The extant literature on corporate governance and board composition agree that board size is important. These studies (Coles et al., 2008; Harris and Raviv, 2008; Raheja, 2005) observe that there are a number of factors that determine optimal board size and these include; the proportion of insiders and outsiders on the board, the industry in which the firm operates, the size and complexity of the firm. Small boards are easy to coordinate, able to have effective discussions and agree on issues effectively and efficiently. They also have fewer independent directors with versatile skills, who are able to demand private information disclosure from insider members in order to reduce earnings management
practices and financial reporting irregularities (Xie et al., 2003). The empirical evidence indicates mixed results between board size and financial reporting irregularities. For example, Abbot et al., (2004) and Beasley (1996) observe a positive relationship between board size and financial statement fraud, board size and earnings restatement respectively. On the contrary, Xie et al., (2003) and Peasnell et al., (2005) find a negative relationship between abnormal working capital accruals and board size but Osma (2008) observe no relationship between real earnings management and board size.
1.2.6.2 Audit Committee
The size of audit committee might influence the level of earnings management. Audit committees provide relevant expertise and work to promote shareholders’ interests. Large audit committees are expected to be more independent are less susceptible to CEOs undue influence than small audit committees. A good corporate governance mechanism mandates each firm to establish an audit committee with a minimum number of at least 3 independent directors (Combined code, 2008; Smith committee, 2003). The empirical evidence demonstrates the significance of audit committee size. For example, prior studies Abbot et al., 2004; Bedard et al., 2004; Xie et al., 2003) observe that the relationship between audit committee size and accruals-based earnings management is insignificantly negative. In a related study, Lin and Hwang (2010) and Yang and Krishnan (2005) find that large audit committees are control accruals-based earnings management effectively. It is expected that large audit committees are likely to have independent directors who are willing and capable to mitigate opportunistic managerial behaviour in earnings management.
1.2.6.3 Independent Board
Fama and Jensen (1983) observe that board composition plays a crucial role in protecting the interests of shareholders as well as reduce agency costs arising from separation of ownership and control. Specifically, they indicate that independent or non-executive directors (NEDs) help to improve the board monitoring against financial reporting irregularities. Prior research (Bedard et al., 2004; Gerety and Lehn, 1997) indicates that NEDs who violate accounting and financial reporting requirements are more likely to have their contracts terminated as directors. However, independent directors who are deemed to have reputation as experts to monitor management opportunistic behaviour are likely to obtain additional directorships. This suggests that NEDs are incentivised to confront managerial aggressive financial reporting behaviour rather than conspire with them. A high proportion of independent board is desirable but as the number increases, the inducements for individual directors to become informed decreases. Similarly, as independent board members increases, insider directors’ number also decrease, this hinders inside directors incentives to disclose private information. This could also result from less competition among insider directors or CEO control of insider directors (Raheja, 2005). Empirical evidence indicates that a higher proportion of independent board increases and improves the quality of financial reporting. For example, Beasley (1996) observe a positive relationship between a lower proportion of independent directors and conduct of fraud. Again, Osman (2008) and Klein (2002) find a negative relationship between a proportion of independent directors and earnings management practices. As a result of different conflicting theoretical arguments, this thesis does not predict a sign for the proportion of independent directors.
1.2.6.4 Stock Ownership
The agency theory indicates that stock ownership by the independent directors will motivate them to scrutinise managerial behaviour by better aligning their interests with shareholders, thus making it easier for them to question and challenge management proposals (Bedard et al., 2004; Beasley, 1996; Jensen, 1993). On the contrary, when independent directors have too high share ownership, they will act as insiders; collude with mangers to safeguard their investments in the company and to exploit non-controlling interest shareholders (Carcello and Neal, 2003). In fact, corporate governance mechanism in most countries forbids independent directors to receive stock option compensation (Bedard et al., 2004). The empirical evidence substantiates the above viewpoints. Beasley (1996) observe a negative relationship between the level of independent directors’ stock ownership and probability of fraud. Similarly, Klein (2002) indicates that there is a negative relationship between accruals-based earnings management and the existence of outside block shareholders on audit committee, an indication that stock ownership aligns the interests of both external shareholders and independent directors. On the contrary, Bedard et al., (2004) and Yang and Krishnan (2005) observe that as stock ownership on audit committees members (whether independent or not) increases, the level of accruals-based earnings management also increases. Again, Lin and Hwang (2010) undertake a meta- analysis and find that stock ownership by audit committee members is positively related to earnings management, supporting the alignment of the interests of independent directors with insider directors.
1.2.6.5 Powerful CEOs
The recent flurry of corporate humiliation involving top management in reputable organisations creates uncertainties and serious concerns among investors (Farber, 2005).A significant body of research with varying results is devoted to understanding the relationship between powerful CEOs (defined in this thesis as: longer tenure in the position and CEO share ownership) corporate decision-making, financial performance and reporting (eg. Cadman and Sunder 2014; Morse et al. 2011; Adams et al. 2005; Kang & Zardkoohi, 2005). These studies observe that CEOs who wield a degree of influence and power make decisions that maximise their own interest at the expense of shareholders. Morse et al (2011) reveal that powerful CEOs have the tendency to even manipulate compensation agreements to agree with favourable measures of performance. Previous studies (eg. Evans, Luo and Nagarajan 2014; Veprauskaite and Adams 2013; Jiraporn et al. 2012; Liu & Jiraporn, 2010; Combs et al. 2007) also indicate that directors can be influenced and firm performance prejudiced when CEO dominates the board members in decision-making because of “structural power”. The implication of this observation is that CEO power is likely to influence firm’s financial performance and reporting either positively or negatively. Recently, Evans et al., (2014), Veprauskaite and Adams (2013) find that the degree of relationship between CEO power and firm financial performance is negative. The findings confirm that higher concentration of power in the hands of CEOs adversely affect financial performance and reporting. Again, several studies have investigated the link between top management characteristics and financial reporting irregularities and observe that CEO with long tenure and substantial share ownership make deviant decisions which affect financial reporting of the firm (Jermias and Gani, 2014; Brochet and Srinivasan, 2013; Hennes et al. 2008; Srinivasan, 2005; Beasley, 1996;
Beasley et al. 1999; Dechow et al. 1996). Consequently, the extant literature reveals that CEOs with structural power are likely to engage in financial reporting irregularities and issue fraudulent financial statements (Srinivasan, 2011, 2008; Dunn, 2004; Farber, 2005; Dechow et al. 1996). Similarly, other studies (Srinivasan, 2013, Hennes et al. 2008; Faber, 2005; Finkelstein, 1992; Haleblian & Finkelstein, 1993) observe that CEO that has concentration of power resulting from share ownership is more likely to engage in aberrant decision-making to affect financial reporting quality of the firm. Another measure of committee governance quality is CEO Directors. They might form part of the board and work as CEO of another unaffiliated firm. There is a growing discussion about their presence on the board. Sun and Cahan (2009) find that CEO Directors appear more sympathetic and are more likely to support their fellow CEOs as they share similar views. Prior studies (Faleye, 2008; Daily et al., 1998) indicate that they may be motivated to take steps that can be used as benchmarks to help them justify their aberrant decisions in their own firms. This signals that the presence of CEO Directors can lead to lower governance quality and ignores the impact on their market value. However, CEO Directors are concerned about how to gain reputation for independence and competence. They aim at improving the efficiency of corporate committees because of their expertise and experience (Sun and Cahan, 2009; Faleye, 2008)
1.2.6.6 Outside Directorship
Fama and Jensen (1983) argue that independent directors have a motivation to act in a way that will protect their reputation as monitoring experts, and this helps them to secure outside directorships positions. The opportunity for the new outside directorships, will increase their exposure, experience and improve best practice (Bedard et al., 2004). This suggests
that earnings management is minimised in firms where board and audit committee members has more directorships. Conversely, more time and effort are required to effectively monitor management as the number of outside directorship increases, the effect is a reduction in monitoring quality and the likelihood of earnings management (Beasley, 1996). The existing studies support both stories. For example, Beasley (1996) observe a positive relationship between outside directors and the probability of fraud. On the contrary, these studies (Yang and Krishnan, 205; Bedard et al., 2004) find a negative relationship between accruals based earnings management and directors holding multiple directorships. The tenure of outside directors has also been found to affect financial reporting quality. Beasley (1996) observe that the probability of fraud decreases the longer the tenure of outside directorship. Similarly, Yang and Krishnan (2005) and Bedard et al., (2004) observe that as outside directorship tenure increases, the lower the degree of accruals earnings management. Again, empirical evidence support the role of financial experience on the board or among the audit committee members. Previous studies (Yang and Krishnan, 2005; Xie et al., 2003) find that the relationship between audit committee members with high finance or banking background and accruals earnings management is negative. Similarly, Hossain et al., (2011) and Abbott et al., (2004) find that audit committee with one at least one member with financial expertise mitigates accruals earnings management and the lowers the probability of restatement. The extant literature suggests that the above factors are important, however, neither theory nor empirical evidence has reached consensus on the exact relationship between these factors and earnings management.
Unlike the previous studies, this thesis focuses on the interaction between corporate governance variables (defined in this thesis as the presence of an audit committee, board size and independent board) and the religiosity of the firms’ environment on earnings management practices. Even though, there are several measures of corporate governance mechanism as discussed in the extant literature, this thesis uses only three variables (audit committee, board size and independent board) as proxies of corporate governance because of lack of data availability for other governance variables. The researcher did not have access to the databases of the remaining governance variables. Again, the other governance variables (such as; CEO Duality, Share Ownership, CEO Directors, Outside Directorship etc.) were not accessible or the researcher did not have sufficient data firm-year observations that correspond with the estimate of unexpected core earnings or abnormal accruals. Therefore, in this thesis, these three variables (audit committee, board size and independent board) will be used as proxies of corporate governance mechanism. Admittedly, this is a limitation but it does not affect the results and findings of the study.