To What Extent Does the Structure of the Board Affect Earning Management in the United Kingdom - Research Paper Example

To what extent does the structure of the Board affect earning management in the United Kingdom? BY YOU YOUR SCHOOL INFO HERE HERE of the Project To what extent does the structure of the Board affect earning management in the United Kingdom? 2. Summary Corporative governance consists of different policies and processes that assist in guiding a corporation strategically, operationally and financially. Business decisions are formulated at the level of the Board of Directors which are guided by regulatory systems and best practices that dictate executive management activities and also control their compliance expectations to established internal policies and relevant UK laws on corporate governance codes of conduct (Clarke 2004). Governance members have the ultimate responsibility of examining market conditions external of the organisation and attempting to align internal practices and policies to meet these market conditions to achieve higher competitiveness and profitability (Charan 2005; Bowen 2004). Corporate governance in the UK is usually structured as a means of meeting and considering shareholder needs as primary objectives. This is supported by the consumerist economy in the United Kingdom and the notion of a free market society where shareholders become important owners of the corporation. Government in the UK is limited to the level of regulation and control that they can establish over corporations in relation to supply, demand and even industrial product output. This type of economy has been heralded by such historical theorists as Milton Friedman and Adam Smith who suggest that the only legitimate responsibility of corporations is to seek profitability for the corporation and sustain its financial interests (Fleischacker 2011). Because corporate profitability increases have supplemental impact on improving communities, local governments and society stakeholders, such as being able to provide more jobs, profit objectives should be a primary concern of corporations (Dunn 2010). Therefore, in an effort to improve shareholder and corporate wealth, the Board of Directors structures itself toward meeting this objective. The majority of UK corporations structure governance teams to be inclusive of Directors, executives, auditors and even shareholders to establish policies, rules and procedures that will improve strategic decision-making and enhance profitability (Baker and Anderson 2010). This occurs through cost control methodologies determined by the Board, adopting acceptable accounting practices, examining expenditures throughout the operational model, and aligning such support divisions as sales and marketing to build a better competitive brand and business identity (Mallin 2013; Monks and Minow 2011). Therefore, from a theoretical perspective, corporate governance Boards attempt to structure themselves to better fit evolving business conditions and establish metrics and strategies to improve the financial position and return on investment for the corporation whilst taking into consideration multi-faceted contextual factors that drive corporate success or failure. 3. Problem statement The main problem of the Board of Directors of corporations is to serve as guardians and overseers of the organisation to ensure that the business operates in the most effective and productive way to satisfy shareholders who serve as owners of the business. “Effective Boards build capabilities within themselves and their organisations which allow them to do both, protect existing asserts and manage threats to future growth” (Deloitte 2009, p.1). This assertion by Deloitte (2009) indicates that asset management and growth are tightly linked with financial objectives. This would require a Board structure that could assess a plethora of business divisions, operations, accounting practices, and support units that provide the potential for maximum return on investment. Therefore, there should theoretically be a Board structure with multi-level competencies and knowledge in order to provide maximum profitability as it is necessary to examine such an intricate and complicated system of business inter-dependencies that lead to ROI, efficiency and productivity (Nahandi et al. 2012). 4. Research questions Having an understanding of governance, what structure is most appropriate and relevant for maximising profit and positively impacting earnings management practices? This study intends to examine this important question. When serving as asset protectors, how should the Board be structured to prevent any questionable activities related to accounting and reporting procedures? 5. Aims and objectives The aim of the study is to determine the extent to which the Board of Directors’ structures manage to affect earning management within corporations in the United Kingdom. The study has three research objectives: Determine what Board structures are relevant and recognised as being viable for UK corporations. Determine the size and scope of the Board which could potentially contribute either positively or negatively to earnings management ideologies. Formulate recommendations for real-world UK corporations on what type of Board structure would be most viable preventing or improving earnings management practices and ideologies. 6. Rationale In the wake of such scandals as Enron, it is important to understand how Board structure prevents questionable accounting and reporting activities. Creative accounting practices are conducted as a means of putting the organisation first. This is often considered unethical by stakeholders and under UK law that establishes the first duty is to shareholders. It would be relevant for protecting shareholders to uncover what specific motives occur for creative accounting activities (earnings management) and whether Board structure affects these incentives. 7. Literature review This chapter offers an examination of available literature on the potential structures of UK corporate Boards as well as defining earning management. It also provides a foundational knowledge of the advantages or potential disadvantages of adopting disparate governance structures that could theoretically contribute to more effective or less-effective earnings management practices and ideologies. 7.1 What is earning management Earning management is a type of deviation from established norms of standardised accounting practices. It is also referred to as a type of creative accounting methodologies whereby incomes and assets of the organisation are manipulated to achieve a more productive financial end for the corporation. Though earning management practices may deviate from established accounting norms, in the wake of such scandals as the U.S.-based Enron, corporations that engage in these practices attempt diligently to follow the letter of the law as it pertains to acceptable accounting procedures (De la Torre 2009). Historically, this type of creative accounting has been believed to be a deliberate effort to influence reporting in a way that misleads shareholders about genuine corporate performance. However, earnings management, in most instances where it occurs, is an intentional influence of reporting and accounting practices, whilst still complying with the law, to give a business a predetermined gain (Schipper 1989). However, it should be recognised that not all UK corporations are ethically-minded when engaging in earnings management and seek to actively manipulate financial data to deliberately fraud shareholders. For this sake of this proposed research, more moderate earnings management as a means of only finding gain whilst considering compliance should be recognised as viable and widespread. Common activities in earnings management include such methods as changing the timing of accounting transactions and altering a variety of estimates that are often part of financial reporting. Negating estimates associated with accounts that are uncollectible has the ability to effect net income of the corporation which looks less risky on financial reports generated to shareholders. Companies that use the LIFO accounting method associated with inventory volumes are actually able to produce higher net incomes by putting off a variety of purchases that will be reported on future accounting periods. These are just a few examples of moderate earnings management practices that occur in some UK corporations as a means of fostering a perception of better financial position. 7.2 The independent Board member Most UK corporations have adopted a Westernised model of governance in which there is a single-tier system that maintains executives on the Board that are insider representatives of the corporation as well as external, non-executives. This strategy guarantees that there is less prejudice in decision-making that can occur by those who show favouritism and bias toward the firm and also provides the knowledge and underpinning experience necessary to make quality strategic decisions. Internal executives have advanced knowledge of operational systems, accounting practices, and financial management activities of the organisation that are absolutely critical to making sound decisions about the corporation (Lim, Matolcsy and Chow 2007; Karamanou and Vafeas 2005). Contemporary Boards of Directors require skills of independent Board members, theoretically, to control a variety of different agency problems that exist within the corporation. This is inclusive of supervisory issues, contract fulfilment, and potential economic losses associated with operational strategy developments. When Boards have members that are independent, meaning they maintain no legitimate authority in the Board, they provide higher levels of financial prowess and competencies that assist in establishing controls over a variety of managerial behaviours (Nahandi et al. 2012). Independent members maintain an official duty to dictate and control decision-making when there are agency issues occurring between members who are in charge within the Board and shareholders. One such example is coming up with solutions and criteria for reward and punishment systems of managers at the corporation as well as serving to assist in supervising the activities of executives at the firm. Such independent membership also creates a better shareholder support system who tend to serve as more appropriate supportive agents for this ownership (Lim et al. 2007). Why is this? Independent members when assigned to the Board have less prejudice and bias, or favouritism, regarding the corporation and can be more impartial in their decision-making and problem solutions (Razaee 2009; Clarke 2004). Hence, having these independent members within a UK organisation ensures that asymmetrical relationships between managers and shareholders is reduced and profits better supported (Lim et al. 2007). This would have communications considerations and control systems establishment features that provide opportunities for better earnings management and profitability. It is even recognised that having independent members on the Board provides opportunities to more effectively reduce agency expenditures that have increased value for the corporation (Xie and Davidson 2003). Having high levels of knowledge of financial matters, understanding how to better engage with shareholders, and using impartial judgments about managerial and cost controls would theoretically be an effective Board structure that strongly, positively impacts earnings management practices. Hence, it would appear that having independent Board members would reduce the potential risk of having Board members or executives engage in deceptive earnings management practices and better mitigate its prevalence. 7.3 Internal and external auditing teams Many UK Boards have inter-dependent relationships with internal and external auditors that ensure more compliance and best practice in accounting and reporting activities of financial data. Many of the relationships with external auditing teams are long-standing. However, the International Federation of Accountants sees such relationships as being dangerous for ensuring fair and accurate accounting procedures and reporting. Over time, auditors become intimately familiar and establish social relationships with Board members and executives at the corporation which can serve to influence judgment and fair evaluation of this information (Boxer 2008; Carey and Simnett 2006). This would indicate a higher level of potential risk for Boards that have established a close-knit structure with external auditing teams that could serve to allow negative earnings management practices to go unreported and dismissed. Fiolleau, et al. (2010) believes that auditing companies are actively engaged in what is referred to as beauty contests in certain industries where auditing firm competition is highly saturated and firms want to improve their reputations and increase industry exposure to gain new business partnership opportunities. Therefore, in order to theoretically stay with a corporation as an auditing agency, they might be more willing to try to gain favour and build relationships with Board and executive team members which could be inclusive of less-ethical reporting of earnings management activities. Status and repute of the firm is important and is often dictated by Board sentiment about the competencies and aptitude of auditing firms. Therefore, it should theoretically be of advantage for corporations and shareholders to have a more balanced auditing system within the governance Board team to avoid such instances. Carey and Simnett (2006) suggest that rotating auditors as part of corporate policy can have significant advantages in providing more impartial and accurate auditing services. It appears to be becoming common practice for companies to rotate auditors in order to prevent the type of aforementioned cosiness and intimacy that stems from long-term relationships with auditing firms in UK corporations. 7.4 Increasing membership Several studies have shown that Boards that have more members, both independent and internal, can provide more effective governance of the organisation (Belkhir 2009; Andres and Vallelado 2008). Having more members provides a more diverse set of advising functions and has proven more efficiency in controlling and monitoring managerial actions. Earnings management is not occurring within a vacuum when present in the UK organisation, hence it requires active involvement by many members of accounting, management, or the Board (or a combination thereof) in order to accomplish such manipulations and creative accounting practices. Having more members provides the foundation for better oversight and the ability to control more activities of management that might theoretically be engaged in negative earnings management practices. The findings of the studies provided by Belkhir (2009) and Andres and Vallelado (2008) were inclusive of the banking industry (solely), however the theoretical constructs would appear to make logical sense: having a broader scope of control and oversight would reduce opportunities to use creative accounting methods to defraud investors or put the interests of the organisation ahead of shareholder interests which is mandated as inappropriate under British law. Furthermore, Heng, Azrbaijani and San (2012) found that board size and scope provides, coupled with independent Board membership, serves a positive influence and role in controlling and evaluating the financial mix of the corporation. This is supportive of the aforementioned assertions that having more oversight and higher volumes of Board membership should theoretically provide limited opportunities for dishonest or fraudulent earnings management practices. At least, running under the assumption that not all Board members will maintain the questionable moral code that leads to rather dubious earnings management practices, having more members should provide some form of ethical foundation that ensures managers and Board members comply with accepted, international accounting standards and reporting norms. 8. Research methods This chapter describes the research approach for the proposed study and a justification for methodology as it pertains to the objectives identified in Chapter One of the proposal. 8.1 Research design It would be difficult to quantify, statistically, the rationale for what causes Board members and executives to engage in creative accounting and earnings management practices. There are likely professional, psychological and sociological factors that serve as catalysts for this approach and belief in its acceptability as relevant accounting and reporting practices. Henerson, Morris and Fitz-Gibbon (1987) indicate that when variables of a study have many multi-faceted aspects related to psycho-social factors, it requires inference and a blend of subjectivity in analysis to determine these factors. Measuring attitudes is not achievable quantitatively (Henerson et al 1987). Since attitudes are disparate from one individual or group to another and known to be ever-changing over time (Joppe 2000), it can impact the reliability of the study to attempt a quantitative approach to research. Therefore, the study will take a qualitative approach to research, developing a series of open-ended interview questions to better engage attitude, motivations and beliefs of executives and/or Board members in real-world corporations as it pertains to earnings management practices and the role and structure of the Board. The study will recruit a sample of between six and eight executive-level or Board –level governors within UK corporations. Questions regarding earnings management, Board activities and structure, and perceptions of the potential relationship of Board structure in mitigating or enhancing earnings management practices will be constructed. The researcher will make contact via telephone with leaders of relevant UK corporations maintaining Boards of Directors in order to gain access to important potential participants in the interview process. The qualitative approach, the interview questions, will provide more depth of knowledge of not only Board structure impacting earnings management practices, but also the potential catalysts and contextual factors that lead to its approval or rejection by Board members. This might take into consideration legal compliance fears or psycho-social and professional factors that lead to a desire to protect and insulate the firm through earnings management ideologies. This is not achievable through statistical methodology. Interviews will be scheduled for sessions ranging between 50 and 60 minutes per recruited participant. Questionnaires, which were originally considered as a potentially viable instrument for study, were ultimately rejected as they often fail to achieve the high level of in-depth study necessary when the specific variables of what is intended to be measured are known by the researcher. It would prevent achieving the richness and breadth of knowledge that comes from engaging real-world individuals that have immediate experience and attitudes regarding certain professional practices. This is the rationale for selecting interviews as a relevant research approach. 8.2 Data analysis In order to analyse inferred data findings and fully assess the many complicated factors that will likely drive the decision-making for earnings management, the researcher will require consultation with further professional secondary literature ranging from corporate governance theory to psychological theory to enhance the capabilities for effective analyses. This supplementary research will provide enhanced validity for the research study by ensuring that accuracy in evaluation and analyses of interviews is accomplished. Interviews will be appropriately transcribed and then evaluated to determine whether any relationships or associations exist with disparate interview participants. Once identified, these will be appropriately charted, tabled or graphed to illustrate these parallels (if relevant). Basic demographics of the participants will also be collected, including tenure in the firm, their level of authority, and engagement with other Board members and executives as well as stakeholders to assist in identifying potential demographic correlations. 9. Ethical issues Participants, due to the sensitive nature of information about reporting practices and any potential earnings management activities, will be presented a consent form that ensures there will be absolute anonymity for participants. The name of the organisation in which interview participants are employed will be obscured from findings and in no way published. There will also be acknowledgement to the participants that no compensation for involvement in the interview process will be provided. 10. Timescale Development of interview questions will require approximately three weeks after consulting with further secondary literature on earnings management, Board structures and best practices in corporate governance. Concurrently, contact will be made with appropriate organisations to secure access to participants and schedule the series of interviews. The following represents the expected timescale for project completion: 1. Prepare research instruments – 3 Weeks 2. Schedule interviews and secure access – 3 Weeks 3. Perform interviews and analyse – 3 weeks 4. Construct analysed data presentation – 3 weeks 5. First draft of dissertation – 3 Weeks 6. Finalize completion of project – 2 Weeks This dissertation requires approximately 17 weeks from research design through final project completion. 11. Resources and cost The financial burdens of conducting research are quite minimal, as the majority of project research, instrument construction, and interview processes rely on researcher competency and capability. There are no extenuating concerns or reimbursements required for the research. Access to university secondary resources, to basic word processing software, and generic office tools are the only resource considerations for this project. References Andres, P. and Vallelado, E. (2008). Corporate governance in banking: the role of the board of directors, Journal of Banking & Finance, 32(12), pp.2570-2580. Baker, H.K. and Anderson, R. (2010). Corporate governance: a synthesis of theory, research and practice. Hoboken: John Wiley and Sons. Belkhir, M. (2009). Board of director’s size and performance in the banking industry, International Journal of Managerial Finance, 5(2), pp.201-221. Bowen, W. (2004). The board book: an insider’s guide for directors and trustees. 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Xie, B., Davidson, W.N. and DaDalt P.J. (2003). Earnings management and corporate governance: the role of the board and the audit committee, Journal of Corporate Finance, 9, pp.295-316. Read More