The Reciprocal Relationship between Earnings Management, Disclosure Quality and Board Independence: UK Evidence

Abstract

We empirically examine the reciprocal relationships between disclosure quality, board independence and earnings management. Disclosure quality is measured using the IR Magazine Award, the number of forward looking information in the annual report as well as the analyst forecast accuracy. We estimate earnings management using modified Jones Model, while board independence is measured using the percentage of independent directors in the board. We remedied the simultaneity bias in our study using a simultaneous system of equation, which was estimated using two-stage least square regression (2SLS). Match-paired samples comprised of the winners and non-winners of the IR Magazine Award during the years from 2005-2008 were employed in our study. Our finding reported that there is a negative reciprocal relationship between disclosure quality and earnings management. We notice that these findings are robust across all disclosure quality measurement that we utilised in our 2 Stage Least Square (2SLS) regression. Only one way (negative) causality between board independence and earnings management is demonstrated (in the board independence equation). In regards to disclosure quality and board independence, we found mixed findings. In this instance, our result demonstrated that there is no reciprocal relationship between disclosure quality and board independence (measured using IRAWARD). Nonetheless, we reported a positive reciprocal relationship between board independence and disclosure quality when forward looking information is utilized as to represent disclosure quality and a negative relationship between these variables when analyst forecast accuracy is employed. Our finding suggests that future research should take into account the potential simultaneity bias when examining the relationship between disclosure quality, earnings management and board independence.