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

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.