Does board governance improve the quality of accounting earnings?

Abstract

PurposeThe purpose of this paper is to examine the contention that a strengthening of corporate governance mechanisms would result in the improved relevance and reliability of financial statements.Design/methodology/approachUsing pooled ordinary least squares regression, the paper analyse the quality of reported earnings for a sample of firms over the 1998‐2002 time period.FindingsThe findings show negative and statistically significant associations between reported earnings quality and the proportion of CEO incentive pay and firm's growth opportunities. It is also found that earnings quality is positively and significantly related to the existence of an orderly CEO transition process. However, board independence does not seem to be associated with earnings quality.Research limitations/implicationsSince the sample of firms is from the 1998 to 2002 period, consistent with the paper's motivation, the results may not generalize to the more recent time period.Practical implicationsThe results provide support for the argument that the current structure of executive pay does adversely impact the quality of reported earnings and hence provides a rationale for closer scrutiny of executive pay by regulatory bodies. Additionally, the findings suggest that the emphasis on board independence as an effective monitoring device may be misplaced.Originality/valueUnlike prior studies, the paper's hypotheses are derived from an explicit agency theoretic optimization model of managerial decision making. The paper uses the Ball and Shivakumar model for estimating abnormal accruals unlike previous analyses that relied more heavily on the Jones model. The paper also adds to past studies of the relationship between corporate governance and earnings quality and the role of executive compensation.