Controlling for specific motivations that firms may

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Unformatted text preview: of the Jones (1991) model. Controlling for specific motivations that firms may have to manage earnings and for alternative control mechanisms, we find that earnings management is significantly related to some of the governance practices in the audit committee and the board of directors. Audit committees with a clear mandate for the oversight and monitoring of financial reporting, with a higher proportion of outside members who are not managers in other firms, or with at least one financial expert are significantly less likely to have high levels of earnings management. While we find no direct significant support for the BRC’s recommendation that audit committees be composed entirely of independent directors, our results seem to suggest that completely independent audit committees that hold more than two meetings in the year are more likely to have low levels of earnings management. Hence, it seems that the audit committee is more efficient if all of its members are independent and it meets regularly. We also find that the proportion of short-term stock options held by non-executive committee members increases the likelihood of positive earnings management. This is consistent with other findings that stock options, while encouraging the convergence of committee members’ interest towards those of the shareholders, provide an incentive to favor short term rather than long term performance. Consistent with Beasley (1996), we find that some overall board of directors characteristics also have an important effect on the quality of financial reporting. In particular, independent board members’ experience as directors both with the firm and with other firms decreases the likelihood of high earnings management. We conclude that our results support the assertion that good governance practices proposed by various independent bodies (Joint Committee on Corporate Governance 2001; SEC 2000; BRC 1999; Cadbury Committee 1992) do not only reduce the likelihood of 4 fraudulent reporting activities but also reduce the likelihood of earnings management, where earnings reports may reflect the desires of management rather than the underlying financial performance of the company. These results also suggest that the proposed best practices may be improved. For example, the independence of the audit committee could be strengthened by considering non-executive directors who are managers in other firms as non independent directors and, as proposed by Cadbury (1992), by excluding non-executive directors from share options schemes. The remainder of our paper is organized as follow. In the next two sections we provide the motivation for the predicted association of characteristics of the audit committee and board of directors with earnings management. In section four we discuss sample selection and research design. We present our results in section five and our conclusions in section six. 2. The role of the audit committee Audit committee independence Independence is considered an essential quality for an audit committee to fulfill its oversight role. This explains why stock exchanges have rules and regulations regarding audit committee independence. According to the Blue Ribbon Committee (1999, p. 22) “several recent studies have produced a correlation between audit committee independence and two desirable outcomes: a higher degree of active oversight and a lower incidence of financial statement fraud.” If we accept the assertion that independence is associated with a better oversight, we expect that audit committee independence will be associated with lower levels of earnings management. For the National Commission on Fraudulent Financial Reporting (1987) and the Public Oversight Board (1993) the audit committee must be entirely composed of non-executive 5 members to be effective. McMullen and Randghun (1996) show that firms subject to SEC enforcement actions or restating their quarterly reports are less likely to have an audit committee composed entirely of non-executive directors. A major shortcoming of this criterion is that non-executives may not be effectively independent from management. The board of directors may choose non-executive audit committee members who have an affiliation or business ties with client firms and are less likely to be effective monitors. According to Vicknair, Hickman and Carnes (1993) these “gray” directors are invading the audit committees with 74% of NYSE companies studied having at least one “gray” member on their committee. The BRC (1999) recommends that the audit committee should be comprised only of directors who have no relationship to the corporation that may interfere with their independence. Several papers support the negative link between the presence of these members and the committee’s monitoring effectiveness. The proportion of independent external directors on the audit committee is positively associated with the probability of the auditor issuing a going-concern report for a firm experiencing financial distress (Carcello and Neal 2000), negatively associated with the probability of litigation against the external auditor (Park 1999), and negatively associated with the...
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