The impact of corporate governance on the trade-off between accrual-based and real-based earnings management in the UK and India

Abstract

This research aimed to investigate whether mechanisms of corporate governance affect the trade-off between methods of manipulation of earnings management (EM) that involve accrual based earnings management (AEM) and methods of
manipulation that involve real-based earnings management (REM) in the UK and India.
Mechanisms of corporate governance are considered to be the most important influences in monitoring the quality of financial reporting (Brown et al. 2014). This study identified the most important corporate governance mechanisms that have affected AEM and REM which managers’ use to decrease or increase earnings in firms.
To achieve this, the study examines secondary data for the period 2006-2015, on FTSE 350 companies, in the non-financial sectors in the UK, and on 500 non-financial companies, listed on the Bombay Stock Exchange (BSE) in India. The absolute
values of discretionary accruals were used as a proxy for AEM using the modified Jones model (Dechow et al. 1995) and REM_1 and REM_2 were used to estimate aggregate real activities, as a proxy for REM. Performance-matched Model (Kothari et al. 2005) was used as a proxy for AEM and Roychowdhury Model (2006) was used as a proxy
for REM, when testing for robustness.
The results provide strong evidence that firms use AEM, REM_1 and REM_2 techniques as substitutes rather than as complements. The results also provide strong evidence that board characteristics, audit committee characteristics and
ownership structures constrained either AEM, REM, both or neither in the UK and in India. The results suggest that some, but not all, corporate governance mechanisms play a role in managers’ trade-off decisions between AEM and REM in the UK and India.