Formalization of Corporate Governance and Earnings Management

Although the influence of various corporate governance mechanisms on earnings management has been analyzed in many studies, few studies have been made on the formalization of corporate governance which is, however, one of the important problems after the promulgation of the Sarbanes-Oxley Act. In this paper, a game model is built to analyze the influence of the formalization of corporate governance on earnings management. It is believed that there is obvious correlation between the degree of the formalization of corporate governance and the degree of earnings management in this paper. The greater the corporate governance is formalized, the bigger the difference in degree of managerial opportunism between reputation and reality will be, and the less the regulators and investors will suspect managerial opportunism. Thus, the more difficultly supervisors and investors understand the behavior of earnings management, the higher the degree of manager's earnings management will be. Managers have incentive to formalize corporate governance actively, because, besides the demand of supervisors and investors, the greater the formalization of corporate governance is, the higher utility the earnings management will bring to managers. The conclusion in this paper can provide some policy recommendations for strengthening and improving supervision in the post-Enron era: 1. Besides promulgating relevant laws and regulations, proactive supervision shall be strengthened; 2. Supervision on the so-called Star Enterprises shall be strengthened in times of prosperity; 3. News and public opinion shall play a proper role in corporate governance.