Earnings Management
and
Corporate Governance
Thomas Laarman
Student number: 10267166
Bachelor Thesis (Accountancy and Control) Date: June 30, 2014 (Final version)
2 Abstract
This study examines the relation between corporate governance and earnings management. Prior research has focused on individual mechanisms of corporate governance or subparts of mechanisms. This study examines whether six corporate governance mechanisms are associated with earnings management. The six mechanisms include compensation practices (the effect of both bonus schemes and stock options), board of directors (composition and other characteristics), audit and compensation committees (characteristics), legal actions by regulators (investor protection regulation), corporate governance reforms (SOX) and accounting regime (IFRS, local GAAP) and are analysed based on the literature available. Based on the assumption that corporate governance reduces earnings management a negative association between earnings management and corporate governance mechanisms is expected. I found that four of the six mechanisms show negative associations with earnings management. These mechanisms include board of directors, audit and compensation committees, legal actions by regulators and corporate governance reforms. Board of directors and legal actions by regulators show a distinct negative association, audit and compensation committees a slightly negative association (because only audit committees show a negative association) and corporate governance reforms a neutral association with earnings management (because also a positive association was found that offsets the associations). Furthermore, I found that compensation practices are positively associated with earnings management and accounting regime showed no association with earnings management. The results suggest that corporate governance is an effective tool to prevent managers to engage in earnings management. It should be clear that there is still a lot to improve in corporate governance because only two mechanisms showed a distinct negative association with earnings management.
Samenvatting
In dit onderzoek wordt de relatie tussen corporate governance en earnings management onderzocht. Eerder onderzoek heeft zich gefocust op een specifiek onderdeel van corporate governance of zelfs op een subonderdeel van een specifiek onderdeel van corporate governance. Daarentegen, focust dit onderzoek zich op het gehele corporate governance concept. Hiervoor wordt een literatuuronderzoek gedaan naar de volgende zes corporate governance mechanismes: compensatie van managers (bonusstructuren
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en aandelenopties), de raad van bestuur (de compositie en andere karakteristieken), audit en compensatie comités (karakteristieken), juridische acties van toezichthouders (wetgeving inzake de bescherming van investeerders), verandering van corporate governance (in het bijzonder de Sarbanes-Oxley Act), en het accounting regime (International Financial Reporting Standards ten opzichte van lokale Generally Accepted Accounting Principles).
Uit de analyse blijkt dat vier corporate governance mechanismes een negatief verband vertonen met het sturen van de winst. Twee mechanismes hiervan vertonen een overduidelijk negatief verband, de raad van bestuur en juridische acties van toezichthouders. Het mechanisme audit en compensatie comités vertoont een licht negatief verband, en verandering van corporate governance vertoont een neutraal verband (dit komt omdat er ook een positief verband is gevonden waardoor deze verbanden tegen elkaar wegvallen). Verder wordt er een positief verband gevonden bij compensatie van managers en bij een ander mechanisme, het accounting regime, helemaal geen verband. De resultaten van de analyse suggereren dat corporate governance een effectief hulpmiddel is om te verhinderen dat managers zich er toe laten verleiden om de winst te sturen. Er moet tot slot opgemerkt worden dat er nog heel wat aan corporate governance verbeterd kan worden aangezien maar twee van de zes mechanismes een duidelijk negatief verband vertonen met het sturen van de winst.
4 Table of contents Page Abstract 2 Samenvatting 2 Table of contents 4 1 Introduction 5 2 Earnings management 6
2.1 Earnings management using accounting policies 6 2.2 Earnings management using real variables 7 2.3 Earnings management outside GAAP (accounting fraud) and patterns and motives for earnings management 8
3 Corporate governance 10
3.1 Concept of corporate governance 10 3.2 Corporate governance and earnings management 11 4 Impact of corporate governance practices on earnings management 12
4.1 Compensation practices 12
4.1.1 Bonus schemes 12
4.1.2 Stock options 14
4.2 Board of directors 15
4.2.1 Composition of the board 15
4.2.2 Other characteristics of the board (members) 16 4.3 Committees, audit and compensation 17
4.3.1 Audit committees 18
4.3.2 Compensation committees 19
4.4 Legal actions by regulators 20
4.5 Corporate governance reforms (Sarbanes-Oxley Act) 21 4.6 Accounting regime (IFRS, local GAAP) 23
5 Conclusion 24
5 1 Introduction
So far, the 21th century is anything but free from accounting scandals or outside-GAAP earnings management (Enron, WorldCom, HealthSouth and Tyco to name a few). Earnings management entails the situation in which managers of firms use judgment to change financial reports (Healy & Wahlen, 1999). Their intention of this practice is to cover the real performance of their firm or to influence contractual outcomes (Healy & Whalen, 1999). Earnings management in essence is allowed. However, a fine line exists between managing earnings within the boundaries of GAAP which is legitimate and beyond which is illegal. Opportunistic or negative earnings management can lead to fraud and disclosures that do not present a fair and true view of the company in question and consequently harms the shareholders of the firm. The negative earnings management practices revealed at Enron in 2002, one of the biggest practices so far, led to the Sarbanes-Oxley Act in America and similar regulations in several other countries. The aim of these regulations was to improve the quality of financial reporting and thereby corporate governance in order to reduce earnings management. Corporate governance is defined as the system of rules, procedures and policies by which the firm is operated and controlled. Unfortunately, new earnings management practices were revealed after the implementation of the Sarbanes-Oxley Act (Cohen et al., 2008). Are the new regulations not strict enough? Or are other factors of corporate governance resulting in the possibility of earnings management?
Although recent research is done about the questions mentioned above, science has failed to develop an overall perspective on the usefulness of corporate governance related to earnings management. Up to now research about corporate governance related to earnings management is mostly about one particular mechanism of corporate governance or even a component of a mechanism. For example Healy examined the effect of bonus schemes and accounting choices (1985). Healy revealed that the choice of policies relating to the accounting for accruals are correlated with profit-reporting stimuli of their bonus contracts and that changes in such policies are correlated with changes in their bonus contract (1985). Another study by Xie et al. about a totally different corporate governance mechanism identified that board and audit committee activity and their members’ financial expertise may be of importance to suppress the propensity of managers to manage earnings (2003). The breach of these studies is that they are so focused on one particular mechanism that it is hard or even impossible to
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draw a general conclusion about corporate governance in reducing earnings management as a whole and if a general conclusion is drawn, it contains too many snags. The aim of this study is to contribute to research in the area of earnings management by developing a comprehensive perspective on the usefulness of corporate governance as a tool against earnings management. In order to develop this comprehensive perspective a literature review is conducted. In the literature review six frequently practised corporate governance mechanisms will be identified and then reviewed. The key research question that will be addressed in this literature review is: What is the relation between corporate governance and earnings management?
In the following section literature about the concept of earnings management is explained. Section 3 is about the concept of corporate governance and the link between corporate governance and earnings management. In section 4 the impact of six corporate governance practices on earnings management are discussed. Section 5 includes the conclusion regarding to the research question.
2 Earnings management
In this section the concept of earnings management is examined. Starting out with a definition of earnings management. Secondly, earnings management is placed in perspective by identifying the two methods to manage earnings. Thirdly, the difference between inside and outside GAAP earnings management is highlighted and then four patterns of earnings management are examined and the motivation for each one is given.
2.1 Earnings management using accounting policies
In this study earnings management is defined as the selection of particular accounting policies or actions taken by managers to manipulate earnings in order to achieve a specific goal (Scott, 2009). This specific goal can be misleading for shareholders by hiding the real performance of the firm or to influence covenants outcomes that are related to the earnings of the firm (Healy & Wahlen, 1999). From this definition there are two ways to steer earnings first by the choice of accounting policies and second by taken actions. The key point of why to explain these ways of managing earnings is to understand the value implications of both.
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The first possibility of steering earnings by accounting policies can be subdivided in policies itself (different deprecation methods or revenue recognition) and discretionary accruals (provisions for credit losses, warranty costs, inventory values, and timing and amounts of non-recurring and extraordinary items such as write-offs and provisions for reorganization) (Scott, 2009). It is important to know that accrual based earnings management is surrounded by an ‘iron law’ (Scott, 2009). This means that accruals will reverse. Consequently, if a manager uses accruals to boost earnings but he does this in a too opportunistically way then in the following periods the reversal will lower the future earnings (Scott, 2009).
For this method of managing earnings, in particular when the manager is steering earnings too opportunistically, an extensive corporate governance system may be useful. Such an extensive system may help develop more efficient contracts for managers that reduce the difference in interests of the managers and the shareholders and in turn lead to less opportunistic behaviour of managers. Also the quality of earnings may be higher if an extensive corporate governance systems exists. First, the earnings are under increased supervision (audit committee) and second other mechanisms of corporate governance may lead to more disclosure on the reported accruals. The shareholders may in turn also benefit from the increased disclosure because they are better informed. 2.2 Earnings management using real variables
The second way to steer earnings is actions taken, which means influencing real variables. A couple of examples of real variables that can be influenced are advertising, research and development, maintenance, timing of purchases and disposals of capital assets and stuffing the channels (Scott, 2009). Managing earnings by using real variables increased since 2002 (Cohen et al., 2008 and Graham et al., 2005). The reason for this increase is that managing earnings by accounting variables has become more costly as a result of new regulations that have been implemented after large recent financial reporting scandals.
Earnings management using real variables can improve the performance of the firm in the short run for example by reporting less maintenance. However, this may be at the expense of the performance in the long run because in the future more maintenance costs should be incurred. If the managers of the firm have a shorter time horizon than the shareholders this could harm shareholders in the long run. A good
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corporate governance system may lead to better alignment of the time horizons of both the managers and shareholders and ultimately may reduce the level of earnings management.
2.3 Earnings management outside GAAP (accounting fraud) and patterns and motives for earnings management.
Managers who manage earnings too opportunistically can find themselves ending up in earnings management outside GAAP, this is accounting fraud and illegal – also called cooking the books. As long as managers manage earnings within GAAP this is allowed. In the worst case the shareholders are misled and in the future the value of the firm is negatively affected.
Managers who engage in the practice of earnings management typically follow a particular pattern. Scott identifies four patterns that will be each discussed (2009). These patterns are taking a bath, income minimization, income maximization and income smoothing.
The first pattern, taking a bath is mostly followed by managers when firms face organizational difficulties or are in the middle of an reorganization (Scott, 2009). During these periods of time firms commonly must report losses and managers may be motivated to increase these losses. The motivation of managers to do so can be illustrated for example by a Chief Executive Officer (CEO) change during a reorganization. The CEO tends to enlarge the loss in the year he arrives by reporting large asset write-offs and foresee for future expected costs. The benefit of this increase of the losses payoffs in the future due to the iron law mentioned earlier on. By reporting large accruals future earnings are parked and in the future the reversals of these accruals will lead to improved reported earnings. A study by Wells confirms the example of the taking a bath pattern during CEO changes (2002). Wells found evidence that new CEO’s specifically during times of reorganization and other organizational difficulties engage in earnings management in their first year as CEO and achieve this by reporting abnormal and extraordinary items that reduce earnings (2002).
Income minimization, the second pattern is similar to the first one except for the fact that it is a less severe (Scott, 2009). Scott points out that motivation for this type of pattern may arise if the firm is a high profitable politically visible firm – or for income tax purposes or the threat of foreign competition because of the high profitability
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(2009). Usually income minimization is achieved by using rapid write-offs of assets and reporting advertising and research and development expenses (Scott, 2009).
The third pattern is income maximization, the opposite of taking a bath and income minimization. Managers can be motivated to maximize earnings in two ways. The first reason is personal and assumes that the contract of the manager includes a bonus alongside his or her salary (Scott, 2009). If the managers receives a bonus if a specific earnings level is achieved the manager may be motivated to manage earnings in order to receive the bonus. The second reason is firm related and assumes that the firm has debt covenants (Scott, 2009). These debt covenants often require the firm to have certain financial ratios and earnings levels. Violation of the debt covenant will lead to firm punishment which is also specified in the debt covenant. Because of the risk of punishment managers may be motivated to manage earnings upwards if it is possible that they will not meet the requirements of the debt covenant (DeFond & Jiambalvo, 1994).
The fourth and last pattern is income smoothing. The goal of this pattern is to reduce the magnitude of the fluctuations in earnings over the years. Scott identifies several reasons why managers may be motivated to follow this pattern (2009). First motivation may be the managers’ compensation (Scott, 2009). Risk-averse managers prefer a contract with high salary and relatively low bonuses and therefore they could be motivated to smooth income to receive a less volatile compensation. Second motivation may be penalties faced by the firm by violation of debt covenants – similar to the debt covenant motivation mentioned in the income maximization pattern (Scott, 2009). By smoothing earnings and financial ratios required by the debt covenants over the years the chance of debt covenant violation can be reduced. Third motivation is the risk to be fired (Scott, 2009). If the firms’ earnings are poor the risk exists that the manager would be fired. By smoothing income the chance of poor earnings can be reduced.
Furthermore it is important to know that managers may switch between the patterns of earnings management. As their motivation over time may change (i.e. different compensation contract, change in firms’ financial sustainability) they may switch to another pattern. Managers’ motivations for earnings management may conflict as do their patterns. For example the manager is motivated to increase income to
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maximize his or her bonus, reduce income for tax purposes and smooth income because of the risk of debt covenant violation.
Corporate governance in theory may be an adequate tool to reduce earnings management because it is a broad concept which has the potential to combat several factors that influence managers to engage in earnings management regardless of which earnings management pattern the manager follows. Application of corporate governance in the fraud triangle (applied to opportunistic earnings management) shows that all the factors in the fraud triangle can be influenced by corporate governance (motivation, opportunities and rationalization). The motivation of managers can be influenced by corporate governance through modification of the contracts of managers. The opportunities can be reduced by implementation of new laws and regulations set by national or international authorities. Finally, the rationalization of earnings management can be influenced through increased monitoring of the earnings and through punishment of managers who engaged in opportunistic earnings management. 3 Corporate governance
This section is about corporate governance. It starts out with a definition of corporate governance and is followed by a description of the goals of corporate governance. Lastly, the concepts of earnings management and corporate governance are linked to each other.
3.1 Concept of Corporate governance
The concept of corporate governance originates from 1970s when the first studies about the concept were published (Calder, 2008). These studies were about the responsibilities of the board. Today, corporate governance includes much more than the responsibilities of the board. Corporate governance can be referred to as the framework by which corporate entities are operated and controlled (Calder, 2008). This framework includes rules, procedures and policies. The framework serves as a tool to allocate the rights and obligations between stakeholders in the firm. These stakeholders include among others directors, managers, shareholders, creditors and regulators. Furthermore the framework establishes a decision-making model for the firm by specifying rules and procedures. The benefit of establishing an decision-making model is that managers can objectively make decisions regarding activities and problems that affect the firm.
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The concept of corporate governance has several goals. The first goal is to protect the shareholders of the firm. Therefore the firm’s intentions and plans must be aligned with the interests of the shareholders who invested in the firm. The second goal of corporate governance is to protect the reputation of the firm against fraud committed by managers of the firm. In order to achieve the second goal the firm needs to create an atmosphere by setting rules and establish procedures that stimulate managers to perform their job in alignment with the firms’ interests instead of their own interests. 3.2 Corporate governance and earnings management
The effect in practice of the second goal of corporate governance, protecting the firms’ reputation against fraud committed by managers is reviewed in this study. In particular, the type of fraud is analysed in which managers engage in earnings management that negatively affects the firm.
Before starting the analysis it is important to know that earnings management is not necessarily bad. An example of good earnings management is the concept of blocked communication (Scott, 2009). Firms’ managers announce from time to time their earnings forecasts for the long-term to investors. Consider the following, a firm announces that on the long-term they expect earnings to be one million euros. This expected one million euros earnings on the long-term contains lots of insider information. The investors initially attach no value to such an announcement because it is too expensive for them to verify the announcement. However, assume that the firm sold a division during the year for 200.000 euros and that it led to an increase in this years’ earnings of 180.000 euros resulting in earnings this year of 1.18 million euros in total. By managing earnings downwards to one million euros by recording a restructuring facility of 180.000 euros the manager unblocks the information of the announcement made and therefore investors attain nevertheless value to the announcement (Scott, 2009).
However, managers also engage in bad (also called opportunistic) earnings management. Managers do so to maximize their bonuses, to prevent a debt covenant violation or to maximize the proceeds from the issuance of shares (Scott, 2009). This leads in practice to mixed earnings management and this form can harm the shareholders. Take for example the earnings management pattern income maximization mentioned in paragraph 2.3 that is not necessarily bad for investors in the short run
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because the current share price is maximized. However, in the long run the manager may not be able to keep following this pattern because maximizing profits is costly or it could result in fraud and this has negative implications for the shareholders. The relation between corporate governance and earnings management examined in the next section includes earnings management that can negatively affect shareholders. This form of earnings management is most of the time in studies measured by models measuring earnings management using accruals – and in a few other studies by models that measure earnings management using real variables.
4 Impact of corporate governance practices on earnings management
The previous sections provided the background for understanding the concepts of earnings management and corporate governance. This section analyses the relation between these concepts. To analyse this relation six frequently practised corporate governance mechanisms are reviewed. The six mechanisms used in this analysis include compensation practices, board of directors, audit and compensation committees, legal actions by regulators, corporate governance reforms (SOX) and accounting regime (IFRS, local GAAP). These mechanisms will be analysed one after another by using the literature available.
4.1 Compensation practices
Compensation practices are here defined as the compensation received by managers for the effort they put in the firm. To analyse the possible relation between compensation practices and earnings management compensation is subdivided in bonuses and stock options. A positive theoretical relation is hypothesized between the corporate governance mechanism compensation practices and earnings management because if earnings management leads to higher compensation managers could have an incentive to engage in earnings management.
4.1.1 Bonus schemes
Firms frequently use bonus schemes to compensate their managers. Lots of different bonus schemes exists. For example, is it a constant or a variable bonus and is it a bonus with boundaries, and if it has boundaries, are they fixed?
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One of the prominent studies about bonus schemes and earnings management is conducted by Healy. He investigated whether managers who were compensated by bonuses depending on the level of earnings selected accounting policies that increased their bonus (Healy, 1985). Healy analyses the design of common bonus schemes. The benefit of this analysis is that it provides a more complete view of the effects of the bonus schemes on accounting incentives (Healy, 1985). Healy suggests from his analysis that the use of bonuses to compensate managers creates incentives to manage earnings by selecting particular accounting procedures and accruals to receive the highest possible bonus (Healy, 1985). Secondly, he suggests that there is a strong relation between the change in a bonus scheme and the number of voluntary changes in the firms’ accounting procedures in the subsequent years (Healy, 1985). Important to mention is that he finds evidence that there is a difference in earnings management due to the nature of the boundaries of the bonus scheme (Healy, 1985). If the lower and upper boundaries of the bonus scheme are fixed, managers tend to manage earnings downwards. In the other situation in which these boundaries are not fixed, managers tend to manage earnings upwards. Guidry et al. apply the analysis of bonus schemes and earnings management at business-unit level managers unlike Healy, who applies the analysis at firm level managers (1999). Although Guidry et al. investigate the relation between bonus schemes and earnings management using managers operating at a lower level in the firm they find evidence that is consistent with the results provided by Healy (1999).
Research about annual bonus schemes and earnings management nuances the results of Healy’s study (Holthausen et al., 1995). Holthausen et al. have also found evidence that managers manage earnings downwards if their bonus is at their maximum level – or upper boundary (1995). However, they have found no evidence that managers manage earnings downwards if the level of earnings is below the lower boundary – or below the minimum level of earnings in order to receive a bonus (Holthausen et al., 1995). Holthausen et al. suggest that the method used by Healy may be the reason that Healy contrary to their study has found evidence that managers manage their earnings downwards if the level of earnings is below the lower boundary (1995).
The analysis of bonus schemes shows that bonus schemes are related to the level of earnings management and that this relation is positive. So, compensation (partly)
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based on bonuses tend to create an incentive for managers to engage in more earnings management.
4.1.2 Stock options
In addition to the regular salary firms often compensate their managers by awarding stock options of the firm. The value of these stock options depends on the performance of the firm. The goal of stock options is to stimulate managers and make managers more responsible for the firm because if the firm performs better the managers also benefit through their stock options from the improved performance and vice versa. Even though the intentions of stock options are well-founded in practice it is the question whether such stock options not also create an incentive to engage in earnings management.
Baker et al. try to answer the question mentioned in the previous sentence (2003). They investigate in their study whether managers’ compensation and in particular stock options create an incentive to engage in opportunistic earnings management (Baker et al., 2003). They hypothesize and find evidence that managers that are predominantly compensated by firms through stock options tend to manage earnings downwards using accruals prior to the option award date (Baker et al., 2003). The hypothesis comes from prior research that supposes that stock options create an incentive to suppress the share price of the firm prior to the award date of the stock options. The benefit of this suppression would result in a lower exercise price of the stock options which is advantageous for managers. Baker et al. also find that the relation between stock options compensation and earnings management is more apparent if the manager can publicly announce the earnings (2003).
A study by Bergstresser and Philippon involves besides stock options also the relation between shares and earnings management. Their research confirms the relation between stock option compensation and earnings management. They have found evidence in their study indicating that managers of firms whose compensation is more related to the stock price and stock options, show more earnings management using discretionary accruals than firms in which managers’ compensation is less related to the stock price and stock options (Bergstresser & Philippon, 2006). Furthermore, Bergstresser and Philippon find important evidence that improves the evidence on the relation between compensation and earnings management. They not only show that managers use accruals to manage earnings because of their compensation method but
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also actually exercise uncommonly many stock options and sell lots of shares during these periods of earnings management (Bergstresser & Philippon, 2006).
Lastly, additional evidence comes from the researchers Cheng and Warfield who have studied equity incentives – the relation between stock-based compensation and earnings management and stock ownership and earnings management (2005). Their study shows that managers whose compensation scheme contains high equity incentives tend to record less major positive earnings surprises (Cheng & Warfield, 2005). These managers keep the positive earnings at hand to tackle future earnings shortfalls (Cheng & Warfield, 2005). Thereby they can smooth their earnings over the years and stabilize the stock price which in turn leads to a more stable prosperity level for these managers who have shareholdings in the firm.
The overall conclusion of the studies discussed in this paragraph is that even though the goal of stock options to stimulate and make managers more responsible for the firm is well-founded, it also has its drawbacks. Namely, in fact it creates also incentives for managers to engage in earnings management. This implies that the awarding of stock options leads to an increase instead of a decrease in the level of earnings management.
4.2 Board of directors
This paragraph analyses whether the board of directors of firms is related to earnings management. To investigate the possible relation of the board of directors and earnings management researchers have tested multiple characteristics of the boards of directors. 4.2.1 Composition of the board
Board of directors independence in monitoring earnings is a characteristic which is repeatedly investigated by researchers. One of these investigations is conducted by Klein. He proves in his study that board of directors independence is negatively correlated with abnormal accruals (managing earnings upwards in this study) (Klein, 2002). Furthermore, a decrease in the board of directors independence leads to a major increase in abnormal accruals (Klein, 2002). A decrease in board of directors independence which leads to an increase in abnormal accruals is most apparent if a minority of the members of the board are outside directors (Klein, 2002).
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Peasnell et al. also use the composition of the board in their study. They hypothesize whether the practice of earnings management by UK firms is correlated with board monitoring (Peasnell et al., 2005). The main difference of their study compared to Klein’s study is that they not only have investigated managing earnings upwards but also managing earnings downwards. Peasnell et al. suggest from their research that the chance of managers managing earnings upwards if pre-managed earnings are lower than expected or there is a loss is negatively correlated with the proportion of outside directors on the board (2005). In contrast to the evidence found for upwards earnings management, Peasnell et al. have found limited evidence that the proportion of outside directors on the board of directors influence downwards earnings management if pre-managed earnings are high (2005). Both Klein and Peasnell et al. conclude that the level of outside directors on the board is negatively correlated with managing earnings upwards. Consequently, they suggest that the composition of the board of directors contributes to monitoring the quality of reported earnings which is later proved plausible (Dimitropoulos & Asteriou, 2010). Namely, Dimitropoulos and Asteriou conclude that firms with boards mainly consisting of outside directors report earnings which are of a higher quality compared to firms with boards with little outside directors (2010).
Overall, independence of the board and the level of outside directors on the board are characteristics of the board of directors that are negatively correlated with earnings management. This implicates that the board of directors consisting of mainly outside directors is less likely to engage in earnings management and contributes to the quality of reported earnings. Furthermore, a decrease in the independence of the board of directors leading to an increase in earnings management is more visible if the board mainly consists of inside directors.
4.2.2 Other characteristics of the board (members)
Besides the composition of the board of directors which apparently influences the level of earnings management also the size of the board of directors is analysed. Bradbury and his research partners have studied data from Singapore and Malaysia. Their analysis reveals that if the size of the board of directors increases this is accompanied by lower abnormal working capital accruals, a type of accruals used to manage earnings (Bradbury et et al., 2006). However, their results do not apply in general. This is shown
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by a study on data from New Zealand. The study shows that there is a negative correlation between the size of the board and the informativeness of the reported earnings. Therefore it depends on the country how the size of the board of directors and earnings management are related.
Research about board members’ skills and activity of the board also seem to be important factors related to the level of earnings management (Xie et al., 2003). Xie et al. use corporate and financial expertise as skills in their study. Xie et al. reveal that board members who have corporate or financial expertise are related to firms that have lower discretionary current accruals – i.e. less manage earnings (2003). Furthermore, Xie et al. have studied the activity of the board of directors and the level of earnings management. They indicate that boards that often organize meetings are also associated with firms that have lower discretionary current accruals (Xie et al., 2003).
It is striking that the importance of the characteristics board independence, board members’ skills and activity which combat earnings management seems to depend on the level of development of economies. In developing economies the latter characteristic seems to be of more importance than the former characteristic (Sarkar et al., 2008). Sarkar et al. comment that for firms in India, a large developing economy which they have analysed, board independence is less important than board quality (2008).
Besides, the composition of the board two other characteristics of the board of directors are clearly negatively correlated with earnings management. First, the expertise of the members of the board of directors are negatively correlated, these include corporate and financial expertise. Second, the activity of the board of directors is negatively correlated, measured by how often the board of directors organizes meetings. About another characteristic of the board of directors, the size of the board, no general statement can be given due to the fact that the relation of the characteristic and earnings management depends on the country.
4.3 Committees, Audit and Compensation
In addition to the research about the board of directors and earnings management discussed in paragraph 4.1, science has examined the relation between corporate committees and earnings management. Two corporate committees that are present in most firms are the audit committee and the compensation committee. Both committees
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are analysed in this paragraph. In advance, a negative relation with earnings management is expected because the audit committee serves to increase the quality of the reported earnings by overseeing the financial reporting process and the compensation committee exists to improve the efficiency of contracts of managers keeping in mind the differences between the interests of the managers and the shareholders.
4.3.1 Audit committees
Audit committees are often an integral part of one-tier boards (boards consisting of both inside and outside directors). One of their main tasks is to oversee the financial reporting process. Part of that task is monitoring whether managers of the firm try to manage earnings (Yang & Krishnan, 2005). Multiple studies indicate that the characteristics of audit committees are related to the level of annual earnings management (Klein, 2002; Be’dard et al., 2004). Yang and Krishnan show that this also holds for quarterly earnings management (2005).
Earlier mentioned Klein also has investigated the relevance of the audit committee independence in curbing earnings management. He has found a negative relation between audit committee independence and the magnitude of reported accruals (Klein, 2002). This implicates that a reduction in independence of the audit committee leads to an increase in reported accruals (Klein, 2002). Therefore, audit committees should be positioned independent from the Chief Executive Officer to ensure high independence of the audit committee and reduce earnings management is as much as possible (Klein, 2002).
Be’dard et al. have conducted a broader investigation of the effects of audit committee characteristics on the practice or earnings management (2004). Besides independence of the audit committee they also have analysed expertise and activity of the audit committee. The results confirm the negative relation between audit committee independence and earnings management found by Klein (Be’dard et al., 2004). Furthermore a negative relation is found between two other characteristics, expertise and clarity in responsibilities of the audit committee and earnings management. Expertise of members of the audit committee seems to be an important characteristic. Three types of expertise are proved to be negatively related to the level of earnings
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management. Namely, the presence of financial, governance and legal expertise increases the quality of reported earnings (Be’dard, 2004; Krishnan, 2011).
The analysis so far is about the relation of audit committee characteristics and annual earnings management. However, audit committee characteristics also affect quarterly earnings management (Yang & Krishnan, 2005). Three out of seven investigated characteristics show a relation with quarterly earnings management. First, presence of members with governance expertise on the audit committee reduces besides annual earnings management also quarterly earnings management (Yang & Krishnan, 2005). Second, the number of stocks hold by members of the audit committee is positively related to quarterly earnings management (Yang & Krishnan, 2005). This implicates audit committee members should not have stocks of the firm otherwise the quality of the earnings is more at risk. And third, experience of the members of the audit committee is negatively related to quarterly earnings management (Yang & Krishnan, 2005). However, it is not empirically proved yet that the second and third characteristic also correlate with annual earnings management.
The investigated studies show that multiple characteristics of the audit committee are negatively correlated with earnings management, indicating that they can help reduce the level of earnings management. The studies reveal that independence, members’ expertise and clarity of the responsibilities of the audit committee are negatively correlated with annual earnings management. Evidence relating members’ expertise is found for three types expertise financial, governance and legal. The second type, governance expertise is also negatively related with quarterly earnings management.
4.3.2 Compensation committees
Another committee, made up of the board of directors is the compensation committee. This committee has to assess and approve the compensation of the firms’ higher management. This involves deciding on the salary, bonuses, shares and stock options that higher management will receive. The goal of the committee is to align interests of shareholders and higher management (Sun et al., 2009).
Analysing the relation of compensation committees and earnings management is far more difficult than the audit committee simply because there is little research done about compensation committees and earnings management. However, a research about
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the quality of compensation committees might provide at least some answers (Sun et al., 2009). Sun et al. have found evidence that Chief Executive Officer stock option awarding in firms which have a compensation committee of high quality leads to improved future firm performance (2009). The outcomes of their study underpin the notion compensation committees of high quality foster compensation agreements of higher management that better align interests of shareholders and higher management (Sun et al., 2009). Drawing on this notion this may implicate compensation of higher management is more efficient. More efficient compensation of higher management may in turn lead to less propensity of managers to engage in earnings management. Though, due to the lack of empirical evidence this remains conjecture and therefore no founded judgment can be given whether the compensation committee is related to earnings management.
4.4 Legal actions by regulators
This paragraph analyses the relation between legal actions by regulators and earnings management. One type of regulation that firms often have to cope with and is related to corporate governance is used for this analysis. This type of regulation is investor protection regulation. Firms that do not comply with this regulation face the risk of receiving fines or end up in court. Prior to the analysis, a negative relation with earnings management is assumed because investor protection regulation in theory should reduce the benefits managers receive if they engage in earnings management. Therefore, it would be less advantageous for managers and ultimately may lead less earnings management. Furthermore, besides it is less beneficial for the managers also potential punishment by authorities may have an influence on managers propensity to engage in earnings management.
The goal of investor protection regulation is very clear, protecting persons who invest in firms. These investors need protection due to their shortage of expertise and knowledge about the firm they invest. This protection consists of two parts. First, high quality of reported earnings so investors can make adequate investor decisions. Second, that all investors have access to the same amount of information of the firm so each investor is in theory equally well informed. Whether this protection impacts in practice the quality of earnings, implicating the level of earnings management is now analysed.
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Research conducted by Leuz et al. have tried to comment on the proposed relation between investor protection regulation and earnings management by investigating the incentives of managers of firms to engage earnings management if the firm has to deal with investor protection regulation (2003). In advance, they assume that high investor protection should be negatively correlated to earnings management because high investor protection reduces the personal control benefits of managers and therefore they have less incentives to engage in earnings management (Leuz et al., 2003). The result of their study is consistent with their pre-set assumption. Evidence proves that quality of investor protection, determined by minority shareholder rights and legal enforcement, is negatively correlated with the level of earnings management (Leuz et al., 2003). The relevance of minority shareholder rights for the quality of investor protection in relation to earnings management is also demonstrated by another study (Nabar & Boonlert-U-Thai, 2007). Legal enforcement is also confirmed by a second study which concluded that a strong legal system leads to less earnings management in firms (Burgstahler et al., 2006).
Multiple other studies confirm and complement the results found by Leuz and his research partners (DeFond et al., 2007; Shen & Chih, 2005). A study by DeFond et al. about investor protection regulation and the informativeness of annual earnings announcements complements the evidence found by Leuz et al. (2007). They conclude that earnings announcements in countries which have institutions that provide high investor protection are overall more informative. Furthermore, Shen and Chih have proved the importance of investor protection regulation in reducing earnings management in the banking industry (2005).
In summary, there is convincing evidence that the existence of (strong) investor protection regulation reduces the level of earnings management. This indicates investor protection regulation is in practice negatively related to earnings management. Furthermore, legal enforcement seems to play an important role in the correlation of investor protection regulation with earnings management. This confirms that legal enforcement is a factor which affects the propensity of managers to engage in earnings management.
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The most recent major corporate governance reform is the Sarbanes-Oxley Act (hereafter SOX). The SOX regulation came into force in 2002 after U.S. Congress passed the regulation. The intention of the SOX regulation was to improve auditing in the U.S. and to protect the society after multiple large scandals of firms that committed fraud were revealed, including earnings management. Despite the good intentions of the SOX regulation the effects in practice are at least doubtful. Namely, after 2002 new corporate frauds have been identified. This calls for analysis that examines whether there is a relation between SOX and earnings management.
Cohen et al. investigated this relation for both methods of earnings management: earnings management using accruals and using real variables (2008). For both types they have examined the levels of earnings management before and after the implementation of the SOX regulation. An increase of earnings management using accruals is observed before the implementation of the SOX regulation and after the implementation they observed a decrease (Cohen et al., 2008). The decrease in earnings management using accruals observed by Cohen et al. is consistent with earlier evidence found by Lobo and Zhou (2006). So far, this implicates the implementation of the SOX regulation negatively affected earnings management using accruals. However, the other method, earnings management using real variables has shown the complete opposite. A decrease of earnings management using real variables is observed before the implementation of the SOX regulation and after the implementation an increase is observed (Cohen et al., 2008). Consequently, pooling the evidence from both methods of earnings management suggests that the implementation of the SOX regulation led to a switch between methods of earnings management instead of a reduction in earnings management (Cohen et al., 2008).
It is difficult to give a final verdict about the relation between SOX and earnings management. So far, there is little research conducted about this relation. However, the studies that do exist have in common they all conclude the SOX regulation is negatively correlated with earnings management using accruals (Cohen et al., 2008; Lobo & Zhou, 2006; Wilson, 2013). Two studies also indicate a positive relation between the SOX regulation and earnings management using real variables (Cohen et al., 2008; Wilson, 2013). According to Wilson, the proven positive relation found by him and by Cohen et al. has it flaws because the nature of the increase in earnings management using real variables is yet vague (Wilson, 2013). He points out that the increase can be explained in
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two different ways. First, it may be the case it has become more attractive to use earnings management using real variables instead of using accruals due to the implementation of the SOX regulation (Wilson, 2013). This would be permanent and strengthen the relation. Second, if the increase in earnings management using real variables is simply the result of the series of scandals revealed prior to announcement of the SOX regulation, the increase would be temporary and remain existent until investors not solely focus anymore on earnings management using accruals (Wilson, 2013). This would harm the power of the relation. Anyway, further research has to prove the claim of Wilson. At this moment, the implementation of the SOX regulation is partly successful because it decreases earnings management using accruals but increases earnings management using real variables.
4.6 Accounting regime (IFRS, local GAAP)
In this paragraph the influence of accounting regimes on earnings management is analysed. Throughout the world several different accounting regimes exist. For example, International Financial Reporting Standards (IFRS) and local Generally Accepted Accounting Principles (GAAP). This analysis investigates whether the implementation of one accounting regime over another improves the quality and transparency of reported earnings, implicating less earnings management.
The first mentioned regime is International Financial Reporting Standards (hereafter IFRS). The purpose of this accounting regime is to create more accounting uniformity so that firms’ accounts of firms from different countries in the world are easier to read, understand and compare. The adoption of the IFRS regime has become mandatory for public listed firms in Europa since January, 1st 2005. Also in other areas in the world the IFRS regime is mandatory or voluntary.
Jeanjean and Stolowy have investigated the effect of mandatory adoption of the IFRS regime on earnings management (2008). They have studied the mandatory adoption of the IFRS regime in two European countries, France and the United Kingdom and in Australia. Their results indicate that the mandatory adoption in Australia and the United Kingdom not led to a reduction of earnings management practices by firms (Jeanjean & Stolowy, 2008). The reason that earnings have not decreased after the mandatory adoption of the IFRS regime is that earnings management also depends on the incentives of the managers of the firms and legal actions by national regulators – i.e.
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the level of investor protection and the legal system (Jeanjean & Stolowy, 2008). Furthermore, Jeanjean and Stolowy have also found that the earnings management practices by firms in France actually increased after the adoption (2008). This increase may be the consequence of some extra opportunities to manage earnings under the IFRS regime compared to the local GAAP (Callao & Jarne, 2010).
A prior study, by Van Tendeloo and Vanstraelen, also has investigated the influence of the IFRS regime on earnings management (2005). They have examined earnings management in Germany under voluntary (instead of mandatory) adoption of the IFRS regime compared to earnings management under German Generally Accepted Accounting Principles (hereafter GAAP). They conclude the voluntary adoption of the IFRS regime does not lead to less earnings management than under German GAAP (Van Tendeloo & Vanstraelen, 2005). Similar to Jeanjean and Stolowy, they explain their outcome by stating that the IFRS regime alone, is not strong enough to reduce earnings management because of another factor which influences earnings management: the level of investor protection, which is low in Germany (Van Tendeloo & Vanstraelen, 2008).
In summary, it is not proved that the accounting regime is negatively related to the level of earnings management. This is due to other factors that have a major influence on earnings management. Only if these other factors are also taken into account there may be a negative correlation between earnings management and the adoption of the IFRS regime instead of local GAAP.
5 Conclusion
This study provides an comprehensive view on the association between corporate governance and earnings management. Prior research conducted about the association between corporate governance and earnings management includes particular components of corporate governance or even subparts of a particular component of earnings management. This research examines whether various frequently practised corporate governance mechanisms have an impact on earnings management. Earnings management still exists today and is far from being exterminated. Hence, research is required to look again at solutions to reduce the level of earnings management. In this light, the literature available about multiple corporate governance mechanisms is
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analysed and then combined in order to develop a comprehensive view about the effectiveness of corporate governance as a tool against earnings management.
In total, six frequently practised corporate governance mechanisms are examined: compensation practices, board of directors, audit and compensation committees, legal actions by regulators, corporate governance reforms (SOX) and Accounting regime (IFRS, local GAAP). The former four mechanisms are split in subparts. For the first mechanism, compensation practices, which is subdivided in bonus schemes and stock options, evidence is found that both elements creates incentives for managers to engage in earnings management. Managers who are compensated by a bonus or highly compensated through the awarding of stock options tend to be positively associated with earnings management. The second mechanism, the board of directors is analysed by multiple characteristics. Evidence is found that independence of the board, proportion of outside directors on the board, the presence of board members with corporate or financial expertise and board activity are negatively associated with earnings management. The third mechanism, committees (audit and compensation) are also analysed based on their characteristics. A negative relation is found between independence of the audit committee, presence of expertise among the members (corporate, financial or legal) and clarity in the responsibilities of the audit committee and earnings management. There has been found no empirical evidence that compensation committees are related to earnings management. The fourth mechanism, legal actions by regulators is investigated by investor protection regulation. There has been found a negative relation between investor protection regulation and earnings management. Legal enforcement of the investor protection regulation seems to be an important determinant of the strength of the link between investor protection regulation and earnings management. The analysis of the fifth mechanism, corporate governance reforms (SOX) shows that there is both a negative and positive association with earnings management, due to the fact that the use of one method of earnings management is reduced after the implementation of SOX while the other method increased. The sixth mechanism, accounting regime (IFRS, local GAAP) alone has not been proved to be negatively correlated with earnings management. This is due to other important factors that influence earnings management (investor protection regulation and legal system).
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In summary, four of the mechanisms showed a negative correlation with earnings management of which two of them showed a distinct negative correlation (board of directors and legal actions by regulators) while the third partly tested negative and partly neutral (audit and compensation committees), and the fourth partly negative and partly positive, neutral in this case (corporate governance reforms). Furthermore, one mechanism has shown a positive relation with earnings management (compensation practices) and also one mechanism has shown no correlation with earnings management (accounting regime).
The results lead to the following conclusion that corporate governance overall is negatively correlated with earnings management. This implicates that corporate governance is an effective tool in preventing managers to engage in earnings management. Lastly, it should be clear that there is still a lot to improve in corporate governance because only two mechanisms were distinctly negatively correlated with earnings management.
Prior research showed that the results from earnings management studies cannot be used to demonstrate a causal link between corporate governance practices (board of directors and audit committees) and earnings management (Xie et al., 2003). Furthermore, all the studies about earnings management using accruals use models to measure discretionary accruals. It is well known that these models have problems measuring earnings management (Yang & Krishnan, 2005).
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