Linking earnings management practices and corporate governance system with the firms’ financial performance. A study of Indian commercial banks

Author:Prity Kumari, Jamini Kanta Pattanayak
Position:Department of Management Studies, Indian School of Mines, Dhanbad, India
Pages:223-241
SUMMARY

Purpose In the shadow of global financial crisis, practice of earnings management can be hazardous for the growth and development of an economy, especially for a developing economy like India. This empirical study is performed to analyse the presence of earnings management practices in Indian public and private commercial banking industry. This study also aims at developing a framework... (see full summary)

 
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Linking earnings management
practices and corporate
governance system with the
rms’ nancial performance
A study of Indian commercial banks
Prity Kumari and Jamini Kanta Pattanayak
Department of Management Studies, Indian School of Mines, Dhanbad, India
Abstract
Purpose In the shadow of global nancial crisis, practice of earnings management can be hazardous for
the growth and development of an economy, especially for a developing economy like India. This empirical
study is performed to analyse the presence of earnings management practices in Indian public and private
commercial banking industry. This study also aims at developing a framework for the three-way relationship
existing between the variables of corporate governance, earnings management practices and rm
performance.
Design/methodology/approach Data have been collected for a period of 11 nancial years (2003-2013)
from Prowess (Centre for Monitoring Indian Economy) 4.14 database. A bank-based accrual model has been
used for calculating earnings management practices. OLS regression has been used for analysing degree of
interdependence among variables of corporate governance, earnings management practices and nancial
performance.
Findings The analysis supports the fact that there is the existence of income increasing earnings
management practices in Indian commercial banks. It is also observed that corporate government practices
(viz. board characteristics, audit practices and performance-based remuneration) basically work as restricting
variables for earnings management practices. It is evident from the analysis that market-based rm
performance variables (viz. PE ratio, yield and prot after tax) are signicantly related to earnings
management and corporate governance system.
Practical implications The nding of this study will help in monitoring and controlling fraudulent
earnings management practices existing in Indian commercial banks.
Originality/value Thisstudy is the initial research about the presence of earnings management practices
in Indian commercial banks.
Keywords Earnings management, Performance indicators, Corporate governance,
Discretionary accruals
Paper type Research paper
1. Introduction
In the present global economy, there is growing concern about the relevance of nancial
reports produced by business entities. The basic purpose of any nancial report is to provide
an insight for the different stakeholders and potential investors about the nancial
performance of the business and to also provide an opportunity to assess its nancial health
for meeting future business requirements. The main concern is about the presence of
earnings management practices in nancial reporting processes that produce manipulated
JEL classication – M41, G21
The current issue and full text archive of this journal is available on Emerald Insight at:
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Indian
commercial
banks
223
Journalof Financial Crime
Vol.24 No. 2, 2017
pp.223-241
©Emerald Publishing Limited
1359-0790
DOI 10.1108/JFC-03-2016-0020
and misleading nancial reports to inuence investor and stakeholder decisions. According
to Schipper (1989), earnings management is the purposeful intervention in the external
nancial reporting process with the intent of obtaining some private gains by the managers.
Healy and Wahlen (1999) stated that earnings management occurs when:
[…] managers use judgement in nancial reporting and in structuring transactions to alter nancial
reports to either mislead some stakeholders about the underlying economic performance of the
company or to inuence contractual outcomes that depends on reported accounting numbers.
The process of earnings management practice can be construed as planning and controlling
the nancial reporting system to meet the management objective of misleading investors,
meeting analysts’ expectations, maintaining the economic growth projector or arriving at the
predetermined target income for their incentive pay (Leuz et al., 2003).
The recent focus on the topic of earnings management is a direct outcome of the sudden
collapse of large business entities over the past few years, including Enron (USA), WorldCom
(USA), Bank of Credit and Commerce International (UK) and Subprime Mortgage (USA).
Researchers and various statutory governing bodies in their studies found that weak
corporate governance systems and the presence of earnings management practices are initial
factors that lead to a weakening of the nancial health of rms and ultimately results in their
collapse. It has been identied that managers use discretion usually permitted by the
prevailing accounting standards and laws when using alternative accounting practices.
Available discretionary measures assist managers in manipulating nancial reports and in
their ability to produce the desired accounting numbers for investors and stakeholders by
hiding the actual facts. As constructive measures, various accounting reforms and
constructive governance structures have been introduced to improve the governance
environment and promote fair business practices, including the Organisation for
Co-operation and Development Principles OECD (1999), the Stock Exchange Listing
Standards, Sarbanes –Oxley Act (2000) and the International Financial Reporting Standards
rules. Researchers found that corporate governance, used as a measure to control earnings
management practices, improves the business environment and enhances the nancial
reporting quality. It has been appropriately noted that “good corporate governance simply
means good business” (OEDC, 1999). Corporate governance provides a structure for
directing and controlling the business with a higher level of efciency, transparency,
accountability and fairness. In addition, corporate governance practices include the
decision-making and controlling processes for a business. It provides an understanding of
the managerial structure of business rms, resource utilisation and various other issues,
including company law and business ethics (Adams et al., 2009). The various attributes of
corporate governance structure, including a board of directors, an audit committee,
independent directors, various other administrative committees within a board, owners
participation and director remuneration, are factors inuencing the rms’ decision-making
process and thus play an important role in controlling managers discretionary power,
earnings management practices and nancial reporting process (Davidson et al., 2005; Mitra
et al., 2005; Buniamin et al., 2012).
There is extensive literature available on earnings management practices by rms. A
large amount of research has been focused on developing measures and models to
calculate the amount of earnings management practices (Jones, 1991; Dechow et al., 1995;
Burgstahler and Dichev, 1997;Kothari et al., 2005). A good amount of literature available
concentrates on identifying control measures for restricting earnings management
practices focused on corporate governance as a primary control measure (Baetov et al.,
2000; Bedard, 2001; Ayers et al., 2006;Sarkar et al., 2008; Miyamoto and Higuchi, 2007;
Dechow et al., 2012). We also nd a number of research studies that focus on
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