Is Strong Corporate Governance Associated with Informative Income Smoothing?

Abstract

This study examines the links between corporate governance, income smoothing, and informativeness in financial reporting. Firms’ strong corporate governance is measured by variables employed in other studies – the presence of a financial expert serving on the audit committee; whether the audit committee consists entirely of independent directors; whether the members of the audit committee meet at least four times annually; and the percentage of outsiders serving on the board of directors. Income smoothing is measured by the Albrecht-Richardson (AR) and Tucker-Zarowin (TZ) income smoothing measures. The AR measure encompasses four definitions of earnings that include accrual and cash-based transactions. The TZ measure includes only accrual-based transactions. The degree of informativeness is measured by association with two opposing ends of the spectrum.

On the one hand, firms that are the most informative are predicted to have a greater association between earnings and one period ahead operating cash flows. Prior researchers have defined in a similar manner the information content of earnings to predict cash flows. On the other hand, the existence of a regulatory violation clearly indicates firms’ lack of informativeness (i.e., deceptiveness) in financial reporting.

The results do not show a strong relationship between strong corporate governance and degree of income smoothing. First, results for the link between income smoothing and informativeness show only a strong, positive association between accrual-based income smoothing (i.e., TZ measure) and informativeness. Second, results for the links between deceptiveness, corporate governance, and income smoothing are weak. The corporate governance variables show no significant association with deceptiveness. A negative relationship between corporate governance and deceptiveness was predicted. For the link between income smoothing and deceptiveness, only the AR measures show the predicted negative relationship. The TZ measure shows no significant association with deceptiveness.

Taken together, the results of this study provide unique insights into the links between corporate governance, income smoothing, and informativeness in financial reporting. The results confirm the informativeness of accrual accounting, but do not resolve the debate of whether corporate governance measures impact the quality of financial reporting.