Is Modified Jones Model Effective in Detecting Earnings Management? Evidence from A Developing Economy

Abstract

This study analyzes the effectiveness of Modified Jones Model in detecting earnings management among the initial public offerings that are listed between 1985 -2005 in the Dhaka Stock Exchange (DSE). Prior research documented that the Modified Jones model is effective in detecting earning management in mostly developed economies. However recently an empirical research of Korean stock exchange revealed that the Modified Jones model was not effective in detecting earnings management in the context of Korea. Our findings are similar to the Korean experience. Results of our study confirmed that Modified Jones model is not effective in detecting earnings management in the context of Bangladesh. We employed the modified Jones model to detect earning management in context of Bangladesh capital market and found out that it was not found very effective as the explanatory power of the model was only about 9 percent. This study then attempted to extend the modified Jones model and found it to be very successful. The inclusion of few factors such as revenue, depreciation expenses, retirement benefit expenses, asset disposal gains/losses with the modified model was very effective in detecting earning management in the context of Bangladesh. The explanatory power of the model was increased to about 84 percent. Therefore it is concluded that the modified Jones model is not effective in gauging the extent of earnings management practiced by the IPO firms in the Bangladesh capital market. Keywords: Earning management, Modified Jones Model, Dhaka Stock Exchange 1. Introduction Studies of short run and long run behavior of returns on IPOs reveal that IPOs are underpriced in the short run, whereas in the long run the evidence is that of underperformance, i.e., negative returns accrue to the investors holding these IPOs (Balwinder Singh and RK Mittal, 2003). IPO firms can enhance their earnings by adopting discretionary accounting accrual adjustments that raise reported earnings. Over time, investors may recognize that the firms' earnings are not maintaining momentum, and hence, investors may lose their optimism, resulting in poor long run performance. Teoh et al., (1998) and Abdullah and Susanne (2004) revealed that the offering firms report significant improvements in their operating performance in the pre-offer period, which are not due to their cash flow performance. They have also recorded that an aggressive earnings management pre-offer leads to worse operating and return performance post-offer. Most of the prior studies on earnings management have focused on why firms manage earnings. Several reasons have been identified that include; income smoothing (Yoon and Miller, 2002b), ownership control (DeAngelo, 1988), equity offerings (Rangan, 1998; Teoh et al., 1998; Yoon and Miller, 2002a) and political costs (Jones, 1991). Researchers found it arduous and challenging to detect or measure earnings management. It is not possible to observe earnings management directly. Therefore, researchers have investigated two venues...

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