@cbs.curtin.edu.au J-L.W. Mitchell Van der Zahn Curtin University, Perth, Australiae-mail:mitchell.vanderzhan@cbs.curtin.edu.au Abstract This study examines the association between related party transactions and earnings man-agement, based on a sample of 50 Indonesian publicly listed companies for the periods ending 2004and 2005. The hypothesis developed in this study draw on past literature and the tenets of agencytheory which suggest that the existence of related party transactions represent potential conflict of interest which may results in earnings management and appropriation by controlling shareholder to minority shareholders. The empirical findings of the study suggest that there is no statistically significant evidence of the association between related party transactions and earnings manage-ment attributes. Additional sensitivity analysis conducted with alternative measures of earningsmanagement and related party transactions confirm the initial regression results. The results of this study suggest that the mere presence of related party transactions in Indonesian companies doesnot necessarily indicate that management engage in greater earnings management. This study pro-vides a valuable starting point for similar research in other developing countries.  Keywords: Earnings management; Related party transactions; Indonesia Abstrak   Penelitian ini menguji hubungan antara transaksi-transaksi diantara pihak-pihak yang berhub-ungan dan manajemen laba, berdasarkan data dari 50 perusahaan yang terdaftar di pasar modal dalam periode 2004 dan 2005. Hipotesis dibangun dari penelitian-penelitian sebelumnya yang terkait dengan teori keagenan yang menyatakan bahwa keberadaan transaksi-transaksi diantara pihak-pihak yang berhubungan berpotensi untuk menimbulkan konflik kepentingan sehinggamenghasilkan manajemen laba dan kecenderungan pengendalian pemegang saham untuk  pemegang saham minoritas. Temuan empiris dari studi menunjukkan bahwa tidak ada bukti statistik yang signifikan dari hubungan antara transaksi pihak terkait dan atribut manajemen laba.Sensitivitas analisis tambahan dilakukan dengan langkah-langkah alternatif pendapatanmanajemen pemerintah dan transaksi pihak terkait mengkonfirmasi hasil regresi awal. Hasil studiini menunjukkan bahwa Kehadiran transaksi pihak terkait di perusahaan-perusahaan Indonesiatidak selalu menunjukkan bahwa manajemen laba yang lebih besar. Studi ini merupakan titik awal  yang berharga untuk penelitian serupa di negara-negara berkembang lainnya.  Kata Kunci: manajemen laba, transaksi pihak terkait, Indonesia      INTRODUCTION The purpose of this study is to investi-gate whether there is an association betweenrelated party transactions (RPTs) 1 and earn-ings management (EM) 2 in Indonesian public-ly listed companies. The hypothesis is basedon agency theory tenets concerning the separa-tion of ownership, conflict of interest and in-formation asymmetry. This study utilises asample of Indonesian publicly listed compa-nies for the periods ending 2004 and 2005.The modified Jones (1991) accruals 3 estima-tion model is used to measure discretionaryaccruals (the proxy for EM).   EM and RPTs are very important as- pects of financial reporting over the years andhave been under intense media after a series of spectacular corporate collapses (e.g. Enronusing their Special Purpose Entities) (Jian andWong, 2004). These RPTs are usually com- plex and differ between companies dependingon factors such as the ownership structure andthe nature of the business. Gordon and Henry(2005: 1) argues that,” users of financial re- ports view the existence of RPTs as an indica-tor of increased likelihood of aggressive ac-counting”. Furthermore, American Institute of Certified Public Accountants (AICPA) sug-gests that one of the important and difficultaspects of financial statement audit is the iden-tification of related parties and transactionswith related parties. “Related parties such ascontrolled entities, principal stockholders or management can execute transactions that im- properly inflate earnings by masking their economic substance or distort reported resultsthrough lack of disclosure, or can even de-fraud the company by transferring funds toconduit related parties and ultimately the per- petrators” (AICPA, 2001, p.5).As a result of the increase significanceof these issues, government and standard set-ters have increased the emphasis of regula-tions on RPTs as can be seen in the UnitedStates Sarbanes-Oxley Act (2002), the Aus-tralian Commonwealth Government’s Corpo-rate Law and Economic Reform Program(CLERP 9) and Australian Securities and In-vestment Commissions’ (ASIC) (2005) cam- paign. The Sarbanes-Oxley Act (2002)amended disclosure requirements of RPTs viathe Section 402 provisions with enhanced con-flict of interest disclosures. The CLERP 9 Billset out that government proposed legislativeresponse on corporate disclosure including thedisclosure of the executive remuneration and policies (Allens, et al., 2003). Furthermore,ASIC have announced campaign to crack down on related party (RP) disclosure docu-ments and to ensure that shareholders receivesufficient information to make a decision aboutwhether to grant RP benefits (ASIC, 2005).EM is a vibrant area in accounting re-search. There are numerous publications andresearch which examine EM by measuringcompanies’ discretionary accruals (Jones,1991). These publications investigate the rela-tion of EM with respect to many issues suchas auditor independence (Frankel, Johnson,and Nelson, 2002), auditor specialization(Krishnan, 2003) and corporate governance(Peasnell, et al., 2006). However, research published regarding the issue of EM withRPTs are still limited. Although there are stud-ies conducted to investigate the issue of RPand tunneling 4 , they focus on the market valu-ation effects of this behaviour (Claessens, etal., 2000). This study seeks to fill the gap inthe literature through the investigation of RPTsand EM in Indonesian publicly listed compa-nies.Several studies found that Indonesiahas characteristics that might indicate highlevel of RPTs and EM. Past researchers pro- pose that Indonesia has high concentrationlevel of ownership (La Porta, et al., 1999;Claessens, et al., 2000), low level of transpar-ency and disclosure quality 5 (Fan and Wong,2002), low efficiency of judicial system, lowrating in rule of law, significantly high corrup-tion level and moderate risk of expropriation(La Porta, et al., 1999). According to Leuz, etal., (2003: 508), “earnings management ismore pervasive in countries [like Indonesia 6 ]where the legal protection of outside investor is weak, because in these countries insider en- joy greater private control benefits and hencehave stronger incentives to obfuscate firm per-  Related Party Transactions   … (Linvani Kuan, et al.) formance” 7 . These characteristics that Indone-sia possessed indicate possible high levels of RPTs consequently high level of EM. Indone-sia thus provides an important setting to testthe association between EM and RPTs.This study contributes to the account-ing literature in several ways. Firstly, thisstudy provides further evidence on the asso-ciation of RPTs with EM 8 . Despite worldwidemedia and government attention over the con-cern of RPTs involved in recent corporate col-lapses, there is little rigorous academic re-search conducted to investigate the extent of RPTs in companies and their underlying na-ture (Gordon, et al., 2004; Jian and Wong,2004). Secondly, this is the first known studyof RPTs and EM that focuses on Indonesia.Previous studies of RPTs and EM have lookedat countries such as China (Jian and Wong,2004; Aharony, et al., 2005). Our study exam-ines the different impact of using RPTs tomanage earnings in emerging country of Indo-nesia with different characteristics such asownership structure, disclosure quality, inves-tor protection, corporate government, and le-gal enforcement. Furthermore, this research provides an overview on the actual RPTs inIndonesia and as an important basis for futureresearch in Indonesian context.The remainder of this paper is organ-ised as follows. The next section presents thetheoretical framework underlying RPTs andEM linkage. Hypothesis is also provided in thenext section. Section Three describes the re-search design. Primary results including de-scriptive statistics, correlations and regressionanalysis are presented in Section Four. Resultsof the study and implications for future re-search are discussed in the concluding section. THEORETICAL FRAMEWORK ANDHYPOTHESIS DEVELOPMENT The majority of the literature that seek to explain the incentives of managing earningsutilised agency theory. Agency theory is themajor theory that serves as a basis for this re-search and hypothesis development. Jensenand Meckling (1976) argue that agency con-flict exists between the manager and share-holder due to the separation of ownership andcontrol. Agency theory focuses on the rela-tionship 9 between principal and agents (for example the relationship between shareholdersand corporate managers), a relationship thatcreated much uncertainty due to informationasymmetry between two parties. The study of EM and RPTs presents an excellent opportuni-ty to apply agency theory in a sense that thereis conflict of interest and information asym-metry between controlling and minorityshareholders in Indonesian companies that fa-cilitate the controlling shareholders to act in aself-interest way such as manage earnings for their own benefits.Furthermore, as implied by the mediaand standard setters, RPTs represent the po-tential expropriation of the firm’s resources(Gordon and Henry, 2005) 10 . Kohlbeck andMayhew (2004) propose that RPTs also raiseconcerns based on agency theory that manag-ers will over consume perquisites (i.e. inap- propriate wealth transfer) and alter the reliabil-ity of financial statements thereby reducingthe effectiveness of contracts designed to re-duce agency conflicts and damages the firm’sstakeholders (Jensen and Meckling, 1976).The results of study conducted by Gordon, etal . (2004) also provide support for the view of RPTs as conflict of interest between manag-ers/board members and their shareholders.There are several past studies that fo-cus on the cost and benefits of corporategroups (Khanna and Palepu, 1997; Fishmanand Khanna, 1998; Claessens, et al., 2006).However, association between RPTs and EMis a relatively new topic in accounting re-search. There are limited studies conducted onthese issues and the results are mixed and far from conclusive. Carmichael (1999) proposesthat there is a long history of revenue-recognition manipulations involving related parties that are connected with fraudulent fi-nancial reporting. The study conducted by Jianand Wong (2004) look into whether and howcontrolling shareholders use RPTs in EM andtunneling as well as the market response tosuch activities in China. It is found that thegroup-controlled firms report an abnormally    JAAI VOLUME 14 NO. 2, DESEMBER 2010: 115–93 high level of RP sales when they have the in-centives to inflate earnings in order to meetgovernment requirements for the new equityofferings or to avoid delisting (Jian and Wong,2004). This study provides direct evidence onhow large shareholders expropriate minorityshareholders. In addition, Aharony et al . (2005)investigates RPTs as a means of EM and tun-neling during IPO process in China. Their pa- per contributes by providing empirical evi-dence on earnings management using RPTs byexamining RPTs patterns in both pre- and post-IPO periods and enhances understandingof the motives of earnings manipulation in the pre-IPO period.More recent study, such as Ashbaugh-Skaife et al. (2006) suggests that when there isno or little scrutiny over RPTs, the manager has greater incentives to expropriate firm re-sources and manage earnings. Cheng andChen (2007) research of Chinese IPO firms,argue that there are two ways for IPO firms tomanipulate pre-IPO reported earnings, by ma-nipulating discretionary accruals and structur-ing artificial operating RPTs (non-loan) withcontrolling shareholders. Gordon and Henry(2005) propose that if managers engage inRPTs to expropriate the firm’s resources, thenthey have the incentives to manage earnings tomask such expropriation. On the contrary,Gordon and Henry (2005) conclude that con-cerns about RPTs are warranted but only for certain transactions and the mere presence of RPTs is not necessarily an indication that afirm is likely to engage in greater EM.Kohlbeck and Mayhew (2004) suggest thatRPTs with investments appear to be associatedwith efficient contracting, while simple trans-actions with directors, officers and sharehold-ers are associated with opportunism. Accord-ing to Duprey (2006), although most of theRPTs are legal, often these transactions weresupposed to be conducted at arm’s length butultimately benefited several of the principalsinvolved. He also suggests that RPTs will bemore prevalent in a family-owned and operated business.In brief, most of the studies conductedfocus on RPTs with respect to EM on IPO pe-riod and/or China. The majority of these stud-ies suggest that there is empirical evidencethat Chinese firms use RPTs as a means of EM and tunneling during IPO process. Giventhat there is no known prior study that utiliseIndonesian data, this study seeks to provide amore comprehensive picture of RPTs and EMin Indonesian firms.Dye (1988) and Trueman, et al . (1988)show analytically that the existence of infor-mation asymmetry between management andshareholders is a necessary condition for EM.Lobo and Zhou (2001) argue that in such envi-ronment where shareholders they have lessinformation than management and cannot per-fectly observe a firm’s performance, manage-ment can use its flexibility to manage reportedearnings.In relation to concentrated ownership,McCahery and Vermeulen (2005) suggest thatinefficient controlling shareholders have givenrise to a huge variety of sophisticated tech-niques to tunnel assets, profits and corporateopportunities. Fan and Wong (2002) proposethat when ownership is concentrated to a levelat which an owner obtains effective control of the firm, as the case in East Asia (like Indone-sia 11 ), the nature of the agency problem shiftsaway from manager-shareholder conflicts toconflicts between the controlling owner (whois also the manager) and minority shareholders.This view is further justified by the study con-ducted by Lukviarman (2004) on Indonesianownership structure and firm performance.Lukviarman (2004) finds that only a small proportion of private-domestic Indonesianfirms have a widely dispersed ownershipstructure and the agency problem shifted tostrong controlling shareholders and weak mi-nority owners. Furthermore, the study propos-es that inappropriate institutional, law and le-gal enforcement insulate the controllingshareholders from external interference, moni-toring and supervision. In another Indonesianstudy, Patrick (2002) suggests that Indonesianstock exchange, self-regulating institutions,and government oversight practice are notstrong. Thus, highly concentrated and family- based ownership structure leaves corporate
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