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Financial status, corporate governance quality, and the likelihood of managers using discretionary accruals
Sebahattin Demirkan
School of Management, SUNY Binghamton University, Vestal, New York, USA, and

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Harlan Platt
College of Business Administration, Northeastern University, Boston, Massachusetts, USA
Abstract
Purpose The purpose of this paper is to investigate, using data on US manufacturing rms, how and when corporate governance affects managers decisions to use discretionary accruals and thereby articially inuence company nancial reports. Design/methodology/approach Three-stage least squares is employed to study the relationship between nancial status, corporate governance and nancial reporting discretion. The sample spans the years 2001-2003 during a severe downturn in the US stock market. Financial status is measured with the Altman Z-score. Findings A signicant difference is found between rms not classied as healthy or failed (i.e. the mid-range group) and the two extreme categories when examining governance quotient using a well-known index. A positive relationship is found between discretionary accruals and the governance index. Strong governance appears to reduce the incidence of mid-range rms engaging in accruals management. The least healthy and the most distressed companies have the weakest relationship with discretionary accruals. By contrast, mid-range rms are more likely to resort to discretionary accruals. Practical implications Non-executive members of boards of directors are warned to be particularly vigilant about discretionary accruals with rms transitioning between healthy and high-failure risk. Originality/value The relationship between rms nancial health and discretionary accruals reveals an agency problem in credit markets with nancially stressed rms. More attention is required on rms whose nancial condition is uncertain. Also, it is documented that signicant ndings of importance to the earnings quality and corporate governance literature by documenting the role of corporate governance on discretionary accruals and nancial status. Keywords Corporate governance, Financial reporting, Financial performance, United States of America, Manufacturing industries Paper type Research paper

The authors are grateful to the reviewers for their keen insights and extraordinary diligence. The authors also thank Arnie Wright for his valuable comments. The authors would like to acknowledge nancial support from College of Business Administration, Northeastern University and School of Management, SUNY Binghamton University.

Accounting Research Journal Vol. 22 No. 2, 2009 pp. 93-117 q Emerald Group Publishing Limited 1030-9616 DOI 10.1108/10309610910987475

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1. Introduction Accounting literature uses discretionary accruals to measure earnings management and market efciency since earnings are composed of cash ow from operations (CFO) and accruals (DeFond and Jiambalvo, 1994; Rees et al., 1996). Bernstein (1993) argues that:
Cash ow from operations, as a measure of performance, is less subject to distortion than is the net income gure. This is so because the accrual system, which produces the income number, relies on accruals, deferrals, allocations and valuation, all of which involve higher degrees of subjectivity than what enters the determination of CFO.

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His explanation highlights why academic researchers focus on discretionary accruals to detect all kinds of earnings management and opportunistic behaviors of managers. Market efciency is also measured by how the information in discretionary accruals is contained in investors decision-making process (Sloan, 1996). Managers may be motivated to manage their rms earnings as a consequence of self interest (e.g. compensation, stock awards or pension contributions) especially if the remunerative event depends on observable performance measures such as earnings or protability (Fields et al., 2001). Earnings manipulations affect the quality of earnings by distorting the portion of earnings that are a result of corporate success and the portion resulting from managerial discretion. Not surprisingly, investors respond appropriately if they believe earnings numbers are distorted (Dechow and Schrand, 2004). On the other hand, successful detection of earnings management is problematic due to the surfeit of variables that inuence the managers decision set about the rm. Greater recent attention on discretionary current accruals (DCA) is a consequence of major accounting frauds (such as Enron) and in response to mounting evidence of corporate earnings management (Clarke, 2005). It is doubtful that all companies use DCA to inuence their earnings level. We speculate that the greatest incidence of DCA occurs when companies nancials are under the closest scrutiny[1]. Such times include when credit lines are being reviewed by lenders, unexpected shocks hit either the company or its industry, or the companys operating and nancial results are under stress. This research focuses on this later case. That is, we study how a companys nancial condition (as measured by the Altman Z-score) inuences its use of DCA by taking into consideration their corporate governance quality[2]. Financial status of the rm is important for both creditors and investors. The literature also shows that corporate investment decisions are related to nancial factors (Cleary, 1999). Firms investment strategies are closely related to their accruals (Ohlson, 1995; Faireld et al., 2003). Basically, investment strategies of rms are sensitive to the availability of both internal and external funds and as a consequence accruals play a signicant role in their decisions. External sources of nancing may come with agency costs. Therefore, rms may prefer to nance their investments with internal sources of nancing to avoid this additional agency cost. Following the above argument, Bernanke and Gertler (1990), Gertler (1992) and Fazzari et al. (1988) classify rms according to their nancial constraints by using dividend payout, size, age, group memberships or debt ratings, and show that investment decisions of rms that are nancially constrained are more sensitive to rm liquidity than otherwise. Kaplan and Zingales (1997) found the opposite result that investment decisions of the least nancially constrained rms are less sensitive to the availability of cash ows. Cleary (1999), like Kaplan and Zingales (1997), classies rms according to their nancial variables which is similar

to how the Altman Z predicts bankruptcy[3]. Cleary (1999) notes that corporate investment (real activity decision) is sensitive to rm liquidity and that the relationship is more severe among less creditworthy rms. We document a strong relationship between a rms nancial classication (according to the Altman Z-score which includes liquidity ratios) and its use of performance adjusted DCA (PADCA)[4] which is nancial accounting reporting choice of managers, see the Appendix for PADCAs calculation. This relationship is most sensitive for rms that are in the mid-range between healthy and distressed classications. This study contributes to both the accounting and the nance literature in various ways. First of all, we document the relationship between rms nancial health and their discretionary accruals. This result is important because it shows the existence of agency problems in credit markets if nancial statements signal that the rm is nancially stressed. Second, we document the importance of paying more attention to rms whose nancial condition is uncertain since they appear to be more prone to accrual manipulations. This is especially important for the non-executive members of boards of directors of the rm concerned with governance issues in the Sarbanes-Oxley constrained environment. Finally, we document signicant ndings of importance to the earnings quality and corporate governance literature by documenting the role of corporate governance on PADCAs and nancial status. The remainder of the paper is organized as follows. Section 2 discusses the motivation behind the study, Section 3 reviews existing literature, Section 4 develops hypotheses, Section 5 presents research design, Section 6 documents empirical results and the conclusions are offered in Section 7. 2. Motivation A number of motivations for managers to use discretion in accounting have been proposed in the literature including hitting targets to affect employee bonuses and debt covenants as well as motivations affecting stakeholders and stock price by achieving targeted earnings goals (Healy and Wahlen, 1999; Dechow and Skinner, 2000; Fields et al., 2001). In addition, managers may want to increase their reputation with stakeholders, such as customers, suppliers, and creditors, to gain bargaining power and thereby inuence their terms of trade (Bowen et al., 1995; Burgstahler and Dichev, 1997). Companies reporting better results, even if they have been managed, are likely to be rewarded with advantageous credit terms relative to similar companies not managing their accounts. Executive pay may be related to some preset earnings number pushing managers to use accounting discretion to realize earnings goals and thereby increase their personal wealth and continue their tenure at the rm (Healy, 1985; Matsunaga and Park, 2001; Farrell and Whidbee, 2003; Francis et al., 2008). Managers may also manage earnings to avoid violating debt covenants that would increase the cost of capital for the rm (Watts and Zimmerman, 1990). Our study contributes to the stream of research that asks why do managers use accounting discretion? We incorporate two factors that previously were separately tested as determinants of discretionary accruals: the companys nancial status and corporate governance. A companys nancial health is related to the other factors discussed above that explain discretionary accruals including impacts on executives careers, corporate reputation, stock price, and debt covenants. Our study also makes a contribution to the literature regarding classication of rms according to their

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nancial health by considering the role that discretionary accruals play in that matter[5]. Graham et al. (2005) report that companies are more likely to take real actions such as asset sales or reducing investments to facilitate the meeting of earnings targets. They note that accounting actions to meet earnings benchmarks get notably little support (p. 36), from their survey respondents, 401 nancial executives. It is precisely this negation of the admission that discretionary accruals are used by rms that leads us to investigate their use by nancially stressed rms. That is, we agree that it is likely that normal or healthy companies are averse to using discretionary accruals; however, it is companies that either are falling from a state of health or which are in the process of working their way out of distress that we believe are likely candidates to be users of discretionary accruals. 3. Literature review Yeh and Lee (2004) nd that weak corporate governance increases the probability of a rm being classied as nancially distressed, but not vice versa. Observant and involved members of a board of directors provide a forum that promotes better managed rms. They also note that healthy rms are more likely to have strong corporate governance than weaker rms. Cook et al. (2008) examine the effect of tax planning on the relationship between effective tax rates (ETRs) and earnings management that is documented by Dhaliwal et al. (2004). Following that argument they also look at the effect of the Sarbanes-Oxley Act (SOX) of 2002 on the relationship between earnings management and ETR. They nd that tax planning effects a rms ETRs and its earnings management. On the other hand, they nd no signicant result between SOX and earnings management. Bowen et al. (2008) investigate whether managers use of accounting discretion for opportunistic purposes or for shareholder wealth maximization, as efcient contracting theory anticipates. They nd some evidence that managers use accounting discretion to increase shareholder wealth. Unlike the conclusions of the prior literature, they also document that poor governance is positively associated with future CFO and return on assets (ROA). Therefore, they assert that earnings management may benet shareholders by signaling future performance of the company. On the other hand, their nding does not support the idea that managers exploit lax governance structures and engage in accounting discretion at the shareholder expense. Similar to Bowens et al. (2008) argument in our case, managers may use discretionary accruals to signal that a rm deserves a healthy classication if it would be classied otherwise. On the other hand, opportunistic usage of discretionary accruals may increase the managers own wealth and entrench their position at their company by avoiding disclosure of nancial distress or bankruptcy. Corporate governance quality plays a signicant role in the decision to exercise discretionary accrual in nancial reports. Jones et al. (2008) investigate the relationship between restatements and several models of discretionary accruals. They document that accrual estimation errors are correlated with restatements. Their nding suggests the need for research on whether rms use discretionary accruals to avoid being classied as distressed rms. Both restatements and distressed classications lead investors to discount the value of rms signicantly. Later after a rms health has organically improved, they may correct nancial statement manipulation through restatements.

Holthausen et al. (1995) document that managers manipulate earnings to maximize their bonus plan payments. This nding supports Healys (1985) idea but did not support his other idea that managers manipulate earnings downward (income decreasing earnings manipulation) when earnings fall below the minimum necessary to receive bonuses. We support the income increasing argument and think that managers may forsake accruals management when their rm is stressed because manipulation then has no affect on their compensation. Dhaliwal et al. (2005) examine the relationship between institutional ownership, nancial health and market valuation weights on earnings and book value of equity. They document that rms that have high-institutional ownership are nancially healthier. Their nding is supportive of prior studies that show institutional investors playing a duciary and positive governance role (Shleifer and Vishny, 1997; Bushee, 1998). Prior studies also suggest that institutional investors prefer to invest in nancially healthy rms (Hessel and Norman, 1992; Del Guercio, 1996). Managers may seek to keep institutional investors as owners in order to benet from their nancial power but also to achieve stock appreciation which may increase the value of managers bonuses. Our study contributes to this stream of research by showing that managers use accounting discretion to make mid-range companies appear healthier and thereby become the targets of institutional investors in the future, which may affect their corporate governance quality as well. Ali et al. (2007), Mather and Ramsay (2006) and Hsu and Koh (2005) examined the impact of corporate governance on discretionary accruals. Ali et al. (2007) nd better quality earnings reports among family rms who they nd are also more reticent about their corporate governance practices. Mather and Ramsay (2006) consider how characteristics of strong corporate boards are associated with the degree of earnings management at the time of chief executive ofcer (CEO) transition. Notably, they uncover evidence in cases where the CEO resigned of negative unexpected accruals. This is limited by larger boards and boards with a higher proportion of independent directors. When the CEO retires they nd that discretionary accruals are somewhat controlled when there is a higher proportion of executive and afliated director shareholdings. Hsu and Koh (2005) consider the corporate governance role of institutional investors. They nd upward accruals management at companies whose shares are owned by institutional investors that sell out as opposed to take long-term positions. In contrast, institutions with a long-term hold strategy constrain upward accruals management even among companies that have strong incentives for such behavior. 4. Hypothesis development 4.1 Altman Z-score There are many studies in the nance and accounting literature that investigate how to classify and to measure rms according to their nancial health. Altmans (1968) initial study developed a measure to estimate bankruptcy risk based on accounting ratios. Follow up literature to improve the efciency of Altmans approach include Merton (1974), Shumway (2001), Zmijewski (1984) and Platt and Platt (1991). These studies generally conclude that bankruptcy is determined by: . rm liquidity, protability and leverage; . market variables; and . macroeconomic or business cycle variables.

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In this study, we use the Altman Z-score to classify rms according to their nancial health. 4.2 Discretionary accruals Investors respond negatively to information indicating that a rm is distressed (Chi and Tang, 2007). This is called the distressed rm discount in the academic literature. In order to avoid this discount executives of a rm may use discretionary accruals to manipulate their disclosures, e.g. earnings management (Kasznik, 1999). Accrual management is one of the ways managers obtain desired earnings numbers (Dechow and Schrand, 2004). Accruals are open to manipulation because they require the manager to forecast and to make judgments. Consequently, accruals are subject to all kinds of management discretion[6]. Of course, accrual management changes only the timing of the recognition of earnings. That is, managers shift earnings between quarters but do not create real earnings. The earnings management literature generally reports that high-accrual companies have the potential to manage their earnings (Dechow et al., 1996; Richardson et al., 2002). These studies have bifurcated accruals into those that are nondiscretionary and those that are discretionary in order to detect earnings management by managers. Jones (1991) employed what is now a commonly used method to determine discretionary accruals. The main criticism of her model is that it does not control for performance and growth. Subsequent developments in the literature have attempted to improve the power of this model to estimate the amount of nondiscretionary accruals (Dechow et al., 1996; Kothari et al., 2005). In this study, we follow the method developed by Kothari et al. (2005). Their discretionary accrual estimation method is an extension of Dechow et al. (1996) but they go one step further and adjust discretionary accruals with the performance of the rm which is measured by lagged ROA. Firms wishing to appear healthier than their true condition use discretionary accruals in order to avoid being identied as in distress and thereby avoid the nancial market discount. Corporate governance of the rms inuences their nancial reporting decisions (Bowen et al., 2008). By following above argument, our main hypotheses concern the timing of when managers engage in discretionary accruals. Specically, we test the following hypotheses in alternative format: H1. Discretionary accruals of rms are related to their nancial health and corporate governance quality. Firms nancial classications are calculated using the Altman Z-score which depends upon numbers that come from nancial statements. Therefore, the Z-score itself may be affected by those accounts. Moreover, corporate governance quality may affect corporate nancial reporting decisions by inducing strategic management decisions. This leads to our second hypothesis becomes: H2. Financial classications of rms are related to discretionary accruals and corporate governance quality. A rms governance mechanism is mainly affected by its economic environment, shareholders and creditors. Therefore, a rms nancial status may inuence managements strategic decisions. While the effect of discretionary accruals on corporate governance is less clear, we include that possibility in our H3:

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H3. Corporate governance quality is related to nancial health and discretionary accruals. 5. Research design, measurements and sample 5.1 Altman Z-score Altman (1968) used multiple discriminate analyses to determine the nancial conditions of rms. From a list of 22 nancial ratios, he put ratios in ve categories including liquidity, protability, leverage, solvency and activity to discriminate between healthy and to-be-bankrupt rms. Altman selected the ratios according to their popularity in the literature rather than a theoretical basis resulting in a linear combination of variables that discriminated between bankrupt and non-bankrupt rms. The linear equation is as follows: Z 0:012X 1 0:014X 2 0:033X 3 0:006X 4 0:999X 5 1

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where X1 working capital/total assets; X2 retained earnings/total assets; X3 earnings before interest and taxes/total assets; X4 market value of equity/total liabilities; X5 sales/total assets; Z overall index, the lower a companys Z-score the higher its probability to bankrupt. We use the Altman Z-score to measure the nancial health of companies. Later research conrms that the Altman Z-score works better for manufacturing rms (Grice and Ingram, 2001). Therefore, we conned our study to manufacturing rms[7]. Following Altmans (1968) study we classied rms into three groups according to their Z-score level. If Z-score exceeds 2.67 then the rm is called nancially healthy, if the Z-score is between 1.81 and 2.67, rms are called gray-area companies, and nally if the Z-score is smaller than 1.81, rms are classied as nancially distress. 5.2 Discretionary accruals Examples of items that may be subject to discretionary include accounts payable, account receivable, future tax liability, depreciation, and future interest expense among others. SFAS No. 95 requires companies to disclose information necessary to compute accrual components of earnings in the operating section of cash ows. Accrual components of earnings are computed by following prior literature (Dechow et al., 1995): Total current accruals DCA 2 DCash 2 DCL 2 DSTD 2

where DCA change in current assets (Compustat item no. 4); DCash change in cash/cash equivalents (Compustat item no. 1); DCL change in current liabilities (Compustat item no. 5); DSTD change in debt included in current liabilities (Compustat item no. 34). As mentioned above, managers may inuence accruals to get their desired earnings numbers. According to this hypothesis, companies do not change their activities rather they report opportunistic (manipulated) earning numbers. For example, companies may be avoiding write-offs, or capitalizing some expenses. The idea of accruals being discretionary means that they require managers to forecast, estimate and make judgments (Dechow and Schrand, 2004). The discretionary accrual measure is obtained by subtraction of normal accruals from estimated total accruals thereby providing an estimate of discretionary accruals that a rm might take in a year (Kothari et al., 2005).

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A higher estimate of discretionary accruals may signal a greater level of earnings management (Dechow and Schrand, 2004)[8]. Lower discretionary accruals estimate may signal higher earnings quality. To estimate abnormal discretionary accruals, we follow Kothari et al.s (2005) and calculate PADCA. First, we estimate the modied Jones model separately for each year for each two-digit Standard Industrial Classication (SIC) code (Dechow et al., 1995). Then, PADCA is computed as the difference between the abnormal accrual and the closest matched rms abnormal accrual, where the closest matched rm is the rm in the same two-digit SIC code with the closest ROA in the prior year[9]. To test whether a rms health inuences its use of PADCA, we examine whether the amount of PADCA is related to its Altmans Z-score. There is a possibility that the Altman Z-score itself, which relies on nancial data that may be altered by the rms use of PADCA, may be affected by PADCA. That is, there is a possibility that the estimated level of Altmans Z itself is related to the rms use of PADCA. Healthy rms may have stronger governance because of their ability to hire better skilled executives than distressed rms. Therefore, the corporate governance mechanism may inuence nancial status classication. This relationship may hold for discretionary accruals as well. Moreover, corporate governance quality may affect the discretionary accruals, and vice versa. This may lead to three-way endogeneity in our model between corporate governance, nancial health and discretionary accruals. We thus consider a simultaneous relationship model with PADCA, Altmans Z and corporate governance quality score (GINDEX). To test this question, we use a three-stage least squares (3SLS) model similar to Al-Tuwaijri et al. (2004)[10]. The basic three equation model is shown below: PADCA f Y 1 ; Altman Z 2 score; GINDEX Altman Z gY 2 ; PADCA; GINDEX GINDEX gY 3 ; PADCA; Altman Z 2 score 3 4 5

where Y1, Y2 and Y3 are vectors of additional variables that inuence PADCA, Altmans Z-score, and GINDEX, respectively, where Altman Z is a proxy for corporate health and GINDEX is an indicator for the corporate governance quality. The incidence of PADCA is assumed to be related to Y1 (a vector of determinants), Altman Z, and GINDEX. We believe that companies engage in PADCA as their health deteriorates and no pre-assumption for corporate governance. Moreover, we believe that a companys health (measured by Altmans Z) is affected by Y2 (a vector of determinants), by PADCA, and by GINDEX. That is, a company affects its measured nancial health (via Altmans Z-score) when it engages in the use of PADCA, and having good corporate governance. Finally, corporate governance quality (measured by GINDEX) is inuenced by Y3 (a vector of determinants), PADCA and Altman Z. The simultaneous relationship between PADCA, Altman Z and GINDEX creates an identication problem which leads to biased and inconsistent parameter estimates if the model is estimated using ordinary least squares. To avoid this problem, a 3SLS regression is performed[11]. Using some of the control variables similar to Ali et al. (2007) and including more, a 3SLS model for the years 2001-2003 is run to examine the relationship between discretionary accruals and the rms nancial health[12]. We also include dummy variables for each year and two-digit industry classications[13]:

PADCA a b1 Altman 2 Z b2 GINDEX b3 HEALTH b4 AltmanZ HEALTH b5 DISTRESS b6 Altman 2 Z DISTRESS b7 LagPADCA b8 LEVERAGE b9 SIZE b10 LOSS b11 ROA b12 CFO error Altman 2 Z a b1 PADCA b2 GINDEX b3 SIZE b4 LOSS b5 ROA b6 CFA b7 LagAltman 2 Z b8 EPS b9 MB b10 LITIGATION b11 R&D b12 DEPRECIATION b13 PP&E b14 INTANGIBLE b15 SPECIAL b16 INTEREST error GINDEX a b1 Altman 2 Z b2 PADCA b3 SIZE b4 LITIGATION b5 MERGER b6 PREFERRED b7 DIVIDEND error where PADCA (see the Appendix for the calculation) is performance adjusted discretionary accruals that is calculated by following Kothari et al. (2005). PADCA is scaled by total assets[14]. Altman Z is the Z-score developed by Altman (1968) to estimate the nancial condition of rms. The variables in equation (7) that explain the level of Altman Z beyond PADCA and GINDEX reect hypotheses about rm characteristics and Altman Z. SIZE, R&D, MB, ROA and EPS are expected to control for the performance and information environment of the rms therefore we expect they have positive coefcients as higher values for these variables contribute to healthier companies. In contrast, LOSS, LITIGATION, CFO, DEPRECIATION, PP&E, INTANGIBLE, SPECIAL and INTEREST, capture the operational and nancial riskiness of the rm, are expected to have negative coefcients since higher values of these variables reduce the health of rms. MERGER and LEVERAGE are used specically to capture agency problem which are interpreted as the higher the values for these variables the higher the agency costs. All of the variables have expected signs except for ROA. GINDEX is a corporate governance index that is developed by Gompers et al. (2003) to measure the governance quality of the rm where GINDEX score is extracted from the IRRC database. HEALTH is an indicator variable that takes the value of one if the Z-score exceeds the value of 2.67, and zero otherwise. DISTRESS is also an indicator variable that takes the value of one if Z-score is smaller than 1.81, and zero otherwise[15]. LagPADCA is equivalent to last years PADCA scaled by total assets[16]. LEVERAGE is the ratio of total debt to total assets at the beginning of the scal period (total assets minus its book value divided by its total assets) scaled by total assets. SIZE is the natural logarithm of total assets. MERGER (MA) is a dummy variable that takes the value of one if the rm has engaged in a merger and/or acquisition activity during the current scal year, zero otherwise. LOSS is an indicator 8 7 6

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variable that takes the value of one if the rm reports a net loss for the scal period, and zero otherwise. ROA is the current years return on asset calculated as net income before extraordinary items divided by total assets scaled by total assets. CFO is scaled by the beginning of the years total assets scaled by total assets. EPS is earnings per share which is calculated by dividing net income before interest and taxes by numbers of shares outstanding scaled by total assets. MB is the market-to-book ratio that is calculated by using the market value of equity divided by the book value of equity scaled by total assets. LITIGATION is a dummy variable that equals one if the rm operates in the high litigation industries with the SIC codes of 2833-2836, 3570-3577, 3600-3674, 5200-5961 and 7370-730, zero otherwise. R&D is research and development expense scaled by total assets. DEPRECIATION is depreciation expense in the current year scaled by total assets. PP&E is total net plant, property and equipment that is reported on the rms balance sheet scaled by total assets. INTANGIBLE is total intangible assets scaled by total assets. SPECIAL is total special items scaled by total assets. INTEREST is total interest expense within a year reported on a rms income statement scaled by total assets. PREFERRED is total preferred stock holders equity that is reported under the owners equity section of the balance sheet in the rms annual report scaled by total assets. DIVIDEND is total dividend issued and distributed by the rm in the current year scaled by total assets[17]. 5.3 Sample We use US rm data, over the period 2001-2003. This period is chosen because it includes a large downturn in the stock market which may be an environment more susceptible to PADCA activity[18]. Only, manufacturing rms are analyzed to conform to the Altman Z-score original design and due to its greater efcacy for these rms (Altman, 1968; Grice and Ingram, 2001). Specially, we collected all the data from the Compustat database between the years 2001 and 2003 for manufacturing rms. Manufacturing rms have the SIC code between 2000 and 4000. From 67,899 rm-year observations originally gathered, the sample decreases to 8,655 rm-year observations after calculating PADCA, Altman Z-score, and other variables in the two equation model. We used Gompers et al. (2003) governance index (GINDEX) to measure the governance strength of the rms in our sample. 6. Empirical results and analysis Table I, Panel A provides descriptive statistics of the dependent variables. The mean (median) Altman Z for sample rms is 2.8374 (2.6980). The mean (median) performance adjusted discretionary accruals (PADCA) 0.0006 (2 0.0005) indicates on average sample rms have income increasing accruals. GINDEX 9.1836 (9.000) suggests that on average sample rms have good corporate governance quality. Panel B of Table I presents the descriptive statistics for independent variables. Leverage with 0.6659 (0.3996) is positively skewed that indicates that sample rms have on average 66.8 per cent total liabilities on their balance sheets. Average size which is measured with market value of equity in our sample is approximately $126 million. The merger variable shows that, on average, 27 per cent of companies engage in M&A. In our sample, 49 per cent of companies report losses which may be because our sample consist of only manufacturing rms. ROA average is 2 17.22 per cent and its median is 0.2 per cent in part because our sample period is between 2001 and 2003.

Variables

Mean

SD 14.6280 0.1779 2.6813 6.4737 2.4434 0.4419 0.5000 0.5052 0.4257 0.0655 1.8147 0.4784 0.5052 0.0445 0.3601 0.1537 0.1604 0.0643 0.2191 0.0011

25th percentile 1.0901 20.0832 7.0000 0.2128 3.1286 0.0000 0.0000 20.2079 20.0893 20.0130 0.0010 0.0000 0.0000 0.0274 0.2130 0.0000 20.0249 0.0017 0.0000 0.0000

Median 2.6980 20.0005 9.0000 0.3996 4.7694 0.0000 0.0000 0.0020 0.0454 0.0000 0.0075 0.0000 0.0322 0.0429 0.4111 0.0344 0.0000 0.0130 0.0000 0.0000

75th percentile 5.1304 0.0806 11.000 0.5877 6.5128 1.0000 1.0000 0.0638 0.1105 0.0022 0.0443 1.0000 0.1171 0.0626 0.6871 0.1671 0.0000 0.0297 0.0000 0.0000

Discretionary accruals

Panel A: dependent variables Altman Z 2.8374 PADCA 0.0006 GINDEX 9.1836 Panel B: predetermined variables LEVERAGE 0.6659 SIZE 4.8391 MERGER 0.2659 LOSS 0.4934 ROA 20.1722 CFO 20.0819 EPS 20.0189 MB 20.0480 LITIGATION 0.3546 R&D 0.1059 DEPRECIATION 0.0527 PP&E 0.4903 INTANGIBLE 0.1100 SPECIAL 20.0486 INTEREST 0.0294 PREFERRED 0.0447 DIVIDEND 0.0003

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Notes: All variables are winsorized at 1 per cent level; reported values of variables are for a rm at current year if it is not stated otherwise; variable denitions: Altman Z is nancial indicator score that was developed by Altman (1968). Detailed calculation for Altman Z is provided in the text; PADCA is performance adjusted discretionary accruals that is calculated by following Kothari et al. (2005) which is scaled by total assets; GINDEX is governance index that is developed by Gompers et al. (2003). This variable is extracted from Thomson IRRC governance database; LEVERAGE is the ratio of total debt to total assets at the beginning of the scal period scaled by total assets; SIZE is the natural logarithm of the total assets; MERGER (MA) is a dummy variable that takes the value of 1 if the rm has engaged in a merger and/or acquisition activity, 0 otherwise. LOSS is an indicator variable that takes the value of 1 if the rm reports a net loss for the scal period and 0 otherwise, i.e. negative net income before extraordinary items; ROA is the current years return on assets calculated as net income before extraordinary items divided by total assets scaled by total assets; CFO is cash ow from operations scaled by total assets; EPS is earnings per share which is calculated as dividing net income before interest and taxes by numbers of shares outstanding corresponding year scaled by total assets; MB is the market-to-book ratio that is calculated by using the market value of equity divided by the book value of equity scaled by total assets; LITIGATION is a dummy variable that equals one if the rm operates in the high litigation industries with the SIC codes of 2833-2836, 3570-3577, 3600-3674, 52005961, and 7370-730, 0 otherwise; R&D is research and development expense scaled by total assets; DEPRECIATION is depreciation expense scaled by total assets; PP&E is total net plant, property and equipment that is reported at rms balance sheet scaled by total assets; INTANGIBLE is total intangible assets scaled by total assets; SPECIAL is total special items reported in income statement scaled by total assets; INTEREST is total interest expense within a year that is reported at rms income statement scaled by total assets; PREFERRED is total preferred stock holders equity that is reported under the owners equity section of balance sheet at rms annual report scaled by total assets; DIVIDEND is total dividend issued and distributed scaled by total assets

Table I. Descriptive statistics of 8,655 numbers of observations except GINDEX variable has 1,340 observations

CFO is negative (a value of 8.19 per cent) with a positive median value which indicates skewness to the left. EPS share is also negative again because our sample period spans an economic downturn. Market to book ratios show that on average sample rms are established, and conservative in their reporting decisions. About 35 per cent of rms are in litigated industries as dened earlier. On average rms spend 10 per cent of their

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total assets on research and development investments. Median value for this variable is 3.22 per cent. Depreciation expense is 5.27 per cent of total assets. About 49.03 per cent of assets are PP&Es which is not surprising given the heavy investment of manufacturing rms in machineries, buildings, etc. On the other hand, intangible assets are 11 per cent of total assets and could be generated by research and development investments or patents. Special items which are usually one-off items have mean and median values of 2 4.86 and 0.00 per cent, respectively. Total interest expense is on average 2.94 per cent with an average rate of 5 per cent (2.94/66.59). Preferred stock ownership percentage is 4.47 per cent on average with a median value of 0.00 per cent. Finally, sample rms distribute few dividends with the average size of 0.3 per cent. This may be because half of our sample rms report loss. Table II presents descriptive statistics for healthy, distressed and gray area rms. The average Altman Z-scores for healthy rms is 9.4361, for distressed rm is 2 6.4160, and for gray area rms is 2.2336. Differences between the means are signicant at the 1 per cent level according to the mean difference t-test. The PADCA score reports a different story than the Altman Z-score using the mean comparison test. The mean PADCA score for healthy rms is 0.0057, for distress rms is 2 0.0088, and for gray area rms is 0.0057. Both healthy and gray area rms have statistically signicant mean PADCA differences compared with distressed rms. On the other hand, healthy rms and gray rms average PADCA are not statistically different. After determining the Altman Z-score and PADCA for rms in our sample, we had three sets of companies: those in the healthy area (787 rms), those in the mid-range or gray area (262 rms), and those in the distress region (291 rms). We calculated the value of the governance index (GINDEX) for the healthy, gray, and distressed rm groups. We found mean values of 9.531, 9.137 and 8.997, respectively, as seen in Table II. The gray area has a mean according to t-tests that is signicantly different at the 5 per cent level from the mean values of the healthy rms but is not different from distressed area rms at conventional levels. Distressed rms have smaller GINDEX values than healthy rms and their mean GINDEX value is signicantly different at the 5 per cent level from that of healthy rms. In other words, there appears to be less corporate governance quality when rms depart from being healthy and are not clearly identied as distressed. That is, gray area companies have less governance quality applied to them than their counterparts healthy rms. Mean difference tests document that healthy rms corporate governance quality is better than both gray and distressed rms[19]. Later, we introduce the governance index into our regression model to see how well it explains the level of PADCA. There are fewer discretionary accruals among distressed companies; healthy and gray area companies have more discretionary accruals than distressed companies but about the same level of discretionary accruals between them. Managers of these rms may feel that it is in their best interest to produce better results this quarter/year than the rm justiably deserves. Some healthy and gray area companies appear to creatively use accruals to bolster their nancial results. Some healthy rms may be using PADCA to achieve a healthy classication. Similarly, some gray area companies may use PADCA to avoid being classied as distressed. In fact, the lower proportion of PADCA among distressed companies may result from those rms having fewer remaining PADCA opportunities. Another reason for higher discretionary accruals among gray area rms may be noise in their accounting information, i.e. information

Variables 9.4361 0.0057 9.531 0.0054 0.2910 5.1225 0.2673 0.3267 2 0.0568 0.0245 13.1239 2 0.0021 0.1639 0.3894 0.0861 0.0425 0.4176 0.0933 2 0.0274 0.0105 0.0100 0.0005 4,374 26.4160 20.0088 8.997 20.0058 1.2759 3.9572 0.2475 0.7936 20.4000 20.2865 21.6090 20.0491 20.3811 0.3743 0.1635 0.0698 0.5689 0.1168 20.0852 0.0583 0.1093 0.0000 3,038 2.2336 0.0057 9.137 0.0110 0.4950 5.9975 0.3065 0.3459 20.0213 0.0435 3.0889 20.0050 0.0200 0.1842 0.0356 0.0469 0.5541 0.1492 20.0337 0.0256 0.0089 0.0002 1,243 15.8521 * * * 0.0145 * * * 0.534 * * 0.0012 * * 2 0.9849 * * * 1.1653 * * * 0.0198 * 2 0.4669 * * * 0.3432 * * * 0.31110 * * * 14.7329 * * * 0.0470 * * * 0.5450 * * * 0.0151 2 0.0774 * * * 2 0.0273 * * * 2 0.1513 * * * 2 0.0235 * * * 0.0578 * * * 2 0.0478 * * * 2 0.0993 * * * 0.0005 * * * 7.2025 * * * 0.0000 0.394 * * 20.0056 20.2040 * * * 20.8750 * * * 20.0392 * * * 20.0192 20.0036 * * * 20.0190 * * 10.0350 * * * 0.0029 * * * 0.1439 * * * 0.2052 * * * 0.0505 * * * 20.0044 * * * 20.1365 * * * 20.0559 * * * 0.0063 * 20.0151 * * * 0.0011 0.0003 * * *

Healthy

Mean Distress Gray Healthy-distress Gray-distress 8.6496 * * * 0.0145 * * 0.140 0.0168 * * * 20.7809 * * 2.0403 * * * 0.0590 * * * 20.4477 * * * 0.3787 * * * 0.3300 * * * 4.6979 * * * 0.0441 * * * 0.4011 * * * 20.1901 * * * 20.1279 * * * 20.0229 * * * 20.0148 0.0324 * * * 0.0515 * * * 20.0327 * * * 20.1004 * * * 0.0002 * * *

Mean difference Healthy-gray

Altman Z PADCA (%) GINDEX LagPADCA (%) LEVERAGE SIZE MERGER LOSS ROA CFO LagAltman Z EPS MB LITIGATION R&D DEPRECIATION PP&E INTANGIBLE SPECIAL INTEREST PREFERRED DIVIDEND No. of observations

Notes: Signicant at: *0.10, * *0.05 and * * *0.01 levels, respectively; mean test based on t-test; HEALTHY rms are the ones with Altman Z-score exceeds the value of 2.67; DISTRESS rms are the ones with Altman Z-score is smaller than 1.81; all other rms are classied as GRAY area rms with Altman Z-score smaller than 2.67 and larger than 1.81; number of observations for GINDEX for healthy, distress and gray are 787, 262 and 291, respectively; variables are dened in Table I; LagPADCA (Altman Z) is previous years PADCA (Altman Z)

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Table II. Comparative descriptive statistics

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environment. On the other hand, these rms are probably under the close scrutiny of nancial market participants such as auditors, banks, investors or banks and therefore they may not have a tendency to manage their earnings (Bushee, 1998). In that case, the larger discretionary accrual result may be the outcome of a noisy information environment. There may be incentives for managers to use discretionary accruals to retain their job and to get high compensation until regulators catch up with them. On the other hand, if the market expects discretionary accruals, managers may be compelled to manage earnings in order to reach equilibrium[20]. Almost all other rm characteristics for healthy rms are signicantly different from distressed rms at the 1 per cent level (5 per cent for L1PADCA and 10 per cent for MERGER dummy variables) with the exception of LITIGATION. Similar results are noted between gray area and distressed rms. Between healthy and gray area rms the other rm characteristic variables are signicantly different at 1 per cent level (CFO at 5 per cent and SPECIAL at 10 per cent levels) except for the LagPADCA, PREFERRED and LOSS. Overall, healthy, distressed and gray area rms have different characteristics which need to be controlled for in our multivariate analysis. Table III presents the correlation matrix of our dependent and independent variables. As depicted in Table III PADCA and Altman Z-score are positively correlated. On the other hand, Altman Z-score and GINDEX are negatively correlated with p , 0.001. PADCA and governance score are not correlated signicantly at conventional levels with the association being positive[21]. Table IV presents two-stage least squares (2SLS) regression results[22]. We used 2SLS regressions to resolve the identication problem possibly caused by the Altman Z-score and PADCA simultaneously inuencing each other. As shown in Table III, Altman Z-score (0.0035), and HEALTH (2 0.0187) of the rm (a health indicator variable) inuence PADCA signicantly at the 1 per cent level. These results indicate that PADCA increases with an increase in the Altman Z-score, and decreases with rm health. An interaction variable between Altman Z and HEALTH is statistically signicant at the 1 per cent level (t 3.24) with a coefcient value of 2 0.0018. This indicates that being healthy decreases the effect of Altman Z-score on PADCA, almost 50 per cent from 0.0035 to 0.0017 (0.0035-0.0018). This result indicates that nancially healthy rms use less PADCA type accounting discretion than other rms. The coefcient estimates for DISTRESS and the interaction variable Altman Z DISTRESS are not signicant at conventional levels indicating that nancially distressed rms are not engaged in manipulating their earnings. Perhaps, they fail to perceive a benet from such manipulation[23]. The second regression reported in Table IV gives the results for the relationship going from the level of PADCA to the level of Altman Z. That is, it examines whether a rms Altman Z is related to its use of PADCA. We are particularly concerned with the coefcient estimated on the PADCA variable. Notably, that coefcient (144.944) is signicant at the 0.01 level and suggests that rms have better (higher valued) Altman Z-scores when they make more use of PADCA to inuence their nancial data. The implication of this nding is that analysts who believe that a company is not distressed as a result of a score from the Altman Z model may be misled if the rms use of PADCA has contributed to its perceived Altman Z-score value. We report 3SLS regression results in Table V. This technique accounts for the three way endogeneity problem identied in equations (6)-(8). We discuss the three

PADCA 2 0.07 * 2 0.65 * 0.22 * 0.01 2 0.36 * 0.46 * 0.38 * 0.44 * 0.29 * 0.07 * 0.05 * 2 0.31 * 2 0.25 * 2 0.04 * 0.13 * 2 0.51 * 2 0.25 * 0.13 * 0.16 * 0.24 * 0.11 * 2 0.15 * 0.07 * 0.09 * 0.04 2 0.16 * 2 0.18 * 2 0.07 * 0.00 0.16 * 0.08 * 0.01 0.13 * 0.03 0.27 * 0.22 * 0.06 * 0.06 * 2 0.11 * 2 0.06 * 2 0.14 * 2 0.39 * 2 0.20 * 2 0.25 * 0.25 * 0.30 * 0.13 * 2 0.06 * 0.76 * 0.17 * 0.04 * 0.23 * 20.36 * 0.43 * 0.45 * 0.33 * 20.56 * 20.12 * 20.25 * 20.04 * 0.12 * 0.29 * 20.10 * 0.07 * 20.11 * 0.46 * 20.08 * 0.09 * 0.07 * 0.07 * 20.14 * 20.02 20.05 * 20.03 * 20.07 * 0.24 * 20.11 * 0.03 * 20.00 0.08 * 2 0.87 * 2 0.63 * 2 0.87 * 0.10 * 0.24 * 0.35 * 0.16 * 2 0.12 * 2 0.12 * 2 0.29 * 0.04 * 0.15 * 2 0.38 * 0.75 * 0.89 * 20.07 * 0.23 * 20.38 * 0.10 * 0.10 * 0.11 * 0.29 * 20.08 * 20.17 * 0.37 *

PADCA ALT Z GINDEX LEV SIZE MA LOSS ROA CFO EPS MB LITG RD DEP PP&E ING SPEC INT PREF DIV 0.67 * 20.15 * 20.23 * 20.40 * 0.01 0.23 * 0.16 * 0.09 * 0.01 20.15 * 0.37 *

ALT Z 0.06 *

0.04 * 0.02 20.06 * 0.00 0.01 20.08 * 0.09 * 20.14 * 0.10 * 0.06 * 20.02 20.04 * 20.15 * 20.02 * * * 20.05 * 0.08 * 20.03 * 20.02 20.01

GINDEX 0.03 2 0.09 *

LEV 2 0.04 * 2 0.19 * 0.09 *

SIZE 20.00 * 0.29 * 0.21 * 20.08 *

MA 0.00 * 0.01 0.11 * 20.00 * 0.22 *

LOSS 2 0.07 * 2 0.17 * 2 0.20 * 0.04 * 2 0.37 * 2 0.08 *

ROA 0.07 * 0.35 * 0.07 * 20.09 * 0.43 * 0.05 * 20.51 *

CFO 20.06 * 0.52 * 0.07 * 20.17 * 0.48 * 0.08 * 20.42 * 0.70 *

EPS 0.08 * 0.46 * 0.04 2 0.18 * 0.40 * 0.07 * 2 0.40 * 0.58 * 0.65 * 0.00 * 2 0.22 * 2 0.36 * 2 0.20 * 0.08 * 0.10 * 0.29 * 2 0.09 * 2 0.20 * 0.32 * (continued)

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Table III. Correlation coefcients for all variables included in simultaneous equation model

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PADCA ALT Z GINDEX LEV SIZE MA LOSS ROA CFO EPS MB LITG RD DEP PP&E ING SPEC INT PREF DIV 0.48 * 2 0.03 * 2 0.12 * 2 0.12 * 2 0.06 * 2 0.24 * 2 0.00 2 0.26 * 0.04 * 2 0.28 * 2 0.13 * 2 0.08 * 2 0.34 * 0.01 2 0.29 * 0.56 * 2 0.18 * 2 0.18 * 0.22 * 0.10 * 0.04 * 20.11 * 0.02 * * 0.31 * 0.03 0.30 * 20.12 * 0.17 * 0.02 0.13 * 2 0.05 * 2 0.034 0.05 * 0.15 * 0.05 *

Notes: Signicant at: *1, * *5 and * * *10 per cent levels, respectively; all variable denitions are provided in Table I; number of observation for GINDEX is 1,340 and for other variables 8,655; Pearson coefcients are in upper right and Spearman coefcients are in lower left

Table III. LITG 2 0.01 0.07 * 2 0.17 * 2 0.01 2 0.11 * 2 0.02 * * 0.24 * 2 0.18 * 2 0.16 * 2 0.07 * 0.02 * * * RD 2 0.05 * 2 0.26 * 2 0.12 * 0.03 * 2 0.34 * 2 0.08 * 0.34 * 2 0.53 * 2 0.63 * 2 0.38 * 2 0.11 * 0.33 * DEP 2 0.16 * 2 0.41 * 2 0.05 * * * 0.07 * 2 0.19 * 2 0.03 * 0.23 * 2 0.29 * 2 0.33 * 2 0.34 * 2 0.13 * 0.04 * 0.27 * PP&E 20.04 * 20.27 * 0.14 * 0.03 * 0.06 * 20.09 * 20.07 * 0.04 * 0.01 20.06 * 20.10 * 20.22 * 20.05 * 0.41 * ING 20.50 * 20.03 * 0.05 * * * 0.01 0.20 * 0.22 * 20.06 * 0.02 * * * 0.08 * 0.06 * 0.02 * * 20.09 * 20.09 * 0.04 * 20.23 * SPEC 0.07 * 0.19 * 0.01 2 0.02 * * * 0.06 * 2 0.04 * 2 0.21 * 0.25 * 0.18 * 0.27 * 0.04 * 2 0.05 * 2 0.11 * 2 0.30 * 2 0.02 2 0.04 * INT 20.06 * 20.51 * 0.01 0.19 * 20.26 * 20.03 * 0.19 * 20.44 * 20.43 * 20.45 * 20.25 * 20.05 * 0.15 * 0.31 * 0.17 * 0.03 * * 20.17 * PREF 20.03 * 20.30 * 20.06 * * 0.16 * 20.02 * 20.02 * * 0.17 * 20.28 * 20.31 * 20.33 * 20.16 * 0.04 * 0.23 * 0.21 * 0.03 * 20.01 20.08 * 0.24 * 20.07 * DIV 2 0.00 * 0.04 * 2 0.03 2 0.01 2 0.02 * * * 2 0.03 * 2 0.19 * 0.11 * 0.11 * 0.12 * 0.01 2 0.10 * 2 0.10 * 2 0.05 * 0.11 2 0.07 * 0.05 * 2 0.07 * 2 0.05 *

MB 0.03 * 0.38 * 0.01 20.12 * 0.08 * 0.02 20.04 * 0.21 * 0.25 * 0.22 *

0.16 * 0.26 * 20.14 * 20.24 * 20.17 * 0.13 * 20.37 * 20.12 * 20.29 *

Dependant variables PADCA Independent variables Intercept Altman Z PADCA HEALTH Altman Z HEALTH DISTRESS Altman Z DISTRESS LagPADCA LEVERAGE SIZE MERGER LOSS ROA CFO LagAltman EPS MB LITIGATION R&D DEPRECIATION PP&E INTANGIBLE SPECIAL INTEREST PREFERRED DIVIDEND Adjusted R 2 (per cent) No. of observations Coefcient 0.0381 0.0035 2 0.0187 2 0.0018 0.0061 2 0.0000 0.0101 2 0.0028 2 0.0029 0.0074 2 0.0335 0.0744 2 0.1510 t-statistics 4.22 * * * 4.96 * * * 22.69 * * * 23.24 * * * 0.80 20.61 0.83 20.96 22.56 * * 1.44 25.64 * * * 8.54 * * * 212.79 * * * Altman Z Coefcient t-statistics 2 0.2380 144.944 2 0.19 6.52 * * *

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12.95 8,655

0.5450 2 1.8104 1.5252 2 9.2826 28.8656 0.1801 2 13.4442 0.9028 0.2234 8.6875 48.3391 2 6.1869 2 2.2409 6.5919 2 36.3476 2 6.34052 299.9099 4.74 8,655

4.01 * * * 2.84 * * * 2.30 * * 2 5.80 * * * 10.11 * * * 16.55 * * * 2 1.69 * 5.38 * * * 0.36 3.49 * * * 3.87 * * * 2 6.45 * * * 2 1.12 3.61 * * * 2 6.86 * * * 2 4.67 * * * 1.17

Notes: Signicant at: *0.10, * *0.05 and * * *0.01 per cent levels, respectively; all variables are winsorized at 1st and 99th percentiles; HEALTH is an indicator variable that takes the value of 1 if the Z-score exceeds the value of 2.67, and zero otherwise; DISTRESS is also an indicator variable that takes the value 1 if Z-score is smaller than 1.81 and 0 otherwise; other variable denitions are provided in Table I

Table IV. 2SLS regression estimates

regressions separately starting with the PADCA regressions. Unlike in the 2SLS regression where the coefcient estimated for the Altman Z was positive, with 3SLS the coefcient is negative (t 2 2.55) and signicant at 5 per cent level. The other results are similar between the 2SLS and 3SLS. The healthy dummy coefcient is 2 0.0241 (t 2 1.94) which indicates that healthy rms have lower discretionary accruals. Distressed rms also have lower discretionary accruals. We suspect that this later case arises because these rms have fewer discretionary accrual opportunities. The GINDEX coefcient is 0.0221 and signicant at 1 per cent level. This result indicates that companies with good corporate governance use income increasing discretionary accruals. This positive association may be attributable to governance quality and the subsequent performance outcome may benet the shareholders (Subramanyam, 1996). Governance affects the use of PADCA by rms possibly

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Independent variables 20.1470 20.0077 41.9155 21.9728 2.55 * * 24.95 * * * 22.20 * * 22.55 * * 18.3804 5.60 * * * 7.6764 20.1176 2.6284

Intercept Altman Z PADCA GINDEX HEALTH Altman Z HEALTH DISTRESS Altman Z DISTRESS LagPADCA LEVERAGE SIZE LOSS ROA CFO LagAltman EPS MB LITIGATION R&D DEPRECIATION PP&E INTANGIBLE SPECIAL INTEREST MERGER PREFERRED DIVIDEND System weighted R 2 (per cent) Durbin-Watson F-value 0.0221 20.0241 0.0117 20.0364 0.0180 20.0142 20.0085 20.0031 0.0025 0.1538 20.3588 2.93 * * * 21.94 * 13.64 * * * 23.12 * * * 8.38 * * * 20.49 20.33 20.83 0.29 3.88 * * * 28.32 * * * 0.3332 20.5632 20.9039 19.4324 0.3318 19.4271 0.0930 21.1083 3.6897 213.6701 20.2331 22.2245 20.5195 214.9252 1.94 * 21.36 20.20 2.83 * * * 18.21 * * * 0.85 0.38 22.39 * * 0.84 21.44 20.19 22.56 * * 20.27 21.62 1.89 3.79 * * * 43.51 1.89 3.74 * * *

Notes: Signicant at: *0.10, * *0.05 and * * *0.01 per cent levels, respectively; variable denitions are given in Table I; n 767

Table V. 3SLS regression estimates with governance index

PADCA Coefcient t-statistics Coefcient Dependant variables Altman Z Coefcient t-statistics GINDEX t-statistics 14.20 * * * 23.86 * * * 1.10 0.2936 4.19 * * * 20.5775 22.64 * * * 0.2710 21.3273 131.2161 2.03 2.03 * * 1.63 20.92 1.03

because managers may use their discretion to achieve some reporting objective to benet shareholders[24]. Managers apparently are not grilled on the details of nancial reports by non-executive members of their board of directors. This may be due to the extreme level of detail that would be required for the board of directors to uncover cases of PADCA[25]. The second regression equation has Altman Z-score as the dependent variable. Here, GINDEX is negatively associated with Altman Z-score. This indicates that as rms strengthen their corporate governance that their Altman Z-score declines. Since this result is found with the 3SLS regression there is no confusion as to the direction of the relationship. That is, our result suggest that as corporate governance strengthens that rms become less healthy which may occur because they may lose markets and prots to rms with less governance. The positive and signicant coefcient on PADCA suggests that the more rms use discretionary accruals the better their nancial health appears, as measured by Altman Z. In equation (3), the GINDEX is the dependent variable. The signicant coefcient on the Altman Z-variable suggests that the higher is the Altman Z-score (the better the rms nancial health) the lower is the GINDEX. This result serves as a counterpoint to the results in the second equation; now the argument is that members of the board of directors of healthier rms are less vigilant and have lower governance scores. The coefcient estimated on PADCA is not signicant, as we expected a priori. The amount of discretionary accruals does not affect the governance index. We also (results not shown) tested lagged PADCA as a determinant of the GINDEX thinking that the board might increase its vigilance after managers engaged in discretionary accruals. The coefcient estimated on lagged PADCA was not signicant. Perhaps, the most interesting nding is that a higher GINDEX lowers a rms Altman Z while a higher Altman Z lowers the rms GINDEX. The interpretation is that better corporate governance is not associated with improved corporate health and that improved corporate health is not associated with better corporate governance. Firms may reach an equilibrium level of GINDEX and Altman Z after which increases in either governance or health leads to undesired results. 7. Conclusion We investigate the relationship between discretionary accrual level, rms nancial distress as measured by the Altman Z, and corporate governance quality as extracted from the IRRC database applied to US manufacturing rms between the years 2001 and 2003. We nd that rms managers appear to exercise discretionary accruals when their rms are in the mid-range or gray area of the Altman Z in order to avoid being classied as distressed or if they are successful in doing it to be classied as a healthy rm. We did not observe the same behavior for rms in either the distressed or healthy classication areas based on the Altman Z-score. Gray area companies have larger PADCAs. There are two possible explanation for this; they are either opportunistic or they face noise in their accounting information. We do not nd that heightened governance reduces the incidence of discretionary accruals. Our nding suggests that non-executive members of boards of directors need to pay closer attention to rms in the gray region. This study contributes to both the accounting and nance literature in three ways. First of all, we document the relationship between a rms nancial health and its use of

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discretionary accruals by taking into consideration corporate governance quality. This result is important because it shows the existence of agency problems in credit markets when nancials signal stressful results especially when there is good corporate governance. Second, we document the importance of paying attention to rms at the boundaries of healthy and gray areas as they appear to be more open to accrual manipulation. This result is interesting in the sense that both creditor and equity investors must be careful about the nancial classications of rms when they evaluate potential investments. They should also pay close attention to accruals, if the rm is on the boundary or in the gray area that corporate governance may play intervening role in this. When endogeneity is tested between the three variables, GINDEX, Altman Z and PADCA, the 3SLS results yield an interesting conclusion that better corporate governance is not associated with improved corporate health and that improved corporate health is not associated with better corporate governance. We suspect that rms that deviate from an equilibrium or best level for their GINDEX and Altman Z suffer unexpected changes in the other variable.
Notes 1. One may argue that a rm under close scrutiny may not be able to manage its earnings since detection of earnings management would not be good for managers. On the other hand, managers know that nancial reports are value relevant because they are closely followed therefore they are motivated to fudge the numbers to inuence the investors expectations. 2. Some might argue that a 40-year-old model, the Altman Z, is not the best choice since other models exist (e.g. the Shumway, the Merton, the KMV, or the Ohlson, 1980 models). Our choice of Altmans model was based on its widespread acceptance and reuse throughout the world. Some authors, Begley, Ming and Watts, for example argue that his cutoff points are outdated. We continue with the original cutoff points since our objective is not to predict nancially distressed rms but rather to document the relationship between nancial status classication, corporate governance quality and the likelihood managers using discretionary accruals. 3. The advantage of using an Altman Z-approach to classify rms is that it considers an entire prole of characteristics shared by a specic rm and transforms that into a univariate statistic (Cleary, 1999). 4. Reasoning behind the use of PADCA specically to measure discretionary accruals will be explained in subsequent sections. 5. The sample period is chosen specically to select rms with a higher probability of having lower Altman Z-scores than during periods of economic health. We also choose the manufacturing industry since it has been established that the Altman Z-methodology works well for these rms. We also control for leverage and other rm characteristics as a result of the signaling hypothesis. 6. The more discretion exercised by management, the greater the opportunity for them to manipulate reported earnings. 7. The Altman Z-score is a widely used classication and bankruptcy estimation measurement tool in the eld of credit risk analysis, distressed investing; mergers and acquisitions (M&A) target analysis, and turnaround management by both practitioners and academics (Calandro, 2007).

8. Accruals may also be used opportunistically by executives, because they need to make judgments while reporting. Therefore, the greater a companys management discretion concerning accruals the greater the opportunity to manipulate reported earnings. 9. When calculating PADCA, previous year ROA is used. That may create limitation in our research design since we do not match rms according to their nancial status, i.e. Altman Z-score. This is also limitation of PADCA measures that assume rms are identical at the previous year just by looking at their ROA. But this method is the most efcient one available compared with other methods (Kothari et al., 2005). In our design to decrease this measurement issue, we used ROA at the current period as a control variable that is correlated signicantly with Altman Z, PADCA and G-score. 10. Regular ordinary least squares (OLS) regression provided similar results with the same coefcient signs. Firms were divided into distressed, gray and healthy classications and OLS was run for each subsample. We tested for multicollinearity in both our 2SLS and 3SLS specication and rejected it. 11. We employed 2SLS to solve the endogeneity problem between PADCA and Altman Z without taking into consideration corporate governance quality where sample size decreases from 8,655 to 767 with 3SLS regression. 12. Ali et al. (2007) investigates the corporate disclosure practices of family rms, and they document that family rms report better disclosure quality earnings and are more likely to warn for a given magnitude of bad news in comparison with non-family rms. We also reported the 2SLS regression model results because with 3SLS our sample size decreases from 8,655 to 767. Some inferences are also affected because of this sample size difference, but overall our conclusions are similar. 13. The t-statistics are corrected using the Huber-White procedure by following Petersen (2009). 14. Discretionary accruals reverse over time (Guay et al., 1996). They state that the discretionary accrual is expected to reverse in the future periods and nondiscretionary earnings are also expected to decline. They do not say accruals reverse at the next period, but in the future. For example, a manager may think to boost earnings by choosing a lower depreciation expense in the current period. Of course, a higher expense is required in subsequent periods to make up for the difference but it may take many years for the two depreciation methods to be equal. The authors recognize this problem and control for depreciation and other kinds of discretionary accruals. The correlation and time series properties of discretionary accruals and earning process are shown in Beaver et al. (1980) and Ashton (2005). They document that the serial correlation of discretionary accruals from one to subsequent periods is negative but not perfect which indicates that they do not reverse next period but takes time. On the other hand, one discretionary accrual may be replaced with another one over time that provides a large room for managers to maneuver their nancial reporting strategies. The time horizon of our study may not be long enough for discretionary accruals to reverse. 15. Altman Z-score is a widely used classication and bankruptcy estimation measurement tool in the eld of credit risk analysis, distressed investing; M&A target analysis and turnaround management by both practitioners and academics (Calandro, 2007). 16. The LagPADCA variable is included in the regression model to test for the reversal of accruals over time. 17. Firms in the Compustat database for which the required data is available are included in the estimation process. We also use the two-digit industry denition for these tests. 18. Obviously, there are other periods of market downturn before 2001. Moreover, the economic downturns may have different effects on the business environment. The sample period may

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where TCA change in non-cash current assets minus the change in current liabilities excluding the current portion of long-term debt so that TCA DCurrent assets-DCash and short-term investments-DCurrent liabilities DDebt in current liabilties; SCASSET one scaled by lagged total assets (1/lagASSET); DREVj,t change in total revenue (sales) for rm j at year t scaled by lagged total asset; DARj,t change in account receivable for rm j at year t scaled by lagged total assets; errorj,t error term for equation (A1) for rm j at year t. The two-digit industry and year-specic estimates obtained from estimating equation (A1) are used to compute normal accruals (NAj,t). The difference between TCAj,t and NAj,t is the abnormal (discretionary) accruals for rm j in year t. Following Kothari et al. (2005) rm j in year t is matched with a companion rm with the closest lagged-return on assets in the same two-digit SIC code in year t. We obtain PADCA by subtracting matched rms abnormal accruals from rm js abormal accrual at year t.

Corresponding author Harlan Platt can be contacted at: h.platt@neu.edu

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