Internal governance structures and earnings management


  • The authors acknowledge with thanks the helpful comments of two anonymous reviewers and the Associate Editor, Professor Stephen Taylor. We also thank Christine Jubb, Ping-Sheng Koh and participants at the 2003 Annual Conference of the Accounting and Finance Association of Australia and New Zealand, held in Brisbane, Australia. Financial support from the UQ Business School/KPMG Centre for Business Forensics and Queensland University of Technology is also gratefully acknowledged.


This paper investigates the role of a firm's internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross-sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non-executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee.