Unformatted text preview: ve
members are less likely to be subject to accounting enforcement actions by the SEC for
alleged GAAP violations. We test if this result holds for earnings management and we expect
a negative association between the proportion of independent directors on the board and the
level of earnings management.
Both corporate governance reports (Cadbury Committee 1992; Committee on Corporate
Governance 1998; TSE 1994) and researchers (Fama and Jensen 1983; Jensen 1993)
recommend that the roles of chair and CEO not be assigned to the same person so as to avoid
a considerable concentration of power in the hands of the CEO (Cadbury Committee 1992, p.
21). This power to control the board of directors comes from the fact that the chair is
11 responsible for setting the agenda and running board meetings, and from the importance of
the board’s role in appointing and monitoring management. Dechow et al. (1996) provide
evidence that firms whose CEO chairs the board of directors are more likely to be subject to
accounting enforcement actions by the SEC for alleged violations of GAAP, while Park
(1999) shows a positive link with the existence of litigation against the auditors. These
findings suggest that earnings management is positively related to the combination of CEO
and chairman role.
The presence of an independent nomination committee is important for board
effectiveness and monitoring ability because it takes away the CEO’s power in nominating
new members to the board. In its absence managers establish their employment contracts with
one hand and sign them with the other hand (Williamson 1985). Regulators recognize the
significance of an independent nomination committee: the Cadbury Committee (1992, p. 27)
recommends the establishment of such a committee composed in majority of non-executive
directors and the Committee on Corporate Governance (1998) recommends this as best
practice. Hence, we expect that the existence of an independent nomination committee will
be negatively related to the level of earnings management.
Financial motivation of independent directors
It is generally believed that a director with a sizeable ownership in the firm is more likely to
question and challenge management’s proposals (Mace 1986; Patton and Baker 1987)
because his or her decisions impact his or her own wealth (Minow and Bingham 1995).
Presumably, such a director is less likely to support actions that would reduce shareholders’
wealth. Several studies show a positive link between effective monitoring and stock
ownership by outside directors. Gerety and Lehn (1997) report that accounting fraud is a
decreasing function of the board members’ stock ownership, while Beasley (1996) provides 12 evidence that financial reporting fraud is negatively related to non-executive directors’
ownership stake in the firm. Shivdasani (1993) shows that, in hostile takeover target firms,
outside directors have significantly lower ownership stakes than in other firms, which is
consistent with the view that equity ownership in the firm provides outside directors with
greater incentives to monitor management’s decisions. These findings support Jensen’s
(1993) assertion that encouraging outside directors to hold a substantial ownership position in
the firm provides them with better incentives to monitor management closely and suggest that
earnings management are negatively related to outside directors’ ownership.
Competence of board members
Cadbury (1992, p. 22) states that the competence of non-executive board members is of
special importance for the effectiveness of the board and the results of many studies support
this statement (87990; Beasley 1996; Gerety and Lehn 1997). We hypothesize a similar
relationship between competence and the quality of financial reporting.
Among the necessary competencies, knowledge of the company affairs and knowledge
of the governance process are particularly essential for the board is monitoring role. A nonexecutive director may acquire these competencies through internal or external training and
experience. Thus, both the Cadbury Committee (1992) and the TSE (1994) reports
recommend that companies provide formal orientation programs for their new directors and
support the development of external courses on issues of corporate governance. While
training is important, expertise research (Bédard and Chi 1993) shows that experience is
essential in the development of superior competency.
Non-executive directors’ experience on the company’s board allows them to develop
some monitoring competencies while providing them with better knowledge of the company
and its executive directors. Thus, they become more capable of overseeing the firm’s
13 financial reporting process effectively. This assertion is supported by Kosnik (1987) who
finds that the longer the average tenure of non-executive directors, the more likely the
company is to resist hostile takeover bids and by Beasley (1996) who finds that the likelihood
of financial reporting fraud is a decreasing function of the average tenure of non-e...
View Full Document
This document was uploaded on 11/27/2013.
- Fall '13