Management Fraud Propensity Factors, Governance Interactions and Earnings Manipulation: a Case of Malaysian Public Listed Companies

Abstract

This study aims to determine Management Fraud Propensity Factors of Fraud Triangle and International Standards on Auditing no: 240 (ISA 240) relationship with earning manipulation. It also examines potential moderating effect of Corporate Governance, measured by index as proxy to opportunity on relationship between Management Fraud Propensity Factors and Earning Manipulation. Samples of this study consisted of 504 firm-year observations comprising of 252 earnings manipulating firms matched with 252 non-earnings manipulating firms based on industry, year and size. Corporate governance disclosure was measured using corporate governance index (CGI), replicated from ASEAN Corporate Governance Scorecard (ACGSC) components. Management fraud propensity factors (pressure/ incentives, opportunity, rationalization/ attitude) were examined using logistical regression to assess relationship with earnings manipulation. This study is unique as it utilised CGI as proxy for opportunity, replacing limited numerous governance attributes commonly used argued for deficiency in portraying existing linkage within corporate governance ecosystem. CGI was also tested on its potential moderating effect on relationship between management fraud propensity factors (pressure/ incentives; rationalization/ attitude) and earnings manipulation, in line with Agency Theory. Results revealed management fraud propensity factors of pressure/incentives (recurring negative cash flows from operation, rapid growth, unusual profitability, need for financing), opportunity (corporate governance index) and rationalisation/attitudes (management interest on earnings trend) significantly related with earnings manipulation. Contradictory to expectation, CGI also showed significant positive interaction on strengthening relationship between pressure-related fraud propensity factors due to recurring negative cash flows from operations and earnings manipulation. Possible explanation is firms with strong corporate governance but experiencing weak financial standings are constantly pressured by shareholders to meet their interests which driven management to manipulate profit. This study provides tools to regulators to stay vigilant of firms with characteristics of potential earnings manipulation engagement and useful in providing insights to shareholders for selecting stocks not prone to earnings manipulation.