«Aman Asija IMImobile, Hyderabad 1.amanasija Vijaya B. Marisetty Department of Economics, Finance, and Marketing, RMIT University ...»
DO INSIDERS WHO PLEDGE THEIR SHARES
MANIPULATE REPORTED EARNINGS?
Vijaya B. Marisetty
Department of Economics, Finance, and Marketing, RMIT University
Finance and Control Area, Indian Institute of Management, Bangalore
First Draft: June 2014 This Draft: December 2014 We are grateful to Nagpurnanand Prabhala, our discussant at the NSE - NYU Stern Initiative on the Study of Indian Capital Markets 2014 Conference, for his detailed comments. We also thank Viral Acharya, Venkatesh Panchapagesan, and other conference participants for their helpful suggestions.
Abstract In January 2009, the Securities Exchange Board of India (SEBI) issued a new regulation that made it mandatory for Indian firms to report the number of shares pledged by their promoters to borrow loans. We take advantage of these quarterly disclosures on share pledges to examine whether and how pledging motivates promoters to manage accruals and discretionary expenses.
Our results suggest that pledging reduces the likelihood of accruals-based earnings management. Potential monitoring by lenders deters earnings management by pledging promoters despite the strong incentive to manage earnings upward. However, when we distinguish between first-time and continuing pledgers we find that the former record positive discretionary accruals, while continuing pledgers record significant negative discretionary accruals. In the first year of the pledge, the incentive to manage accruals upward is sufficiently important that it dominates any deterrence caused by monitoring by lenders.
Alternatively, lender monitoring of pledgers is low in that year. After the first year, either the first year’s earnings management reverses and / or the deterring effect of lender monitoring becomes strong enough that firms record negative discretionary accruals.
Our examination of discretionary expenses indicates that pledging is associated with lower levels of R&D spending, but is unrelated to advertising costs. Further, the negative association between R&D spending and pledging does not depend on whether the promoters are pledging for the first time or continuing to pledge. The contrasting results for discretionary accruals and R&D are consistent with promoters viewing real management activities such as cutting R&D as being subject to less scrutiny by lenders, auditors, and regulators.
1. Introduction Several studies in finance and accounting have examined the effect of corporate borrowing on a wide variety of firm decisions including investments, dividends, plant closings, and financial reporting choices (see Jackson, Keune, and Salzsieder (2013) for investments, Kalay (1982) for dividends, Kovenock and Phillips (1997) for plant closings, and Defond and Jiambalvo (1994) for accounting choices). In contrast, very little is known about how personal borrowing by the insider-owners of these corporations influences the very same decisions. In this study, we address this lacuna by taking advantage of a recent regulation that requires Indian corporations to publicly disclose the number of shares that their promoters have pledged to borrow loans. Specifically, we focus on financial reporting strategy and examine whether share pledge loans by promoters influence the magnitude of short-term earnings management.1 In January 2009, the Securities Exchange Board of India (SEBI) issued a new regulation that made it mandatory for firms to report the number of shares pledged by their promoters to borrow loans. The rationale for this new regulation was a concern that the nondisclosure of share pledges may mislead investors about the effective stake of promoters in their firms. Pledging shares is a fairly popular means of raising funds; close to forty percent of our sample of National Stock Exchange (NSE) firms had promoters involved in pledging over the years 2009-2013. Further, within the sample of pledgers, the end-of-quarter mean of pledged shares as a fraction of shares owned ranged from 31 to 42 percent over the same period.
Share pledges involve an insider-owner voluntarily assuming the incremental role of a borrower with the firm’s shares serving as collateral. A fall in the firm’s share prices subsequent to the pledge can be quite costly to the pledger as the lender can require the 1 Throughout the paper, we use the terms promoters, managers, and insiders interchangeably.
liquidate the pledged shares to recover the loan, leading to a further fall in price. Hence, we expect that pledging manager to be motivated to take cost-effective actions to support or increase the stock price. We consider upward earnings management as one of the responses that managers will undertake to avoid share price declines. While pledging increases incentives to manage earnings, we expect that the ready availability of daily collateral values will also increase the intensity of monitoring by lenders. Share prices are salient and directly related to loan payoffs. Consequently, pledging can have the opposite effect of deterring earnings management. Thus, it becomes an empirical issue as to whether pledging increases or reduces incentives to manage earnings.
To investigate whether share pledge loans influence earnings management, we assemble a panel data set from Prowess, a database of the Centre for Monitoring the Indian Economy Private Ltd., for the years 2009-2013. We examine two alternate measures of earnings management – discretionary accruals and manipulation of discretionary expenses.
Annual estimates of discretionary accruals are constructed using the Jones (1991) model and the modification to the Jones (1991) model proposed by Dechow, Sloan, and Sweeney (1995). To measure pledging, we compute an annual average of shares pledged by promoters scaled by the shares owned by the same promoters. Additionally, we use an indicator variable for whether or not a firm had pledged shares during the year. For our tests of discretionary expense manipulation we examine two expense categories that have been employed in prior research – R&D and Advertising expenses. Rather than estimating abnormal discretionary expenses via a first stage regression (Roychoudhury (2006)), to maximize sample size, we directly correlate the two discretionary expense levels with pledging activity.
several control variables including level and changes in promoter share ownership, current and lagged cash flows, four measures of financing activity (equity issuance, buybacks, borrowings, and repayment of loans), capital expenditures, age, leverage, institutional ownership, market capitalization, and the market-to-book ratio. Further, we include firm, year, and industry effects as controls for unobserved heterogeneity and compute standard errors that reflect clustering across firms and years.
Our first set of results show that discretionary accruals are negatively related to pledging activity. We interpret this as suggesting that monitoring by lenders of share pledge loans deters accruals-based earnings management. In contrast to this finding for discretionary accruals, we find that pledging is associated with lower levels of R&D spending. That is, as pledging increases the desire to increase or maintain a stock price motivates pledging promoters to cut R&D spending. We find no such effect for advertising expenses. The differing results for discretionary accruals and discretionary R&D indicate that perceived managerial costs of manipulating the two amounts differ. In a survey of top executives, Graham, Harvey, and Rajgopal (2005) provide evidence that managers prefer real earnings management activities compared to accrual-based earnings management. One reason for this preference is that real management activities are less likely to be scrutinized by auditors and regulators.
To obtain deeper insights into the effect of pledging on earnings management, we compare sub-samples where we expect the incentive to manage earnings to differ.
Specifically, we compare firms whose promoters are pledging for the first time during the sample period with firms whose promoters have pledged shares at the beginning of the year and continue to pledge shares throughout the year. We also examine the effect of the
that are individuals and corporate pledgers.
Our supplemental regressions provide the following insights. First, pledging promoters manage discretionary accruals upward in the first year of the pledge. However, either because of the reversing nature of accruals and / or increasing monitoring in subsequent years, pledgers engage in lower levels of accruals management than do firms that do not pledge at all. In contrast to discretionary accruals, we observe no difference between first-time and continuing pledgers for discretionary expenses. Second, we find no evidence that the incentive to avoid a loss magnifies pledgers incentives to increase discretionary accruals or to cut R&D. Third, the negative relation between pledging and discretionary accruals is observed for both individual and corporate promoters. However, only individual promoters appear to cut R&D when they pledge shares.
We conduct additional analyses to assess the robustness of our findings. First, for our discretionary accrual models we account for the endogeneity of pledging (as well as that of control variables) with instrumental variable regressions and dynamic panel methods (Blundell and Bond (1998)). Our conclusions remain the same under these alternate estimation methods. Second, we drop observations related to 2009 as the incentives to manage earnings might differ in the first year of the pledging regulation. Third, we use alternate measures for age and institutional ownership (two of our control variables). The results remain unchanged under these modifications.
Our study contributes to the literature that examines the relation between borrowing and financial reporting strategy. While prior research in accounting and finance has focused on corporate-level borrowing, we study how personal borrowing by the firms’ insider owners influences reporting strategy. Be that as it may, our evidence relates to a very specific type of borrowing where the collateral consists of firm shares. Hence, more research on how
growing literature that examines the relative trade-offs of accrual-based and real earnings management (Cohen, Dey, and Lys (2008); Cohen and Zarowin (2010); and Zang (2012)).
Our evidence suggests that, in general, pledging promoters appear to view real earnings management as less costly. However, they do engage in accrual-based manipulation in the first year of the pledge.
The rest of the paper is organized as follows. Section 2 describes the institutional background related to share pledge loans in India. Section 3 presents the links between pledging and earnings management. Section 4 describes the measurement and design choices. In section 5, we discuss sample selection criteria and descriptive statistics and in section 6 we describe the results. Section 7 concludes.
2. Institutional Background
2.1. Pledging Regulation in India Pledging of shares involves the promoters’ use of firm shares as collateral to borrow funds. Lenders are usually commercial banks or non-banking financial institutions.
Pledging came under regulatory scrutiny in January 2009 after Mr. Ramalinga Raju, the former chairman of Satyam Computer Services Limited, a leading information technology firm, admitted to falsifying the firm’s financial statements. In the week, preceding this admission, lenders liquidated Satyam shares that had been pledged by Mr. Raju, precipitating a significant decline in stock prices.2 Before the Satyam scandal, firms and their promoters were not required to disclose the existence or magnitude of share pledges. In light of the increased risk of price declines associated with lenders selling pledged shares, SEBI announced disclosure requirements on 2 The sell-off by lenders was probably motivated by a significant decline in Satyam’s share price in December 2008 and negative news related to Satyam in that month.
shares pledged in return for loans. This was achieved by inserting regulation 8A, “Disclosure of Pledged Shares,” as an amendment to the Substantial Acquisition of Shares and Takeovers (Amendment) Regulations, 2007.
Regulation 8A requires that promoters inform their firms about a share pledge within seven days of commencement of the Regulation. Besides this initial disclosure requirement, the regulation also has a continuing disclosure requirement for promoters and their firms.
Promoters are required to inform their firms about a share pledge within seven days of a share pledge.3 Further, firms are required to disclose the information on share pledges to all the stock exchanges on which the shares of the particular company are listed, within seven days of the receipt of the information from the promoters. The firm-level disclosure requirement is triggered when the number of shares pledged by its promoters exceeds the lower of, (a) 25,000 shares or (b) one percent of the total shareholding of the firm.
Additionally, SEBI amended clauses 35 and 41 of the Equity Listing Agreement between firms and stock exchanges. These clauses relate to the quarterly reporting of shareholding pattern of a company and its financial results. The format of these filings was amended to include details of shares pledged by promoters and promoter group entities.