On the Interrelation between Corporate Governance, Audit and Earnings Quality: A Review of the Underpinning Theories

Abstract

The quality of reported earnings is important to investors in the financial market, as investors and analysts heavily rely on the company’s reported earnings in making investment decisions. The board of directors, the audit committee, and the internal audit function represent the internal monitoring mechanism within a company, whereas the external auditors serve as an external monitoring mechanism providing independent verification of the quality of a company’s financial reporting. Besides that, interdependencies exist between a firm’s internal corporate governance structure and its external audit function. Given the important effect of these monitoring mechanisms on a company’s financial reporting process, this paper aims to to discuss the relevance of various theories used in academic research in explaining the role of corporate governance and auditors in promoting higher earnings quality. Through the review of literature, we have found that the agency theory, stewardship theory, institutional theory, and managerial hegemony theory as the main theories that provide significant insights into the efficiency and effectiveness of corporate governance and audit functions from various perspectives. Hence, this suggests that future research could consider the use of multiple theories together in the explanaining the interrelation between corporate governance, audit, and earnings quality. Our paper would be of interest to academicians, practitioners, regulators, and policymakers in trying to understand how a company’s internal corporate governance characteristics such as the board, audit committee, and internal audit function, as well as how the external auditors affect the quality of financial reports produced by companies. Our paper also contributes to the literature as this paper comprehensively provides a synthesis and a holistic view of how these four theories complement each other in explaining the interrelation between the different governance mechanisms and financial reporting.