Geography, business strategy and accruals-based earnings management

Clusters are characterized as geographical concentrations of firms in a similar industry with the benefits of sharing resources and creating better opportunities for innovation. This study examines the effect of geographical cluster’s characteristics – cluster size and cluster knowledge, on the earnings management behavior of firms. Cluster size refers to the industry density of firms in a region, while cluster knowledge is a proxy for innovation activities within the same geographic area. This thesis offers two competing arguments to explain the relationship between clusters characteristics and earnings management from competence and governance perspectives. The competence perspective suggests that the geographic concentration of firms in a similar industry encourages co-operation and competition among cluster actors. Repeated interaction among proximate partners and inter-firms collaborations can facilitate knowledge transfer and strengthen mutual trust among cluster firms. Strong social capital coupled with trust can mitigate opportunistic behavior such as earnings management. The high number of firms in a cluster is likely to reduce earnings management behavior via trust building processes. However, based on the governance perspective of cluster theory, collaborations among competing firms do not necessarily generate trust. Transaction costs economists argue that co-operation in a joint project potentially increases the probability of hold-up problems, as some important transaction terms (such as delivery time and quality of output) cannot be predefined in formal contracts, and thus increase the hazards associated with opportunistic behavior. Moreover, this also potentially increases the risk of unintended knowledge spillover, where a partner firm, which is also a close competitor may use the knowledge gleaned in the collaboration as a “weapon” to compete. In addition, more firms competing for the same and limited resources in a large cluster will lead to competitive uncertainty that can induce firms to engage in opportunistic earnings management. In so far as opportunistic earnings management is concerned, the competence and the governance perspectives of cluster theory generate competing predictions between clusters and earnings management. According to the competence perspective, clusters are drivers of innovations which is considered critical to generating competitive advantage for a region. In a competitive and uncertain business environment, the competitive advantage that firms generate from innovation is the key to sustaining long term survival in an industry. As innovation is a key factor in limiting competitive uncertainty it is regarded as a leading factor in mitigating opportunistic earnings management. Firms located in a knowledge cluster are expected to manage earnings less. On the other hand, based on the governance perspective, the realization of the potential benefits of investment in innovative activities is uncertain until the innovation projects are certified as “successful”. Therefore, the potential return on investment in innovative projects comes with a higher risk of uncertainty. As high uncertainty is attached to knowledge clusters, it is logical to predict that firms located in a knowledge cluster may manage earnings more. Based on the above arguments, the two cluster characteristics - cluster size and cluster knowledge may induce or mitigate earnings management behavior. Assuming the presence of potential asymmetry in benefits and hazards from geographic clustering, each firm competes with its rivals using its business strategy (or competitive strategy) that could, in turn, affect the link between clusters and earnings management. Applying the topology of Miles and Snow (1978, 2003) into this research context, the two extreme business strategies of “prospectors” and “defenders” affect the relationship between clusters and earnings management. Prospector firms are customer-orientated and heavily involved in the innovative activities that can differentiate them from their rivals. Defender firms are competitor-orientated, less innovative and try to beat financial performance of their competitors. When a cluster becomes larger, less innovative defender firms will face highly competitive uncertainty and tend to manage earnings more to beat the financial performance of their proximate competitors. However, defender firms are expected to enjoy more benefits than costs within innovative clusters (cluster knowledge) as they enjoy the benefits from knowledge inflows from their proximate innovative firms (such as prospector firms). They can translate the knowledge gained into better performance. The primary data used in this research consist of unbalanced panel data of U.S. firms, covering the period of 2000 to 2011. Regression models for testing the hypotheses are estimated using ordinary least squares (OLS) proposed by Petersen (2009). Even though the issue of endogeneity or reverse causality is not a major concern in this study, a change model and instrument variables method are used to address the problems. This study supports the argument based on the governance perspective, and shows that both cluster characteristics (cluster size and cluster knowledge), are associated with higher earnings management. Consistent with the predictions, defender firms manage earnings more when they locate themselves in a larger (highly dense) cluster; and manage earnings less when they locate themselves in a knowledge cluster. Cluster theory is a new topic in accounting literature even though it has been examined extensively in the strategic management and geographic economics literature. This research contributes to the accounting literature by linking the cluster theory and business strategy to the earnings management literature. It is relatively new to the accounting literature. Clusters are considered competitive business environments as competing firms in similar and related industries are concentrated in the same geographic regions. Therefore, clusters matter to entrepreneurs who wish to make location decisions by considering whether they can fully leverage the benefits from the cluster environment. Since the level of competition in a cluster is an important factor affecting a firm’s business risk, the research findings of this thesis are useful for various social actors in a cluster environment. The ability of firms to manage risks via an efficient internal control system is the main concern of auditors and regulatory bodies such as the SEC (U.S. Securities and Exchange Commission). The SEC should pay attention to clustered firms regarding internal control issues, as U.S. firms are committed to complying with the Sarbanes-Oxley Act of 2002 (SOX) by ensuring the adequacy of internal control over financial reporting. In order to mitigate opportunistic earnings management, auditor rotation policies should be implemented to improve audit quality. Auditors may charge higher audit fees if their assessment of a client’s business risk is high and there are additional regulatory requirements for auditing a clustered firm. This study also has implications for practice since policy makers should consider clusters in designing policies that could discourage earnings management. Cluster policy makers also can further enhance their knowledge of the importance of considering the types of business strategies in any cluster policy or program. Prospector firms, as compared to defender firms, are less likely to manage earnings in a cluster, as they are capable of sustaining their business by creating innovation. This indicates that the participation of prospector firms in a cluster program is important in stimulating the cluster’s growth