The joint effect of internal and external governance on earnings management and firm performance

Abstract

AbstractThis study examines whether shareholders use internal governance mechanisms (i.e., manager compensation, shareholder rights protection at firm level) to substitute for weak external governance (i.e., investor protection mechanisms at country level) in restricting earnings management. We find that the impacts of internal governance on earnings management are stronger in countries with weak external governance. Examining the consequence of earnings management on firm performance, we find that internal governance restricts earnings management more efficiently than external governance. This study extends prior literature by quantifying the impacts of internal and external governance on earnings management and firm performance. Our findings suggest that investors should pay more attention to internal governance than to external governance in controlling for earnings management.