This preview shows page 1. Sign up to view the full content.
Unformatted text preview: probability of SEC enforcement
action (Wright 1996). Hence, we expect that audit committees comprised only of independent
directors will be negatively associated with the level of earnings management.
Independent non-executive directors may also have views that are biased toward
management. Indeed, if they are managers of another company, these directors may be less
inclined to criticize the firm’s management (Mace 1986; Lorsch and Maclver 1989; Westphal
and Zajac 1997). DeZoort and Salterio’s (2001) results support this assertion for the audit
committee. In an experiment they find that audit committee members who are also managers
are more likely to support management in disputes opposing corporate management to the
auditor. Similarly, we expect that the percentage of members who are independent non6 executive directors and are not managers in other firms will be negatively associated with the
level of earnings management.
In addition to affiliation with the company and sharing beliefs with management, stock
option schemes may compromise independence. While executive stock options align
manager’s interest with those of the shareholders, they may also have some perverse effects.
For example, Callaghan, Saly and Subramaniam (2000) show that firms that reprice executive
stock options time the repricing event so that it occurs before a quarterly earnings
announcement if the news is good and after the announcement if the news is bad. Even if no
research has examined the effect of stock options in the specific case of non-executive
directors, some independent bodies suggest that they should not be used. Indeed, the Cadbury
Committee (1992, 4.13) “regards it as good practice for non-executive directors not to
participate in share option schemes” in order to safeguard their independent position. The
Committee on Corporate Governance (1998, 4.8) agrees with this good practice. We believe
that such a practice is even more important for audit committee members because it is their
duty to monitor the quality of the financial reports. This problem is greater for options that
can be exercised in the short run as earnings management may have an effect on share value
at the time the options can be exercised. We then expect that the relative level of
compensation based on stock options will be positively associated with the level of earnings
Competence of audit committee members
Because of their responsibility for overseeing internal control and financial reporting, good
governance dictates that audit committee members should possess a certain level of financial
competencies. Thus, the BRC (1999, p. 25) recommends that each member of the audit
committee should be or become financially literate and that at least one member should have 7 accounting or related financial management expertise, where “expertise” is defined as “past
employment experience in finance or accounting, requisite professional certification in
accounting, or any other comparable experience or background which results in the
individual’s financial sophistication, including being or having been a CEO or other senior
officer with financial oversight responsibilities.” This recommendation is supported by
various empirical and experimental studies such as McMullen and Randghun (1996) who find
that firms subject to SEC enforcement actions or restating their quarterly reports are less
likely to have CPAs on their audit committee. Using an experimental case, DeZoort and
Salterio (2001) find that the accounting experience of audit committee members as well as
their knowledge of auditing are positively associated with the likelihood that they will
support the auditor in an auditor-corporate management dispute. These recommended best
practices and research findings suggest that the financial competence of audit committee
members decreases the likelihood of earnings management.
Audit Committee Activity
Independence and competence will not result in effectiveness unless the committee is active.
Two important aspects of the committee’s level of activity are the duties it has to perform and
the frequency of its meetings.
Various professional publications and professional reports list the various activities that
an effective committee must perform (e.g. BRC 1999; NCFFR 1987; Coopers and Lybrand
1995). These responsibilities can be classified into three categories (Verschoor 1993;
Wolnizer 1995): oversight of the financial statements, oversight of the external audit,
oversight of the internal control system (including internal auditing). Furthermore, the BRC
(1999) recommends that the responsibilities should be memorialized in a formal charter
approved by the board of directors. A formal charter not only provides guidance to members 8 as to their duties but it is a source of power for the audit committee. In support of these
recommendations, Kalbers and Fogarty (1993) find that a formal written charter plays an
important role in the power of the audit committee and th...
View Full Document
This document was uploaded on 11/27/2013.
- Fall '13