Corporate Governance and Earnings Management: A Survey of Literature

Abstract

Corporate governance commonly viewed as an effective and efficient principal-agent (i.e. shareholder-managers) mechanism to reduce or even eradicate earnings management activities, evidenced by widely published documents. Usually, under an ideal institutional environment that provides better legal protection toward investors, CG can likely control managers’ self-interest (corporate disruption) behaviour in a certain extent. Takeover forces as a market resource allocation force can exert market pressure on managers to do the best interest for shareholders. Prior studies have investigated different corporate governance mechanisms to show that CG can alliterative with the managers' intention on engaging earnings management. Board independence can also enhance certain monitoring and suppress managers' self interest behaviours scarify the whole corporation and shareholders' interest, eg the misappropriation use of corporate resources/tunnelling of corporate valuables outside. Female board directors can perform trust leadership, promote managers to more share information, and they are more likely risk-averse to prevent frauds and opportunistic behaviours, like earnings management. An audit committee can oversee the internal control system for financial reporting to ensure the quality of financial information outside, more protecting shareholders. Financial-expertise Directors can provide incremental control forces on reducing earnings management activities, especially in the case of firms under weak corporate governance environment. This paper contributes to corporate governance field by providing detailed reviews of different corporate governance mechanisms in prior studies, thus the fact that this paper reviews the latest findings on classification shifting, one stream of earnings management through financial reporting, and summarize other earnings management measures and telling about a new diagnostic system. In the future, this new diagnostic system is likely being investigated in different contexts in future. Corporate governance continues to be an area of importance while earnings management still appears to be a problematic issue. This paper aims to review the extant literature and examine whether the evidence supports the view that additional corporate governance and regulatory measures will mitigate earnings management. However, this paper does not address the agency theory behind corporate governance mechanisms, as reviewed by Shleifer and Vishny (1997). Many studies argue that some of the currently used accrual models are questionable; hence, it would be better to review the latest findings in earnings management measurements. In the future, this new diagnostic system, as well as Dechow’s novel model, may be investigated in different contexts. The remainder of this paper is organized as follows. Section 2 introduces the concept of corporate governance. Section 3 presents various corporate governance mechanisms. Section 4 reviews different types of earnings management. Section 5 reviews different measures of earnings management. Section 6 discusses the relationship between corporate governance and earnings management and the last section concludes this paper.