Journal of Applied Accounting Research

The role of corporate governance in earnings management: experience from US banks

Stergios Leventis Panagiotis Dimitropoulos
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The role of
The role of corporate governance corporate
in earnings management: governance
experience from US banks
Stergios Leventis 161
School of Economics and Business Administration,
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International Hellenic University, Thessaloniki, Greece, and

Panagiotis Dimitropoulos
Department of Sport Management, University of Peloponnese, Sparta, Greece

Abstract
Purpose – The purpose of this research paper is to investigate the role of corporate governance
in earnings management behaviour by US listed banks during the era of the Sarbanes-Oxley Act
(2003-2008).
Design/methodology/approach – The paper examines the issue of accounting quality and
corporate governance within banking corporations through the use of two different measures of
earnings management, namely small positive net income and the difference between discretionary
realized security gains and losses and discretionary loan loss provisions (LLPs), by applying a
corporate governance index estimated from 63 governance provisions.
Findings – The research found convincing evidence that banks with efficient corporate governance
mechanisms report small positive income to a lesser extent than banks with weak governance
efficiency. Also well-governed banks engage less in aggressive earnings management behaviour
through the use of discretionary loan loss provisions and realized security gains and losses.
Practical implications – The findings could prove to be valuable to investors since they must take
into consideration the efficiency of each bank’s corporate governance and demand supplementary
information in order to reach a better investment decision when earnings are not highly informative.
Social implications – The findings could prove to be useful for regulators since they are responsible
for the acceptable level of corporate governance standards. Thus, they must consider strengthening
governance mechanisms either though new legislation or stronger enforcement where earnings
management is of such magnitude to that serious impedes information transparency and quality.
Originality/value – The present study aims to bridge a gap in the literature by investigating
corporate governance and earnings management behaviour during a period of transition to an
intensively legalized governance environment (SOX Act). The results contribute further evidence to
the ongoing debate about the effectiveness of established corporate governance mechanisms.
Keywords Earnings management, Earnings quality, Corporate governance, Banking institutions,
Banking, United States of America
Paper type Research paper

1. Introduction
Corporate governance has attracted considerable attention during the last decade from
researchers and market participants[1]. The collapse of well-respected companies such
as Enron, WorldCom and Arthur Andersen raised many concerns about the reliability
of financial reporting and the efficiency of existing monitoring mechanisms. As a
result, investors lost confidence in corporate disclosures and the efficiency of the Journal of Applied Accounting
Research
Vol. 13 No. 2, 2012
JEL classification – M41, G21, G30, G34 pp. 161-177
r Emerald Group Publishing Limited
The authors acknowledge helpful comments by Asokan Anandarajan, Sandra Cohen, 0967-5426
Yiannis Tsalavoutas, three anonymous reviewers and the Guest Editor, Khaled Hussainey. DOI 10.1108/09675421211254858
 JAAR capital markets deteriorated ( Jain et al., 2003; Jain and Rezaee, 2003). To restore public
13,2 confidence the US Congress passed the Sarbanes-Oxley (SOX) Act in July 2002 (United
States Public Laws, 2002). SOX introduced new provisions for managers and directors
regarding the proper functioning of the firm and for auditors and analysts responsible
for information dissemination (Zhou, 2008). Moreover, SOX raised the criminal
penalties for securities fraud and any attempt to deliberately mislead shareholders and
162 potential investors (Zhou, 2008).
Banks present some unique regulatory characteristics in terms of capital structure
(Staikouras et al., 2007) since inefficiencies related to bank solvency and liquidity might
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provide severe impacts to the smooth operation of the financial system (Herring and
Santomero, 2000; Allen and Herring, 2001; Sbracia and Zaghini, 2003), as bitterly
witnessed by the current financial crisis. Banking institutions are also unique from
a corporate governance perspective. It has been argued that “safety-nets” in terms of
deposit insurance policies and lender of last resort functions creates “moral hazard”
problems since depositors and creditors rely heavily on governmental guarantees
which limit efficient monitoring of management actions (DeBandt and Hartmann,
2000; Santos, 2001). Prior research has empirically found that corporate governance
in the banking firms is significantly different when compared to manufacturing firms
(e.g. Adams and Mehran, 2003; Macey and O’Hara, 2003). The relative importance
attributed to efficient corporate governance mechanisms has been recognized by the
Basel Committee (Basel Committee on Banking Supervision, 1999, 2005), the
Organization for Economic Cooperation and Development (OECD, 2004) and the World
Bank (see Fremond and Capaul, 2002; Guevas and Fischer, 2006). Due to the eminent
position of banks in the financial sector it is expected that banking governance
structures might be of particular importance when compared to other sectors (Santos,
2001). While financial markets appear to reward banks with stronger disclosure
and corporate governance mechanisms (Akhigbe and Martin, 2008), the current
financial crisis has revealed the need for strengthening accounting quality and
corporate governance in the banking sector.
Many researchers have examined whether the implementation of SOX since
2002 has improved the quality of financial reporting and particularly whether SOX
has contributed to a decrease in earnings management behaviour. Cohen et al. (2004)
document a sharp decline in earnings management behaviour after the passage of
SOX, a result which is verified by Zhou (2008). Additionally, Lobo and Zhou (2006)
document that firms report lower discretionary accruals in the post-SOX period.
In the context, however, of the increased attention of researchers in the impact of
SOX on the quality of accounting information and earnings management specifically,
the established research agenda has demonstrated a preference towards non-financial
firms. Banks are special institutions since their viability is a critical concern for
regulators and a form of efficient corporate governance could be proved significant
for evaluating and monitoring managers’ decisions. A recent paper by Cornett et al.
(2009) provides significant evidence that board independence and pay-performance
sensitivity are negatively related to earnings management behaviour by large US
bank-holding companies. However, this study was mainly focused on the pre-SOX
era (1994-2002) employing a very small sample of very large and financially healthy
banks and therefore new evidence is needed relative to the investigation of the
impact of the new governance provisions imposed by SOX enactment. Dechow et al.
(2010) examine the use of securitization gains as a tool for earnings management
in the US during 2000-2005. They employ four measures of corporate governance
 indicating independent directorship. Overall they report that better monitoring The role of
does not reduce earnings management or CEO pay sensitivity to reported corporate
securitization gains.
The motivation of our study is to shed further light on the association between governance
governance efficiency and earnings management within the US banking industry
during the SOX era. Our research period spans from 2003 to 2008 covering six years
after the enactment of the “Public Company Accounting Reform and Investor 163
Protection Act” (SOX). We contribute to the on-going debate about the relationship
between earnings management and corporate governance in several ways: we provide
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up-to-date evidence on the association between governance efficiency and earnings

management after the implementation of the SOX Act by utilizing an aggregate
measure of corporate governance; and we extend the research by Cornett et al. (2009)
and Dechow et al. (2010) by employing a wider sample of 315 banking institutions
holding different characteristics (i.e. we have included smaller and less financially
healthy banks), by examining the relation between accounting quality and corporate
governance by employing three different measures of earnings management, namely
small positive net income, the difference between discretionary realized security gains
and losses (RSGL) and discretionary loan loss provisions (DLLPs), and the magnitude
of discretionary accruals and by employing an aggregate measure of governance
efficiency comprising 67 governance provisions, instead of single governance proxies
(see Dechow et al., 2010).
The empirical findings suggest that US banks with efficient corporate governance
mechanisms report small positive income to a lesser extent than banks with weak
governance efficiency. Also well-governed banks engage less in aggressive earnings
management behaviour through the use of discretionary accruals, LLPs and RSGL.
These findings corroborate the results in Cornett et al. (2009) in a different estimation
window (i.e. the SOX era), employing a wider sample of US banks and they are robust
to several sensitivity tests related to the specification of the empirical models and the
research design.
The rest of the paper is organized as follows: the next section provides a discussion
on relevant literature and develops the research hypotheses. The Section 3 explains the
sample selection procedure and the research design. Empirical findings and robustness
checks are discussed in Section 4. Finally, the last section concludes and indicates the
implications together with avenues for future research.

2. Literature review
The issue of bank earnings management has been on the international research agenda
for more than two decades. The seminal paper by Scheiner (1981) examined a sample
of US commercial banks and found convincing results that the use of LLPs is an
important tool of earnings management. Ma (1988) and Greenawalt and Sinkey (1988)
provided evidence that bank managers tend to raise LLPs in periods of high operating
income in order to decrease the volatility of reported earnings. These findings are
also supported by many studies focusing on the US banking industry (see Healy and
Wahlen, 1999; Ahmed et al., 1999; Liu et al., 1997; Beaver and Engel, 1996; Liu
and Ryan, 1995; Collins et al., 1995; Wahlen, 1994; Scholes et al., 1990; McNichols and
Wilson, 1988) which all conclude that LLPs are used by banks as a mechanism for
aggressive earnings management. Studies using non-US banks also arrive at similar
conclusions (Anandarajan et al., 2003, 2007; Pérez et al., 2008). Beatty et al. (1995, 2002)
found that banks manage reported earnings via the realization of security gains and
 JAAR losses. Security gains and losses (unlike LLPs) are an unregulated and un-audited
13,2 (both by auditors and regulators) discretionary management action and have proved
useful as a tool for managing income figures (Beatty et al. (1995, 2002)). Similar results
are reported by Collins et al. (1995), Moyer (1990) and Scholes et al. (1990). Shrieves
and Dahl (2003) and Agarwal et al. (2007) are two distinctive studies concluding that
Japanese banks used security gains and loan loss provisions (LLPs) as mechanisms
164 to manage earnings during the period 1985-1999. Similar results are reported by
Hazera (2005), who argues that major Mexican banks (in the late 1990s) took advantage
of the weak accounting standards in order to delay the recognition of loan losses.
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Furthermore, Shen and Chih (2005) by conducting an international research of bank

earnings management within 48 countries report evidence for significant income
manipulation in more than two-thirds of country settings. They argued for stronger
investor protection and transparency in accounting disclosure for reducing incentives
for earnings management.
Even though there are significant results on aggressive earnings management
behaviour by banks, there has been no systematic investigation on the role of corporate
governance. The passage of SOX Act on July 2002 led to significant changes to the
corporate governance structure and the financial disclosure obligations of all listed
firms. The most noticeable changes were the obligation of firm CEO’s and auditors to
certify the accuracy of the financial reports and the effectiveness of internal controls.
Also the criminal penalties for any fraudulent behaviour have increased and firm’s
governance was made more independent from managerial controls. Studies on the
impact of corporate governance on earnings management have mainly been
conducted using samples of non-financial firms. Proxies of corporate governance, such
as family (Hsu and Koh, 2005) and institutional ownerships (Wang, 2006), have been
examined for their effects on earnings quality. Both report significant (negative)
relationships with earnings management. Jaggi and Tsui (2007) document that a high
proportion of independent directors on corporate boards and low family ownership
both mitigate the positive relation between earnings management and insider
selling in Chinese companies. Machuga and Teitel (2009) corroborate the findings
of Jaggi and Tsui (2007) in Mexico by arguing that less family-concentrated
ownership contributes to a greater improvement in earnings quality. Furthermore,
Gao and Shrieves (2002), Bergstresser and Philippon (2006), Cheng and Warfield
(2005) and Cohen et al. (2004) all find evidence that earnings management is
more common in firms where managers’ compensation is closely tied to the value
of stock options. Burns and Kedia (2008), Jensen and Murphy (1990) and Minnick
et al. (2008) report that firms with large CEO stock-option positions are more
likely to file earnings restatements and proceed with value-minimizing managerial
decisions.
Additionally, there is a considerable literature examining the effect of board
independence and size on the firm’s financial performance in relation to earnings
management. For instance, Byrd and Hickman (1992), Brickley et al. (1994),
Subrahmanyan et al. (1997), Dimitropoulos and Asteriou (2010) found that board
independence is strongly associated with improved financial performance and stock
returns and lower use of earnings management to inflate earnings. In the same
direction, Jensen (1993) and Yermack (1996) found that smaller boards are more
effective monitors of firm’s activities than larger boards, since they are less related with
aggressive earnings management behaviour. Also Cohen et al. (2004) and Zhou
(2008) provide evidence of a decrease in earnings management behaviour after the
 implementation of the SOX Act, arguing that the respective law imposed stricter The role of
internal controls which improved accounting quality. corporate
Finally, there exist a limited number of studies controlling for the impact of
corporate governance quality (CGQ) on the bank managers’ incentives to manipulate governance
accounting income numbers. Sullivan and Spong (2007) argue that bank managers
have less incentive to manage earnings when they have more of their wealth
concentrated in their banks and possess increased stock ownership. Also Cornett et al. 165
(2009) examined the impact of CGQ on earnings management behaviour by large US
bank-holding companies. They found that banks with high levels of income and
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capital record more loan losses and fewer security gains. Income smoothing is
constrained when board independence is increased and CEO pay-performance
sensitivity is reduced. Finally, a recent paper by Dechow et al. (2010) found evidence
that US banks take advantage of the flexibility available in fair value accounting
rules and use securitization gains as a mechanism to manipulate earnings. However,
efficient corporate governance does not seem to mitigate this behaviour, suggesting
that CEOs are rewarded for the gains they report and boards do not intervene.
Overall, prior research tends to support a negative association between earnings
management and corporate governance structures. We investigate relevant
associations in a period of increased corporate governance provisions within a
highly regulated industry. We employ a wider sample of banks, when compared to
Cornett et al. (2009), including smaller and less financially healthy banks. Overall,
based on the massive majority of prior literature and the increased corporate
governance regulation during the SOX era, we expect a negative association between
CGQ and earnings management.

3. Data and methodology

3.1 Data selection procedure
The dataset used in our study is limited to US-listed commercial banks for a six-year
period (2003-2008). Accounting data were extracted from Thomson ONE Banker
database and carefully reviewed for any data inconsistencies and availability. The
corporate governance data were extracted from the RiskMetrics Group, which
estimates a CGQ index using publicly available documents and website disclosures on
67 different issues mandated by the SOX Act and the SEC certification requirements,
broadly relating to structures and mechanisms on boards of directors, internal
auditing, anti-takeover and compensation/ownership. This is an aggregate measure
of corporate governance efficiency used by several prior studies (see Cornelius, 2005;
Epps and Cereola, 2008; Aggarwal et al., 2009; Anderson and Gupta, 2009; Bauer et al.,
2010; Brown and Caylor, 2009). Based on this information, a scoring system is
developed by an external advisory panel for each observation. We extracted the
industry CGQ for every bank (the higher the score the higher governance quality).
Commercial banks with incomplete accounting and corporate governance data, central
banks, government development banks, cooperative banks and export-import banks
were excluded from the sample. This procedure produced a complete balanced sample
of annual end-of-year information for 315 listed commercial banks originating from all
States of the US with a total number of 1,890 firm-year observations.

3.2 Testing for earnings management

We employ three different metrics for earnings management. The first measure
identifies positive earnings as a common target of earnings management. Burgstahler
 JAAR and Dichev (1997), Leuz et al. (2003) and Barth et al. (2008) use the frequency of
13,2 small positive net income as a metric of managing towards positive earnings. The
underlying notion is that managers make every possible effort to report small positive
net income rather than negative net income. Consequently, we expect banks with
efficient CGQ to report small positive net income less frequently.
In order to test this assertion we follow Burgstahler and Dichev (1997), Lang et al.
166 (2003) and Barth et al. (2008) and estimate an indicator variable SPOS that equals 1 if
net income deflated by lagged total assets is between 0 and 0.01 for each given year
and 0 otherwise[2]. After estimating this dichotomous variable, we introduce it as the
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dependent variable in the following logit regression model:

Logit ðSPOSit Þ ¼ a0 þ a1 EBTit þ a2 CGSit þ a3 CGSit EBTit þ gControlit

þ dYear dummies ð1Þ
where EBT is the earnings before taxes deflated by lagged total assets, CGS the
corporate governance quotient for every bank in year t, CGS  EBT the interaction
term of CGS and EBT and the control variables: SIZE the natural logarithm of
year-end total assets, GR the ratio of market-to-book value of equity indicating
growth opportunities, LEV the ratio of total debt to total common equity, AUDQ the
dummy variable – 1 if a bank is audited by a Big-4 audit firm, 0 otherwise – CAP
the ratio of actual regulatory capital (Tier 1 capital) to the minimum required
regulatory capital.
A negative coefficient on the CGS variables[3] will indicate that firms with increased
CGQ report small positive income less frequently, thus efficient corporate governance
mitigates earnings management behaviour. We control for bank size by including
the natural logarithm of total assets. Large banks are more in the public eye and they
have more analysts following them. Consequently they are less likely to engage into
aggressive earnings management (Cornett et al., 2009). Thus, we expect a negative
coefficient on the SIZE variable. We control for banks’ growth opportunities using
the market-to-book ratio (GR). Lai (2009) indicates that firms with increased growth
opportunities are more likely to report less discretionary accruals when they
experience increased monitoring. Banks are in general more regulated and more closely
monitored institutions by regulators. Moreover, high-growth banks in our sample are
audited by Big-4 audit firms significantly more frequently than low-growth firms[4],
similar to Lai (2009). Therefore, we expect that increased monitoring by regulators
and increased level of audit quality provide less scope or incentive for earnings
manipulation. So we expect this coefficient to be negative. LEV is included as an
additional explanatory variable capturing the effect of risk on earnings management
behaviour. Riskier banks may tend to artificially inflate accounting earnings for
reasons related to capital adequacy requirements and regulatory scrutiny (Cornett
et al., 2009). Thus, we expect a positive coefficient on the LEV variable. We control for
audit quality by including a dummy variable (AUDQ) for the Big-4. Banks audited
by Big-4 audit firms are expected to report financial statements of enhanced quality
thus are less subject to earnings management (Teoh and Wong, 1993; Gul et al., 2003,
2006; Park and Pincus, 2001; Ghosh and Moon, 2005). Consequently we expect a
negative coefficient on this variable. Finally, we have included the capital adequacy
ratio (CAP). Well-capitalized banks experience less scrutiny by regulators, thus they
have greater opportunities for managing earnings (Cornett et al., 2009). However,
managers of low capitalized firms might have more incentives to manage earnings
 than managers belonging in well capitalized firms (Cornett et al., 2009). Consequently, The role of
the association between capital adequacy and earnings management is not monotonic. corporate
Our second metric for earnings management is based on LLPs and RSGL as
mechanisms for aggressive earnings management (Ahmed et al., 1999; Anandarajan governance
et al., 2007; Beatty et al., 2002). LLPs and realized securities gains and losses are
the combination of both a non-discretionary component which brings loan loss
allowances to an acceptable level, and a discretionary portion which is closely 167
regulated (Cornett et al., 2009). Therefore, in order to produce a salient estimate of
banks’ earnings management behaviour we estimate the discretionary part of LLPs
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and realized securities gains and losses. We follow Cornett et al. (2009) and estimate
the following fixed effect OLS regression model for calculating the discretionary part
of LLPs:

LOSSit ¼ at þ b1 LnTAit þ b2 NPLit þ b3 LLRit þ b4 LOANRit þ b5 LOANCit

þ b6 LOANIit þ eit ðaÞ

where LOSS is the loan loss provision deflated by total loans, LnTA the natural
logarithm of total assets, NPL the ratio of non-performing loans to total loans, LLR
the ratio of loan loss reserves to total loans, LOANR the ratio of
real-estate loans to total loans, LOANC the ratio of commercial and industrial loans
to total loans, LOANI the ratio of consumer and installment loans to total loans The
discretionary component of LLPs (DLLP) is the error term from the above regression.
We standardize the error term by total assets and define our measure as
DLLPit ¼ (eit  LOANSit)/ASSETSit, where LOANS is total loans and ASSETS is
total assets.
The next step is to estimate the discretionary part of RSGL. Following Cornett et al.
(2009), we estimate the following fixed effects regression model:

RSGLit ¼ at þ b1 LnTAit þ b2 URSGLit þ eit ðbÞ

where RSGL is the realized security gains and losses deflated by total assets, LnTA the
natural logarithm of total assets, URSGL the unrealized security gains and losses
deflated by total assets.
The error term of regression (b) is the discretionary part of realized securities gains
and losses. Our measure of earnings management (EM) is the difference between the
discretionary part of RSGL and the discretionary part of LLP. Therefore, higher levels
of EM increase earnings and vice versa, i.e. higher levels of EM correspond to
underreporting LLPs and higher levels of RSGL.
The earnings management variable (EM) is estimated from the previous step and
introduced as the dependent variable in the following regression model:

EMit ¼ a0 þ a1 EBTit þ a2 CGSit þ a3 CGSit EBTit þ gControlit

þ dYear dummies þ eit ð2Þ

where EM is the earnings management variable defined as previously, other variables

are determined as previously.
Model 2 controls for bank size, risk, growth, accounting quality, capital adequacy
and includes year dummies to capture time-specific effects and deal with the problem
of heteroscedasticity in the error term, similar to Model 1. We expect to find a negative
 JAAR coefficient on the CGS variable designating that higher corporate governance efficiency
13,2 mitigates aggressive earnings management behaviour. We have also included the
interaction effect CGS  EBT similar to prior studies (Dechow et al., 2010).
Our third and final measure of earnings management is the magnitude of
discretionary accruals estimated from the Jones’s (1991) model as modified by Yasuda
et al. (2004) for banking institutions. We run the following regression so as to obtain
168 the discretionary portion of bank’s total accruals:

ACCRt ¼ c1 ð1=TAt1 Þ þ c2 ðDOIt =TAt1 Þ þ c3 ðBREt =TAt1 Þ þ et ðcÞ

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where ACCR is the total accruals estimated as the difference between net income and
operating cash flows, TA the total assets, DOI the change in bank’s operating income
between t1 to t, BRE the bank’s premises and equipment.
All variables and the intercept are deflated with lagged total assets in order to
reduce heteroscedasticity. The residuals from Equation (c) are denoted as the
discretionary portion (DACC) of total accruals which is dependent on managerial
discretion and is our primary interest variable. The following step is to introduce
it as the dependent variable in the following model:

DACCit ¼ a0 þ a1 EBTit þ a2 CGSit þ a3 CGSit EBTit þ gControlit

þ dYear dummies þ eit ð3Þ

Model 3 also controls for bank size, risk, growth, accounting quality, capital adequacy
and includes year dummies to capture time-specific effects and deal with the problem
of heteroscedasticity in the error term, similar to Models 1 and 2. We expect a negative
coefficient on the CGS variable designating that higher corporate governance efficiency
is associated to lower magnitude of discretionary accruals signifying less earnings
management.
All models have been tested for potential endogeneity (Kennedy, 2008, p. 139;
Koutsoyiannis, 1977, pp. 331-4; Gujarati, 1995) applying the Hausman’s (1978)
simultaneity specification test, as suggested by Pindyck and Rubinfeld (1991, pp. 303-5).
Our results suggest no serious problems of endogeneity. Therefore, our dependent
variable does not lead to biased and inconsistent OLS estimates.

4. Empirical results
4.1 Descriptive statistics and correlations
Table I presents the descriptive statistics of the sample variables. The earnings
management variable EM has a mean (median) value of 0.007 (0.001). The mean level
of earnings before taxes is 0.8 per cent of total assets. The mean level of the corporate
governance index (CGS) is 53.8 per cent indicating again that the quality of bank
governance is above the average level. Almost 51 per cent of US banks have reported
small positive earnings during the period of investigation. The mean level of
discretionary accruals is 0.001 and total accruals have also a negative mean up to
0.006.
Table II presents the Pearson correlation coefficients among the sample variables.
Results indicate no serious problems of multicollinearity. SPOS is positively and
significantly associated with EM (0.036) and negatively correlated with CGS (0.081).
EM is positively and significantly associated with earnings (0.321) and negatively
 Variables Mean Median SD Minimum Maximum
The role of
corporate
EM 0.007 0.001 0.003 0.041 0.018 governance
EBT 0.008 0.009 0.009 0.102 0.028
CGS 0.538 0.549 0.279 0.005 0.999
SPOS 0.510 1.000 0.500 0.000 1.000
AUDQ 0.365 0.000 0.481 0.000 1.000 169
GR 1.723 1.639 0.761 0.091 5.452
SIZE 7.492 7.190 1.401 4.307 14.08
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LEV 0.164 0.153 0.095 0.000 0.711

CAP 12.114 11.30 3.153 3.300 23.32
LLP 0.013 0.012 0.005 0.001 0.075
RSGL 0.002 0.001 0.001 0.015 0.018
ACCR 0.006 0.004 0.027 0.794 0.302
DACC 0.001 0.006 0.032 0.747 0.294
Notes: The sample comprises published financial data from 315 US banking institutions (1890 firm-
year observations) for the period 2003-2008. EM is the earnings management metric, estimated as the
difference between discretionary realized security gains and losses and discretionary loan loss
provisions, EBT is earnings before extraordinary items and taxes deflated by lagged total assets, CGS
is the general corporate governance score for each bank, SPOS is a dummy receiving 1 when a bank’s
income deflated by total assets is between 0 and 0.01 and 0 otherwise, AUDQ is a dummy receiving 1 if
the bank is audited by Big-4 audit companies (PwC, KPMG, Delloitte & Touche, Ernst & Young) and 0
otherwise, GR is measured as the ratio of market-to-book value of equity indicating growth
opportunities, SIZE is the bank size measured as the natural logarithm of total assets, LEV is the
leverage measured as the ratio of total debt to common equity. CAP is the capital adequacy ratio, LLP
is the ratio of loan loss provisions to total loans and RSGL is the ratio of realized security gains and Table I.
losses deflated by total assets, ACCR is total accruals estimated as net income minus operating cash Descriptive statistics
flows deflated by lagged total assets, DACC is the discretionary accruals estimated from Jones of sample variables
(1991)model as being modified by Yasuda et al. (2004) (2003-2008)

correlated with CGS (0.036). DACC is negatively correlated with CGS but not
significantly within conventional levels. All other associations make economic sense.

4.2 Evidence on earnings management

Table III reports the results of the first earnings management metric, i.e. the frequency
of small positive net income (SPOS) described in Model 1.
The coefficient of the corporate governance index (CGS) is negative and statistically
significant (0.135), indicating that banks with increased CGQ report small positive
income less frequently. Thus, efficient corporate governance mitigates earnings
management behaviour. This result is similar to Burgstahler and Dichev (1997) and
Shen and Chih (2005). The interaction term of pre-tax earnings and CGS is positive and
statistically significant (1.588). The magnitude is smaller compared to the EBT
coefficient (2.036) suggesting that efficient corporate governance further reduces any
aggressive earnings management behaviour. Therefore, these findings verify our
expectation and corroborate the results presented by Cornett et al. (2009). Referring to
control variables, SIZE is statistically significant with a negative coefficient (0.0063),
suggesting that large banks report small positive income less frequently, similar to
many prior studies (Cornett et al., 2009). The same holds for banks with increased
growth opportunities (0.0018, significant at 1 per cent) similar to Lai (2009) and less
leveraged banks, verifying our expectations. However, the CAP coefficient has the
expected sign but is not significant within conventional levels.
 JAAR Variables EM EBT CGS SPOS AUDQ GR SIZE LEV CAP
13,2
EBT 0.321
CGS 0.036 0.015
SPOS 0.036 0.135 0.081
AUDQ 0.019 0.067 0.198 0.079
170 GR 0.050 0.541 0.060 0.340 0.152
SIZE 0.004 0.075 0.228 0.183 0.394 0.161
LEV 0.002 0.097 0.051 0.156 0.069 0.120 0.235
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CAP 0.028 0.065 0.029 0.007 0.048 0.041 0.035 0.002

DACC 0.001 0.001 0.026 0.039 0.007 0.005 0.037 0.010 0.002
Notes: Correlations in bold indicate statistical significance at less than 0.05 (two-tailed test); the
sample comprises published financial data from 315 US banking institutions (1,890 firm-year
observations) for the period 2003-2008. EM is the earnings management metric, estimated as the
difference between discretionary realized security gains and losses and discretionary loan loss
provisions, EBT is earnings before extraordinary items and taxes deflated by lagged total assets, CGS
is the general corporate governance score for each bank, SPOS is a dummy receiving 1 when a bank’s
income deflated by total assets is between 0 and 0.01 and 0 otherwise, AUDQ is a dummy receiving 1 if
the bank is audited by Big-4 audit companies (PwC, KPMG, Delloitte & Touche, Ernst & Young) and 0
otherwise, GR is measured as the ratio of market-to-book value of equity indicating growth
Table II. opportunities, SIZE is the bank size measured as the natural logarithm of total assets, LEV is the
Pearson correlation leverage measured as the ratio of total debt to common equity, CAP is the capital adequacy ratio,
coefficients of sample DACC is the discretionary accruals estimated from Jones (1991)model as being modified by
variables (2003-2008) Yasuda et al. (2004)

Our second test on earnings management is based on the difference between

discretionary realized security gains-losses (DRSGL) and DLLP. The results of Model 2
are also presented in Table III. The coefficient of the CGS variable is negative and
statistically significant (0.0011) suggesting that improved governance efficiency
deteriorates the distance between DRSGL and DLLP (earnings management). The
EBT coefficient has a positive significant association suggesting that more profitable
banks engage in higher earnings management. This result contradicts Cornett et al.
(2009), probably for reasons of differential sampling or time period. The interaction
term EBT  CGS has a positive and significant coefficient (0.107) with a smaller
magnitude relative to the EBT coefficient (0.116). Once again we argue that efficient
corporate governance mechanisms further reduce any aggressive earnings management
behaviour. Therefore, results derived from Model 2 are similar to Model 1, verifying our
expectations. Regarding the control variables, GR (0.0006) is the only statistically
significant coefficient but with a different sign when compared to Cornett et al. (2009). We
have attributed this result to increased audit quality associated to our high growth
banks. Finally, CAP is non-significant contrary to Cornett et al. (2009). We attribute our
difference to differential sample. Contrary to Cornett et al. (2009), in our sample banks
with a CAP o5 per cent regulatory benchmark are included, suggesting that some of our
sample banks are poorly capitalized.
Finally, the estimation of the third model yield similar results compared to the other
two models. The CGS variable was found negative and statistically significant
(0.027) indicating that banks with improved governance quality report earnings of
enhanced quality having smaller discretionary accruals. This finding corroborates
previous results and verifies our initial assumption that efficient corporate governance
mechanisms mitigate aggressive earnings management behaviour. Regarding the
 Variables Model 1 Model 2 Model 3
The role of
corporate
Constant 1.174* 0.0003 0.0075** governance
(7.47) (0.77) (1.66)
EBT (a1) 2.065 0.179* 0.188**
(0.71) (4.14) (1.92)
CGS (a2) 0.135* 0.0011** 0.027** 171
(2.69) (3.31) (1.95)
CGS  EBT (a3) 1.593** 0.127* 0.344**
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(2.23) (3.87) (2.19)

SIZE (g1) 0.0063* 0.0001 0.0010**
(7.41) (0.28) (1.68)
GR (g2) 0.0018* 0.0007* 0.0039
(2.85) (5.47) (0.40)
LEV (g3) 0.854* 0.0058 0.047
(7.45) (0.77) (0.06)
AUDQ (g4) 0.029 0.0011 0.019**
(1.23) (0.71) (2.16)
CAP (g5) 0.0005 0.0004 0.0012
(0.36) (0.38) (0.11)
R2L/R2-adjusted (%) 16.1 13.9 16.3
w2/F-statistic 46.44* 36.12* 5.76*
Year fixed effects Included Included Included
Notes: t-statistics are in the parentheses, *,**statistical significance at 1 and 5 per cent level,
respectively (two-tailed test)

SPOSit ¼ a0 þ a1EBTit þ a2CGSit þ a3CGSit  EBTit þ gControlit þ dYear dummies þ eit (1)
EMit ¼ a0 þ a1EBTit þ a2CGSit þ a3CGSit  EBTit þ gControlit þ dYear dummies þ eit (2)
DACCit ¼ a0 þ a1EBTit þ a2CGSit þ a3CGSit  EBTit þ gControlit þ dYear dummies þ eit (3)

SPOS is a dummy receiving 1 when a bank’s income deflated by total assets is between 0 and 0.01 and
0 otherwise, EM is the earnings management metric, estimated as the difference between discretionary
realized security gains and losses and discretionary loan loss provisions, DACC is discretionary
accruals estimated as the residuals from the cross-sectional Jones (1991)model as modified by Yasuda
et al. (2004). EBT is earnings before extraordinary items and taxes deflated by lagged total assets, CGS
is the general corporate governance score for each bank, CGS  EBT is the interaction term between
CGS and EBT, SIZE is the bank size measured as the natural logarithm of total assets, GR is measured
as the ratio of market-to-book value of equity indicating growth opportunities, LEV is the leverage Table III.
measured as the ratio of total debt to common equity, AUDQ is a dummy receiving 1 if the bank is Regression results on
audited by Big-4 audit companies (PwC, KPMG, Delloitte & Touche, Ernst & Young) and 0 otherwise, earnings management and
CAP is the capital adequacy ratio governance efficiency

control variables, coefficient on SIZE was found negative and significant (0.0010) as
expected, while on the contrary the coefficient on AUDQ was found positive and
significant (0.019).

4.3 Sensitivity analysis

In order to examine the robustness of the results, we performed several sensitivity tests
related to the specification of the empirical models and the research design. First,
following Clinch and Magliolo (1993), who argue that DLLPs and RSGL should not
be combined into a single earnings management variable, we re-estimated Model 2
including DLLPs and realized security gains-losses separately as our measure of
 JAAR earnings management. Results remained qualitatively unchanged relative to the
13,2 results presented in Table III. Second, in order to capture any biases in the estimation
of discretionary accruals, we eliminate the upper and lower 1 per cent of absolute value
of discretionary accruals and re-estimated Model 2. Results remained relatively
unchanged compared to the results presented in Table III. Finally, in order to examine the
sensitivity of our results to the size effect we separated the sample into big and small
172 banks[5] based on the median. Results of all model specifications are qualitatively similar
to the overall sample. We further separated the sample into big 50 and small 50 banks.
The results of the two subsamples differ materially in between and also when compared
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to the overall sample. The explanatory power of the models is particularly increased for
the group of big 50. Our tests suggest that results might be sensitive to the sample
selection, particularly when the groups of very big or very small banks are concerned[6].

5. Conclusions
The efficiency of corporate governance mechanisms and their impact on the quality of
accounting earnings, particularly after the SOX enactment, has been on the active
agenda of many market participants. There is a wide perception, supported by empirical
results, that corporate governance mechanisms achieve effective monitoring (Cohen et
al., 2004; Gao and Shrieves, 2002; Bergstresser and Philippon, 2006; Cheng and Warfield,
2005; Cornett et al., 2009; Dechow et al., 2010). Although relative inferences have been
widely tested in non-financial sectors, there has been only very limited research with
respect to financial institutions. Our study aims to bridge this gap in the literature by
investigating corporate governance and earnings management behaviour during a
period of transition to an intensively legalized governance environment. Our results
contribute further evidence to the ongoing debate about the relationship between
accounting quality (earnings management) and corporate governance mechanisms.
Our sample consists of 315 US-listed commercial banks for 2003-2008. The
empirical findings suggest that banking firms with efficient corporate governance
report small positive income to a lesser extent than banks with weak governance. Well-
governed banks engage less in aggressive earnings management behaviour through
the use of discretionary accruals, LLPs and RSGL compared to their poorly governed
counterparts. These findings corroborate and further extend the results in Cornett et al.
(2009) and are robust to several sensitivity tests related to the specification of the
empirical models and the research design used in our study.
Our findings could be proved valuable to investors and regulators since they have
implications for both parties. Investors must take into consideration the efficiency of each
bank’s corporate governance and demand supplementary information in order to reach a
better investment decision when earnings are not highly informative. Since regulators
define the acceptable level of corporate governance standards, they must consider the
aggregated effect on the actions of bank managers of all governance mechanisms employed
instead of considering the impact of each governance mechanism separately. However our
results are subject to the sensitivity of the CGS index. Future research can extended the
present findings by considering if and how efficient governance mechanisms enhance
the quality of accounting information in the aftermath of the recent financial crisis.

Notes
1. Cornett et al. (2009) have investigated 46 very large banks (controlling 79 per cent of total
bank assets) during 1994-2002, while we have investigated 315 banks during 2003-2008.
Results should be interpreted based on sample characteristics.
 2. Burgstahler and Dichev (1997) have examined the SPOS range between 0 and 0.01 for The role of
non-financial but also for financial firms (p. 101, note 3). They found evidence of earnings
management similar to the results reported for non-financial firms. They explain the specific corporate
SPOS range due to asymmetric distribution around the 0.01 level (Burgstahler and Dichev, governance
1997, p. 107). Shen and Chih (2005) have used a similar proxy. We plot our EBT data for the
range 0.062 to þ 0.025 in a histogram. The figure showed a single peaked bell shaped
distribution with an irregularity near 0. We followed Burgstahler and Dichev (1997) arguing
that this practice is consistent with discretion to avoid earnings decreases. Earnings 40 173
occur more frequently than it would be expected and they are gathered within the interval
(0.00-0.013). We assumed that in the absence of earnings management the distribution of
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earnings will be symmetric (around 0.01) and the right half of distribution would be
unaffected by earnings management, similar to Burgstahler and Dichev (1997). The specific
procedure yield a significant t-statistic (p ¼ 7.237) indicating discontinuity of the distribution
around 0, suggesting that bank managers use discretion for avoiding earnings decreases.
3. We have included the dummy DCGS separating for CGS median instead of CGS and the
interaction between DCGS and EBT (DCGS  EBT). Results are similar.
4. A non-parametric Mann-Whitney test suggests that high-growth banks are audited
significantly more frequently (significant 0.000) by big-four audit firms when compared to
low-growth banks.
5. We acknowledge this comment by an anonymous reviewer.
6. Results are available, upon request, from the first author.

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Further reading
European Central Bank (2005), “Fostering an appropriate regime for shareholder’s rights”,
second consultation by the Services of the Internal Market Directorate General, MARKT,
European Central Bank, 13 May.

About the authors

Stergios Leventis is a Lecturer in Accounting (appointment in process) at the School of
Economics and Business Administration at the International Hellenic University. Before joining
IHU, he was a Lecturer at Lancaster University and has worked as an Accounting Consultant.
His research focus is on accounting disclosure and quality, accounting choice in emerging
markets, auditing and environmental accounting. He has published work in a number of
scientific journals including the European Accounting Review, Accounting and Business
Research, International Journal of Auditing, Accounting Forum, Advances in International
Accounting, etc. Stergios Leventis is the corresponding author and can be contacted at:
s.leventis@ihu.edu.gr
Panagiotis Dimitropoulos is a Teaching and Research Associate in Accounting at the
University of Peloponnese. His research interests are on financial and managerial accounting. He
has published articles in journals such as Research in International Business and Finance,
Journal of Financial Services Research, Journal of Applied Accounting Research and Advances in
Accounting.

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