Academic journal article The Lahore Journal of Economics

The Effectiveness of Corporate Governance in Constraining Earnings Management in Pakistan

Academic journal article The Lahore Journal of Economics

The Effectiveness of Corporate Governance in Constraining Earnings Management in Pakistan

Article excerpt

1. Introduction

The International Financial Reporting Standards (IFRS) allow firm managers greater flexibility in choosing from among alternative accounting treatments. These choices can have different effects on a firm's reported income. Islam, Ali, and Ahmad (2011) argue that managers tend to prefer accounting choices that benefit them economically. The likelihood of this opportunistic behavior rises in the presence of weak governance structures, eventually causing the quality of reported earnings to deteriorate and reducing investors' confidence in financial reports (González & García-Meca, 2014). This opportunistic behavior, known as earnings management, entails the creative use of accounting techniques in such a way that the financial reports produced give an overly positive picture of firms' business activities and financial position. Earnings management can include changes in the estimated amount of assets impaired, the volume of bad debts written off, the amount of inventory recorded, the estimated useful life of long-term assets, and estimated post-employment benefits and warranty costs (McKee, 2005).

Prior studies suggest that good governance is crucial in monitoring managerial activities because it helps reduce agency costs by aligning the interests of the management and owners. Several studies have examined the role of corporate governance in earnings management and found that good governance can effectively constrain managers from being involved in earnings management practices (see Jiang, Lee, & Anandarajan, 2008; Dimitropoulos & Asteriou, 2010; Alzoubi & Selamat, 2012; González & García-Meca, 2014).

This study is motivated by two considerations. First, investment or capital is crucial for an emerging economy such as Pakistan where the domestic saving rate is only 13.5 percent of gross domestic product: this is insufficient to ensure economic growth of at least 7-8 percent a year. Second, the country's investment climate is not attractive, given that firms involved in earnings management are liable to spread false information in the market. This induces investors to make sale or purchase decisions that lead to losses, ultimately eroding their confidence. In order to attract more capital and enhance investor confidence, companies need to provide an attractive investment climate and good governance, increase overall transparency, and reduce information asymmetry.

In this context, the study's first objective is to examine the effectiveness of corporate governance mechanisms in constraining earnings management. We do so by looking at eight such mechanisms grouped into three categories: (i) board characteristics, (ii) audit committee characteristics, and (iii) ownership structure.

Our second objective is to investigate whether the role of corporate governance in constraining earnings management differs between high- and low-growth firms. This builds on the argument presented by Bowen, Rajgopal, and Venkatachalam (2008) that the market severely penalizes highgrowth firms for negative earnings surprises. This suggests there is a strong incentive for high-growth firms to meet earnings benchmarks, perhaps to maintain their capital or avoid a higher cost of capital. Moreover, Cohen, Krishnamoorthy, and Wright (2004) indicate that the impact of governance mechanisms differs with a firm's growth opportunities.

The study contributes to the existing literature in the following ways. First, it extends the very limited research on the relationship between corporate governance and earnings management in Pakistan by providing a detailed and comprehensive picture of this association. Second, it analyzes the empirical evidence on growth differences in this relationship, which has not yet been done.

Section 2 provides a comprehensive literature review, on the basis of which we formulate a series of hypotheses. Section 3 describes the variables used as well as the sample and data sources employed. …

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