Hence we expect that audit committees comprised only

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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 management. 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...
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This document was uploaded on 11/27/2013.

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