This study aims to test empirically the relationship between board equity ownership and corporate governance on earnings quality of for‐profit corporations, to help practitioners enhance corporate governance practices.
The study examines two competing theories of equity ownership (convergence of interests and management entrenchment) to explain how board members react to owning the firm's stock and whether governance impacts their behavior. In a sample of 499 publicly traded firms, a governance index was calculated and the relative power of equity ownership and governance was regressed on reported earnings quality.
The results support the management entrenchment theory. Both independent and insider board members become entrenched, negatively impacting reported earnings quality and the strength of the governance structure. However, effective governance using a composite of mechanisms moderates the effects of entrenchment.
The effect of individual governance variables on earnings quality is not identified. The reader should not generalize the results of this research to other types of organizations, such as not‐for‐profit or governmental entities. The authors studied for‐profit, publicly held firms where directors act as agents of the stockholders and corporate governance is tasked with the responsibility to monitor management and improve investor confidence in reported earnings quality. The authors acknowledge that in other types of entities, the governance culture and objectives may be different and the results of this study may not apply.
The results provide insight regarding the motivations and behavior of board members and the impact of stock ownership on their actions. Stronger governance controls are needed within the entrenchment range of stock ownership. Firms should not rely on oversight by independent board members to control insider board members. A composite of governance mechanisms can moderate negative behavior.
The results challenge commonly held beliefs that independent board members and board members who own stock will perform their fiduciary duty. This means that governance mechanisms should address all board members, not just specific types and that equity ownership must be very high before it can be relied upon as effective.
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