Determinants to Consequents: The Intricate Web of Earning Management and the Moderating Influence of Corporate Governance

Abstract

This study examines the intricate web of determinants, consequences, and moderating effects of corporate governance on earnings management using panel data for 694 Pakistani listed firms from 2010-2022. Earnings management is measured through discretionary accruals estimated using the modified Jones model. The determinants analyzed are firm size, dividend policy, leverage, growth opportunities, free cash flow, and asset tangibility. Firm performance is measured through return on assets (ROA). Corporate governance is an index based on board independence, audit committee, etc. Panel regressions with fixed effects are employed to test the hypothesized relationships. The results show firm size and dividend payout have significant negative effects on earnings management. Leverage and free cash flows increase income-increasing manipulation. Earnings management negatively impacts next year ROA, indicating short-term manipulation hampers long-term performance. Corporate governance dampens the influence of size and dividends on earnings management. It also moderates the negative consequences of earnings management on subsequent ROA. The findings suggest larger firms, higher dividend payout, and strong governance constrain earnings manipulation. Highly levered firms with excess cash exhibit greater management. Earnings manipulation leads to underperformance, but strong governance helps mitigate this adverse impact. Overall, corporate governance plays a moderating role in both determinants and consequences of earnings management. The study contributes to literature by providing a simultaneous analysis of an exhaustive set of determinants, as well as examining consequences and moderating effects. It offers new evidence that governance reforms in Pakistan have likely reduced earnings management and its detrimental impacts on performance. The results have implications for managers, investors, and policymakers in evaluating quality of reported earnings and enhancing governance practices.

Keywords: Earnings Management, Discretionary Accruals, Income Smoothing, Determinants