The impact of corporate governance mechanisms on real and accrual earnings management practices: evidence from Jordan

• DOI: https://doi.org/10.1108/CG-05-2018-0183
• Pages: 1167-1186
• Date: 09 July 2019
• Published date: 09 July 2019
• Author: Lara Al-Haddad,Mark Whittington

The impact of corporate governance

mechanisms on real and accrual

earnings management practices:

evidence from Jordan

Lara Al-Haddad and Mark Whittington

Abstract

Purpose –This paper aims to investigatethe impact of corporate governance (CG) mechanisms on real

(REM), accrual-based earnings management (AEM) and REM/AEM interaction in Jordan following the

2009 JordanianCG Code (JCGC).

Design/methodology/approach –The study used a sample of 108 Jordanian public firms covering

2010-2014.Hypotheses are tested using pooledOLS-regression models.

Findings –The authors find that bothinstitutional and managerial ownership constrainthe use of REM

and AEM. In contrast, bothindependent directors and large shareholdersare found to exaggerate such

practices, and CEO-duality is found to exaggerate REM only. However, foreign ownership does not

appear to have a significantimpact. They further find that managers use REM and AEM jointlyto obtain

the greatestearnings impact.

Practical implications –The findings have important implications for policymakers, regulators, audit

professionals and investors in their attempts to constrain earnings management (EM) practices and

improvefinancial reporting quality in Jordan.

Originality/value –The authors believe this to be the first Jordanian study examining the relationship

betweenCG mechanisms and both REM and AEM following the introductionof the 2009 JCGC, as well as

the first in Jordan andthe Middle East to examine board characteristicsand REM. Moreover, it is the first

to test for the potential substitution of REM and AEM since the 2009 JCGC enactment. As such, the

findingsdraw attention to EM practices and therole of monitoring mechanisms in Jordan.

Keywords Ownership structure, Jordan, Corporate governance, Real earnings management,

Board characteristics, Accrual earnings management

Paper type Research paper

1. Introduction

Earnings is a critical reported number, and managers understand this to be a key metric for

outsiders to assess not only the company’s and the Chief Executive Officer’s (CEO’s)

performance (Graham et al.,2005), but also executive compensation and future prospects

of the firm (Xu et al.,2007). Thus, there are strong incentives to bias financial reports by

manipulating the reported earnings to attain desired benchmarks. As such, earnings

manipulation, even when not violating general accounting standards, may lead to

inappropriate information about the firm (Rahman and Ali, 2006). Such EM has detrimental

effects on the quality of financial reporting and may be reduced by applying good CG

mechanisms (Uadiale, 2012) to improve the integrity of financial reports and act as a

deterrent to manipulation. We focus on the monitoring and disciplining role of two critical

Lara Al-Haddad is based at

the Yarmouk University,

Irbid, Jordan. Mark

Whittington is based at

Business School, University

of Aberdeen, Aberdeen,

UK.

Received 22 May 2018

Revised 12 May 2019

Accepted 13 May 2019

DOI 10.1108/CG-05-2018-0183 VOL. 19 NO. 6 2019, pp. 1167-1186, ©Emerald Publishing Limited, ISSN 1472-0701 jCORPORATE GOVERNANCE jPAGE 1167

internal mechanisms, specifically, the board of directors and ownership structure (Jensen

and Meckling, 1976;Fama and Jensen, 1983;Gonzalez and Garcia-Meca, 2014).

Studies based on US and UK data show good CG can minimize earnings manipulation

(Klein, 2002, and Peasnell et al., 2005). Here we investigate whether US and UK findings

hold for Jordanian firms, extending research by investigating whether CG can assist in

mitigating real earnings management (REM) and accrual-based earnings management

(AEM) and impact substitution between REM and AEM. Differences in findings are to be

expected as Jordan is a Middle East and North African(MENA) country where ownership is

highly concentrated and investorprotection is considered weak (World Bank, 2016).

CG reforms in Jordan are part of the country’s economic reforms. The cornerstone of these

reforms is the 2009 JCGC for companies listed on the Amman Stock Exchange (ASE)

(2002).Thiscodeaimsto:

䊏establisha clear framework regulatingthe relationships and managementof ASE listees;

䊏to define rights, duties and responsibilities; and

䊏to safeguard rights of all stakeholders (JCGC, 2009).

However, as the code is not legally binding, managers may still be tempted to manipulate

earnings.

Consistent with prior studies in EM (Roychowdhury, 2006;Cohen et al.,2008;Cohen and

Zarowin, 2010;Kuo et al., 2014;Alhadab et al., 2015, among others) we compute REM

statistics by using the residuals from the Roychowdhury model (2006) and AEM ones by

using residuals from the Kothari et al. (2005) model. In summary we have four key findings.

First, board independence is significantly and positively related to REM and AEMin Jordan.

Second, consistent with the ‘‘Convergence of Interests’ Hypothesis’’, institutional ownership

appears to constrain both REM and AEM; managerial ownership also appears to limit

manipulation. Third, in line with the “Expropriation-of-the-Minority Shareholders Hypothesis",

the presence of large shareholders appears to raise the incidence of both REM and AEM.

Finally, Jordanian firms are found to followan overall EM strategy, using both REM and AEM

to obtain the desired earnings impact.

Our results contribute to the existing literature in EM and CG in five ways. First, this study is

the first to investigate the impact of CG mechanisms on constraining REM and AEM after the

introductionof JCGC in 2009. PreviousEM research has largely been focused on developed

countries and developing countries, which the OECD estimates will generate 60 per cent of

world GDP by 2030 (OECD Development Centre, 2010), have been under researched.

Second, previousresearch on CG and EM has focused primarily on AEM (Klein,2002;Chen

and Zhang, 2014;Gonzalez and Garcia-Meca, 2014, among others) rather than REM. Third,

the study examines the impact of foreign share ownership on EM. Fourth, this is the first

study that classifies Jordanian listed companies according to their one-digit SIC code in

order to estimate the normal levels of REM and AEM based on an industry-year basis as in

the original models (Kothari et al.,2005and Roychowdhury, 2006). Fifth, the findings of this

study are useful for policyand regulators who seek to devise CG mechanisms.

The remainder of this paper is structured as follows: Section 2 reviews the previous light of the

previous literature; Section 3 describes our research design; Section 4 presents the empirical

results; robustness checks are presented in Section 5 and conclusions are presented in Section 6.

2. Literature review and hypotheses development

2.1 Earnings management and corporate governance

EM can be classified into two categories: AEM and REM (Roychowdhury, 2006;Lo, 2008;

Cohen et al., 2008;Cohen and Zarowin, 2010;Kuo et al., 2014;Alhadab et al., 2015).

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