Prospect theory, industry characteristics and earnings management: A study of Malaysian industries

This paper aims to detect earnings management activity in different industries in Malaysia by using the earnings distribution model. Further, the prospect theory and the possible influence of various industry variables are tested to understand the role of the industry in the motivation to manage earnings among firms in Malaysia.

A sample of 538 firms from 15 different industries over the years 2005-2011 is used for this purpose. The earnings distribution model is used to detect earnings management activity across industries, and various regression techniques are used to test the influence of the prospect theory and various industry variables on earnings management activity.

The findings indicate the presence of earnings management practices in Malaysian industries, but the prevalence of earnings management activity and the motivation to do so are found to differ across industries. The prospect theory is found to be a possible motivation for earnings management overall but not when industries are considered separately. Industry competitiveness, capital intensity and profitability are found to influence both motivations to manage earnings while industry leverage is found significant only in the case of motivation to manage earnings to avoid reporting losses. Finally, earnings volatility and size are insignificant in influencing the propensity to manage earnings.

To the authors’ knowledge, this is the first study which documents the role of various industry characteristics in influencing earnings management activity. It highlights the importance of considering industry level variables in a study on earnings management and, hence, adds to the growing literature on earnings management.