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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.
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.
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.
- Fall '13