Audit Committee, Board of Director Characteristics, and Earnings Management

Journal of Accounting and Economics 33 (2002) 375400
Audit committee, board of director

characteristics, and earnings management
$
April Klein*
Stern School of Business, New York University, New York, NY 10012-1118, USA
Received 20 October 2000; received in revised form 2 February 2002
Abstract
This study examines whether audit committee and board characteristics are related to
earnings management by the rm. A negative relation is found between audit committee
independence and abnormal accruals. A negative relation is also found between board
independence and abnormal accruals. Reductions in board or audit committee independence
are accompanied by large increases in abnormal accruals. The most pronounced effects occur
when either the board or the audit committee is comprised of a minority of outside directors.
These results suggest that boards structured to be more independent of the CEO are more
effective in monitoring the corporate nancial accounting process. r 2002 Elsevier Science
B.V. All rights reserved.
JEL classication: K0; G3; M4
Keywords: Earnings management; Corporate governance; Audit committee; Board of directors
1. Introduction
In December 1999, the NYSE and NASDAQ modied their requirements for
audit committees. Under the new standards, rms must maintain audit committees
with at least three directors, all of whom have no relationship to the company that
$
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
nancial support.
*Corresponding author. Tel.: +1-212-998-0014; fax: +1-212-995-4004.
E-mail address: aklein@stern.nyu.edu (A. Klein).
0165-4101/02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved.
PII: S 0 1 6 5 - 4 1 0 1 ( 0 2 ) 0 0 0 5 9 - 9
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 SECs call for improving the effectiveness of corporate audit
committees in overseeing the nancial reporting process. One specic area of concern
to the SEC is inappropriate earnings management by the rm dened as the
practice of distorting the true nancial 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. rm-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 nd the magnitude of abnormal
accruals to be more pronounced for rms with audit committees comprised of less
than a majority of independent directors. I also nd a negative association between
abnormal accruals and the percent of outside directors on the audit committee.
However, and contrary to the SECs intent, no difference in abnormal accruals is
found between rms with and without wholly independent committees.
Given that the audit committees effectiveness is embedded within the larger
corporate governess process, I also investigate whether abnormal accruals are related
to other board characteristics. I nd signicantly 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 ndings 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 ndings. Firms that change their boards and/or audit committees
from majority-independent to minority-independent have signicantly larger
increases in abnormal accruals vis-" a-vis their counterparts. These ndings support
the hypothesis that earnings management is negatively related to independent boards
and audit committees, but can also be a reection 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 rms committing
egregious nancial fraud (e.g., Dechow et al., 1996 and Beasley, 1996) or rms 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. rms which a priori have no systematic upwards or downwards earnings
1
See SEC Chairman Arthur Levitts Address to NYU Center for Law and Business on September 28,
1998, the SECs proposed rule 32-41987 published on October 8, 1999, and the nal rule on audit
committee disclosure dated January 10, 2000 for use and denition of earnings management by the SEC.
All three can be found on www.sec.gov.
A. Klein / Journal of Accounting and Economics 33 (2002) 375400 376
management. Thus, my results lend support to the exchanges and SECs 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 rms earnings process when measuring
abnormal accruals. Specically, 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
rm) 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.
2. 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 denition of independence was
given.
In December 1999 the NYSE and NASDAQ modied their requirements by
mandating listed companies to 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.
2
Simultaneously, the SEC adopted new rules to improve disclosures related to the
functioning of corporate audit committees.
3
Excluded from the audit committee are
2
See NYSE Listing Guide, Section 303.01(B)(2)(a); NASDAQ Market Listing Requirements Section
4310(c)(26)(B). See also SEC Release Numbers 34-42231, 34-42232 and 34-42233, Adopting Changes to
Listing Requirements for the NASD, AMEX, and NYSE Regarding Audit Committees. For the NYSE,
foreign companies are excluded if their audit committee structure abides by the countrys rules. For the
NASDAQ, companies with revenues less than $25 million are excluded. To be listed on the NYSE, rms
must have at least $100 million of revenues.
3
See Release Number 34-42266, Adopting Rules Regarding Disclosure by Audit Committees,
Including Discussions with Auditors Regarding Financial Statements.
directors who are current employees, former employees within the last 3 years, have
cross compensation committee links, or are immediate family members of an
executive ofcer. In addition, the NASDAQ excludes any director who accepts non-
director compensation from the rm in excess of $60,000 or whose employer receives
at least $200,000 in any of the past 3 years.
These rules, however, are not steadfast. NASDAQ Rule 4310(c)(26)(B)(ii) allows
the board under limited circumstances to appoint any non-current employee or
family member to the audit committee. NYSE Section 303.01(B)(3)(b) gives the
board broader discretion in appointing directors with business relationships to the
rm. If the board determines that the independence of the director is not
compromised by the business relationship, then that director may serve on the
boards audit committee. Thus, rms may maintain audit committees that are not
100% independent.
3. Corporate governance mechanisms and monitoring the rms nancial reporting
process
3.1. The role of board audit committees in resolving conicts between management
and outside auditors
The audit committee primary oversees the rms nancial reporting process. It
meets regularly with the rms outside auditors and internal nancial managers to
review the corporations nancial statements, audit process, and internal accounting
controls.
Although much emphasis has been put on the audit committees 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) argue
that legitimate differences of opinion may exist between management and outside
auditors in how to best apply GAAP. Antle and Nalebuff (1991) conclude that these
differences result either in the auditor being dismissed or, more likely, in a negotiated
nal nancial report. DeFond and Subramanyam (1998) postulate that client
litigation risk may result in auditors preferring more conservative accounting choices
than management for clients they perceive to be more risky. They present evidence
consistent with this assertion for a sample of rms experiencing auditor changes.
Nelson et al. (2000), using survey data, conrm that many reported earnings
numbers are negotiated. Overall, prior research suggests that the audit committees
role as arbiter between the two parties is to weigh and broker divergent views of both
parties to produce ultimately a balanced, more accurate report. Equivalently, its role
is to reduce the magnitude of positive or negative abnormal accruals.
The maintained hypothesis throughout this paper is that an independent audit
committee is best able to serve as an active overseer of the nancial accounting
process. I predict that audit committee independence will be negatively related to
earnings management.
3.2. Board independence
Several papers present evidence suggesting that effective governance and rm
performance increase with board independence (for example, see Brickley et al.,
1994; Byrd and Hickman, 1992; Weisbach, 1988). Others document a negative link
between outside directors and the incidence of nancial fraud (see Dechow et al.,
1996; Beasley, 1996). I test the assertion that a boards relative independence from
management is negatively related to earnings manipulation.
3.3. Relationship investing
Relationship investing encompasses all situations in which a large blockholder
takes an active, interventionist role in the rms economic processes. For large U.S.
companies, relationship investing is often achieved by giving a large non-manage-
ment shareholder or one of his representatives a seat on the board of directors. Being
on the boards audit committees gives these investors the opportunity to monitor the
rms nancial reporting process. I predict a negative relation between earnings
management and the incidence of at least one large (e.g., at least 5% shareholdings)
outside director on the boards audit committee.
3.4. CEO shareholdings
Wareld et al. (1995) nd a negative relation between managerial stockholdings
and the absolute value of abnormal accruals. They interpret their results as being
consistent with managerial shareholdings acting as a disciplining mechanism (Berle
and Means, 1932; Jensen and Meckling, 1976). In a similar vein, Morck et al. (1988),
and McConnell and Servaes (1990) nd a positive relation between Tobins Q and
inside director shareholdings. However, Healy (1985) presents evidence that CEOs
manage earnings to maximize their bonuses. Aboody and Kasznik (2000) and
Yermack (1997) show that CEOs manage investors earnings expectations downward
prior to scheduled stock option award to increase the value of their awards, and
Nagar et al. (2000) present evidence that a rms discretionary disclosure of
accounting data is related to the form of the CEOs compensation. If the CEO
manages earnings to increase his overall compensation, then there will be a positive
relation between CEO shareholdings and earnings management. Thus, no a priori
prediction is made.
4. Data description
4.1. Sample selection
Data about boards and board audit committees are hand-collected from SEC-led
proxy statements. The initial sample contains all rm-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 nal sample is constructed. I
eliminate 28 rm-years for rms domiciled outside the U.S. I also exclude 53 banks
(SIC codes: 6000 to 6199) and 36 insurance companies (SIC codes: 63006411)
because it is difcult to dene accruals and abnormal accruals for nancial services
rms. Thus, all inferences in the paper are limited by the particular time period and
sample selection.
Schedule 14A (the proxy statement) requires rms to disclose each directors
name, business experience during the last 5 years, other current directorships, family
relationships between any director, nominee or executive ofcer, signicant current
or proposed transactions with management, signicant business relations with the
rm and number of shares held.
4
Schedule 14A (Item 7(e)(1)) requires rms to state
whether they have a standing audit committee. If such a committee exists, rms are
required to disclose its functions and responsibilities, its members, and the number of
times the committee met during the last scal year. Four rm-years are eliminated
due to missing information about their audit committees.
Compustat provides the earnings, cash ows from operations, and other nancial
data needed to construct the abnormal accruals. CRSP and Compustat provide data
for many of the independent variables. One hundred and eighty rm-years are
eliminated due to insufcient Compustat or CRSP data. The deletions arise
primarily from two sources. First, I use a cross-sectional Jones regression model to
estimate the unadjusted abnormal accruals for each sample rm. The models
parameters are estimated by industry and I require each rm-year to have at least
eight observations with the same two-digit SIC code. Second, I use variants of
Kaszniks (1999) matched-portfolio technique to adjust the rms abnormal accrual
for effects that are correlated with board and/or audit committee independence. One
technique ranks all Compustat rms into percentiles by the 10-year standard
Table 1
Sample used in analyses
Firm-years
Initial S&P 500 Sample for 19921993 1000
Non-US rms (28)
Banking rms (four-digit SIC code: 60006199) (53)
Insurance rms (four-digit SIC code: 63006411) (36)
Missing data on audit committees (4)
Missing Compustat or CRSP data (180)
Outlier for absolute value of abnormal accrual (7)
Final sample 692
4
Item 404(a) of Regulation SK of the 1934 Securities and Exchange Act denes signicant business
transactions as any transaction between rm and director (or his/her place of business) that exceeds
$60,000. Item 404(b) delineates the transactions as payments in return for services or property, signicant
indebtedness, outside legal counseling, investment banking, consulting fees and other joint ventures.
deviation of past total accruals and requires each sample rm-year to have an
appropriate matched-portfolio for the adjustment. Thus, each sample rm must have
11 years of Compustat data, ending in 1991 or in 1992. Finally, I remove seven
abnormal accrual outliers; each being more than 5 standard deviations from the
mean. In total, these requirements yield 692 observations.
4.2. Corporate governance characteristics
Consistent with prior research (e.g., Weisbach, 1988; Byrd and Hickman, 1992;
Brickley et al., 1994), I classify directors as insiders, outsiders, or afliated (gray)
with the rm. Insiders are current employees of the company. Outsiders have no ties
to the rm beyond being a board member. Consistent with the NYSE and NASDAQ
listing requirements, afliated directors are past employees, relatives of the CEO, or
have signicant transactions and/or business relationships with the rm as dened by
Items 404(a) and (b) of Regulation SX, or are on interlocking boards as dened by
Item 402(j)(3)(ii) of Regulation SX.
Table 2 reports data on board and audit committee composition. On average,
58.4% of board members and 79.6% of audit committee members are outsiders.
While no rm has a completely independent board, 73.8% of the rms in the sample
have boards in which the majority of directors are independent of management.
5
In
contrast, 43.4% of audit committees are comprised of outside directors only and
86.7% have a majority of independent directors.
5. 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
Moreover, Dechow et al. (1995),
Guay et al. (1996), Kasznik (1999), Bartov et al. (2000), and Kothari et al. (2001)
show that any proxy for abnormal accruals yields biased metrics if measurement
error in the proxy is correlated with omitted variables. More importantly, if the
omitted variable is associated with the independent variable of interest or is within a
non-random sample, then well-specied tests must include an adjustment for the
omitted variable. Kasznik (1999) and Kothari et al. (2001) control for the correlated
variable by using a matched-rm or portfolio technique to adjust the abnormal
accruals. I employ Kaszniks (1999) matched-portfolio technique.
5
In 1992 and today, the NYSE, AMEX, and the NASDAQ required domestic listed rms to have a
minimum of two outside or independent directors on their boards.
6
Many papers use the terms discretionary and non-discretionary accruals for expected and abnormal
accruals.
7
Bernard and Skinner (1996), Guay et al. (1996), Dechow and Skinner (2000), and Kothari et al. (2001)
contain excellent discussions of this issue.
I begin by estimating a cross-sectional variant of the Jones (1991) expected
accruals model for all rms k in industry j for year t:
8
The model is
ACCR
jk;t
=TA
jk;t1
a
j;t
1=TA
jk;t1
b
j;t
DREV
jk;t
=TA
jk;t1
g
j;t
PPE
jk;t
=TA
jk;t1
e
jk;t
; 1
where ACCR
jk;t
are total accruals for rm k in industry j in year t [Compustat item
#18-Compustat item #304], TA
jk;t1
are total assets [Compustat item #6], DREV
jk;t
is
the change in net sales [Compustat item #12], and PPE
jk;t
is gross property, plant and
equipment [Compustat item #7]. The changes in revenues and PPE are used to
control for expected (i.e., economic-based) components in total accruals.
9
I use all rms on Compustat having the same two-digit SIC code for the rm-year.
Industries with less than eight observations are dropped from the sample. The
number of rms used in each industry model ranges from 8 to 315. In total, 114 two-
digit industry regressions for the 2-year period are estimated.
Table 2
Descriptive corporate governance data
Whole board Audit committee
Percentage of directors who are
Insiders
a
(%) 22.5 1.4
Outsiders
b
58.4 79.6
Afliates
c
19.1 19.0
Percentage of rms with
100% outside directors (%) 0 43.4
Majority of outside directors 73.8 86.7
Sample is for 692 US rms-years with audit committees 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.
a
Insiders are current employees of the company.
b
Outsiders have no afliation with the company beyond for being directors.
c
Afliates are former employees, relatives of the CEO, board interlocks, or have signicant transactions
and/or business relationships with the rm as dened by Items 404(a) and (b) of Regulation SX.
8
Other papers using this model include DeFond and Jiambalvo, 1994; Subramanyam, 1996; DeFond
and Subramanyam, 1998; Becker et al., 1998; Teoh et al., 1998a, b; Peasnall et al., 1998; Guidry et al.,
1999; DuCharme et al., 2001.
9
Bartov et al. (2000) test the efcacy of the unadjusted cross-sectional Jones model vis-" a-vis other cross-
sectional and time-series expected accruals models. They conclude that the cross-sectional original Jones
model is the only model consistently able to detect earnings management for a sample of rms receiving
audit qualications. Dechow et al. (1995) and Guay et al. (1996) contrast the time-series Jones and
modied Jones time-series models with other time-series models and conclude that the Jones models
perform the best in detecting abnormal accruals.
Next, for each rm-year ij; t in the S&P 500 sample, I calculate the unadjusted
abnormal accrual dened as
AAC
ij;t
ACCR
ij;t
=TA
ij;t1
fa
j;t
1=TA
ij;t1
b
j;t
DREV
ij;t
=TA
ij;t1
g
j;t
PPE
ij;t
=TA
ij;t1
g; 2
where a
j;t
; b
j;t
; and g
j;t
are the tted coefcients from Eq. (1).
Table 3 reports descriptive statistics for the entire sample. The average (median)
abnormal accrual is 0.004 (0.003). Testing for whether the mean abnormal accrual
is different from zero yields a t-statistic of 0.54 (p-value=0.59). Forty-eight percent
Table 3
Descriptive statistics on accruals, and abnormal accruals
Variable Mean Std. dev. Median Minimum Maximum %Positive
Abnormal accruals (AAC)
Unadjusted
a
0.004 0.189 0.003 1.79 1.89 48
p-value 0.588 0.425
Abs(AAC)
Unadjusted
a
0.077 0.173 0.035 0.00003 1.886 100
p-value 0.001 0.001
Adjusted for s(total accruals)
b
0.014 0.177 0.013 0.281 1.838 100
p-value 0.001 0.001
Total accruals
c
0.061 0.047 0.057 0.405 0.139 10
Abs(total accruals)
c
0.067 0.050 0.059 0.0002 0.4053 100
Non-discretionary accruals
d
0.064 0.190 0.065 2.17 1.80 11
Net income
e
0.056 0.075 0.048 0.298 0.576 84
Operating cash ows
f
0.117 0.077 0.107 0.126 0.483 97
Assets
g
(in $millions) 8,960 21,352 3,145 179 174,429 100
Abs is the absolute value.
a
Unadjusted abnormal accruals (AAC) are the accruals prediction error, e.g., the difference between
total accruals and estimated expected accruals. See Eq. (2).
b
Adjusted abnormal accruals is the unadjusted Abs(AAC) minus the Median Abs(AAC) for a portfolio
of rms matched by the same standard deviation of the rms past 10 years total accruals.
c
Total accruals are the difference between net income before extraordinary items (Compustat item #18)
and cash ows from operations (Compustat item #308), deated by lagged total assets (Compustat
item #6).
d
Non-discretionary accruals are estimated for each rm-year as the expected value of accruals based on
Eq. (1).
e
Net Income is net income before extraordinary items (Compustat item #18) deated by lagged total
assets (Compustat item # 6).
f
Operating cash ows is from the cash ows statement (Compustat item #308) deated by lagged total
assets (Compustat item # 6).
g
Assets are total assets (Compustat item # 6).
of the abnormal accruals are positive; a sign test yields a p-value of 0.43. Thus, no
evidence of systematic upward or downward earnings management activity is
detected. This nding most likely is due to the S&P 500 being a relatively random
sample with respect to earnings management incentives (see Healy and Wahlen,
1999; Nelson et al., 2000). Because of this quality, I use the unsigned (absolute value
of) abnormal accruals as a proxy for the unadjusted combined effect of income-
increasing and income-decreasing earnings management. Other earnings manage-
ment studies using this measure are Wareld et al., 1995; Becker et al., 1998; Bartov
et al., 2000.
Next, I use Kaszniks (1999) matched-portfolio method to adjust the absolute
value of the AAC. The adjustment for each sample rm is the median absolute value
of the AAC for a portfolio of rms matched by a variable that is correlated with
both the absolute value of abnormal accruals and board and/or audit committee
independence. As Table 4, Panels A and B illustrate the absolute value of abnormal
accruals, audit committee independence and board independence are correlated at
Table 4
Spearman correlations (p-value in parenthesis)
Panel A: Spearman correlations of absolute values of total accruals (TA)
a
, abnormal Accruals (AAC)
b
,
adjusted abnormal accruals (AAAC)
c
, with possible correlated variables
Variable Abs(TA) Abs(AAC) AAAC
s(TA)
a,i
0.33 (0.01) 0.19 (0.01) 0.01 (0.73)
Abs(earnings)
d
0.08 (0.03) 0.13 (0.01) 0.03 (0.40)
Abs(earnings
t1
) 0.07 (0.08) 0.11 (0.01) 0.00 (0.93)
Earnings 0.27 (0.01) 0.15 (0.01) 0.00 (0.99)
Abs(Dearnings) 0.26 (0.01) 0.20 (0.01) 0.13 (0.01)
Abs(DCFO)
e
0.18 (0.01) 0.20 (0.01) 0.11 (0.11)
Abs(DTA) 0.06 (0.11) 0.08 (0.03) 0.06 (0.10)
Debt
f
0.05 (0.18) 0.14 (0.01) 0.06 (0.11)
Log(Assets) 0.01 (0.83) 0.22 (0.01) 0.15 (0.01)
Panel B: Spearman correlations of percentages of outside directors on audit committee (%Audout) and boards
(%Outsiders on board) with possible correlated variables
Variable %Audout
g
%Outsiders on board
h
s(TA)
i
0.09 (0.01) 0.18 (0.01)
Abs(earnings) 0.09 (0.01) 0.17 (0.01)
Abs(earnings
t1
) 0.10 (0.01) 0.20 (0.01)
Earnings 0.08 (0.04) 0.20 (0.01)
Abs(Dearnings) 0.05 (0.17) 0.03 (0.40)
Abs(DCFO) 0.05 (0.17) 0.07 (0.07)
Abs(DTA) 0.01 (0.80) 0.02 (0.53)
Debt 0.06 (0.13) 0.16 (0.01)
Log(Assets) 0.07 (0.05) 0.13 (0.01)
MV/BV
j
0.14 (0.01) 0.19 (0.01)
Negative income
k
0.07 (0.05) 0.01 (0.74)
the 0.01 level with the standard deviation of past total accruals, the absolute value of
current earnings, and the absolute value of last periods earnings, and at the 0.01 or
0.04 level for the level of current earnings. Each earnings variable controls for the
rms inherent accruals or earnings process and is consistent with Kothari et al.
(2001) assertion that this periods AAC is associated with the rms earnings process.
In particular, each variable allows for this periods earnings to take into account
reversals of prior year accruals or growth trends in earnings.
10
Table 4 (continued)
Panel C: Correlations among earnings, cash ows, and total accruals
Abs(earnings) Abs(earning
t1
) Earnings Abs(Dearnings) Abs(DCFO) Abs(DTA)
s(TA) 0.37 (0.01) 0.38 (0.01) 0.26 (0.01) 0.24 (0.01) 0.23 (0.01) 0.13 (0.01)
Abs(earnings) 0.73 (0.01) 0.82 (0.01) 0.08 (0.04) 0.21 (0.01) 0.09 (0.01)
Abs(earnings
t1
) 0.71 (0.01) 0.09 (0.02) 0.21 (0.01) 0.07 (0.06)
Earnings 0.11 (0.01) 0.16 (0.01) 0.04 (0.24)
Abs(Dearnings) 0.20 (0.01) 0.20 (0.01)
Abs(DCFO) 0.23 (0.01)
a
Total accruals are net income before extraordinary items minus cash ows from operations. Total
accruals are deated by lagged total assets.
b
AAC are abnormal accruals measured as the difference between total accruals and expected accruals
using the cross-sectional Jones model (Eq. (1)).
c
AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median
Abs(AAC) for a portfolio of rms match on the standard deviation of past total accruals.
d
Earnings and earnings
t1
are net income before extraordinary items deated by lagged total assets for
the current and lagged year, respectively.
e
CFO is cash ows from operations deated by lagged total assets.
f
Debt is long-term debt deated by lagged total assets.
g
%Audout is the percent of outside directors on the audit committee.
h
%Outsiders on board is the percent of outside directors on the board.
i
s(TA) is the standard deviation of total accruals for the 10 years prior to the current year.
j
MV/BV is the market value of common equity divided by the book value of total common equity.
k
Negative income is equal to one if the rm has two past years of negative income before extraordinary
items and zero otherwise.
Abs is the absolute value
10
The positive correlation between the standard deviation of past total accruals and the absolute value
of current abnormal accruals signies that rms with extreme accruals inherent in their business are more
likely to have high discretionary accruals. The negative correlation between this variable and board
(audit committee) independence supports Hermalin and Weisbachs (1998) prediction that rms
with past extreme accruals are less likely to have an independent board. The positive correlations
between the absolute value of current abnormal accruals and the earnings numbers are congruent to
Kothari et al. (2001); Dechow et al. (1995); and Kaszniks (1999) ndings that this periods AAC is re-
lated to last period return on assets. The negative associations between the earnings numbers and board
or audit committee independence are similar to results reported by Hermalin and Weisbach (1991) and
Klein (2002).
Initially, I match by the standard deviation of total accruals. The adjusted
abnormal accrual for sample rm-year ij;t is
AAAC
ij;t;p
AbsAAC
ij;t;p
Median AbsAAC
t;p
; 3
where AbsAAC
ij;t;p
is the absolute value of the abnormal accrual for rm-year ij;t;
Median AbsAAC
t;p
is the median absolute value of the abnormal accruals for a
portfolio of Compustat rms, and p is the percentile ranking of the Compustat rms
standard deviation of total accruals.
To get the percentile rankings, I compute the standard deviation of total accruals
for the 10 years prior to 1991 or 1992 for all Compustat rms with non-missing data
and assign them to percentiles based on their ordered rank. Each Compustat
percentile for 1991 contains approximately 87 rms; for 1992 each percentile has
approximately 90 rms. Similarly, I compute each sample rms standard deviation
of total accruals for the 10 years prior to 1991 or prior to 1992. Each sample rm is
matched by the percentile, p; and the AAAC is computed using Eq. (3).
As Table 4, Panel A shows, AAAC is insignicantly correlated with the standard
deviation of past total accruals (r 0:01; p-value=0.73), the absolute value of
current earnings (r 0:03; p-value=0.40), the absolute value of past earnings
(r 0:00; p-value=0.93), and current earnings (r 0:00; p 0:99). Thus, much of
the measurement error due to these factors is removed. Note too from Panel C, the
correlations among these variables range from 0.37 to 0.82, suggesting that the
variables capture much of the same processes. Finally, as shown in Table 3, the
AAAC has a lower mean (median) of 0.014 (0.013) than the unadjusted Abs(AAC)
(mean=0.077; median=0.035).
6. Cross-sectional analyses
6.1. Dening 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 denitions of independence. The rst 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 denition used in the academic literature (e.g., Beasley,
1996). However, as Hermalin and Weisbach (1991) show, the relation between
economic outcomes (i.e., Tobins Q for Hermalin and Weisbach) and board
independence may not be linear.
A second path is to follow the NASDAQ and NYSEs guidelines and consider an
audit committee independent only if all members are outside directors. Since no
boards are comprised solely of outside directors, this denition is not feasible for the
entire board. Under this denition, audit committees can function independently if
and only if all members are free from managerial inuence.
A third denition of board or audit committee independence is for a majority of
members to be independent of management. Dechow et al. (1996), for example,
dene a board as being inside-dominated if at least 50% of board members are rm
ofcers. The rationale behind this metric is that majority rule dominates board and
committee actions.
The differences among denitions, particularly between the 100% and 51% rules,
can inuence how rms structure their boards. The exchange rules suggest that
effective monitoring requires boards to maintain audit committees with independent
directors only. To achieve this, rms need to recruit independent directors and may
have to increase board size (Klein, 2002). Yet, Yermack (1996) argues and shows
that rms with smaller boards (i.e., under 10 directors) are better performers. Fama
and Jensen (1983) and Klein (1998) articulate that rms benet greatly by having
insiders on the board since top managers bring in expertise about the organization to
the boards top-level decision making apparatus. These papers suggest that it may be
costly for companies to maintain 100% independent audit committees. Thus, using
the 51% (majority) denition may be a desirable alternative to many rms.
6.2. Univariate models
The dependent variable is the AAAC. Examination of its distribution reveals that
its shape is approximately lognormal. Accordingly, I estimate the regression
coefcients by maximum likelihood using a NewtonRaphson algorithm on a
lognormal-dependent variable. Since there are sign predictions for all of the variables
except %CEO shareholdings, one-tailed tests are reported except for that variable.
Table 5 presents coefcients for the univariate models.
11
As predicted, I obtain
signicantly negative coefcients for both board denitions and for the 51% audit
committee independence denition. In contrast, the coefcients on the 100% audit
committee independence denition, the percent of outsiders on the audit committee,
the incidence of a large blockholder on the audit committee and the percent of
common equity owned by the CEO are insignicantly different from zero.
The most statistically signicant coefcients are for the 51% board and audit
committee cutoff levels. To check the sensitivity of the ndings, I re-estimate models
using cutoffs of 40% and 60%. Only the coefcient on the 60% cutoff of outside
directors is signicant at the 0.10 level or better. Taken as a whole, these results
suggest that a majority outside membership may be a critical threshold for deriving a
meaningful relation between director independence and the absolute value of the
adjusted abnormal accruals.
6.3. Multivariate models
This section uses multivariate models relating board characteristics to abnormal
accruals. I control for other factors that may be related to the absolute value of
11
Pearson and Spearman correlations present similar results to the regression models. The one exception
is Aud51%, which has a weaker relation (po0:10) than those presented in Table 5.
abnormal accruals or board/audit committee independence. As Bartov et al. (2000)
show, failure to control for confounding factors may result in falsely rejecting the
null hypothesis of no abnormal accruals when in fact the null is true.
Previous studies suggest that the absolute change in the previous years income
before extraordinary items divided by total assets, and nancial leverage (total debt
divided by total assets) are positively associated with earnings management, and
political costs (log of beginning years assets) are negatively related to earnings
management (see Wareld et al., 1995; Dechow et al., 1995; DeFond and Jiambalvo,
1994; Becker et al., 1998; Dechow et al., 1996; Bartov et al., 2000). As the last column
of Table 4, Panel A shows, AAAC is signicantly correlated at the 0.01 level with the
absolute value of the change in earnings and with the log of rm assets.
Klein (2002) reports that audit committee and board independence are
signicantly related to market-to-book ratios, past negative earnings (two or more
previous consecutive years), and rm size (log of beginning years assets). From
Table 4, Panel B, we see that %Audout is signicantly correlated with these three
variables; %Outsiders on the board is signicantly correlated with rm assets and
Table 5
Univariate models of absolute values of adjusted abnormal accruals (AAACs)
a
on corporate governance
explanatory variables
Explanatory
variable
Bd51%
b
%Out
c
Aud100%
d
Aud51%
e
%Audout
f
5%Block. on
aud. comm.
g
%CEO shares
h
Intercept 0.14 0.01 0.08 0.17 0.15 0.09 0.08
(48.85)
n
(0.09) (36.70)
n
(36.93)
n
(13.50)
n
(71.13)
n
(50.73)
n
Coefcient 0.07 0.14 0.01 0.09 0.06 0.11 0.31
(w
2
-Values) (9.36)
n
(6.72)
n
(0.36) (10.05)
n
(2.21) (2.27) (1.27)
n
Signicant at the 0.01 level.
a
Abs(AAC) for a portfolio of rms match on the standard deviation of past total accruals. The dependent
variable is modeled as a lognormal distribution. The parameters are estimated by maximum likelihood
using a NewtonRaphson algorithm.
b
Bd51% takes on the value of one if the rms board has at least a majority of outside directors, and
zero otherwise.
c
%Out is the percentage of outsiders on the rms board.
d
Aud100% takes on the value of one if the rms audit committee has outside directors only, and zero
otherwise.
e
Aud51% takes on the value of one if the rms audit committee has at least a majority of outside
directors, and zero otherwise.
f
%Audout is the percentage of outsiders on the rms audit committee.
g
5%Block. on aud. comm. is an indicator if an outside 5% blockholder sits on the boards audit
committee.
h
%CEO shares is the percentage of common equity owned by the CEO.
the market-to-book ratio, but not to negative income. %Outsiders is also
signicantly correlated with debt.
Table 6 contains the multivariate results. AAACs are negatively related at the 0.01
level to whether the board or its audit committee has a majority of independent
directors. In addition, the coefcients on the percentages of outsiders on the board or
audit committee are signicantly negative at the 0.10 and 0.01 levels, respectively.
Thus, cross-sectionally, board and audit committee compositions are related to
abnormal accruals. However, contrary to the intentions of the new guidelines
promulgated by the exchanges, there appears to be no meaningful relation between
abnormal accruals and having an audit committee comprised solely of independent
directors.
The associations between earnings management and having a 5% outside
blockholder on the audit committee or CEO shareholdings are unclear since the
coefcients for the former variable are signicantly negative for three models only
and the coefcients for the latter variable are signicantly positive for two
Table 6
Multivariate models of absolute values of adjusted abnormal accruals (AAACs)
a
on Board and Audit
Committee Composition (parameter estimates and w
2
-Values)
Predicted sign Model 1 Model 2 Model 3 Model 4 Model 5
Intercept 0.12 0.03 0.08 0.16 0.14
(2.89)
n
(0.17) (1.07) (4.70)
nn
(3.57)
nn
Bd51%
b
0.08
(12.59)
nnn
%Out
c
0.10
(3.13)
Aud100%
d
0.003
n
(0.03)
Aud51%
e
0.12
(18.89)
nnn
%Audout
f
0.10
(6.11)
nnn
5%Blockholder 0.09 0.14 0.12 0.11 0.11
on audit comm.
g
(1.44) (3.68)
n
(2.84)
n
(2.56)
n
(2.31)
%CEO shares
h
? 0.21 0.48 0.38 0.47 0.39
(0.58) (2.84)
n
(1.87) (3.04)
n
(1.97)
MV/BV
i
? 0.01 0.01 0.01 0.01 0.01
(4.08)
nn
(7.61)
nnn
(6.52)
nnn
(7.47)
nnn
(5.96)
nn
Abs(DNI)
j
+ 0.65 0.54 0.59 0.71 0.66
(6.07)
nnn
(4.20)
nn
(5.01)
nn
(7.29)
nnn
(6.18)
nnn
Neg. NI
k
? 0.09 0.09 0.09 0.09 0.10
(2.06) (2.37) (2.40) (2.38) (2.47)
specications only. Finally, the control factors, with the exceptions of negative
income and the log of assets, are signicantly different from zero.
6.4. Summary
In summary, the results indicate that after holding other factors constant, rms
with boards and/or audit committees composed of less than a majority of
independent directors are more likely to have larger AAACs than their counterparts.
A negative relation exists between AAACs and the percent of independent directors
on the board and/or audit committee. In contrast, there is no evidence of a
systematic association between having an all-independent audit committee and
abnormal accruals.
Table 6 (continued)
Predicted sign Model 1 Model 2 Model 3 Model 4 Model 5
Debt
l
+ 0.22 0.15 0.18 0.19 0.19
(9.21)
nnn
(4.31)
nn
(6.25)
nnn
(7.43)
nnn
(6.67)
nnn
Log(Assets)
m
0.01 0.01 0.01 0.01 0.01
(1.09) (1.74) (1.40) (0.96) (1.11)
n
Signicant at the 0.10.
nn
nnn
a
Abs(AAC) for a portfolio of rms match on the standard deviation of past total accruals. The dependent
variable is modeled as a lognormal distribution. The parameters are estimated by maximum likelihood
using a NewtonRaphson algorithm.
b
Bd51% takes on the value of one if the rms board has at least a majority of outside directors, and
zero otherwise.
c
%Out is the percentage of outsiders on the rms board.
d
Aud100% takes on the value of one if the rms audit committee has outside directors only, and zero
otherwise.
e
Aud51% takes on the value of one if the rms audit committee has at least a majority of outside
directors, and zero otherwise.
f
%Audout is the percentage of outsiders on the rms audit committee.
g
5%Block. on audit comm. is an indicator if an outside 5% blockholder sits on the boards audit
committee.
h
%CEO shares is the percentage of common equity owned by the CEO.
i
MV/BV is the market value of the total rm over book value of assets, measured at the beginning of the
scal year.
j
Abs(DNI) is the absolute value of the change in net income between years t 1 and t:
k
Neg. NI. is an indicator if the rm had two or more consecutive years of negative income, ending on
the scal year prior to the shareholders meeting.
l
Debt is long-term debt divided by last years assets.
m
Log(Assets) is the natural log of the book value of assets.
7. 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 rms having the required data for both 1992 and 1993. DAAAC is
dened as the AAAC for 1993 minus the AAAC for 1992. A positive number
indicates an increase in the level of abnormal accruals. The change in board or audit
composition is the percent of outside directors on the board (audit committee) in
1993 minus the percent of outside directors on the board (audit committee) in 1992.
Greater independence is associated with a positive number. The alternative
hypothesis is that boards (audit committees) moving towards more (less)
independence will be accompanied by a decrease (increase) in abnormal accruals.
12
Both between-sample tests and regression analyses are used. In the between-
sample tests, I determine whether the change in the level of abnormal accruals is
statistically different for rms experiencing changes in their board (audit committee)
structures as compared to rms not experiencing the changes. The t-test assumes
normal distributions and tests for differences between means. When appropriate,
adjustments to the denominator are made to accommodate statistical differences in
variances between samples. The z-test does not assume normality and tests for
differences between medians. One-sided tests are performed.
As one would expect, and as Klein (2002) shows, there is a signicant relation
between changes in board independence and changes in audit committee
independence. For the sample, the Spearman correlation coefcient between the
two variables is 0.45, signicant at the 0.01 level. Sixty-six rms had an increase in
audit committee independence between 1992 and 1993. For these rms, 48 also had
an increase in board independence, 9 had a decrease in board independence, and 9
had no change in board independence over the same 2 years. Seventy-eight rms had
a decrease in audit committee independence between 1992 and 1993. For these rms,
49 had a reduction in board independence, 15 had an increase in board
independence, and 14 had no change in board independence over the same 2 years.
Panel A of Table 7 presents the between-sample tests. First, I examine changes in
AAACs around changes in board independence. The 116 rms that reduced its
percentage of outsiders on the board experienced a 0.051 mean increase in abnormal
adjusted accruals, compared to a decrease of 0.001 for other rms. The 24 rms
whose boards moved from a majority of outsiders to less than a majority of outsiders
12
Weisbach (1988) nds that poorly performing rms are more likely to change their boards towards
more independence. Since audit committee independence is related also to board independence (Klein,
2002); Weisbachs (1988) ndings suggest that a positive relation between the change in adjusted abnormal
returns and audit committee independence may arise due to economic events. This phenomenon will bias
my results away from the hypothesis of a negative relation between adjusted abnormal returns and board
(audit committee) independence.
Table 7
Changes in adjusted abnormal accruals (DAAAC) following changes in board and audit committee composition for all rms in sample with two years of data
(N 339)
Panel A: Mean changes in adjusted abnormal accruals (DAAAC)
a
Change in
%Outside directors
on board or audit
committee
No change or
opposite change in
%Outside directors
on board or audit
t-Statistic for
difference
between
means
z-Statistic for difference between
medians
committee Chg NoChg
Mean
DAAAC
N Mean
DAAAC
N #>
median
#>
median
z-stat
Board composition
Increase in %Out.
b
0.002 133 0.021 206 0.82 109 60 1.44
n
Decrease in %Out. 0.051 116 0.006 223 1.89
nn
67 102 2.06
nn
To >51% Out. 0.025 19 0.016 320 1.86
n
9 160 0.22
To o51% Out. 0.161 24 0.002 315 1.79
n
18 151 2.55
nnn
Audit committee composition
Increase in Audout
c
0.015 66 0.020 273 1.60
n
30 139 0.68
Decrease in Audout 0.035 78 0.007 261 0.79 41 128 0.55
To 100% Audout 0.000 23 0.014 316 0.57 9 160 1.06
To o100% Audout 0.049 28 0.010 311 1.91
nn
18 151 1.59
n
To >51% Audout 0.083 6 0.015 333 1.10 4 165 0.83
To o51% Audout 0.131 10 0.001 329 1.74
n
2 167 1.92
nn
A
.
K
l
e
i
n
/
J
o
u
r
n
a
l
o
f
A
c
c
o
u
n
t
i
n
g
a
n
d
E
c
o
n
o
m
i
c
s
3
3
(
2
0
0
2
)
3
7
5
4
0
0
3
9
2
Panel B: Regression of DAAAC on changes in board or audit committee composition
Variable Predicted sign Coefcient
(t-statistic)
Coefcient
(t-statistic)
Intercept 0.01 0.01
(1.21) (0.99)
D%Out 0.13
(0.97)
D%Audout 0.16
(2.15)
b
Adjusted R
2
0.00 0.01
F-value 0.95 4.61
nn
n
nn
nnn
a
AAAC is the absolute value of adjusted abnormal accruals measured as abs(AAC) minus the median abs(AAC) for a portfolio of rms match on the
standard deviation of past total accruals.
b
%Out is the percentage of outside directors on the board
c
%Audout is the percentage of outside directors on the audit committee
A
.
K
l
e
i
n
/
J
o
u
r
n
a
l
o
f
A
c
c
o
u
n
t
i
n
g
a
n
d
E
c
o
n
o
m
i
c
s
3
3
(
2
0
0
2
)
3
7
5
4
0
0
3
9
3
had a 0.161 average increase in abnormal adjusted accruals, against a 0.002 increase
for other rms. Both partitions produce statistically signicant differences in means
and medians.
Next, I examine changes in audit committee independence. Firms moving from a
wholly independent audit committee to a lesser independent committee produce an
average increase in abnormal adjusted accruals of 0.049, compared to an average
increase of 0.010 for other rms. The 10 rms whose audit committees shifted from a
majority of outsiders to a less than a majority of outsiders had a 0.131 average
increase in abnormal accruals, against an average increase of 0.001 for other rms.
Again, both classications yield statistically different means and medians.
In Panel B, I regress the change in AAAC on changes in board or audit committee
independence. The coefcients on each variable are negative as expected. However,
only the change in audit committee independence yields a statistically signicant t-
statistic.
7.1. Summary
In summary, the results indicate that rms with boards and/or audit committees
that move from majority-independent to a minority-independent structures
experience large increases in AAACs in the year of the change compared to their
counterparts.
8. 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 rm characteristics
included in the model. Adjusting the Jones model for extreme accruals inherent in
each rms business (e.g., the standard deviation of past total accruals) is one
mechanism. In this section, I perform other tests to ensure further that the inferences
drawn thus far are valid.
8.1. Modied cross-sectional Jones model
Dechow et al. (1995) propose a modied Jones model in which
AAC
jk;t
ACCR
jk;t
=TA
jk;t1
fa
j;t
1=TA
jk;t1
b
j;t
DREV
jk;t
DREC
jk;t
=TA
jk;t1
g
j;t
PPE
j;t
=TA
j;t1
g: 4
The modication is that in the expected accruals model, revenue changes are
adjusted for DREC
jk;t
; the change in receivables for year t: Dechow et al. (1995)
calculate a
j;t
; b
j;t
; and g
j;t
from their original model (Eq. (1) of this paper) and use
these estimates in Eq. (3). Bartov et al. (2000) and Kothari et al. (2001) follow this
methodology. Other papers, e.g., Kasznik (1999), re-estimate a
j;t
; b
j;t
; and g
j;t
by
modifying Eq. (1) to include the adjustment for receivables. I use both specications.
Using Eq. (4) as my measure of abnormal accruals, I follow the same methodology
described in Section 5 and calculate an AAAC for each rm-year. The univariate and
multivariate results with specication are almost identical to those presented in
Tables 57. Kothari et al. (2001) also nd statistically insignicant differences
between using the Jones and modied-Jones cross-sectional models.
8.2. Adjustment for current or past abnormal earnings
Kasznik (1999) nds that measurement error for the signed abnormal accrual of
the cross-sectional Jones model is positively related to net earnings. Kothari et al.
(2001) nd the same result for last years net earnings. As Table 4, Panel C shows, the
correlation between this years and last years abnormal earnings is 0.73 and the
correlation between this years signed and unsigned earnings is 0.82. Further, all
three variables are highly correlated with the conditioning variable used thus far, i.e.,
the standard deviation of past total accruals. Thus, it can be argued each is
surrogating for aspects of the rms earnings process.
To control for the possibility that my results reect these omitted correlated
variables, I adjust the unsigned abnormal accruals by the median value of the
unsigned abnormal accrual for three matched portfolios of Compustat rms. The
matchings are based on (1) the absolute value of this years earnings, (2) the absolute
value of last years earnings, and (3) this years signed earnings. Using the unsigned
(absolute) values preserves the research design. However, it assumes that the degree
of earnings manipulation is unaffected by rm performance (net earnings), an
assumption that Kasznik (1999) and Kothari et al. (2001) show to be untrue for rms
that a priori have incentives to manage earnings. Thus, I match rms by both signed
and unsigned earnings.
The procedure to compute the AAAC is the same as described in section 5. The
difference is that the Abs(AAC) is adjusted by the Median Abs(AAC) for differently
matched portfolios. Both univariate and multivariate tests akin to Tables 5 and 6 are
conducted with the newly calculated dependent variables. For the multivariate
process, the same independent variables are included.
Table 8 contains the parameter estimates and w
2
-values for the univariate and
multivariate procedures. Panel A has the results on matching by the absolute value
of current earnings. Panel B contains the results on matching by the absolute value
of last years earnings. Panel C matches by the current signed earnings. Since
5%Blockholder on audit committee and %CEO shares are included in each
multivariate regression, I present the range of parameter estimates and w
2
-values
over the ve regressions.
As Table 8 illustrates, the parameter estimates and statistical signicant levels are
qualitatively the same whether I match by the past standard deviation of total
accruals or the level of earnings. For example, in Panel A, the coefcients on
Aud51% are 0.096 (p 0:01) and 0.120 (p 0:01) for the unsigned current
earnings-matched univariate and multivariate models vis-" a-vis 0.09 and 0.12
(p |:01;0.01) for the standard deviation-matched models in Tables 5 and 6. In
Panel B, the coefcients on Aud51% are 0.095 and 0.127, respectively. In Panel
C, the coefcients on Aud51% are 0.101 and 0.124, respectively. Thus, the overall
results are robust to whether I match by the standard deviation of total accruals, the
unsigned levels of current or last years earnings, or the signed level of current
earnings.
8.3. Regression approach
A second method for controlling for omitted correlated variables is to include
them as separate regressors (see Bartov et al., 2000). The regression is the unadjusted
Abs(AAC) on the independent variables included in Table 6 alongside the standard
deviation of total accruals, the absolute value of this years earnings or the absolute
value of last years earnings.
The advantage to using this technique over the matched-portfolio approach is that
mismatching on the conditioning variable introduces noise into the dependent
variable, which weakens the power of the independent variables. The disadvantage
to the regression approach over the matched-portfolio approach is that the former
imposes a cross-sectionally linear relation, with a xed coefcient on the
conditioning variable. In contrast, the matched-portfolio method does not impose
restrictions these restrictions.
Table 8
Parameter estimates and chi-square values for board independence and audit committee independence for
univariate and multivariate models in which the AAACs are calculated by matching portfolios of current
or past earnings
Variable Univariate procedure
a
Multivariate procedure
b
Panel A: Matching by absolute value of current earnings
Board51% 0.068 (9.71)
n
0.084 (14.06)
n
%Out 0.121 (5.36)
nn
0.084 (2.08)
Aud100% 0.000 (0.02) 0.006 (0.51)
Aud51% 0.096 (11.41)
n
0.120 (19.27)
n
%Audout 0.080 (3.77)
nn
0.110 (7.85)
n
5%Blockholder on audit comm.
c
0.136 (3.43)
nn
(0.093, 0.144)
d
(1.71, 3.24)
e
%CEO shares
c
0.288 (1.14) (0.222, 0.501)
d
(0.66, 3.23)
e
Panel B: Matching by absolute value of last years earnings
Board51% 0.067 (9.28)
n
0.076 (11.54)
n
%Out 0.123(5.61)
nn
0.094 (2.78)
nnn
Aud100% 0.002 (0.01) 0.008 (0.16)
Aud51% 0.095 (11.17)
n
0.127 (22.21)
n
%Audout 0.078 (3.61)
nn
0.118 (9.21)
n
c
0.124 (2.76)
nn
(0.102, 0.150)
d
(2.04, 4.34)
e
%CEO shares
c
0.392 (2.07) (0.280, 0.557)
d
(1.07, 3.67)
e
I estimate three regressions on the abnormal unadjusted AACs (untabulated).
Each regression includes one of the three correlated variables. I do not include two
or all three together because of the high degree of co-linearity among the variables.
The regression results with these specications exhibit many similarities to those
reported in Tables 5 and 6. Specically, the coefcients and signicance levels on the
audit and board independence variables remain qualitatively the same. One
difference is that the coefcient on whether a large blockholder sits on the audit
committee is signicantly negative (p-values between 0.01 and 0.02) for the
regression approach. A second difference is that the coefcient on rm assets is
Table 8 (continued)
Variable Univariate procedure
a
Multivariate procedure
b
Panel C: Matching by this years earnings
Board51% 0.073 (11.43)
n
0.080 (13.02)
n
%Out 0.100 (3.68)
nn
0.088 (2.30)
Aud100% 0.004 (0.03) 0.005 (0.07)
Aud51% 0.101 (12.79)
n
0.124 (20.93)
n
%Audout 0.088 (4.76)
nn
0.112 (8.34)
n
c
0.121 (2.76)
nnn
(0.095, 0.144)
d
(1.82, 4.04)
e
%CEO shares
c
0.411 (2.34) (0.267, 0.534)
d
(0.97, 3.83)
e
n
nn
nnn
a
Univariate procedure is the maximum likelihood estimates of the abnormal earnings-adjusted accruals
on the independent variable.
b
Multivariate procedure is the maximum likelihood estimates of the abnormal earnings-adjusted
accruals on the independent variable and the other variables in Table 6.
c
5%Blockholder on audit committee and %CEO shares are used singularly in the univariate
procedures. They are included alongside the board or audit committee independence variable in the
multivariate procedures.
d
This is the range of parameter estimates over the ve multivariate procedures. For example,
5%Blockholder on audit committee is included as an independent variable in the multivariate regressions
alongside Board51%, %Out, Aud100%, Aud51%, and %Audout, respectively. For the regressions on
current-earnings adjusted AACs, the parameter estimates on 5%Blockholder on audit committee range
between 0.093 and 0.144.
e
This is the range of chi-square values over the ve multivariate procedures. In Panel A: for
5%Blockholder on audit committee, three chi-Square values are signicant at the 0.10 level, one is
signicant at the 0.05 level and one is not signicant at the 0.10 level. For %CEO shares, two chi-square
values are signicant at the 0.10 level and three are not signicant at the 0.10 level. In Panel B: For
5%Blockholder on audit committee, three chi-Square values are signicant at the 0.10 level, one is
signicant at the 0.05 level and one is not signicant at the 0.10 level. For %CEO shares, one chi-square
values is signicant at the 0.10 level, one is signicant at the 0.05 level and three are not signicant at the
0.10 level. In Panel C: For 5%Blockholder on audit committee, two chi-square values are signicant at the
0.10 level, two are signicant at the 0.05 level and one is not signicant at the 0.10 level. For %CEO
shares, one chi-square values is signicant at the 0.10 level, two are signicant at the 0.05 level and two are
not signicant at the 0.10 level.
signicantly negative at the 0.01 level for the regression approach. Thus, as Kothari
et al. (2001) show, disparate approaches can produce different inferences.
Nevertheless, the main result that abnormal accruals are related to board and
audit committee independence remains robust to this technique.
8.4. CEO on board nominating committee or executive compensation committee
Klein (1998, 2000) and Shivdasani and Yermack (1999) demonstrate a negative
association between board independence and whether the CEO sits on the boards
nominating or executive compensation committee. Thus, I test if earnings manage-
ment is positively related to whether the CEO sits on these committees by including
two indicators into the regression analysis performed in Table 6 (untabulated). CEO
on nominating committee equals one if the CEO sits on the nominating committee or
if the board has no nominating committee, and zero otherwise. CEO on
compensation committee equals one if the CEO sits on the compensation or if the
board has no compensation committee. The coefcient on CEO on nominating
committee is insignicantly different from zero, suggesting no relation between this
variable and earnings management. In contrast, the coefcient on CEO on
compensation committee is signicantly different from zero at conventional levels,
suggesting a positive relation between earnings management and whether the CEO
sits on this committee. This nding is consistent with Aboody and Kaszniks (2000)
and Yermacks (1997) research showing that CEOs manage investors expectations
on earnings downwards prior to the issuance of stock option awards.
9. Summary and conclusions
This study examines whether audit committee and board characteristics are
related to earnings management by the rm. 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 signicantly, strong results are found
when either the board or the audit committee has less than a majority of independent
directors. Contravene to the new regulations, no signicant cross-sectional
association is found between earnings management and the more stringent
requirement of 100% audit committee independence. In addition, I nd that rms
changing their board or audit committee from having a majority to a minority of
outside directors experience large increases in AAACs relative to their counterparts.
The implications of this study depend on ones view of how accurately the AAAC
measures earnings management. A generous interpretation is that, consistent with
the SECs and the exchanges concerns, a negative relation exists between audit
committee or board independence and earnings management for all large traded
U.S. rms. This interpretation suggests that the exchange rules are reasonable,
although maintaining a wholly independent audit committee may not be necessary.
A less liberal interpretation is that rms with large accruals inherent in their earnings
structure are less inclined to have independent boards or audit committees.
This paper uses sensitivity analyses to examine the robustness of the AAAC with
respect to it being a good measure of abnormal accruals. The results are robust to
four separate measures of AAAC and to an alternative regression approach. Still,
future work needs to be done on nding better measures of abnormal accruals.
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