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Effect of Corporate Governance on Earnings Management in UK

Corporate Governance And Earnings Management In The UK


Research Background

Corporate governance has great importance in the long-term success of organizations. Corporate governance set out policies for the company and decide about the roles and responsibilities of the directors and executive manager (Alhadab, 2016). Earning management is the system through which companies manipulate the financial data to change the financial position of the company. History of the earning management is as old as the history of the financial report making. In the past times earning management was not enough organized as it is now in the present age. But still, executives and directors were used to manipulating financial data in different ways with the purpose to earn their personal benefits. Now manipulation and earning management is quite common in our businesses.

Corporate governance is playing the active role in this earning management and data manipulation. A number of empirical research studies are conducted on this topic to analyze the role of corporate governance in the earning management systems, and to view the adoption of earning management strategies in the companies of United Kingdom. Research conducted by the Dube and Howell claims that earning management system is not an invention of the 20th century. According to their research findings in early 1880s companies were used to manipulate data with the support of their directors and executives.

Effect of Corporate Governance on Earnings Management in UK

Research Aim

The research aim is to explore the use of earning management system by the corporate governance in the United Kingdom. The research will critically view the role of corporate governance in the manipulation of the financial data and other earning management systems. The research will view the literature and case studies on the earning management use in the UK companies listed in London stock exchange.

Research Objectives

The major objectives of the research are presented below in a list

  • To identify the role of corporate governance in the earning management
  • To evaluate the impact of earning management on profitability
  • To elaborate on the effects of earning management on shareholders
  • To provide the view of earning management use in UK companies.

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Research Hypothesis

There is two Hypothesis developed for the research study that is stated below:

H1: There is a positive relationship between the earning management system and the role of corporate governance in the UK companies.

H2: There is a positive relationship between earning management and manipulation of audit reports by UK companies.

Literature Review

Corporate Governance And Earning Management

Corporate governance is the system through which the top level management of the company control and manage the overall company. In accordance with this system roles and responsibilities are delegated to the directors and executives of the company. Basically, it deals with all the activities and responsibilities that a director or board of director do. Corporate governance also set values and deals with the social responsibilities. In the United Kingdom, the corporate governance code is applied to all companies (Aguilera, Williams, Conley, & Rupp, 2006). According to this code, companies are liable to provide their fair accounting and financial reports. UK corporate governance overview and monitor all the listed companies for different accountability structures.

In the United Kingdom, Earning management is adopted widely. According to the research studies, corporate governance in the United Kingdom is playing its role as reactive rather than proactive. Corporate governance of the companies is trying to manipulate the accounts and financial data in order to change their market value and financial condition for the stakeholders of the company. At the time of investment, shareholders view the profit margin of the company to get the estimation about the possible dividend as turn on investment. Therefore sometimes companies apply to earn management strategies to manipulate the financial data in such a way that present high profit for the latest operations. Thus the company can easily sell out shares in the market at the high prices.

While companies sometimes also present the financial information wrong or manipulated to avoid high taxes. For this purpose, they try to add up special items accounts and special expenses that reduce their profit over the years and show the company is nor earning as high as it was in actual earning. Thus earning management support the corporate governance of the company to pay less amount as tax expense and save their earning in the retained earning portion. However, earning management cannot be considered as the fair technique or strategy for the business.

An Overview Of London Stock Exchange Companies

London stock exchange is one of the biggest stock exchange in the world. In London, stock exchange companies are also listed to sell out their shares in the open international markets. UK companies are also selling their stock on the London stock exchange. In the London stock exchange, a number of companies are registered that are using the earing management technique in the business to present the manipulated financial data to the shareholders. A research study conducted by the (Dube & Howell, 2010) has studied companies of the United Kingdom listed in the London stock exchange. Some of these companies are Vedanta resources PLC, Next PLC, and Whiteboard PLC. According to the findings of the research corporate governance of the companies manipulate data to increase the value of their stock that attracts the investors.

According to a study held on the FTSE 350 companies (of United Kingdom) found that reports were manipulated and there was real and accrual earning management. FTSE is the companies that are listed in the London stock exchange as the member to sell out their equity. Studies also elaborate that in the structure of the audits reports that were the clear difference for the qualified and non-qualified audit reports. Research elaborate that UK based companies are also using other types of earning management techniques as abnormal cash flows from operations and discretionary accruals. Abnormal cash flows from the operations are related to the manipulation or changes in the sales and revenue of the company.

Corporate Governance Mechanism

Corporate governance has basically three major types of mechanism. In the companies of United Kingdom internal mechanism and external mechanism are in use for corporate governance. The internal mechanism of corporate governance monitor the activities and practices done by the company to figure out the misleading factors and errors. The internal mechanism also takes action for the correction of these activities to keep the business on track. The internal mechanism also works for the independent auditing reports and responsibilities for the directors or executives of the company (Davoren, 2018). It decides the control of the directors and executives on the business and its financial data. While in the external mechanism of corporate governance authority is given to the external parties that can be the stakeholders of the company.

In the external mechanism government, financial regularity institutes and the trade unions take control over the responsibilities and policies of the company. Companies adopt internal mechanisms without any force from the external entities and stakeholders. While in the external mechanism stakeholder form the external environment put emphasis on the management of the company to accept their decisions (Weir, Laing, & McKnight, 2002). The external mechanism provides the limited view of the internal working of the organization in the audit reports.

Control Measures By The London Stock Exchange

In the past corporate governance were not accountable to their shareholders. Therefore window dressing for the accounts and financial data was the easy job for the corporate governance in old times.  While now in present age earning management problem in the London stock exchange is increasing because of the controlling managerial behavior. London stock exchange is now working on the control measures for the earning management systems by the corporate governance of the companies. In the past London stock exchange was unable to monitor and adjudicate the financial statements presented by the member companies in their audit reports because of the unstable financial condition of the stock exchange. While in 1801 regulatory authorities decided to start up the auditing process that will monitor and adjudicate the reports.

Now in the present times, the London stock exchange has an active committee that is working to control the manipulation and earning management techniques by the corporate governance. According to the research companies that are caught for using earning management system in their audits reports are disqualified. Such companies cannot get the membership again until they present the actual financial data without any type of earning management, manipulation and window dressing.

While auditing system is now compulsory for the companies. Each company should have their own auditing system that controls and reviews the financial data of the company. Now present time’s new rules and regulations are presented by the accounting regularity authorities. According to the new standards of auditing, reports companies are obliged to provide the name of auditors and their information with their signatures on the auditing reports that presents that auditors are responsible for any type of manipulation, wrong presentation of financial data and window dressing of accounts. Committee of the auditors at the London stock exchange check out the responsibility of the auditors also while checking the financial statements of the company.

  • Aguilera, R. V., Williams, C. A., Conley, J. M., & Rupp, D. E. (2006). Corporate governance and social responsibility: A comparative analysis of the UK and the US. Corporate Governance: an international review, 14(3), 147-158. Retrieved 07 28, 2018
  • Alhadab, M. (2016). AUDITOR REPORT AND EARNINGS MANAGEMENT: EVIDENCE FROM FTSE 350 COMPANIES IN THE UK. Risk Governance & Control: Financial Markets & Institutions, 6(4), 334-344. Retrieved 07 28, 2018
  • Davoren, J. (2018). Three Types of Corporate Governance Mechanisms. Retrieved 07 28, 2018, from Smallbusiness.chron.com: https://smallbusiness.chron.com/three-types-corporate-governance-mechanisms-66711.html
  • Dube, Z., & Howell, K. E. (2010). Assessing Corporate Governance and the London Stock Exchange: A Historical Analysis. International Journal of Applied Finance for Non-Financial Managers, 1(3), 1-9. Retrieved 07 28, 2018
  • Weir, C., Laing, D., & McKnight, P. J. (2002). Internal and external governance mechanisms: their impact on the performance of large UK public companies. Journal of Business Finance & Accounting, 29(5), 579-611. Retrieved 07 28, 2018


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