The Reciprocal Relationship Between Earnings Management, Disclosure Quality, and Board Independence: Evidence from Pakistan

Abstract

This study investigates the reciprocal relationship between earnings management, disclosure quality, and board independence using panel data from non-financial firms listed on the Pakistan Stock Exchange (PSX) from 2015 to 2020. Drawing on agency theory and the evolving corporate governance landscape in emerging markets, the study explores how governance mechanisms not only constrain earnings manipulation but are also shaped by it over time. Earnings management is proxied through discretionary accruals using the Modified Jones Model, while disclosure quality is measured through a customized disclosure index developed from firm annual reports. Board independence is operationalized as the percentage of independent non-executive directors on the board. Using simultaneous equation modeling (2SLS), the analysis reveals a significant negative association between board independence and earnings management, and between disclosure quality and earnings management, supporting the hypotheses that governance mechanisms reduce financial reporting opportunism. More notably, the findings demonstrate that prior-year earnings management significantly weakens board independence and deteriorates disclosure quality in subsequent periods—highlighting a feedback loop where earnings manipulation erodes governance integrity. These results underscore the importance of reciprocal accountability in corporate governance. In an environment like Pakistan, where enforcement mechanisms are still developing, the research provides timely policy insights. Regulators such as the Securities and Exchange Commission of Pakistan (SECP) must emphasize not only compliance with governance codes but also the prevention of cyclical deterioration in transparency and oversight. The study contributes to the literature by offering a dynamic perspective on governance and earnings management in emerging markets.