Role of discretionary earning management in corporate governance-value and corporate governance-risk relationships

• DOI: https://doi.org/10.1108/CG-11-2019-0347
• Pages: 561-581
• Published date: 27 April 2020
• Date: 27 April 2020
• Author: Affaf Asghar,Seemab Sajjad,Aamer Shahzad,Bolaji Tunde Matemilola
• Subject Matter: Corporate governance,Strategy

Role of discretionary earning management

in corporate governance-value and

corporate governance-risk relationships

Affaf Asghar, Seemab Sajjad, Aamer Shahzad and Bolaji Tunde Matemilola

Abstract

Purpose –Corporate governance (CG) is an ongoing interesting topic getting the attention of market

participant, business regulators and researchers in today’s business environment. The purpose of this

study is to analyzethe moderating role of earnings managementon CG-value and CG-risk relationshipin

the emergingeconomy of Pakistan.

Design/methodology/approach –A panel data analysis is used in thisstudy. A panel data of 71 non-

financial listed companiesof Pakistan for the 2008-2017 period is considered forthis study. Secondary

data is collected from the annual reports of non-financial firms listed on PSX. Seven econometric

equationsare developed to test the research hypothesis.

Findings –The results reveal that CG significantlyenhances the firm value and performance measures.

Moreover, CG mitigates the practices of earning management and eliminates the risk that develops

opportunisticbehavior among managers to commit frauds.

Practical implications –The results of this study suggest that the board of directors (BODs) should

intensify theirgovernance role and ensure that the executivesperform their duties to maximize the wealth

of the shareholders and not engage in any misrepresentation of accounts that may lower the company

position and decrease the firm value. Moreover, the managers should be informed about their

accountability and acknowledged that at the end of the year, they would be audited by an expert’s

auditors for their responsibilities.Concerning regulatory bodies,regulatory authorities should ensure that

there must be at least oneindependent member on the board. The better-governedsystem reduces both

agencyconflicts and enhances firm value.

Originality/value –A number of studieshave already been undertaken by multiple investigatorsto build

connection among CG with firm performance, but there is not even a single study in the literature that

considers CG, firm value, firm Risk and discretionary earning management as a whole in one model to

generalizeits results in the emerging economy of Pakistan. A fundamentalelement of current analyzation

process addresses that thisis the very first graft of study conducted in Pakistan having combination of

four variables together in one revision. There is minimal work that focuses on moderating effects of

earningmanagement on the CG-value and CG-riskrelationships. This study uses twostandard measures

of firm performance (i.e. ROA and Tobin’s Q), one proxy of earning management (DEM) and three

attributes of CG (board size, audit quality and ownership structure). Previously, researchers have not

investigated a modelthat combines variables (CG as independent and Firm performanceand Firm Risk

as dependentalong with DEM as moderator) in a single study.

Keywords Firm performance, Corporate Governance, Tobin’s Q, Discretionary Earning Management,

Return on assets (ROA)

Paper type Research paper

1. Introduction

Corporate governance (CG) is a mechanism that connects every stakeholder by giving

them equal strength to minimize agency conflicts. CG provides a governance control

mechanism to an organization and influences the relationship of not the only the Board of

Directors (BODs) and shareholders but also the employees, suppliers,customers and most

Affaf Asghar and

Seemab Sajjad are both

based at the Department of

Business Administration,

University of the Punjab,

Gujranwala Campus,

Pakistan.

Aamer Shahzad is based at

the Department of

Commerce, University of

the Punjab, Gujranwala

Campus, Pakistan.

Bolaji Tunde Matemilola is

based at the Department of

Accounting and Finance,

Faculty of Economics and

Management, Universiti

Putra Malaysia, Serdang,

Malaysia.

Received 6 June 2019

Revised 24 February 2020

Accepted 24 February 2020

DOI 10.1108/CG-11-2019-0347 VOL. 20 NO. 4 2020, pp. 561-581, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 561

importantly to community and society as a whole. Over the years, concern for CG has been

increasing in emerging economies because of problems such as inefficient control of

management and the issue of reoccurring bankruptcy. These problems have occurred

because of the absence of a sound CG system and corporate rules and regulations in the

corporation (Buallay et al.,2017).

Mechanism of good corporate structure explains that management is doing their best to

appropriately use its available resources. CG mechanism helps companies to reduce the

issue that arises between empowered management and shareholders. The effective use of

CG not only mitigates the information asymmetry for enhancing managerial efficiency but

maximizes the shareholder’s wealth by refraining management to get involved in fraudulent

acts. A majority of practitioners haveconcluded these remarks as market participants in the

capital market assigned a higher value to the firm in the presence of a better-governed

system.

The term CG refers to the set of rules, policies, laws, procedures and instructions and how

the firm’s tasks are managed and controlled. BODs use CG practices to safeguard the

interest of shareholders and stakeholders, to ensure the transparent systemand to maintain

equality and concern for accountability (Reilly et al., 2018). Good CG discourages earning

management practices because it examines, analyzes or monitors financial figures,

ensured by generally accepted accounting principles (GAAP). In the absence of CG

practices, management could influence the reported earnings or manipulate the accounting

information over the interest of the firm by discretionally making investors choose (Patrick

et al.,2015

).

Earnings management is the alteration of firms’ reported economic performanceby insiders

either to mislead stakeholders or to influence promised outcomes (Leuz et al.,2003).

Earning management arises when management uses their estimations in shaping the

financial broadcasting results either to mislead the shareholders and stakeholders or to

manipulate the aspects that can be influenced by accounting numbers (Healy and Wahlen,

1999). Capital markets are the important factors that majorly rely on financial statements or

the credibility of accounting information. The financial problem that happened in the USA

and Europe (e.g. Enron, WorldCom and Parmalat) were attributed to weak CG control in a

specific slot of the 2000s. The practices of earning management proved to be riskier factor

in the financial industry than any other industry because financial institutions such as banks

are responsible for ensuring economic stability. If managers of financial establishments will

not sincerely perform their duties and hide the extremist risky information, then they might

create a bubble that will burst and thus collapse the whole economy. To prevent such

economic adversities, shareholders should plan systemized strategies to control and avoid

the discretionary behaviour of managers. To avoid such opportunisms behaviour of

managers and staff agency theorycontemplates, CG is most probably the best mechanism

in reducing earning managementpractices at workplaces (Mersni and Ben Othman, 2016).

Financial scandals increase the importance of improving quality of financial reporting by

specifically focusing on earning quality because companies with better-earning quality are

ranked high in the capital market.

To avoid losses faced by investors, the “Sarbanes-Oxley Act” was introduced in 2002in the

USA. This reform provides instructions to maintain the strong internal control system and

provide guidance to the board for corporate accountability improvements that are directly

related the reduction of risk of insolvency in the organization. Other regulatoryreforms have

highlighted the role of CG and corporate risk management as seen in the Financial

Reporting Council published in the UK in 2011. This reform underlined numerous

accountabilities that board or management ought to adopt to mitigate risk factor and

enhance working proficiency. CG is quite a new term in Pakistan. In March 2002, the

Security and Exchange Commission of Pakistan recognized the code for all listed

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