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1、Internal governance structures and earningsmanagement RyanDavidson ,JennyGoodwin-Stewart ,PamelaKentAbstractThis paper investigates the role of a firms internal governance structures constraint in earnings management. It is hypothesized that the practice of earnings management is systematically rela
2、ted to the strength of internal corporate governance mechanisms,including the board of directors ,the audit committee,the internal audit function andthe choice of external auditor. Based on a broad cross-sectional sample of 434 listed Australian firms,for the financial year ending in 200,a majority
3、of non-executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management,as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of audit ar
4、e not significantly related to a reduction in the level of discretionary accruals. Our additional analysis,using small increases in earnings as a measure of earnings management,also found a negative association between this measure and the existence of an audit committee. Key words:Audit Committee;C
5、orporate Governance;Earnings Management;Internal audit function1 IntroductionRecent cases of inappropriate accounting practices,both in Australia and overseas,have focused attention on the need for strong corporate governance mechanisms. Strong governance involves balancing corporate performance wit
6、h an appropriate level monitoring(Cadbury,1997). In the present paper,we explore the relationship between governance mechanisms and earnings management by firms in Australia and,hence,our focus is on the monitoring role of governance. The mechanisms we examine are an independent board of directors(S
7、hleiferandVishny,1997),an independent board chair person,an effective audit committee(MenonandWilliams,1994),the use of internal audit(Clikeman,2003)and the choice of external auditor(Becker etal.,1998;Francis etal.,1999). Prior research has investigated the role of governance mechanisms reducing fr
8、audulent financial reporting(Beasley,1996;Dechowetal.,1996;Jiambalvo,1996).These studies have established a negative relationship between effective governance mechanisms and financial reporting decisions that are in breach of Generally Accepted Accounting Principles(GAAP). However,a relatively new a
9、rea of research is the association between corporate governance and earnings management. Peasnell et al(2000) document that earnings management is negatively associated with the independence of the board of directors,while other studies find significant relationships between audit committee characte
10、ristics and earningsmanagement(Chtourouetal.,2001;Xieetal.,2001;Klein,2002a). The examination of the association between internal governance structures and the practice of earnings management in Australian firms is motivated by several factors. With The Exception of Peasnell et al.(2000),which uses
11、data,existing research is predominantly US based. Therefore,we explore whether the internal governance-earnings management relationship holds in an institutional environmen where corporate governance is less regulated and choice of governance mechanisms is voluntary(VonNessen,2003). In Australia,at
12、the time of the present study(2000),listed companies were not required to have an audit committee or an internal audit function. Furthermore,corporate regulators favour principles-based approach to governance rather than a rules-based approach(ASX,2003). Although a similar approach exists in the UK,
13、Peasnelletal.(2000)examine only the relationships between earnings management and the proportion of outside directors on the board and the existence of an audit committee. We extend this research by exploring the effect of additional audit committee variables such as size and frequency of meetings a
14、s well as the independence of members. We also extend board independence to examine whether the separation of the chief executive and board chair roles is associated with earnings management. A further contribution is the inclusion of internal audit as a governance mechanism that is likely to be ass
15、ociated with a reduction in the level of earnings management. While there has been increasing emphasis on the role played in governance by internal audit,no prior earnings management studies have included this variable. Australia is an ideal setting to examine this issue as evidence suggests that ma
16、ny listed companies in Australia do not have an internal audit function. Goodwin and Kent(2003)report that the use of internal audit is associated with the size of the company and its commitment to strong corporate governance and risk management.Our principal tests,using absolute discretionary accruals to measure earnings management,suggest that a lower level of earnings management is associated with the presence of non-executive directors on the board. We also find a negative
