Control-Enhancing Mechanisms and Earnings Management: Empirical Evidence from Pakistan

Abstract

Separation of ownership and control plays a significant role in determining the agency cost, and there are many consequences of this agency problem. The control-enhancing mechanisms enhance control of controlling shareholders who expropriate small shareholders. Controlling shareholders are different in different countries; majorly, family firms are controlling firms in Pakistani context. The use of control-enhancing mechanism is rampant in emerging economies, and even some developed countries, related research especially in Pakistan requires evidence. This study exhibits a pooled cross-sectional analysis of listed companies in Pakistan between 2005 and 2016. In this research, we have examined the influence of control-enhancing mechanisms on firms’ earnings management and which mechanism (pyramid control, multiple control chains, and cross-holding control) is significantly influencing the earnings management of firms. We have analyzed both types of earnings manipulation techniques (accrual and real earning management). Our results explicate that the pyramid control and multiple control chain mechanisms are significantly positively related to the accruals earning management and real earnings management, unveiling that firms with these controls manipulate earnings with discretionary accruals as well as with real activity manipulation. Real activity manipulation enhances firms to overproduce the inventory (decreasing the unit price) and to reduce the discretionary expenses (increasing the reported earnings).