Dissertation 01

Corporate Governance, Earnings Management, and the Information Content of Accounting Earnings: Theoretical Model and Empirical Tests

A dissertation submitted to the Faculty of Business in candidacy for the degree of Doctor of Philosophy

by
Turki Bugshan
Bond University
Queensland 4229
Australia

ABSTRACT

The primary objective of this dissertation is to show that corporate governance affects the value relevance of earnings in the presence of earnings management. The role of corporate governance is to reduce the divergence of interests between shareholders and managers. The role of corporate governance is more useful when managers have an incentive to deviate from shareholders’ interests. One example of management’s deviation from shareholders’ interests is the management of earnings through the use of accounting accruals. Corporate governance is likely to reduce the incidence of earnings management. Corporate governance is also likely to improve investors’ perception of the reliability of a firm’s performance, as measured by the earnings, in situations of earnings management. That is, corporate governance will be value relevant when earnings management exists. The results of this research support these propositions.

In this thesis, the value relevance of earnings is measured using the earnings response coefficient. Earnings management is measured using the magnitude of abnormal accruals as estimated by the modified Jones (Dechow et al., 1995) model. A review of the corporate governance literature revealed nine attributes that were expected to impact on shareholders’ perception of earnings reliability due to their role in enhancing the integrity of the financial reporting process. The nine attributes represent three categories of corporate governance: 1) organisational monitoring; 2) incentive alignment; and 3) governance structure.

Organisational monitoring includes ownership concentration, debt reliance, board independence, and the independence and competence of the audit committee. Incentive alignment includes managerial ownership and independent directors’ ownership. Governance structure includes CEO dominance and board size. These attributes are used in this study to assess the impact of corporate governance on earnings management and the information content of earnings.

Information dynamics models, such as the Ohlson (1995) model provide a testable
pricing equation that also identifies the role non-accounting information (i.e. corporate
governance) plays in determining firm value. Based on Ohlson’s (1995) model, the
change in value model, as developed by Easton and Harris (1991), is modified to include
the proposed interaction between corporate governance and earnings management.

Pooled GLS regression is employed as the primary technique to estimate the coefficients. Four hypotheses are used to test the connections among corporate governance, abnormal accruals, and the earnings response coefficients. The returns-earnings model is used to test the interaction coefficients after incorporating earnings management (Hypothesis Two), corporate governance (Hypothesis Three), or both These coefficients are then examined using the Wald test to find out

(Hypothesis Four). whether the earnings response coefficients after incorporating indictors of earnings reliability are significantly different from the earnings response coefficients irrespective
of any propositions. The sample was drawn from the top ASX 500 listed companies for the years 1997 to 2000. The final sample contained 778 firm-year observations. Certain industries (financial, regulated, and mining) were excluded from the sample. One of the reasons the period 1997-2000 was chosen is due to the expected impact of the Asian currency crisis on increasing firms’ incentive to manage earnings.

The results reveal that: 1) board size and audit committee independence are negatively associated with the magnitude of abnormal accruals; 2) incorporating the magnitude of abnormal accruals to the returns-earnings model does not significantly alter the earnings response coefficient; 3) the earnings response coefficients are significantly different after incorporating CEO dominance and independent directors’ ownership; and 4) conditioning on the magnitude of abnormal accruals improves the explanatory power of the interaction between corporate governance and earnings over share returns.

Although not all corporate governance attributes suggested in the literature impact on investors’ perception of a firm’s performance, the primary proposition that corporate governance affects this perception when earnings are managed is supported. The primary contribution of the study is finding evidence supporting the moderating effect of earnings management on the relationship between corporate governance and the value relevance of earnings. These results validate Hutchinson and Gul’s (2004) claim that the role of corporate governance attributes in firm performance should be evaluated in concurrence with a firm’s organisational environment. Future research should control for corporate governance and earnings management, as indicators of earnings reliability, when using returns-earnings regressions to address a research question.

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