Earnings Management, Corporate Governance, and True Financial Performance

30 Pages Posted: 3 Mar 2006

See all articles by Hassan Tehranian

Hassan Tehranian

Boston College - Department of Finance

Marcia Millon Cornett

Bentley University - Department of Finance

Alan J. Marcus

Boston College - Department of Finance

Anthony Saunders

New York University - Leonard N. Stern School of Business

Date Written: January 2006

Abstract

This paper addresses two questions. First, do corporate governance mechanisms that have been shown to affect firm behavior in other contexts also affect the degree to which firms advantageously manage their reported financial performance? Second, does past research investigating the impact of governance structure and option-based compensation on firm performance stand up when measured performance is adjusted for the impact of earnings management? We demonstrate that corporate governance mechanisms effectively constrain discretion in earnings management and that the estimated impact of governance variables on corporate performance is far stronger when discretionary accruals are removed from reported earnings. Institutional ownership of shares, institutional investor representation on the board of directors, and the presence of independent outside directors on the board all reduce the use of discretionary accruals in earnings management. These factors largely offset the impact of options compensation, which we find strongly encourages earnings management. Earnings management strongly affects patterns of reported corporate performance. While conventional profitability measures suggest a strong relationship between option compensation and firm performance, profitability measures that are adjusted for the impact of discretionary accruals show no relationship with option compensation. In contrast, the estimated impact of corporate governance variables on firm performance more than doubles when discretionary accruals are eliminated from measured profitability.

Keywords: Earnings management

JEL Classification: M41, M43, G34, J33

Suggested Citation

Tehranian, Hassan and Cornett, Marcia Millon and Marcus, Alan J. and Saunders, Anthony, Earnings Management, Corporate Governance, and True Financial Performance (January 2006). Available at SSRN: https://ssrn.com/abstract=886142 or http://dx.doi.org/10.2139/ssrn.886142

Hassan Tehranian (Contact Author)

Boston College - Department of Finance ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States
617-552-3944 (Phone)
617-552-0431 (Fax)

Marcia Millon Cornett

Bentley University - Department of Finance ( email )

175 Forest Street
Waltham, MA 02154
United States

Alan J. Marcus

Boston College - Department of Finance ( email )

Fulton Hall
Chestnut Hill, MA 02467
United States
617-552-2767 (Phone)
617-552-0431 (Fax)

Anthony Saunders

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
9-190, MEC
New York, NY 10012-1126
United States
212-998-0711 (Phone)
212-995-4220 (Fax)

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