Corporate governance mechanism, CEO power and earnings management among publicly listed firms in Kenya

Abstract

Earnings management has attracted recent research discourse due to the financial scandals that emanate from compromised quality of financial reports and untrue firm values. Opportunistic managers use their discretion to make financial reporting choices that maximize their own utilities at the expense true economic reflection of the firm. This practice has been depicted to have an adverse implication on the shareholders as it misleads them on the true value of their investment which eventually affects their decision making. In its quest to address this pertinent issue, the study sought to investigate the moderating role of CEO power on the relationship between corporate governance mechanism and earnings management. The study’s specific objectives were to determine the effects of audit committee’s; independence, meeting frequency, financial expertise, blockholder ownership and institutional ownership on earnings management, as well as to assess the moderating role of CEO power on each of the relationships. A positivism research paradigm was adopted in the study. The research was guided by agency, entrenchment and stakeholder theories. Explanatory research design and a panel approach was used to conduct a survey of listed firms at the NSE that met the inclusion criteria. The study population comprised of 65 listed firms out of which the research focused on the 35 firms that were consistently in operation during the study period between 2004 and 2017, resulting in a total of 490 firm-year observations. Secondary data obtained from the financial reports were analyzed using both descriptive and inferential statistical techniques. Corporate governance mechanism was found to have a significant effect on earnings management with its effects moderated by CEO power. The study results specifically indicate a negative and significant effect of audit committee’s; independence (β= -0.813, ρ<0.05), meeting frequency (β= -0.028, ρ<0.05), financial expertise (β= -2.064, ρ<0.05), and blockholder ownership (β= -1.778, ρ<0.05) on earnings management, while institutional ownership (β= 2.952, ρ<0.05) indicated a positive and significant effect. CEO power moderates the relationships between; audit committee’s independence (β=0.214, ρ<0.05, ΔR 2 =2.83%), meeting frequency (β= -0.087, ρ<0.05, ΔR 2 =1.7%), financial expertise (β=0.144, ρ<0.05, ΔR 2 =0.1%), blockholder ownership (β= -0.079, ρ<0.05, ΔR 2 =1.22%), institutional ownership (β= -0.101, ρ<0.05, ΔR 2 =0.7%) and earnings management. Corporate governance mechanisms specifically the audit committee attributes and shareholder activism present monitoring mechanisms that aid in constraining earnings management. More independence, higher financial expertise and a higher level of activity which is indicated by the meeting frequency is desirable in reducing earnings management. Blockholders play a crucial role in monitoring managerial activities, and therefore increased blockhoder ownership structure reduces earnings management to a greater extent due to their activism. The findings further supports agency theory propositions which suggests monitoring mechanisms as a measure to reduce divergence of interests in the firm. Institutional investors who were found to increase earnings management due to their transient nature. It is therefore in the best interest of the firm for institutions to refrain from pressurizing management for higher short-term performance, but instead focus on the long-term prosperity of the firm. Based on the study findings, CEO power reduces the effectiveness of audit committee attributes and blockholders in constraining earnings management. It is therefore recommended that corporate governance mechanisms should be allowed to operate without undue influence of the CEOs.