Management entrenchment, corporate governance, and earnings quality

This study uses the convergence-of-interests hypothesis from agency theory and the management entrenchment hypotheses to examine a corporation's earnings quality relative to the strength of its governance structure and to insider equity ownership.; To do this I compute the earnings quality of 499 publicly traded firms using the Dechow and Dichev model of accrual estimation errors. For each firm I calculate a governance index from proxy statement data and use the proportional ownership of insider and independent board members to assess the relative power of these two groups on earnings quality.; I find that both independent and insider board members can become entrenched. This results in lower earnings quality. Entrenched board members negatively impact the strength of the governance structure. However, governance is still strong enough to partially offset the negative effect of entrenchment on earnings quality. Differences in earnings quality are not explained by a single governance variable, such as the independence of corporate boards or audit committees, but rather by groups of governance variables. The exact combination of effective governance mechanisms was not identified due to sample size limitations. Future research efforts should focus on analyzing composite governance scores to determine what mechanisms really matter.