Corporate Governance Characteristics And Earning Management Accounting Essay

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In the emerging market, the role of corporate governance in monitoring the control of the companies is becoming vital. Corporate governance in general will normally concerns with the relationship among management, Board of Directors, controlling shareholders, minority shareholders and other stakeholders. Good and effective corporate governance monitoring mechanism on the management is essential to ensure the management's action is parallel with shareholder's interest and failure to monitor the management may lead to ineffiecient resource allocation and corporate scandals (Norhashimah, Norman, Romlah and Mohamat Sabri, 2008). Corporate governance control is also designed to encourage the efficient use of company resources as well as to promote accountability for the resources used by managers (Sir Adrian Cadbury, 2000 as cited by Hutchinson, Percy and Leyal, 2006). Conflict of interest that may arise between management and shareholders could be reduced to a very low level with the good corporate governance control (Norhashimah, et. al, 2008). Furthermore, better governance through prevention the expropriation of controlling shareholders and ensuring better decision-making is supposed to lead to better corporate governance performance (Syed Zulfiqar, Safdar and Arshad, 2009).

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According to Norhashimah et. al., (2010) and Norman, Takiah and Mohd. Mohid, (2005) states that after the Asian Financial crisis in 1997, business community has placed little confidence to the effectiveness of the corporate governance mechanism. The cases of Enron in 2001 and Worldcom in 2002 and some other firm in the US and recently Transmile Bhd. in Malaysia provides strong evidence to support the perception. During this time in Malaysia, in order to improve the monitoring function of corporate governance mechanism, the Code of Corporate Governance was drafted in 1999 and subsequently approved in 2000 by the Ministry of Finance (Norman, et. al., 2005). The Code provides a guideline to the board of directors, audit committee, and external auditors functioning process in safeguarding the interest of the shareholders as well as highlighted the importance of corporate governance and disclosure requirements (Rashidah and Fairuzana Haneem, 2006). According to Norman, et. al. (2005) the disclosures of corporate governance statement are mandatory as compared to the compliance which are not mandatory. Any deviation arises due to non-compliance, the boards should be reported in the annual report and indirectly it will bring a bad signal to the market because it implies a poor management of the firm. Hence, the disclosure on the corporate governance statement is in fact a mechanism to ensure compliance with the Code (Norman, et. al., 2005).

Corporate governance refers to the structures and processes for the direction and control of companies (The World Bank, 2005) and implies an explicit responsibility for boards in the financial reporting process (Epps and Tariq, 2008). However, along with the responsibility, inherent expectation that boards will constrain earnings management activity. Earning management as defined by Healy and Wahlen (1999);

[...] occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers.

This paper will examine the relationship of corporate governance characteristic with earning management by reviewing the past literature study. Recent empirical studies on the corporate governance have given a clear picture on the contribution of the board of directors as a controlling party in the companies. A lack of independence, competency and non-compliance to the code of practices may lead to the ineffective and inefficient resource allocation and hence will result the financial misrepresentations (Norhashimah, at. al., 2008). The researcher also stated that the financial misrepresentations or indicated as earning management can be detected at the earlier stage of the reporting process by an effective board before it is released to the shareholders.

Previous studies in this area have examined the internal and external factors affecting corporate governance, the general impact of corporate governance on earning management, the roles played by management and the board of directors, audit committee involvement, the influence of board independence, competency, the size of the company as well as the ownership structure of the company (Kim and Yoon, 2008). In particular, this paper discusses the corporate governance and it association with the earning management and the impact of corporate governance on earnings management is the core theme of this paper. Further discussions in this paper will examine several board characteristics (variables) and its evidence as whether these characteristic have any relationship with the practice of earnings management. In this review article, I will also discuss on the family ownership control over the firms and its evidence about earnings management.

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The reminder of the paper is organised as follows. The next section discusses the relevant literature on issues pertaining to earnings management and the association with corporate governance characteristic's which lead to the review on the hypotheses. Finally, I draw conclusions from the literature discussed in the rest of the paper.

LITERATURE REVIEW

EARNINGS MANAGEMENT

Earnings management can be defined in many ways. According to former SEC Chairman, Arthur Levitt, he defines the earnings management as: "accounting hocus-pocus" where flexibility in financial reporting is exploited by managers who are trying to meet earnings expectation (Levitt, 1998). InvestorWorld.com defines the earning management as:

"Manipulation of a company's financial earnings either directly or through indirect accounting methods. This is more likely to occur when a company habitually is unable to meet investor expectations or in periods of volatile earnings. Earnings management is often considered materially misleading and thus a fraudulent activity. Even though the changes may follow all of the accounting standards and laws, they may go against what the standards and laws were originally trying to establish. For example, a change from FIFO to LIFO in inventory management may help a company's financial ratios, but may not reflect the true value of its inventory."

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The accounting literature on earnings management is undertaken using appropriate loopholes in accounting standards and the accounting standards itself allows managers to exercise judgment in financial reporting (Bhaumik and Gregoriou, 2009). Manager is the person responsible to convey financial report to the users of the financial statements. Given this the opportunity the management has a vital power to report the earnings based on their interest. Hence, manager's knowledge on the accounting choices is important to bring company at the good stand of earnings or knowledgeable to manage earnings. Earnings management should not to be confused with illegal activities. Earnings management is the reasonable and legal management decision-making made by the management with the intention to achieve a stable financial result to the company but not to their personal interest.

In part of that, the accounting standard is offering room for judgment. Generally accepted accounting principles (GAAP) requires the manager to use judgment in preparing the financial statement. Changing of accounting standard and time lag to fully adoption the new standard is one reason for earnings management. Manager is trying to add value to their financial statement with all the specific knowledge acquired and use to select reporting methods and disclosures and communicate the results to the shareholders (Bhaumik and Gregoriou, 2009). However, Sevin and Richard (2005) stated that during 1990's due the extreme pressure faced by the corporate executives to attain the targeted earnings and to reach the earnings projections, their turn to the use of aggressive and event fraudulent financial reporting practices. Further, Healy and Wahlen (1999) suggests that varieties reasons for earnings management to be occurred, such as influencing the stock market, increasing management compensation, reducing the likelihood of violating lending agreements, and avoiding intervention by government regulators. With a believed that earnings management is benefited to the users of financial statements such as investor and creditor to make decisions, managers may attempts to manage earnings (Sevin and Richard, 2005).

Earnings Management: An Ethical Issue

Elias (2002) finding stated that the earnings management practice has attracted attention among regulators, standards setters and accounting profession and Levitt (1998) found that the earnings management strategy is not new among the accounting profession but it has been applied as a secret strategy among corporate executives (Elias, 2002). Norhashimah et. al. (2008) stated that earnings management practices with the intention to fulfil the users' perception are considered unethical even though accounting standard are not violated. Evidenced by Elias (2002) stated that majority of the respondents from his research do not believe that earnings management is ethical.

On the other hand, some believed that the earnings management is practiced by the executives of the firm is for the benefits of the investors or potential investors. However, Healy and Wahlen (1999) did argue that financial reporting may increase firm value if economic earnings and firms' performance is reliable and available on time. Therefore, as discusses previously, approved accounting standard should provide management complete procedures on various alternative methods needed in applying their own assumptions based on general principles described in the standards (Norhashimah et. al., 2008). Norhashimah et. al. (2008) suggested from their finding that it is not proper to control managerial accounting choices by virtue of rule-based standards, since it would limit the private information to be signalled to the market. Hence, the best way to monitor the earnings management practices is through corporate governance mechanism. Norman et. al. (2005) suggested that the manager's manipulation in earnings is within the permitted accounting treatments and is not classified as non-compliance, therefore it is the role of the board to ensure compliance with the standards, select the best choice of accounting methods and best estimates on the underlying economic events.

BOARDS OF DIRECTORS' CHARACTERISTIC

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Boards of directors are responsible to ensure financial statements of a company are prepared in accordance with approved accounting standards and compliance to all rules and regulation. However, of the regulatory requirement is followed and comply, it does not to conform that the company may free from eliminating the entire practice of earnings management (Norman et. al., 2005). Therefore, the board is collectively seen as a team of individuals with fiduciary duties of leading and directing a firm with a primary objective of protecting the firm's shareholder's and stakeholder's interest (Shamsul Nahar Abdullah, 2006). As stated under the Malaysian Code of Corporate Governance 2001, the major components of the principles and best practices of good governance includes some benchmarks of the BOD's characteristics which are board composition, board size, directors' ownership, number of directorships and duality status of the chairman and CEOs (Norman et. al., 2005). This study attempts to examine the relationship between the corporate governance characteristic and earnings management within the Malaysian environment. The characteristic is extended to the impact of family control on the association between board independence and earnings management. This study is sought to accumulate result or evident from the past literature on the issue discussed.

Board's Independence and Earnings Management

The balanced board composition plays a crucial role in corporate governance mechanism as well as to ensure the integrity of the corporation's accounting and financial reporting system (Hutchinson, Percy and Erkurtoglu, 2008). The Malaysian Code on Corporate Governance (2007) stated that "The board should include a balance of executive directors and non-executive directors (including independent non-executives) such that no individual or small group of individuals can dominate the board's decision making". Shamsul Nahar (2001) stated the composition of the boards should not be dominated by board members with executive power, and consists of members who are independent from the management and shareholders. Therefore, the board of directors should consist of independent members which are executive and/or external directors (Hutchinson, et. al., 2008). Executive directors is the board of directors who have a power to make a decision in a company and referred as insiders where the appointment of managers as a directors. Inside directors is important as they know a lots about the organization as compared to outside director (Norman, et. al., 2008). Outside directors are appointed on the board mainly to obtain independent monitoring mechanism over the board process and therefore, it can reduce agency conflict and improve performance (Craven & Wallace, 2001).

Previous studies provide evidence on the effective mechanism role of non executive and external directors in monitoring the financial reporting (Norhashimah, et. al. 2008, Hutchinson, et. al., 2008, Norman, et. al., 2008 and Epps and Tariq, 2008). However, by looking to the association between boards' independence and earnings management, majority of the researcher agreed that the board independence is likely to be associated a reduction in earnings management. Hence, the hypothesis is that:

H1 There is a negative association between the level of board independence and earnings management.

From the result, it shows that the board independence and audit committee independence are associated with lower performance -adjusted discretionary accrual or earnings management. However, increasing executive shareholdings provides incentive to manage earnings (Hutchinson, et. al. 2008). This is supported by Kim and Yoon (2008) where their findings states that activity of outside directors in a board meeting are significantly correlated with the level of discretionary and are consistent with the hypothesis that the activities of external board are reversely related with earnings management. Epp and Tariq (2008) from their study identify that none of the income-decreasing discretionary firms have boards controlled by a majority of insiders or boards with any affiliated outsiders. Zulfiqar, et. al. (2009) their findings state that the discretionary accruals are found positively correlated with quality of corporate governance. In addition, their findings show that the relationship exists between corporate governance and earning management. Rashidah and Fairuzana, (2006) found the contradicting result where there is no significant relationship between independent directors and earning management.

CEO Duality and Earnings Management

CEO duality arises when the CEO is also a chairman of a firm. According to the Malaysian Code, it's recommended that the role of chairman should be separated from that of the CEO. This is to avoid CEO to having too much power and to show his credibility to handle daily business with efficient. Carrying too much power may lead the CEO to jeopardize the function of the board over earnings management since he has the direct access and more discretion to manipulate the financial reports (Finkelstein and D'Aveni, 1994). Therefore, the separation of the post between CEO and the chairperson of the firm is important for the effective monitoring system (Norhashimah, et. al. 2008). Mohd Salleh et. al. (2005) provides evidence that firms with the CEO duality are positively related to earnings management. Further, their study reported that nearly 45 % of the sample firms with the chairman hold the position as the CEO. There is an issue when the CEO holding two big position at one time because the CEO may not perform well. As a result, under Malaysian Code of Corporate Governance (Revised) 2007, it strictly discouraged of the CEO duality practices. In addition, Klein (2002) found that absolute value of discretionary accrual is positively related to the CEO who holds two positions on the board's nominating and compensation committee and the result from his research has identified that a CEO with excessive power over board matters could manipulate the earnings easily. Hence, it is hypothesis that:

H2 CEO Duality is positively related with earnings management

From the past literature findings, it shows that only a small percentage of the company where the CEO is also the Chairman of the company, majority of sample separated the position among different individuals (Norhashimah et. al. 2008). These findings also identified that significantly more firms comply with the best practice benchmark stated in the Malaysian Code of Corporate Governance 2001. This is contradicting by Rashidah and Fairuzana (2006) where the result indicates that there is insignificant relationship between discretionary accrual (DAC) and the duality role. Separating the role of the CEO and chairman has no effective monitoring function in curbing earnings management. Norman et. al. (2005) found that there is a positive relationship between CEO duality with the earnings management and indicate there is a need to strengthen these elements of corporate governance. Supported by Epps and Tariq (2008) found that when the CEO serves as a chairman of the board, even if there is a lead director, negative discretionary accruals are higher and suggested to have a separation of role and position.

Competency of the Directors and Earnings Management

One of the best practices of the Malaysian Code of Corporate Governance in Malaysia required the board to have a competent, knowledgeable and experience, particularly in financial aspects. It same applied to audit committee member where to be appointed as an audit committee a person should posses some knowledge in accounting because one of his function to give advice on the financial aspects. The directors with no knowledge in accounting field would not be able to detect any earnings management activities. Board of directors who are competent would able to minimise earnings management activities (Norhashimah, et. al. 2008). Therefore, the next hypothesis is:

H3 The existence of at least one board member with knowledge in accounting and finance is negatively related with earnings management.

From the article reviewed, Chtourou, Bedard and Courteau (2001) found that firms with experienced independent boards or external directors show significantly lower level of income increasing earnings management as compared to other firm which is less experienced. This is consistent with Xie, Davidson and DaDalt (2001) who found that the board members with corporate or financial background are associated with firms that have a smaller discretionary current accruals. However this finding is contradicting with Norhashimah, et. al. (2008) where the result state that the director s knowledge in the field of accounting and finance, and the number of experience they are in the field, do not make any differences in the earning management practice. This finding also supported by Rashidah and Fairuzana (2006) who found that competent and experience of the boards is not sufficient to decrease the discretionary accruals in the firms, thus rejected the third hypothesis.

Management Ownership and Earnings Management

Management ownership may become an important function in influencing the monitoring effectiveness in the financial reporting process. According to agency theory, the interest of the management and the shareholders starts to converge when management also hold a portion of equity ownership in a firm (Warfield, Wild, J and Wild, K, 1995). Prior studies provide inconsistent results on the relationship between management ownership and earnings management. Mohd Saleh et. al (2005) provide evidence that management ownership is negatively related with earnings management. Unlike this result, Warfield, et. al. (2005) provide evidence which the result show managerial ownership is positively associated with earnings' explanatory power for returns and inversely related to the earnings management. Further suggestions include ownership is less important for regulated corporation, suggesting regulation monitors managers' accounting policies. Past study also shows that as the level of discretionary accruals decrease, managerial ownership increases and the firm returns increase (Salsiah et. al. 2008).

Past study also found, in consistent with the agency theory, managers tend to maximise firm value and have incentive to manipulate earnings at the time when their share ownership in the firm is high. With holding significant number of shares in the firm, managers and shareholders start to converge. Twofold objectives of manager, maximize their own wealth and at the same time maximizing the wealth of the firm owners. Therefore, based on agency theory and result from prior research, here the next hypothesis:

H4 Management ownership is negatively related with earnings management

Past research from Norhashimah et. al. (2008) found that the management ownership is positively related with earnings management. It indicates that the more manager own companies share, the more they manage earnings. This result supported Warfield, et. al. (2005) state managerial ownership is positively associated with earnings' explanatory power for returns and inversely related to the earnings management. This is consistent with Salsiah et.al. (2008) found the managerial ownership positively related to earnings management. This results indicate that the higher the level of management ownership, the higher the incentive for managers to manage earnings. Salsiah et.al. (2008) also suggested that conflicts that occur due to the separation of ownership and control will be reduced as managerial ownership increases. This study also explores whether there is an entrenchment effect of managerial ownership on agency conflict.

Size of the Directors and Earnings Management

Size of the boards is viewed as the important factor in board characteristic that may have an effect on the earnings management (Rashidah & Fairuzana, 2006). Malaysian Code of Corporate Governance (2000) state that the optimum number of board members should be determined by the whole board to ensure there are enough members to discharge responsibilities and perform various functions. Xie et.al. (2001) discusses the effect of smaller boards size and larger board size. A smaller board may be less encumbered with bureaucratic problems and may be more functional and may provide better financial reporting oversight. A larger board may be able to draw from a broader range of experience. In the case of earnings management a larger board may be more likely to have independent director. Larger boards may be more likely to have independent directors with corporate or financial experience. If so, a larger board might be better at preventing earnings management and offer no directional expectations between earnings management and board size.

Rashidah and Fairuzana (2006) investigate the extent of monitoring functions of BOD, audit committee and concentrated ownership in reducing earnings management. This study employs the modified version of Jones (1991), where abnormal working capital accruals are used proxy for earnings management. The result show boards' size is positively related to the earnings management. By using these findings, here is the next hypothesis:

H5 The size of the board is negatively related to earnings management

As reported by Epps and Tariq (2008) approximately 25 percent of the sample size has boards with fewer than six members, while there are no firms in the sample with boards greater than 15 members, as reported by ISS. This study examine that the coefficient for board size between nine to 12 (inclusive) to be positive i.e. a larger board size is associated with higher level of earnings management. While the coefficient for board size less than six is negatively related to income-decreasing discretionary accruals. Hence the result advocates other findings that smaller boards are more efficient. This finding is consistent with the idea that the smaller board firm's size are more accountable to their shareholders and more efficient with decision making and better monitor company's activity as compared to the larger board's firm size. This result supports Norman et. al. (2005) findings state that more income decreasing accruals (earnings management) is associated with larger sized firm. This result also consistent with Rashidah and Fairuzana (2006) found that there is a significant positive relationship between DAC and board size. The result indicates that the larger the board size, the more ineffective it is in its monitoring function and smaller boards are associated with better firm performance.

Family control and earnings management

From the past literature, this variable is less tested. However, for the purpose of this review the family control firm will discuss from the two opposing theoretical on the impact of family control on earnings management. On one hand, it is proposed that the earnings management to be lower in family-controlled firm. Result from Ali, Chen and Suresh (2006) based on research on US firms show that family firms are significantly less likely to manage earnings. From this finding, Jaggi, Leung and Gul (2009) argued on three matters. First, controlling families are expected to monitor managerial behaviour and action effectively to reduce managerial opportunities engagement in earnings management. Second, earnings are less likely to be manipulated because controlling families would identify their interest more closely with the firm's wealth as in accordance with the stewardship theory. Third, the focus of the controlling families are more on long term, therefore there will be less pressure on management to meet short-term earnings expectations.

Ali, et. al. (2006) reported from the findings that the earnings are of better quality for family firms as compared to non-family firms and the earnings was measured by the level of discretionary accruals in earnings. This finding is consistent with the notion that the family firms face less severe Type I agency problem and more severe Type II agency problem. Therefore, less severe agency problems lead to less manipulation of earnings for opportunistic reasons and thereby higher earnings quality. Therefore, the next hypothesis is:

H6 The family control is negatively related to earnings management

The hypothesis is accepted by Jaggi, et. al. (2009) where the findings provide evidence that a higher proportion of independent non-executive directors (INEDs) is associated with more effective monitoring to constrain earnings management. This suggests that the monitoring effectiveness of INEDs is reduced in family-controlled firms, proxies by family ownership concentration or the presence of family members as board of directors. These results suggest that an increase in the proportion of outside directors to strengthen board monitoring is unlikely to be effective in family-controlled firms.

CONCLUSION

From the discussion done by the past literature, I found that corporate governance function is very crucial in monitoring the company's earnings performance. Based on the article review, I have identified the variables used in corporate governance characteristic to measure the level of earnings management. This paper discussed the finding from the hypothesis from the past study on the association of corporate governance characteristic with the earnings management. Six hypotheses has been summarised from the past study and from the hypotheses this paper discuss together the finding or result available.

First, is on the association between the level of board independence and earnings management. There is an association between the board independence and earnings management either positively or negatively. Second, is on the CEO duality is positively associated with earnings management. The result from past study show the association is vary where there is a positive relationship between CEO duality with earning management (Mohd Saleh, et. al. (2005) and Rashidah and Fairuzana (2006) indicates that there is insignificant relationship between discretionary accrual (DAC). Third, is the existence of at least one board member with knowledge in accounting and finance is negatively related with earnings management. Result from the past study is not consistent. The board members with corporate or financial background are associated with firms that have smaller discretionary current accruals (Xie, et. al. 2001) and the director s knowledge in the field of accounting and finance, and the number of experience they are in the field; do not make any differences in the earning management practice (Norhashimah, et. al. 2008 and Rashidah and Fairuzana, 2006). Fourth, management ownership is negatively related with earnings management. However, most of the past study rejected this hypothesis because large ownership by managers may induce managers to act opportunistically and extract wealth from minority shareholders (Norhashimah, et. al. 2008). Fifth, the size of the board is negatively related to earnings management. Past study advocates that as the board firm size smaller, the earnings management is more efficient, so it support the hypothesis. Lastly, the family control is negatively related to earnings management. Past literature agreed to say that the earnings are of better quality for family firms as compared to non-family firms.

The corporate governance characteristics that have been discussed above, will give a guideline to directors on monitoring the earnings to be reported to the users of financial statements. By having a good monitoring system, agency problem will reduced, shareholders and management together will happily getting their return fairly. Management will decrease the manipulation of earnings; therefore the value reported is at fair presentation.