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1. Introduction
Corporate governance associated failure, due mainly accounting scandals have raised concerns as to the honesty of accounting information provided to investors and culminated in the latter’s shaken confidence. Such failures have made it essential for both the financial market’s specialist and accounting researchers to improve the understanding of internal control effectiveness, as well as the promotion of the pervasiveness of control issues and their association with the earnings management attached behavior.
As mandated by Section 404 of the 2002 Sarbanes–Oxley Act (SOX, US house of representatives, committee on financial services), management has to document and test their internal control system to provide an annual report that contains an assessment of the internal control structure’s effectiveness. The securities and exchange commission stipulates that such requirement would enhance the quality of reporting and reestablish the investor’s confidence in the fairness and truthfulness of the securities markets. While the internal control systems are designed and implemented by management, their weaknesses implicitly create doubts about the management’s competence and views in regard of financial reporting. Furthermore, a weak system of internal control system might influence management attempts to further manipulate firm operations by means of controlled production costs, discretionary expenses and sales.
According to Roychowdhury (2006), real earnings management (REM) refers to the manipulation practices or acts introduced on real operational activities to achieve short-term financial goals. The purpose lying behind such practices consists in decreasing future cash flows rather than enhancing long-term company value over the current period. Contrary to accrual-based earnings management, REM is not related to accounting issues per se and, may, therefore, be fully executed within the generally accepted accounting principles without necessarily falling within the purview of auditors or regulators (Cohen et al., 2008). In fact, the wide-ranging use of manipulated real activities as in touted to manage earnings, either instead of or further to accounting manipulation (Graham et al., 2005; Cohen et al., 2008), along with the pervasive problems relating to the control environment and governance as perceived to persist in companies with internal control weaknesses (Zhang et al., 2007; Hoitash et al., 2009; Skaife et al., 2013) raise the question of whether the REM issue is rather more commonly prevalent in companies characterized with...