By Nelson M Waweru and George K. Riro
The main motivation for this study is to examine the relationship between the quality of corporate governance and earnings management in a developing country, Kenya. Specifically this paper investigates the influence of corporate governance
characteristic (Ownership structure, Independence of the Audit Committee and Board Composition) and firm specific characteristics (Firm size, Firm Performance and Leverage) on earnings management by Kenyan listed companies. We seek to
contribute to the debate of whether good corporate governance may be viewed as a prerequisite to good business (Che Haat et al., 2008) by reducing earnings management.
Whereas many of corporate governance studies have been carried out in developed countries of Europe, United States of America (USA) and Japan (Joshi and Wakil, 2004), only a few studies have been completed in developing countries of Africa (for example
Uddin and Choudhury, 2008). According to Zoysa and Rudkin, (2010) empirical studies on corporate governance and reporting quality reveal that the majority of them have been conducted in countries with developed capital markets, and studies conducted in countries with emerging capital markets are extremely sparse. The conclusions of the studies conducted in developed capital markets cannot be considered as applicable to emerging capital markets due to the large differences in political, cultural, technological, economic, and social factors between the two markets. It is therefore necessary to study the question of quality of information reported by Kenya listed companies (an emerging capital market) and examine whether corporate governance and firm specific variables have an impact on the quality of this information.
The main objective of this paper is to investigate the influence of corporate governance and firm specific characteristics on earnings management in Kenyan listed companies. The study extends research on the quality of reporting by examining the impact of corporate governance and firm specific variables on earnings management in Kenya.
The results of this study are important to investors in developing countries, who must interpret financial statement numbers reported by companies while making investment decisions. Furthermore, the study contributes to our understanding of how corporate governance influences financial reporting in developing economies, such as Kenya.
Overall results indicate that corporate governance plays an important role in enhancing the quality of reporting in Kenya Specifically, the study found that companies with concentrated ownership structures are more likely to engage in earnings management. These findings are important to developing countries such as Kenya where ownership structures are reported to be highly concentrated, hence the need for regulators to offer more protection to the minority shareholders. Our findings also suggest that firms with more independent boards are less likely to manage their earnings. We therefore argue that the boards that are dominated by non-executive directors may constrain manager’s motives hence improving the quality of reporting. The results support the recommendations of the KCMA (2002) which calls for a board consisting of a balance between executive and non-executive directors preferably with a majority of NEDs, of who a majority number should be independent.
The results provide empirical evidence to policy makers that corporate governance and firm specific variables are associated with quality of reporting. Therefore companies should re-examine the criteria used in selecting their directors and ensure that
corporate boards are more independent. This will ensure that the directors are accountable to the shareholders with a ripple effect of improving investor confidence. Interestingly the relationship between the independence of the audit committee and the levels of earnings management was not significant. Previous studies Waweru and Uliana, (2005); Bokpin and Isshaq, (2009) and McGee, (2009) have argued that most developing countries suffer from a lack of skilled human resources, suggesting that companies in developing economies may experience difficulties in attracting people with accounting or finance knowledge to their audit committees. This may make it difficult for Kenyan boards and their audit committees to monitor and control financial reporting. Overall our findings suggests that investors can rely more on the financial reports of firms with lower debt to equity ratios, higher proportions of outside directors, and with more dispersed shareholding.
This study is not without limitations. First only listed companies have been included in the study and the quality of information reported by unlisted companies represents a limitation of the study. Restricting the study of quality of reporting to publicly traded corporations excludes a significant and most efficient institutional arrangement for undertaking productive activities. Secondly like many empirical studies that rely on disclosed proxy data, proxy disclosures may not represent all aspects of corporate governance practices. As discussed in section 2.3, the accrual methods of detecting earnings managements have several shortcomings and these are some of the limitations of this study. Further research may be directed in comparing the findings of this study with findings that relate to firms operating in other developing countries of Africa.
