Of the three categories of responsibilities oversight

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Unformatted text preview: at its perceived effectiveness is significantly related to this concept of power. Of the three categories of responsibilities, oversight of financial statements and oversight of external auditing are the most relevant for earnings management. The former includes the review of financial statements, accounting policies and key management estimates (Wolnizer 1995), while the latter is expected to strengthen the independence of the auditor and improve the effectiveness of the audit. Hence, we expect that the presence of a formal written charter where these two oversight responsibilities are clearly established will be negatively associated with the level of earnings management. Our second measure of committee activity is the number of meetings. Indeed, an audit committee eager to carry out its functions of control must maintain a constant level of activity (NCFFR 1987). Best practices suggest three or four meetings a year (Cadbury Committee 1992; Price Waterhouse 1993; KPMG 1999). McMullen and Randghun (1996) show that the audit committees of firms subject to SEC enforcement actions or restating their quarterly reports are less likely to have frequent meetings than those of other firms. The committees of only 23% of their problem companies met more than twice a year compared to 40% for the other firms. Abbott et al. (2000) found a similar result with a more recent sample. Similarly, we expect that the frequency of meetings will be negatively associated with the level of earnings management. 3. The Role of the Board of Directors The audit committee is a committee of the board of directors. Its responsibility to oversee the financial reporting process of the firm is delegated to the committee by the board. While an 9 effective audit committee is crucial to providing reliable financial reports, the board of directors also plays an important role. Thus, the BRC (1999, p. 6) states that the “performance of audit committees must be founded in the practices and attitudes of the entire board of directors”. The Public Oversight Board (1995, p. 3) “urges the board of directors to play an active role in the financial reporting process.” Theories regarding boards of directors, prior empirical research and various recommendations suggest that some characteristics of the board have an influence on the quality of the financial reports as measured by the level of earnings management. Four board characteristics are examined here: size, independence, directors’ motivation, and competence. Board size The number of directors is an important factor in the effectiveness of the board (TSE 1994). Unfortunately, the literature provides no consensus about the direction of the relationship between board size and effectiveness. On the one hand, a larger board is less likely to function effectively and is easier for the CEO to control (Jensen 1993). On the other hand, a larger board provides better environmental links and more expertise (Dalton, Daily, Johson and Ellstrand 1999). The evidence regarding financial statement reliability is mixed. Beasley (1996) finds a positive relationship between board size and the likelihood of financial statement fraud whereas Abbott et al. (2000) find no relationship between the two. Because of this lack of consensus, we examine the relationship between earnings management and size of the board but we do not predict the direction of the association. Board independence An important aspect of effective corporate governance is “the recognition that the specific interests of the executive management and the wider interest of the company may at times diverge” (Cadbury Committee 1992, p. 21) and that an independent board plays an important 10 role in these situations (Cadbury Committee 1992, TSE 1994). This focus on board independence is grounded in agency theory (Fama and Jensen 1983; Shleifer and Vishny 1997) that recognizes the oversight, or control, function of the board as the most critical of directors’ roles. We thus expect that the effectiveness of the board in limiting earnings management is contingent on the relative independence of its members. We consider three characteristics of board independence: the inclusion of independent directors on the board, the separation of the roles of chair and Chief Executive Officer and the presence of an independent nomination committee. Independent directors are generally considered better monitors than other directors because they have the “ability to act with a view of the best interests of the corporation.” (TSE 1994, p. 24). Further, non-executive directors have incentives to develop a reputation as experts in decision control and monitoring (Fama and Jensen 1983). Several studies demonstrate an association between the directors’ independence from management and the board’s monitoring effectiveness. Beasley (1996) finds a negative relationship between the percentage of non-executive members on the board and the likelihood of fraud while Dechow, Sloan, and Sweeney (1996) find that firms with a large percentage of non-executi...
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This document was uploaded on 11/27/2013.

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