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What is the Relationship Between REIT Governance and Earnings Management?

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Abstract

The empirical corporate finance literature claims that better corporate governance constrains earnings management, while others argue that the unique legal and reporting structure of REITs may reduce the need for such internal corporate governance. Using a sample of publicly traded REITs for the 2004–2008 time period, we examine the relationships amongst corporate governance, accruals earnings management, manipulation of Funds from Operations (FFO), and real earnings management. We find that corporate governance quality is unrelated to accruals earnings management and manipulation of FFO. At first glance, the findings suggest that managers need less internal oversight because of the more transparent reporting structure of REITs. However, we document that REITs engage in significant real activities manipulation for earnings management purposes. Our empirical findings further show that corporate governance characteristics, in particular board size, independence, number of board meetings and audit committee financial expertise, are essential for constraining such activities. Finally, by focusing on a subset of REITs that act in ways which previous research has identified as more susceptible to earnings management activities, we demonstrate that good corporate governance effectively reduces accruals earnings management and manipulation of FFO for these REITs. Overall, our findings indicate that, despite the unique legal and reporting structure, REITs engage in certain forms of earnings management, and that the ability for REITs to manipulate earnings is reduced when corporate governance is more effective.

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Notes

  1. The dividend distribution was required to be at least 95% of taxable income before 1999.

  2. Healy and Whalen (1999) provide a review of the earnings management literature.

  3. Prior studies (e.g., Jones 1991; Dechow et al. 1995; Dechow and Dichev 2002; Francis et al. 2005) develop different models to measure discretionary accruals. We use the modified Jones model in Dechow et al. (1995) in our main empirical analysis. However, in unreported robustness analysis, we conduct our study using alternative accrual measures and obtain similar results.

  4. However, the evidence on the size of board on firm performance is mixed. While Dalton et al. (1999) find a positive relationship between board size and firm performance, Yermack (1996) demonstrates that smaller boards are associated with better firm performance.

  5. These definitions for DIR_TENURE, DIR_EXP and DIR_SHARE are computed by The Corporate Library.

  6. Watts and Zimmerman (1978) suggest that larger firms confront greater “political costs,” and Warfield et al. (1995) find that political costs are negatively related to earnings management. Hence, we expect a negative relationship between firm size and EM. Smith and Watts (1992) show that firm growth tends to provide more opportunities for discretion in accounting choices. Therefore, we include GROWTH and expect a positive relationship. Yu (2008) shows that managers are less likely to engage in earnings management when they are being scrutinized by analysts; hence, we include ANALYST and expect a negative relationship. DeFond and Jiambalvo (1994) and Sweeney (1994) show that managers use discretionary accruals to manage earnings to meet debt covenants, we include leverage, LEV, and expect positive relationship between LEV and EM. Daniel et al. (2008) note that firms may engage in earnings management to meet dividend thresholds. We include DIVPAY and expect that a negative relationship, since higher dividend payout means that the firm is less likely to manage earnings to meet the REIT dividend threshold. Lobo et al. (2008) conjecture that firms which are losing money and firms which are performing well have different incentives to manage earnings. Non-profitable firms may have an incentive to incur large income-decreasing accruals. Firms that perform well in one year may wish to incur income-decreasing accruals in order to smooth their income over time. We include ROA and expect a negative relationship with EM.

  7. We also used a different threshold (i.e., 15th percentile) as a robustness check and obtained similar results.

  8. We use firms with a December fiscal year end, and exclude firms in the mortgage/financing sector.

  9. We collect our data through The Corporate Library as it offers detailed and unique corporate governance variables that enable us to examine the impact of different aspects of corporate governance on earnings management. Our data analysis starts in 2004 because The Corporate Library only provides detailed governance data starting 2003, and we use last-period CG variables as instrument variables in our empirical analysis. As we require last-period CG variables for each firm-year observation, we have to delete observations with non-consecutive years of data. The number of REITs in the usable sample size decreases from 158 to 68.

  10. Prior research (e.g., Wintoki 2007) provides evidence that corporate governance is not strictly exogenous to firm performance and it is potentially beneficial to use a two-stage least squares estimation procedure. In this paper, the first stage instrumental variables consist of macroeconomic variables, including corruption perceptions index, interest rate, GDP growth and saving ratio, as well as prior-period corporate governance variables. We report all our empirical results for the 2SLS regressions. In unreported preliminary analysis, we also conduct the same analysis using OLS regressions and obtain similar statistical results.

  11. We thank one of our anonymous reviewers for raising this issue.

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Acknowledgements

The authors would like to thank the audiences at the Maastricht-MIT-NUS symposium and the Third Annual UCI Spring Research Symposium, plus our discussant, Gangzhi Fan, for helpful comments. We also thank an anonymous referee whose comments helped us while revising this paper.

We gratefully acknowledge financial support from the Fisher Center for Real Estate and Urban Economics at University of California at Berkeley, McGill University, University of Alberta, and the Social Sciences and Humanities Research Council of Canada (SSHRC).

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Authors and Affiliations

  1. University of Guelph, Guelph, ON, Canada

    Paul Anglin

  2. University of California at Berkeley, Berkeley, CA, USA

    Robert Edelstein

  3. University of Alberta, Edmonton, Alberta, Canada

    Yanmin Gao

  4. McGill University, Montreal, Quebec, Canada

    Desmond Tsang

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  1. Paul Anglin
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  2. Robert Edelstein
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  4. Desmond Tsang
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Correspondence to Paul Anglin.

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Table 9 Definitations of variables
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Anglin, P., Edelstein, R., Gao, Y. et al. What is the Relationship Between REIT Governance and Earnings Management?. J Real Estate Finan Econ 47, 538–563 (2013). https://doi.org/10.1007/s11146-012-9367-y

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