Board of directors' governance challenges and earnings management

Purpose – The purpose of this paper is to examine the relationship between corporate governance and earnings management in US context and provide further insights on the effects of board of directors' characteristics on earnings management. Design/methodology/approach – The paper uses a sample of three groups of US firms; where firms with relatively high negative, firms with relatively high positive, and those with low levels of discretionary accruals in the year 2004 are examined. Descriptive statistics, univariate analysis, multivariate analysis, board of directors' characteristics, and possible relationships between corporate governance variables and earnings management proxy provide the basis for discussion. Findings – Firms with annually elected boards, small size boards, 100 percent independent nominating committees, and 100 percent independent compensation committees have more negative discretionary accruals. However, firms with 75‐90 percent independent board or firms with a board size of between nine and 12 have higher positive discretionary accruals. Research limitations/implications – Certain board characteristics may be the important factors associated with constraining the propensity of managers to engage in earnings management. Practical implications – Results are limited by the accuracy of the models applied to isolate discretionary accruals. Additionally, the direction diverse of discretionary accruals may differ with selecting a time series of three or more years as a base for the analysis. Originality/value – In contrast to prior literature, where board composition is defined as an insiders‐ or outsiders‐controlled board, this paper classifies board composition into seven discrete categories, using the same seven categories employed by Institutional Shareholder Services in evaluating and assigning corporate governance quotient scores to firms. The paper's major contributions to the existing literature are its findings that income‐increasing and income‐decreasing discretionary accruals have a different relationship with corporate governance practices and its expansion of the scope of corporate governance from board independence and audit committee independence to other corporate governance characteristics. This paper provides evidence that supports US regulators' initiatives that stronger corporate governance mechanisms provide greater monitoring of the financial accounting process and may be the important factors in improving the integrity of financial reporting.