Earnings Management, Related Party Transactions and Corporate Performance: The Moderating Role of Internal Control

Abstract

The primary purpose of this study is to investigate the impacts of earnings management (EM) and related party transactions (RPTs) on corporate financial performance in an emerging market, Iran. This paper also aims to examine the moderating role of internal control weakness (ICW) in the relationship between them. The study sample includes 108 Iranian manufacturing companies listed on the Tehran Stock Exchange (TSE) between 2013 and 2018, and panel data with random effects are used to test the hypotheses. When an accounting-based measure called ROA is defined as a proxy for corporate performance, the results show that there is a negative association between real earnings management (REM) and corporate financial situation, while accrual-based earnings management (AEM) and firm value are correlated positively. However, when Tobin’s Q index is defined as a proxy for corporate performance, we do not find any significant association between them. Consistent with the tunneling hypothesis or agency theory, our findings confirm RPTs damage corporate value (ROA and Tobin’s Q) because managers probably consider it a mechanism to exploit enterprise resources owing to existing conflictual interests. Moreover, purchase-related party transactions lead to lower ROA, whereas sale-related party transactions and Tobin’s Q are correlated negatively. Moreover, weak internal control has a positive moderating influence on the linkage between AEM and Tobin’s Q index. Finally, we provide robust evidence that there is a positive association between sale growth and institutional owners with ROA and Tobin’s Q, although financial leverage and mergers and acquisitions (M&A) have a destructive effect on corporate value.

The Effect of Mandatory Audit Firm Rotation on Earnings Management and Audit Fees: Evidence from Iran

“…CFO shows the ratio of cash flows from operation to lagged total assets; LOSS equals one if the firm has reported a loss and zero otherwise (Ruiz-Barbadillo et al 2009;Kighir 2013;Corbella et al 2015;Cicovic and Dhanoa 2016;Azizkhani et al 2018;Salehi et al 2018a;Dao et al 2019). Return on assets (ROA) is evaluated by net income divided by average total assets (Dao et al 2019;Arniati et al 2019;Zimon et al 2021); besides, the market to book ratio (MB) indicates total market capitalization to book value of equity (Corbella et al 2015;Azizkhani et al 2018;Salehi et al 2018a). SG shows the company's sales growth, and finally, the AGE variable specifies the number of years the firm has been listed on the exchange (Ruiz- Barbadillo et al 2009;Kighir 2013;Cicovic and Dhanoa 2016;Azizkhani et al 2018;Salehi et al 2018aSalehi et al , 2018bBratten et al 2019;Dao et al 2019;Moradi et al 2021;Tarighi et al 2022c).…”

“…Then, to calculate abnormal discretionary expenses (ABN-DEXP), actual discretionary expenses must be deducted from the normal level of discretionary expenses (Zimon et al 2021). The normal level of the discretionary expenses is estimated using the regression coefficients of the previous relationship.…”

“…The null hypothesis (H0) is generally defined as the presence of a unit root and the alternative hypothesis is stationary. Hence, we use both methods of augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) in this study, which have often been recognized among the most standard unit root tests (Zimon et al 2021;Moradi et al 2021;Tarighi et al 2022aTarighi et al , 2022bTarighi et al , 2022c. The results of the unit root test are shown in Table 2.…”

“…Multicollinearity is a phenomenon in which one predictor variable in multiple regression models can be linearly predicted from the others with a substantial degree of accuracy. In statistics, the variance inflation factor (VIF) evaluates the severity of multicollinearity in a regression analysis (Salehi et al 2018b;Zimon et al 2021;Tarighi et al 2022aTarighi et al , 2022b.…”

“…As for the VIF, if the VIF of the estimated model coefficients is less than 10, there would be no linearity problem (Moradi et al 2021;Zimon et al 2021;Tarighi et al 2022c). Based on Table 3, this value is less than 10 for all research models, which means that there is no linearity concerning the research hypotheses.…”