The Effect of Corporate Governance on Firm Financial Performance with Mediating Role of Earnings Management: Evidence from Pakistan Stock Exchange

Abstract

The paper investigates the impact of Corporate Governance on firm financial performance in Pakistani listed firms, with earnings management acting as a mediator. The study employed 191 non-financial companies that are listed on the Pakistan Stock Exchange from 2010 to 2019. Several diagnostic tests were run before applying the panel data model to the Ordinary Least Squares (OLS). The four variables used as proxies for Corporate Governance are board size, board independence, audit committee size, and ownership concentration. Financial performance may be approximated by the return on assets (ROA), while earnings management can be approximated by the discretionary accrual (DA). The research relied on Kothari et al., 2005 to determine DA rates. Findings suggest that Board Independence and Audit Committee size are important corporate governance factors for influencing earnings management. Earnings management is also intrinsically linked to a company's performance. The research used a four-stage mediation process developed by (Baron & Kenny, 1986). As earnings management was shown to be the only mediator between board independence and company financial performance, this finding suggests that the presence of independent directors boosts firm performance by reducing earnings management. Earnings management has no effect on the remaining corporate governance variables studied. It is Pakistan's first study to use earnings management as a mediating factor and to calculate discretionary accruals using the Kothari, Leone, and Wasley (2005) method. According to the study, board independence improves a firm's financial performance only by limiting management's earnings management activities