Earnings Management and Corporate Governance: A brief overview Edit

Article by : Prof. Paromita Dutta, Assistant Professor, CBS

Corporate governance is defined as the relationship among the corporation and all of its stakeholders. It is defined as a set of mechanisms through which outside investors protect themselves against expropriation by the insiders. Corporate governance initially appeared to minimize conflict of interest between management and shareholders given the separation between ownership and control but, duality takes place when the chairman of the board and CEO roles are combined.

On the other hand, Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

Firms often resort to earnings management practices with a variety of motives.  Several factors may motivate firms to manage their earnings but ‘market reaction’ has remained as one of the most important factors. If reported earnings of a firm are markedly less than the estimated earnings, it may adversely impact its share prices, and if this trend continues, it may give rise to questions in the market about the earnings stability of the firm. Hence, managers are often motivated to use earnings management to smooth out fluctuations in earnings performance. Receiving increased amount of bonus, fear of government investigation and intervention may also motivate managers toward earnings manipulation.

Earnings management can have significant impact on all stakeholders of a firm including the economy and society at large. This raises the question as to what can protect the interest of the stakeholders with regard to earnings management, and here emerges the role of Corporate Governance system in place.  An effective corporate governance system ensures that managers of a firm work at the best interest of the shareholders, and report true financial position of the firm. Several studies in United Kingdom and United States show that, company boards influence earnings management and the quality of financial statements.

Worldwide, many reforms have been initiated to strengthen corporate governance practices to restore investors’ confidence on financial reporting practices of publicly traded firms. The underlying belief behind all such initiatives is that, an effective corporate governance mechanism helps in enhancing the quality of reported earnings through proper monitoring of managers in the financial reporting process

I would like to highlight some of the benefits of corporate governance to my CBS students, who will be the future manager of an organization viz; good corporate governance ensures corporate success and economic growth, maintains investors’ confidence, creates a positive impact on the share price and creates a transparent set of rules and controls in which shareholders, directors and managers have aligned incentives.