CHAPTER ONE

INTRODUCTION

1.1    Background to the study

Accounting information has been the major input in capital allocation decisions of

investors and lenders in the capital markets. Specifically, accounting earnings remain the

strategic financial statement variable for assessing firm‟s viability and future prospects. For

accounting earnings to be useful and relevance to investors and lenders it has to be of higher

quality, that is, free from errors and material misstatements. Accounting information particularly

the “earnings” indicate firm‟s direction, reduces information asymmetry and ensures efficient

capital allocation. This is achievable only if the managers did not interfere with the financial

reporting process. The incidences of corporate failures that are related to creative accounting

practices has raised concerns and remain a topical to researchers, regulators, standard setters, and

investors in the 21st century and during the last two decades in particular. This rising concern

among the stakeholders is not unrelated to some accounting practices that threaten the quality of

corporate financial reporting and erode public confidence in the accounting profession. It also

raised concerns about the reliability and credibility of financial reporting globally (Ge & Kim,

2013).

Corporate financial reporting is the management‟s responsibility, through which the

managers communicate their stewardship performance to the owners and other stakeholders.

Several researches on Capital Market are of the view that stock market responds favorably to

earnings news when reported earnings meet or beat earnings expectations, while it reacts

unfavorably when reported earnings fall short of earnings benchmarks. To avoid unfavorable

reactions, managers have a tendency to avoid the release of bad earnings news at times of

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earnings announcements (Ge & Kim, 2013). As such managers can manipulate earnings through

discretionary accounting choices (accrual-based earnings management) or by structuring real

transactions and/or changing their timing (real earnings management). Earnings management is

known in increasing information asymmetry between managers and outsiders and hide firm‟s