Corporate Governance and Earnings Management. Evidence from Europe

In response to the many corporate scandals, regulators developed laws and recommendations in order to improve the governance of firms. This paper studies the relation between different corporate governance mechanisms and earnings management in a European context. Prior research focused mainly on U.S. firms. However, Europe is quite distinct from the U.S. in terms of country- and company-level characteristics. Our results show that better corporate governance is associated with less (income-increasing) earnings management by European firms. More specifically, we find that better shareholder rights, fewer anti- takeover mechanisms, and a good functioning board of directors and director committees lead to higher accounting quality. We also find that the extent of corporate governance recommendations issued at the country level influences the effectiveness of corporate governance practices in constraining earnings management. These relations are especially evident in code law countries, where the opportunities for earnings management are larger than in common law countries.