Examination of the Relationships between Transactions with Related Parties, the Disclosure Rank, and the Evidences of Earnings Management in the Companies of Tehran Stock Exchange Hamid Reza Vakilifard Department of Accounting, Associate, Science and Research Branch, Islamic Azad University, Tehran, Iran. Maryam Salmanian* Department of Accounting, Science and Research Branch, Islamic Azad University, Tehran, Iran. *Corresponding author: maryam_salmanian@gmail.com

Keywords Abstract Related Party Transactions Disclosure Rank Evidence of Earnings Management

Weakness in financial reporting was one of the reasons of scandals of big American companies and the most important thing in these weaknesses was in reporting exchanges with dependent persons. The presence of related party transactions1 is a sign of aggressive accounting. The presence of related party transactions is one of 9 main reasons that result in firms being forced to report their financial reports again. Accordingly, the goal of the present research is to identify the relationship between exchanges with dependent persons, disclosure rank, and evidence of earnings management in firms enlisted in Tehran Stock Exchange. In this, research 143 firms enlisted in Tehran Stock Exchange within the period between 2008 and 2012 have been investigated. To test the hypotheses we have used a multiple linear regression model. Research findings have shown that there has been a negative relationship between related party transactions and disclosure rank and there has been a positive and meaningful relationship between related party transactions and evidence of earnings management.

1. Introduction One of the items of the financial statements considered as an index to assess the functionality and profitability of profitable organization is "profit reporting." However, calculating the net profit of a profitable organizations influenced by the accounting methods and estimates. The managers authority to use" realization and matching principles, estimating and prediction" as well as operating such methods as "change of the goods inventory valuation method, key-money depreciation, perception of expenditure on research and development as current or capital expenditure and determine the costs of doubtful receivables," are of items by which application, the managers the managers can change the benefit. On the other hand, due to more knowledge of managers on the company, it is expected that the information is produced and presented in a way that best reflects the company's status. On the other hand, due to such reasons as remaining at the company, taking cash bonus, etc., the managers may pretend the company's status favorable through changing the profit report either on purpose or unconsciously. Under such circumstances, the earnings reported in the financial statements conflict with the actual profit and an event has occurred as the interest management [6]. On the other hand, the disclosure rank is one of the important factors to investors helping them in choosing the stocks, so the meaning of the so-called disclosure is presenting true and correct information in its widest concept, which one of them is dealing with dependent persons. To increase the dealings with individuals may reduce the transparency and reliability and ultimately lead to the earnings management. Therefore, in this paper through stating the subject, necessity of the research, research hypotheses, and finally the domain of research etc. we examine the relationship between the transactions with related parties, the disclosure rank, and the evidences of earnings management.

2. Theoretical Principles Earnings management is to arrange the interests, knowledgably, to achieve a desired level or trend [1]. Securities Exchange Commission (SEC) has also described it as the usage of accounting accepted principles in an inappropriate form. Earning Management occurs when the managers take advantages of their judgment in financial reporting and organizing transactions, to change the financial statements in order to mislead some beneficiaries on particular economic performance in the company or to affect the results of the contract provisions based on accounting elements [11]. According to these items in the current accounting researches, earnings management has been considered as a proxy of the quality reduction of financial reports. Transactions with related parties are common and usual in the business and commerce. Commercial units often perform some certain parts of their activities through a subsidiary or affiliate, and the other business units earn interest for the investment purposes or commercial reasons. The benefits are to such extent that enable the investor company, affect the management and operational decisions of the investee entity. The relationship between commercial affiliates may also be made in other situations, like the case in which a person is a board member of two independent companies [7]. If the parties in the transaction have dependence, the available independence may be removed at the transaction. In the Statements of Financial Accounting Standards 57, disclosure of transactions with related parties has been stipulated within the accepted accounting principles [7].The occurred financial scandals of recent years in some big corporations of world, leaded to the bankruptcy of companies (including Enron and WorldCom), the loss of investors' trust, and criticizing the accounting profession. Crisis in the stock and financial markets in the United States led to codify new laws and regulations to impose stricter government supervision on the companies' performance[8]. In 2002 the law of protecting the investors' benefits and amendment of accounting procedures of 2002 LLP2 corporations, known as Sarbannes-Oxley was approved as an appropriate response to deal with corporate and financial scandals leading to the stand for the financial scandals of United States big and outstanding cooperation. The section 402 of this law revised the requirements of transactions disclosure the Act deals with related parties [16].

1A transaction between two businesses that have a personal or other relationship. 2A limited liability partnership (LLP) is a partnership in which some or all partners (depending on the jurisdiction) have limited liabilities. It therefore exhibits elements of partnerships and corporations.

Int. j. econ. manag. soc. sci., Vol(4), No (3), March, 2015. pp. 257-262

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Weakness in financial reporting was one of the reasons of scandals of big American companies and the most important part of it was relate to reporting exchanges with dependent persons. The presence of related party transactions is a sign of aggressive accounting. The presence of related party transactions is one of 9 main reasons that result in firms being forced to report their financial reports again (Gordon and Henry, 2005). Accordingly, dealing with the related parties is described by two theories: Conflict of Interest Hypothesis: due to separation of management from ownership, and conflict of interest between them, exchange with affiliated persons may cause loss in shareholders' wealth. Efficient Transaction Hypothesis: According to this theory, the exchanges may be done to meet the company's economic needs, so there is no incentive to manage earnings [9]. Given the above two points of view, sometimes the incentive of transactions with the related parties is to quit the company's assets for the affiliated person's benefits and the manager to cover it would launch earning management3. Although the second approach suggests that sometimes in order to bring the experience, expertise, and unique skills of related persons or services compensation to the company, such transactions take place in which case there is no incentive to earnings management. On the other hand, the disclosure rank is one of the so important factors to investors helping them during choosing stocks, thus the term "disclosure" means to provide information in its widest intention. Accountants use this word more specified and their intention is to publish the financial information about a company in the financial reports (usually as an annual report). In some cases, this concept is still limited and means to provide information not recorded in the financial statements. Giving out the information of balance sheet, profit and loss statement, statement of cash flows, is often considered as the recognition and measurement. Thus, as the most limited implication, the disclosure of data includes management analysis, accompanying financial statements, and the supplementary reports [2]. Various financial and economic features can affect on the amount and quality level of the companies' disclosure in different periods. In different times, managers provide various levels of disclosure with respect to incentives, financial measures, and company's economic status as well as considering the cost-benefit criterion attributed by disclosure presentation in order to reach their goals and objectives. On this regard, numerous studies have been conducted and a lot of different factors, including the related ones to management, some mechanisms of corporate governance, the cost of confidential information and the financial and environmental features of the companies have been studied [25].According to the research of Fouladi and Salehabadi (2011), the disclosure rank is one of the important indicators in decision making of investors. Therefore, the investors look for all the information on the economic unity, but according to research of "Qajari" 1392, another significant point is how to calculate the disclosure rank, which is calculated predicated on reliability and timely in Iran. Accordingly, the increase of transactions with persons (purchase or vend etc), may lead to reduce the transparency and reliability because the investors think and the manager has taken advantage of its position and prefer its personal benefits rather than the beneficiaries'. This matter can result in the owners distrust and consequently exiting the property out of the company's stock market [21]. According to conducted review on the earning management, the quality of disclosure and transactions with related parties as well as representation theory and conflict of interests between managers and owners, the following questions are stipulated in this research:

Is it possible for the managers to earning managing through exchanges with related parties? Could transactions with related parties be another motivation of earnings management? Could using transactions with related parties by the managers affect the disclosure rank?

3. Literature Review Ming and Wang (2003)presented such evidence of earnings management incentives in companies with high levels of transactions with related parties, or to preventing to be removed from the list or prior to the issuance of new shares. Jian and Wong(2004) examined the interest amplification through transactions with related parties in the companies enlisted in China's Stock Exchange during 1998 to 2002. The results showed that these companies' owners have participated in the profit amplification through transactions with related parties. They showed that sales to the related parties have been replaced for optional commitment goods and the companies having transaction with the dependent persons, have used these exchanges instead of commitment goods to earnings management. Gordan & Henry (2005) examined the relationship between earnings management and transactions with related parties. They measured earning management using abnormal commitment goods and evaluated transactions with related parties from four views. Then they concluded that concern about transactions with related parties prevails only for some types of them, and just exchanging with some related parties is not the reason to earnings management. Based on the results of Henry et al (2006) research, in addition to trade of the goods, trade of assets among the related parties has been used to earnings management and fraudulent reporting. Choan et al (2010) examined the relationship between transactions with related parties during and earnings management during a research, based on a sample of 50 Indonesian firms during the various years. They developed the research hypothesis based on the representation theory and conflict of interest. The experimental results of their study showed there was no statistically significant evidence about the relationship between earnings management and transactions with related parties there. Sai Chang & Lin Lin (2012) investigated the relationship between the expertise in the audit business, and the quality of disclosure and finally it was found that expertise in the audit firm has a positive impact on the quality of disclosure. Relationship between transactions with related parties and the earnings management is relatively new in accounting-oriented researches and few studies have been done at this end as follows: Mashayekhi et al (2005) examining the manufacturing companies enlisted in Tehran Stock Exchange during the years 1996 to 2003indicated that the earning management was imposed in these companies and to compensate the reduction of cash produced by the operations (representing the poor performance of the business unit), the management unit tried to increase profits through increasing the optional commitment goods. Noravesh et al (2005) examining the enlisted companies in Tehran Stock Exchange during the years 1995 to 2003 showed that Earnings management is applied in them, and management unit gain this subject through editing the commitment goods. Mashayekhi& Safari (2006) examining the enlisted companies in Tehran Stock Exchange during the years 2000 to 2003 showed that Earnings management is applied in them and also the companies with poor operating activities execute approach of increasing accruals4 and the corporations with excellent launched the strategy of reducing the accruals. Etemadi & SalehiRad (2011) reviewed the life cycle in the relationships between transactions with related parties and the performance of listed companies in Tehran Stock Exchange during a research. The outcomes of their work showed that in the growth phase, there is significant positive relationship between transactions with related parties and the firm's performance and in this level, the effective transactions perspective is dominant. In the puberty step, there is a negative and significant relationship between transactions with related parties and the company's performance, and in this stage the approach of conflicts of interest is predominant view and ultimately, on the wane step, there is no significant relationship between the transactions with the related parties and performance and at this stage the dependent persons' incentive and goal in the transaction with the company are the determinant factor of positive or negative effect of these exchanges on the company's performance. 3 Earnings management, in accounting, is the act of intentionally influencing the process of financial reporting to obtain some private gain. 4 The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received).

258 Hamid Reza Vakilifard, Maryam Salmanian *International Journal of Economy, Management and Social Sciences Vol(4), No (3), March, 2015.

4. Research hypothesis Regarding to the researcher questions, the following hypotheses were formulated: 1. There is a significant relationship between transactions with related parties and the disclosure rank. 2. There is a significant relationship between transactions with related parties and evidences of earnings management.

5. Methodology This study is correlation in terms of method and is applicable as of purpose, the present study is considered as descriptive accounting researches. In addition, since the historical data will be used to test the hypotheses, so it is classified in non-experimental researches group. The present study in terms of epistemology is also considered empiricist, with inductive reasoning systems and in terms of studying type isfield-library, using the historical information as the post-event (i.e. using past information). In the following, how to calculate each of the variables has been presented: Variables and how they are calculated: In this paper, relationship between transactions with related parties, the disclosure rank, and the evidence of earnings management has been examined. Thus, the independent variable is related to the transaction with dependent persons and the dependent variables are aligned to the disclosure rank and evidence of earnings management. The control variables are also related to institutional shareholder ownership, board structure, company's size, financial leverage, and return rate of assets so that the variables are defined as follows: - The dependent variables The dependent variable in this study is the disclosure rank and evidences of earnings management, calculated as follows: - Disclosure rank: In this study, to measure the quality of disclosure we utilized the annual scores presented by the stock exchange for the firms listed on stock. These scores are based on reliability and timely [24]. - Earning Management: In order to calculate the earnings management, the optional commitment goods are used, and to count the optional commitment goods, we also utilized the modified Jones model (Jones, 1991) founded by Decho and Dicho[5]. Because the results of Nikoomaram et al research, conducted on evaluation of the accrual-based models to detecting the earnings management, revealed that the next versions of the Jones model had acceptable ability to detect the earnings management [22]. The model is as follows:

=

+

()

+

+it

In the equation number 1, we have: TA it: total accruals of firm i in year t, obtained from the result of net profit before unexpected items subtracted from operating cash. Ait-1: Total assets of firm i in year t-1 REV: change in the earning of firmi between the years t-1 and t REC: Changes in receivable accounting of firm i between the years t-1 and t PPE: The amount of property, machineries and equipment (gross) of firm i in year t In this model, at first the parameters estimated for the firm, were counted through the estimation method of least squares in longer time, then they were tested for the research period. In this model, the index (optional commitment goods) of the same certain magnitude is the error () [15].

- Independent variable The independent variable in this study is transaction, to which calculationin this research, the ratio of total amount of transactions costs with related parties on the total sales. - Control variables According to the model Ray Dick and Vited (2009) and Cheng et al (2012), these two variables are considered as control ones. How to calculate institutional shareholder ownership: in this research, to determine the institutional shareholder ownership for each firm, we collect the share percentage of top shareholders above 5%. How to figure out the board structure: in this research, to figure out the board structure, we use the ratio of non-charged managersto whole members. Company size: There are different standards to measure the variable "company size" including the total amount of assets, sales and total number of employees. However, in this study, the company size is calculated using ln the asset cost value. Financial leverage: total assets calculate it from division of total debt. Return rate of assets: total assets obtain it from division of net profit. Data analyze The table below shows the results of the descriptive statistics for the 715 observed variables:

Table 1. Descriptive statistics of research variables of smoother society and variability of operating efficiency

Variable Sign Mean Middle Maximum Minimum Criterion Deviation Skewness Elongation coefficient

Evidences of earnings management DAC 0.109 0.071 1.064 0.000 0.150 5.713 59.37 Disclosure Rank DIS 63.260 66.000 99.000 -8.000 22.568 -0.572 2.696 Transactions with related parties RPT 0.465 0.284 2.949 0.000 0.499 1.645 6.425 Institutional Shareholder ownership OSI 0.693 0.740 1.000 0.000 0.229 -1.165 3.839 Board of Directors formation BF 0.650 0.600 1.000 0.000 0.219 -0.797 3.821 Company Size SIZE 18.518 18.320 23.970 15.420 1.409 0.974 4.696 Return on assets rate ROA 0.165 0.136 0.726 -0.274 0.335 19.797 470.1 Financial Leverage LEV 0.661 0.658 0.986 0.096 0.227 1.393 10.32

259 Examination of the Relationships between Transactions with Related Parties, the Disclosure Rank, and the Evidences of Earnings Management in the Compa...

International Journal of Economy, Management and Social Sciences Vol(4), No (3), March, 2015.

Table 2. The results of examination of normality of dependent variable distribution of the research

Variable Sign Statistics Asymp (sig) Evidences of earnings management DAC 1.272 0.168 Disclosure Rate DIS 0.657 0.781

According to this table, after normality test, the significance level of statistic Z of KS test goes upper than 0.05 for the dependent variable, thus the hypothesis H1 meaning the normality of the dependent variable distribution will be accepted.

Table 3. Unit root test using generalized Dickey-Fuller

Variable T statistic amount Significance level Evidences of earnings management -23.179 0.000 Disclosure Rate -16.694 0.000 Transactions with related parties -14.806 0.000 Institutional Shareholder ownership -12.174 0.000 Board of Directors -12.849 0.000 Company Size -7.343 0.000 Return rate of assets -16.101 0.000 Financial Leverage -12.395 0.000

According to the results presented in Table 4, all the research variables enjoy 95% confidence level.

Table 4. Pearson correlation matrix for the quantitative variables of research

Variable DAC DIS RPT OSI BF SIZE ROA LEV DAC 1 DIS -0.047 1 RPT 0.171** -0.223 ** 1 OSI -0.108 ** 0.084* 0.065 1 BF -0.167 ** 0.125** -0.120 ** -0.072 1 SIZE -0.017 -0.008 0.048 -0.077 * 0.010 1 ROA 0.105** 0.076* 0.002 -0.034 0.036 0.124** 1 LEV 0.070 -0.153 ** 0.090* 0.092* -0.105 ** -

0.277 ** -0.225** 1

Items * & ** are significant and related to 95% and 99% confidence respectively.

In the next step, to test the research hypotheses, the following tests are used: - Test results of the first hypothesis There is a significant relationship between the transactions with related parties and the disclosure rank. DISit = 0 + 1RPTi,t + 2OSIi,t + 3 BFi,t + 4SIZEi,t+ 5 ROA i,t + 6 LEV i,t +it

Table 5. Test results of 1sthypothesis

Variable name Variable symbol Coefficients t-Statistic Prob.

Constant C 0.774 1.389 0.165 Transactions with related parties RPT -0.405 -5.831 0.000 Institutional Shareholder Ownership OSI 0.624 042.4 0.000 Board of Directors BF 0.363 260.2 024.0 Size of company SIZE -0.045 -1.719 0.086 Return on assets ROA 0.163 1.575 0.115 Financial Leverage LEV -0.721 -4.239 0.000 The coefficient of determination R Square 0.178 Adjusted coefficient of determination Adjusted R Square 0.167 Camera Watson Durbin-Watson 1.939 Statistic F 15.345 Probe. 0.000 Statistic Godfrey 2.751 Probe. 0.214 Statistic F-white 1.887 Probe. 0.094 Statistic Hausman 12.324 Probe. 0.006 Statistic F-limer 18.036 Probe. 0.000

Regarding to the test results of first hypothesis presented in the table (4-5), the significance level of statistical F - Limer (0.000) is less than the acceptable error level (5%), so the panel data method (panel) has preference for the pooled data method (combined). In addition, given that the significance level of statistical H- Hausma (0.006) is less than the acceptable level of error (5%), the regression method with fixed effects prefers regression with random effects. In the following, the significance level of statistical F-white was 0/094.This indicates that the regression does not have variance difference and finally the significance level of statistical Godfrey was 0.214, hence the regression does not have the serial self-correlation problem. In the next step, since the statistic F (0.000) have the significance level less than 5%, so the regression enjoys explanatory power. In addition, given that the variable of transactions with related parties (independent variables) have the significance level less than 5% and are related to disclosure rank, so the transactions with related parties have a negative and significant relationship between with the disclosure rank. The controlling variables, institutional shareholder ownership, the board structure have also positive relationship with disclosure rank whiles this relationship between the financial leverage and disclosure rank is negatively significant. Since Watson5 statistic camera is 1.5 to 2.5,

5Watson is an artificially intelligent computer system capable of answering questions posed in natural language.

260 Hamid Reza Vakilifard, Maryam Salmanian *International Journal of Economy, Management and Social Sciences Vol(4), No (3), March, 2015.

and then as a result there is no self-correlation problem between the variables. Moreover, the measure of determination coefficient indicates that the changes in the independent and controlling variables represent 17.8 percent changes in the dependent variable. Concerning the financial analyze, it can be noted that increasing transactions with persons (purchase or vend etc.) leads to reduce transparency and reliability, why in the investors view, managers are exerting their impetus to prefer their own interests. This matter can result in the investors distrust and dropping out in the stock exchange. The results and findings of this hypothesis have been equal with the results of Ming (2003) and Ginglingor and Sadur (2012). The results of second hypothesis There is significant relationship between transactions with related parties and the evidences of earnings management. DAC it = 0 + 1RPTi,t + 2 OSI i,t + 3 BFi,t + 4SIZEi,t+ 5 ROA i,t + 6 LEV i,t +it

Table 6. Test results of second hypothesis

Variable name Variable symbol Coefficients t-Statistic Prob.

Transactions with related parties RPT 0.047 4.626 0.000 Institutional Shareholder Ownership OSI -0.087 -4.238 0.000 Board of Directors BF -0.105 -2.946 0.003 Company Size SIZE -0.003 -0.495 0.620 Return rate on assets ROA 0.056 0.754 0.450 Financial leverage LEV 0.048 334.1 182.0 Constant C 0.232 2.007 0.045 The determination coefficient R Square 0.085 Adjusted coefficient of determination Adjusted R Square 0.077 Watson-Durbin Durbin-Watson 1.745 Statistic F 11.053 Probe. 0.000 Statistic Godfrey 1.860 Probe. 0.312 Statistic F-white 42.964 Probe. 0.000 Statistic F-limer 1.937 Probe. 0 .102

According to the outcomes of second hypothesis test presented in Table (4-6), the significance level of statistical F-limer (0/102) has been more than acceptable level of error (5%); hence, the pooled data method (combined) has preference for the panel data (panel). In addition, regarding to the significance level of statistical F-white equals 0.000, this matter demonstrated variance difference in regression. Therefore, after correcting the standard errors and variance difference, the regression would be fitted and finally the significance level of statistical Godfrey gets0/312, so the regression does not have the serial self-correlation problem. In the next step, since the statistical F (0.000) has the significance level less than 5%, so the regression hold the explanatory power. In addition, since the variable of transactions with related parties (dependent variable) has the significance level less than 5% and is related to the evidences of earning management, so there is a positive and significant relation between exchanges with dependent persons and evidences of earning management. Amid the controlling variables, institutional shareholder ownership, board structure hold negative relationship and the financial leverage has a significant positive relation with the evidences of earning management. Regarding to Watson camera statistic 1.5 to2.5, then there is no self-correlation problem between the variables consequently. Moreover, the determination coefficient indicates that the changes in the independent and controlling variables represents 85 percent change in dependent variable. As to financial analysis, regarding to separation of ownership from management as well as hypothesis of conflicts of interest, transactions with related parties may result in loss of shareholders' wealth. Because the incentive of transaction with related parties is quitting the properties of company for them so that the manager tries to earning management to cover it up. The results and outcomes of this hypothesis was on the same page with Ming research 2003 and was not the same as the results of Gordon & Henry (2005) and Koan et al (2010).

6. Discussion and Conclusions Weakness in financial reporting was one of the reasons of scandals of big American companies and the most important thing in these weaknesses was in reporting exchanges with dependent persons. The presence of related party transactions is a sign of aggressive accounting. The presence of related party transactions is one of 9 main reasons that result in firms being forced to report their financial reports again. Accordingly, the goal of the present research is to identify the relationship between exchanges with dependent persons, disclosure rank, and evidence of earnings management in firms enlisted in Tehran Stock Exchange. In addition to the mentioned theoretical principles, the research findings indicate that there is a positive and significant relationship between transactions with related parties and the evidences of earning management. Concerning the positive effect of the former item on the latter one, it can be noted that regarding to the hypothesizes "conflict of interests" and "separation of ownership from management" exchanges with related parties can lead to the loss of the shareholders property. As respect to this point of view, sometimes the incentive of transaction with related parties is quitting the properties of company for them so that the manager tries to earning management to cover it up. On the other hand, the disclosure rank is one of the important indices, helping the shareholders to choose the appropriate stock. Various financial and economic factors and features can affect the quality amount and level of disclosure in the companies for different periods. Accordingly, increasing transactions with persons (purchase or vend etc.) may lead to reduce transparency and reliability, why in the investors' view the managers are exerting their impetus to prefer their own interests. This matter can result in the investors distrust and quitting their assets in the stock exchange. According to the outcomes of first hypothesis (showing a significant relation between transactions with related parties and the disclosure rank which was accepted), as suggestion, the investors better consider such variables as transactions with related parties while analyzing the purchase of companies' shares, because the mentioned variable causes the disclosure rank reduction. Regarding to the negative relation transactions with related parties and the disclosure rank, is also suggested that the Stock Exchange Organization impose such rules as obliging the companies to have powerful controlling structure. As regards to the outcomes of second assumption (showing a significant relation between transactions with related parties and the evidences of earning management which was accepted), it is suggested to the investors to examine such variables as transactions with related parties why it leads to increase of the evidences of earning management. It is also suggested to the managers to consider that increasing transactions with related parties results in increase of the organization's evidences of earning management, so the managers must present the information more transparent in order to remove the investors' distrust.

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262 Hamid Reza Vakilifard, Maryam Salmanian *International Journal of Economy, Management and Social Sciences Vol(4), No (3), March, 2015.