Does Corporate Governance Affect Earnings Management? Evidence from an Exogenous Shock to Governance in Korea

Abstract:     
Whether corporate governance causally affects earnings management is hard to study because firm-level variation in governance (above regulatory minima) and accruals are both endogenous firm-choices and there is limited time variation in governance. We exploit an opportunity to study this question in Korea, which undergoes in 1999 an exogenous legal shock to the board structure of large firms (assets over 2 trillion Won, about US$2 billion), with no similar shock to smaller firms. The new rules require large firms to have 50% outside directors and an audit committee with a majority of outside directors and an outside chair; prior to the reforms, almost no firms had 50% outside directors and none had an audit committee.

In cross-sectional and panel regressions, similar to those in prior studies, higher scores on an overall Korean Corporate Governance Index predict lower absolute abnormal accruals. But in difference-in-differences and regression discontinuity analyses that exploit the legal shock to large firms’ board structure, we find no evidence that board structure causally predicts abnormal accruals. These non-results cast doubt on whether the association between governance and accruals, which we and others find, is causal. Korean firms appear to manage earnings in ways similar to U.S. firms, suggesting our results may generalize beyond Korea.

Number of Pages in PDF File: 53

Keywords: earnings management, audit committees, corporate governance, Korea, causal inference

working papers series