Internal Corporate Governance and Classification Shifting Practices

Abstract

The corporate governance literature shows that strong internal corporate governance improves the monitoring of managerial discretion over accounting choices. However, most of these studies investigated the role of internal governance in a setting highly regulated through accounting standards, such as the treatment of accruals. Thus, there is little evidence available on whether internal governance collaborates or substitutes for strict accounting regulations. This study therefore investigates whether boards and audit committees also protect shareholders’ interests in areas that are less regulated through generally accepted accounting principles (GAAP). Non-recurring items are relatively lightly regulated under International Accounting Standard 1 (IAS 1) and there is increasing concern over the use of non-recurring items to mislead investors (i.e., classifying some recurring expenses as non-recurring). This study therefore investigates whether internal corporate governance constrains classification shifting. Using a sample of 713 U.K. firm-year observations, we find that high-quality internal governance, in terms of the overall quality of board and audit committees, mitigates classification shifting, suggesting therefore that strong internal governance tends to act as a substitute for strict accounting standards. In particular, it appears that long tenure and independence help to mitigate classification shifting, and more CEO directors and share ownership instead may lead to lower quality monitoring.