Earnings Management and Corporate Governance
IOpportunity of earnings management is provided to the firms by GAP allowing them the use of accrual accounting. Besides the management compensation problem, earnings management could mislead investors by giving them false information. In fact, investors use financial information to decide whether to buy, sell, or hold securities. Market efficiency is based on the information flow to capital markets so that when this information is incorrect the market will value securities incorrectly. The board and the audit committee have important role in preventing earning management.
The statistical approach in measuring and decomposing accruals is based on the method in Teeth, Welch, and Wong (AAA) and Jones (1991). In this research I work with discretionary accruals. Because manager can control or manipulate discretionary accruals easily to show more or less earnings. I find that from the analysis earnings management is less likely to occur or occurs less often in companies whose boards include both more independent outside directors and directors with corporate experience. I also find the proportion of audit committee members with outside member is negatively related to the level of earnings management.
Our results find an association between lower levels of earnings management and the meeting frequency of boards and audit
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Introduction earnings for different purposes. Role of board of directors, in this regard, has given special importance specially to restrict the opportunistic earnings manipulation and envying true information about firm operations as result (Young et al. , 2000). In many emerging markets, a number of studies have also emerged which examine whether the initiatives of corporate governance have led to an improvement in the quality of financial reporting and whether these initiatives have been effective in tackling the problem of earnings management.
Sheen and Chi (2007), for example, find in nine Asian countries that firms with good corporate governance tend to conduct less earnings management. Also, In India, Karakas et al. (2008) show that diligent boards are associated with lowers earnings manipulation. Additionally, in Jordan, AAA-Kasbah and Latitudinal (2009) provide evidence that the existence of internal governance structure has a significant influence on the practice of illegitimate earnings management.
In support, Camel and Albania (2010) find a consensus among their respondents regarding the importance of combating earnings management in Egypt through greater reliance on internal corporate governance mechanisms. In particular, this paper examines the roles board, audit committee, board size, and number of board meeting to reduce earnings management practices in Bangladesh. In a September 1998 speech to lawyers and Caps, Arthur Levity, chairman of the Security Exchange Commission committed “the SEC in no uncertain terms to a serious, high-priority attack on earnings management” (Loomis, 1999, p. 6). There followed the formation of a Blue Ribbon Panel by the Public Oversight Board, an independent private sector group that oversees the self-regulatory programs of the SEC Practice Section of the American Institute of Certified Public Accountants. How widespread is the earnings management problem? In an article in Fortune magazine, Loomis (1999) argues that earnings management is rampant and that Coos view earnings management as a LOL to ensure that their firms meet earnings expectations.
Loomis (1999) 1 | Page Earnings Management and Corporate Governance: The Role of the Board and the reports that to SEC chairman Levity, falsified reports and doctored records are a common problem and there are “great expanses of accounting rot, Just waiting to be revealed” (p. 77). The board of directors may have a role in constraining earnings management. The Blue Ribbon Panel recommends, among other things, that board members serving on audit committees should be financially sophisticated to help 2. Problem Statement
In Bangladesh most of the companies manage their earnings as a result the investors cannot see the actual performance of the firm. It plays a bad impact in the stock market. Investors become unable to invest accurately of their money. This study will show the role of board and audit committee to prevent earning management of the firm in Bangladesh. Existing studies show that corporate governance structure exerts a significant impact on firm value and shareholder welfare. For example, Compeers, Sushi and Metrics (2003) find significant correlation between corporate governance and several forward looking performance measures.
The authors used proxy variables to capture the shareholders” rights and concluded that firms with higher investors” protection are well capable of performing better. In addition, the authors construct a governance index to measure impact of governance on firm performance. They find that firms with high governance index outperform those with lower index. Investors” protection and dividend can be the key tools to mitigate the agency problem. John and Kneecap (2006) have argued that dividend policy is a pre commitment device that can be adopted to reduce agency costs and raise firm value.
A promise to distribute cash on a regular basis serves to mitigate the magnetosphere’s agency conflict. The authors propose an agency driven explanation for the choice between dividends and share repurchases, and provide empirical support for the relationship between governance quality and corporate payout. In Bangladesh, however, neither there have been any serious corporate scandal that could send shock waves to undermine confidence in the financial system, nor has the country found that it has reached the limits of conventional corporate financing.
The relatively low level of international investment in Bangladesh does not provide a sufficient motivation for improving corporate governance. In addition, there is no domestic motivation to improve corporate governance practices. But this does not mean that Bangladesh should give low priority to corporate governance given the potential growth and 21 Page needs of the economy. Good corporate governance practices will help develop and stimulate better business management, strategic management and risk management, which will, in the long term, make Bangladesh businesses more competitive.
From the experience of the neighboring countries in South Asia are such hat Bangladesh can deploy good corporate governance to prevent the problems, which have afflicted other countries, rather than to solve them after the event (Osborn & Werner, 2001). In addition, good corporate governance will bring in much needed foreign investment in future. Sometimes there is a high involvement of earning management for the week of board composition. A strong board composition can committee is very important to prevent earning management. 3.
Purpose of the Study Shareholders accept restrictions on their rights in hopes of maximizing their wealth and hence they delegate decision-making power to the managers. And the board of directors is appointed to protect the shareholders rights. But the role of this governing body is yet to be fully explored in the agency context. In this paper, an endeavor to answer the question “Is there any relationship between the corporate governance and earning management? ” has been made. The focus of the study will be the DES listed companies of Bangladesh.
The purpose of this study is to find out the role of board and audit committee to prevent earning management in the context of DES listed companies in Bangladesh. Some other objectives of the study are given low: 0 To identify the earning management companies. 0 To identify the causes of earning management. 0 To identify the advantages and disadvantages of earning management. 0 To focus on impact of earning management on securities. 0 To identify the role of different directors and audit committee to prevent earning management. 3 | Page 4.
Data Sources The date that are being used in this report are collected from both Primary and Secondary sources. Both sources have played equal role to show it in a positive way. Some Essential points of the Sources are listed according to related components. Primary sources: 0 0 0 0 Personal observation Face to face conversation Personal interview Oral and written information from the directors Secondary Sources: 0 Annual Reports 0 Audit Report 0 Web Sites 0 Financial Journals 5. Literature Review 5. 1 Earning Management Earnings management is a strategy used by the management of a company to deliberately manipulate the company’s earnings.
So that the figures match a pre-determined target. In the report we are trying to find out the role of the board and the audit committee to prevent earning management of the Bangladesh companies. The end of the sass and the beginning of 21st century eve witnessed a series of corporate accounting scandals across the United States and Europe. Examples include Enron, Healthiness, Parallax, Tycoon, World and Xerox. At the core of these scandals was usually the phenomenon of earnings management (Contractor, 2005).
Earnings management has been a great and consistent concern among practitioners and regulators and has received considerable attention in the accounting literature (Shah et al. , 2009). It has been businesses and obscures facts that stakeholders ought to know (Loomis, 1999). Healy and Whalen (1999), in their article states that earning management is often done by he 41 Page management to increase compensation and Job security. Beside it, earning management is also done to avoid rules breaking in a loan contract, reduce regulatory cost, or increase regulatory benefit (Coronet et al. , 2008).
In literature various definitions and measures of earnings management have been proposed. Healy and Whalen (1998) define earnings management as: “when managers use judgment in financial reporting and in structuring transaction to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company, or to influence contractual outcomes that depend on ported accounting numbers”. According to Chipper (1989) Earning Management is a purposeful intervention in the external financial reporting process in order to obtain private gain for shareholders or managers. . 2 Causes of Earning Management There are many causes of earning management. Managers can use earning management to extract rents from shareholders in the form of increased compensation (Healy, 1985). When managers incentives are based on their companies” financial performance, they could be interested in giving the appearance of better performance through earnings management. In many indirectly ( prestige, future promotions, and Job security) depending on firm”s earnings management is provided to the firms by GAP allowing them the use of accrual accounting.
According to FAST (1985) accrual accounting “attempts to record the financial effects on an entity of transactions and other events and circumstances that have cash consequences for the entity in the periods in which those transactions, events, and consequences occur rather than only in the period in which cash is received or paid by the entity. ” This holds that by use of accrual accounting mangers an control the timing of expense and timing of revenue recognition and thus can manipulate the actual earnings of a firm for a given period (Shah et al. 2009 and Shari et al. , 2008). 5 Page earnings management could mislead investors by giving them false information. In fact, investors use financial information to decide whether to buy, sell, or hold securities. Market efficiency is based on the information flow to capital markets so that when this information is incorrect the market will value securities incorrectly. So that, earnings management can be considered an agency cost in the perspective that t conceals real performance and weakens the ability of shareholders to make informed decisions.
Many studies have been performed about earnings management influence on capital markets. In which there may be contractual incentives for firms to manage earnings (Dye, 1988; Truman and Titian, 1988). The nature of accrual accounting gives managers a great deal of discretion in determining the actual earnings a firm reports in any given period. Management has considerable control over the timing of actual expense items (e. G. , advertising expenses or outlays for research and development).
They also can to some extent alter the timing of connection of revenues and expenses by, for example, advancing recognition of sales revenue through credit sales, or delaying recognition of losses by waiting to establish loss reserves (Teeth, Welch, and Wong, AAA). For example, in a understate earnings in an management buyout, there are clear incentives for managers to attempt to acquire a firm at a lower price. By using of accrual accounting mangers can control the timing of expense and timing of revenue recognition and thus can manipulate the actual earnings of a firm for a given period (Shah et al. ,2009 and Shari et al. , 2008).
Other studies have examined the incentives f managers to manipulate earnings in order to influence various capital market participants. The above discussion highlights that earnings management is costly to shareholders. In fact, they will benefit from earning management only if managers use accounting discretion to signal private information about future performance. For this reason, the monitoring role of the board is very important to curb this discretion. In takeover or merger settings, Sisterhood (1997) and Erickson and Wang (1999) have found evidence of earnings management in both hostile takeovers and in stock for stock mergers.
Sisterhood (1997) finds evidence consistent with the hypothesis that targets of hostile takeover attempts inflate earnings in the period prior to a hostile takeover attempt in an attempt to dissuade their shareholders from supporting the takeover. Likewise, in the case of mergers, Erickson and Wang (1999) find that firms engaging in stock for stock 61 Page mergers inflate their earnings prior to the merger in order to inflate their stock price and thereby reduce the cost of the merger. Other studies have examined the incentives of managers to manipulate earnings in an attempt to influence various
Decode, Sloan, and Sweeney (1996) provide evidence that managers inflate earnings prior to seasoned equity offerings. Their results are consistent with the notion that managers seek to manage pre-issue earnings in an attempt to improve investors” expectations about future performance. There is, however, a cost associated with earnings management. Teeth, Welch, and Wong (Bibb) show that firms that managed earnings prior to initial public equity offerings experience poor stock return performance in the subsequent three years. . 4 The Role of Board 5. 4. 1 Board Composition The board and the audit committee eve important role in preventing earning management. There are two types of directors, inside directors and independent outside directors. Independent directors and audit committees, being independent on management influence, are able to better protect shareholders from managerial opportunism (Fame and Jensen, 1983, Weakfish, 1988; Rosenstein and Wyatt, 1990; Byrd and Hickman, 1992; McMillan and Seen, 1997).
On the other side, it was argued that outside independent directors do not necessarily produce a better performance (Begat and Black) because the boards are “controlled” by management having better information than outside independent directors (Berne and Means 1932). In fact, even if outside independent directors play a significant role, inside directors are always the key players of every firm”s board of directors (Fame and Jensen 1983). Moreover, on the other hand, the presence of outside independent directors could reduce the efficient cooperativeness of the board, because of their limited involvement in day-to -day corporate activities.
It could prove to be an impediment to management in the attempt to manage and monitor the operations of the firm (Klein, 1998). Keener (1988) maintains that most important board sections originate at the committee level, and Vance (1983) argues that there are four board committees that greatly influence corporate activities: audit, executive, compensation, nomination committee. Klein (1998) finds that overall board composition is unrelated to firm 71 Page performance but that the structure of the accounting and finance committees does impact performance.
In the I-J, Passel et al. , (2005), examine whether the association between board composition and earnings management differs between the pre and post-Catbird periods. They find evidence of accrual management to et earnings targets in both periods. However, only the post-Catbird period indicates less income-increasing accrual management to avoid earnings losses or earnings declines when the proportion of nonconsecutive directors is high. These results offer clear evidence of the impact of independent outside directors on constraining earnings management in the I-J. Analyses the effect of independent boards on constraining research and development (R&D) spending manipulation. In Canada, Park and Shin (2004) investigate the effect of board composition on the level of earnings management in a sample of 539 firm-years. Using the modified Jones model as a proxy for earnings management, they find that independent outside directors parse do not reduce discretionary accruals whereas outside directors from financial intermediaries and active institutional shareholders do reduce earnings management.