Corporate Governance and Real Earnings Management

Abstract

ABSTRACT The role of corporate governance in financial reporting has received significant attention in recent years. In particular, researchers have examined whether certain governance factors restrain earnings management practices at companies. This research has primarily focused on accrual type earnings management. This study examines the role of corporate governance in the context of earnings management where firms attempt to achieve desired earnings numbers by departing from normal operating activities. Using a sample of 6, 759 firm years, the study examines several overall board characteristics and audit committee characteristics in the context of real earnings management. The study finds limited support for some of the factor s that have been found to be significant in constraining accruals type earnings management. Having a higher proportion of independent directors appears to be helpful in limiting this type of earnings management, however. These results should be of interest to investors and regulators who rely on governance mechanisms to oversee the integrity of corporate financial reporting. INTRODUCTION The passage of Sarbanes-Oxley Act of 2002 by the U.S. Congress and the several high profile accounting restatements that occurred in recent years have focused the attention of researchers and the media on various types of earnings management undertaken by corporations and the reforms needed to minimize such actions. In this regard, considerable critical attention has been focused upon the role of the board of directors and audit committees in overseeing the activities of executives, in particular in instances of earnings manipulation. Sarbanes-Oxley Act enacted provisions that deal with rules governing corporate governance in general and board of directors in particular that should likely constrain earnings manipulation. Several research studies prior to and after Sarbanes-Oxley Act have examined the role of board of directors in constraining earnings management (for example, see Klein 2002a). Much of the attention focuses on accrual type earnings management such as aggressive revenue recognition and misstatement of inventories or accounts receivable etc. Companies manipulate earnings not only by accruals but also by taking or postponing production or operating actions that adjusts the earnings towards the desired target. The latter type is labeled as earnings management. In contrast to accruals management, real earnings management is likely to lead to value reduction by misallocation of appropriate corporate activities. Prior research has primarily studied the role of corporate governance in the context of accruals management. This study examines whether certain characteristics of governance constrain real earnings management. Graham et al (2005) document the pervasive occurrence of earnings management through real activities and note that managers are likely to turn toward this type of earnings management in the post-Sarbanes-Oxley era because much of the media and analyst attention is focused on accrual type earnings management. In contrast to evidence and attention on accruals management the research focus on real earnings management has been scarce and relatively new. Given the importance of real earnings management as noted by Graham et al. this study seeks to answer the question whether and what type of corporate governance characteristics constrain real earnings management. To address this issue this study uses a sample of 9,567 firm years over the period 1996 to 2002. Several data on overall board characteristics such as the number of directors in the board, whether the chief executive office and the chairmanship of the board are occupied by the same person, and the proportion of directors who are independent are used in the analysis. Similarly, characteristics of audit committees such as the size of the audit committee, the proportion of directors who are independent in the audit committee and the number of meetings held by the committee are also used. …