CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Corporate governance plays a vital role in ensuring the transparency, accountability, and integrity of banks (Ashraf et al., 2022). Earnings management, on the other hand, refers to the discretionary manipulation of financial statements to influence reported earnings (Ozili, 2020). The relationship between corporate governance and earnings management has garnered significant attention in academic literature and practical settings due to its implications for financial reporting quality and investor confidence (Ashraf et al., 2022).

Ayembe intermediation has a function that is raising funds from the public and then transferring financial assets to the unit in the form of credit. The characteristics of the Ayembe banking system are different from other banking systems, as most of the banks’ capital (over 80 percent) comes from customers, financial markets, and funds outside the company (Lawal et al., 2018).

Earnings management arises due to a conflict of interest between the management (agent) and the owner (principal). This arises because each party seeks to achieve and maintain the desired level of prosperity. Conflict of interest occurs because of the separation of ownership from the management of the bank (agency conflict). The owners give authority and freedom to the manager to take care of the bank, but the owners (shareholders) give particular attention to managers. So managers engage in earnings management because of the pressure to report a stable financial position annually to shareholders, creditors, and other parties (Ozili, 2020) who have an interest, leading them to take actions to manipulate the financial statements.

Corporate governance is the set of rules that govern the relationship between shareholders and the management of banks. Good corporate governance is required to implement a way or method called good corporate governance (Ozili, 2020). The concept of good corporate governance is proposed in order to achieve more transparent corporate management for all users of financial statements.

1.2 Statement of the Problem

The effect of corporate governance on earning management in AYEMBE has become a matter of concern and requires careful examination. Earnings management refers to the manipulation of financial statements by management to present a distorted picture of a company’s financial performance, often with the aim of meeting or exceeding financial targets or influencing stock prices. Corporate governance, on the other hand, encompasses the systems, processes, and structures through which a company is directed and controlled, including the relationship between the board of directors, management, shareholders, and other stakeholders.

In the case of Ayembe, there is a need to assess how corporate governance practices within the company affect the occurrence and extent of earnings management. The problem arises from the potential risks associated with earnings management, such as misleading investors, distorting financial statements, and eroding shareholder value.

By examining the relationship between corporate governance and earnings management, the problem statement aims to address the following question:

1. To what extent does the quality of corporate governance practices in Ayembe influence the occurrence of earnings management?

The quality of corporate governance practices in Ayembe plays a significant role in influencing the occurrence of earnings management. Numerous studies have demonstrated a strong relationship between effective corporate governance and reduced earnings management practices (Ashraf et al., 2022; Ozili, 2020; Lawal et al., 2018).

When a company has robust corporate governance practices, it establishes a framework that promotes transparency, accountability, and ethical behavior. This framework acts as a deterrent to earnings management by reducing the opportunities and incentives for manipulation. Here are some key ways in which the quality of corporate governance practices in Ayembe can influence the occurrence of earnings management:

Independent Board of Directors: The presence of independent directors on the board is crucial for effective corporate governance. Independent directors bring objectivity, diverse perspectives, and a focus on shareholder interests. They can provide a check on management’s actions, including earnings management practices. When boards have a sufficient number of independent directors, they are more likely to scrutinize financial reporting and challenge management decisions, reducing the likelihood of earnings manipulation.

Audit Committee Oversight: An active and independent audit committee is essential for effective corporate governance. The audit committee is responsible for overseeing the integrity of financial reporting and internal control systems. When the audit committee is composed of independent members with financial expertise, they can enhance the quality of financial disclosures and mitigate the risk of earnings management (Olaoye & Adewumi, 2020; Nwaobia, Kwarbai & Fregene, 2019). A strong audit committee ensures that financial statements are reviewed thoroughly, internal controls are robust, and external audits are conducted diligently.

Ethical Culture and Tone at the Top: Corporate governance practices that promote an ethical culture and tone at the top are essential for deterring earnings management. When the board and senior management emphasize integrity, ethical behavior, and compliance with accounting standards, it sets the tone for the entire organization (Freeman, 1984; Baltagi, 2005). Employees are more likely to follow ethical practices, reducing the occurrence of earnings manipulation.

Shareholder Activism and Engagement: Active shareholders who engage in corporate governance practices can contribute to reducing earnings management. Shareholders who exercise their voting rights, voice concerns, and participate in corporate decision-making processes can hold management accountable (McCullough, 1997; Wooldridge, 2002). This engagement creates a system of checks and balances, discouraging management from engaging in earnings management practices that may harm shareholder interests.

Disclosure and Transparency: Transparent and comprehensive disclosure practices are essential for effective corporate governance and reducing earnings management. When companies provide clear and accurate information about their financial performance, accounting policies, and risk factors, it enhances transparency and reduces the scope for manipulation (Gaur & Gaur, 2006; DeFond & Park, 2001). Transparent disclosure practices enable investors and stakeholders to make informed decisions based on reliable information.

Compensation Structures: The design of executive compensation structures can impact earnings management. When compensation packages are aligned with long-term performance goals and include metrics beyond short-term financial targets, it reduces the incentives for manipulating earnings to achieve short-term gains (Zubaidah et al., 2021; Tran & Dang, 2021; Ngo & Le, 2021). Additionally, including clawback provisions in compensation agreements can act as a deterrent, allowing the company to recover excessive bonuses obtained through fraudulent practices (Abubakar et al., 2021; Wati & Giltom, 2022; Githaiga, Kabete & Bonareri, 2022; Musa, Latif & Majid, 2022).

In conclusion, the quality of corporate governance practices in Ayembe has a significant influence on the occurrence of earnings management. Effective governance practices, such as an independent board, strong audit committee oversight, an ethical culture, shareholder engagement, transparent disclosure, and appropriate compensation structures, contribute to reducing the incentives, opportunities, and likelihood of earnings manipulation (Alhassan & Mamuda, 2020; Shohreh et al., 2015; Mirza & Javed, 2013; Khamis et al., 2015; Zouari & Taktak, 2014; Moussa & Aymen, 2014; Demsetz & Villalonga, 2001; Kobeissi & Sun, 2010; Denis & McConnel, 2003; Orumo, 2018; Badu & Appiah, 2017; Sanda et al., 2010; Sobhan, 2021; Isik & Ince, 2016; Pathan & Faff, 2013; Abed et al., 2012; Alwan, 2021). By implementing and maintaining robust corporate governance practices, Ayembe can foster an environment of integrity, accountability, and transparency, thereby mitigating the risks associated with earnings management.

1.3. Research Questions

1.3.1. Main Research Question

What is the effects of corporate governance on earning management in Ayembe?

1.3.2.Specific Research Questions

What is the effects of Board of directors on earning management in Ayembe?

What is the effects of risk management on earning management in Ayembe?

How does corporate governance affect earnings management in  Ayembe?

1.5.Objective of the Study

The main objective of this case study is to analyze the effect of corporate governance on earnings management in company Ayembe. The specific objectives are as follows:

-To assess the impact of board independence on the level of earnings management in  Ayembe.

-To analyze how executive compensation structure influences earnings management in  Ayembe.

-To examine the role of ownership structure in earnings management practices at Ayembe.

-To evaluate the influence of audit quality on the level of earnings management in  Ayembe.