Corporate governance is a decision-making structure or process that monitors and controls firms and their managements in order to achieve firms' goals. The efficiency of this corporate governance depends on controlling agency problems that occur between managers and owners, shareholders, and creditors. However, managers have many incentives to control their reported earnings such as compensation, debt covenant, or avoiding loss, even though it may sacrifice shareholder's wealth. Managers could achieve target earnings by making accounting choices among Generally Accepted Accounting Principles (GAAP) and/or by making operating decisions in response to circumstances as they arise. Recent studies report that managers prefer to use real operating decisions, such as delaying a new project or reducing expenses, to control earnings, rather than to use abnormal accruals (Graham et al. 2005). These preferences seem to have become more prevalent since the SOX Act came into force because management arbitrary decisions are more difficult to detect which are protected by 'business judgment rule' while abnormal accruals are easy to detect.
If corporate governance, in the form of such bodies as the board of directors or audit committee, is effective, then managers' discretionary accounting choices and arbitrary operational/investment decisions could both be reduced. Earlier studies show that earnings management through accounting accruals is influenced by corporate governance and identify some of the factors that are significant in constraining it. However, there is no study that examines the relationship between corporate governance and the management of earnings via real operating decisions (henceforth, real activity). The imposition of constraints on manager's real operating decisions or investment decisions by corporate governance entails that the control rights that shareholders and creditors confer on managers are effectively reduced, with the consequence that firms' future value will not be damaged by a manager's private interests.
This paper examines the role of corporate governance in the context of real activity-based earnings management. We focus on board characteristics and consider three kinds of real activity-based earnings management: aggressive sales promotions, overproduction, and cutting discretionary expenses at either the individual or aggregate level. In order to examine contextual analysis, we examine the relationships between corporate governance and real activity based earnings management when the committee operates inside a firm or when firms incur a loss. For the test of the robustness of our findings, a corporate governance index and control for endogenous variables are used. Both OLS and 2SLS regressions were employed to examine the associations between corporate governance and a firm's real activity-based earnings management.
The empirical results show that overall real activity-based earnings management is reduced when the board of directors is either independent or large. Overproducing or cutting discretionary expenses is reduced as the size of the board increases, and aggressive sales or overproducing is reduced as the number of outside directors on the board increases. In the case of firms that have an internal audit committee, these results are more pronounced at aggregate levels, whereas it seems that the corporate governance of firms that have made a loss does not influence manager's real operational decisions incrementally. The findings are the same when we use a corporate governance index and when we control for endogenous problems among variables. Finally, we find that strong corporate governance reduces real activity based earnings management.
The study reported herein differs from previous studies in that it examines the relationships between corporate governance and real activity-based earnings management, whereas previously, corporate governance has been examined exclusively with regard to accrual-based earnings management (Klien 2002; Xie et al. …