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Financial Status, Corporate Governance Quality, and the Likelihood of Managers Using Discretionary Accruals

Accounting Research Journal, Vol. 22, No. 2, pp. 93-117

47 Pages Posted: 11 Jun 2008 Last revised: 4 Nov 2013

Sebahattin Demirkan

Morgan State University

Harlan D. Platt

Northeastern University

Date Written: September 1, 2009

Abstract

We investigate, using data on US manufacturing firms, how and when corporate governance affects managers’ decisions to use discretionary accruals and thereby artificially influence company financial reports. We employ 3SLS to study the relationship between financial status, corporate governance and financial reporting discretion. The sample spans years 2001 to 2003 during a severe downturn in the US stock market. Financial status is measured with the Altman-Z score (Altman, 1968). A significant difference is found between firms not classified as healthy or failed (i.e., the mid-range group) and the two extreme categories when examining governance quotient using a well known index. A positive relationship is found between discretionary accruals and the governance index. Strong governance appears to reduce the incidence of mid-range firms engaging in accruals management. The least healthy and the most distressed companies have the weakest relationship with discretionary accruals. By contrast, mid-range firms are more likely to resort to discretionary accruals. Non-executive members of boards of directors are warned to be particularly vigilant about discretionary accruals with firms transitioning between healthy and high failure risk. The relationship between firms’ financial health and discretionary accruals reveals an agency problem in credit markets with financially stressed firms. More attention is required on firms whose financial condition is uncertain. Also, we document significant findings of importance to the earnings quality and corporate governance literature by documenting the role of corporate governance on discretionary accruals and financial status.

Keywords: Financial Health, Earnings Management, Altman-Z, Simultaneous Relationship, Corporate Governance

JEL Classification: M41, M43, C15, G32, G33, E32

Suggested Citation

Demirkan, Sebahattin and Platt, Harlan D., Financial Status, Corporate Governance Quality, and the Likelihood of Managers Using Discretionary Accruals (September 1, 2009). Accounting Research Journal, Vol. 22, No. 2, pp. 93-117. Available at SSRN: https://ssrn.com/abstract=1142851

Sebahattin Demirkan (Contact Author)

Morgan State University ( email )

Baltimore, MD 21251
United States

Harlan D. Platt

Northeastern University ( email )

Boston, MA 02115
United States
617-373-4740 (Phone)
617-373-8798 (Fax)

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