REVIEW OF LITERATURE ON INTERNAL CORPORATE GOVERNANCEMECHANISMS AND FINANCIAL REPORTING.

BYOLUWAREMI FEYITIMI (B.Sc, MBA, FCA)

PHD STUDENT IN ACCOUNTINGJOMO KENYATTA UNIVERSITY OF AGRICULTURE & TECHNOLOGY

REG. NUMBER: HD439-1544/2013

ABSTRACTAgency theory predicts that corporate governance mechanisms play animportant role in enhancing financial reporting, while institutional theoryviews these mechanisms as practices or regulations which result fromcoercion by legislators who impose certain practices in order to improveorganizational effectiveness and transparency. In terms of earningsmanagement practices, both theories provide an appropriate theoreticalframework. Taking agency theory and institutional theory as points ofdeparture, the primary purpose of this study is to: (1) review the existingliterature on the roles of the Board of Directors in the presentation ofFinancial Statements and; (2) the impact of earnings management on thequality of the financial statements and perception of the stakehlders. Toachieve this aim, extensive review of relevant literature was carried outto explore the motivations and techniques of earnings management amongcompanies. In terms of the effect of corporate governance on earningsmanagement practices, various models at measuring earning management werereviewed from literature and the relationship that exist between internalcorporate governance mechanisms and earning management practice .

KEY WORDS: CORPORATE GOVERNANCE, AGENCY THEORY, EARNINGS MANAGEMENT,

1. INTRODUCTIONDuring the last ten years, the financial scandals in developed countries,such as the UK and the USA, have brought about a major awareness of theneed for more transparency and credibility in order to protect shareholdersand stakeholders alike (Glaum et al, 2004; Fearnley et al., 2005). Globally,financial crises and companies scandals which occurred between 2006 and2008 damaged investors’ trust, have evidently raised questions andincreased concerns about the role of corporate governance mechanisms and towhat extent they can be accommodated in the economic environment(Alrehaily, 2008). Earnings management (EM), as a phenomenon of previousscandals (Goncharov, 2005) which has received considerable attention, isone of the most important challenges confronting corporate governance (CG)mechanisms which endeavour to resolve the negative impact of earningsmanagement on financial reporting (Jaggi and Tsui, 2007). Academicresearch has concluded that managers engage in earnings management toaccomplish certain objectives such as avoiding loss, meeting marketexpectations, avoiding debt covenant violations etc. Whatever the

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motivation, it is documented that earnings management harms earningsquality (Jaggi and Tsui, 2007) and misleads financial reporting users. Evenin developed countries the practice of adopting international accountingand auditing standards has failed to provide sufficient assurances thatfinancial reports are free from earnings management (Pornupatham, 2006).According to Al-Khabash and Al- Thuneibat (2009), based on Lo’s (2007)argument, EM has many victims such as equity investors, creditors,suppliers, regulators and customers.

The objective of financial statements is defined as follows in the Framework for the Preparation and Presentation of Financial Statements published by the IASC in 1989: ‘‘The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions’’ (paragraph 12). Financial statements provide information that is used by interestedparties to assess the performance of managers and to make economic decisions. Users may assume that the financial information they receive is reliable and fit for its purpose. Accounting regulation attempts to ensure that information isproduced on a consistent basis in accordance with a set of rulesthat make it reliable for users.

Fundamentally, this paper is motivated by factors attributed to developingcountries as classified by Leuz et al. (2003) who concluded that developingcountries that have weakening economies show low investor rights, inactiveregulations and opacity of higher-level earnings management whichinevitably serve as great injustice to vast number of stakeholders toexisting corporations. Consequently, the main aim of this paper is toexplore literature and identify empirically the expected role of the boardin the presentation of the financial statements and how earnings managementpractices among corporations damage the trust and integrity of thefinancial information being released to the shareholders and otherstakeholders.

2. LITERATURE REVIEW

2.1 INTRODUCTIONRekha Sethi, Director General, All India Management Association (AIMA),says "The whole idea behind corporate governance is ensuring theaccountability of certain individuals in an organization through mechanismsthat try to reduce or eliminate unfair practices within the corporatesystem. So, corporate governance is all about transparency” Poor corporategovernance and lack of transparency of corporate financial reporting havefrequently been identified as some of the root causes of major financialcrisis across the globe. Financial accounting information is the product of

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corporate accounting and external reporting systems that measure andpublicly disclose audited, quantitative data concerning the financialposition and performance of publicly held firms. Financial accountingsystems provide direct input to corporate control mechanisms, as well asproviding indirect input to corporate control mechanisms by contributing tothe information contained in stock prices. An important theme of corporategovernance is to ensure the accountability of certain individuals in anorganization through mechanisms that try to reduce or eliminate theprincipal-agent problem.Financial reporting plays a significant role in communicating financialinformation to users in a right time and credible conduct (Xiong, 2006).Based on agency theory, the issues related to the separation betweenownership and management might lead managers to collude against owners toincrease their own personal wealth (Abdul Rahman and Ali, 2006).Institutional theory (North, 1990) also provides an appropriate theoreticalframework for managerial behaviour. Institutions in a society provide therules of the game that monitor the interplay between organizations, whichare the players in the game, who attempt to exploit the opportunitiescreated by the institutions to increase their welfare (Li, 2004). In otherwords, society may create many formal constraints, such as public laws andgovernment regulations, or informal ones, such as social customs andconventions collectively known as culture (Li et al, 2008). These constraintsmay create incentives for managers to manipulate earnings. Thus,opportunities are given for managers to practise their discretion regardingbusiness in order to enhance the effectiveness of financial reporting as ameans of communicating with investors and creditors. In other words,current accounting standards offer management a wide choice of alternativeways to treat the same financial transaction or event (Al-Khabash and Al-Thuneibat, 2009). Different accounting methods may be chosen according totheir objectives.

2.2 DIRECTORS’ RESPONSIBILITIES FOR THE FINANCIAL STATEMENTSThe Directors are responsible for preparing the Annual Report and theFinancial Statements in accordance with applicable law and regulations.Company Law requires the directors to prepare Financial Statements for eachfinancial year. Under the law the directors have elected to prepare theFinancial Statements in accordance with the Generally Accepted AccountingPrinciples and other applicable laws. The Financial Statements are requiredby law to give a true and fair view of the state of affairs of the companyand of the profit or loss of the company for that period underconsideration.

To prepare a true and fair view Financial Statements, the directors arerequired to: 1) Select suitable accounting policies and then apply themconsistently. 2) Make judgements and estimates that are reasonable andprudent. 3) State whether applicable accounting standards or GenerallyAccepted Accounting Principles have been followed, subject to any material

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departure disclosed and explained in the Financial Statements and 4)Prepare the Financial Statements on the going concern basis unless it isinappropriate to presume that the company will continue in business.

The directors are responsible for keeping proper accounting records thatdisclose with reasonable accuracy at any time the financial position of thecompany and enable them to ensure that the Financial Statements comply withrelevant companies Act. They are responsible for safeguarding the assets ofthe company and hencefor taking reasonable steps for the prevention anddetection of fraud and other irregularities. Finally, The Directors areresponsible for the maintenance and integrity of corporation and financialinformation included on the website. In other words, directors areresponsible for the way and manner information contained in the financialstatements are disseminated.

2.3 TRUTH IN ACCOUNTINGIn Philosophy, knowledge of a proposition arises from its truthfulness.Truth relates to the reporting of occurrence or the existence of a state ofaffairs. Other ways of stating truth are: 1) Truth as correspondence,meaning when the proposition is true if it corresponds to a fact. 2) Truthas coherence, when the proposition is true because it is coherent withother proposition and 3) Truth as what ‘works’, implying that a trueproposition is what works. However, the preparation and presentation offinancial information have been based on expediency rather than on truth.This position is clearly stated by K. MacNeal (1939) that Accountingmethods and hence Accounting reports have been based on expediency ratherthan on truth. Financial Statements today are composed of a bewilderingmixture of accounting convention, historical data, and present facts,wherein even Accountants are often unable to distinguish between truth andfiction.

Yes, the lack of concern with truth in accounting has always been a majorissue in the accounting literature. In the recent time, the financialinformation being fed by the directors to the information users are notcorrespond to existing facts, incoherent with other existing informationand unsupportive to the users in making their economic decision about theorganisation. Most times the users are misled into believing the existenceof non-existence facts which had caused colossal losses to most investorsand other stakeholders. In the last decade, corporate transparency hasbeen lost in the information market. There has been high velocity oferosion of the credibility of financial reporting coming from companies,especially big and notable companies across the globe. Communicationsbetween entities and shareholders have been deliberately distorted by theactivities of financial statement preparers who wish to alter the contentof the messages being transmitted. This type of distortion is oftenreferred to as ‘‘creative accounting’’ or ‘‘earnings management’’.Empirically, various games are being played in the presentation of

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financial statements amongst them are: 1) two or more methods areacceptable for the same fact. 2) Less conservative accounting methods arebeing used rather than the earlier, more conservative methods. 3) Reservesare used to artificially smooth earning fluctuations. 4) Off-Balalnce Sheetfinancing (i.e disclosure in the notes to the financial statements) iscommon now. 5) Financial Statements fail to warn of impending liquiditycrunches as deferrals are followed by ‘big bath’ write-offs, and many otherunholy practices. While opinions on the acceptability of accountingmanipulation vary, it is often perceived as reprehensible. The ChairmanArthur Levitt, United States of America’s SEC said in a titled ‘NumbersGame’ that ‘if a company fails to provide meaningful disclosure toinvestors about where it has been, where it is and where it is going, adamaging pattern ensues. The bond between shareholders and the company isshaken; investors grow anxious; prices fluctuate for no discerniblereasons; and the trust that is the bedrock of our capital markets isseverely tested’.

A fundamental feature of the information environment is corporatetransparency, defined as the widespread availability of relevant, reliableinformation about the periodic performance, financial position, investmentopportunities, governance, value, and risk of publicly traded firms(Bushman, Piotroski, and Smith 2001). Bushman, Piotroski, and Smith (2001)develop a framework for conceptualizing and measuring corporatetransparency at the country level. In their framework, corporatetransparency has three main elements: 1) corporate reporting (voluntary andmandatory), 2) information dissemination via the media and Internetchannels, and 3) private information acquisition and communication byfinancial analysts, institutional investors, and corporate insiders. Thefirst element in the BPS framework is the quality of corporate reporting.They consider not only corporate disclosure intensity as measured by theCIFAR index, but also the prevalence of specific types of accounting andgovernance disclosures, the timeliness of disclosures, and the credibilityof disclosures as measured by the share of Big-6 accounting firms in totalvalue audited. All measures of corporate reporting used in BPS arecollected from Center for International Financial Analysis and Research(1995), and appear in the figure 1.

2.4 MANIPULATIONS, LAW, AND THE CONCEPT OF TRUE AND FAIR VIEWFirst of all, is accounts manipulation legal? In most countries, GAAP allowa certain amount of interpretation. These interpretations can be in line with the spirit of the standard or, at the other extreme, completely farfetched. However, all these interpretations remain in the limit of the law. They may be erroneous, but never fraudulent.A fraud is made when somebody is doing an illegal action. In term of financial statements, for instance, the fabrication of false invoices to boost the sales figure is a fraud. Interpreting consignment sales as ordinary sales is an error, innocent or not. However, the difference does not appear as clearly to everyone. The American commission created to

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investigate on fraudulent financial reporting defines fraud as any act resulting in “materially misleading financial statements” See comments by Swinson [1992] and Cassidy et al. [1992].

In his classification of fraudulent behavior Merchant [1987, quoted by Belkaoui, 1989, p. 67] defined what we consider to be real fraud, i.e., falsifying or altering documents, suppressing transactions from records, recording forged transactions or concealing significant information. However, he also included later some elements falling under our definition of accounts manipulation related mainly to the interpretation of accountingstandards. Brown [1999] analyzed the difference between earnings managementand reporting fraud and pointed out that the distinction between the two isoften a fine one. An accounts manipulation is situated in the space where there are choices and interpretations to be made among accounting procedures. If we take the example of creative accounting, as Jameson [1988, p. 20] stated: it “is not against the law. It operates within the letter both of the law and of accounting standards but it is quite clearly against the spirit of both. It should also be remembered that creative accounting is not necessarily practiced only by dishonest and corrupt accountants and crooked company directors. This is one of the aspects that makes it difficult to deal with. It is essentially a process of using the rules, the flexibility provided by them and the omissions within them, to make financial statements look somewhat different from what was intended bythe rule. It consists of rule-bending and loophole-seeking”. This space, between a rigid an automatic application of the standards and the choice ofthe most representative standard is exactly where the auditor judgment is to be exercised. The auditor has to choose, among all the allowed procedures, the one that will produce a true and fair view of the financialsituation of the firm. Shah [1996] proposed a new concept: creative compliance, describing the capacity of creative accounting to remain within the limits of the law although bending its spirit. Such a process includes the participation of bankers who are often proposing new financing schemes going around the law, lawyers to check that the detour can be defensible, which means spending a lot of money. However, those having the resources “to resist regulations are unregulatable” [Shah, 1996].

Foggy accounting standards are useful for everybody in the system, and mainly the regulatees [Revsine, 1991]. The motivations of managers for misrepresentation are well known. Revsine analyzed also the motivations of shareholders as a smooth profit will decrease the perceived level of risk and increase the market value of their shares. Such standards will also provide opportunities to avoid debt covenant restrictions. Auditors may find easier to retain clients with loose accounting standards. In the Anglo-Saxon world, financial statements were long reputed to provide a “true and fair view” of the financial situation of the firm if the accounting standards had been followed. However, in the US as well as in the UK the situation is evolving toward a separation of these concepts. Briloff [1976, p.12] presented both ideas as separated. In the UK now, if the compliance with the Companies Act does not lead to a true and fair

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view, another choice must be done, although it must be documented in a noteto the financial statements.

The notion of true and fair view is not understood in the same way by everyinterested parties [Parker and Nobes, 1991; Rutherford, 1985]. Many auditors interviewed by them don’t make any difference between true and fair, and will not depart accounting standards to be sure to provide a trueand fair view; in fact, they don’t even take any action to ensure they are presenting such a true and fair view. Managers interviewed seem to act accordingly. Rutherford [1985] believed that compliance with GAAP must be the measure of the true and fair view, which, even at the time, seems somewhat retrograde. For us, the true and fair view cannot be the result ofan automated application of GAAP. Firstly because such an automated application is impossible in regard of the choices permitted. So, in each case, these choices have to be made in order to produce a set of financial statements providing the right image of the situation to the decision-maker. This is done through auditors judgment, and we do not see the role of the auditor any where else. Therefore, in our opinion, accounts manipulation consists in choosing an accounting standard or procedure which, although permitted, will not present a true and fair view of the financial situation of the firm.

2.5 EARNINGS MANAGEMENT MOTIVATIONSAccording to positive theory developed by Watts and Zimmerman (1986), thereare three primary hypotheses regarding earnings management motivations: thebonus plan hypothesis, the debt covenant hypothesis, and the political costhypothesis. Current research of earnings management has, however, shiftedits focus away from positive theory and back again to capital marketmotivations as interpretations of the opportunistic behaviour of managers(Xiong, 2006). On the other hand, agency theory, as an economic model ofbehaviour, expects that, as long as the objectives of the principal andagent are aligned, the agent will attempt to maximize the objectives of theprincipal; however, when their objectives are conflicted, the view ofagency theory is that the agent will attempt to maximize his/her self-interest over the principal’s interests. Accordingly, the motivation formanipulating earnings begins when alignment is conflicted. According toinstitutional theory, earnings management incentives may be effected byformal or informal pressure, and change may be created by an organisationin order to model itself on other organisations. Kury (2007) views thatinstitutional theory provides the best perspective for examining earningsmanagement practices. He offers the institutional argument for explainingearnings management, which is helpful to complete the view of agency theoryand suggests that insights for earnings management comprise the blending ofagency and institutional theory perspectives to obtain a more completeunderstanding of the behaviour and the positing of a continuum of earningsmanagement.

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Overall, a large body of literature has spawned different evidenceinvestigating various aspects of managers’ motivations to manipulateearnings management. For example, Gaa and Dunmore (2007) suggest thatearnings management is engaged in order to affect stakeholders’ beliefs andbehaviour or to affect how contracts are carried out. Merchant andRockness, (1992) spelt out lots of incentives derived by managers formanipulating earnings or the consequences of their actions. Such incentivesinclude: (1) Remuneration, (2) Compliance with the debt convenant, (3)Official Examination (4) Initial Public Offerings, (5) Accounting Choices,(6) Minimisation of Income Tax

2.5.1 Remuneration One good reason for managers to enter into EM would be their remunerationpackage. Healy [1985] is among the first to propose this explanation,recalling that earnings-based bonus scheme is a popular mean of rewardingcorporate executives. It is logical to believe that managers receiving aremuneration partially based on the level of profit will manipulate thisprofit to smooth their remuneration. Such a view is consistent with the bigbath accounting. However, Holthausen, Larcker and Sloan [1995], using moresophisticated data, were able to find that managers having reached the topof their compensation possibilities decrease reported earnings.

2.5.2 Compliance with Debt Covenants Clauses Another motivation, also contained in the positive accounting theory [Wattsand Zimmerman, 1986] would be the compliance of the firm with debt covenantclauses. Sweeney [1994] found significant manipulations for firms havingdefaulted the conditions of their contract. Defond and Jiambalvo [1994]obtained similar results for comparable firms for the years preceding thedisclosure of a default.

2.5.3 Official Examination A third motivation is official examination following some allegations ofill behaviour from a firm or a sector. Often it is a sector event likehaving exaggerated average profits in average for a sector, repetitiveaccidents like tanker breaks, dumping or the possible existence of acartel. The normal behaviour during such a period will be to decreaseprofits as huge profits are a signal of a monopolistic situation, illicitoperations or the ability to repay for the damages caused. Profit-decreasing accruals were found by Jones [1991] during officialinvestigations. Hall and Stammerjohan [1997] reached similar results,showing that EM may be performed in response to firm and industry specificfactors such as high debt levels, pending legal damage rewards and foreigncompetition. In the context of anti-dumping complaints against foreigncompetitors, Magnan, Nadeau and Cormier [1999] showed that Canadian firmsreduce their reported earnings by a significant amount during the year inwhich they are under investigation.

2.5.4 Initial Public Offerings

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Initial public offerings seem to be a good opportunity to manage earnings.The firm has no previous price on the market, so manipulating earningswould increase the introductory price. This reasoning however iscontradicted by studies finding a systematic initial underpricing of theseissues. The case of IPOs is a little different than for seasoned issues.For new issues there is no settled value and a shortage of information,therefore investors will rely more heavily on financial statementsinformation [Friedlan, 1994; Neill, Pourciau and Schaefer, 1995]. Earningsmanipulations then appear as an opportunity for initial shareholders toincrease their wealth [Aharony, Lin and Loeb, 1993] through possibilitiesof biasing information [Titman and Trueman, 1986; Datar et al., 1991]2.5.5 Accounting ChoicesBremser [1975] contrasted the reported earnings (EPS) of a sample of 80companies electing to make accounting changes with those of 80 companiesnot disclosing changes. This study revealed that companies reportingdiscretionary accounting changes in the period under review exhibited apoorer pattern or trend of EPS than a random sample of companies with noreported changes during the same period.

2.5.6 Minimization of Income TaxMaydew [1997] investigated tax-induced intertemporal income shifting byfirms with net operating loss carrybacks. This research extends priorexaminations of intertemporal income shifting by profitable firms [Scholes,Wilson and Wolfson 1992; Guenther 1994]. Eilifsen, Knivsflå and Sættem[1999], following Chaney and Lewis [1995], showed that if taxable incomewere linked to accounting income, there will exist an automatic safeguardagainst manipulation of earnings within the analyzed framework (seecomments by Hellman [1999]).

2.6 EARNINGS MANAGEMENT TECHNIQUESThe technique of earnings management can be defined as a method or a way ofselecting or violating accounting standards in order to affect financialevents. Previous studies suggest that earnings may be manipulated in twomain ways: accounting choices and discretionary accruals (Aljifri 2007). Asmentioned earlier, managers may exploit or abuse the flexibility ofaccounting standards by selecting appropriate methods such as revenuerecognition methods or FIFO to LIFO in inventory to manipulate earnings orviolating accounting standards.Various techniques have been illustrated to explain the methods ofmanipulation. Hang and Wang (1998) conclude that oil companies useinventory and special items to manipulate earnings management. For example,there is an incentive for American companies to manipulate earnings inorder to reduce political costs by using inventory and special items astechniques of manipulation.

Numerous prior studies have attempted to join hypotheses that are involvedin empirical testing of whether assets sales are an incentive for earnings

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manipulation. For example, Poitras et al. (2002), who examined Singaporeancompanies using a sample of 44 public firms, demonstrate that somecompanies use flexibility of accounting methods to manipulate earnings viasales and depreciation of assets as a way of manipulation. Based oninterview surveys including financial executives from public companies inUS firms and using descriptive statistics and correlation analysis, Grahamet al. (2005) document that earnings is manipulated via real economicactions: for example, delaying advertising expenditures, as opposed tomanipulation by adopting accounting discretion within GAAP as employingaccrual management. Interestingly, a study conducted by Roychowdhury (2006)comprising a sample of 4,252 US firms demonstrates that firms changereported earnings by employing price discounts to temporarily improvesales, by managing overproduction to report lower costs of goods sold, andby decreasing discretionary expenditures to enhance margins. Employing casestudy and using a sample of 50 of the largest British companies, Breton andTaffler (1995) claim that earnings management is practised via taxation,pension contribution, holidays, extraordinary items, creating profit viaasset disposals, merger accounting, subsidiaries, non-capitalization ofleased assets, concealed interest charges, and non-consolidatedsubsidiaries. Amat et al. (2003) who examined audit reports of 35 listedcompanies in the Spanish Stock Exchange, conclude that numerous techniquesare used by Spanish managers in order to practise earnings management.These techniques include expenses charged to reserves instead of includingthem in the income statement, expense capitalization, altering theinventory, accelerated depreciation methods, extraordinary fees for pensionplans, and reduction of earnings because of future losses. Aljifri (2007)divides the managing of earnings management into two approaches: (1)accruals accounting choices including the timing of expenses and revenuerecognition, which is easier to manage, cheaper, and difficult to detect byexternal auditors. (2) accounting method changes (FIFO to LIFO) which areexpensive, observable, and easier to detect by external auditors. Bothmethods may be employed to decrease or increase earnings management;however, most previous studies focus on the former approach, while thelatter is still not evident. Defond and Park (1997) highlight that managerstend to shift earnings from good years to bad years; for example, ifpresent earnings are "good" and expected earnings are "bad", managers wouldtransfer some earnings from the good year to the bad year in order to eventhem out. FIFO and LIFO are the most commonly-used methods for manipulatinginventory. Forexample, when a company adopts or selects FIFO and LIFO, it might lead to achange in the firm’s cash flow because of the effect of such inventory costmethods on taxable earnings; however, which one they choose depends ontheir motivation or objective.

2.7 EARNINGS MANAGEMENT MEASUREMENTEarnings management is characterized as being intangible or invisible andcan be deemed successful solely if it goes undiscovered. Accordingly,studies of earnings management endeavour to find a simple way of measuring

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earnings management employing statistical methods. As a result, a number oftechniques have emerged in accounting literature such as specific accrualsor single accruals (McNichols and Wilson, 1988), aggregate accruals (Jones,1991; Dechow et al., 1995), statistical distribution of earnings changes andearnings (Burgstahler and Dichev, 1997), comprising determination ofthresholds (Degeorge et al., 1999). On the other hand, some studies haveattempted to employ different methodology such as using questionnairesurveys or interviews. McNichols (2000) presents and argues the researchdesigns of the three main commonly-used approaches in the earningsmanagement literature: specific accruals, total accruals, and thedistribution of earnings. Specific accruals assume that profit includescash flow and total accruals and the manipulation of profit numbers maypoint to manipulation of accruals. However, specific accruals are verylimited in their concentration since they only detect the relationship withother accruals in business transactions and the accounting process. Totalaccruals include across-time and across-firms and provide the opportunityto seek other explanatory variables such as auditors and corporategovernance mechanisms. The third method developed by Burgstahler and Dichev(1997) and Degeorge et al. (1999), attempts to test the statisticalproperties of earnings to explore behaviour that influences earnings. Inaddition to the discussion presented by McNichols (2000), another approachof earnings management investigation has emerged in order to elicit theprofessionals' perceptions on earnings management. For example, Nelson et al.(2003); Kamel and Elbanna (2010); Baralexis (2004); Al-Khabash and Al-Thuneibat (2009) and Graham et al. (2005) provide evidence as to how and whymanagers attempt to manipulate earnings management.

2.7.1 Total Accruals ModelsThe usual starting technique for the measurement of discretionary accrualsis aggregate accruals which is the most common approach employed by theaccounting literature to measure earnings management (Dechow et al.1995).Total accruals consist of discretionary accruals, which are representativeof earnings management, and non-discretionary accruals, which managerscannot determine since they are economically determined. In other words,managers find a way to use discretionary accruals in order to exercisetheir discretion over accounting choices and estimates that enable them topractise earnings management and this way is supported by prior studies,such as Bartov et al. (2001), Dechow et al. (1995), Holthausen et al. (1995),Warfield et al. (1995) and Jones (1991). Previous studies have presented twoapproaches for estimating total accruals. The first approach represents thebalance sheet method employed by a large number of studies such as Healy(1985), Jones (1991), Dechow et al. (1995) and Kothari (2005). The balancesheet approach is computed as follows:

TACt = ΔCAt - ΔCasht - ΔCLt + ΔDCLt - DEPt

where:ΔCAt = Change in current assets in year tΔCasht = Change in cash and cash equivalents in year t

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ΔCLt = Change in current liabilities in year tΔDCLt = Change in debt included in current liabilities in year t.DEPt = Depreciation and amortization expense in year t

The second approach is the cash flow method used by other studies such asDeFond and Subramanyam (1998), Becker et al. (1998), Klein (2002), Xie et al.(2003), Abdul Rahman (2006); Huang et al. (2007) and Jaggi et al. (2009).Under the cash flow approach, total accruals are measured as follows:

TAC t = Income t – Cash Flow tWhere:Income = Earnings before extraordinary and abnormal items in year tCash Flow t = Operating cash flow in year t

The differential aspects between the two approaches are investigated byCollins and Hribar (2002) who find that the cash flow approach is betterthan the balance sheet approach when companies experience mergers oracquisitions. In other words, some non-articulation events, such as mergersand acquisitions, may break down the association between changes in balancesheet working capital accounts and accrued revenues and expenses on theincome statement (Habbash, 2010). In addition, the balance sheet approachis biased in estimating accruals for firms with discontinuing operationsthat may be deemed discretionary items. As a result, the study employ Cashflow method to compute TA.

2.7.2 Other Models for Capturing Earnings ManagementNumerous accrual-based models for detecting earnings management areproposed by different studies such as the Healy Model (1985), the DeAngeloModel (1986), the Industry Model, the Jones Model (1991), the modifiedJones Model (1995), and the Margin Model, Kothari et al. Model (2005) andrecently the Stubben Model (2010) . Among these models, the Jones Model(1991) and the modified Jones Model still attract attention in studies ofearnings management, since they are the most powerful test of earningsmanagement and the best in terms of robustness according to most of theprior studies. On the other hand, the Kothari et al. Model (2005) hasrecently become the focus of accounting researchers and is characterized bycontrolling for the prior performance of the company. The development ofmeasuring earnings management began with total accruals, then others modelswere presented in the accounting literature as follows:

The Healy Model (1985)The Healy Model (1985) attempts to measure earnings management by employingmean aggregate accruals (measured by lagged total assets) in the computingperiod as the measure of nondiscretionary accruals. This model was thefirst attempt to measure manipulation. Healy’s argument was that systematicearnings management takes place in every period; thus, accruals weredefined as the difference between reported earnings and cash flow fromoperations. Measuring discretionary accruals as total accruals for theperiod as follows:

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EDA it = TA it / A it -1Where:EDAit = Measured discretionary accruals for the period;TAit = Aggregate accruals for the period;Ait-1 = Overall assets at the beginning of the period

The DeAngelo Model (1986)The second attempt was provided by DeAngelo (1986) who avoided theshortcomings of the Healy Model (1995) by ignoring a benchmark for whatexpected accruals may be (Aljifri, 2007). According to this model,discretionary accruals are measured by calculating the differencebetween total accruals in the current period and total accruals inthe previous period. This model is presented below:

EDAit = (TAit – TAit-1 ) / Ait-1Where:EDAit = Estimated discretionary accruals for the period;TAit = Total accruals for the current period;TAit-1 = Total accruals for the prior period;Ait-1 = Total assets for the prior period.

However, this model was criticized for misclassifying non-discretionaryaccruals as discretionary accruals, and the prior year, which could beemployed as a benchmark for what anticipated accruals should be, couldcomprise earnings manipulation (Aljifri, 2007).

The Jones Model (1991)A more influential model was presented by Jones (1991) and measures non-discretionary accruals including plant, property and equipment variables inorder to control any change in non-discretionary accruals stemming fromdepreciation and arising from changes in business activities of thecompany.

TAC it = α (1 / TA it -1) + β1 (Δ REV it / TA it -1) + β 2 (PPE it / TA it -1)+ ε it

Where:TAC it = aggregate accruals.TA it -1 = the book value of total assets of firm i at the end of year t -1,Δ REVit / TA it -1 = sales revenues of firm i in year t less revenues in yeart – 1 scaled by TA it -1,PPE it / TA it -1 = gross property, plant and equipment of firm i at the endof year t scaled by TA it -1,α β1 β 2 = estimated parameters.ε it = the residual

The Jones model has attracted a large number of studies such as Subramanyam(1996) and Guay et al. (1996) which suggest that the Jones Model is morepowerful than others models (the DeAngelo Model and the Healy Model) sincethey produce discretionary accruals that are consistent with the

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opportunistic accruals and measure performance hypotheses. Moreover, it hasbeen found that using the Jones Model with cross-section provides morecontrol than using it with time series. In addition Dechow et al (1995) findthat the Jones Model is considered the most effective model for detectingearnings management. However, Aljifri (2007) claims that this model ignoresthe manipulation of sales because it assumes that all sales in the periodare nondiscretionary and estimates are stationary and, over time, maygenerate a survivorship bias.

The Modified Jones Model (1995)The shortcomings of the Jones Model (1991) was a focus of Dechow et al. (1995)who presented a more effective model than the Jones Model for detectingearnings management. Dechow et al. (1995) believe that the Jones Model (1995)disregards the potentiality of revenues manipulation, which is consideredas non-discretionary according to the Jones Model. Therefore, the modifiedJones Model takes into consideration property, plant, and equipment and thechange in revenues are adjusted for changes in receivables. In other words,the modified Jones Model regresses aggregate accruals on gross property,plant, and equipment and changes in cash revenues to present coefficientsthat are then employed to measure unmanaged accruals as follows:TAC it /A it = γ0 (1/A it-1) + γ1 ((ΔREV it - ΔREC it)/A it-1) + γ 2 (PPE it /A it-1) +ε itWhere:TAC it = Aggregate accruals.TA it -1 = the book value of total assets of firm i at the end of year t -1,Δ REV it / TA it -1 = sales revenues of firm i in year t less revenues in yeart – 1 scaled by TA it -1,Δ REC it = the change in accounts receivables.PPE it / TA it -1 = gross property, plant and equipment of firm i at the end ofyear t scaled by TA it -1,α β1 β 2 = estimated parameters.ε it =The residual

Numerous studies have investigated the performance of discretionary accrualmodels and suggest that the Jones Model and the modified Jones Model arethe most effective models for detecting earnings management (Habbash,2010). Although the two models were presented as time series, many studiessuch as Subramanyam (1996) and Bartov et al. (2001) who compare these modelsin terms of cross-sectional and time series, document that the Jones andmodified Jones Models are more powerful in cross-sectional than in time-series at detecting earnings management. In other words, the cross-sectional Jones Model controls for year- and industry-specific influence;thus, the cross-sectional model is estimated by year and industry.Moreover, the cross-sectional model is characterized by having largersamples and more observations and does not presume the stationarity of thediscretionary accrual models (Subramanyam 1996; Peasnell et al. 2000b).

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2.8. RELATIONSHIP BETWEEN INTERNAL CORPORATE GOVERNANCE MECHANISMS AND EARNINGS MANAGEMENT.Agency theory anticipates that boards will enhance the integrity of theirfinancial reporting through monitoring management (Peasnell et al, 2005). Interms of audit committee, agency theory assumes that the role of the auditcommittee is to monitor and oversee the integrity of financial reporting.Much emphasis has been placed on the fact that the audit committee’s roleattempts to prevent fraudulent accounting statements (Klein, 2002). Ingeneral, the previous academic literature has reached some significantconclusions about the relationship between earnings management and internalcorporate governance. For example, Shen and Chih (2007) and Cornett et al.(2008) show that companies with beneficial corporate governance tend toalleviate their earnings management issues. Also, Ali Shah et al.(2009)declare a positive relationship between corporate governance and earningsmanagement. Accordingly, this section aims to review the literature thatattempts to determine a relationship between internal corporate governancemechanisms and earnings management.

As mentioned above, agency theory anticipates that boards will enhance theintegrity of their financial reporting by monitoring management. Corporateboards are responsible for monitoring managerial actions, notably thoserelated to performance, financial disclosure, and tasks delegated to sub-committees (Vafeas, 2005). The following section presents an overview ofthe relationship between board characteristics and earnings management.

Board independenceAccording to Agency theory, Zahra and Pearce (1989) suggest that thepresence of outside directors may affect the quality of directors’information and the decisions they make, which may lead to enhancedperformance. Overall, a large number of studies Peasnell et al. (2005);Bedard et al. (2004); Klein (2002); Xie et al. (2003); Benkel, et al. (2006);Niu (2006) and Osma (2008) have documented a negative relationship betweenthe presence of outside directors and earnings management, therebysupporting agency theory. Peasnell et al. (2000a) used information from UKfirms to investigate the relationship between earnings management andcorporate governance. They found that firms with a higher percentage ofnon-executives is associated with income-increasing accruals when earningsfall beneath the threshold.

Board size (number of board members)Board size is deemed another pivotal element in board characteristics whichmay influence earnings management practice. According to the Saudi Code ofcorporate governance, the number of board members should be no less thanthree and no more than eleven members. There is disagreement regarding theeffect of board size. For example, Goodstein et al. (1994); Jensen (1993) andYermack (1996) claim that smaller boards, between four to six members, mayhave the ability to make beneficial decisions and monitor CEO’s behaviour.The other view argues that small boards may not be effective in monitoring

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the behaviour of top management (Zahra and Pearce, 1989). However, themajority of prior studies argue that larger boards with varied expertiseare capable of developing the synergetic monitoring of the board tomitigate the incidence of earnings management (Xie et al. 2003; Peasnell etal. 2005). A plausible explanation of this view is that smaller boards areexpected to be dominated by blockholders or executives while larger boardshave a variety of members from different positions. Based on a samplecollected from 282 US firms for the years 1992, 1994 and 1996, andemploying the Jones model (1991), Xie et al. (2003) investigated the effectof board size on earnings management. They found that earnings managementpractices may not occur with firms that have larger boards. Likewise, Yu(2008) suggests that small boards are less likely to be helpful indetecting earnings management. A study conducted by Habbash (2010) who useda sample of 471 UK firms covering the period between 2003 and 2006confirmed that a large board is more likely to constrain earningsmanagement. His findings reinforce the argument of John and Senbet (1998)that an increase in board size increases the board’s monitoring capacity.Opponents of large boards argue that they provide a lack of coordinationand communication between members. For example, based on samples of 97 and1,097 Malaysian firms respectively, Abdul Rahman and Ali (2006) and Kao andChen (2004) examined the effectiveness of board size on the level ofearnings management. Both studies found that there is a positiverelationship between board size and level of earnings management.

Board MeetingsWhile no specific number of meetings is mandated in the literature for goodcorporate governance, members of boards of directors should meet at leastfour times a year in order to endorse the quarterly financial statements.The number of meetings has been employed in prior studies as an indicatorof a board’s diligence, since inactive boards are less likely to monitormanagement effectively. It is argued that directors on boards that meetfrequently are more likely to discharge their duties in line withshareholders’ interests since more time can be devoted to controllingissues such as earnings management, conflicts of interest and monitoringmanagement (Habbash, 2010). A study undertaken by Xie et al. (2003),employing a sample of 282 firm-year observations, highlights that a boardthat meets frequently may have time to look at issues such as earningsmanagement. Their findings conclude that earnings management issignificantly negatively associated with the number of board meetings.Moreover, Vafeas (1999) found a positive relationship between boardmeetings and performance. However, most studies found an insignificantrelationship between board meetings and earnings management. For example,Ebrahim (2007) and Habbash (2010) who used a different sample and periodfound that the number of meetings may not restrict earnings managementpractices. Habbash (2010) justified his finding by stating that frequentmeetings may not always be a characteristic of an active board ofdirectors. It is worth pointing out that the studies conducted toinvestigate board meetings and earnings management have been low-key, thus

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their claims cannot to be generalised. Therefore, further investigation isneeded in order to determine whether this element is effective or not.

CEO DualityUnder agency theory, the chair of the board should be independent, since aCEO with excessive power can easily manipulate earnings management (AbdulRahman and Ali, 2006). Prior studies have documented that firms withduality function may not be able to discharge their operations properly andare expected to be subjected to accounting enforcement actions by the SECfor infringement of GAAP (Abdul Rahman and Ali, 2006). Klein (2002) using asample of 687 U.S firms and the Jones model (1991) found that the aggregateof discretionary accruals is positively associated with a CEO who holds aposition on the board’s nominating and compensation committee. His findingssuggest that a CEO with too much power over board responsibilities caneasily manage earnings. Furthermore, based on a sample of 27 Turkish banksoperating in the market in the period 2001-2004, Kaymak and Bektas (2008)found that duality and board tenure are negatively associated withperformance. Their findings support the view of agency theory that the boardchair should be independent, since a CEO with excessive power can easilymanipulate earnings management (Abdul Rahman and Ali, 2006). Early post-Enron qualitative research by Cohen, Krishnamoorthy, and Wright (2002)interviewing 36 auditors finds that inconsistent with agency theory, seniormanagement, or “tone at the top”, is the “primary driver of corporategovernance” (p. 573). Subsequent “tone at the top” research by Lamberton,Mihalek and Smith (2006) finds that up to 62% of internal accountantssurveyed feel pressure to alter performance results and this “pressureseems to relate to tone at the top” (p. 38). Subsequently Kalbers (2009)finds a paucity of research into the “tone at the top” factor relative tothe important findings by Cohen et al, and no direct evidence linking thisvariable to earnings management, which is arguably the most importantgovernance outcome for boards, and most certainly for capital marketinvestors who look for boards to control earnings management and generallyreduce information asymmetries.

Audit Committee IndependenceThe recent financial crises of many companies resulting notably fromaccounting manipulation has raised questions about the role of auditcommittees which are expected to protect investors’ interests and monitoropportunistic managerial behaviour (Ebrahim, 2007). Audit committees mightbe responsible for alleviating the agency problem between the firm and theoutside shareholders by monitoring its financial reporting. In other words,agency theory expects the audit committee to monitor and oversee theintegrity of financial reporting. Thus, much emphasis has been placed onthe fact that the audit committee's role is to prevent Irregular andfraudulent accounting statements (Klein, 2002). Independence of auditcommittee members has been the focus of most previous studies since thepopular theme is that independent audit committee members would providebetter financial reporting and this is generally confirmed by existingempirical studies (Lin et al.2006). Specifically, a study conducted by Klein

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(2002) using a sample of 692 US firms showed a negative association betweenearnings management and the proportion of independent directors on theaudit committee. Moreover, using a sample of 300 US firms for the year1996, Bedard et al. (2004) studied the role of audit committeecharacteristics, namely: expertise, independence and activity, on theextent of earnings management. They employed signed earnings managementwhich includes the level of income-increasing and income decreasingdiscretionary accruals using the modified Jones (1995) cross-sectionalmodel. Their findings reveal that aggressive earnings management isnegatively associated with fully independent audit committees.

2.9 EMPIRICAL CORPORATE SCANDALS AIDED BY CREATIVE ACCOUNTINGThere are uncountable faulty accounting practices adopted by bestperformimg companies across the world. These accounting scandals, orcorporate accounting scandals, are political and business scandals whicharise with the disclosure of misdeeds by trusted executives of large publiccorporations. Such misdeeds typically involve complex methods for misusingor misdirecting funds, overstating revenues, understating expenses,overstating the value of corporate assets or under-reporting the existenceof liabilities, sometimes with the cooperation of officials in othercorporations or affiliates. In public companies, this type of "creativeaccounting" can amount to fraud and investigations are typically launchedby government oversight agencies, such as the Securities and ExchangeCommission (SEC) in the United States, Securities exchange board ofIndia(SEBI) in India, Kenya Exchange Commission, Securities and ExchangeCommission in Nigeria etc. In Bank of Credit and Commerce International(BCCI), this was founded in Karachi, Pakistan in 1972 and registered inLuxembourg, London by Aga Hasan Abedi. It was a major international bankwith 30,000 employees and had operations in 78 countries. It was theseventh largest private bank up to 1991 until it was closed. This companyrecorded the largest scandals in the financial history with $ 20billionmisappropriation and more than $13 billion funds are unaccounted for. Otherallegations include bribery, support of terrorism, money laundering,smuggling, the sale of nuclear technologies etc. Also, Enron Corporationwhich was founded in Houston, Texas in 1985 used to be the world’s leaderin electricity, natural gas, pulp and paper and communications and employed22,000 people. This compny lost its fame in 2001 with its accounting fraud.Now it is quite common for corporate scandals to be called as an Enronscandal. The debts of the company were hidden and profits were inflated bymore than $1 billion. It offered bribes to foreign governments to wincontracts abroad. Another compay WorldCom was the United States‟ secondlargest long distance phone company that was founded in the year 1983 asLDDS. Bernard Ebbers is its CEO and it became LDDS WorldCom in 1995. After19 years of establishments i.e. in 2002 the company’s accounting scandalcame into exposure. The company under-reporting interconnection expenses bycapitalizing on the balance sheet and $3.8 billion cash is overstated ascapital expenses rather than operating expenses. Another financial scandalwas in Tyco International. This company was a global manufacturing company

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founded in 1960. Its operational headquarters is in Princeton, New Jersey.With 118,000 employees it is composed of security services, safetyproducts, fire protection services, flow control, electrical and metalproducts. Allegations: CEO Dennis Kozlowski and former CFO Mark H. Swartzwere accused of the theft of $600 million from the company in 2002. KaneboLimited was a textiles and cosmetics group giant in Japan. It wasoriginally established in 1887. It has 13,580 employees. In 2003 a majoraccounting fraud was revealed which was considered as the largest fraud inJapan. The profits of the company were inflated by $2 billion over a five-year period. Waste Management, Inc was founded 1894 based on theheadquarters in Houston, Texas. It is a waste management and environmentalservices company with 50,000 employees and a network of 413 collectionoperations. The company was found to have inflated its Earnings by $1.7billion by increasing the depreciation time length for their property andequipment in 2002. Parmalat was founded in 1961 in Italy by Calisto Tanzi.It is a multinational Italian dairy and food corporation with more than15,000 employees. This leading company collapsed in 2003 with an accountingscandal of $ 20 billion which is considered as the biggest bankruptcy. Itwas discovered that the company’s total debt was more than doubled on thebalance sheet. Forgery and bankruptcy are some other allegations. AmericanInternational Group (AIG) was founded in 1919 in Shanghai, China byCornelius Vander Starr, it went to public in 1969. It is a major AmericanInsurance Corporation based in New York City with 116,000 employees. Thecompany maintained lucrative payoff agreements, soliciting rigged bids forinsurance contracts and inflated financial position by $2.7 billion in2005. Satyam Computer Services was founded in 1987 in Hyderabad, India byRamalinga Raju to offer information technology services. The company has anetwork in 67 countries with 53,000 employees. Very recently i.e. on 7thJanuary, 2009 the accounting scandal came into exposure. Allegations:Inflated cash and bank balances of more than $1.5 billion (INR 7,000crore), overstated debtors‟ position of $100 million and understatedliability of $250 million was arranged for CEO Raju.

SUMMARY AND CONCLUSIONAs a recap, the aim of this paper is to review the existing literature onthe motivations, techniques and measurement of earnings management and towhat extent internal corporate governance mechanism can affect earningsmanagement practices in financial reporting of companies . Accordingly,this paper has provided a comprehensive review of prior studies that havediscussed earnings management practices and the effects of corporategovernance on financial manipulations in companies. The paper employsagency theory as the main theory for its study because agency theory is thebackground theory for corporate governance. The literature related to theeffectiveness of internal corporate governance on earnings managementconceives that the board of directors is the apex of internal corporategovernance and the main means of decreasing agency problems by aligning theinterests of shareholders with managers’ interests. Additionally, agencytheory predicts that the board of directors and its committees will enhance

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the integrity of their financial reporting through monitoring management.Moreover, internal corporate governance monitoring costs on one hand, andearnings management as residual costs, converge in agency cost. Moralhazard is caused by different factors such as firm size and its complexitywhich lead to difficulty in monitoring which in turn increases agency cost;thus, it plays a role, as a monitoring mechanism, in reducing agency cost.However, literature reviewed shows how various studies confirmed thatinstitutional theory and agency theory are complementary approaches tocorporate governance effectiveness; so, using both as a framework might behelpful in providing a deeper understanding of corporate governance andboard functions in ensuring qualitative Financial Reporting free fromearning management.

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Figure 1 -Variables Used to Measure Corporate Transparency and Data Sources

Corporate reportingFinancial accounting disclosuresLong-term investments: Research and development, capital expendituresSegment disclosures: Product segments, geographic segmentsSubsidiary disclosuresFootnote disclosures

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Governance disclosuresIdentity of major shareholdersRange of shareholdingsIdentity of managersIdentity of board members and affiliationsRemuneration of officers and directorsShares owned by directors and employeesTimeliness of disclosuresFrequency of reporting

Number of specific accounting items disclosed in interim reportsConsolidation in interim reportingReporting of subsequent eventsAccounting policiesConsolidation of subsidiariesUse of general reservesCredibility of disclosuresShare of Big-6 accounting firms in total value audited

Information disseminationPenetration of mediaNumber of newspapers per 1,000 peopleNumber of televisions per 1,000 peopleMedia ownershipPercentage state-owned newspapers of top five daily newspapers in 1999Market share of state-owned newspapers of aggregate market share of topfive daily newspapers in 1999Private information acquisition and communicationDirect reporting of detailed private informationNumber of analysts following firmsIndirect communication of aggregate value-relevant information via trades

aSource: Bushman, Piotroski, and Smith (2001).bSource: Center for International Financial Analysis and Research (1995).cSource: World Development Indicators (2000).dSource: Djankov, McLiesh, Nenova, and Shleifer (2001).eSource: Chang, Khanna, and Palepu (2000).fSource: Beck, Demirguc-Kunt, and Levine (1999).gSource: Bhattacharya and Daouk (2001)

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