Corporate Governance Quality and Earnings Management: Evidence from UK FTSE 100 and AIM (2007-10)

Contextual setting, motivation and objectives There is some evidence to suggest that the quality of corporate governance positively influences both financial performance and share price. Accordingly, it is of merit to assess that quality. This is heightened by increasing regulatory and procedural impositions on financial reporting coupled with continuing demands for greater transparency. As such, current features within, and the publication of, the UK Code on Corporate Governance (2010) provides a fresh and further opportunity to evaluate the impact of Corporate Governance Quality (CGQ) on Firm Performance (FM) in terms of mitigating managerial opportunism. Accordingly, the purpose of this research paper is to empirically assess the impact of Corporate Governance Quality (CGQ) on Firm Performance (FO) and on managerial opportunism to mitigate unallocated accruals, on a recent sample of UK listed companies (FTSE 100 and AIM). Design/ methodology/ approach Corporate Governance quality is a computed composite function of some key corporate governance characteristics such as duality, board characteristics and various CG committees. Sample companies evaluated within the research are classified as having strong or weak CGQ and as such CGQ is employed a dichotomous variable. An empirical approach is used to test three hypotheses, evaluating the relationship between CGQ and Firm Performance in the presence of Earnings Management (EM). Firm Performance is determined by firm profitability (FP), firm value (FV) and stock returns (SR) using the following proxies: Earnings per Share (EPS), Share Price (SP) and Dividend Yield (DY) respectively, on a sample of 40 companies from FTSE 100 and AIM companies over 2007-2010. OLS Pooled Panel Data regression techniques are used to test the hypotheses whereas discretionary accruals (DAC) are estimated using the Cross-Sectional Modified Jones (1991) model. Findings Prior results suggest that due to regulatory impact, firms constrain EM in the UK. In the context of leverage, it is argued that highly leveraged FTSE 100 firms are as likely to manipulate earnings as highly leveraged AIM companies. Moreover, the findings demonstrate that CGQ impacts firm performance negatively suggesting that CGQ is mitigating managerial opportunism. Furthermore, contrary to prior results, this investigation indicates a positive correlation between CGQ and DAC which indicates that CGQ constrains managerial opportunism in the presence of optimal contracts between the principal and the agent creating managerial efficiency resulting in managers conveying underlying economic reality to the outside world through earnings smoothing rather than earnings management. Originality/value/implications Contrary to prior research, a negative and significant relationship is found between CGQ and Firm Performance, proxied by EPS, SP and DY suggesting greater levels of transparency in financial reporting. The association between CGQ and EM, as a mechanism of controlling managerial behaviour, should provide policy makers an impetus to strengthen Corporate Governance (CG) practice as a tool for greater transparency and minimal information asymmetry. This has some positive implications for both the internal and external audit. If Corporate Governance mitigates agency costs, this should be reflected in the audit price, whereby, auditors can relax assumptions and the complexity of substantive tests. Particularly in the case of external audit, the internal audit function may provide basis for reliance and hence assist management and external auditors in concentrating on quality issues.