Earnings management and firm value : The role of investor protection and corporate governance

Earnings management usually refers to the efforts of firm managers or executives to manipulate the earning figures in financial reporting. In general, these activities can be perceived negatively, as they can stem from managerial opportunism. Managers can use earnings management to report earnings for their own benefit, e.g. to get advantage from their compensation plans. However, some may argue that managers can use earnings management techniques to communicate or convey certain information and to smooth the earnings to reduce volatility. Therefore, earnings management can be both beneficial and harmful to firm value based on how managers employ it. Previous studies have shown evidence to support the role of investor protection and corporate governance in reducing the level of earnings management. However, if both investor protection and corporate governance can help to restrain managerial opportunism, they should reduce only the negative earnings management but not positive management. This study examines whether investor protection and corporate governance can reduce the negative effect of earnings. Using both firmlevel analysis in the United States and Thailand, and country-level analysis from 31 countries, the results support the fact that the effect of earnings management is more positive, or at least less negative, for firms with a higher level of corporate governance and for countries with a higher level of investor protection. The evidence from this study shows that managerial discretion, such as earnings management, is not actually unfavorable. Therefore, encouraging good governance or improving investor protection is as important as improving accounting rules and standards in order to restrain negative earnings management.