The joint effect of internal and external governance on earnings management and firm performance

• Published date: 01 April 2022
• Author: Hong Kim Duong,Helen Kang,Stephen B. Salter
• Date: 01 April 2022
• DOI: http://doi.org/10.1002/jcaf.22536

Received:  Octobe r Accepted:  December 

DOI: ./jcaf.

RESEARCH ARTICLE

The joint effect of internal and external governance on

earnings management and firm performance

Hong Kim Duong1Helen Kang2Stephen B. Salter3

School of Accountancy, Strome College

of Business, Old Dominion University,

Norfolk, Virginia, USA

School of Accountancy, University of

New South Wales, Sydney,Australia

Department of Accountancy, Middle

Tennessee State University, Murfreesboro,

Tennessee, USA

Correspondence

HongKim Duong, School of Accountancy,

StromeCollege of Business, Old Dominion

University, Constant Hall, Norfolk,

VA   , US A.

Email:hkduong@odu.edu

Abstract

This study examines whether shareholders use internal governance mechanisms

(i.e., manager compensation, shareholder rights protection at firm level) to sub-

stitute for weak external governance (i.e., investor protection mechanisms at

country level) in restricting earnings management. We find that the impacts

of internal governance on earnings management are stronger in countries with

weak external governance. Examining the consequence of earnings management

on firm performance, we find that internal governance restricts earnings man-

agement more efficiently than external governance. This study extends prior lit-

erature by quantifying the impacts of internal and external governance on earn-

ings management and firm performance. Our findings suggest that investors

should pay more attention to internal governance than to external governance

in controlling for earnings management.

KEYWORDS

earnings management, external governance, firm performance, internal governance

JEL CLASSIFICATION

G, M, M

“Knowing our risks provides opportunities to

manage and improve our chances of success.”

Roger VanScoy (Carnegie Mellon University)

1 INTRODUCTION

Corporate governance is the system of laws, rules, and fac-

tors that control operations at a company (Gillan, ,

p. ). The corporate governance mechanisms can be

split into two broad classifications: internal governance

and external governance. Internal governance includes the

actions of board of directors, managerial compensation,

capital structure, bylaw charter and provisions, and inter-

nal control systems. External governance consists of insti-

tutional factors such as law and regulation, managerial

labor market and take-over market mechanisms (Gillan,

). While internal governance is determined within the

firm, external governance is beyond firm control and deter-

mined by the national institutions.

Prior literature has documented that external gover-

nance mechanisms, measured by investor protection,

have significant influence on firm decisions (La Porta

et al., ; Shleifer & Vishny, ) and accounting

practices (Burgstahler et al., ;Leuzetal.,).

Leuz et al. () document that, in an attempt to protect

their private control benefits, managers manage earnings

through discretionary accruals to conceal firm perfor-

mance from shareholders. Their findings also indicate

that a weaker investor protection enhances earnings

68 ©  Wiley Periodicals LLCJ Corp Account Finance. ;:–.wileyonlinelibrary.com/journal/jcaf

DUONG  .69

FIGURE 1The joint effect of internal and external governance

on earnings management and firm performance

management because inside managers enjoy more private

control benefits and have higher incentives to conceal

firm performance from shareholders.

These findings suggest an interesting research question:

If external governance is beyond corporate control, apart

from requiring higher rate of returns, what else would

shareholders do to mitigate the risk of their wealth being

expropriated by inside managers in weak investor pro-

tection countries? We propose that internal and external

governance mechanisms interact with each other as

they play out in earnings management and that internal

governance is an important mechanism that shareholders

use to substitute for weak external governance to pro-

tect themselves against wealth expropriation risk. This

prediction is presented in Figure by the horizontal two

headed arrow connecting the External Governance and

the Internal Governance boxes. We first hypothesize that

the effect of internal governance on constraining corporate

earnings management is stronger in countries with weak

external governance than in those with strong external

governance (H in Figure ). The stronger influence of

Internal Governance is presented by a bold arrow with

double negative sign connecting Internal Governance box

and Earnings Management box.

Provided that the first hypothesis is supported, that

Internal Governance has a stronger influence on con-

straining earnings management, we take a step further

and test whether the earnings management variation

explained by Internal Governance is associated with bet-

ter firm future performance (H in Figure ).

To examine our hypotheses, we expand the research

model of Leuz et al. () by introducing internal gov-

ernance and its interaction with external governance as

two independent variables to explain the variation in earn-

ings management. A negative (positive) coefficient on the

interaction term presents a substitute (complement) rela-

tion between internal and external governance in restrict-

ing earnings management. We then takea step further and

examine the effectiveness of internal and external gover-

nance mechanisms on earnings management by compar-

ing their comparative impacts reflected in the firm’s future

performance.

Following Leuz et al. (), we measure earnings

management by earnings smoothing and accrual manip-

ulations. We use six measures of external governance at

country-level; outside investor rights, legal enforcement,

equity market development, ownership concentration,

national accounting compliance index, and the number

of certified accountants/auditors per , population.

We then use cluster analysis to group countries with

similar legal and institutional characteristics and obtain

three distinct country clusters with different levels of

external governance: () outsider economies with large

stock markets, dispersed ownership, strong investor rights

and strong legal enforcement; () insider economies with

less-developed stock markets, concentrated ownership,

weak investor rights but strong legal enforcement; and

() insider economies with weak legal enforcement. The

international governance measure is obtained from Thom-

son Reuters Datastream ASSET database, computed at

firm-level as a pillar index aggregated from five categories:

board function, board structure, compensation policy,

shareholder rights, and vision and strategy.

Our analysis is based on a sample of , firm-

year observations ( non-financial firms) for the fiscal

years – across  countries covered by Compus-

tat Global and DataStream ASSET Databases. The results

indicate that internal governance substitutes for external

governance in restricting earnings management. Share-

holders use stronger internal governance mechanism in

countries with weak external governance to protect them-

selves against wealth expropriation risk. The test results

about the consequences of earnings management reflected

in firm future performance suggest that internal gover-

nance matters more than external governance in control-

ling earnings management.

We implement additional investigations to check the

robustness of our findings. First, we address the pos-

sible endogeneity which may exist between earnings

management and internal governance mechanisms, and

between earnings management and investor protection

using instrument variable approach and show that our

main findings are robust. Second, we exclude each coun-

try from our sample and re-examine prior tests to examine

whether the results are influenced by observations from

a certain country. Our previous findings remain robust.

Third, to address autocorrelation concern, in another

robustness check, we compute the averagesof all firm-level