2. Theoretical framework

1. Introduction

opportunism.

Familiar Quotations, 10th ed. 1909.

178 Corporate Governance and Strategic Decision Making

provisions of governments and regulators.

occurs as a result of that relationship.

The best plan is… to profit by the folly of others. Taken from Pliny the Elder, by John Bartlett,

Recent corporate scandals across the globe have drawn attention to the field of corporate governance. Users of financial information such as investors, governments and regulators are increasingly concerned about how earnings numbers are derived [1]. This is due in large part to the countless examples of managers who have used their discretionary decision-making power to misreport their firms' profits. Petrobras in Brazil, which overpriced contracts for private benefits, or Disco in Argentina, which was found to have inappropriately recorded the financial results from several joint ventures, are just two examples of high profile firms that have inflated their earnings, to the detriment of investors and in direct contradiction to the

This chapter studies the impact of financial reporting quality on firms' market performance in a sample of LATAM corporations, using these data to examine the perception processes of investors as a mediating variable between reporting quality and market performance. Specifically, we address whether the perceived performance of an organization is in reality based upon actual organizational performance, or is instead more a function of the results overtly exhibited in the organization's financial reporting structures, which may have been discretionally manipulated. We propose that, especially in contexts of high asymmetry of information, investors are not able to effectively discern the quality of information provided to them for decision-making purposes and can therefore be easily 'fooled' by managerial

Empirically, we base this upon data collected in six Latin American countries by applying the Generalized Method of Moments (GMM) model [2], thereby hypothesizing that a positive relationship will be observed between the opportunistic manipulation of earnings and the firm's market performance. We then examine these results using a lens that combines agency theory with a social cognitive approach, to analyse the manipulated perception process that

There are a number of principal contributions from this chapter. We begin by viewing the process of manipulation with a holistic approach that integrates both a cognitive and agency perspective and allows us to better understand the relationship between earnings management, financial reporting quality and market performance as a whole, thereby providing a more comprehensive vision of the entire process. This contribution is even more valuable because we have situated our study in the under-researched context of Latin America. We also believe that we are the first to apply the GMM methodology in this context, empirically showing how financial manipulation occurs and then impacts upon investor decisions, thus influencing the organization's market valuation. By doing so we have created an algorithm and adapted an overall model that can be more generally used to rank the quality of any earnings reports, thereby contributing to a more transparent market information system. Finally, we hope that our research will go on to inform and serve decision-makers who analyse firms' The extent to which financial statements reflect actual operating fundamentals is of growing concern throughout the world, especially in emerging markets where managerial controls and practices can vary substantially from those in the USA or Europe. Some more economically developed countries have passed legislation to ensure better corporate governance and have adopted codes of good conduct in order to reduce the asymmetries of information between shareholders and the firm and to increase the rational component of the decision-making process around choosing one's investments [3, 4]. At the same time, a large difference in the quality of financial reporting across countries has been extensively documented [5]. This has led, according to the behavioural finance approach, to the conclusion that the perception of market participants is likely to be biased as a consequence of the lack of transparency in pricing and the poor quality of financial information [6]. Such losses in the quality of financial information have been modelled through earnings management [7].

Earnings management can be defined as the adjustment of a firm's reported economic performance by insiders, done either to mislead some stakeholders or to influence contractual outcomes [8, 9]. Earnings management is considered to be the most informative and trustworthy to investors if it is supported by what is perceived to be a good system of governance. However, the act of managing earnings does not necessarily reflect the true performance of the company, a situation that may contribute to shareholders and investors making inaccurate judgements about the company [9]. To examine this, we first turn to agency theory, well used in the financial arena, which holds that managerial behaviour can be opportunistic and fuelled by self-interest. Most importantly for our purposes, it accounts for the existence of asymmetries of information between managers and shareholders. Executives accept agent status because they perceive an opportunity to maximize their own utility [10]. Consequently, agency theory holds that managers may take advantage of the information they have and their latitude in making accounting and reporting decisions to overstate financial information. They generally do this by acting in what they perceive to be in their own interest [11]. Reducing agency costs by imposing internal mechanisms of control should therefore encourage managers to behave in the best interest of shareholders instead of in their own interests. However, because controls are imperfect, we would expect some degree of opportunism to remain [10]. Since managers are widely paid based on firm's performance, it is plausible to expect that active earnings manipulation will occur in order to enhance managerial compensation packages [12]. This approach is highly focussed on bounded rational decision making around incentives, information and self-interest. Thus, it is a viewpoint that suggests that it may be necessary to limit managers' discretion with respect to accounting, since investors, as a consequence of asymmetrically distributed market information, cannot unravel the valuation effect of reported earnings in a timely manner under current reporting standards.

We suggest, however, that in addition to agency theory, a more cognitive viewpoint can also be used, to guide and further understand managerial behaviour. Social cognitive theory advocates that behaviour, cognitive and other personal factors and the external environment are the three main factors that drive the decision-making process [13]. These three factors are known to be asymmetrical, similar to the asymmetry of information in agency theory, in that they do not influence each other simultaneously, instantly or with equal strength, but they do influence each other multidirectionally. As a result, both investors and managers can be understood to be making decisions based upon a combination of factors that include a triad of perceptual, environmental and behavioural elements, all converging to ultimately produce an investment decision.

Regarding cognition, two of the most relevant elements related to decision making are managerial biases and heuristics. The most common biases that managers revert to using include representativeness, availability and anchoring-and-adjustment [14] although there are now many other biases and heuristics that have been studied at length in a financial context [15]. The use of heuristics is considered a necessary way for humans to cope with our more limited capacity to process information [16]. More specifically to our study, many researchers have identified the biases and heuristics used in making financial decisions as highly relevant to understand the human and cognitive elements of the processes involved [6, 17]. Thus, according to the social cognitive approach, the market may wrongly perceive the actual firm performance disclosed in financial reports, as a consequence of biases and heuristics held perceptually and socially, in addition to behavioural and environmental elements. Thus, when managers overstate a firm's earnings, due to their bounded rationality and to information asymmetries, they can be easily misled to overprice the firm's shares.

As described in Figure 1, by suggesting a complementary relation between agency and social cognition theories, we have produced a model that further explains how this process occurs and shows how the process is reinforced by the lack of sound corporate governance systems in the institutional context of Latin American countries, as is our case.

Financial markets in the region are still in a stage of early development, which allows managers to make use of accounting discretion to manipulate financial information. In immature financial Earnings Quality and Market Performance in LATAM Corporations: A Combined Agency and Cognitive Approach… http://dx.doi.org/10.5772/intechopen.68485 181

Figure 1. Theoretical and contextual framework, a basis for the operationalized model.

markets, where there are large imbalances of information and opacity, and where the markets are not integrated, investors may not be able to discriminate between companies that provide high or low quality information [18, 19]. Therefore, in the midst of inefficient financial markets in Latin America, managers have more room to manipulate financial statements. Leuz et al. [20] present evidence that the level of outside investor protection endogenously determines the quality of financial information reported to outsiders, showing how legal protection influences the agency conflicts between investors and controlling shareholders. In Latin America investor protection is weak, and this therefore gives insiders more incentives to manipulate earnings. In conclusion, in the institutional context of Latin America, investors suffer more acutely the consequences of earnings manipulation by managers when compared to more developed financial systems, and therefore they may not be able to make optimal investment decisions.

Therefore, based upon the previous arguments regarding agency theory, cognitive theory and the institutional setting in Latin America, we hypothesize that:

H1: A positive relationship is expected between the opportunistic manipulation of earnings and the firm's market performance.
