The Effect of Corporate Governance on Earnings Quality and Market Reaction to Low Quality Earnings: Korean Evidence

Abstract

This study investigates whether corporate governance mechanisms are associated with earnings quality, especially accurate earnings reporting, and whether investors react differently to inaccurate earnings according to governance strength. Earnings accuracy is one of the key factors affecting a firm’s sustainability in the sense that reported earnings provide information about a firm’s long-term sustainability and further are directly associated with a firm’s cost of capital. In this paper, we employ the independence of the board of directors (BOD) and foreign ownership as governance mechanisms associated with the earnings gap between audited and unaudited earnings. Using 1976 non-financial firm-year observations listed on the Korea Stock Exchange from 2013 to 2016, we find that the gap between unaudited earnings and actual earnings is smaller for firms with independent BODs and foreign ownership, suggesting that earnings accuracy is higher for firms with effective corporate governance. This study also examines how investors react to the earnings gap. Stock returns to the earnings gap are less negative for firms with independent BODs and are more negative as foreign ownership increases, implying that each mechanism of corporate governance has different effects.

Good Corporate Governance: Does The Timeliness of Financial Reporting Has an Effect to The Investors’ Reaction?

“…Audit Committee meeting negative significant affects investor's reaction, this is in line with the results of research conducted by (Ashraf et al, 2019;Kang, 2019) where the intensity of the meeting conducted by the audit committee will cause anxiety for investors related to negative issues or mistakes made by the company so that, it requires an ongoing audit with intensity with a long period. Then, Foreign ownership has a negative significant effect on investors' reaction, this is in line with research conducted by (Shin & Kim, 2018), the large amounts of foreign ownership will threaten the company because foreign investors with large holdings can withdraw and sell their shares when dissatisfied so that the company's performance can be threatened unstable which makes investors give a negative assessment of the company in question.…”

“…This is because they tend to believe that the large number of independent commissioners boards can automatically make oversight of the company's operations increasing and the possibility of losses is minimized. This result does not in line with the results of research by (Cullinan et al, 2012;Shin & Kim, 2018;Suhadak et al, 2019), that the lagre number of composition of independent commissioners board appointed to supervise and inform the company it will be more effective because the managerial ownership is fairly high can be balancing the interests of stakeholders, in this case, is investors so that the occurrence of collusion actions in a company can be minimized. Meanwhile, Auditor quality has a positive effect on investors' reaction, this is in line with the results of research (Tarmidi et al, 2019) in which the quality of audit improves the quality of financial reportings so that investors respond positively.…”

The impact of innate accruals quality on the future market value moderated by dividend policy

“…By having informative earnings that are high, the company will have the convenience to conduct financing; this result proves Johnston (2009), when management can obtain funding easily. This test proves Shin and Kim (2019) regarding the negative investor responses on the earnings distortions, so there are negative stock price movements. When the investor could have predicted the expected return in the following period with high accuracy, there is a positive investor perception on the actual earnings on the current period (Hu et al 2015).…”

“…This illustrates that the quality of corporate performance reporting is low. Shin and Kim (2019) pointed out that accruals quality indicators are the level of management consistency in determining earnings. Investors can react to low earnings quality; this is related to the estimated level of expectations in the coming period, including encouragement for management to perform high earnings quality.…”

Corporate governance mechanism and financial performance: role of earnings management

“…Earnings management is an option available to managers when they choose policies or select accounting methods, but it can have an impact on income and also on achieving the specific objectives of managerial statements (Scott, 2015). Earnings obtained by an entity are often used as a benchmark for users of financial statements in assessing the success of that entity (Shin & Kim, 2019;McNichols & Stubben, 2008;Savitri, 2018). This is one of the reasons for the existence of earnings management.…”