Internal Governance and Real Earnings Management

Abstract

We examine whether internal governance affects the extent of real earnings management in U.S. corporations. Internal governance refers to the process through which key subordinate executives provide checks and balances in the organization and affect corporate decisions. Using the number of years to retirement to capture key subordinate executives' horizon incentives and using their compensation relative to CEO compensation to capture their influence within the firm, we find that the extent of real earnings management decreases with key subordinate executives' horizon and influence. The results are robust to alternative measures of internal governance and to various approaches used to address potential endogeneity, including a difference-in-differences approach. In cross-sectional analyses, we find that the effect of internal governance is stronger for firms with more complex operations where key subordinate executives' contribution is higher, is enhanced when CEOs are less powerful, is weaker when the capital markets benefit of meeting or beating earnings benchmarks is higher, and is stronger in the post-SOX period. This paper contributes to the literature by examining how internal governance affects the extent of real earnings management and by shedding light on how the members of the management team work together in shaping financial reporting quality. JEL Classifications: G32; M40.

The Type I Versus Type II Agency Conflict on Earnings Management

“…It implies that alignment as such director ownership encourages decreasing manager self-interest. Cheng et al (2016) also support the finding about separation between manager and shareholder affect in achieving management self-interest. Cheng et al (2016) reveal that check and balances mechanism in CEO team could reduce real earnings management.…”

“…Cheng et al (2016) also support the finding about separation between manager and shareholder affect in achieving management self-interest. Cheng et al (2016) reveal that check and balances mechanism in CEO team could reduce real earnings management. CEO in corporate has subordinates and the team will decide financial decision, therefore, many kinds of self-interest between members of CEO team, such as desire to be next CEO or to have more career encourage for caring future cash flow, can motivate to monitor other CEO.…”

“…The findings of Lafond and Roychowdhury (2008) and Cheng et al (2016) show that separation between agent as equity manager and principle as equity owner could encourage management maximizing his/ her self-interest. The separation will encourage management decreasing conservatism and increasing real earnings manipulation (Lafond & Roychowdhury, 2008;Cheng et al, 2016).…”

“…The separation will encourage management decreasing conservatism and increasing real earnings manipulation (Lafond & Roychowdhury, 2008;Cheng et al, 2016). Therefore, in dispersed ownership setting, it needs a mechanism that can control and monitor management for behaving as shareholder interest.…”

Female CEOs and Core Earnings Quality: New Evidence on the Ethics Versus Risk-Aversion Puzzle

“…Following Cohen and Zarowin (2010) and Cheng et al (2015), we use two proxies for REM, namely REM1 and REM2,15 where REM1 is (UN_DEX + UN_OCF) and REM2 is (UN_DEX + UN_PROD). Following Roychowdhury (2006), UN_DEX, UN_OCF and UN_PROD are the residual from the following three equations run annually for each industry.…”