Does Regulation Substitute or Complement Corporate Governance? Evidence from Earnings Management of U.S. Firms

Abstract

This study investigates the empirical question of joint substitutability and complementarity of mechanisms within governance bundles, the corporate governance and industry regulation, on earnings management. This study finds that managers’ earnings management are more responsive to high quality governance bundles and effect of corporate governance is modified in relatively highly regulated industries on earnings management practices. Governance bundles with relatively high quality mechanisms have lower rate of substitutability and complementarity on earnings management practices compared to bundles of relatively highly regulated with low quality corporate governance structure. These evidence support heterogeneous effect of governance bundles on earnings management policies, imperfect substitutability and complementarity, as well as diminishing marginal rate of substitution between mechanisms within governance bundles in relation to earnings management policies. The imperfect substitutability and complementarity of governance bundles’ mechanisms in relation to earnings management explains interaction of the mechanisms within these bundles and their modifying effect on earnings management and it contributes to understanding of theory of “Bundle of Governance Mechanisms” by Ward et al. (2009). The evidence obtained by this study shows that mechanisms within governance bundles should be developed and applied simultaneously, and the external stakeholders’ impact on practices like earnings management internal to the firms can be greater than expected through external mechanisms’ substitute and complementarity effects for the internal mechanisms.