180 Afro-Asian J. Finance and Accounting, Vol. 1, No.

2, 2008

111
2 Corporate governance and earnings management:
3 evidence from Iran
4
5
6
7 Bita Mashayekhi
8 University of Tehran, Tehran, Iran
9 Email: mashaykhi@ut.ac.ir Email: bitamashayekhi@gmail.com
1011
1 Abstract: This paper examines the relationship between board characteristics
and earnings management in Iranian firms. The results show that when the CEO
2 is the board chair and if the board size grows, the level of earnings management
3 would increase. However, when there are more non-executive and institutional
4 directors on the board, the level of earnings management will be lower. Even
5 holding more board meetings does not decrease the extent of earnings
6 management and the presence of an audit committee does not have any
significant influence on earnings management.
7
8 Keywords: board characteristics; corporate governance; earnings management;
9 institutional directors; non-executive directors.
2011
1 Reference to this paper should be made as follows: Mashayekhi, B. (2008)
‘Corporate governance and earnings management: evidence from Iran’,
2 Afro-Asian J. Finance and Accounting, Vol. 1, No. 2, pp.180–198.
3
4 Biographical notes: Bita Mashayekhi is an Assistant Professor of Accounting
5 at the University of Tehran in Tehran, Iran. Her research interests are agency
6 theory, corporate governance and financial reporting. Her research has been
published in journals, such as International Journal of Accounting, Finance
7 India and Iranian Accounting and Auditing Review. She has presented about ten
8 papers in international conferences and has published a book entitled Cost
9 Accounting in Farsi.
30
1
2
3 1 Introduction
4
Accounting numbers are important indicators of the financial performance of firms and,
5
therefore, are of interest to stockholders. Due to the fact that size of earnings is affected
6
by accounting decisions, there are two interesting questions:
7
8
Do firms ‘manage’ earnings through such decisions?
9

What does, in fact, determine earnings management?
40
1 When firms engage in earnings management, information revealed in the financial
2 statements will be compromised. The board of directors is so designed as to monitor
3 management in order to avoid opportunistic behaviour, including earnings management
4 (Kao and Chen, 2004). Under effective corporate governance mechanisms, the firms are
5 monitored and their managers should be prevented from engaging in earnings
6 management. Schipper (1989) defines earnings management as purposeful intervention in
711 the external financial reporting process, with the purpose of obtaining private gain for
8

Copyright © 2008 Inderscience Enterprises Ltd.

 Corporate governance and earnings management: evidence from Iran 181

111 stockholders or managers. Stockholders will gain when earnings management is used to
2 signal the private information of managers (Healy and Palepu, 1995) or to reduce political
3 costs (Watts and Zimmerman, 1986).1 However, stockholders may lose when earnings
4 management results in irregular private gains to managers. Such gains could take the form
5 of increased compensation (Healy, 1985; Holthausen et al., 1995).
6 A popular definition of earnings management has been given by Healy and Wahlen
7 (1999, p.368):
8 “Earnings management occurs when managers use judgement in financial
9 reporting and in structuring transactions to alter financial reports to either
1011 mislead some stockholders about the underlying economic performance of the
1 company or to influence contractual outcomes that depend on reported
2 accounting numbers.”
3
The definitions of earnings management agree on the point that managerial purpose is a
4
precondition for earnings management but whether this intent should be opportunistic in
5
nature is not clearly obvious. Subramanyam (1996) refers to earnings management only in
6
relation to opportunistic behaviours but not when managerial discretion is used to improve
7
the persistence and predictability of earnings. The view that earnings management is
8
somewhat opportunistic and harmful, in that it is used to deceive at least some
9
stockholders, is also expressed by the US Securities and Exchange Commission (SEC) and
2011
by Healy and Wahlen (1999). The objective of misleading someone about financial
1
performance usually requires that earnings management will be hard to detect.
2
Fama and Jensen (1983) indicate that the structure of the board of directors (as an
3
index for corporate governance) affects the functions of the board. They argue that outside
4
directors are more efficient in monitoring the management and will not collude with the
5
management. Kao and Chen (2004) show that management engages in earnings
6
management when it is faced with a larger board size. Klein (2000) finds a relationship
7
between board independence and earnings management. Klein (2002) also provides
8
evidence that there is a significant negative relationship between audit committee
9
independence and earnings management.
30
However, little research has been done on the effects of corporate governance on
1
financial statement fraud and earnings management – especially in Iran. Therefore, this
2
paper focuses on this issue to provide more evidence about the relationship between
3
earnings management and corporate governance in Iranian firms.
4
The rest of the paper is organised as follows: Section 2 introduces corporate
5
governance in Iran. Section 3 reviews related literature and hypothesis development.
6
Section 4 describes the models and variable measurement. Section 5 is about research
7
design, with the empirical results being reported in Section 6 and, finally, Section 7
8
comprises the conclusions and limitations.
9
40
1 2 Corporate governance in Iran
2
3 Along with the establishment of the Tehran Stock Exchange (TSE) in 1967, the process of
4 instituting and controlling firms has been mentioned briefly in Iranian Trade Law – especially
5 in its amendment in April 1968. In the past, most firms in Iran were private and had limited
6 owners. However, similar to that of other developed and developing countries, Iranian
711 firms have tended to go public during recent years. For this reason, these firms have to
8
 182 B. Mashayekhi

111 address governance issues to enhance their competitive position in the capital market.
2 However, the Iranian government’s recent effort to attract non-Iranian investment to
3 Iranian public firms is another reason for improving these corporate governance
4 mechanisms in Iran.
5 Corporate governance was addressed for the first time in early 2000. At that time, the
6 managers of the TSE, Islamic Parliament Research Center and a specialised committee of
7 the Economic and Finance Ministry, started to do some surveys on corporate governance
8 in Iran.
9 A review of the corporate governance characteristics in Iran shows their similarity to
1011 internal governance structures.2 However, in recent years the effort to expand capital
1 markets shows that Iran is interested in changing this system into one of external
2 governance. For instance, in the third and fourth economic development plans,
3 privatisation of governmental organisations is given a great deal of importance; it would
4 appear to be an instrument for changing to external governance structures. Nevertheless,
5 observing firms and the stock market in Iran shows that, nowadays, there are some
6 external controlling mechanisms in place, for example:
7

required legal supervision according to Iranian Trade Law (especially clauses
8
144–156)
9
2011
Iranian Stock Exchange Law
1
Iranian Audit Organisation statute
2
3
Iranian Official Accounting Society rules.
4 Fortunately, in late 2004, the TSE Research and Development Center published the first
5 edition of the Code of Corporate Governance in Iran. The 22 clauses contain some
6 necessary definitions, clarify management, board and shareholder responsibilities, outline
7 financial disclosures and describe accountability and auditing concepts. This code was
8 edited in 2005 based on ownership structure, the capital market situation and Iranian Trade
9 Law. The second edition of the Code of Corporate Governance in Iran has five chapters
30 and 37 clauses. The observation of this code has not been mandatory; however, it has been
1 implemented by many firms. Appendix 1 provides a summary of the second edition of the
2 Code of Corporate Governance in Iran.
3
4
5 2.1 Do Islamic principles matter?
6 The fundamental concept of corporate governance is not unknown to the Islamic attitude.
7 The purpose of corporate governance is to enhance accountability, accuracy and
8 truthfulness; in fact, these values are at their highest level in the Islamic context.
9 Therefore, it could be said that the principles and objectives of corporate governance are
40 very familiar to Muslims and its issues are recently realised by them3 (Asri and Fahmi,
1 2003).
2 The Islamic financial systems have been successful for centuries during the popularity
3 of the Muslim civilisation but, with the appearance of a modern economy, the Islamic
4 civilisation is replaced. Additionally, Islamic economies have been developed as a social
5 discipline in response to this environment. This is also true for corporate governance and
6 other financial issues in Iran. Since Iran is an Islamic country, Iranian financial systems
711
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 Corporate governance and earnings management: evidence from Iran 183

111 and capital markets are affected accordingly by Islamic principles. However, since their
2 introduction to Iran (mainly via academic books and journals), western and American
3 principles have been considered as a base for setting Iranian principles. The same thing
4 happens in setting the code of corporate governance. Therefore, western and American
5 experiences have a direct effect on setting the code of corporate governance in Iran. This
6 research investigates, primarily, possible similar relationships between corporate
7 governance and earnings management found in the western and American contexts and
8 Iran. This investigation of the influence of board structure on earnings managements also
9 will help to shape better corporate governance structures for Iranian companies.
1011
1
2 3 Literature review and hypothesis development
3
4 Theories concerning boards of directors (i.e. agency theory4) and various recommendations
5 (e.g. the Blue Ribbon Panel recommendation) suggest that some characteristics of the
6 board influence the quality of financial reports as measured by the level of earnings
7 management. Previous studies investigate also the governing role of the board of directors
8 and support its effect on monitoring the manager. These studies argue that the proportion
9 of outside directors, duality of the board chair, size of the board and the other
2011 characteristics of the board can influence the level of earnings management.
1 In this section, I will develop hypotheses pertaining to the relationship between
2 earnings management and some features of the board of directors. The particular board
3 characteristics and features that I investigate are
4
board size
5
6
board independence
7
board leadership
8
9
institutional directors
30
number of meetings
1
2
audit committees.
3
4
5 3.1 Size of the board
6 Jensen (1993) believes that a smaller board of directors has a controlling function while a
7 larger one is easier for the CEO to control. Similarly, Lipton and Lorsch (1992) suggest
8 that larger boards are less effective monitors and are easier for CEOs to control. Dechow
9 et al. (1996) find, also, that when the board size is relatively large, the likelihood of
40 engaging in earnings management is relatively high. Beasley (1996) indicates that, as the
1 board size increases, the possibility of financial statement fraud increases also. This result
2 is consistent with the view that smaller boards provide more control functions than do
3 larger boards (Jensen, 1993). Furthermore, if the board size is larger, it may be more
4 difficult for the board members to communicate with one another efficiently. Kao and
5 Chen (2004) show that when there is a larger board, management engages in earnings
6 management.
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 184 B. Mashayekhi

111 Following the above arguments, it is expected that board size will be positively related
2 to the degree of earnings management. Therefore, I hypothesise that board size is
3 positively related to the degree of earnings management:
4 Hypothesis 1: there is a positive relationship between board size and the extent of earnings
5 management.
6
7
8 3.2 Board independence5
9 Some corporate reform proposals have concluded that independent directors will improve
1011 the audit process (e.g. Blue Ribbon Committee, 1999; Treadway Commission, 1987).
1 Fama and Jensen (1983) argue that the board of directors is the highest internal control
2 mechanism responsible for controlling the actions of top management. Fama (1980)
3 suggests that the top management’s authority on the board of directors can lead to
4 collusion and a transfer of shareholder wealth. Williamson (1985) suggests that managers
5 have a massive informational advantage due to their full-time status and insider
6 awareness, so that the board of directors easily can become an instrument of management,
7 thereby sacrificing the interests of shareholders. Fama (1980) and Fama and Jensen (1983)
8 state that outside directors (non-executive directors) have incentives to carry out their
9 monitoring responsibilities and have incentives to avoid colluding with top managers to
2011 expropriate shareholder wealth. They state also that outside directors (non-executive
1 directors) have incentives to develop reputations as experts in decision control. Therefore,
2 the inclusion of outside directors (non-executive directors) improves a board’s
3 independence and its capability to monitor top management effectively in agency settings
4 arising from the separation of corporate ownership and decision control. Much existing
5 empirical evidence indicates that independent directors (non-executive directors) are
6 associated with stronger corporate governance and financial reporting reliability (Beasley,
7 1996; Core et al., 1999; Dechow et al., 1996; Rosenstein and Wyatt, 1990). Moreover,
8 Klein (2000) finds a relationship between board independence and earnings management.
9 In Iran, similar to Western countries, there are some rules governing board
30 independence. For example, according to TSE Articles of Association (Article 26), Iranian
1 firms shall be managed by an independent board of directors and, consequently, they must
2 have some non-executive directors on their boards. Besides, the Iranian Code of Corporate
3 Governance (clause 5) states that more than half of the persons on a board of directors in
4 an Iranian firm should be non-executive. It is presumed that the presence of non-executive
5 directors on the board may decrease the likelihood of earnings management in Iranian
6 firms. Therefore, in my study I hypothesise that:
7 Hypothesis 2: there is a negative relationship between the proportion of independent
8 directors on the board and the extent of earnings management.
9
40
1 3.3 Board leadership (CEO-chair duality)
2 Jensen (1993) states that the role of the board chair is to monitor the CEO. He suggests
3 that CEOs who hold also the position of board chair (duality) exert undue influence on the
4 board, compromising the strength of the board’s governance. In fact, if the CEO is the
5 board chair at the same time, the likelihood of there being a lack of independence between
6 management and the board will be increased. Dechow et al. (1996) and Farber (2005) find
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 Corporate governance and earnings management: evidence from Iran 185

111 a positive relationship between firms that disobey GAAP and firms that have a CEO who
2 serves as the board chair.
3 Similar to Western practices and according to clause 2 of the Iranian Code of
4 Corporate Governance, the board chair should not simultaneously hold the position of
5 CEO.
6 It is expected that the likelihood of earnings management in Iranian firms will increase
7 if the CEO is also the board chair. Therefore, I hypothesise that:
8 Hypothesis 3: there is a positive relationship between the Chair/CEO dual role and the
9 extent of earnings management.
1011
1
2 3.4 Institutional directors
3 Institutional investors are large investors, other than natural persons, who exercise
4 discretion over the investments of others (Lang and McNichols, 1997). For example,
5 insurance firms, pension funds, investment trusts, financial institutions (including banks,
6 finance firms, building societies and credit cooperatives,) and investment firms are
7 institutional investors. Much evidence suggests that corporate monitoring by institutional
8 investors can restrict managers’ behaviour (Del Guercio and Hawkins, 1999; Hartzell and
9 Starks, 2003; McConnell and Servaes, 1990; Nesbitt, 1994; Smith, 1996). Large
2011 institutional investors have the opportunity, resources and ability to monitor, discipline
1 and influence managers. Based on the evidence, it can be concluded that corporate
2 monitoring by institutional investors can make managers focus more on corporate
3 performance and less on opportunistic behaviour. The presence of large institutional
4 investors also has been found to mitigate managerial incentives to report aggressively
5 (Dechow et al., 1996). Rajgopal and Venkatachalam (1998) find that institutional
6 ownership is associated with less income, increasing discretionary accruals. Moreover,
7 when there is pressure to increase earnings, active institutional investors mitigate income,
8 increasing discretionary accruals (Cheng and Reitenga, 2000).
9 Like Western countries, the main shareholders in Iran are institutional investors and
30 they introduce an individual or individuals to the board of directors according to the shares
1 they hold or the right they have to vote in the company. Therefore, if institutional
2 ownership enhances monitoring, it could also be associated with less earnings
3 management in Iranian firms. As a result, I hypothesise that:
4 Hypothesis 4: there is a negative relationship between the presence of director(s) from
5 institutional investors on the board and extent of earnings management.
6
7
8 3.5 Number of meetings
9 Vafeas (1999) finds that, as the number of board meetings increases, the operating
40 performance of firms improves. This suggests that the frequency of meetings is an
1 important aspect of an effective board. A board that meets frequently should be able to
2 assign more time to issues such as earnings management.
3 According to clause nine of the Iranian Code of Corporate Governance, board
4 meetings should be held at least once per month. It is expected that an increase in the
5 number of board meetings will decrease the likelihood of earnings management in Iranian
6 firms. As a result, I hypothesise that:
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8
 186 B. Mashayekhi

111 Hypothesis 5: there is a negative relationship between the number of the board meetings
2 and the extent of earnings management.
3
4
3.6 Audit committees
5
6 Some previous studies (e.g. Klein, 2002; Xie et al., 2003) have explicitly considered the
7 role of audit committees in earnings management and have found that the level of earnings
8 management is inversely related to the level of audit committee independence. The audit
9 committee is a sub-committee of the board of directors that provides an official
1011 communication between the board, the internal monitoring system and the independent
1 auditor. The audit committee has the oversight of the firm’s financial reporting process
2 and its major purpose is to improve the credibility of audited financial statements. In other
3 words, the audit committee acts as an intermediary between management and the auditors.
4 Klein (2002) finds that independent audit committees have a restrictive effect on earnings
5 manipulation, particularly when a majority of directors is independent. DeFond and
6 Jiambalvo (1991) find that earnings management among firms that have audit committees
7 is less likely. However, Peasnell et al. (2001) do not find adequate evidence on the
8 effectiveness of the audit committee in preventing earnings management.
9 Although internal auditing in Iranian firms has some history, the formation of an audit
2011 committee in Iranian firms is a new issue and, in recent years, it has been under serious
1 consideration. However, some Iranian firms have organised this committee and put it
2 under the board of directors’ supervision. According to the Iranian Code of Corporate
3 Governance (Chapter 2, clause 11), the board of directors should set up an audit
4 committee. The chair of the audit committee should have special knowledge and
5 experience in the application of accounting principles and internal control processes.
6 Therefore, it is expected that the establishment of an audit committee in Iranian firms
7 under the board of director’s supervision will reduce the likelihood of earnings
8 management. Consequently, I hypothesise that:
9 Hypothesis 6: there is a negative relationship between the presence of an audit committee
30 and the extent of earnings management.
1
2
3 4 Model specification and variable measurement
4
5 4.1 Earnings management measure
6
7 In this paper, I focus on measuring earnings management through discretionary accruals.
8 In fact, accruals have the desirable feature of giving a summary measure of firms’
accounting choices. In earnings management research, accruals usually are separated into
9
two parts, discretionary and nondiscretionary accruals, of which the first is the surrogate
40
for earnings management (Dechow et al. 1995; Jones, 1991). In other words, discretionary
1
accruals is the part of accruals that can be manipulated and is typically used as the measure
2
of earnings management.
3
Since discretionary accruals can not be detected directly from financial statements,
4
they have to be estimated by using some kind of model. A frequently used accrual
5
estimation model in earnings management researches is the Jones Model (1991). This
6
model is as follows:
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 Corporate governance and earnings management: evidence from Iran 187

111
2
3 where TAi,t is total accruals6, ∆REVi,t is change in sales from period t – 1 to t for firm i,
4 PPEi,t is gross property, plant and equipment, Ai,t – 1 is total assets at the beginning of the
5 year t and εit is the error term for firm i in year t. Then, the parameters that are estimated
6 from above model will combine with data from the test period to produce the discretionary
7 accruals:
8
9
1011
1
2 In this method, the coefficients are estimated by running the regression on firms matched,
3 for example, by year and industry. The original model itself has been expanded on many
4 events in previous studies. Dechow et al. (1995) assume that sales are not managed in the
5 estimation period but that the whole change in accounts receivable in the event year
6 represents earnings management. As a result, they use the parameters from the Jones
7 Model estimated in the pre-event period for each firm in their sample and apply those to
8 a modified sales changes variable defined as (∆REVi,t – ∆RECi,t) to estimate discretionary
9 accruals in the event period. This model, which is entitled ‘modified Jones model’, is as
2011 follows:
1
2
3
4
5
6 where ∆RECi,t is change in sales receivables between period t and t – 1 for firm i.
7 Dechow et al. (1995) state that the modified Jones model is the best model for
8 estimating the discretionary accruals, therefore, I use this model in my research.
9
30 4.2 The corporate governance indices
1
2 In this paper, I consider six characteristics for board of directors. These characteristics are:
3
board size: the number of directors on the board
4

board independence: the proportion of independent directors on the board
5
6
board leadership (CEO-chaired): CEO is also board chair
7

institutional investors: the proportion of director from institutional investors on the
8
9 board
40
board meeting numbers: the number of board meetings
1

audit committee: the presence/absence of an audit committee in the listed firms.
2
3
4
5 5 Research design
6
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 188 B. Mashayekhi

111 5.1 Sample selection

2
As mentioned before, the corporate governance issue in Iran was taken seriously in 2003
3
and the firms tried to adopt these principles according to the regulations in developed
4
countries. Finally, the first version of Iranian Code of Corporate Governance was issued
5
in 2004 and its revised version emerged in 2005. Therefore, the sample for this study
6
comprises firms listed in the Tehran Stock Exchange (TSE) for each of the years 2003,
7
2004 and 2005. Therefore, I started with all of the listed firms on the TSE in 2003. At that
8
time, there were 310 firms listed in the TSE. Then, after removing holding, financial and
9
insurance firms7 (due to insufficient financial data and board of directors’ information
1011
access) I had 150 firms for my study (see Table 1).
1
2 Table 1 Sample selection procedure
3
4 Total number of listed firms in TSE 310
5 Less
6 Holding, financial and insurance firms 20
7 Total number of industrial and commercial firms 290
8
Less
9
2011 Firms for which there was not enough information about financial position and
board of directors 140
1
2 Total number of firms in sample used in main analysis 150
3 Number of firm-year observations per industry used in main analysis 450
4
5
The board composition and other information about characteristics of board of directors
6
are collected directly, either from annual reports or from company handbooks. Required
7
financial and accounting data for computing the discretionary accruals are collected from
8
TSE reports on CDs or the web. For estimating the parameters of the modified Jones
9
model, I use a pooled time series cross-section for the 1990–2005 sample periods
30
including every firm.
1
2
3 5.2 Model specification
4
The relationship between the explanatory variables and discretionary accruals is examined
5
by the following OLS regression:
6
7
8
9
40 where DA is a measure of discretionary accruals, BSIZE is the number of directors on the
1 board, BOUT is the proportion of independent directors on the board, DUAL is 1 if CEO
2 is also board chair and 0 otherwise, BINS is 1 if there is a director from institutional
3 investors on the board, 0 if otherwise, BMEET is 1 if the number of board meetings is
4 more than average and 0 otherwise, AUD is 1 if there is the audit committee in the listed
5 firms and 0 otherwise, LEV is total debt/total assets, SIZE is the natural logarithm (Ln) of
6 total assets8 and MTB is the ratio of market to book equity.
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 Corporate governance and earnings management: evidence from Iran 189

111 As indicated in Equation 4, three control variables have been introduced in this model.
2 While I am interested in examining how corporate governance indices (for example board
3 independence and board leadership) can affect the extent of earnings management, there
4 are other firm level factors which can influence earnings management and they should be
5 controlled for estimation. Previous research has found that the absolute change in a firm’s
6 prior years’ earnings is positively related to earnings management, while political costs,
7 when captured by a firm’s size, are negatively related to earnings management (Bartov
8 et al., 2000; Becker et al., 1998; Dechow et al., 1995, 1996; Warfield et al., 1995). On the
9 other hand, Klein (2002) finds that market-to-book ratios have been related to board
1011 independence. Moreover, DeFond and Jiambalvo (1994) report that managers of highly
1 leveraged firms have some incentives to use discretionary accruals for increasing income.
2 Therefore, in this study, I have market to book ratio, leverage ratio and firm size as control
3 variables, as do Bradbury et al. (2004) in their research.
4
5 6 The empirical results
6
7 Table 2 describes the characteristics of sample firms. In my sample, the maximum
8 discretionary accrual, which is scaled by total assets at the beginning of each period, is
9 0.12 and the minimum is – 0.04. On average, the number of board members is seven
2011 (similar to Bradbury et al. (2004) and near to that of Peasnell et al. (2001) of eight). This
1 implies that, on average, Iranian firms observe the Iranian Code of Corporate Governance
2 (clause 4), which mandates the presence of at least seven persons on the board of directors.
3 In addition, about 39% of people on the board of directors are non-executive or
4 independent. This compares with 60% of non-executive directors reported in Klein (2002),
5 43% in Peasnell et al. (2001) and 33.3% in Bradbury et al. (2004). According to the
6 Iranian Code of Corporate Governance, more than half of the individuals on boards of
7 directors should be non-executive. Therefore, my results show that average Iranian firms
8 do not observe this requirement in the Iranian Code of Corporate Governance (clause 5).
9 In 57.3% of the cases, the CEO is also the board chair, which is in contrast with the
30 15.9% in Bradbury et al. (2004), the 24% in Peasnell et al. (2001) and the 85% in Xie
1 et al. (2003). According to the Iranian Code of Corporate Governance (clause 2), one
2 should not be the board chair and also the CEO at the same time. Therefore, my results
3 imply that, on average, Iranian firms do not meet this requirement of the Iranian Code of
4 Corporate Governance.
5 In 41.3% of the cases, there is at least one representative of the institutional investors
6 on the board of directors. In 54% of my sample firms, the board meetings are held more
7 often than the average, which is 7–8 times per year. This implies that average Iranian firms
8 do not observe clause 9 in the Iranian Code of Corporate Governance, which mandates that
9 public firms should hold at least one board meeting per month.
40 Forty three point three per cent of firms have audit committees. Clause 11 in the
1 Iranian Code of Corporate Governance necessitates Iranian public firms to establish an
2 audit committee. Therefore, my results imply that about 56% of Iranian firms in my
3 sample do not observe this issue in the Iranian Code of Corporate Governance.
4 According to the control variables, firms in Iran heavily rely on debt, with an average
5 debt ratio of 56% and this implies that the default risk for them is very high. Besides, the
6 average of market to book ratios is 1.27 in my sample.
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 190 B. Mashayekhi

111 Table 2 Descriptive statistics of dependent, independent, control and moderating

2
Variable Min Max Mean SD
3
4 DA –0.04 0.12 0.013 0.041
5
BSIZE 4 11 6.979 2.693
6
7 BOUT 0.2 0.5 0.391 0.12
8 DUAL 0 1 0.423 0.497
9 BINS 0 1 0.577 0.497
1011 BMEET 0 1 0.536 0.501
1 AUD 0 1 0.67 0.473
2
SIZE 6.68 8.52 7.44 0.06
3
4 LEV 0.32 0.67 0.50 0.01
5 MTB 0.86 2.18 1.27 0.03
6 DUAL = 1 – – 0.573 –
7 BINS = 1 – – 0.413 –
8 BMEET = 1 – – 0.54 –
9
AUD = 1 – – 0.433 –
2011
1 Notes: Variable definitions: DA – discretionary accruals which is measured by the Modified
2 Jones Model (1995); BSIZE – the number of directors on the board; BOUT – the
proportion of independent directors on the board; DUAL – an indicator of whether or not a
3 firm’s CEO is also the chair of the board of director (DUAL is equal to 1 if the CEO is
4 also the chair of the board and 0 otherwise); BINS – the proportion of directors from
5 institutional investors on the board (BINS is equal to 1 if there is a director from
institutional investors on the board and 0 otherwise); BMEET – the number of board
6 meetings (BMEET is equal to 1 if the number board meetings is more than average and 0
7 otherwise); AUD – the presence of audit committee on the board (AUD is equal to 1 if
8 there is the audit committee on the board of directors and 0 otherwise); SIZE – the size of
the firm as measured by a natural logarithmic function of the firm’s total assets;
9 LEV – the total liabilities divided by total assets; MTB – ratio of market to book equity.
30
1
2 The results of multiple regressions, which examine the impact of corporate governance
3 characteristics on earnings management, are shown in Table 3. Results in Table 3 show
4 that corporate governance characteristics explain a considerable portion (35%) of the
5 variation in discretionary accruals. As I had expected, board size and duality exhibit a
6 significant positive association with discretionary accruals. These results support my first
7 and third hypotheses, which state that the bigger board size and duality work as incentives
8 to manage earnings and, thus, they have a positive impact on discretionary accruals. My
9 results about board size are similar to Beasley (1996), Dechow et al. (1996), Eisenberg et
40 al. (1998), Jensen (1993), Fuerst and Kang (2000), Kao and Chen (2004), Lipton and
1 Lorsch (1992), Loderer and Peyer (2002) and Yermack (1996). However, these results are
2 unlike Chaganti and Mahajan (1985) and Dalton et al. (1998). Moreover, my findings
3 about duality are consistent with Dechow et al.’s (1996) and Farber’s (2005) results.
4 Therefore, my results show that Iranian firms may limit earnings management by
5 decreasing duality and the number individuals on their board of directors.
6
711
8
 Corporate governance and earnings management: evidence from Iran 191

111 Table 3 Regression of discretionary accruals on dependent and control variables

2
Model Standardised t Sig
3
beta
4
5 (Constant) 0.150 0.972 0.332
6
BSIZE 0.517 3.909 0.000
7
BOUT –0.798 –4.989 0.000
8
9 DUAL 0.251 2.604 0.010
1011 BINS –0.339 –3.808 0.000
1 BMEET 0.252 3.260 0.010
2 AUD 0.018 0.175 0.861
3 SIZE 0.331 4.485 0.000
4
LEV 0.013 0.150 0.880
5
6 MTB –0.209 –2.526 0.012
7 Adjusted R square 0.350 – –
8 Durbin-Watson 2.012 – –
9 F 9.901 – –
2011
1 Notes: Variable definitions: DA – discretionary accruals which is measured by the Modified
Jones Model (1995); BSIZE – the number of directors on the board; BOUT – the
2 proportion of independent directors on the board; DUAL – an indicator of whether or not a
3 firm’s CEO is also the chair of the board of director (DUAL is equal to 1 if the CEO is
4 also the chair of the board and 0 otherwise); BINS – the proportion of directors from
institutional investors on the board (BINS is equal to 1 if there is a director from
5 institutional investors on the board and 0 otherwise); BMEET – the number of board
6 meetings (BMEET is equal to 1 if the number board meetings is more than average and
7 0 otherwise); AUD – the presence of audit committee on the board (AUD is equal to 1 if
there is the audit committee on the board of directors and 0 otherwise); SIZE – the size of
8 the firm as measured by a natural logarithmic function of the firm’’s total assets;
9 LEV – the total liabilities divided by total assets; MTB – ratio of market to book equity.
30
1 Similar to Beasley (1996), Core et al. (1999), Dechow et al. (1996), Klein (2000) and
2 Rosenstein and Wyatt (1990) and according to my expectation, board independence
3 exhibits a significant negative effect on discretionary accruals. Unlike Park and Shin
4 (2004), these results support the second hypothesis, which predicts a negative relationship
5 between the board independence and earnings management. Besides, institutional
6 investors on the board of directors has a significant negative relationship with
7 discretionary accruals. These results are similar to some previous research (Del Guercio
8 and Hawkins, 1999; Hartzell and Starks, 2003; McConnell and Servaes, 1990; Smith,
9 1996) and they support the second and fourth hypotheses, which state that board
40 independence and the presence of institutional investors on the board of directors have a
1 negative impact on discretionary accruals. These results suggest that increasing the
2 non-executive directors and institutional investors in the board of directors in Iranian firms
3 may improve governance practices and be helpful to the board in monitoring the firm’s
4 management of earnings.
5 The results indicate also that the number of board meetings shows a significant
6 association with discretionary accruals and, unlike my expectations, these two are
711 positively related to one other. These results, which are different from Vafeas (1999),
8
 192 B. Mashayekhi

111 imply that an increase in the number of board meetings in my sample would not decrease
2 earnings management in Iranian firms. In the board meetings held in Iran, the members of
3 the board do not come to any results regarding preventing managers from opportunistic
4 behaviours, i.e. earnings management.
5 In addition, similar to Peasnell et al. (2001), I find no evidence of any association
6 between discretionary accruals and the establishment of an audit committee in Iranian
7 firms. These results are contrary to DeFond and Jiambalvo (1991) and Klein (1998, 2002).
8 Therefore, I did not find evidence that supports the fifth and sixth hypotheses. Audit
9 committees in Iranian firms do not prevent the occurrence of earnings management. This
1011 indicates that the audit committees in listed companies are not sufficiently prepared to
1 monitor the financial reporting of Iranian firms.
2 For the control variables, I find that the firm size and market to book ratio have
3 significant positive and negative relationships with discretionary accruals, respectively. It
4 may be concluded that the likelihood of engaging in earnings management by managers
5 in large Iranian firms is more frequent than small ones. Besides, it is more likely that
6 Iranian firms with good performance in the capital market get involved in earnings
7 management than those with poor performance.
8 I expected that a higher leverage ratio could result in more monitoring of creditors on
9 financial performance and, consequently, in decreasing earnings management. However,
2011 there is no evidence of a significant relationship between earnings management and
1 leverage ratios in Iranian firms.
2
3
4 7 Conclusions and limitations
5
6 Financial statements can give extensive information to the public about the operations and
7 profitability of the firms. Therefore, investors make their investments at least partly based
8 on the information they find in the firm’s financial statements. However, when firms
9 manage their earnings, the information revealed in the financial statements will be biased.
30 The corporate governance mechanisms and board of directors are designed to monitor
1 managers to limit their opportunistic actions, including earnings management.
2 This paper investigates the effect of the corporate governance mechanisms on earnings
3 management in Iranian firms. For testing the effects of corporate governance issues on the
4 managers’ behaviour, I started with all of the listed companies in the TSE in 2003. After
5 adjusting for outliers, the sample comprised 150 firms. Fortunately, the majority of these
6 firms are large and important. However, it does not mean that these 150 firms necessarily
7 contribute significantly to the Iranian economy and/or future business practice. Yet, I think
8 these firms are rather on the leading edge of change than inconsequential. Therefore, I can
9 say that my study may have implications for Iranian policy and that policy makers may
40 use the results of this research for modifying and improving the current Code of Corporate
1 Governance. For instance, if non-executive directors could prevent managers from getting
2 involved in earnings management, this issue should be taken into special consideration by
3 policy makers when improving or adjusting the Iranian Code of Corporate Governance.
4 Similar to several existing studies in Western countries, I find some evidence of an
5 association between earnings management and board size in my sample. When the board
6 size is larger, monitoring the managers will be less efficient. That is, when there are more
711 members in the board, it is more difficult for board members to monitor management.
8
 Corporate governance and earnings management: evidence from Iran 193

111 These results imply that Iranian firms can probably avoid earnings management by
2 decreasing the number of people on their board of directors. In addition, I show that the
3 extent of earnings management is negatively related to the number of non-executive
4 members on the board of directors. My findings suggest that increasing the numbers of
5 non-executive managers on the board of directors in Iranian firms may improve
6 governance practices and be helpful to the board in monitoring the firm’s management of
7 earnings. In fact, investors can rely on the information revealed in the financial statements
8 when there are more non-executive directors on the board.
9 My findings indicate that the presence of institutional investors on the board of
1011 directors is negatively related to earnings management. These results suggest that adding
1 institutional investors to the board may develop corporate governance mechanisms and
2 help the board in preventing Iranian managers from engaging in earnings management.
3 According to my findings, duality is one of the corporate governance indices which are
4 significantly related to earnings management. If the CEO is the board chair at the same
5 time, the likelihood of earnings management will increase. In other words, the results
6 show that Iranian firms can avoid earnings management by preventing the duality
7 problem.
8 The results indicate that the number of board meetings shows a significant association
9 with discretionary accruals. Unlike my expectations, these two are positively related to
2011 one other. In other words, in my sample, an increase in the number of board meetings
1 would not decrease earnings management in Iranian firms. The probable reason for this
2 result is that the board meetings in Iranian firms are inefficient in making relevant
3 decisions or doing sufficient monitoring for preventing earnings management.
4 On the other hand, unlike several available studies in Western countries, I find no
5 evidence of any association between discretionary accruals and the establishment of an
6 audit committee in Iranian firms. In fact, the audit committee has an insignificant role in
7 preventing the occurrence of earnings management. It indicates that the establishment of
8 the audit committees in Iranian listed companies has not yet achieved its intended goals.
9 The Iranian Code of Corporate Governance stipulates that the main task of an audit
30 committee is to oversee the financial reporting process. However, this study provides
1 evidence that audit committees have not carried out their duties effectively.
2 On the whole, the results about some board-of-director features, such as size,
3 independence and CEO duality, are similar to western findings. However, my findings
4 about board meetings and audit committees are not similar. Although some evidence is
5 presented to support the relationship between corporate governance mechanisms and
6 earnings management, my study is an initiation in investigating the presence of this
7 relationship in an Iranian context and further research is required on this matter.
8 There are some limitations of my study. Firstly, the capability of the modified Jones
9 Model to divide the accruals into non-discretionary and discretionary components is still
40 uncertain. Accordingly, there is a possibility of misclassification of non-discretionary and
1 discretionary accruals. If some components of non-discretionary accruals are incorrectly
2 classified as discretionary accruals, then this may affect the reported relationship between
3 earnings management and corporate governance characteristics in Iranian firms.
4 Secondly, public firms in Iran have implemented the code of corporate governance
5 since 2002. My research covers the period between 2002–2004. Thus, it is probable that
6 the present results of the research are due to this short time span and it is likely that the
711 findings would change if the time span was lengthened.
8
 194 B. Mashayekhi

111 Finally, due to a lack of data on corporate governance indices, I have employed only
2 board size, board independence, board leadership, institutional directors, number of
3 meetings and the audit committees. Nevertheless, there are other indices such as audit
4 quality, management education, board remuneration, etc, which possibly could influence
5 my results.
6 However, further research could develop some other discretionary accrual models to
7 concentrate on the influences of corporate governance mechanisms on earnings
8 management over a longer period. Additionally, more research can be done on the other
9 board characteristics such as management education and experiences.
1011
1
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1 Accounting, Vol. 38, pp.1–22
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2 of Financial Economics, Vol. 40, No. 3, pp.185–211.
3
4
5 Notes
6
1
7 Stockholders (investors) may also obtain some advantage when earnings management is used to
8 avoid violation of debt covenants (Watts and Zimmerman, 1986). Creditors’ interests are
9 sometimes represented at board level in situations where this problem is most acute. Conflicts
between investors and creditors, while important, are not the focus of this study. Hereafter, we
30 intend the term stockholders to be interpreted broadly, to include the interests of both investors
1 and creditors.
2 2
Internal governance structures (inside systems) are characterised as being based on long-term
3 and, therefore, exceptionally steady relationships between firms and at least some of their major
4 shareholders. These relationships may be just financial or based on past or current business
5 relationships. The interests of large shareholders are often supported by board representation,
either directly or through alliances with other shareholders. Thus, insider shareholding and
6 corporate governance systems are characterised as being part of wide-ranging shareholder and
7 board-level corporate networks. These provide a close-knit corporate governance structure but
8 one that also may serve to limit the privileges and control of shareholders and investors outside
9 the core shareholder group. In contrast to the internal control systems (inside systems) of
40 corporate governance, in external control systems (outside systems), corporate ownership tends
to be distributed and dominated by institutional investors. In addition, formal and potentially
1 enterprise-distorting relationships between board members and individuals or groups of
2 shareholders are usually restricted.
3 3
In fact, the Islamic approach is deemed appropriate in improving good corporate governance in
4 business organisation. Through the regulations of Islam, success could be attained by
5 maintaining high human idealism and by fulfilling high religious and ethical requirements in all
6 human affairs, including business activities. In Islam, business activities are concerned with two
respects, namely the physical features of life as well as meeting one’s religious needs.
711
8
 Corporate governance and earnings management: evidence from Iran 197

111 4
Agency theory postulates that, in an agency condition, if the interests of the agent differ from
2 those of the principal, the agent will behave in an opportunistic manner to the detriment of the
3 principal. This must be resolved by establishing motivation systems that bring the interests of the
agent into line with those of the principal (Ogden, 1993, p.185).
4 5
The meaning of the word ‘independence’, in this paper, is being independent of employment. In
5 this paper, I consider those directors as independent on the condition that they are not employed
6 and paid by a company. In fact, the non-executive directors (outside directors) are perceived as
7 independent, whereas the executive managers (inside directors) are dependent directors who are
8 employed by the firms and are paid by them.
6
9 Accruals are adjustments to the cash flows to produce net earnings:
1011
1
2 7
All holding, financial (including banks) and insurance firms are excluded because these
3 industries are regulated differently and are likely to have fundamentally different cash flow and
4 accrual processes.
5 8
The measure of assets for size has been used in many preceding studies (for example, Vander
6 Bauwhede et al., 2003; Koh, 2003). The main reason for this usage is political cost. The political
7 cost (SIZE) hypothesis recommends that larger firms (that is, firms with more political visibility)
8 prefer income-decreasing accounting choices. The variable SIZE is included to control for this
effect. This variable is usually assessed as the natural logarithm of total assets.
9
2011
1
2 Appendix
3
4 The Iranian Code of Corporate Governance (ICCG) – summary
5
6 Chapter 1 – (descriptions) – clause 1
7 This chapter contains the descriptions and expressions used in this instruction manual,
8 including independent manager, non-executive manager, minor shareholder, controlling,
9 considerable dominance, stock trustee, stock services, major shareholder, important/large
30 companies, secret information holders or insiders, main/mother corporations, subsidiary
1 corporations, affiliated corporations, dependent individual, subordinates and main
2 managers.
3
4 Chapter 2 – (board of directors) – clauses 2–20
5 In this chapter, characteristics of the board of directors’ such as selection method, number,
6 structure and duties, are described. The most important issues in this part of the instruction
7 manual are:
8

the board of directors’ qualifications and effectiveness
9
40
the clear separation of responsibilities between board of directors and administrative
1 managers
2

the independence of the CEO from the board chair
3
4
the number and composition of the board of directors
5

the need for the majority of board members to be non-executive
6
711
the necessity of meetings at least once a month
8
 198 B. Mashayekhi

111
the necessity of forming an auditing committee and delivering its responsibilities
2

the necessity of having an effective internal control system for the safekeeping of
3
properties, appropriate reporting and observing the rules and the need for the annual
4
evaluation of that system.
5
6 Chapter 3 – (public-assembly) – clauses 21–30
7
In this chapter, the shareholders public society’s characteristics and responsibilities are
8
discussed. Some of the important issues in this chapter are:
9
1011
the selection method of management boards for public shareholders
1

the determination of compensation for each member of the board of directors
2
3
the need for reports given by the board of directors, legal warden and independent
4 auditors to be made at least ten days before the public-assembly meeting
5

the need for financial statements to receive a public declaration of approval within
6
ten days of the public-assembly meeting
7
8
the need for a majority of the board of directors, independent auditors, legal warden
9 and the representative of the stock exchange to attend the public-assembly meeting.
2011
1 Chapter 4 – (accountability and disclosure) – clauses 31–36
2 In this chapter, mandatory disclosures are discussed, including annual financial
3 statements, six-month financial statements, information about stock transactions related to
4 the board of directors and top executive managers and their families, information related
5 to insiders, general information related to the organisational structure, products, human
6 resources, social responsibilities and company environment and information related to
7 corporate governance, such as audit committees, the board of directors’ characteristics and
8 the dividends paid by the company.
9
30 Chapter 5 – (frauds and penalties) – clauses 37–38
1 In this chapter, the managers’ and companies’ frauds and penalties are discussed.
2
3
4
5
6
7
8
9
40
1
2
3
4
5
6
711
8