**1. Introduction**

In response to recent accounting scandals in both the US and Europe there has been an increased concern regarding the effectiveness of corporate governance practices. Undoubtedly, the concerns are justified. The case of Enron Corporation in 2001 is a well-known example of the destroying consequences of weak corporate governance. The scandal created an international attention on how to systematically implement improved corporate governance practices to prevent fraud and questionable managing of earnings. Immediate responses were proposed reforms of corporate governance through legislation and improved listing standards (Coffee 2002). This included the US Sarbanes Oxley Act (SOX) in 2002 and the UK Higgs Report and the Smith Report in 20031. The motivation behind our study is thus the implicit assertion that earnings management and weak corporate governance practices are positively related.

The concept of corporate governance is not new. Its need aroused with the separation of ownership and control in public companies (Berle and Means 1932), which, according to Jensen and Meckling (1976), resulted in agency problems. Consequently, the responsibility to present credible financial information and protect shareholders' interests fell on the corporate governance system (Fama and Jensen 1983). As information asymmetry between preparers and users of financial information makes opportunism possible (Beatty and Harris 1999), the guardian role of the board become obvious.

The extent of earnings management could implicate how well the corporate governance practices are in protecting shareholder's interests, since corporate governance has the potential to reduce or even eliminate fraudulent behavior (Man and Wong 2013). This study addresses the triangular

<sup>1</sup> Regarding Norway; the result was the establishment of the Norwegian Corporate Governance Board (NUES) in 2004.

interaction between a company's shareholders, board of directors and management in a Nordic setting. Many prior studies on corporate governance and earnings management have come from countries within a two-tier or one-tier model of corporate governance, such as the US, the UK, Italy. Egypt, Malaysia and China (Al-Jaifi 2017; Beasley 1996; Campa and Donnelly 2014; Karmel and Elbanna 2012; Klein 2002; Liu and Lu 2007; Marchini et al. 2018; Peasnell et al. 2000; Xie et al. 2003) which differentiate from the Nordic corporate governance model in several ways. Lekvall et al. (2014) claim that two key distinctive features of Nordic corporate governance are the powers vested with a shareholder majority to effectively control the company and the entirely nonexecutive board. Norwegian boards are characterized by a high shareholder concentration. Accordingly, instead of turning to the market for corporate control, major owners generally take an active part in the governance of the company. The system thus provides dominating shareholders the motivation to take long-term responsibility for the company. Moreover, Norwegian Public Limited Companies (ASA) are comprised exclusively of nonexecutive officers, except for employee representatives. An important implication of this is the distinction the duties and responsibilities of a strategically and monitoring board and a mere executive management function. Lekvall et al. (2014) argues that although these features may not seem individually unique, together they make a comprehensive system. Its success is shown by the competitiveness of Nordic companies on international markets. In 2013, *The Economist* described the Nordic corporate governance model as "The next supermodel", pointing to Nordic countries clustering at the top of global league tables of everything from economic competitiveness to happiness (The Economist 2013; Lourenco et al. 2018).

Although Nordic countries have been declared role models for their corporate governance systems (The Economist 2013), there have been limited studies exploring the relationship between corporate governance and earnings management in countries within the Nordic model of corporate governance. The aim of this paper is to fill these gaps and provide valuable insight for users of financial statements beyond the Nordic countries. We do find as a contribution that the presence of employee representation on the board reduce earnings management. Moreover, board independence seem positively related to earnings management, contradictory to the findings of other well-known studies (Beasley 1996; Dechow et al. 1996; Peasnell et al. 2000; Klein 2002). We also find the same regarding share ownership by directors, thus indicating that large proportions of minority shareholders on the board could give the directors incentives to pursue higher-risk strategies to generate larger financial returns.

The findings will be of interest for countries following the same triangular interaction between a company's shareholders, board of directors and management. In addition, the study aims to provide increased attention to the potential benefits the Nordic corporate governance approach has on improving earnings quality by mitigating earnings management.

The remainder of this paper is organized as follows. Section 2 provides a review of previous literature and the hypothesis development. The data and methodology are presented in Section 3, while Section 4 presents the empirical results. Finally, Section 5 conclude the paper's findings, included the limitations of the study.

#### **2. Review of Literature and Hypothesis Development**

Earnings are the summary measure of firm performance produced under the accrual basis of accounting (Dechow 1994). Healy and Wahlen (1999) provides a commonly cited definition of earnings management:

Earnings management occurs when managers intentionally use judgements in financial reporting and in structuring financial transactions to alter financial reports to mislead some stakeholders about the underlying economic performance of the firm or to influence contractual outcomes that depend on reported accounting numbers.

As the definition points out, firms have two options to manage earnings. First, earnings can be managed through deviations from normal business activities (Xu et al. 2007). The firm could, for example, boost reported profit by cutting down on research and development, selling assets it would otherwise keep and cutting down on employee development. Deviating from normal business practices to manipulate reported income is defined as real earnings management (Roychowdhury 2006). Second, a firm can alter the level of accruals to obtain the desired level of earnings. Using management judgements in financial reporting is defined as accrual-based earnings management (Healy and Wahlen 1999). Real changes in investment and operating activities are costlier than mere accounting manipulation. It is therefore reasonable to assume that firms have a lower threshold to manipulate earnings through accruals rather than real activities. This study focuses on accrual earnings management only.

Many motivations for earnings management have been examined in the literature. The managerial motives are mixed and include motivations such as maximizing firm value (Beneish 2001), management buyouts (DeAngelo 1986), initial public offerings (IPO's) (Teoh et al. 1998) and meeting the expectations of financial analysts, management, investors and social and political pressure (Payne and Robb 2000; Kasznik 1999; Li and Thibodeau 2019). The essence of earnings manipulation is derived from the flexibility given to management in disclosing their reported earnings (Busirin et al. 2015).

Accounting information is traditionally considered to have a dual role as both informer and steward (Ronen and Yaari 2008). The informative role arises because of investors' need to predict future cash flows and assess the risk of investments. This study will focus on the stewardship role of accounting. The stewardship role of accounting comes from the separation of ownership and management in public firms, resulting in agency problems that could lead to divergence between the interest of shareholders and managers (Jensen and Meckling 1976; Gjesdal 1981). A following control difficulty is information asymmetry. Information asymmetry exists when managers have a more complete set of information about the company than the shareholders, leading to agency costs as the managers have opportunities to promote their own self-interest at the shareholders' expense (Beatty and Harris 1999). Prior studies have found a positive relationship between agency costs and the latitude of earnings management (Beatty and Harris 1999; Man 2019). Corporate governance is thus necessary to align and coordinate the interest of the upper management with those of the shareholders to mitigate the occurrence of earnings management. Fama and Jensen (1983) argue that the board of directors is the highest internal control mechanism responsible for monitoring the actions of top management. Monks and Minow (2008) underline that as the body who governs the firm, it is the board of directors' duty to ensure that the company is run in the long-term interests of the shareholders. While there is no generally accepted definition of corporate governance, it may be defined as a system "consisting of all the people, processes and activities to help ensure stewardship over a company's assets" (Messier et al. 2008).

There is mixed evidence on the effect corporate governance practices has on earnings management. Board characteristics that have been frequently investigated in earnings management literature, such as board independence, board activity and the presence of an audit committee will be included in this study (see Table 1). In addition, directors' share ownership, majority shareholding by directors and the presence of employee representatives will be examined as key elements of the Nordic corporate governance model (see Table 1). Following are some prominent studies reviewed in this regard.
