Audit committee, board of director characteristics, and earnings management☆
Introduction
In December 1999, the NYSE and NASDAQ modified their requirements for audit committees. Under the new standards, firms must maintain audit committees with at least three directors, “all of whom have no relationship to the company that may interfere with the exercise of their independence from management and the company” (NYSE Listing Guide, Section 303.01(B)(2)(a)). These new requirements respond to the SEC's call for improving the effectiveness of corporate audit committees in overseeing the financial reporting process. One specific area of concern to the SEC is inappropriate “earnings management” by the firm defined as “the practice of distorting the true financial performance of the company”.1 The common thread running through the SEC and stock exchange proposals is an implicit positive connection between earnings management and non-independent audit committees. Yet no study to date explicitly tests this assertion. The purpose of this paper is to undertake such a study.
Using a sample of 692 publicly traded U.S. firm-years, I examine whether the magnitude of abnormal accruals (the proxy for earnings management) is related to audit committee independence. After controlling for other determinants of abnormal accruals and audit committee composition, I find the magnitude of abnormal accruals to be more pronounced for firms with audit committees comprised of less than a majority of independent directors. I also find a negative association between abnormal accruals and the percent of outside directors on the audit committee. However, and contrary to the SEC's intent, no difference in abnormal accruals is found between firms with and without wholly independent committees.
Given that the audit committee's effectiveness is embedded within the larger corporate governess process, I also investigate whether abnormal accruals are related to other board characteristics. I find significantly negative associations between abnormal accruals and the percent of outside directors on the board, and for whether the board is comprised of less than a majority of outside directors. These results are harmonious to the audit committee findings given that the audit committee reports to the board and that its members come from the full board.
I also examine whether changes in board or audit committee independence are accompanied by changes in the level of abnormal accruals. The results dovetail with the cross-sectional findings. Firms that change their boards and/or audit committees from majority-independent to minority-independent have significantly larger increases in abnormal accruals vis-à-vis their counterparts. These findings support the hypothesis that earnings management is negatively related to independent boards and audit committees, but can also be a reflection of a period of increasing uncertainty.
The uniqueness of this paper versus other papers relating board characteristics to earnings management is that while previous papers either examine firms committing egregious financial fraud (e.g., Dechow et al., 1996 and Beasley, 1996) or firms with incentives to overstate earnings (e.g., DeFond and Jiambalvo, 1994; Teoh et al., 1998a,b; Parker, 2000), I conduct my analyses on a sample of large, publicly traded U.S. firms which a priori have no systematic upwards or downwards earnings management. Thus, my results lend support to the exchanges’ and SEC's assertions that for all large U.S. traded companies, independent audit committees and boards are better able to monitor the earnings process.
This paper also contributes to the growing literature on measuring abnormal accruals. Kasznik (1999), Bartov et al. (2000) and Kothari et al. (2001) demonstrate the importance of controlling for the firm's earnings process when measuring abnormal accruals. Specifically, they show that not controlling for reversals of prior years’ accruals or growth patterns in earnings results in measurement error in abnormal accruals, which can lead to erroneous inferences. This problem is exacerbated if the measurement error is correlated with the partitioning variable (e.g., audit committee or board independence). The methods used throughout this paper address these issues and suggest the necessity of using a matched-portfolio (or firm) technique as advocated by these authors.
Section 2 discusses the stock exchange rules for audit committee composition. Section 3 develops the hypotheses about the expected associations between corporate governance mechanisms and earnings management. Section 4 details the sample selection criteria and contains descriptive statistics of the data. Section 5 discusses the methodologies and econometric issues related to creating the adjusted abnormal accruals. Section 6 contains cross-sectional analyses. Section 7 has the empirical results surrounding the associations between changes in board or audit committee composition and changes in adjusted abnormal accruals. The results in section 8 support the inferences made throughout the paper. Section 9 concludes.
Section snippets
NYSE and NASDAQ rules for audit committees
Prior to December 1999, the stock exchanges and NASDAQ rules for audit committee composition were vague at best. Large, U.S. listed companies were required or encouraged to maintain audit committees with a majority or all members being “independent” of management. However, no definition of independence was given.
In December 1999 the NYSE and NASDAQ modified their requirements by mandating listed companies to maintain audit committees with at least three directors, “all of whom have no
The role of board audit committees in resolving conflicts between management and outside auditors
The audit committee primary oversees the firm's financial reporting process. It meets regularly with the firm's outside auditors and internal financial managers to review the corporation's financial statements, audit process, and internal accounting controls.
Although much emphasis has been put on the audit committee's role in preventing fraudulent accounting statements (i.e., malfeasance of management or the outside auditor), Magee and Tseng (1990), Dye (1991), and Antle and Nalebuff (1991)
Sample selection
Data about boards and board audit committees are hand-collected from SEC-filed proxy statements. The initial sample contains all firm-years listed on the S&P 500 as of March 31, 1992 and 1993 with annual shareholder meetings between July 1, 1991 and June 30, 1993. Table 1 summarizes how the final sample is constructed. I eliminate 28 firm-years for firms domiciled outside the U.S. I also exclude 53 banks (SIC codes: 6000 to 6199) and 36 insurance companies (SIC codes: 6300–6411) because it is
Adjusted abnormal accruals
Any test of earnings management is a joint test of (1) earnings management and (2) the expected accruals model used.6 Acceptance or rejection of the null hypothesis of no earnings management cannot be disentangled from the key methodological issue of how well the chosen expected accruals model separates total accruals into its unexpected (abnormal) and expected components.7
Defining audit committee and board independence
The maintained hypothesis is that more independent audit committees and/or boards are associated with smaller AAACs. One issue is determining independence. This is not a trivial exercise as the following discussion illustrates.
I use three definitions of independence. The first is to interpret audit or board independence as the percentage of outside directors on the audit committee or on the board. This is a common definition used in the academic literature (e.g., Beasley, 1996). However, as
Changes in abnormal adjusted accruals and changes in board and audit committee composition
Regressions using cross-sectional data describe associations between abnormal adjusted accruals and board and audit committee composition. In this section, I scrutinize more directly the link between board and audit committee composition and earnings management by testing whether the level of abnormal adjusted accruals changes when board or audit committee structure changes.
I identify 339 firms having the required data for both 1992 and 1993. ΔAAAC is defined as the AAAC for 1993 minus the AAAC
Additional tests
This paper uses an abnormal adjusted residual from the cross-sectional Jones model as its measure of abnormal accruals. As do other papers in the literature, this measure is interpreted as being a proxy for earnings management. Since the results of my study depend on this measure, it is important to take reasonable steps to ensure the metric is measuring abnormal accruals and not other firm characteristics included in the model. Adjusting the Jones model for extreme accruals inherent in each
Summary and conclusions
This study examines whether audit committee and board characteristics are related to earnings management by the firm. The motivation behind this study is the implicit assertion by the SEC, the NYSE and the NASDAQ that earnings management and poor corporate governance mechanisms are positively related.
Cross-sectional negative associations are found between board or audit committee independence and abnormal accruals. Most significantly, strong results are found when either the board or the audit
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I would like to acknowledge the helpful comments of S.P. Kothari (the editor), an anonymous referee, Eli Bartov, James Doona, Lee-Seok Hwang, Jayanthi Krishnan, Carol Marquardt and the participants at the Temple University and NYU workshops. The Ross Institute of the Stern School of Business provided financial support.