Earnings management and corporate governance in New Zealand : a thesis presented in partial fulfilment of the requirements for the degree of Master of Business Studies in Accountancy at Massey University

Abstract

Despite the enormous body of literature on earnings management, little research has been done in New Zealand. Corporate governance is recognised worldwide as a means to improve corporate performance and increase shareholder value. Boards of directors are held responsible for monitoring the preparation of financial reports and should constrain any earnings management. Earnings management is more likely to occur in companies with weak governance structures such as companies that are targets of takeovers where directors' self-interests may not be aligned with shareholder interests. This study examines the extent of earnings management in a sample of publicly listed New Zealand companies partitioned by takeover activity and tests the relationship between earnings management and the effectiveness of corporate governance. Abnormal working capital and discretionary accruals models are used to detect earnings management. Board effectiveness is measured by various corporate governance structures that include the percentage of independent non-executive directors, board size, existence of an audit committee and ownership features. The results of this study indicate that takeover target firms, relative to control firms, have an increased level of earnings management by abnormal accruals, more earnings losses, lower leverage ratios, a larger board size, a larger number of grey (affiliated) directors, fewer independent directors, and a greater proportion of institutional ownership. Target firms are audited mainly by Ernst & Young or Deloitte Touche Tohmatsu whereas KPMG and PricewaterhouseCoopers mainly audit control firms. The estimated accruals measures provide consistent evidence to indicate there is earnings management by income-increasing accruals. Discretionary accruals are managed upwards to avoid earnings losses and earnings decreases but regressions of the accruals measures produce ambiguous results relating to the effectiveness of corporate governance structures. Some evidence finds associations between measures of discretionary accruals and the existence of an audit committee and between the proportions of independent and grey directors in control firms where there are also significant firm-attributes such as size, leverage, cash flows from operations and earnings loss. There is evidence of an association between the level of working capital accruals and board ownership in target firms. It can be concluded from the research that New Zealand companies exhibit earnings management and sound corporate governance practices. Target firms relative to control firms have weaker governance structures that may have contributed to the takeover activity.