Management Motive, Weak Governance, Earnings Management, and Fraudulent Financial Reporting: Malaysian Evidence

Abstract

This study examines ten factors associated with fraudulent financial reporting (FFR) in Malaysian publicly listed companies. We hypothesize that three factors proxy for management rationalization, four factors proxy for management motives, and three factors proxy for the opportunity to commit fraud. Our sample consists of 53 fraud firms convicted of securities fraud and 53 no-fraud firms, all of which were listed on the Bursa Malaysia and have a complete set of data from 1996–2007. With regard to rationalization, we find that prior violations and founders on the board are positively and significantly associated with FFR. With regard to motive, we find that financial distress is positively and significantly associated with FFR while family ownership is negatively and significantly associated with FFR. Our opportunity for fraud proxies, multiple directorships, and audit quality are positively and significantly associated with FFR. Additionally, we find evidence of earnings management in the years leading up to FFR.

Accounting expertise in the audit committee and earnings management

“…It has been found that EM is significantly and positively related to the occurrences of fraudulent financial reporting (Hasnan et al, 2013). This is in line with the argument of Perols & Lougee (2011), who documented a positive relationship between prior year EM and fraud in US firms.…”

“…The alleged fraudulent listed firms in Malaysia have aggressively used EM prior to the alleged fraud year (Hasnan, Abdul-Rahman, & Mahenthiran, 2013;Sulaiman, Danbatta, & Rahman, 2014) and continue to smoothen their earnings in the years subsequent to the alleged fraud year (Sulaiman et al, 2014). It has been found that EM is significantly and positively related to the occurrences of fraudulent financial reporting (Hasnan et al, 2013).…”

Accounting Irregularities in Related Party Transactions

“…In the positive view of RPTs, RPTs are perceived as value-enhancing mechanisms that are designed to improve efficiency in an organization. RPTs as value-enhancing mechanisms have been discussed from the perspective of efficient transaction [2], contracting efficiency [3], bonding mechanisms [4] and institutional needs [5]. In the negative view of RPTs, RPTs are perceived as a form of private benefits of control, which is used as a mean of transferring firms" wealth to the controlling shareholders (or management) at the expense of other stakeholders.…”

“…The higher frequency of related party transactions for fraud firms suggests that the presence of related party transactions may reflect heightened fraud risk. For Asian In the context of Malaysia, [5] highlights the case of Transmile Bhd for which two Independent Non-executive Directors were sentenced a one-year prison term. In that case, sales and real estate transactions between insider directors and executives were abused, resulting in detrimental effect to the minority shareholders.…”

“…They find that firms with more RPTs are associated with higher likelihood of fraudulent financial reporting. In a study that employs data from the Malaysian market, [5] uses the existence of RPTs as a proxy for "rationalization" for fraudulent financial reporting (FFR). RPTs are measured by the number of separate RPTs disclosed in each company"s annual report.…”