THE EFFECTIVENESS OF CORPORATE GOVERNANCE AND EXTERNAL AUDIT ON CONSTRAINING EARNINGS MANAGEMENT PRACTICE IN THE UK

Abstract

Agency theory predicts that corporate governance and external audit enhance the convergence of interests between shareholders and managers. The primary objective of this thesis is to investigate the effect of corporate governance and external audit on constraining earnings management practice in the UK.

In this thesis, earnings management is measured using the magnitude of discretionary accruals as estimated by the performance matched discretionary accruals (Kothari et al., 2005) model. A review of the corporate governance literature reveals sixteen attributes that can impact on shareholders’ perception of earnings quality due to their role in enhancing financial reporting integrity. The corporate governance attributes are organized in four categories: 1) Board Composition; 2) Audit Committee Effectiveness; 3) Non-Executive Directors’ (NEDs) Commitment; and 4) Ownership Structures. The external audit factors include auditor independence and audit quality.

Two models are constructed and a set of hypotheses are stated. These models are tested using a sample consisting of the top 350 companies listed on the London Stock Exchange. Firms in the financial, mining and regulated industries are excluded due to different accrual choices and valuation processes. The study covers the period of four financial years (2003, 2004, 2005 and 2006). Nineteen hypotheses are derived from both models. These hypotheses are tested using univariate and multivariate techniques to determine if corporate governance attributes and external auditor factors significantly constrain discretionary accruals.

The results reveal that board size and independence, audit committee independence and expertise, nomination committee independence, chairman independence, the level of NED fees and an independent and specialised external auditor are negatively associated with earnings management at significant levels.

The primary contribution to knowledge of this research is its extension of the literature on the role of corporate governance and the external auditor in constraining earnings management practice in the UK. This study’s results are useable by stock market participants in their evaluation of corporate governance and the role of the external auditor in enhancing earnings quality. The findings will also assist regulators in defining effective corporate governance attributes and assessing the disclosure of corporate governance practices.