CHAPTER ONE

INTRODUCTION

1.1 Background to the study

Earnings management is the process of taking deliberate steps within the bands of Generally

Accepted Accounting Practices (GAAP) to bring about a desired level of reporting performance.

Board of directors is charged with the responsibility of accounting for the activities of firms and

rendering proper stewardship on how the financial resources of the shareholders were managed

accordingly. It is the directors’ duty to ensure that the financial statement reported is a reflection of

the firms’ performance. In a bid to reduce tax, increase share values as a way to attract investors and

by extension keep their jobs, some directors capitalize on the loopholes in the standards and tax laws

to alter accounts. This represents purposeful intervention in the external financial reporting process,

with the intent of obtaining some private gains.

Earnings management can have serious effects on the future prospects of companies as prior studies

show evidence of positive and negative effect on both short and long-run performance of companies

(Gul, et. al., 2010). Many firms’ failures today were, attributed to the unawareness of the boards

concerning the management’s manipulations, as well as their inability to ensure the rights of the

shareholders (Clarke, 2007). Corporate scandals, in developing economies like Nigeria, the banking

sector among other sectors has witnessed several cases of collapses, some of which include; the

Alpha Merchant Bank Ltd, Savannah Bank Plc, Societe Generale Bank Ltd, Afribank Plc, Bank

PHB, Spring Bank Plc, Oceanic Bank Plc, Intercontinental Bank Plc, African Petroleum, Fin Bank

Plc, Lever Brothers and Cadbury. This indicates classified beautification of accounts (Onwuchekwan

1
et. al., 2012). The collapse of such large corporations has exposed the intentional misconduct of

managers and weakness of board structure which could not protect investors from expropriation and

earnings management (Supawadee et. al., 2013).

Earnings management has been described as "the deliberate misrepresentation of the financial

condition of an enterprise accomplished through intentional misstatement or omission of amounts or

disclosure in the financial statement to deceive financial statement users" (Certified Fraud

Examiners, 2003). As a result of the fore goings, there are various provisions of codes and statutes

that could be used to save and sanitize the financial system and improve financial reporting practices

all over the world. In response to that, the regulatory authorities in Nigeria have responded by

compelling companies to comply with stringent corporate governance codes.

Idornigie (2010) reported that Nigeria has multiplicity of code of corporate governance with

distinctive dissimilarities, namely; Security and Exchange Commission (SEC) code of corporate

governance 2003 to guide the operation of public companies listed in the Nigerian Stock Exchange,

which was reviewed in 2011; Central Bank of Nigeria (CBN) code of 2006 and National Insurance

Commission (NAICOM) code of 2009. Owing to the above, every public company in Nigeria is

required under section 247 and 248 of the CAMA to have directors. The principle objective of the

Board is to ensure that the company is properly managed, constituted in the manner stipulated and is

able to effectively discharge its statutory duties and responsibilities. It is the responsibility of the

board to oversee the objective performance of the management in order to protect and enhance

shareholder value. The primary responsibility of the board is to ensure good governance, and to

ensure that company carries on its business in accordance with its Articles and Memorandum of

2
Association and in conformity with the laws of country, by observing the highest ethical standards

and on an environmentally sustainable basis. The board should be of a sufficient size relative to the

scale and complexity of the company’s operations and be composed in such a way as to ensure

diversity of experience without compromising independence, compatibility, integrity and availability

of members to attend meeting. The members of the Board should comprise a mix of executive and

non-executive directors, majority of which should be non-executive directors and at least one of

whom should be an independent director.

1.2 Statement of the problem

The financial scandal involving the African Petroleum Plc in 2009, is one not to be taken with levity

as this may be happening among other firms within the sector. There were claims that a credit facility

of 24 billion naira was not disclosed in the financial statements (Kantudu & Samaila, 2015). The

implication of this is that, there will be a continuous rise of skepticisms in the mind of investors,

shareholders and other stakeholders and loss of confidence on the credibility of financial reports of

companies in Nigeria and particularly oil and gas firms due to the fact that financial reporting fraud

could be more pervasive than imagined. This therefore forms the practical problem that formed the

thrust for this research since the tendency for earnings management has been witnessed amongst

companies in Nigeria and this suggest that earnings management is a key challenge for stakeholders

in the Nigerian corporate setting.

In studies conducted in various developed and developing countries such as Guo, Huang, Zhang and

Zhou (2014), Arun, Almahrog and Aribi (2015), Hussaini and Gugong (2015), Ibrahim (2015) and

Ishaq (2017) failed to consider the use of Yoon, Kim and Woodruff (2012) model for measuring

3
earnings management level despite the criticisms levied against the model by Dechow, Sloan and

Sweeney (1995) that these studies adopted. The criticisms are; the improper separation of

discretionary components of accruals that leads to improper inferences. They argued that, if non-

discretionary components are treated as discretionary or vice versa, it will be hard to discern the

degree of earnings management appropriately, while the second criticism is that, studies on earnings

management generally do not decompose accruals into current components and non-current

components.

In Nigeria, researches on Board characteristics and earnings management such as Ishaq (2017),

Obigbemi, Omolehinwa, Mukoro, Ben-Caleb and Olusanmi (2016) as well as Kantudu and Samaila

(2015) failed to conduct robustness tests, multi-collinearity test, heteroscedasticity tests, normality

tests for residuals and long-range multiplier test before drawing inferences from their findings. The

failure to conduct these tests may render their findings and recommendation unreliable. Therefore,

this study takes into considerations all the robustness tests.

There is worldwide identification of value of boards for the achievement of organizational objectives

and goals. Several countries have issued guidelines and recommendations for best governance

practices and board composition (Cadbury, 1992; OECD Principles, 1999; Nigeria SEC code 2003

and revised version of 2011, CBN Corporate Governance code, 2006 and revised version of 2014

and NDIC code, 2009). Therefore, these codes complied with the need to be examined against the

level of earnings management in the firms, because the expectation is that compliance with those

codes will bring out the best practices of firms.

4
Most of the studies in this area (Saleh & Haat, et. al., 2014) were conducted in developed countries,

while other studies such as (Ishaq, et. al., 2017) were carried out in Nigeria. Because of the

peculiarity of these countries data and business environment, there is therefore need to add to the

existing literature in another dimension using a new measurement of earnings management. Based on

the identified problems and gaps above, the study investigates the effect of board characteristics on

earnings management of listed industrial goods companies in Nigeria.

1.3 Research questions

a. What is the relationship between board characteristics and earnings management of listed

industrial goods in Nigeria?

b. What is the effect of board of director size on earnings management?

c. What is the relationship between board independence and earnings management?

d. What is the relationship between the managerial shareholdings and earnings management?

1.4 Objectives of the study

The broad objective of the study is to investigate the relationship between board characteristics and

earnings management of listed industrial goods in Nigeria.

However, the specific objectives are to:

a. Examine the effect of board of director size on earnings management

b. Assess the relationship between board independence and earnings management

c. Evaluate the relationship between the managerial shareholdings and earnings management

1.5 Hypothesis of the study

5
The following research hypotheses were generated for the study:

Ho1: There is no relationship between board characteristics and earnings management of listed

industrial goods in Nigeria

Ho2: There is no effect of board of director size on earnings management

Ho3: There is no relationship between board independence and earnings management

Ho4: There is no relationship between the managerial shareholdings and earnings management

1.6 Significance of the study

The results of this study can be used as a consideration for investors in deciding to invest since

rational investors prefer organizations where their investment is safe and yield higher return. Also,

for the creditor in making lending decisions especially in the aspect of knowing fully well how and

the extent to which these board characteristics help mitigate the managers’ opportunistic tendencies.

It further creates confidence in the minds of the investors and potential investors on the reliability of

their earnings, owing to the board characteristics which mitigates the opportunistic tendencies of the

management and capitalizing on such characteristics to ensure transparent and financial reports free

of misstatements.

Secondly, results from this research provides an understanding and appreciation of the link between

board characteristics and earnings management. Gaining such fact enables regulators to ensure well

organised and strategic board. The costs of meeting corporate governance requirements are more

considerable because the outcome of this study has the potentials to benefit the industrial goods

sector, policy makers, professional bodies, and the community at large.

6
This study also assists the regulators in areas where there is need for improvement on corporate

governance mechanisms, in order to put the firms on the right direction. It further helps investors and

potentials investors in choosing one or some of the corporate governance mechanisms as an indicator

for earnings reliability.

For researchers, the study adds to the existing literatures on the subject matter, owing to the three

board characteristics proxies used i.e. board size, board independence and managerial shareholdings.

Finally, the use and the findings from board gender and board nationality effect on earnings

management is useful to management when they design their corporate boards.

1.7 Scope of the study

The study examines the effect of Board characteristics on earnings management of listed industrial

goods companies in Nigeria as at 31st December 2016. The study covers a period of 8 years starting

from 2009 to 2016. The justification of choosing this period is based on the fact that the period

comes after global financial crises that affected almost every sector in Nigeria that could have paved

way for more earnings management to absorb the shock and report good accounting numbers. Five

proxies of board characteristics (Gender diversity, board nationality, board size, board composition

and board meetings) were used based on the availability of their information in the annual reports

and account. Variables like board age, board qualification and board tenure is not fully available as

there is no stringent requirement for its disclosure.

1.8 Limitations of the study

7
In the course of this study, the researcher encountered a lot of hindrances among these, the most

salient one include finance which the researcher is faced with. Insufficient funds required for

expenses like transportation, acquisition of research instruments, sourcing for both primary and

secondary data etc. Also information on the secondary source of data available to the researcher was

either outdated or incomplete and the one available on the internet requires some form of

subscription before access is allowed. Time also posed a constraint on this research work such as

time to study and time to attend lecture etc. Attitude of respondent is also another limiting factor to

this research work. Most respondents are often reluctant to part with information even after being

assured confidentiality, they still prefer to be secretive.

1.9 Operational definition of terms

Earnings Management: This is the act of intentionally influencing the process of financial reporting

to obtain some private gains.

Board: This is a group of people who are responsible for controlling and organizing a company or

organization

Board of Directors: This is the governing body of a company, elected by shareholders in the case of

public companies to set strategy and oversee management.

Corporate Governance: This is the system by which companies are directed and controlled

Board Independence: This is the proportion of independent non-executive directors on corporate

boards, calculated from the number of independent members divided by the number of members on

the board.

8
 CHAPTER TWO

LITERATURE REVIEW

2.1 Conceptual review

2.2 Earnings Management

Earnings management has been seen in different perspectives by authorities. Earnings management

was a common practice among companies as it allowed managers to exercise their discretion through

accounting practices or policies that were questionable in order to achieve desired earnings in spite of

the presence of other board members (Jiang and Wing, 2005).

Rezaee (2002) notes that earnings management can occur through different implementation practices,

such as falsification, alteration or manipulation of financial documents and records, intentional

omission or misrepresentations of events or transactions or any other information relevant for the

financial statement, deliberate misapplication of accounting principles, policies or procedures,

inadequate disclosures concerning accounting principles of accounting records or amounts.

Consequently, the manipulation can occur by an accounting record, without any effect on cash flows

or on the real dimension of the firm, or by real, involving a change in the firm’s level of investment

or operating activities, both with an intention to impact the reported results (Lev, 2003).

9
However, Supawadee et. al., (2013) consider earnings management to include improper revenue

recognition: creation of fictitious revenue transactions such as; improper cut-off sales; premature

revenue recognition; unauthorized shipments sales; overstatement of assets: capitalization of

expenses as assets, usage of higher market value to increase the value of the asset; Misappropriation

of assets; and; Inappropriate disclosure. Meanwhile, irrespective of the form earnings management

would take, it is deceptive.

Earnings management is defined by (Blom 2009) as a purposeful intervention by the management in

the process of financial reporting in order to gain personal benefit or for the organization. Based on

this definition, earnings management is not informative for shareholders, and therefore it's

opportunistic. Earnings management practice is explained by several theories, according to the

signaling theory, earnings management is considered the indicator to the capital market to test

whether the firm engaged in value adding activities during a certain period or not (Waweru & Riro

2013). The rise of earnings management comes from the application of the accrual base rather than

cash flow that makes it easy for the management to manipulate the financial information as accruals

are less observable (Chen, et al 2014).

Accrual-based accounting leads to the division of total accruals into non-discretionary and

discretionary components. The discretionary accruals are the proportion of accruals that management

chooses to report (Gul, et al 2003). This indicates that by using accrual, accounting managers can

control the timing of revenue and expense recognition and thus can manipulate the firm's earnings for

a given period (Shah, et al 2009). Many prior literatures study the determinants of earnings

management, however very limited research is done to investigate the impact of board characteristics

10
on earnings management and especially in the developing nations, so this study attempts to study the

relation between board characteristics and earnings management in a developing country.

2.3 Board of Directors

According to Fan et al. (2002) and Kiel et al. (2003), there are internal and external mechanisms of

corporate governance. External governance relates to outside organizations that can control and

influence the decisions of managers. The internal mechanism of governance includes three

components: the concentration of ownership, compensation of executives and board of directors.

These elements can help to decrease the agency problem. Board of directors is the leading governing

component in a firm and is responsible for maintaining successful governance practice (Ongore et al.,

2011). A company’s board of directors is not only an essential part of the firm but also the center of

the decision-making process. Notably, the board plays a vital role in both the external and internal

activities of a company. Following the content of agency theory, the board can be seen as a

moderator between managers and shareholders, making sure that the firm’s resource is spent in the

right way. 2.3.1 Board size

The board of directors is not only an integral part of the company but also the brain of the decision-

making process. Board size, which is defined as the number of the board’s members, has an impact

on the effectiveness of the board and the effectiveness of the decision-making process (Pearce et al.,

2002). The company which has a large board size will have more diverse directors with varied

knowledge, information, professional experience and skillsets. Large board size is suitable for firms

11
with large assets and diversification (Coles et al., 2008). In contrast, a smaller board size might lead

to a lack of support for critical decisions and essential management (Golden et al., 2001).

2.3.2 Board independence

A member of the board of directors is independent when he/she is not a part of the managing team.

Agency perspective indicates that non-executive directors are an essential part of avoiding the wrong

decision-making process that does not safeguard the shareholders’ interests. The role of independent

directors is to control and review the managing team’s activities to balances the shareholder’s

interests (Rosenstein et al., 2005). Non-executive directors can deliver unbiased and objective

decisions because they are concerned about their reputations. Boards with a high percentage of

independent members are more successful in monitoring insiders’ opportunism (Khalil et al., 2016).

2.3.3 Board gender diversity

Appointment of female directors is seen as a useful tool to solve the problem of board homogeneity.

Being supported by the agency theory, board gender diversity is expected to mitigate the conflicts of

interest between executives and shareholders (Jensen et al., 2006). There are many supporting ideas

for the diversity of the board. First, it is deemed to be unethical to exclude anyone due to their

gender, race or religion (Carter et al., 2003). Second, in terms of economic benefit, Frobes et al.

(2009) stated that having gender diversity in the board improves its problem solving, decision-

12
making process and management monitoring. Besides, a higher percentage of female directors means

more expert and innovation provided to the firms (Joshi et al., 2009).

However, there are some adverse considerations. Conflicts might occur because males and females

have different perspectives on many matters. Decision-making process, therefore, could consume

more time (Lau et al., 2008). Female board members are moreover, risk-averse in giving investment

decision (Jianakoplos et al., 2008).

2.3.4 Board activity

The frequency of board meetings is a significant influence on a company’s operation. The board

meetings frequency is an excellent determinative factor of the effectiveness of monitoring managers

and decreasing earnings management (Adams, 2005). Regular board activities can help the board to

keep up well with the company’s situation, hence minimizing information asymmetry. If board

members are convened more frequently, they can contribute more time to reviewing and challenging

the decisions of the managing team. As a result, members of the board can monitor the firm better,

and so can lower earnings manipulation. Directors who do not participate in board meetings become

ineffective in protecting shareholders’ properties because they do not have updated information on

managerial behaviors, then are not able to detect unusual actions.

2.3.5 CEO on board

Through articles about CEO sitting on board, Klein (2002) shows that the monitoring function of the

board can be more effective if there are more independent directors. Regarding earnings

management, Davidson et al. (2005) suggest that “this may be due to limited supervision by the non-

executive chairperson and to the board itself being predominantly independent from management”.

13
Besides, Jensen (2003) notes that the CEO who is in the Board has higher control on available

information in comparison with the CEO who is executive only.

2.4 Relationship between Board Characteristics and Earnings Management

2.4.1 Board Size and Earnings Management

Nugroho & Eko (2011) gave a definition that board size is described as the number of members in

the board. It consists of the members on the board of directors and the board of commissioners.

Mentioned in a research by Daghsni et al (2016), a larger sized board improves the ability to have

control over the company. They further explained that the size of the board should not be too big and

not too small. They suggested the optimal size for a board is between 5 to 9 members. This is

because a board too big will lose its effectiveness in the controlling of the company.

The optimal size of board members is ensured by an adequate number of board members to perform

the monitoring functions effectively. According to Rahman & Ali (2006), board size is positively

related with earnings management. In contrast, Xie et. al., (2003) argued that smaller boards are

better able to make timely decisions than large boards. However, they stated that larger boards with

diverse knowledge are more effective for constraining earnings management than smaller boards.

Xie et al. (2003) further stated that large boards with various experts are more likely to have a higher

degree of independence than small boards. Similarly, Peas et. al., (2004) found that having a large

14
board is better in reducing earnings management compared to smaller boards and that the higher the

number of members on the board, the greater the monitoring activity of management. If large boards

enhance monitoring, they would be associated with less use of earnings management. In this same

vein, Ebrahim et. al., (2007) found that larger boards are associated with lower levels of discretionary

accruals.

A reasonable size of the board is expected to be effective in monitoring the activities of firms’

management (Sanda et. al., 2008). A large size of board of directors can improve monitoring

mechanism effectively and prevent managers to engage in earnings restatements (Feng & Shiao,

2009). Larger boards with competent directors having diverse educational and technical knowhow,

have multiple perspectives to improve the quality of firm’s value and more likely to represent the

interests of shareholders thereby preventing managers from earnings management (Jian & Ken,

2004). On the contrary Jensen (2003) stated that streamlined boards can operate more effectively in

maintaining management.

In general, when the size of the board is increasing it is expected to reduce the discretionary accruals

and improve the financial reporting quality due to the higher degree of inspection and monitoring by

the board of directors. Fama & Jensen (2003) describe the board of directors as the most important

mechanism in the internal corporate governance structure of any firm. From an agency perspective,

(Kiel & Nicholson, 2003) clarify that larger boards are more likely to be vigilant for agency

problems because a substantial number of experienced directors can be deployed to monitor and

review management actions. The agency theory perspective also conceives that larger boards support

effective monitoring by reducing CEO dominance within the board and they protect shareholders’

15
interests (Singh & Vinnicombe, 2004). The previous scholars pointed out that larger boards improve

the bargaining position of the board with regard to the CEO and thus larger boards are more effective

in monitoring the management. Moreover, Chekili (2012) examined the impact of Corporate

Governance mechanisms on earnings management and found the significant relationship of earnings

management with board size, the presence of external directors on the board.

Furthermore, Soliman & Ragab (2013) examined the effect of an independent board of director’s

members, board size and CEO duality on earnings management, whereby results proved negative

relation of board size with earnings management. Siam et al. (2014) explored the relationship

between board characteristics and earning management, using board characteristics. Results

supported the role of an effective board to reduce earnings management i.e. independence, financial

expertise board, board size, and board meetings.

Aygun et al. (2014) studied the impact of the size of the board and corporate ownership on earnings

management and found the negative relationship of institutional ownership and board size on

earnings management. Talbi et al. (2015) study investigated the effectiveness of board characteristics

in limiting earnings management.

2.4.2 Board Independence and Earnings Management

This is the proportions of non-executive directors on the board to the total number of board size.

Non-executive directors should be the key members of the board. They should bring independent

judgment as well as necessary scrutiny to the proposals and actions of the management and executive

directors, especially on issues of strategy, performance evaluation and key appointments (Nigerian

SEC code of corporate governance 2011). Studies conducted on the relationship between board

16
independence and earnings management show mixed results. Moradi, Salehi and Bighi and Najari

(2012) studied the relationship between board of directors and earnings management of listed

companies in Tehran for the period of 2006 to 2009. Their result showed a negative but non-

significant relation between board independence and earnings management.

Board independence is mainly related to the number of independent directors as explained in the

agency theory. According to Jouber et al. (2012) using a sample of 180 firms from both France and

Canada between 2006 and 2008, they explore whether the strongest corporate governance

mechanism (e.g. board independence) could lead to a mitigation of earnings at management level. In

the USA, Anglin et al. (2013) found that an independent board led to a constrained level of earnings

management, using a sample of 153 real-estate investment trusts firms between 2004 and 2008. The

aforementioned studies have been expanded to study the influence of the independent board on

earnings management both before and after adopting IFRS.

Callao & Jarne (2010) found that earnings management increased after the adoption of IFRS in

Europe, where the discretionary accruals increased in the period following the implementation. They

referred this result to be arising from the difference between the local (GAAP) and the international

standards (IAS, IFRS), which then leads to the manipulation. Moreover, Marra et al. (2011) found

that the independent board, after adopting the IFRS in Italy, has a negative impact on earnings

management. Based on Zhu & Tian (2009), examined the effect of CEO compensation and Board

characteristics and on firm performance, while adjusting the performance for the effect of earnings

management. Results depicted that independent directors formed more effective Corporate

Governance mechanism in China.

17
Again based on Cornett et al. (2008), also reported that Corporate Governance mechanisms like

board independence helped to control earnings management practices. Moreover, Roodposhti &

Chashmi (2010) examined the relationship between Corporate Governance internal mechanisms,

CEO duality, board independence, ownership concentration, and earnings management. The results

depicted the negative impact of ownership concentration, board independence and CEO duality on

earnings management, as well as Chekili (2012) examined the effect of Corporate Governance on

earnings management and proved that the presence of external directors had a significant relationship

with earnings management. Confirmed by Siam et al. (2014), investigated the impact of Board

characteristics on earning management, whereby Board characteristics included board size, board

independence, board meetings, CEO duality and financial expertise of Board. Results concluded that

effective board reduced earnings management i.e. board independence, size, meetings, and financial

expertise played a significant role in constraining earnings management.

Talbi et al. (2015) carried out a study to investigate the efficacy of board characteristics in restraining

management’s earning management, whereby results showed that board independence played a

significant role in controlling earnings management. According to Man & Wong (2013), while

conducting the review of the literature on earnings management and Corporate Governance, reported

that board independence increased the control of management’s earning management activities. Over

again Sukeecheep et al. (2013) explored the influence of board characteristics on earnings

management behaviors and reported that board independence showed a positive link with earnings

management.

18
Roodposhti & Chashmi (2011) investigated the impact of corporate governance on earnings

management for 2004 to 2008 and found negative significant relationship between board

independence and earnings management. Fodio et al. (2013) examined corporate governance

mechanisms and reported earnings quality in listed Nigerian insurance Firms for the period 2007 to

2010. The study showed that board independence is positively and significantly associated with

earnings management

Issue of board independence has been investigated with great attention, considering the independent

status of the directors as a good indicator of the Board’s effectiveness (Hermalin & Weishbach,

2002). The components within the board are essential ingredients for effective monitoring.

According to Peasnell et.al., (2004), outside directors play a more effective role in monitoring top

managers’ aggressive behaviors than insiders. Their results show that earnings management is

negatively associated with a larger proportion of outside directors. Using data for varying sample

size (ranging from 89 firms for regression to 205 firms for descriptive analysis) obtained from the

Nigerian Stock Exchange for the period 1996 to 2004, it was established (Ahmadu et. al., 2008) that

certain aspects of board independence could possibly have effect on firm performance.

However, Xie et.al., (2003) found that earnings management is less likely to occur in companies

whose boards include both more independent outside directors and directors with corporate

experience. But the level of earnings management may influence the subsequent selection of board.

Davidson et al (2005) found that, based on a broad cross-sectional sample of 434 listed Australian

firms, a majority of non-executive directors on the board are significantly associated with a lower

likelihood of earnings management.

19
Peasnell et al. (2005) examined whether the incidence of earnings management by UK firms depends

on board monitoring. Results indicate that the likelihood of managers making income-increasing

abnormal accruals is negatively related to the proportion of outsiders on the board.

There could be effective monitoring of the managers, when there are high numbers of outside

directors on the board, because board independence responsiveness is connected with monitoring of

managers. Consequently, there would be reduction in agency costs arising from the ownership and

control separation in day-to-day management of the company (Brennan & McDermott, 2004).

Nevertheless, the findings of the existing literature with regards to board independence’s relationship

with earnings management are mixed. In the research by Amran et. al. (2016), board independence is

found to be negatively related to earnings management, indicating the fact that board independence

could curtail the real activities in the companies.

Similarly, Iraya et al. (2015); Klein (2002); Uadiale (2012); and Kang and Kim (2012) found that the

more the independent directors, the better the monitoring of the behavior of corporate managers. This

position agrees with the agency theory perspective. Agency theory postulates that the independent

directors’ monitoring role is of importance. The primary aim of independent directors is to minimize

or mitigate the agency problem which emanates from separation between ownership and

management of the firm (Al-Rassas & Kamardin, 2015).

2.4.3 Managerial Shareholding and Earnings Management

Several prior studies have examined the relationship between the board of directors and earnings

management. The results of prior studies indicate that CEOs manage earnings to maximize their

personal wealth (Cheng & Warfield, 2005). Ali et. al., (2008), Banderlipe (2009) and Persons, (2006)

20
found that managerial shareholdings are associated with lower levels of earnings management. In

fact, managers with high stock shareholdings could gain from earnings management with the purpose

of keeping stock prices high and increasing the value of their shares (Yang et al. 2008).

Meanwhile, Al-Fayoumi et. al., (2010), Cheng & Warfield (2005) and Mitani (2010) found that firms

with higher managerial ownership are associated with more earnings management. Therefore, higher

managerial shareholdings encourage managers to use discretionary accruals to improve earnings and,

consequently, the value of their stock holdings.

2.5 Theoretical framework

2.5.1 Agency theory

Agency theory is a critical theory of Board Characteristics. The main idea of agency theory is that

there is a segregation of ownership and control or management and finance. The separation

mentioned here leads to agency costs, including costs from creating contracts between principals and

agents, monitoring costs from principals, bonding costs from the agents’ side, and the residual loss

from non-optimal decisions taken by the agents (Jensen et al., 1976). Two main assumptions support

agency theory: First, managers tend to pursue their own interests over the interest of shareholder

(Fama et al., 1983). Second, there is an asymmetry of information received between the managers

and the shareholders, showing unfair access to information by the two parties (Spremann, 1987).

However, the agency problem can be eliminated by managers and shareholders when signing a

complete contract (Jensen et al., 1976). Nevertheless, the whole contract establishment is not

practicable, and costly, as it is difficult to foresee all contingencies and expenses incurred for the

21
contract designation, renegotiation and dispute solving (Hart, 1995). Acknowledging the

impossibility of eliminating the agency problems, Fama et al. (1983) propose to use the board of

directors as an effective and inexpensive mechanism of governance to monitor and control the

activities and decisions of managers and then reduce the agency problems and all related expenses.

2.5.2 Stewardship theory

Stewardship theory, in contrast with agency theory, holds the view that executives are trustworthy

stewards, and they will act to maximize the benefits of shareholders (Davis et al., 1997). According

to Shleifer et al. (1997), the motivation of managers to maximize the benefits of shareholders is to

keep their reputation with the investors. From this perspective, managers and directors should be

supported and empowered to maintain good business results for the corporation.

2.5.3 Stakeholder theory

Stakeholder theory could be considered the extension of agency theory. Under the agency theory, the

managers are obliged to act at the interest of the shareholders only. Under the stakeholder theory, the

parties of interest are widened as managers are now required to take into account of other different

stakeholders, such as employees, customers, suppliers, creditors, government parties. As defined by

Freeman (1984), stakeholders include “any identifiable group of individuals who can affect the

achievement of an organization’s objectives or who is affected by the achievement of an

organization’s objectives”.

Freeman (1999) also concludes that managers’ responsibilities are not confined to maximizing

shareholder’s value but also all the other stakeholders’ benefits. Stakeholder theory is viewed to be

too challenging and not practical because the management team can not recognize all stakeholders

22
(Sundaram et al., 2004). Put in the context of this thesis which focuses on the relationship between

the board of directors’ characteristics and managing earnings practice, stakeholder theory may not be

as relevant as the two above mentioned theories. However, when perceived in the broader context,

stakeholder theory suggests that a capable board of directors would make better decisions related to

other stakeholders’ interests.

2.5.4 Resource dependence theory

The primary understanding underlying the resource dependence theory is that companies rely on

external sources, which may include capital resources, human resources, market resources. These

resources are necessary for firms to create and maintain efficiency and effectiveness (Barney, 1991;

Daft, 2006). Following Pfeiffer et al. (1978), the firm needs external resources to generate superior

performance, and the board of directors has responsibilities for facilitating access to the external

resources by utilizing their established liaisons. Therefore, the use of outside directors will help a

firm to get access to a variety of resources, for example, information, experience, suppliers, buyers as

suggested by Hillman et al., (2000). The importance of board size, board composition and the

backgrounds of external directors was also suggested in studies by Pfeiffer (1972) and Pearce et al.

(1992). Thus the resource dependence theory highlights the board as a contact point for firms to get

access to useful external sources.

23
24