The Association between Corporate Governance and Earnings Surprises Games

Abstract

In this paper, I investigate (1) the extent to which corporate governance is associated with managers’ choice of the mix of earnings management and expectations management to avoid negative earnings surprises, and (2) whether the association has changed following the passage of the Sarbanes-Oxley Act (SOX) 2002. Three distinct earnings management tools are considered: real earnings management, accruals management, and classification shifting. I document that higher quality corporate governance is associated with less upward accruals management and classification shifting, but also increases both the likelihood and magnitude of downward expectations management. With respect to real earnings management, the results are less conclusive. While board independence is positively associated with temporarily boosting sales, it is negatively associated with cutting discretionary expenses such as R&D. I also find some evidence that the impact of corporate governance quality on managers’ choice of the four mechanisms to meet or beat analysts’ forecasts has changed in the post-SOX period.