盈余管理外文.doc

Internal governance structures and earningsmanagement RyanDavidson ,JennyGoodwin-Stewart ,PamelaKentAbstractThis paper investigates the role of a firms internal governance structures constraint in earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms,including the board of directors ,the audit committee,the internal audit function andthe choice of external auditor. Based on a broad cross-sectional sample of 434 listed Australian firms,for the financial year ending in 200,a majority of non-executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management,as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of audit are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis,using small increases in earnings as a measure of earnings management,also found a negative association between this measure and the existence of an audit committee. Key words:Audit Committee;Corporate Governance;Earnings Management;Internal audit function1 IntroductionRecent cases of inappropriate accounting practices,both in Australia and overseas,have focused attention on the need for strong corporate governance mechanisms. Strong governance involves balancing corporate performance with an appropriate level monitoring(Cadbury,1997). In the present paper,we explore the relationship between governance mechanisms and earnings management by firms in Australia and,hence,our focus is on the monitoring role of governance. The mechanisms we examine are an independent board of directors(ShleiferandVishny,1997),an independent board chair person,an effective audit committee(MenonandWilliams,1994),the use of internal audit(Clikeman,2003)and the choice of external auditor(Becker etal.,1998;Francis etal.,1999). Prior research has investigated the role of governance mechanisms reducing fraudulent financial reporting(Beasley,1996;Dechowetal.,1996;Jiambalvo,1996).These studies have established a negative relationship between effective governance mechanisms and financial reporting decisions that are in breach of Generally Accepted Accounting Principles(GAAP). However,a relatively new area of research is the association between corporate governance and earnings management. Peasnell et al(2000) document that earnings management is negatively associated with the independence of the board of directors,while other studies find significant relationships between audit committee characteristics and earningsmanagement(Chtourouetal.,2001;Xieetal.,2001;Klein,2002a). The examination of the association between internal governance structures and the practice of earnings management in Australian firms is motivated by several factors. With The Exception of Peasnell et al.(2000),which uses data,existing research is predominantly US based. Therefore,we explore whether the internal governance-earnings management relationship holds in an institutional environmen where corporate governance is less regulated and choice of governance mechanisms is voluntary(VonNessen,2003). In Australia,at the time of the present study(2000),listed companies were not required to have an audit committee or an internal audit function. Furthermore,corporate regulators favour principles-based approach to governance rather than a rules-based approach(ASX,2003). Although a similar approach exists in the UK,Peasnelletal.(2000)examine only the relationships between earnings management and the proportion of outside directors on the board and the existence of an audit committee. We extend this research by exploring the effect of additional audit committee variables such as size and frequency of meetings as well as the independence of members. We also extend board independence to examine whether the separation of the chief executive and board chair roles is associated with earnings management. A further contribution is the inclusion of internal audit as a governance mechanism that is likely to be associated with a reduction in the level of earnings management. While there has been increasing emphasis on the role played in governance by internal audit,no prior earnings management studies have included this variable. Australia is an ideal setting to examine this issue as evidence suggests that many listed companies in Australia do not have an internal audit function. Goodwin and Kent(2003)report that the use of internal audit is associated with the size of the company and its commitment to strong corporate governance and risk management.Our principal tests,using absolute discretionary accruals to measure earnings management,suggest that a lower level of earnings management is associated with the presence of non-executive directors on the board. We also find a negative association between earnings management and audit committees comprising a majority of non executives,but no relationship between earnings management and committees comprised solely of non-executives. Our results do not support a relationship between earnings management and the use of internal auditor the choice of a Big 5 auditor. Additional testing,using small positive changes in earnings as an indication of earnings management,suggests that audit committees are associated with this measure of earnings management.These results have important practical implications because of the heightened interest in corporate governance matters from governments,regulators and standard settersThe remainder of the paper is divided into four sections. Section 2 provides the theoretical background for the study and develops the hypotheses.Section 3 outlines the research method used to test the hypotheses. It also discusses the measurement of earnings management through the estimation of discretionary accruals.Section 4 reports the present studys results. Section 5 concludes by discussing the implications of the research findings,highlighting potential limitations and considering future areas for research. 2 Theoretical background and hypotheses2.1Earnings ManagementThe preparation and disclosure of true and fair financial information is central to corporate governance,as it provides stakeholders with a foundation to exercise their rights,in order to protect their interests(OECD,1999). However,earnings management,defined as the practice of distorting the true financial performance of (a) company (SEC,1999,p.3),effectively weakens this monitoring mechanism as it might conceal poor underlying performance. The published literature has developed and empirically tested a variety of motivations for earnings management to occur(Fields etal.,2001). These fall broadly within the categories of agency costs,information asymmetries and externalities affecting non-contracting parties. However,we are primarily concerned with the extent to which certain corporate governance attributes limit the opportunity to manage earnings,rather than specific incentives for earnings management to occur. Although we attempt to control for two widely documented motives for earnings management;namely,avoiding breaching debt covenants(DefondandJiambalvo,1991,1994) and avoiding political costs(WattsandZimmerman,1978;Jones,1991;Jiambalvo,1996), our approach is to examine a board cross-section of firms rather than identifying a specific subset with strong incentives to engage in earnings management. Such subsets of firms are often context specific(e.g. recent managerial change,hostile takeover or new capital raising)and these contexts are likely to be endogenous to the internal governance mechanisms we examine.2.2 Internal governance structureThe internal governance structure of a firm consists of the functions and processes established to oversee and influence the actions of the firms management. The role of these mechanisms in relation to financial reporting is to ensure compliance with mandated reporting requirements and to maintain the credibility of a firms financial statements(Dechow et al.,1995).The mechanisms that we examine in the present study are the board of directors,the audit committee,the internal audit function and the choice of external auditor.2.2.1 Board of directors Fama and Jensen(1983a,b)recognize the board as the most important control mechanism able because it forms the apex of a firms internal governance structure.In terms of monitoring financial discretion,an effective board of directors should ascertain the validity of the accounting choices made by management and the financial implications of such decisions(NYSE,2002).From an agency perspective,the ability of the board to act as an effective monitoring mechanism is dependent upon its independence from management(Beasley,1996;Dechow et al.,1996).Board independence refers to the extent to which a board is comprised of non-executive directors who have no relationship with the firm beyond the role of director. A non-executive director is defined as a director who is not employed in the companys business activities and whose role is to provide an outsiders contribution and oversight to the board of directors(Hanrahan et al.,2001).A non-executive director who is entirely independent from management is expected to offer shareholders the greatest protection in monitoring management (Baysinger and Butler,1985).Fama and Jensen(1983a,b)posit that the superior monitoring ability of non-executives can be attributed to the incentive to maintain their reputations in the external labour market.The published literature is supported by Australian and international corporate governance guidelines,which recognize the importance of the monitoring role of non-executive directors(AIMA,1997,1995;OECD,1999;NYSE,2002;ASX,2003;StandardsAustraliaInternational