Audit Committee, Board Of Director Characteristics, And Earnings Management x59r

Journal of ing and Economics 33 (2002) 375–400

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 firm. 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 financial ing process. r 2002 Elsevier Science B.V. All rights reserved. JEL classification: K0; G3; M4 Keywords: Earnings management; Corporate governance; Audit committee; Board of directors

1. 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 $

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 . *Corresponding author. Tel.: +1-212-998-0014; fax: +1-212-995-4004. E-mail address: [email protected] (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

376

A. Klein / Journal of ing and Economics 33 (2002) 375–400

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 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-a" -vis their counterparts. These findings 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 1

See SEC Chairman Arthur Levitt’s Address to NYU Center for Law and Business on September 28, 1998, the SEC’s proposed rule 32-41987 published on October 8, 1999, and the final rule on audit committee disclosure dated January 10, 2000 for use and definition of earnings management by the SEC. All three can be found on www.sec.gov.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

377

management. Thus, my results lend 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 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 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 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 country’s rules. For the NASDAQ, companies with revenues less than $25 million are excluded. To be listed on the NYSE, firms 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’’.

378

A. Klein / Journal of ing and Economics 33 (2002) 375–400

directors who are current employees, former employees within the last 3 years, have cross compensation committee links, or are immediate family of an executive officer. In addition, the NASDAQ excludes any director who accepts nondirector compensation from the firm 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 firm. If the board determines that the independence of the director is not compromised by the business relationship, then that director may serve on the board’s audit committee. Thus, firms may maintain audit committees that are not 100% independent.

3. Corporate governance mechanisms and monitoring the firm’s financial reporting process 3.1. 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 ing controls. Although much emphasis has been put on the audit committee’s role in preventing fraudulent ing 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 final financial report. DeFond and Subramanyam (1998) postulate that client litigation risk may result in auditors preferring more conservative ing choices than management for clients they perceive to be more risky. They present evidence consistent with this assertion for a sample of firms experiencing auditor changes. Nelson et al. (2000), using survey data, confirm that many reported earnings numbers are negotiated. Overall, prior research suggests that the audit committee’s 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 financial ing process. I predict that audit committee independence will be negatively related to earnings management.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

379

3.2. Board independence Several papers present evidence suggesting that effective governance and firm 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 financial fraud (see Dechow et al., 1996; Beasley, 1996). I test the assertion that a board’s relative independence from management is negatively related to earnings manipulation. 3.3. Relationship investing Relationship investing encomes all situations in which a large blockholder takes an active, interventionist role in the firm’s economic processes. For large U.S. companies, relationship investing is often achieved by giving a large non-management 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 firm’s financial 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 board’s audit committee. 3.4. CEO shareholdings Warfield et al. (1995) find 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) find a positive relation between Tobin’s 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 firm’s discretionary disclosure of ing data is related to the form of the CEO’s 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-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

380

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Table 1 Sample used in analyses Firm-years Initial S&P 500 Sample for 1992–1993 Non-US firms Banking firms (four-digit SIC code: 6000–6199) Insurance firms (four-digit SIC code: 6300–6411) Missing data on audit committees Missing Compustat or CRSP data Outlier for absolute value of abnormal accrual Final sample

1000 (28) (53) (36) (4) (180) (7) 692

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 difficult to define accruals and abnormal accruals for financial services firms. Thus, all inferences in the paper are limited by the particular time period and sample selection. Schedule 14A (the proxy statement) requires firms to disclose each director’s name, business experience during the last 5 years, other current directorships, family relationships between any director, nominee or executive officer, significant current or proposed transactions with management, ‘‘significant business relations’’ with the firm and number of shares held.4 Schedule 14A (Item 7(e)(1)) requires firms to state whether they have a standing audit committee. If such a committee exists, firms are required to disclose its functions and responsibilities, its , and the number of times the committee met during the last fiscal year. Four firm-years are eliminated due to missing information about their audit committees. Compustat provides the earnings, cash flows from operations, and other financial data needed to construct the abnormal accruals. CRSP and Compustat provide data for many of the independent variables. One hundred and eighty firm-years are eliminated due to insufficient 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 firm. The model’s parameters are estimated by industry and I require each firm-year to have at least eight observations with the same two-digit SIC code. Second, I use variants of Kasznik’s (1999) matched-portfolio technique to adjust the firm’s abnormal accrual for effects that are correlated with board and/or audit committee independence. One technique ranks all Compustat firms into percentiles by the 10-year standard 4

Item 404(a) of Regulation S–K of the 1934 Securities and Exchange Act defines significant business transactions as any transaction between firm 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, significant indebtedness, outside legal counseling, investment banking, consulting fees and other t ventures.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

381

deviation of past total accruals and requires each sample firm-year to have an appropriate matched-portfolio for the adjustment. Thus, each sample firm 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 affiliated (‘‘gray’’) with the firm. Insiders are current employees of the company. Outsiders have no ties to the firm beyond being a board member. Consistent with the NYSE and NASDAQ listing requirements, affiliated directors are past employees, relatives of the CEO, or have significant transactions and/or business relationships with the firm as defined by Items 404(a) and (b) of Regulation S–X, or are on interlocking boards as defined by Item 402(j)(3)(ii) of Regulation S–X. Table 2 reports data on board and audit committee composition. On average, 58.4% of board and 79.6% of audit committee are outsiders. While no firm has a completely independent board, 73.8% of the firms 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 t 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-specified 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-firm or portfolio technique to adjust the abnormal accruals. I employ Kasznik’s (1999) matched-portfolio technique. 5

In 1992 and today, the NYSE, AMEX, and the NASDAQ required domestic listed firms to have a minimum of two ‘‘outside’’ or ‘‘independent’’ directors on their boards. 6 Many papers use the 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.

382

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Table 2 Descriptive corporate governance data Whole board

Audit committee

Percentage of directors who are Insidersa (%) Outsidersb Affiliatesc

22.5 58.4 19.1

1.4 79.6 19.0

Percentage of firms with 100% outside directors (%) Majority of outside directors

0 73.8

43.4 86.7

Sample is for 692 US firms-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 affiliation with the company beyond for being directors. c Affiliates are former employees, relatives of the CEO, board interlocks, or have significant transactions and/or business relationships with the firm as defined by Items 404(a) and (b) of Regulation S–X.

I begin by estimating a cross-sectional variant of the Jones (1991) expected accruals model for all firms k in industry j for year t:8 The model is ACCRjk;t =TAjk;t1 ¼ aj;t ½1=TAjk;t1 þ bj;t ½DREVjk;t =TAjk;t1 þ gj;t ½PPEjk;t =TAjk;t1 þ ejk;t ;

ð1Þ

where ACCRjk;t are total accruals for firm k in industry j in year t [Compustat item #18-Compustat item #304], TAjk;t1 are total assets [Compustat item #6], DREVjk;t is the change in net sales [Compustat item #12], and PPEjk;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 firms on Compustat having the same two-digit SIC code for the firm-year. Industries with less than eight observations are dropped from the sample. The number of firms used in each industry model ranges from 8 to 315. In total, 114 twodigit industry regressions for the 2-year period are estimated. 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 efficacy of the unadjusted cross-sectional Jones model vis-"a-vis other crosssectional 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 firms receiving audit qualifications. Dechow et al. (1995) and Guay et al. (1996) contrast the time-series Jones and modified Jones time-series models with other time-series models and conclude that the Jones models perform the best in detecting abnormal accruals.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

383

Next, for each firm-year ij; t in the S&P 500 sample, I calculate the unadjusted abnormal accrual defined as AACij;t ¼ ACCRij;t =TAij;t1 faj;t ½1=TAij;t1 þ bj;t ½DREVij;t =TAij;t1 þ gj;t ½PPEij;t =TAij;t1 g;

ð2Þ

where aj;t ; bj;t ; and gj;t are the fitted coefficients 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.

Abnormal accruals (AAC) Unadjusteda p-value

0.004 0.588

0.189

Abs(AAC) Unadjusteda p-value

0.077 0.001

0.173

0.014 0.001

0.177

Adjusted for s(total accruals)b p-value Total accrualsc Abs(total accruals)c Non-discretionary accrualsd Net incomee Operating cash flowsf Assetsg (in $millions)

Median

Minimum Maximum

0.003 1.79 0.425

0.035 0.001

0.00003

0.013 0.281 0.001

0.061 0.047 0.057 0.067 0.050 0.059 0.064 0.190 0.065 0.056 0.075 0.048 0.117 0.077 0.107 8,960 21,352 3,145

0.405 0.0002 2.17 0.298 0.126 179

%Positive

1.89

48

1.886

100

1.838

100

0.139 10 0.4053 100 1.80 11 0.576 84 0.483 97 174,429 100

Sample is for 692 US firms-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. 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 firms matched by the same standard deviation of the firms’ past 10 years’ total accruals. c Total accruals are the difference between net income before extraordinary items (Compustat item #18) and cash flows from operations (Compustat item #308), deflated by lagged total assets (Compustat item #6). d Non-discretionary accruals are estimated for each firm-year as the expected value of accruals based on Eq. (1). e Net Income is net income before extraordinary items (Compustat item #18) deflated by lagged total assets (Compustat item # 6). f Operating cash flows is from the cash flows statement (Compustat item #308) deflated by lagged total assets (Compustat item # 6). g Assets are total assets (Compustat item # 6).

A. Klein / Journal of ing and Economics 33 (2002) 375–400

384

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 finding 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 incomeincreasing and income-decreasing earnings management. Other earnings management studies using this measure are Warfield et al., 1995; Becker et al., 1998; Bartov et al., 2000. Next, I use Kasznik’s (1999) matched-portfolio method to adjust the absolute value of the AAC. The adjustment for each sample firm is the median absolute value of the AAC for a portfolio of firms 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, s 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) 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 a,i

s(TA) Abs(earnings)d Abs(earningst1 ) Earnings Abs(Dearnings) Abs(DCFO)e Abs(DTA) Debtf Log(Assets)

Abs(TA) 0.33 0.08 0.07 0.27 0.26 0.18 0.06 0.05 0.01

(0.01) (0.03) (0.08) (0.01) (0.01) (0.01) (0.11) (0.18) (0.83)

Abs(AAC)

AAAC

0.19 0.13 0.11 0.15 0.20 0.20 0.08 0.14 0.22

0.01 0.03 0.00 0.00 0.13 0.11 0.06 0.06 0.15

(0.01) (0.01) (0.01) (0.01) (0.01) (0.01) (0.03) (0.01) (0.01)

(0.73) (0.40) (0.93) (0.99) (0.01) (0.11) (0.10) (0.11) (0.01)

B: Spearman correlations of percentages of outside directors on audit committee (%Audout) and boards (%Outsiders on board) with possible correlated variables Variable s(TA)i Abs(earnings) Abs(earningst1 ) Earnings Abs(Dearnings) Abs(DCFO) Abs(DTA) Debt Log(Assets) MV/BVj Negative incomek

%Audoutg 0.09 0.09 0.10 0.08 0.05 0.05 0.01 0.06 0.07 0.14 0.07

(0.01) (0.01) (0.01) (0.04) (0.17) (0.17) (0.80) (0.13) (0.05) (0.01) (0.05)

%Outsiders on boardh 0.18 0.17 0.20 0.20 0.03 0.07 0.02 0.16 0.13 0.19 0.01

(0.01) (0.01) (0.01) (0.01) (0.40) (0.07) (0.53) (0.01) (0.01) (0.01) (0.74)

A. Klein / Journal of ing and Economics 33 (2002) 375–400

385

Table 4 (continued) C: Correlations among earnings, cash flows, and total accruals Abs(earnings) Abs(earningt1 ) Earnings s(TA) 0.37 (0.01) Abs(earnings) Abs(earningst1 ) Earnings Abs(Dearnings) Abs(DCFO)

0.38 (0.01) 0.73 (0.01)

0.26 (0.01) 0.82 (0.01) 0.71 (0.01)

Abs(Dearnings) Abs(DCFO) Abs(DTA) 0.24 0.08 0.09 0.11

(0.01) (0.04) (0.02) (0.01)

0.23 0.21 0.21 0.16 0.20

(0.01) (0.01) (0.01) (0.01) (0.01)

0.13 0.09 0.07 0.04 0.20 0.23

(0.01) (0.01) (0.06) (0.24) (0.01) (0.01)

a

Total accruals are net income before extraordinary items minus cash flows from operations. Total accruals are deflated 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 firms match on the standard deviation of past total accruals. d Earnings and earningst1 are net income before extraordinary items deflated by lagged total assets for the current and lagged year, respectively. e CFO is cash flows from operations deflated by lagged total assets. f Debt is long-term debt deflated 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 firm has two past years of negative income before extraordinary items and zero otherwise. Abs is the absolute value

the 0.01 level with the standard deviation of past total accruals, the absolute value of current earnings, and the absolute value of last period’s earnings, and at the 0.01 or 0.04 level for the level of current earnings. Each earnings variable controls for the firm’s inherent accruals or earnings process and is consistent with Kothari et al. (2001) assertion that this period’s AAC is associated with the firm’s earnings process. In particular, each variable allows for this period’s earnings to take into reversals of prior year accruals or growth trends in earnings.10

10

The positive correlation between the standard deviation of past total accruals and the absolute value of current abnormal accruals signifies that firms 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 s Hermalin and Weisbach’s (1998) prediction that firms 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 Kasznik’s (1999) findings that this period’s AAC is related 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).

386

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Initially, I match by the standard deviation of total accruals. The adjusted abnormal accrual for sample firm-year ij;t is AAACij;t;p ¼ AbsðAACij;t;p Þ Median AbsðAACÞt;p ;

ð3Þ

where AbsðAACij;t;p Þ is the absolute value of the abnormal accrual for firm-year ij;t; Median AbsðAACÞt;p is the median absolute value of the abnormal accruals for a portfolio of Compustat firms, and p is the percentile ranking of the Compustat firms’ 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 firms with non-missing data and assign them to percentiles based on their ordered rank. Each Compustat percentile for 1991 contains approximately 87 firms; for 1992 each percentile has approximately 90 firms. Similarly, I compute each sample firm’s standard deviation of total accruals for the 10 years prior to 1991 or prior to 1992. Each sample firm is matched by the percentile, p; and the AAAC is computed using Eq. (3). As Table 4, A shows, AAAC is insignificantly correlated with the standard deviation of past total accruals (r ¼ 0:01; p-value=0.73), the absolute value of current earnings (r ¼ 0:03; p-value=0.40), the absolute value of past earnings (r ¼ 0:00; p-value=0.93), and current earnings (r ¼ 0:00; p ¼ 0:99). Thus, much of the measurement error due to these factors is removed. Note too from 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. 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 Hermalin and Weisbach (1991) show, the relation between economic outcomes (i.e., Tobin’s Q for Hermalin and Weisbach) and board independence may not be linear. A second path is to follow the NASDAQ and NYSE’s guidelines and consider an audit committee independent only if all are outside directors. Since no boards are comprised solely of outside directors, this definition is not feasible for the entire board. Under this definition, audit committees can function independently if and only if all are free from managerial influence.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

387

A third definition of board or audit committee independence is for a majority of to be independent of management. Dechow et al. (1996), for example, define a board as being inside-dominated if at least 50% of board are firm officers. The rationale behind this metric is that majority rule dominates board and committee actions. The differences among definitions, particularly between the 100% and 51% rules, can influence how firms structure their boards. The exchange rules suggest that effective monitoring requires boards to maintain audit committees with independent directors only. To achieve this, firms need to recruit independent directors and may have to increase board size (Klein, 2002). Yet, Yermack (1996) argues and shows that firms with smaller boards (i.e., under 10 directors) are better performers. Fama and Jensen (1983) and Klein (1998) articulate that firms benefit greatly by having insiders on the board since top managers bring in expertise about the organization to the board’s 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) definition may be a desirable alternative to many firms. 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’’ coefficients by maximum likelihood using a Newton–Raphson 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 coefficients for the univariate models.11 As predicted, I obtain significantly negative coefficients for both board definitions and for the 51% audit committee independence definition. In contrast, the coefficients on the 100% audit committee independence definition, 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 insignificantly different from zero. The most statistically significant coefficients are for the 51% board and audit committee cutoff levels. To check the sensitivity of the findings, I re-estimate models using cutoffs of 40% and 60%. Only the coefficient on the 60% cutoff of outside directors is significant at the 0.10 level or better. Taken as a whole, these results suggest that a majority outside hip 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.

388

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Table 5 Univariate models of absolute values of adjusted abnormal accruals (AAACs)a on corporate governance explanatory variables Explanatory Bd51%b variable

%Outc

Aud100%d

Aud51%e

%Audoutf

5%Block. on aud. comm.g

%CEO sharesh

Intercept

0.14 (48.85)n

0.01 (0.09)

0.08 (36.70)n

0.17 (36.93)n

0.15 (13.50)n

0.09 (71.13)n

0.08 (50.73)n

Coefficient (w2 -Values)

0.07 (9.36)n

0.14 (6.72)n

0.01 (0.36)

0.09 (10.05)n

0.06 (2.21)

0.11 (2.27)

0.31 (1.27)

Sample is for 692 US firms-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. n Significant at the 0.01 level. a AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms 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 Newton–Raphson algorithm. b Bd51% takes on the value of one if the firm’s board has at least a majority of outside directors, and zero otherwise. c %Out is the percentage of outsiders on the firm’s board. d Aud100% takes on the value of one if the firm’s audit committee has outside directors only, and zero otherwise. e Aud51% takes on the value of one if the firm’s audit committee has at least a majority of outside directors, and zero otherwise. f %Audout is the percentage of outsiders on the firm’s audit committee. g 5%Block. on aud. comm. is an indicator if an outside 5% blockholder sits on the board’s audit committee. h %CEO shares is the percentage of common equity owned by the CEO.

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 year’s income before extraordinary items divided by total assets, and financial leverage (total debt divided by total assets) are positively associated with earnings management, and political costs (log of beginning year’s assets) are negatively related to earnings management (see Warfield 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, A shows, AAAC is significantly correlated at the 0.01 level with the absolute value of the change in earnings and with the log of firm assets. Klein (2002) reports that audit committee and board independence are significantly related to market-to-book ratios, past negative earnings (two or more previous consecutive years), and firm size (log of beginning year’s assets). From Table 4, B, we see that %Audout is significantly correlated with these three variables; %Outsiders on the board is significantly correlated with firm assets and

A. Klein / Journal of ing and Economics 33 (2002) 375–400

389

the market-to-book ratio, but not to negative income. %Outsiders is also significantly 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 coefficients on the percentages of outsiders on the board or audit committee are significantly 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 coefficients for the former variable are significantly negative for three models only and the coefficients for the latter variable are significantly 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 w2 -Values) Predicted sign Intercept

Model 1

Model 2

Model 3

Model 4

Model 5

0.12 (2.89)n

0.03 (0.17)

0.08 (1.07)

0.16 (4.70)nn

0.14 (3.57)nn

Bd51%b

—

%Outc

—

Aud100%d

—

Aud51%e

—

%Audoutf

—

5%Blockholder on audit comm.g

—

0.09 (1.44)

0.14 (3.68)n

0.12 (2.84)n

0.11 (2.56)n

0.11 (2.31)

%CEO sharesh

?

0.21 (0.58)

0.48 (2.84)n

0.38 (1.87)

0.47 (3.04)n

0.39 (1.97)

MV/BVi

?

0.01 (4.08)nn

0.01 (7.61)nnn

0.01 (6.52)nnn

0.01 (7.47)nnn

0.01 (5.96)nn

Abs(DNI)j

+

0.65 (6.07)nnn

0.54 (4.20)nn

0.59 (5.01)nn

0.71 (7.29)nnn

0.66 (6.18)nnn

Neg. NIk

?

0.09 (2.06)

0.09 (2.37)

0.09 (2.40)

0.09 (2.38)

0.10 (2.47)

0.08 (12.59)nnn 0.10 (3.13) 0.003n (0.03) 0.12 (18.89)nnn 0.10 (6.11)nnn

A. Klein / Journal of ing and Economics 33 (2002) 375–400

390

Table 6 (continued) Predicted sign

Model 1

Model 2

Model 3

Model 4

Model 5

Debt

+

0.22 (9.21)nnn

0.15 (4.31)nn

0.18 (6.25)nnn

0.19 (7.43)nnn

0.19 (6.67)nnn

Log(Assets)m

—

0.01 (1.09)

0.01 (1.74)

0.01 (1.40)

0.01 (0.96)

0.01 (1.11)

l

Sample is for 692 US firms-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. n Significant at the 0.10. nn Significant at the 0.05. nnn Significant at the 0.01. a AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms 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 Newton–Raphson algorithm. b Bd51% takes on the value of one if the firm’s board has at least a majority of outside directors, and zero otherwise. c %Out is the percentage of outsiders on the firm’s board. d Aud100% takes on the value of one if the firm’s audit committee has outside directors only, and zero otherwise. e Aud51% takes on the value of one if the firm’s audit committee has at least a majority of outside directors, and zero otherwise. f %Audout is the percentage of outsiders on the firm’s audit committee. g 5%Block. on audit comm. is an indicator if an outside 5% blockholder sits on the board’s 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 firm over book value of assets, measured at the beginning of the fiscal 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 firm had two or more consecutive years of negative income, ending on the fiscal year prior to the shareholders’ meeting. l Debt is long-term debt divided by last year’s assets. m Log(Assets) is the natural log of the book value of assets.

specifications only. Finally, the control factors, with the exceptions of negative income and the log of assets, are significantly different from zero. 6.4. Summary In summary, the results indicate that after holding other factors constant, firms 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.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

391

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 firms having the required data for both 1992 and 1993. DAAAC is defined 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 betweensample tests, I determine whether the change in the level of abnormal accruals is statistically different for firms experiencing changes in their board (audit committee) structures as compared to firms 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 significant relation between changes in board independence and changes in audit committee independence. For the sample, the Spearman correlation coefficient between the two variables is 0.45, significant at the 0.01 level. Sixty-six firms had an increase in audit committee independence between 1992 and 1993. For these firms, 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 firms had a decrease in audit committee independence between 1992 and 1993. For these firms, 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. A of Table 7 presents the between-sample tests. First, I examine changes in AAACs around changes in board independence. The 116 firms 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 firms. The 24 firms whose boards moved from a majority of outsiders to less than a majority of outsiders 12

Weisbach (1988) finds that poorly performing firms are more likely to change their boards towards more independence. Since audit committee independence is related also to board independence (Klein, 2002); Weisbach’s (1988) findings 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.

392

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 committee Mean DAAAC

t-Statistic for difference between means

N

z-Statistic for difference between medians

Chg

NoChg

#> median

#> median

z-stat

Mean DAAAC

N

Board composition Increase in %Out.b Decrease in %Out. To >51% Out. To o51% Out.

0.002 0.051 0.025 0.161

133 116 19 24

0.021 0.006 0.016 0.002

206 223 320 315

0.82 1.89nn 1.86n 1.79n

109 67 9 18

60 102 160 151

1.44n 2.06nn 0.22 2.55nnn

Audit committee composition Increase in Audoutc Decrease in Audout To 100% Audout To o100% Audout To >51% Audout To o51% Audout

0.015 0.035 0.000 0.049 0.083 0.131

66 78 23 28 6 10

0.020 0.007 0.014 0.010 0.015 0.001

273 261 316 311 333 329

1.60n 0.79 0.57 1.91nn 1.10 1.74n

30 41 9 18 4 2

139 128 160 151 165 167

0.68 0.55 1.06 1.59n 0.83 1.92nn

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Table 7 Changes in adjusted abnormal accruals (DAAAC) following changes in board and audit committee composition for all firms in sample with two years of data (N ¼ 339)

B: Regression of DAAAC on changes in board or audit committee composition Variable

Predicted sign

0.01 (1.21)

D%Out

—

D%Audout

—

Adjusted R2 F -value n

Coefficient (t-statistic) 0.01 (0.99)

0.13 (0.97) 0.16 (2.15)b 0.00 0.95

0.01 4.61nn

Significant at the 0.01 level. Significant at the 0.05 level. nnn Significant at the 0.10 level. a AAAC is the absolute value of adjusted abnormal accruals measured as abs(AAC) minus the median abs(AAC) for a portfolio of firms 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 nn

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Intercept

Coefficient (t-statistic)

393

A. Klein / Journal of ing and Economics 33 (2002) 375–400

394

had a 0.161 average increase in abnormal adjusted accruals, against a 0.002 increase for other firms. Both partitions produce statistically significant 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 firms. The 10 firms 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 firms. Again, both classifications yield statistically different means and medians. In B, I regress the change in AAAC on changes in board or audit committee independence. The coefficients on each variable are negative as expected. However, only the change in audit committee independence yields a statistically significant tstatistic. 7.1. Summary In summary, the results indicate that firms 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 firm characteristics included in the model. Adjusting the Jones model for extreme accruals inherent in each firm’s 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. Modified cross-sectional Jones model Dechow et al. (1995) propose a ‘‘modified’’ Jones model in which AACjk;t ¼ ACCRjk;t =TAjk;t1 faj;t ½1=TAjk;t1 þ bj;t ½DREVjk;t DRECjk;t =TAjk;t1 þ gj;t ½PPEj;t =TAj;t1 g:

ð4Þ

The modification is that in the expected accruals model, revenue changes are adjusted for DRECjk;t ; the change in receivables for year t: Dechow et al. (1995) calculate aj;t ; bj;t ; and gj;t from their original model (Eq. (1) of this paper) and use

A. Klein / Journal of ing and Economics 33 (2002) 375–400

395

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 aj;t ; bj;t ; and gj;t by modifying Eq. (1) to include the adjustment for receivables. I use both specifications. Using Eq. (4) as my measure of abnormal accruals, I follow the same methodology described in Section 5 and calculate an AAAC for each firm-year. The univariate and multivariate results with specification are almost identical to those presented in Tables 5–7. Kothari et al. (2001) also find statistically insignificant differences between using the Jones and modified-Jones cross-sectional models. 8.2. Adjustment for current or past abnormal earnings Kasznik (1999) finds that measurement error for the signed abnormal accrual of the cross-sectional Jones model is positively related to net earnings. Kothari et al. (2001) find the same result for last year’s net earnings. As Table 4, C shows, the correlation between this year’s and last year’s abnormal earnings is 0.73 and the correlation between this year’s 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 firm’s earnings process. To control for the possibility that my results reflect 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 firms. The matchings are based on (1) the absolute value of this year’s earnings, (2) the absolute value of last year’s earnings, and (3) this year’s signed earnings. Using the unsigned (absolute) values preserves the research design. However, it assumes that the degree of earnings manipulation is unaffected by firm performance (net earnings), an assumption that Kasznik (1999) and Kothari et al. (2001) show to be untrue for firms that a priori have incentives to manage earnings. Thus, I match firms 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 w2 -values for the univariate and multivariate procedures. A has the results on matching by the absolute value of current earnings. B contains the results on matching by the absolute value of last year’s earnings. 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 w2 -values over the five regressions. As Table 8 illustrates, the parameter estimates and statistical significant levels are qualitatively the same whether I match by the past standard deviation of total accruals or the level of earnings. For example, in A, the coefficients on Aud51% are 0.096 (p ¼ 0:01) and –0.120 (p ¼ 0:01) for the unsigned current

396

A. Klein / Journal of ing and Economics 33 (2002) 375–400

earnings-matched univariate and multivariate models vis-a" -vis 0.09 and 0.12 (p ¼ |:01;0.01) for the standard deviation-matched models in Tables 5 and 6. In B, the coefficients on Aud51% are 0.095 and 0.127, respectively. In C, the coefficients 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 year’s 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 year’s earnings or the absolute value of last year’s 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 fixed coefficient 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 procedurea

Multivariate procedureb

A: Matching by absolute value of current earnings Board51% 0.068 (9.71)n %Out 0.121 (5.36)nn Aud100% 0.000 (0.02) Aud51% 0.096 (11.41)n %Audout 0.080 (3.77)nn c 5%Blockholder on audit comm. 0.136 (3.43)nn %CEO sharesc 0.288 (1.14)

0.084 (14.06)n 0.084 (2.08) 0.006 (0.51) 0.120 (19.27)n 0.110 (7.85)n (0.093, 0.144)d (1.71, 3.24)e (0.222, 0.501)d (0.66, 3.23)e

B: Matching by absolute value of last year’s earnings Board51% 0.067 (9.28)n %Out 0.123(5.61)nn Aud100% 0.002 (0.01) Aud51% 0.095 (11.17)n %Audout 0.078 (3.61)nn 5%Blockholder on audit comm.c 0.124 (2.76)nn %CEO sharesc 0.392 (2.07)

0.076 (11.54)n 0.094 (2.78)nnn 0.008 (0.16) 0.127 (22.21)n 0.118 (9.21)n (0.102, 0.150)d (2.04, 4.34)e (0.280, 0.557)d (1.07, 3.67)e

A. Klein / Journal of ing and Economics 33 (2002) 375–400

397

Table 8 (continued) Variable

Univariate procedurea

C: Matching by this year’s earnings Board51% %Out Aud100% Aud51% %Audout 5%Blockholder on audit comm.c %CEO sharesc

0.073 0.100 0.004 0.101 0.088 0.121 0.411

(11.43)n (3.68)nn (0.03) (12.79)n (4.76)nn (2.76)nnn (2.34)

Multivariate procedureb 0.080 (13.02)n 0.088 (2.30) 0.005 (0.07) 0.124 (20.93)n 0.112 (8.34)n (0.095, 0.144)d (1.82, 4.04)e (0.267, 0.534)d (0.97, 3.83)e

n

Significant at the 0.01 level. Significant at the 0.05 level. nnn Significant at the 0.10 level. 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 five 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 five multivariate procedures. In A: for 5%Blockholder on audit committee, three chi-Square values are significant at the 0.10 level, one is significant at the 0.05 level and one is not significant at the 0.10 level. For %CEO shares, two chi-square values are significant at the 0.10 level and three are not significant at the 0.10 level. In B: For 5%Blockholder on audit committee, three chi-Square values are significant at the 0.10 level, one is significant at the 0.05 level and one is not significant at the 0.10 level. For %CEO shares, one chi-square values is significant at the 0.10 level, one is significant at the 0.05 level and three are not significant at the 0.10 level. In C: For 5%Blockholder on audit committee, two chi-square values are significant at the 0.10 level, two are significant at the 0.05 level and one is not significant at the 0.10 level. For %CEO shares, one chi-square values is significant at the 0.10 level, two are significant at the 0.05 level and two are not significant at the 0.10 level. nn

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 specifications exhibit many similarities to those reported in Tables 5 and 6. Specifically, the coefficients and significance levels on the audit and board independence variables remain qualitatively the same. One difference is that the coefficient on whether a large blockholder sits on the audit committee is significantly negative (p-values between 0.01 and 0.02) for the regression approach. A second difference is that the coefficient on firm assets is

398

A. Klein / Journal of ing and Economics 33 (2002) 375–400

significantly 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 board’s nominating or executive compensation committee. Thus, I test if earnings management 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 coefficient on CEO on nominating committee is insignificantly different from zero, suggesting no relation between this variable and earnings management. In contrast, the coefficient on CEO on compensation committee is significantly different from zero at conventional levels, suggesting a positive relation between earnings management and whether the CEO sits on this committee. This finding is consistent with Aboody and Kasznik’s (2000) and Yermack’s (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 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 committee has less than a majority of independent directors. Contravene to the new regulations, no significant cross-sectional association is found between earnings management and the more stringent requirement of 100% audit committee independence. In addition, I find that firms 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 one’s view of how accurately the AAAC measures earnings management. A generous interpretation is that, consistent with the SEC’s and the exchanges’ concerns, a negative relation exists between audit committee or board independence and earnings management for all large traded U.S. firms. This interpretation suggests that the exchange rules are reasonable, although maintaining a wholly independent audit committee may not be necessary.

A. Klein / Journal of ing and Economics 33 (2002) 375–400

399

A less liberal interpretation is that firms 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 finding better measures of abnormal accruals.

References Aboody, D., Kasznik, R., 2000. CEO stock option awards and the timing of corporate voluntary disclosures. Journal of ing and Economics 29, 73–100. Antle, R., Nalebuff, B., 1991. Conservatism and auditor–client negotiations. Journal of ing Research 29, 31–54. Bartov, E., Gul, F.A., Tsui, J.S.L., 2000. Discretionary-accruals models and audit qualifications. Journal of ing and Economics 30, 421–452. Beasley, M.S., 1996. An empirical analysis of the relation between the board of director composition and financial statement fraud. The ing Review 71, 443–465. Becker, C.L., DeFond, M.L., Jiambalvo, J., Subramanyam, K.R., 1998. The effect of audit quality on earnings management. Contemporary ing Research 15, 1–24. Berle, A.A., Means, G.C., 1932. The Modern Corporation and Private Property. MacMillan, New York. Bernard, V.L., Skinner, D.J., 1996. What motivates managers’ choice of discretionary accruals? Journal of ing and Economics 22, 313–326. Brickley, J.A., Coles, J.L., Terry, R.L., 1994. Outside directors and the adoption of poison pills. Journal of Financial Economics 35, 371–390. Byrd, J.W., Hickman, K.A., 1992. Do outside directors monitor managers? Evidence from tender offer bids. Journal of Financial Economics 32, 195–222. Dechow, P.M., Sloan, R.G., Sweeney, A.P., 1995. Detecting earnings management. The ing Review 70, 193–226. Dechow, P.M., Sloan, R.G., Sweeney, A.P., 1996. Causes and consequences of earnings manipulation: an analysis of firms subject to enforcement actions by the SEC. Contemporary ing Research 13, 1–36. Dechow, P.M., Skinner, D.J., 2000. Earnings management: reconciling the views of ing academics, practitioners, and regulators. ing Horizons 14, 235–250. DeFond, M.L., Jiambalvo, J., 1994. Debt covenant violation and manipulation of accruals. Journal of ing and Economics 17, 145–176. DeFond, M.L., Subramanyam, K.R., 1998. Auditor changes and discretionary accruals. Journal of ing and Economics 25, 36–67. DuCharme, L.L., Malatesta, P.H., Sefcik, S.E., 2000. Earnings management: IPO valuation and subsequent performance. Journal of ing Auditing and Finance 16, 369–396. Dye, R.A., 1991. Informationally motivated auditor replacement. Journal of ing and Economics 14, 347–374. Fama, E.F., Jensen, M.C., 1983. Separation of ownership and control. Journal of Law and Economics 26, 301–325. Guay, W.R., Kothari, S.P., Watts, R.L., 1996. A market-based evaluation of discretionary accrual models. Journal of ing Research 34, 83–105. Guidry, F., Leone, A.J., Rock, S., 1999. Earnings-based bonus plans and earnings management by business-unit managers. Journal of ing and Economics 26, 85–108. Healy, P., 1985. The effect of bonus schemes on ing decisions. Journal of ing and Economics 7, 261–279. Healy, P.M., Wahlen, J.M., 1999. A review of the earnings management literature and its implications for standard setting. ing Horizons 13, 365–383.

400

A. Klein / Journal of ing and Economics 33 (2002) 375–400

Hermalin, B.E., Weisbach, M.S., 1991. The effects of board composition and direct incentives on firm performance. Financial Management 20, 101–112. Hermaln, B.E., Weisbach, M.S., 1998. Endogenously chosen boards of directors and their monitoring of the CEO. American Economic Review 88, 96–118. Jensen, M.C., Meckling, W., 1976. Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3, 305–360. Jones, J., 1991. Earnings management during import relief investigations. Journal of ing Research 29, 193–228. Kasznik, R., 1999. On the association between voluntary disclosure and earnings management. Journal of ing Research 37, 57–81. Klein, A., 1998. Firm performance and board committee structure. The Journal of Law and Economics 41, 275–303. Klein, A., 2000. CEO power, board independence and CEO compensation: an empirical investigation. Working Paper, New York University. Klein, A., 2002. Economic determinants behind variations in audit committee independence. Working Paper, The ing Review 77, 435–452. Kothari, S.P., Leone, A.J., Wasley, C.E., 2001. Performance matched discretionary accruals. Working Paper, Sloan School of Management, Massachusetts Institute of Technology. Magee, R.P., Tseng, M.-C., 1990. Audit pricing and independence. The ing Review 65, 315–336. McConnell, J.J., Servaes, H., 1990. Additional evidence on equity ownership and corporate value. Journal of Financial Economics 27, 595–612. Morck, R., Shleifer, A., Vishny, R.W., 1988. Management ownership and market valuation. Journal of Financial Economics 20, 293–315. Nagar, V., Nanda, D., Wysocki, P.D., 2000. Compensation policy and discretionary disclosure. Working Paper, Business School, University of Michigan. Nelson, M.W., Elliott, J.A., Tarpley, R.L., 2000. Where do companies attempt earnings management, and when do auditors prevent it? Working paper, Cornell University and George Washington University. Parker, S., 2000. The association between audit committee characteristics and the conservatism of financial reporting. Working Paper, Santa Clara University. Peasnell, K.V., Pope, P.F., Young, S., 1998. Outside directors, board effectiveness, and earnings management. Working Paper, Lancaster University. Shivdasani, A., Yermack, D., 1999. CEO involvement in the selection of new board : an empirical analysis. Journal of Finance 54, 1829–1853. Subramanyam, K.R., 1996. The pricing of discretionary accruals. Journal of ing and Economics 22, 249–282. Teoh, S.H., Welch, I., Wong, T.J., 1998a. Earnings management and the underperformance of seasoned equity offerings. Journal of Financial Economics 50, 63–99. Teoh, S.H., Welch, I., Wong, T.J., 1998b. Earnings management and the underperformance of initial public offerings. Journal of Finance 53, 1935–1974. Warfield, T.D., Wild, J.J., Wild, K.L., 1995. Managerial ownership, ing choices, and informativeness of earnings. Journal of ing and Economics 20, 61–92. Weisbach, M., 1988. Outside directors and CEO turnover. Journal of Fniancial Economics 20, 431–460. Yermack, D., 1996. Higher market valuation of companies with a small board of directors. Journal of Financial Economics 40, 185–212. Yermack, D., 1997. Good timing: CEO stock option awards and company new announcements. Journal of Finance 52, 449–476.