International Journal of Social Science Archives
ISSN: 2707-8892
Available at www.ijssa.com
International Journal of Social Science archives, June, 2019, 2(1), 44-54.
Impact of Corporate Governance Practices on Earnings
Management: Case Study of Cement Industry in Pakistan
aMisbah Ud Din*, bJulija Jacquemod, cAbdul Basit, dSayyam, eIhsan Ullah
MS Scholar, Northern University Nowshera, Pakistan, Department of Business,
RISEBA University, Latvia, MS Scholar, Abdul Wali Khan University Mardan,
Pakistan, Research Associate, Abdul Wali Khan University Mardan, Paklistan,
Lecturer, The University of Agriculture Peshawar, Pakistan
*Email: misbah7star1@gmail.com
___________________________________________________________________________________
Abstract: This study shows the impact of corporate governance practice on earnings management in
Pakistan. Using a panel data set of Cement industries listed on Pakistan Stock Exchange (PSX) from
2006-2017. Simple regression analysis was carried out and the results evidenced that corporate
governance practices are positively related with earnings management in Pakistan. Furthermore, the
results suggest that corporate governance quality has increased with the passage of time.
Key Words: Earnings Management, Corporate Governance, Managerial ownership, Board size
_____________________________________________________________________
1. Introduction
Through the development of the modern business, families are controlling most of the organizations
and the significant agency problem is present not only between the owners and management, but it also
exists between small scale investors and the management. In order to ensure best reporting practices
and best governance in all matters of a company the Securities and Exchange Commission of Pakistan
offered code of Corporate Governance in 2002 with revisions made subsequently up to 2017. The basic
aim of Good governance is to bring an improved corporate ability by guiding investors and to affirm a
sincere leadership in a company. Corporate governance also encompasses transparency in financial
reporting according to standards set by IFRS and IASB. Such transparency in financial reporting and
auditing has remained in literature since long including earnings management. The issue of EM and CG
both created concerns for management, auditors, accounting regulatory bodies and investors especially
after the demise of ENRON and WorldCom. As of the disappointment of the board, the integrity,
execution and trustworthiness of financial reporting framework were being questioned. Saleh et al
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Din et al; Impact of Corporate Governance Practices on Earnings Management: Case Study of Cement
Industry in Pakistan
(2005) [1] asserted that the consequence of corporate collapse has restored the importance of
monitoring role of corporate governance. Moreover, the controller/regulators believe the ability of
boards and their committees can be enhanced by good corporate governance control and manage things
in a better way and to the greatest benefit of shareholders and stakeholders, whose hope and assurance
is added [2].
Earning management is essentially distinction among reported and genuine income of a
company [3]. It is an organization cost because managers present false reports for their own advantages
and misdirect stakeholders. It is a dishonest practice and a monetary fraud. It is further believed that
stakeholder’s rights must be ensured by giving them clear knowledge of the firm budgetary position so
that they can safeguard their claims in the firm. In the earning management, there must be legitimate
requirement to protect the stakeholders and also minority investors and other key stakeholders since in
Pakistan the greater part of the organizations are claimed by families with minority stakeholder. This
study is helpful to practitioners and regulators by suggesting the factors of corporate governance and
reporting in mitigating the earning management practices, increasing investor’s protection and hence
developing firm’s standard. This study potentially contributes in two ways. The first and important
contribution is to the literature can that it added to study collectively corporate governance and earning
management, secondly it provides variable contribution and empirical contribution because as per my
knowledge this is the first study in cements sectors which investigations the outcome of Corporate
governance and earning management in Pakistan. So the objective of the current is study is to examine
the influence of board size, audit committee and managerial ownership on earnings management in
cement sector of Pakistan.
2. Literature Review
2.1 Earnings Management
Earning management has turned into an extremely prevalent subject of discussion among financial
regulatory bodies, investors and management. Earning management is the act of accounting strategies
to make a company financial reports extremely positive, various methods in this respect are used to
understate or overstate accounting income. According to Davidson (2005) [5] agency model holds that,
in the existence of information irregularities, set of decisions will be taken by directors that make best
use of their usefulness. Board of director is a key decision-making unit in any firm, and its structure has
important impact on the reported of earnings quality. Corporate governance is the procedures,
processes and control mechanism that guides the corporation for their better performance and value
enhancement [6].It is a procedure used to shield speculator's rights from abuses by insiders of the firm
[7]. Corporate Governance has caught incredible consideration however it's not anything new, is
developed with the need to take care of agency issue excited by partition of the management from
ownership control [8].
Earning management is control of money related reports, which can be wiped out by corporate
administration because corporate governance is the executive’s supervision in the firm basic leadership
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Din et al; Impact of Corporate Governance Practices on Earnings Management: Case Study of Cement
Industry in Pakistan
process [9]. Great corporate administration results in solid investors security as demonstrated exactly
by Eisenhardt (1989) [10], which in turn diminishes the organization issue since abuse by directors
(managers) is fundamentally an agency issue [2]. Abed et al (2012) [11] empirically discovers that
board qualities have no critical Role in controlling manipulation and cheats in opposition to this. Jaggi
(2009) [12] demonstrates that independent audit committee assumes a positive job in expanding firm
financial performance. Abbot et al (2000) [13] examined the relationship among earnings management,
fraud detection and audit committee. They included 156 firms listed in NewYork Stock Exchange as a
sample having 78 firms sanctioned with charges from Securities and Exchange Commission. It was
found that audit committee with more independent directors were less likely to be sanctioned by
Securities and Exchange Commission. Also they were not involved in any financial embezzlement,
fraudulent activity and issuing misleading financial statements. Xie et al (2003) [14] studied the impact
of audit committee and board structure variables on mitigation of manager’s opportunistic behavior to
manage earnings. They used 282 firms listed in S & P index. It was discovered that earning
manipulation is related with audit committee monitoring and board composition. It was further
concluded that frequency of audit committee and financial expertise of board members was more likely
to minimize discretionary accruals. Peasnell et al (2005) [15] argued that audit committee
independence and board meetings enhances integrity of financial statements and lowers earnings
manipulation. Garcia et al (2012) [17] studied the impact of governance structure on earnings quality in
Spain. It was documented that audit committee independence and meetings have negative impact on
quality of earnings in Spain. Uwuigbe (2011) [18] examined a negative relationship between board
size, board composition and earnings management. Pravet (2009) [19] asserted that institutional
ownership on board is important for better surveillance of management at all levels as it controls
resources and ensures better corporate performance. The studies of Hadi (2012) [20], Goal (2012) [21]
and Buniamin et al (2012) [22] all asserted a negative relationship between earnings manipulation and
managerial ownership.
2.2 Research Hypotheses
The following hypotheses have been developed:
H1: Board size has association with earnings management.
H2: Independence of audit committee has association earnings with management.
H3: Managerial Ownership has association with earnings management.
3. Research Methodology
3.1 Data Collection
This study is based on secondary data. The population of the current study is the entire firms (a total of
26) listed in cement sector of Pakistan in Pakistan Stock Exchange (PSX).. Out of these 26 firms only
19 firms are taken as sample for this study based on the availability of data. Data for this study is
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Din et al; Impact of Corporate Governance Practices on Earnings Management: Case Study of Cement
Industry in Pakistan
collected form published annual reports of these nineteen firms from 2006 to 2017. Data for earnings
management is extracted from annual reports of these firms using discretionary accruals by following
Jone’s modified model.
E.M (TA) = ΔCA – Δ Cash − ΔCL + ΔDCL – DEP ………………………. (1)
3.2 Variables
Earning management is a dependent variable and independent variables are corporate governance,
Board size, Audit committee, managerial ownership and control variables used in this study are firm
size, profitability and leverage.
3.2.1 Corporate Governance
Corporate governance is a kind of dealings among organization’s management, its board, investors,
shareholders, and other stakeholders. It provides the system through which the functions of the
enterprise are properly maintained.
3.2.2 Audit Committee Independence
It is the presence of independent director in the audit committee and is measured on the basis of
independent directors in the audit committee.
3.2.3 Managerial Ownership
Refer to the proportion of share held by executive directors of an enterprise and is measured as stocks
held by executive directors divided by total amount of shares.
3.2.4 Board Size:
It is usually the entire number of directors on the board and is measured by taking natural logarithm of
all members on the board.
3.2.5 Measurement of earning management
In literature, accruals used as proxy for earning management. Two different approaches are normally
used for measuring these accruals.
➢ Balance Sheet Approach
➢ Cash flows statements Approach
3.2.5.1 Balance Sheet Approach
On the basis of Balance Method total accruals can remain find through expending the subsequent
formula (Healley, 1986; Jonnes, 1992).
E.M (TA) = ΔCA – Δ Cash − ΔCL + ΔDCL – DEP…………………………. (1)
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Din et al; Impact of Corporate Governance Practices on Earnings Management: Case Study of Cement
Industry in Pakistan
Total accruals, the accrual idea in accounting means that costs and sales are recorded within
the duration they occur, whether or not cash is involved. The advantage of the accrual approach is that
economic statements reflect all of the charges related to the mentioned revenues for an accounting
period.
Current asset refers to an item on a firm's balance sheet which can be either in form of cash, a
cash equivalent, or something that can be change to cash in one year of time.
ΔCA Change in current asset means the difference between previous period current asset and running
period current asset.
A current liability is an obligation that must be paid in a single year.
ΔCL change in current liabilities means the difference between previous liabilities and current year
liabilities.
ΔDCL is the change in debt included in the current liabilities in year,
Debts or responsibility which must be cleared in one year, that seems proceeding the balance sheet of
company and short term debt, accrued liabilities, accounts payable and other debts remain also
included in it.
DEP is depreciation and amortization expense in year,
Amortization is used for intangible assets, while depreciation is used for tangible assets.
3.2.6 Control Variables
3.2.6.1 Firm Size
Firm size as control variable is measured by taking log of total assets. Firms with large board size
respond differently relative to small firms as far as earnings manipulations is concerned.
3.2.6.2 Profitability
Return on Assets (ROA) is used as measurement of profitability in this study and it is calculated by
dividing net profit on total assets of firm.
3.2.6.3 Leverage
The present study uses debt to equity ratio as a proxy for leverage. It is calculated by
Leverage it = Total Debt / Total Assets
3.3 Model Estimation
For testing hypotheses generalized least square method will be used. GLS is more efficient than OLS in
this case, and panel data face problems of heteroscedasticity and autocorrelations that need to be fixed
as well.
MODEL:
EM= β0+ β1BOD+ β2AI+ β3MO+ β4FS+ β5LVG+ β6Pro + ϵit
Where EM is for earning management, BOD is for Board size, AI is for Independent Audit Committee
MO is managerial ownership, LVG is leverage and Pro is for firm Profitability, FS is for firm size.
4. Results and Analysis
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4.1. Descriptive Statistics
Descriptive statistic is one of the most Significant techniques of financial analysis where it
find out the behavior of the data. When first looking at a data set it is wise to use descriptive statistics
to get an idea of what the data look like. Here is a simple data set, showing three variables in these
descriptive statistic techniques.
Table 1: Descriptive Statistics
Variable Mean St Dev Minimum Median Maximum
EM -8859136 8204322 -40136398 -7581149 19217837
B size 2.0408 0.2677 0.3026 2.0794 2.3026
In Audit 0.7716 0.1797 0.3333 0.6667 1.0000
Managerial 23.14 24.64 0.00 17.28 92.89
Firm Size 7.1908 0.4379 5.3707 7.3231 8.0912
Leverage 0.3684 0.3008 0.0136 0.2647 1.7008
ROA() 0.05003 0.12744 -0.25488 0.03059 0.34921
This table gives us the value of mean and standard deviation for variables. From the given table debt
percentage is 36% and when the under observation companies use 100% of assets the resultant value
and the board size mean value is 2.040 the stander deviation is .2677 the independent audit committee
mean value is 0.7716 and standard deviation is 0.1797 and similarly the average value of managerial
ownership is 23.16 the deviation value is 24.64. FP has the average value of .0500, and standard
deviation value is .127. FS has the average value of 7.19, and standard deviation value is .4379. LEV
has the average value of 0.3684, and standard deviation value is .3008.
4.2. Correlations
Correlation is another technique to dig out the association among the variables that may be seen by
plotting on a group. If a relationship between two variables exists and plotted points show a tendency
around a straight line then the correlation exists otherwise nonlinear correlation and it may be positive
as well as negative.
Table 2: Correlation Analysis
Variables Firm Size ROA() Leverage Managerial In Audit B size_1
Firm profitably 0.005
P-Value 0.942
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Industry in Pakistan
Leverage -0.469 0.543
P-Value 0.000 0.000
Managerial 0.064 0.031 -0.096
P-Value 0.339 0.643 0.149
In Audit 0.071 -0.018 0.100 -0.212
P-Value 0.285 0.792 0.134 0.001
B size_1 -0.119 -0.052 0.043 -0.081 0.327
P-Value 0.073 0.431 0.513 0.225 0.000
EM -0.028 0.137 -0.113 0.124 0.075 0.110
P-Value 00.679 00.038 00.090 00.062 00.260 00.098
Table # 4.3, shows correlation b/w variables and for sample period 2006-17
Pearson correlation
P-Value
The Pearson correlation between leverage and firm size is -0.469 and represent a negative relationship
between these variables its mean that as firm size increases the leverage become decline. The p-value is
-0.000 is less than 0.05 which indicate the significant linkamong these variables.
Similarly, the correlation among managerial ownership and firm size is 0.064 consequently it shows
insignificant. It means that there is no association between managerial ownership and firm size. The
relationship of independent audit committee with firm size is 0.071 and p value is 0.285 which is
greater than .05 is show that there is insignificant it’s mean that no association between independent
audit committee and firm size. Similarly relationship of firm size with Board size and earning
management are insignificant because of p value which greater than 0.05.
ROA (Firm Profitability) relationship with leverage is 0.543 which mean that firm profitability increase
the leverage also increase and the value of p is significant which 0.000 is. And with the rest of the
remaining variables Managerial ownership, In Audit, B size and EM is insignificant because of p value
which more than 0.05.
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Industry in Pakistan
Leverage relationship with managerial ownership and EM is -0.096, 0.113 respectively which is show
that the increase in leverage will decrease in managerial ownership and EM the p value is 0.149, 0.09
respectively which more than 0.05 that show insignificant. Now the relation of Managerial ownership
with in audit committee is -0.212 which show the increase in managerial ownership decrease In Audit
committee and the p value is 0.001 which is significant. Managerial ownership with board size is
inverse relationship but the p value is 0.225 which more that is why its show insignificant. And same
with EM relation is positive and p value is insignificant. Similarly the relation of independent audit
committee with board size is 0.327 which is direct relation and p value is 0.000 that is significant.
4.3. Regression
Technique of data analysis and it involves the relation between random variables and non-random
variables. It is necessary to differentiate among the two variables that are IV and DV. Moreover, the
regression is a process of estimating the dependent variable on the basis of another variable. It gives the
average probable change I variable
Table 3: Model summary
Model R R-squared Adjusted R-squared S.E. of regression
1 .5161898875 0.296452 0.253721 6671989
Table # 4.4, shows diversification b/w independent variable and dependent variables.
Model summary table gives the information about the variable is independent variable due to
independent variable and also the model significance. As the R-squared value is 0.2964 that means that
29.60% disparity in dependent variable EM (Earning Management) remains owing to model. The
adjusted R-square value is .2537 which means that our relationship is 25.37% error free.
Table 4: ANOVA
F-statistic 7.23556
ANOVA is the test of analysis of variance which tells about the relationship with variable;
here the F Column shows significance. The F value is 7.235 which is greater than 4; it means that our
model is significant.
4.4. Coefficients
Table 5: Coefficients
Term Co ef SE Coef T-Value P-Value
Constant 11706574 12142401 0.96 0.336
B size_1 3405158 2714426 1.25 0.211
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In Audit 6445180 3152705 2.04 0.042
Managerial 40625 21360 1.90 0.058
Firm Size -4558124 1449594 -3.14 0.002
Leverage -4136332 866447 -4.77 0.000
ROA() 17009847 3587017 4.74 0.000
In the above table of coefficient, the constant value for coefficient is 11706576 represent that when all
other variable are become give us zero response then the earning management having some output
which is the intercept term of the regression model. In the above table the first independent variable is
board size and its coefficient is 3405158 which indicate that when the board size is increase by one unit
the slop term makes a change of 3405158 times when other all variables are held constant. We also
similarly interpret the other variables by looking it coefficient value. For comparing the different t
value for individual independent variables with its p-value resulting show that the variable audit
committee, leverage, firm size and ROA show us a significant association in the model because of their
lower significant value form 0.05. Which indicate that AC, leverage, firm size and ROA significantly
related with earning management? The other remaining variables such managerial proprietorship and
board size are not contributed in the model because of their high value from the significant level 0.05.
The main findings of the study are summarized as the descriptive statistics of the data shows that data
is normal, with debt 36% and when the under observation companies use 100% of assets the resultant
value. FP has the average value of .0644, and Stander deviation value is .122. FS has the average value
of 7.09, and standard deviation value is .404.LEV has the average value is 0.360, and standard
deviation value is .2733.The coefficient of determination as the R-squared value is 0.2966 that means
that 29.60% deviation in dependent variable EM (Earning Management) is due to independent
variables. And adjusted R-square value is .2537 which means that our relationship is 25.37% error free.
The F value of 7.235 which is above 4, shows the model significance. The P value of AC is 0.042, BS
0.211, MO 0.058, LEV 0.000, FS 0.002, FP 0.000 these shows that when the value of P is less than
0.05 the result is significant. In this value the result with AC, and BS, is insignificant due to
significance value which is more than 00.05.
5. Conclusion
The main findings are summarized in the above discussion, and the results are similar with Abed et al
(2012) [11] specified that good corporate governance alleviates agency problems, particularly agency
problems. In this way rights of minority shareholders and large shareholders are safeguarded.
Moreover, companies with developed system of corporate governance may decrease earning
management and thereby ensure transparency in their financial reporting system. Result show that audit
committee independence has insignificant impact on earning management in cement sector of Pakistan.
While board size and managerial ownership have significant positive impact on earning management in
Pakistan. Further studies can be carried out to include more corporate governance variables like board
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Industry in Pakistan
structure, women on board and CEO duality to further explore their relationship on earning
management in Pakistan.
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