Literature Review – Corporate Governance and Earnings Management

Introduction

Corporate governance and earnings management sit at the centre of enduring debates about the credibility of financial reporting. Earnings management describes the use of judgement in financial reporting, and the structuring of transactions, to alter reported results either to mislead stakeholders about a firm’s underlying performance or to influence outcomes that depend on reported numbers (Healy & Wahlen 1999). Corporate governance comprises the mechanisms through which providers of capital seek to constrain the discretion that managers might otherwise exploit, so that reported earnings more faithfully represent economic reality (Jensen & Meckling 1976). The predicted relationship is direct: stronger governance should narrow the scope for opportunistic reporting, whereas weaker governance should widen it.

This review synthesises the empirical evidence on that relationship and interprets it for the Australian setting, in which the ASX Corporate Governance Council’s Principles and Recommendations, the Corporations Act 2001 (Cth), and the standards issued by the Australian Accounting Standards Board (AASB) jointly shape reporting behaviour. It pursues three objectives: to organise the evidence on which governance mechanisms most reliably constrain earnings management; to distinguish accrual-based manipulation from the increasingly documented practice of real earnings management; and to identify where Australian evidence remains limited. The scope is confined to listed-company reporting.

Scope and search strategy

Peer-reviewed articles were identified through Scopus, ProQuest and Google Scholar using combinations of the terms “earnings management”, “discretionary accruals”, “corporate governance”, “board independence”, “audit committee” and “ownership structure”, supplemented by regulatory publications from the Australian Securities and Investments Commission (ASIC) and the ASX Corporate Governance Council. Priority was given to foundational theoretical work, to studies in ranked accounting journals between 1995 and 2025, and to Australian evidence. Figure 1 maps the resulting themes and organises the review that follows.

Board characteristics

Board independence

The monitoring role of the board is the most heavily studied governance mechanism in the earnings management literature, and the proportion of independent, non-executive directors is its most common proxy. Agency theory predicts that outside directors, whose reputational capital is tied to effective monitoring rather than to management, will more vigorously scrutinise reported results (Fama & Jensen 1983). Early evidence is consistent with this expectation: Beasley (1996) finds that firms with a higher proportion of outside directors are significantly less likely to commit financial statement fraud. Extending the argument from fraud to routine discretion, Klein (2002) reports a negative association between board independence and abnormal accruals, and Xie, Davidson and DaDalt (2003) confirm that independent boards constrain discretionary accruals. Australian evidence aligns with these findings; Davidson, Goodwin-Stewart and Kent (2005) show that a majority of independent directors is associated with lower earnings management among ASX-listed firms, supporting the board-composition recommendations of the ASX Corporate Governance Council (2019).

Financial expertise

Independence alone is insufficient if directors cannot interpret the statements they oversee. Financial expertise, particularly among audit committee members, therefore emerges as a distinct determinant. Xie, Davidson and DaDalt (2003) find that boards and audit committees drawn from corporate or investment-banking backgrounds are more effective at limiting accrual management, suggesting that the capacity to detect aggressive reporting matters as much as the incentive to challenge it. This is reflected in the ASX Corporate Governance Council’s (2019) recommendation that audit committees comprise financially literate members, at least some possessing accounting or financial expertise.

Board diversity

Board diversity, and gender diversity in particular, has attracted growing attention as an attribute that may strengthen monitoring by widening perspectives and lowering tolerance for aggressive accounting. The evidence remains mixed and Australian studies are comparatively scarce. Nevertheless, the measurable-objectives approach to diversity promoted by the ASX Corporate Governance Council (2019), together with the advocacy of the Australian Institute of Company Directors (AICD), has kept board composition a live governance question for local firms. On balance, diversity is best understood as one contributor to overall board effectiveness rather than an independent remedy for earnings management.

Audit committee and external audit quality

The audit committee is the board subcommittee most directly responsible for the integrity of financial reporting, and its characteristics feature prominently in the literature. Klein (2002) documents that audit committee independence is negatively associated with abnormal accruals, and that reductions in independence are followed by increases in discretionary accruals. Xie, Davidson and DaDalt (2003) add that the frequency of audit committee meetings, a proxy for diligence, is associated with lower earnings management. In the Australian setting, Davidson, Goodwin-Stewart and Kent (2005) find that audit committee existence and independence reduce discretionary accruals, and Kent, Routledge and Stewart (2010) show that stronger governance improves the discretionary component of accruals quality among Australian listed firms.

External audit quality operates alongside internal oversight. Higher-quality auditors, conventionally proxied by firm size or industry specialisation, are expected to constrain client earnings management, possessing greater competence to detect manipulation and more reputational capital to lose by tolerating it. ASIC’s (2023) financial reporting and audit surveillance programme reinforces this discipline externally, identifying revenue recognition, asset impairment and provisioning as recurring areas where reporting judgement is tested. The interaction of a diligent audit committee with a competent external auditor is therefore best viewed as a joint constraint rather than two independent controls.

Ownership structure

Ownership structure shapes both the incentive and the opportunity to manage earnings. Jensen and Meckling (1976) frame the problem in terms of alignment between managers and owners: as managerial ownership rises, the interests of the two converge, reducing the incentive to misreport. Concentrated ownership introduces a more complex dynamic. Large blockholders have both the incentive and the resources to monitor management, which can discipline reporting; yet where controlling owners can extract private benefits, financial reporting may instead be used to obscure that expropriation from minority shareholders. The net effect depends on whether dominant owners act as monitors or as entrenched insiders (Fama & Jensen 1983).

Institutional ownership is generally associated with lower earnings management, because sophisticated investors demand higher-quality reporting and can exercise voice or exit, although this is contingent on the enforcement environment. Australia’s ownership landscape, marked by substantial institutional holdings through the superannuation system and relatively dispersed ownership among the largest ASX-listed entities, differs from the concentrated family and state ownership common in parts of Asia and Europe. Australian evidence indicates that internal governance structures, rather than ownership concentration alone, are the more consistent constraint on discretionary accruals (Davidson, Goodwin-Stewart & Kent 2005), suggesting that local ownership effects operate through their influence on board and committee quality.

Accrual-based versus real earnings management

A central distinction in the literature is between accrual-based and real earnings management. Accrual-based management exploits the discretion permitted within accounting standards, for example through the timing of provisions, the estimation of allowances, or the recognition of revenue, without altering underlying cash flows. It is typically measured as the abnormal or discretionary component of total accruals, estimated using the modified Jones model, in which discretionary accruals are the residual from a regression of total accruals on the change in revenue less the change in receivables and on gross property, plant and equipment (Dechow, Sloan & Sweeney 1995). Because such management leaves real operations untouched, it can often be reversed and is, in principle, detectable by a diligent auditor.

Real earnings management, by contrast, alters the timing or structure of genuine business activities to reach a reporting target. Roychowdhury (2006) documents three common tactics: accelerating sales through price discounts or lenient credit terms, overproducing to spread fixed costs across more units and lower reported cost of goods sold, and cutting discretionary expenditure such as research, advertising and staff training. These choices are harder to detect because each is a defensible operating decision, yet they can destroy long-term value.

Crucially, the two forms interact. Cohen, Dey and Lys (2008) show that, following the tightening of governance and audit oversight after the Sarbanes-Oxley Act, accrual-based management declined while real earnings management rose, evidence of a substitution effect. Mechanisms that successfully curb accruals manipulation may therefore displace managerial effort into costlier real activities, so governance quality should be assessed against both channels, not accruals alone, a point that the board-composition literature, focused on discretionary accruals, has been slower to absorb.

The IFRS and AASB reporting framework

The reporting framework itself conditions the scope for earnings management, and Australia’s adoption of International Financial Reporting Standards from 2005, through the standards of the AASB, provides a natural setting in which to examine this. Principles-based standards can reduce mechanical, rules-driven manipulation while widening the space for judgement, so the net effect on reporting quality is an empirical question. Chua, Cheong and Gould (2012) examine Australian firms around mandatory IFRS adoption and find evidence of improved accounting quality, including reduced earnings management and more timely recognition of losses, consistent with the view that a higher-quality, internationally comparable framework strengthens reporting discipline.

Standards nonetheless leave substantial room for judgement in areas such as impairment testing, fair-value measurement and revenue recognition, which is precisely why the interaction between the framework and firm-level governance matters. AASB standards define the boundaries of acceptable discretion; governance mechanisms determine how firms behave within them. The framework and the board are therefore complementary, and the enforcement layer discussed next binds the two together.

Enforcement and regulatory oversight

Written standards and recommended practices influence behaviour only to the extent that they are enforced. In Australia, ASIC administers the financial reporting and audit provisions of the Corporations Act 2001 (Cth) and conducts a recurring surveillance programme that reviews the financial reports of selected listed entities. Its published findings (ASIC 2023) regularly identify impairment, revenue recognition and the disclosure of estimation uncertainty as focus areas, signalling to preparers and auditors where scrutiny will fall and thereby raising the expected cost of aggressive reporting.

The ASX Corporate Governance Council (2019) operates through a complementary “if not, why not” disclosure model, under which listed entities report against the Principles and Recommendations and explain any departures rather than complying with a rigid mandate. This regime relies on transparency and market discipline rather than prescription. The combination of a comply-or-explain governance code, a statutory reporting regime under the Corporations Act, and active regulatory surveillance places Australian earnings management within a layered enforcement environment, and cross-country evidence that governance effects strengthen where enforcement is robust implies that these institutions reinforce the firm-level mechanisms reviewed above.

Synthesis of the evidence

Table 1 summarises eight representative studies that anchor this review. Read together, they support several conclusions. Board and audit committee independence, and financial expertise, are the mechanisms most reliably associated with lower accrual-based earnings management, across both United States and Australian samples (Beasley 1996; Klein 2002; Xie, Davidson & DaDalt 2003; Davidson, Goodwin-Stewart & Kent 2005), and the Australian studies confirm that these relationships operate largely through the quality of internal governance structures (Kent, Routledge & Stewart 2010). The literature has also broadened from accruals to real activities, revealing a substitution effect that complicates any simple claim that tighter governance improves reporting quality overall (Roychowdhury 2006; Cohen, Dey & Lys 2008). Finally, the shift to a principles-based AASB framework appears to have improved accounting quality in Australia without eliminating the judgement on which earnings management depends (Chua, Cheong & Gould 2012).

Gaps in the literature

Several gaps remain. First, the Australian evidence base, although consistent, is considerably smaller than the North American literature and is concentrated on discretionary accruals; direct Australian evidence on real earnings management, and on the substitution between the two forms, is limited. Second, much of the foundational work predates recent developments in board diversity, sustainability disclosure, and the expanded audit expectations reflected in ASIC’s surveillance priorities, so its external validity to the current setting is uncertain. Third, the literature tends to treat governance mechanisms in isolation, whereas Figure 1 suggests they operate as an interacting system. Fourth, endogeneity remains a persistent challenge: firms that manage earnings aggressively may also select weaker governance, so associations cannot readily be interpreted as causal. Addressing these gaps calls for Australian studies that examine both channels jointly, exploit the enforcement environment as a source of variation, and treat governance as a bundle rather than a set of independent levers.

Implications for the Australian setting

For Australian listed companies, the evidence carries clear practical implications. It supports the emphasis the ASX Corporate Governance Council (2019) places on independent, financially literate boards and audit committees, the attributes most consistently linked to lower earnings management. The substitution evidence implies that boards and auditors should look beyond discretionary accruals to real operating decisions, such as unusual end-of-period sales incentives or abrupt cuts to research and marketing. This is particularly relevant given ASIC’s (2023) recurring focus on impairment and revenue recognition, areas where both accrual and real management can be concealed.

The layered Australian enforcement environment, combining the Corporations Act 2001 (Cth), the AASB framework, ASIC surveillance and the ASX comply-or-explain code, provides conditions under which firm-level governance is more likely to be effective, since international evidence indicates that governance mechanisms bind more tightly where enforcement is credible. For directors and their advisers, including bodies such as the AICD, the implication is that governance quality should be evaluated as an integrated system rather than a checklist of independent attributes. For standard setters and regulators, the persistence of judgement within a principles-based framework means that surveillance and disclosure, rather than ever more detailed rules, remain the most proportionate response to earnings management.

Conclusion

This review has synthesised the empirical literature linking corporate governance to earnings management and interpreted it for the Australian context. The evidence indicates that independent and financially expert boards and audit committees are the most dependable constraints on accrual-based earnings management, that ownership effects operate largely through their influence on those internal structures, and that the reporting framework and its enforcement condition how much discretion firms can exploit. The distinction between accrual-based and real earnings management, and the substitution between them, is the most important refinement of recent decades, and it cautions against assessing governance quality through accruals alone. Australian evidence is consistent with the international picture but remains thinner, particularly on real earnings management and on the interaction among mechanisms. Within a reporting environment shaped by the AASB framework, the Corporations Act 2001 (Cth), ASIC surveillance and the ASX Corporate Governance Principles, the central message for practice is that reporting integrity depends on the combined operation of governance mechanisms, standards and enforcement, rather than on any single control.

References

ASX Corporate Governance Council 2019, Corporate governance principles and recommendations, 4th edn, Australian Securities Exchange, Sydney.

Australian Securities and Investments Commission (ASIC) 2023, Financial reporting and audit surveillance report 2022-23, ASIC, Sydney.

Beasley, MS 1996, ‘An empirical analysis of the relation between the board of director composition and financial statement fraud’, The Accounting Review, vol. 71, no. 4, pp. 443-465.

Chua, YL, Cheong, CS & Gould, G 2012, ‘The impact of mandatory IFRS adoption on accounting quality: evidence from Australia’, Journal of International Accounting Research, vol. 11, no. 1, pp. 119-146.

Cohen, DA, Dey, A & Lys, TZ 2008, ‘Real and accrual-based earnings management in the pre- and post-Sarbanes-Oxley periods’, The Accounting Review, vol. 83, no. 3, pp. 757-787.

Davidson, R, Goodwin-Stewart, J & Kent, P 2005, ‘Internal governance structures and earnings management’, Accounting & Finance, vol. 45, no. 2, pp. 241-267.

Dechow, PM, Sloan, RG & Sweeney, AP 1995, ‘Detecting earnings management’, The Accounting Review, vol. 70, no. 2, pp. 193-225.

Fama, EF & Jensen, MC 1983, ‘Separation of ownership and control’, Journal of Law and Economics, vol. 26, no. 2, pp. 301-325.

Healy, PM & Wahlen, JM 1999, ‘A review of the earnings management literature and its implications for standard setting’, Accounting Horizons, vol. 13, no. 4, pp. 365-383.

Jensen, MC & Meckling, WH 1976, ‘Theory of the firm: managerial behavior, agency costs and ownership structure’, Journal of Financial Economics, vol. 3, no. 4, pp. 305-360.

Kent, P, Routledge, J & Stewart, J 2010, ‘Innate and discretionary accruals quality and corporate governance’, Accounting & Finance, vol. 50, no. 1, pp. 171-195.

Klein, A 2002, ‘Audit committee, board of director characteristics, and earnings management’, Journal of Accounting and Economics, vol. 33, no. 3, pp. 375-400.

Roychowdhury, S 2006, ‘Earnings management through real activities manipulation’, Journal of Accounting and Economics, vol. 42, no. 3, pp. 335-370.

Xie, B, Davidson, WN & DaDalt, PJ 2003, ‘Earnings management and corporate governance: the role of the board and the audit committee’, Journal of Corporate Finance, vol. 9, no. 3, pp. 295-316.