Corporate Governance and Investor Protection: Earnings Management in the U.K. and U.S.

Abstract

This study extends the work of Leuz et al. (2003) by examining the incidence of earnings management in countries where the level of investor protection provided by the legal environment is high. We question whether Leuz et al.'s (2003) country clusters are overly broad in seeking to effectively explain the relation between countries' legal environments and earnings management. Hofstede (2001) notes that, while the U.K. and U.S. are similar in numerous respects, various cultural and organizational differences exist. Accounting research identifies a number of differences in corporate governance between the two countries that could influence earnings management. We examine samples of U.K. and U.S. firms that were taken private in a management buyout (MBO) so as to focus on situations epitomizing the conflict between corporate insiders and outside shareholders. Overall, our results indicate that managers in both the U.K. and U.S. manage earnings downward prior to an MBO, with U.S. managers being significantly more aggressive than U.K. managers. These results may be interpreted as indicating that Leuz et al.'s (2003) country cluster groupings are too broad to adequately explain the relation between countries' legal environments and the extent to which managers engage in earnings management.