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MAJ
27,1 Earnings management
and board oversight:
an international comparison
66
Habib Jouber and Hamadi Fakhfakh
Faculty of Economic Sciences and Management,
Received 4 November 2010
Revised 29 April 2011 University of Sfax, Sfax, Tunisia
Accepted 19 May 2011
Abstract
Purpose This paper attempts to investigate the relationships between the board of directors
characteristics and earnings management being a proxy of earnings quality in two separate countries,
France and Canada. Specifically, it aims to investigate how certain contextual features affect
differently earnings management behavior, and to reveal which factors are the most prominent
incentives of management discretion in both cases.
Design/methodology/approach The paper uses a performance matched discretionary accruals
(PMDA) measure as a proxy for earnings management. Three separate panel-regressions are then
performed on a full sample, comprising a French sub-sample and a Canadian sub-sample, to detect
board characteristics and institutional features impacts on the PMDA. Regressions are based on a
panel of 180 French and Canadian listed firms data over the period 2006-2008.
Findings Evidence shows that CEO stock ownership, independent monitoring and institutional
investors property are strong earnings management determinants in both the French and Canadian
frameworks. Nevertheless, leadership structure and board size seem to be neutral. Furthermore,
French firms show specific earnings management incentives which are related to high ownership
concentration, low equity widespread and high contractual debt costs. Dominant minority ownership
and capital market forces are the key earnings management incentives in the Canadian context. These
findings are robust to alternative sensitivity tests.
Research limitations/implications Even though the findings answer some questions, earnings
management incentives are still to be decided. Future research could further highlight the impact of
contractual, legal, cultural, ethical and political country-specific factors related to financial reporting.
Originality/value This paper investigates how an effective board of directors is able to provide a
monitoring mechanism to ensure high quality of earnings. Moreover, it builds on cross-country
variations in corporate governance features and contextual-specific factors to reveal earnings
management behaviors incentives in two separate environments, namely French and Canadian ones.
The underlying promise is that poor corporate governance (weak board monitoring), high ownership
concentration, and intensive financial market forces create incentives that largely influence managers
willingness to report earnings that dont reflect a firms true performance.
Keywords Earnings management, Board of directors, Corporate governance, Discretionary accruals,
Canada, France
Paper type Research paper
1. Introduction
Following the significant increase of earnings restatements, earnings manipulation
scandals, and several high-profile bankruptcy filings by firms such as WorldCom,
Managerial Auditing Journal
Vol. 27 No. 1, 2012
pp. 66-86 The authors gratefully acknowledge comments from Wan Ong (Editorial Assistant),
q Emerald Group Publishing Limited
0268-6902
Philomena Leung, Barry J. Cooper and Steven Dellaportas ( Joint Eds) and two anonymous
DOI 10.1108/02686901211186108 referees for helpful comments and suggestions.
Enron, Adelphia and Parmalat, studies on earnings management are becoming the Earnings
subject of many recent researches in financial economics. These accounting cover-ups management
have cast doubt on the reliability and the dependability of data published by companies.
Thus, can we still have trust on earnings quality? This question is increasingly asked by
both investors and regulators who call for more precise ways to control factors that
potentially causes earnings opacity. Among these factors, managerial discretion is
largely pronounced. Managerial discretion appears when some inadequacies infect the 67
agent-principal relationship or if corporate governance implements do not matter. Most
prior studies on earnings quality document that if such managerial behavior emerges,
firms true economic performance is missed. Researches in this direction have focused
on other different causes to care about a reasonable answer for the above question but
small attention has been addressed to corporate governance features. Jensen and
Meckling (1976) argue that poor corporate governance and weak financial controls leave
managers and controlling owners with considerable discretion to manage reported
earnings in order to mask true firms performance and to conceal their private control
benefits from outsiders. If so, further concern should be put into corporate governance
tools to provide evidence on the usefulness of earnings.
The board of directors is the main important tool among the different corporate
governance mechanisms. It remains the potential monitoring mechanism designed to
mitigate the inherent agency problems in the publicly traded firm. Thus, it is useful to
study its impact on the executives discretional behavior. Board oversight efficiency
with regard to such behavior depends largely on factors such as its size, composition,
independence and structure. This paper attempts to investigate the relationship between
these boardroom characteristics and earnings management being a proxy of earnings
quality in two separate countries, France and Canada. Its second aim is, however, to
investigate how specific contextual features affect differently earnings management
behavior, and which factors are the most prominent motives of management discretion
in each case. By focusing on board oversight effectiveness and specific earnings
management motives which prevail in these environments, we hope to contribute to the
extant research on earnings management and to draw firm partners attention to look
upon these motives when taking investment decisions.
The remainder of the paper is organized as follows. Section 2 develops some Canadian-
and French-specific contextual features and searches on their implications for earnings
management behavior. Section 3 provides an overview of the literature and develops the
hypothesis. Sample selection and methodology design appear in Section 4. Empirical
resultants are widely explored in Section 5. Section 6 summarizes and concludes the paper.
Table I.
Sample selection
France Canada Full sample
Industry Two-digit SIC Number Percentage Number Percentage Number Percentage
1. Petrolium 13, 29 13 11 10 8 23 10
2. Consumer durables 25, 30, 37, 50, 55, 57 11 9 11 9 22 9
3. Basic industry 10, 12, 14, 26, 28 07 6 10 8 17 7
4. Paper product 26 13 11 10 8 23 10
5. Construction 15, 16, 17, 32, 52 10 8 15 13 25 10
6. Textiles and trade 22, 23, 31, 51, 56, 59 17 14 14 12 31 13
7. Good stores 54 8 7 9 8 17 7
8. Service 72, 73, 75, 76, 80, 82, 87 19 16 22 18 41 17
9. New economy a 35, 36, 38, 42, 79, 83 13 11 8 7 21 9
10. Other 99 9 7 11 9 20 8
Total 120 100 120 100 240 100
Notes: This table displays the breakdown of observations by industry and by country using the two-digit SIC; aare Firms belong to R&D services,
Programming, Computers or Electronic industries
(www.lesechos.fr). Data on corporate governance attributes have required detailed Earnings
researches on the companies web sites. We have also consulted the official French management
Financial Market Authoritys web site (www.amf-france.org) to exhaust data on
institutional and managerial ownership holdings.
A similar procedure was followed to collect data on the Canadian sub-sample firms.
Accounting and financial data and data on blockholders ownership were collected
from firms proxy statements available from SEDAR database. Moreover, we look into 73
firms web sites to exhaust corporate governance data.
where:
TAit total accruals for firm i in year t;
Ait2 1 total assets for firm i from year t 2 1 to t;
DREVit change in accounts receivable for firm i from year t 2 1 to t;
PPEit gross property plant and equipment for firm i in year t; and
1it error term for firm i in year t.
Formally, the Kothari et al.s (2005) PMDA model is shown below:
TAit 1 PPEit DREVit ROAit21
b1 b2 b3 b4 1it 2
Ait21 Ait21 Ait21 Ait21 Ait21
where:
TAit, Ait2 1 PPEit2 1, and DREVit are as defined above; and
ROAit2 1 Lagged return on asset in year t of the ith firm.
For results analysis, we primarily use the absolute value of PMDA (jPMDAj),
but not PMDA, as a proxy for earnings management. Since earnings management
involves the transfer of earnings from one period to another, the jPMDAj measure
MAJ the total amount of earnings transfer without being sensitive to the precise timing of
27,1 when earnings are increased or decreased.
where i and t denote the firm and the time subscripts. Variable definitions and
hypothesized relations with performance adjusted abnormal accruals are predicted
in Table AI of the Appendix.
MAJ 5. Results and discussion
27,1 5.1 Descriptive statistics
Panels A and B of Table II display descriptive statistics on selected Canadian and
French firms, respectively. The mean (median) PMDA, as a percentage of lagged total
assets, is 7.041 percent (5.05 percent) with the inter-quartile difference ranging from
1.4 percent to 11.91 percent for Canadian firms. The standard deviation is 5.54 percent
76 showing a small variation in jPMDAj. These values do not differ largely from the
average (median) of 5.58 percent (4.46 percent) performance adjusted abnormal accruals
shown by French firms. Canadian sample firms are relatively large with a mean
(median) natural log of total assets of 4.68 (3.84) compared to French sample firms
(Ball et al., 2000)[3]. Moreover, summary statistics show that Canadian boards of
directors are, on average, smaller, and more independent than French directories. Most
firms (59 percent) have CEO/Chair duality. Institutional ownership is presumably
considerable among Canadian sub-sample. Mean proportion of outside independent
directors in the audit committee is consistently higher for Canadian firms than for
French firms. On average, 24 percent of the outstanding common shares are held
Table III.
Pearson correction matrix
Variable 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Panel A: Pearson correlation coefficients for the full sample (720 firm-year observations)
jPMDAj 1 0.05 2 0.28 20.06 2 0.43 0.21 0.12 20.1 2 0.34 0.04 0.16 2 0.11 0.09 0.12
TOTAD 1 0.03 20.01 0.11 20.04 0.1 0.01 0.03 0.01 2 0.03 2 0.03 0.01 0.01
INDEP 1 2 0.01 0.12 20.16 0.03 0.01 0.01 0.01 2 0.05 0.03 2 0.01 0.11
DUAL 1 0.1 0.21 0.01 0.06 20.01 0.01 0.04 2 0.05 0.09 0.07
INST 1 20.09 0.03 0.1 0.11 0.01 0.01 0.22 0.05 0.1
MANOW 1 20.11 0.06 20.01 0.03 0.15 2 0.01 0.13 0.11
LTA 1 0.07 0.02 0.01 2 0.18 0.1 0.1 0.2
PER 1 0.05 0.1 2 0.09 0.07 0.12 0.03
AUDIT 1 0.07 0.01 0.05 0.06 0.11
IND 1 0.1 0.01 0.01 0.01
LEV 1 0.01 0.1 0.11
FOREIG 1 0.13 0.2
OWN 1 0.26
EW 1
Panel B: Pearson correlation coefficients for Canadian (French) sub-sample are represented above (below) the diagonal
jPMDAj 1 20.01 2 0.37 0.01 2 0.14 0.23 0.08 2 0.03 2 0.12 0.2 0.13 2 0.2 0.19 0.07
TOTAD 20.07 1 0.09 0.01 0.03 20.1 0.03 0.01 0.08 0.01 2 0.03 0.02 20.05 0.08
INDEP 20.24 0.05 1 20.03 0.08 20.1 0.05 0.1 0.1 0.03 2 0.12 0.01 2 0.1 0.06
DUAL 20.01 20.07 20.05 1 20.03 0.26 0.05 0.13 20.03 0.06 0.09 0.01 0.21 0.09
INST 2 0.17 0.01 0.14 20.03 1 20.15 0.07 0.1 0.09 0.01 2 0.11 0.04 20.2 0.17
MANOW 0.11 2 0.09 2 0.1 0.31 20.06 1 0.01 0.11 0.01 0.07 0.04 0.01 0.16 0.21
LTA 0.05 0.01 0.01 0.03 0.05 0.01 1 0.05 0.01 0.01 0.13 0.01 2 0.11 0.06
PER 2 0.05 0.86 0.05 0.12 0.21 0.09 0.01 1 0.03 0.01 0.05 0.05 0.03 0.1
AUDIT 20.03 0.01 0.01 20.01 0.05 20.02 0.07 0.05 1 0.01 0.01 0.14 0.07 0.07
IND 0.01 0.01 0.03 0.01 0.02 0.01 0.01 0.01 0.01 1 2 0.03 0.01 0.01 0.01
LEV 0.26 20.03 20.05 0.07 20.09 0.1 20.01 0.13 0.01 0.05 1 0.01 0.03 20.1
FOREIG 20.1 0.02 0.01 20.01 0.06 0.02 0.01 0.05 0.03 0.01 0.01 1 0.1 0.09
OWN 0.1 20.1 2 0.11 0.27 20.13 0.02 0.17 0.05 0.05 0.01 2 0.31 0.03 1 2 0.3
EW 0.11 0.1 0.04 20.09 0.2 0.03 20.03 0.04 0.05 0.01 2 0.33 0.07 0.11 1
Notes: 1 jPMDAj; 2 TOTAD; 3 INDEP; 4 DUAL; 5 INST; 6 MANOW; 7 LTA; 8 PER; 9 AUDIT; 10 IND; 11 LEV; 12 FOREIG;
13 OWN; 14 EW; variable descriptions and measurement are provided in Table AI of the Appendix ; italic numbers indicate significance at the
1 percent one-tailed level
Earnings
Dependent variable: jPMDAj
Independent variables Expected sign (1) (2) (3) management
Intercept NA 0.0211 * * 0.021 0.0406 * * * 0.000 0.0221 * * * 0.000
TOTAD 2 0.0153 0.161 0.0322 0.201 0.073 0.113
INDEP 2 2 0.0911 * * * 0.000 20.0659 * * 0.011 2 0.0833 * * * 0.007
DUAL 2 0.0098 0.151 20.004 0.11 0.0014 0.112 79
INST 2 2 0.0117 * * 0.037 20.266 * * 0.017 2 0.181 * * * 0.000
MANOW 0.3012 * * * 0.000 0.3346 * * * 0.000 0.396 0.14
LTA ^ 0.0411 * * 0.034 0.0721 * * 0.048 0.0581 * * 0.024
PER 2 2 0.0341 * * 0.047 0.0652 * * 0.041 0.0855 * * 0.042
AUDIT 2 2 0.021 * * * 0.004 20.014 * * 0.041 2 0.033 * * * 0.001
IND 0.0924 * 0.047 0.0713 * 0.066 0.0573 * * 0.043
LEV 0.1142 * * 0.0484 0.1529 * * * 0.000 2 0.0914 0.11
FOREIG 2 2 0.014 * * 0.037 20.007 * 0.077 2 0.021 * * * 0.003
OWN 0.0911 * * 0.038 0.1709 * * * 0.000 0.1246 0.109
EW 0.2009 * * 0.0255 0.1214 * 0.069 0.3591 * * * 0.000
Number of firm-year
observations 720 360 360
Adjusted R 2 (%) 14.53 17.57 21.11
x2 4.39 5.73 7.23
p-value 0.000 0.000 0.000
(1) Model (3) applied to the full sample
(2) Model (3) applied to the French sub-sample
(3) Model (3) applied to the Canadian sub-sample
Year dummies Yes Yes Yes
Firm-fixed effects Yes No No Table IV.
Regression analysis of
Notes: *p , 0.01, * *p , 0.05, and * * *p , 0.1 indicate significance at the 1, 5, and 10 percent the relationship between
two-tailed levels, respectively; the dependent variable is the Kothari et al.s (2005) PMDA; independent earnings management
variables are as defined in Table AI of the Appendix and board structure
ownership is positive and significant at better than the 1 percent level. Using a coefficient
estimate of 0.3012, an increase of one sample standard deviation in the manager stock
holdings raise the typical absolute value of PMDA by about 3.21 percent point. This
result is largely consistent with past researches concluding that manager ownership has
a tremendous impact on earnings management (Klein, 2002; Cornett et al., 2007). Firm
size as measured by the natural log of total assets has a positive effect on earnings
management which corroborate the positive accounting theorys claim that large firms
face greater scrutiny from investors, and thus more likely to manage earning to satisfy
their forecasts. The coefficients of the audit quality variable are negative and significant
at better than 5 percent level supporting the view that audit committee independence
have a substantial influence to reduce management discretion. Cross-country stock
exchange listings effect is also as expected. Companies listed in the US stock market are
less likely to make accruals management policies. The remaining estimated coefficients
show largely the predicted signs and are highly significant.
Models (2) and (3) exhibit similar findings, except for coefficient on board size which
changes to be positive, as expected, but remains insignificant. However, results are not
behind stable when we consider control variable interaction terms. We note that firm
characteristics and market forces effects on earnings management differ dramatically when
MAJ considering Canadian and French cases separately. Per-country analyses find prominent
27,1 evidences. On the one hand, financial leverage estimated coefficient is positive and highly
significant for French firms. On the other hand, debt-to-equity ratio shows no significant
association with earnings management for Canadian firms. More surprisingly, it has
unexpected sign. One logic explanation for this evidence is that it is consistent with the debt
covenant hypothesis expected, and so often sustained by Johnson et al. (2002); closeness to
80 debt covenant violations should be positively associated with earnings management.
Hence, according to this hypothesis, the closer a firm is to violation of accounting-based
debt covenants, the more likely the firm manager is to adopt accounting policies to raise
current earnings. This hypothesis is empirically held by several other studies focusing on
insider economy contexts (Klein, 2002; Meek et al., 2007)[6]. Moreover, model (2) reports that
ownership concentration influences significantly french managers discretional behavior.
In contrast, ownership concentration is found to have no major effect on earnings
management behavior for Canadian firms. The associated estimated coefficient is not
significant in model (3) but, it has the predicted sign. Our findings are presumably true for
the following decisive reason; contrary to the institutional French framework, the financing
pattern of Canadian firms is dominated by equity. Shareholders are the main partners of the
firm and there is obvious separation of owners and managers. Diffuse ownership structure
is associated with a dynamic and highly efficient capital market. Canadian managers are
more constrained by shareholders, financial regulators, and financial press control to
publish earnings statements that report true economic performance. In such context,
financial reporting is based on a conceptual framework that has the priority of satisfying
shareholders needs for high-quality accounting information (Ben Othmen and Zeghal,
2006). Hence, we support our prediction that Canadian firms, with large minority
shareholders are less likely to manage earnings than their counterpart French firms.
Furthermore, coefficients on equity widespread approve these findings. Natural log of
annual market capitalization displays a highly significant and negative coefficient in
model (3). Firms characterized by a dominant minority ownership are less likely than
owner-controlled firms to manage earnings. Our finding may counter prior studies showing
that managers rise earnings prior to equity offerings (Teoh et al., 1998a) or when the firm is
first introduced to the stock market (Chtoutrou et al., 2001; Ben Othmen and Zeghal, 2006).
As a robustness test of the ability of debt and market forces to predict earnings
management, we add three interactive variables as supplementary surrogates to detect
earnings management. We include LEV-country, OWN-country and EW-country to
control for differences in contextual factor. LEV-country, OWN-country, and EW-country
are, respectively, leverage, ownership structure, and equity widespread countrys
characteristics, where country is a dummy variable that takes the value of one if the
firm-year observation is French, zero otherwise. Results (not reported) are similar to these
explored above. Also, a notable observation comes from Table IV; when considering
separately Canadian and French firms, estimated coefficients on performance measure are
somewhat surprising. Regressions results show that firms ROE, contrary to our
expectations, have a significant positive effect on earnings management for both
sub-samples. To provide more evidence on the incremental growth in the value of PMDA
where controlling for firm performance, we separate each sub sample in two groups of
firms; high-profit firms, that is, firms with ROE above the 75th sample quartile, and all
other firms, which we call low-profit firms. Afterwards, we run separate OLS regressions
for high- and low-profit firms. Columns 2-5 of Table V display check regression results Earnings
separately for both specifications.
Results from columns 3 and 5 of this table show that performance adjusted abnormal
management
accruals are strongly positively correlated for the subsample of firms that have
consistently low profit. These finding corroborate the income smoothing hypothesis.
Burgstahler et al. (2006) found evidence that management of under-performed firms may
manage earnings slightly to project a smooth earnings path. Thus, they meet or beat 81
analysts forecast and/or avoid scrutiny from media and investors. Income smoothing
hypothesis is supported even if we include high and low profits as additional control
variables into the basic model.
6. Conclusion
Firms partners (e.g. investors, analysts, media, auditors) are more interested in earnings
management because it makes earnings less reliable. Less reliable earnings are harmful
for both firm and stock market reputation and can results on a potential misallocation of
resources. Recent accounting research identifies a number of earnings management
determinants. The more attention has been addressed to corporate governance
attributes such as audit type, existence and composition of committees, CEOs age
and tenure, among others. These attributes were taken separately (Klein, 2002; Uzun
et al., 2004; Cornett et al., 2007) or broadly in the shape of corporate governance scores
referred to as Gov-score (Gompers et al., 2003; Brown and Caylor, 2006; Jiang et al., 2008).
Academic research has found a close association between poor corporate monitoring
and greater earnings management. However, the majority of investigations focus on
Notes
1. Fiscal year is the year covering the final month of the fiscal year chosen by the corporation.
Thus, a fiscal year from September 2005 to October 2006, for example, is considered as an
observation for 2006.
2. Adjusting for performance is important as documented by prior research. We adjust here for
performance to control for possible effects of performance volatility do to the 2007-2008
market meltdowns.
3. Not surprisingly, French firms are considerably more leveraged, with higher concentrated
ownership structure and limited equity widespread than there counterpart Canadian firms.
France belongs to the Euro-Continental accounting model where indirect finance prevails.
Within a stakeholders corporate governance model; Ball et al., notice the prominence of banks,
governments, and families as the main capital providers. In contrast, Canada prevails in the
Anglo-American accounting model, where stockholders are the principal patterns of the firm.
Equity is diffused among the public, and the capital market plays the most important role in
providing finance.
4. In order to address this potential problem separate tests, we perform without board size
variable. Results (not reported) were robust to this specification.
5. This value is close to the 1.2 percent decrease showed by Cornett et al., 2007.
6. France, along with continental European countries is an insider economy where indirect
finance is prevalent. In such environment; bank loans heavily encourage an upward
earnings management in order to avoid the violation of debt covenants. Further,
executives of leveraged firms generally opt to the continuous support of their lenders in
order to avoid an increase in capital cost. Therefore, they manage earnings upwards
to safe guard the trust of bankers or other lenders and hence continue to contract at
favorable conditions.
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Corresponding author
Habib Jouber can be contacted at: jouberhabib@yahoo.fr