Impact of Earnings Management on Capital Structure of Non-Financial Companies Listed on (KSE) Pakistan

Abstract

Introduction In the current decade Earnings Management has become a researchable topic due to collapse of many firms. It has been defined by many researchers in several different ways but Schipper (1989) defined as ... a purposeful intervention in the external financial reporting process, with inventing of obtaining some private gain (as opposed to merely facilitating the natural operation of the process). While Healy and Whalen (1999) said Earnings management occurs when managers use judgment in financial reporting and 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 depend on reported accounting numbers A firm whose incomes are relatively stable can safely take on more debt and incur higher fixed charges than a company with volatile incomes. Managers through the adjustment of discretionary accruals do these miracles as change the unstable incomes into stable incomes i.e. called earnings management. Temporarily it enhances the market value of the firms, build the confidence of the stakeholders and change the psyche of investors. But later on, this long-term artificial process creates bulk of problems for the firms especially regarding cash flows. The total shareholder's capital of a company consists on Ordinary Share Capital and Reserves. The ordinary share capital represents the total paid up capital against issue of ordinary shares. It includes shares paid in cash (subscribed/ right issued), issued as bonus shares and share issued for considerations other than cash. Reserves are evaluated by aggregating all kinds of reserves except depreciation reserves and reserves for bad debts. The total shareholder's equity is the sum of ordinary share capital and total reserves. The preference shares pay fixed dividend but no voting right. In case of liquidation of the company their status considered normally prior to the status of ordinary shares but after other liabilities like bonds, bank loans and certificates etc. The bonds/ certificates issued by a company to raise funds for long term period. They are debentures and term finance certificates. The total fixed liabilities are the sum of preference shares, debentures and other fixed liabilities. The total capital employed is the sum of total fixed liabilities and total shareholder's equity. The proportion of total fixed liabilities to the total capital employed is called gearing ratio. Gearing ratio indicates the extent to which debt financing is used relative to the total capital employed. The creditors/ investors desire low gearing ratio for sanctioning of new loans or make investment to a firm. Dechow & Skinner (2000) admitted that it is very difficult to operationalize these definitions in the real sense of the word on financial reporting system because managerial intent by nature is unobservable. Managers, most probably, get desired net-income through the adjustment of discretionary accruals that cause impact on capital structure (gearing ratio). Discretionary accruals are an important part of earnings management that largely has reversible process (Mc Nichols 2000). Temporarily, it may cover some weaknesses of the companies and polish its financial ratios but on the long run collapse seems indispensable. Mangers violate the timing and matching principle that results not only misstatement of earnings but also buff the capital structure and make it attractable. In the long run the wealth of the companies grossly suffers due to this type of manipulation and even some times robes innocent stakeholders including investors like Enron and WorldCom. Higher the debt to total capital employed ratio (gearing ratio) shows financial weakness and risk of the company that may degenerate the credit rating and confidence of all stakeholders. Also it creates difficulty to generate more funds through the permanent long term financing by debt, preferred stock and common stock equity. …