Board of Directors' Governance Challenges and Earnings Management

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Board of directors governance challenges and earnings management

Ruth W. Epps
School of Business, Virginia Commonwealth University, Richmond, Virginia, USA, and
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Received 5 February 2008 Revised 10 May 2008, 21 June 2008 Accepted 25 August 2008
Tariq H. Ismail
Faculty of Commerce, Cairo University, Cairo, Egypt
Abstract
Purpose The purpose of this paper is to examine the relationship between corporate governance and earnings management in US context and provide further insights on the effects of board of directors characteristics on earnings management. Design/methodology/approach The paper uses a sample of three groups of US rms; where rms with relatively high negative, rms with relatively high positive, and those with low levels of discretionary accruals in the year 2004 are examined. Descriptive statistics, univariate analysis, multivariate analysis, board of directors characteristics, and possible relationships between corporate governance variables and earnings management proxy provide the basis for discussion. Findings Firms with annually elected boards, small size boards, 100 percent independent nominating committees, and 100 percent independent compensation committees have more negative discretionary accruals. However, rms with 75-90 percent independent board or rms with a board size of between nine and 12 have higher positive discretionary accruals. Research limitations/implications Certain board characteristics may be the important factors associated with constraining the propensity of managers to engage in earnings management. Practical implications Results are limited by the accuracy of the models applied to isolate discretionary accruals. Additionally, the direction diverse of discretionary accruals may differ with selecting a time series of three or more years as a base for the analysis. Originality/value In contrast to prior literature, where board composition is dened as an insiders- or outsiders-controlled board, this paper classies board composition into seven discrete categories, using the same seven categories employed by Institutional Shareholder Services in evaluating and assigning corporate governance quotient scores to rms. The papers major contributions to the existing literature are its ndings that income-increasing and income-decreasing discretionary accruals have a different relationship with corporate governance practices and its expansion of the scope of corporate governance from board independence and audit committee independence to other corporate governance characteristics. This paper provides evidence that supports US regulators initiatives that stronger corporate governance mechanisms provide greater monitoring of the nancial accounting process and may be the important factors in improving the integrity of nancial reporting. Keywords Boards of directors, Compensation, Corporate governance, Earnings, United States of America Paper type Research paper
Journal of Accounting & Organizational Change Vol. 5 No. 3, 2009 pp. 390-416 q Emerald Group Publishing Limited 1832-5912 DOI 10.1108/18325910910986981
I. Introduction The subject of corporate governance is of enormous economical importance. Corporate governance addresses the ways in which stakeholders of capital to corporations assure
themselves of getting a return on their investment. Corporate governance implies an explicit responsibility for boards in the nancial reporting process. In doing so, it raises the expectation that boards will constrain earnings management activity. Healy and Wahlen (1999, p. 6) dene earnings management as occurring:
[. . .] when managers use judgment in nancial reporting and in structuring transactions to alter nancial reports to either mislead some stakeholder about the underlying economic performance of the company, or to inuence contractual outcomes that depend on reported accounting numbers.
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One might wonder how management can manipulate earnings. Under US Generally Accepted Accounting Principles, rms use accrual accounting which focuses on the recording of the nancial effects on an entity of transactions and other events and circumstances that have cash consequences for the entity in the periods in which those transactions, events, and consequences occur rather than only in the period in which cash is received or paid by the entity. The nature of accrual accounting gives managers a signicant amount of discretion in determining the actual earnings a rm reports in any given period. Management has considerable control over the timing of actual expense items. They also can, to some extent, alter the timing of recognition of revenues and expenses (Teoh et al., 1998). When managers incentives are based on their companies nancial performance, it may be in their self-interest to give the appearance of better performance through earnings management. Additionally, earnings management may impact investors by giving them false information. Capital markets use nancial information to set security prices. Investors use nancial information to decide whether to buy, sell, or hold securities. Market efciency is based upon the information ow to capital markets. When the information is incorrect, it may not be possible for the markets to value securities correctly. Hence, earnings management may obscure real performance and lessen the ability of shareholders to make informed decisions. Teoh et al. (1998), Rangan (1998) and Dechow et al. (1996), also provide evidence that managers inate earnings prior to seasoned equity offerings. Their results are consistent with the notion that managers seek to manage pre-issue earnings in an attempt to improve investors expectations about future performance. General evidence on the link between earnings management and corporate governance is provided by Cheng and Wareld (2005). They addressed the question of whether the propensity for earnings management is lower when management interests and owners interests are more closely aligned through higher managerial stock ownership. Their results conrm that earnings management is lower for rms with higher managerial ownership. The current paper explores the analysis of Cheng and Wareld (2005) further by examining whether board governance is relevant in constraining earnings management. The central issue of corporate governance is how to ensure accountability of senior managers to their stakeholders while simultaneously providing executives with the autonomy and incentives to exploit wealth producing strategies. There is a great deal of disagreement on how good or bad the existing governance mechanisms may be. For instance, Jensen and Warner (1988) and Jensen (1993) provide evidence that the US corporate governance system is deeply awed and that a major move from the corporate form to a much more highly leverage organization is on the horizon. In contrast, Romano (2005) provides a very optimistic assessment of the US corporate governance system.
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During the last decade, policy makers, regulators, investors and other market participants have become increasingly aware of the need for corporations to have sound corporate governance policies and procedures. A major cause of the failure of corporations such as Enron, Tyco, and WorldCom was due in part to a weakness in their corporate governance systems as each allowed management to have an excessive concentration of power. In response to the corporate scandals, congress enacted the Sarbanes-Oxley (SOX) Act on July 30, 2002. The act specically targets corporate governance reform and has created a reporting system that now makes corporate governance more transparent to the public. In addition, the development of rating schemes for corporate governance has added to its transparency. While previous research suggests a relation between good governance practices and less fraudulent nancial reporting (Beasley, 1996), the studies examining earnings management and SOX corporate governance issues are sparse and no denitive relationship has been determined. Hence, the current study expands this literature through the utilization of a study group generated from the overlap between two comprehensive data sets. The rst data set consists of active Compustat companies with a December 31, 2004 scal year-end. The second data set consists of the 6,000 US rms whose corporate governance practices are rated by the Institutional Shareholder Services (ISS). The main objective of the paper is to provide further evidence on the effects of the structure of the board of directors on earnings management as measured by discretionary accruals. The paper extends prior research in this area by providing an extensive analysis of a broad range of board of directors characteristics. Board characteristics are examined by looking at seven categories: (1) board composition, consisting of seven variables; (2) board structure, consisting of two variables; (3) board size, consisting of ve variables; (4) chief executive ofcer (CEO) and director characteristics, consisting of four variables; (5) board disclosure polices, consisting of three variables; (6) the existence and composition of a nominating committee, consisting of six variables; and (7) the existence and composition of a compensation committee, consisting of six variables. The rest of the paper is organized as follows; Section II provides hypotheses development. Section III presents the research model and variables; data analysis and discussion are included in Section IV; and the conclusions of the study are presented in Section V. II. Hypotheses development The importance of corporate governance has been a question of substantial interest to regulators, nancial institutions, investors, and the media. Conicts of interests, between shareholders and managers, coupled with the impossibility of writing explicit contacts on all future contingencies, lead to unresolved agency problems that affect rm valuation (Hart, 1995). Corporate governance mechanisms are intended to mitigate
agency costs by increasing the monitoring of managements actions and limiting managers opportunistic behavior (Ashbaugh et al., 2004). A central issue to corporate governance is how to ensure accountability of senior mangers to their stakeholders while simultaneously providing executives with the autonomy and incentives they need to produce wealth producing strategies. Stockholders do not choose board members but simply ratify the choices given to them (Vafeas, 1999). Prior research in the area of the relationship of corporate governance internal and external mechanisms and earnings management or rm performance has many directions. For example, the effect of board composition has been tested in numerous studies (Barnhart et al., 1998); the relationship between the board size and market valuation (Yermack, 1996) has been investigated; the relationship between boards and executive compensation has been examined (Conyon and Peck, 1998; Mangel and Singh, 1993; Core et al., 1999); and the inuence of institutional investors on executive compensation has been investigated (Karpoff et al., 1996; Hartzell and Starks, 2003; Gillan et al., 2003). Additionally, CEO tenure has also been studied. Fizel and Louie (1990) found that CEO turnover is more related to internal governance structure than to rm performance. Berger et al. (1997) found that managerial entrenchment led to lower rm leverage, suggesting that entrenched management avoids long-term projects that could improve long-term stockholder value. Niu (2006) examined the association between corporate governance mechanisms and the quality of accounting earnings, where the quality of earnings is measured in two ways: the accounting-based measure of earnings management and the market-based measure of earnings informativeness. Using rm-level corporate governance data for a sample of Canadian rms in the years 2001-2004, regression analysis explores the relation between corporate governance (including board composition, management shareholding, shareholders rights and the extent of disclosure of governance practices), and the quality of earnings. Empirical tests demonstrate that overall governance quality is negatively related to the level of abnormal accruals and positively inuences the return-earnings association. In addition, the magnitude of abnormal accruals is negatively associated with the level of independence of board composition, the extent of alignment of management compensation with interests of shareholders and the strength of shareholder rights. Lai and Tam (2007) empirically examined whether independent directors serve an effective role as a corporate governance mechanism in reducing income-smoothing earnings management in China. Using board of directors and nancial accounting data for a sample of rms listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange from 2000 to 2002, Lai and Tam explore whether the adoption of independent directors affects the negative relationship between the change in cash ows and accruals. The empirical results suggest that Chinese rms that voluntarily adopt independent directors, as well as rms that have larger fraction of independent directors, have less severe practice of income smoothing. Shen and Chih (2007) studied the impacts of corporate governance on earnings management. They use rm-level governance data, taken from Credit Lyonnais Security Asia, of nine Asian countries, in addition to the country-level governance data used in past studies. They conclude that: rst, rms with good corporate governance tend to conduct less earnings management. Second, there is a size effect for earnings smoothing,
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that is, large size rms are prone to conduct earnings smoothing, but good corporate governance can mitigate the effect on average. Third, there is a turning point for leverage effect, i.e. when the governance index is large, leverage effect exists, otherwise, reverse leverage effect exists. The results support that a highly leveraged rm with poor governance is prone to be scrutinized closely and thus nds it harder to fool the market by manipulating earnings. Fourth, rms with higher growth (lower earnings yield) are prone to engage in earnings smoothing and earnings aggressiveness, but good corporate governance can mitigate the effect. Finally, rms in stronger anti-director rights countries tend to exhibit stronger earnings smoothing. The current paper concentrates on discussing and analyzing the effects of board of directors characteristics on earnings management. Hence, several hypotheses are developed that identify and link specic elements of governance to earnings management. Board composition Board composition variables deemed important by investors in a survey conducted by McKinsey & Company (2002) include the percentage of outside directors, the percentage of independent directors, the percentage of director stockholdings (i.e. stock options) and frequency of formal director evaluations. The McKinsey Global Investor Opinion Survey shows that 15 percent of European institutional investors consider corporate governance as more important than a rms nancial issues, such as prot performance or growth potential. Additionally, the report indicates that 22 percent of European institutional investors are willing to pay an average premium of 19 percent for a well-governed company. Nevertheless, empirical studies on board composition in relation to rm performance have shown mixed results. Osma and Noguer (2007) test whether corporate governance mechanisms promoted by best practice codes are effective in constraining earnings manipulation for a Spanish sample of quoted companies during the period 1999-2001. They analyze the association between earnings management and two key aspects of corporate governance: board composition and the existence of board monitoring committees. The results show that board composition signicantly determines earnings manipulation practices. However, the main role in constraining such practices is not played by independent directors, as the UK- and the US-based research suggests, but by institutional directors. No correlation is found between the existence of an independent audit committee and earnings management measures. Finally, the existence and composition of a nomination committee affects the role of independent directors in constraining earnings manipulation. We hypothesize that rms with a greater proportion of independent directors will be less likely to engage in earnings management than those whose boards are staffed primarily with inside directors. Hence, H1 is as follows (in alternate form): H1. Firms with more independent outsider boards have less discretionary accruals. Board size Empirical evidence suggests that efciency is reduced by boards that are too large. Huther (1997) identies a negative relationship between board size and rm performance and argues that efciency gains will result for the US rms by reducing
the size of their governing boards. Yermack (1996) also nds that smaller boards are more efcient and that they exhibit better nancial ratios. Andres et al. (2005) analyze rms from ten countries in Western Europe and North America and nd a negative relationship between rm value and size of the board directors. Rahman and Ali (2006) investigate the extent of the effectiveness of monitoring functions of board of directors, audit committee and concentrated ownership in reducing earnings management among 97 rms listed on the Main Board of Bursa Malaysia over the period 2002-2003. The study employs the cross-sectional modied version of Jones (1991), where abnormal working capital accruals are used as proxy for earnings management. The results reveal that earnings management is positively related to the size of the board of directors. The study also found that ethnicity (race) has no effect in mitigating earnings management, possibly due to the more individualistic behavior of the Bumiputra directors. The modernization of Malaysia and also the increase in Bumiputra ownership of national wealth may have caused the Malays to be more individualistic, similar to their Chinese counterparts. This discussion leads to the development of H2: H2. Firms with a smaller size of board of directors have less discretionary accruals. CEO as chairman of the board Drawing from the ndings of the corporate governance literature, the monitoring effectiveness of the board is typically viewed as a function of its independence, size, and leadership structure. Within the theoretical governance literature, independence and size are relatively well dened, however, the debate within the corporate governance framework as to whether the leadership structure consisting of the combination or the separation of the roles of the CEO and the chairman of the board contribute to or inhibit rm performance, is based on contradictory arguments presented by two different theories. Agency theory suggests that CEO duality is bad for performance because it compromises the monitoring and control of the CEO. Stewardship theory, in contrast, argues that CEO duality may be good for performance due to the unity of command it presents. Brickley et al. (1997) report that in approximately 80 percent of US companies, the CEO is also the chairman of the board. CEO/chairman duality concentrates power in the CEOs position, potentially allowing for more management discretion. The dual ofce structure also permits the CEO to effectively control information available to other board members and thus impede effective monitoring ( Jensen, 1993). In their 1997 study of earnings management at large banks, Brickley et al., nd CEO/chairman duality is signicantly related to the use of discretionary loan loss provisions. When the CEO is also the board chairman, the bank is more likely to record fewer discretionary loan loss provisions and as a result inate net income. Faleye (2003) nds that CEO duality is more likely when insider ownership is relatively large and the board is small. Similarly, Braun and Sharma (2007) examine the relationship between CEO duality and rm performance in family controlled public rms (FCPFs). They nd that duality by itself does not inuence rm performance in FCPFs. However, their results do indicate that the relationship between duality and performance is contingent on the familys ownership stake in the rm. When family ownership is low, the separation of CEO and board chairman is benecial in terms of shareholder returns. Thus, having different persons occupy the CEO and board
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chairman positions is a useful governance control as the risk of family entrenchment increases. Using a sample of Egyptian listed rms, Elsayeds (2007) results indicate that CEO duality has no impact on corporate performance. However, when an interaction term between industry type and CEO duality is included in the model, the impact of CEO duality on corporate performance is found to vary across industries. CEO duality attracts a positive and signicant relationship only when corporate performance is low, thus, stimulating increase usage of discretionary accruals to inate income. Following the above line of reasoning, we argue that board structure may likely impact managements willingness to manage earnings, thus, the following H3 is developed: H3. Firms with separation of the role of board chairman and CEO have less discretionary accruals. Inside/outside directors and board independence The question of whether or not an effective board should be comprised of a greater percentage of outside directors has been much debated. Rosenstein and Wyatt (1990) argue that outside directors are selected in the interest of the shareholders, whereas, Core et al. (1999) nd no evidence that independent outside directors create a more effective board. Bathala and Rao (1995) argue that a majority of outside directors on the board is not necessarily optimal as rms employ multiple mechanisms to control agency costs in the rm. Kiel and Nicholson (2003) nd a positive relationship between the proportion of insider directors and the market-based measure of rm performance. Bhagat and Black (1999) and Klein (1998) suggest that adding insiders to the board may enhance rm performance in some rms. Romano (2005) suggests that SOX was enacted too quickly by congress after the corporate scandals of 2000 and that empirical literature published prior to the enactment did not support the view that SOX would improve corporate governance or performance. Romano suggests further that independent boards do not improve performance. Davidson et al. (2005) investigate the role of a rms internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross-sectional sample of 434 listed Australian rms, for the nancial year ending in 2000, a majority of non-executive directors on the board and on the audit committee are found to be signicantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not signicantly related to a reduction in the level of discretionary accruals. Using small increases in earnings as a measure of earnings management, the results also found a negative association between this measure and the existence of an audit committee. This discussion leads to the development of H4: H4. Firms with independent outside directors have less discretionary accruals.
III. Research model and variables The model that is used in the current study comprises two types of variables; cash ow accruals and corporate governance variables. Both variables should be incorporated in formulas that express the effects of or the relationships between corporate governance and earnings managements. The corporate governance variables are taken from the set of board characteristics variables used by ISS to determine a rms corporate governance index or score. The discretionary accruals are estimated using the modied Jones cross-sectional model (DeFond and Subramanyam, 1998) with return on assets included as a control variable for performance (Kothari et al., 2005). Governance variables All of the corporate governance characteristics of the board of directors are obtained from the ISS database for rms with nancial statement year-end of December 31, 2004. Each of the corporate variables is a dichotomous variable; where a numeric value is assigned to reect the status of each variable. The characteristics that represent corporate governance characteristics of the board of directors are board composition, board structure, board size, CEO, board disclosure polices, nominating committee, and compensation committee. Table I summarizes the board of directors characteristics. Seven board composition variables, taken from the ISS database, are employed in this study; board structure according to the ISS database includes two board structure variables which are examined in the study: classied boards and annually elected boards. The term classied board is dened as boards whose members are elected on a staggered basis and serve a term of two to three years before coming up for election again. Unlike annually elected boards, only some fraction of the board membership of a classied board would be up for election in a given year rather than the entire board membership. Five categories of board size taken from the ISS database are investigated. The characteristics of the CEO are examined along four aspects. Board disclosure policies related to director characteristics are examined. Six dichotomous variables related to the nominating committee are examined and six characteristics summarized in the ISS database related to the compensation committee are investigated. Control variables There are many factors that may affect the board of directors as well as the level of earnings management. Among of these factors are rm size, audit rm, and capital structure. For example, Becker et al. (1998) and Shen and Chih (2007) conclude that rm size has an impact on earnings management level. In this study, we use the control variable LNSIZE, measured as the natural log of total assets, to control for this effect. The effects of audit rm on earnings management have inconsistent empirical results. Becker et al. (1998) and Francis et al. (1999) reveal that rms audited by Big 6 auditors report lower levels of discretionary accruals than rms employing non-Big 6 auditors. Piot and Janin (2007), investigate the effect of various audit quality dimensions (i.e. auditor reputation and tenure, audit committee existence and independence) on earnings management in France. The main ndings are, the presence of: . an audit committee (but not the committees independence) curbs upward earnings management; and . a Big 5 auditor makes no difference regarding earnings management activities.
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Governance variables Board composition BDCOMPa BDCOMPb Board controlled by insiders (insiders $ 50%) Board controlled by a majority of insiders and afliated outsiders (I and AO $ 50%) Board controlled by a majority of independent outsiders (50 # IO # 66.7%) Board controlled by a supermajority of independent outsiders (66.7 , IO # 75%) Board controlled by a supermajority of independent outsiders (75 , IO # 90%) Board controlled by a supermajority of independent outsiders (IO . 90%) Board has no more than 1 ofcer and zero afliated outsiders on the board Staggered elected and serve a term of two to three years before elected again Annually elected boards Board size Board size Board size Board size Board size is is is is is less than 6 $6 and # 8 $9 and # 12 $13 and # 15 greater than 15
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BDCOMPc BDCOMPd BDCOMPe BDCOMPf BDCOMPg Board structure BSTRUCTc BSTRUCTa Board size BDSIZEa BDSIZEb BDSIZEc BDSIZEd BDSIZEe Chief executive ofcer CEOSER
Table I. Model variables
A dichotomous variable to examine the number of boards on which the CEO serves; it is assigned a value of 1 if the CEO serves on the boards of two or fewer public companies and 0 if the CEO serves on three or more boards of public companies CEOONBD A dichotomous variable refers to whether or not the former CEO is on the board or if there are no former CEOs on the board; the variable is assigned a value of 1 if the former CEO is on the board and 0 if there are no former CEOs on the board CEOCHAIRDIR A dichotomous variable examines the chairman and CEO relation. If the chairman and CEO are not separate but there is a director, then the variable has a value of 1; otherwise a value of 0 is assigned if there is no lead director CEOCHAIR A dichotomous variable examines the separation of chairman and CEO; the variable is assigned a value of 1 if the chairman and CEO are separate and 0 otherwise Board disclosure policies DIRAGERET A variable to examine the policy issue related to whether or not there is disclosure of a mandatory retirement age for directors. It is a dichotomous variable with a value of 1 if there is a mandatory age requirement and 0 if no disclosure DIRTERM A variable to examine the policy issue related to the disclosure of director term limits. The variable is a dichotomous variable with a value of 1 if term limits are disclosed and 0 if no disclosure DIRSTOCK A variable examines the issue of directors and stock ownership. The variable is assigned the value of one if all directors with more than one year of service own stock; otherwise the variable is 0 Nominating committee NOMCOMa Refers to who is performing the nominating function. The variable is assigned the value of 1, if the full board fullls the nominating function; otherwise the variable is assigned a value of 0 (continued)
Governance variables Refers to whether or not the committee includes afliated outsiders. If afliated outsiders are present, the variable is assigned a value of 1; otherwise the value of the variable is 0 NOMCOMc Refers to whether or not the nominating committee is comprised solely of independent outsiders. The variable is assigned a value of 1 if only independent outsiders are included on the nominating committee and 0 if otherwise NOMCOMd Refers to the presence or absence of a nominating committee. The variable is assigned a value of 1 if there is no nominating committee NOMCOMe Is used to examine the presence of insiders on the nominating committee. This insiders variable is assigned the value 1 if the nominating committee includes insiders and 0 if otherwise NOMCOMf Examines whether the nominating committee is comprised solely of independent outside directors and the board has the authority to hire its own advisors. This variable has a value of 1 if the nominating committee is comprised solely of independent outside directors and may, if necessary, hire their own advisors Compensation committee COMPENCOMa Refers to who is performing the compensation function. The variable is assigned the value of 1, if the full board fullls the function; otherwise the variable is assigned a value of 0 COMPENCOMb Used to denote whether or not the committee includes afliated outsiders. If afliated outsiders are present, the variable is assigned a value of 1; otherwise the value of the variable is 0 COMPENCOMc Denotes whether or not the compensation committee is comprised solely of independent outsiders. The value 1 is assigned if the compensation committee is comprised solely of independent outsiders and 0 if not COMPENCOMd Used to investigate the presence or absence of a compensation committee. The variable is assigned a value of 1to denote the existence of a compensation committee and 0 if otherwise COMPENCOMe Used to examine the presence of insiders on the compensation committee. The insiders variable is assigned the value 1 if the compensation committee includes insiders and 0 if otherwise COMPENCOMf Denotes whether the compensation committee is comprised solely of independent outside directors and the board has the authority to hire its own advisors if needed. This variable has a value of 1 if the compensation committee is comprised solely of independent outside directors and may, if necessary, hire their own advisor; otherwise the variable is assigned a value of 0 Control variables LNSIZE Control variable to denote rm size; is measured as the natural log of total assets BIG4AUD Control variable to denote whether or not the rms auditor is a Big 4 rm; it takes a value of 1 if the auditor is a Big 4 rm, otherwise the variable is assigned a value of 0 LEV Control variable to denote the rms leverage; is measured as the ratio of total debt to total assets NOMCOMb
Table I.
These contradictory results are considered in this study and hence we use the indicator variable BIG4AUD to control for this effect. Capital structure has an effect on earnings management as Piot and Janin (2007) indicated that there is a turning point for leverage effect, i.e. when the governance
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index is large, leverage effect exists, otherwise, reverse leverage effect exists. In this study, we employ the control variable LEV to denote the companys leverage; measured as the ratio of total debt to total assets. We employ three control variables in the study: rm size, rms auditor, and rms leverage. The relation between discretionary accruals and governance characteristics is examined by estimating the coefcients in the following logistic regression model (Model 1) after all corporate governance variables as well as control variables are considered. Model 1: logistic regression model of earnings management: EARNMAN b0 b1 BDCOMPa b2 BDCOMPb b3 BDCOMPc b4 BDCOMPd b5 BDCOMPe b6 BDCOMPf b7 BDCOMPg b8 BSTRUCTc b9 BSTRUCTa b10 BDSIZEa b11 BDSIZEb b12 BDSIZEc b13 BDSIZEd b14 BDSIZEe b15 CEOSER b16 CEOONBD b17 CEOCHAIRDIR b18 CEOCHAIR b19 DIRAGERET b20 DIRTERM b21 DIRSTOCK b22 NOMCOMa b23 NOMCOMb b24 NOMCOMc b25 NOMCOMd b26 NOMCOMe b27 NOMCOMf b28 COMPENCOMa b29 COMPENCOMb b30 COMPEMCOMc b31 COMPENCOMd b32 COMPENCOMe b33 COMPENCOMf b34 LNSIZE b35 LEV b36 BIG4AUD 1 Denitions of all governance variables and control variables included in Model 1 are presented in Table I. Using the discretionary extremes, two denitions of earnings management (EARNMAN) subset models can be derived based on Model 1 as: Model 1.A. EARNMANhn is an indicator variable for rms in the high income-decreasing category. Model 1.B. EARNMANhp is an indicator variable for rms in the high income-increasing category. The two denitions of earnings management, EARNMANhn and EARNMANhp, permit the examination of whether income-decreasing and income-increasing accruals have the same relationship with corporate governance practices or whether they have very different affects on corporate governance. IV. Data analysis and discussion Sample selection The study sample is based on a complete set of rms on Compustat with a December 31, 2004 year-end and complete accrual data for 2004. Firms from regulated (Standard Industrial Classication SIC 4000-4900), nancial (6000-9000), and government (SIC 9900) sectors are excluded due to their unique accounting practices which make the estimation of their discretionary accruals difcult.
The total accruals computation model used in this study requires an estimation of a cross-sectional regression for each industry. Hence, the two-digit SIC codes are used and rms from industries with less than ten rms are eliminated. We rst estimate the ordinary least square regressions of total accruals on the change in sales from the previous year and on the gross level of xed assets for rms in the same industry listed in Compustat in period t. These requirements resulted in 3,220 observations for the calculation of discretionary accruals. The discretionary accruals for each rm in each of the industries are dened as the residual from the regression of total accruals on the change in revenue and the level of xed assets subject to depreciation. The sample used to separately estimate discretionary accruals for each of the 38 industries contains 3,126 rms after eliminating 94 of the 3,220 original rms due to missing data or having a Compustat value of zero for the rms previous year total assets amount. Discretionary accruals are then computed for each of the 3,126 rms. Consistent with Becker et al. (1998) and Subramanyam (1996), 126 rms with discretionary accruals in excess of the top and bottom 2 percent of all the observations are dropped to eliminate the effects of outliers because rms with very large income or cash ows from operations have been shown to bias the estimation of discretionary accruals. The rms are then ranked by the size of their discretionary accruals in order to stratify the sample into three groups of rms, those with: (1) the largest positive accruals (523 rms); (2) the largest negative accruals (487 rms); and (3) small positive and negative discretionary accruals (506 rms). By design, the study maintains the assumption that more positive discretionary accruals indicates a greater extent of earnings management upwards, whereas more negative discretionary accruals indicates a greater extent of downward earnings management. Descriptive statistics The information on the corporate governance variables comes from the ISS database. The specic denition for the variables appears in the Table I. The descriptive statistics for the sample consisting of the two extreme earnings management groups, high-negative and high-positive discretionary accruals are presented in Table II. Baysinger and Butlers (1985) and Byrd and Hickmans (1992) categorization of board members is used in describing the composition of the sample rms boards. An insider refers to one who is employed by the rm. An afliated member is one who has some relationship with the rm or its executives. An outsider refers to one in which the only relationship to the rm or its executives is through the board of directors. Income-decreasing discretionary accrual rms. Table II presents a summary of descriptive statistics for the corporate governance characteristics and the control variables for the two sample groups; the income-decreasing and income-increasing earnings management rms. As shown in the rst column of Table II, 88 percent of the income-decreasing discretionary rms have boards which are controlled by a majority of independent outsiders. Within this group, 35 percent of these rms are controlled by a supermajority of more than 75 percent of independent outsiders. Table II indicates that none of the income-decreasing discretionary rms have boards controlled by a majority
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Variables 20.28666 0 0.114989 0.45174 0.080082 0.349075 0.008213 0 0.513347 0.488706 0.246406 0.583162 0.170431 0.002053 0 0.985626 0.229979 0 0.500335 0.500386 0.431361 0.493542 0.376397 0.045314 0 0.119148 0.421252 0.09034 0.477168 0.27169 0.105162 0.369024 0.03250 0.001912 0.575525 0.424474 0.126195 0.554493 0.296367 0.021032 0.001912 0.96749 0.210325 0.498177 0.399617 0.319337 0.091778 0 0 0 0.28898 0.490288 0.307056 0.483002 0.177506 0.043726 0.494736 0.494736 0.332386 0.497497 0.457092 0.143630 0.043726 0.177506 0.40792 0.273181 0.186324 0.115831
Discretionary accruals Board composition Board controlled by insiders I $ 50% Board controlled by a majority of insiders and afliate I and AO $ 50% Board controlled by a majority of independent outsiders 50 , IO # 66.7% Board controlled by a supermajority of independent outsiders 66.7 , IO # 75% Board controlled by a supermajority of independent outsiders 75 , IO # 90% Board controlled by a supermajority of independent outsiders IO . 90% Board controlled by a supermajority of independent outsiders IO . 90% Board structure Classied board Annually elected board Board size Board size is less than 6 Board size is $6 and #8 Board size is $ 9 and # 12 Board size is $13 and #15 Board size is greater than 15 Chief executive ofcer CEO serves on the boards of two or fewer public companies CEO is former CEO on the board
Table II. Discretionary descriptive statistics High-negative discretionary accruals (n 487) Mean SD High-positive discretionary accruals (n 523) Mean SD Test on differencea 0 924.34 * 31.32 * 1,039.58 * 131.68 * 1,414.35 * 1,528 * 1.765 1.632 621.79 * 21.15 * 391.04 * 1,464.76 * 1,520.02 * 1,410.51 * 5,12.4 * (continued)
Variables 0.110882 0.572895 0.878850 0.0862 0.008213 0.004106 0.13963 0.020533 0.248459 0.04312 0.544147 0.006160 0.170431 0.065708 0.04312 0.059548 0.652977 0.248026 0.203338 0.236891 0.476512 0.078325 0.376397 0.498559 0.68833 0 0.141491 0.022944 0.015296 0.040152 0.780114723 0.14196 0.43256 0.203338 0.009560 0.120458 0.030592 0.064018 0.346959 0.001912 0.149139 0.043726 0.356567 0.097401 0.325809 0.172376 0.463616 0 0.348861 0.149870 0.122846 0.196505 0.41456 0.326636 0.281010 0.09034 0.852772 0.260038 0.024856 0.35467 0.439075 0.155837 0.31431 0.495166 0.340344 0.395793 0.474278 0.489488 476.06 * 3.018 827.6 * 644.9 * 1,433.63 * 1,508.1 * 763.27 * 1,449.15 * 579.12 * 1,297.72 * 66.47 * 1,512.07 * 716.01 * 1279.37 * 1334.79 * 1,193.15 * 253.51 *
High-negative discretionary accruals (n 487) Mean SD High-positive discretionary accruals (n 523) Mean SD Test on differencea
Chairman and CEO are not separated but there is a lead director Chairman and CEO are separated Board disclosure policies All directors with more than one year of service own stock Mandatory retirement age for directors Director term limits Nominating committee Full board fullls function Committee includes afliated outsiders Committee comprised solely of independent outsiders No committee Committee includes insiders Committee comprised solely of independent outside directors and the board can hire its own advisor Compensation Committee Full board fullls function Committee includes afliated outsides Committee comprised solely of independent outsiders No committee Committee includes insiders Committee comprised solely of independent outside directors and the board can hire it own advisor
Notes: *Signicant at 0.001 level; atest statistic comparing the two groups: x 2 for the dichotomous governance variables and Kruskal-Wallis for the control variables; n 1,010
Table II.
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of insiders (I $ 50 per cent) or boards with any afliated outsiders. The income-decreasing sample rms are almost evenly split between those boards which elect members with staggered year terms (one-year term, two-year term, three-year term, etc.) and those which annually elect all members of the board. As shown in Table II, 51.3 percent of the income-decreasing discretionary rms have classied boards and 48.8 percent have annually elected boards. In an examination of board size, Table II reveals that 58.3 percent of the income-decreasing discretionary rms have board sizes consisting of six to eight members. Approximately, 25 percent of the sample rms have boards with fewer than six members, while there are no rms in the sample with boards greater than 15 members, as reported by ISS. As shown in Table II, 98.6 percent of the CEOs in the income-decreasing discretionary rms serve on boards of two or fewer public companies. For 23 percent of the sample rms the former CEO currently serves on the board. In 11 percent of the rms the chairman and CEO are not separate but there is a lead director. However, for a majority of the income-decreasing discretionary rms, 57.3 percent, the chairman and CEO are separate. A look at the director characteristics in Table II shows 87.9 percent of all the directors with at least one year of service own company stock. Only, 8.6 percent of the sample rms have a mandatory retirement age policy disclosure for directors and less than 1 percent of the sample rms have a disclosure policy relating to term limits for directors. A total of 121 rms (24.8 percent) in the income-decreasing discretionary sample group listed no nominating committee. However, a majority (54.4 percent) of the sample rms list nominating committees comprised solely of independent outside directors with the authority to hire their own advisors, if desired. In contrast to the nominating committee, Table II shows that 21 rms or 4.3 percent of the income-decreasing discretionary rms listed no compensation committee. Similar to the nominating committee, however, majority of the income-decreasing discretionary rms (65.3 percent) list compensation committees comprised solely of independent outside directors with the authority to hire their own advisors, if desired. Income-increasing discretionary accrual rms. The summary of the high-positive discretionary accruals in Table II for the income-increasing accrual group shows that 40 percent of the income-increasing rms have boards that are controlled by a majority of independent outsiders but the percentage of independent outsiders is less than or equal to two-thirds of the total board. In contrast, another 37 percent of the income-increasing rms have boards that are controlled by a supermajority of independent outsiders, in which cases, the percentage of independent outsiders is greater than 75 percent but less than or equal to 90 percent of the boards membership. Similar to the income-decreasing rms, there are no income-increasing discretionary rms with boards controlled by a majority of insiders (I $ 50 per cent). In total, 58 percent of the income-increasing rms indicate that their boards are classied. A majority, 55 percent, of the income-increasing accrual rms have board sizes between six and eight (inclusive) members. Approximately, 13 percent of the income-increasing rms have a board size of less than six members. Column 3 of Table II indicates that 97 percent of the income-increasing rms CEOs serve on the boards of two or fewer public companies. For 21 percent of the income-increasing rms, the former CEO currently serves on the board. In 34 percent of the income-increasing rms, the chairman and CEO are not separate but there
is a lead director. However, in 40 percent of the income-increasing rms the chairman and CEO are separate. A look at the directors characteristics for the income-increasing rms reveals that 26 percent of the income-increasing rms have a disclosed mandatory age retirement policy. Only 2.5 percent have a disclosure policy related to director term limits. In the case of directors and stock ownership, 85 percent of all the directors with at least one year of service own company stock. Unlike the 121 income-decreasing accrual rms, only 63 income-increasing rms listed no nominating committee. A majority, 68.8 percent, of the income-increasing rms listed nominating committees comprised solely of independent outside directors with the board having the authority to hire its own advisors. In contrast to the nominating committee, Table II indicates that eight or 1.5 percent of the 523 income-increasing accrual rms listed no compensation committee. However, for a majority of the income-increasing accrual rms, 78 percent, the compensation committee is comprised solely of independent outside directors with the board having the authority to hire its own advisors, if necessary. Univariate analysis. Ordinary least square regression is used to test the relation between the dependent variable, discretionary accruals and the independent variables, governance characteristics for the two accrual models high-negative discretionary accruals (EARNMANhn), and high-positive discretionary accruals (EARNMANhp) (Tables are available from the authors). Board composition, whether controlled by insiders, afliated outsiders or independent outsiders, is unrelated to income-decreasing discretionary accruals. However, there is a signicant correlation of income-decreasing accrual with board structure. Both variables are signicant at the 0.05 level. Annual election of board members has a negative coefcient, indicating that when the entire board is elected each year, income-decreasing discretionary accruals are lower. On the other hand, companies which elect board members on a staggering basis have a positive coefcient, indicating that with a classied board structure income-decreasing discretionary accruals are higher. In summary, the univariate analysis of the association of income-decreasing discretionary accruals with the corporate governance characteristics for board composition and board structure indicates that only board structure has a signicant correlation. The univariate examination of income decreasing accruals indicates that board sizes between six and eight (inclusive) and between 13 and 15 members are unrelated to income-decreasing discretionary accruals. We nd the coefcient for board size between nine and 12 (inclusive) to be positive and signicant at 0.05, indicating that a larger board size is associated with higher levels of earnings management. While the coefcient for board size less than six is negatively related to income-decreasing discretionary accruals and signicant at the 0.05 level. This nding is consistent with prior research that smaller boards are more efcient. Thus, the summary of ndings from both univariate tests indicate that when entire boards are elected annually, as opposed to staggered terms (some directors serving two-year terms and some three-year terms) and the number of directors is less than six, discretionary accruals are lower. These ndings are consistent with the idea that smaller boards with yearly elections of each member are more accountable to stakeholders, more efcient with decision making and better monitors of the
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companys activities than larger boards with members elected to a two-or three-year staggered-rotation basis. The univariate regression results of the roles of the CEO and chairman and the boards disclosure policies indicate that the dual role of the CEO is related to income-decreasing discretionary accruals. The coefcient of the variable for the chairman and CEO are the same, however, when there is a lead director, the coefcient is positive and signicant at the 0.01 level. This nding indicates that when the CEO serves as chairman of the board, even if there is a lead director, negative discretionary accruals are higher. Examining the other characteristics of the CEO, the ndings indicate that CEOs serving on the boards of two or fewer public companies and former CEO currently serving on the board are unrelated to negative discretionary accruals. The univariate analysis of the director policy disclosure characteristics, indicate that only the disclosure policy related to the mandatory retirement age for directors is related to income-decreasing discretionary accruals. The coefcient of the mandatory age retirement policy is positive and signicant at the 0.01 level, indicating that as the more experienced directors are forced to retire, the level of negative discretionary accruals increases. This nding is consistent with prior research which supports the notion that experienced directors seem to play a role in limiting earnings management. Results of the boards nominating committee characteristics indicate that the full board fullling the nominating function is unrelated to negative discretionary accruals. Similarly, the proportions of afliated outsiders or, no nominating committee or, whether the committee can hire its own advisors, are all unrelated to income-decreasing discretionary accruals also. A different behavior with respect to discretionary accruals is revealed by a nominating committee which includes insiders. The coefcient of the variable is positive and signicant at the 0.10 level, indicating that negative discretionary accruals are higher for companies whose nominating committee includes insiders. However, the coefcient for a nominating committee comprised solely of independent outsiders is negative and signicant at the 0.01 level, indicating that earnings management is reduced by the presence of a nominating committee that is totally independent. Similar to the nominating committee characteristics, the ndings show that the full board fullling the compensation function is unrelated to negative discretionary accruals. Additionally, the proportions of afliated outsiders or, insiders or, no compensation committee or, whether the compensation committee can hire its own advisors, are unrelated to income-decreasing discretionary accruals as well. However, the coefcient for a compensation committee comprised solely of independent outsiders is negative and signicant at the 0.01 level, indicating that a totally independent compensation committee is associated with a reduced level of earnings management. The results of the control variables, rm size and the employment of a Big 4 auditor have positive coefcients and are signicant at the 0.01 and 0.05 levels, respectively. These ndings indicate that high-negative discretionary accrual rms are large rms and more likely to hire Big 4 auditors. The coefcient of the leverage variable is negative and signicant at the 0.01 level, indicating that as debt increases the ability to engage in income-decreasing earnings management is reduced. In summary, the univariate ndings of the control variables indicate that when size is observed independently, rm size is positively associated with income-decreasing
earnings management. Likewise, when examining the type of auditor effect on decreasing discretionary accruals, the results indicate a positive and signicant (0.05 level) association of Big 4 auditors with decreasing earnings management. This nding indicate that income-decreasing discretionary accrual rms are more likely to hire one of the Big 4 US accounting rms Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers. The univariate results of the analysis of the leverage control variable indicate that the coefcient of the variable is negative and signicant at the 0.01 level. These ndings indicate that high-negative discretionary accrual rms tend to have less debt, which is counterintuitive. If, as shown in prior literature involving cases of fraudulent and restated earnings studies, then one would expect high-negative discretionary accrual rms to have negative net income, negative cash ows from operation and be highly leveraged. However, we must keep in mind that this result is the single effect of leverage on earnings. We carried out a univariate ordinary least square regressions analysis for the corporate governance characteristics and control variables results of the high-positive discretionary accrual rms (Tables are available from the authors). From the regression analysis of the high-positive discretionary accrual rms only one board governance characteristic had signicant; where, board controlled by a supermajority of independent outsiders (75 , IO # 90 percent) is marginally signicant at the 0.10 level and positively associated with income-increasing discretionary accruals. In summary, based upon the directional signs of the b coefcients of the high-positive discretionary accrual rms, smaller rms engage in more income-increasing earnings management. Income-increasing discretionary rms tend not to be audited by the Big 4 and are likely to be highly leveraged. Test of difference between the two groups of rms; rms with high-negative dictionary accruals and those with high-positive dictionary accruals, using x 2-test for dichotomous governance variables and Kruskal-Wallis test for the control variables, reveals signicant association of all of the variables except the board structure variables, chairman and CEO duality and leverage. Multivariate analysis. We conducted a multivariate regression analysis to take into consideration the simultaneous effects of all corporate governance variables and the control variables on earnings management. Our ndings indicate that there is no meaningful direct relation between low-discretionary accrual earnings management and the effects of board composition, size, structure, and board policies investigated in the current study. Hence, only high-negative and high-positive logistic regression models are used to test the relation between discretionary accruals and corporate governance characteristics. Using a Wald test and simultaneously testing the effects of all of the corporate governance characteristics, the high-negative discretionary accrual model is highly signicant with x 2 1193.968, df 33, p 0.000, and Cox and Snell R 2 70 percent. Table III presents the result of the omnibus tests of the coefcients and the model summary statistics for the income-decreasing discretionary accrual model (EARNMANhn). Unlike the simple regression which indicated no signicant board composition variables, the results of the multivariate regression of the income-decreasing discretionary accrual rms indicate that the coefcient of the variable board controlled by a supermajority of independent outsiders (IO . 90 percent) is signicant when included simultaneously with the seven variables intended to capture board composition. The supermajority independent outsider variable has a negative coefcient and is signicant
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Multiple regression results Variables Intercept Board controlled by a majority of insiders and afliated outsiders (I and AO $ 50%) Board controlled by a majority of independent outsiders (50 # IO # 66.7%) Board controlled by a supermajority of independent outsiders (66.7 , IO # 75%) Board controlled by a supermajority of independent outsiders (75 , IO # 90%) Board controlled by a supermajority of independent outsiders (IO . 90%) Classied board Annually elected board Board size is less than 6 Board size is 6 and 8 Board size is 9 and 12 Board size is 13 and 15 Board size is greater than 15 CEO serves on the boards of two or fewer public companies Former CEO on the board Chairman and CEO are not separated but there is a director Chairman and CEO are separated Mandatory retirement age for directors Director term limits All directors with more than one year of service own stocks Full board fullls nominating function Nominating committee includes afliated outsiders Nominating committee comprised solely of independent outsiders No nominating committee Nominating committee includes insiders Full board fullls compensation function Compensation committee includes afliated outsiders Compensation committee comprised solely of independent outsiders No compensation committee Compensation committee includes insiders Compensation committee comprised solely of independent outside directors LNSIZE Leverage BIG4AUD x2 Adjusted R 2
Predicted sign None 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Coefcient 211.224 2.504 2.340 2.110 2.043 24.165 20.631 19.743 16.672 17.312 16.502 14.810 0.097 22.476 20.329 20.240 0.247 5.304 3.183 29.185 2.267 21.041 21.038 20.022 0.779 221.507 223.861 223.900 225.803 224.501 223.529 20.770 1.294 1.053
p-value 1.000 0.375 0.387 0.455 0.454 0.017 * 1.000 1.000 1.000 1.000 1.000 1.000 1.000 0.228 0.596 0.729 0.621 0.000 * 0.002 * 0.000 * 0.926 0.208 0.659 0.975 0.443 1.000 1.000 1.000 0.999 1.000 1.000 0.000 * 0.055 0.047 *
408
1,193.968 0.70
Table III. High-negative logistics regression results: EARNMANhn model
Notes: *Signicant at 0.01 level. The model of high-negative earnings management: EARNMANhn b0 b1 BDCOMPa b2 BDCOMPb b3 BDCOMPc b4 BDCOMPd b5 BDCOMPe b6 BDCOMPf b7 BDCOMPg b8 BSTRUCTc b9 BSTRUCTa b10 BDSIZEa b11 BDSIZEb b12 BDSIZEc b13 BDSIZEd b14 BDSIZEe b15 CEOSER b16 CEOONBD b17 CEOCHAIRDIR b18 CEOCHAIR b19 DIRAGERET b20 DIRTERM b21 DIRSTOCK b22 NOMCOMa b23 NOMCOMb b24 NOMCOMc b25 NOMCOMd b26 NOMCOMe b27 NOMCOMf b28 COMPENCOMa b29 COMPENCOMb b30 COMPEMCOMc b31 COMPENCOMd b32 COMPENCOMe b33 COMPENCOMf b34 LNSIZE b35 LEV b36 BIG4AUD 1
at the 0.10 level. This nding indicates that income-decreasing discretionary accruals are reduced when boards are comprised almost entirely of independent outside directors, hence, H1 is not rejected. Surprisingly, the multivariate ndings of the research indicate that the presence of income-decreasing discretionary accruals is not related to board size or CEO duality. The results lead to the rejection of both H2 and H3. However, there is a very strong positive association of income-decreasing discretionary accruals with board disclosure policies related to mandatory retirement for directors and director term limits. This nding can be interpreted to imply that as the seasoned, more mature and experienced directors retire companies are left with less experienced directors and this tend to lead to an increase in negative discretionary accruals. The research ndings also indicate that the director stock ownership governance variable is negatively related to the level of income-decreasing discretionary accruals, same as in the simple regression but differing in signicance. When simultaneously regressed with all of the corporate governance characteristics, director stock ownership variable shows the strongest association of all of the signicant variables. Perhaps, this is an indication of the agency theory at its best; greater stock ownership by the directors leads to more efcient monitoring and a reduction in income-decreasing discretionary earnings management. The simultaneous regressions of the control variables, LNSIZE, LEVERAGE, BIG4AUD, with the dependent variable, decreasing discretionary accruals are shown in Table IV. The results indicate that all of the control variables are signicant at the 0.01 level and the model is signicant with a x 2 189.40, df 3, p 0.000, and Cox and Snell R 2 17.2 percent. The leverage variable is positively associated with income-decreasing discretionary accruals, unlike, the unexpected negative direction found in the univariate analysis The Big 4 variable is positively associated with income-decreasing discretionary accruals; however, the size variable (LNSIZE) as measured by total assets is negatively associated with decreasing income discretionary accruals. In summary, the results of the logistic simultaneous regression of the income-decreasing discretionary accruals with the control variables indicate that the rms more likely to engage in income-decreasing discretionary accrual earnings management are smaller, more highly leveraged and tend to be audited by the Big4 US accounting rms. These results are consistent with the results of a similar study using UK data (Peasnell et al., 2005). However, Peasnell et al. nd that good governance is effective in reducing positive discretionary accruals but not negative. The Wald-test of the simultaneous effect all of the corporate governance characteristics for the high-positive discretionary accrual model (EARNMANhp) indicate that the model is statistically signicant with x 2 90.215, df 31, p 0.000,
Variable Firm size Firms leverage Firm audited by the Big 4 x2 Adjusted R 2 Note: *Signicant at 0.01 level Coefcient 20.553 0.547 0.459 189.404 0.172 p-value 0.000 * 0.009 * 0.009 *
Table IV. Control variables logistic regression results: high-negative discretionary accruals
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and Cox and Snell R 2 8.4 percent. Table V presents the result of the omnibus tests of the coefcients and the model summary statistics for the income-increasing discretionary accrual model (EARNMANhp). Surprisingly, the multivariate ndings of the research indicate that the presence of income-increasing discretionary accruals is not related to any of the variables employed to capture board composition characteristics. However, the ndings do indicate that the structure of the board is signicant. The results indicate that the variable, classied board (BDSTRUCTc) is signicant at the 0.05 level and positively associated with income-increasing earnings management. This nding could be interpreted to imply that staggered board terms lead to a perceived unequal distribution of power by the newly elected directors. This perception may result in the newly elected directors following the leadership of the senior directors who may be more closely aligned with management and less effective monitors. The multivariate ndings of the CEO characteristics indicate that only the CEO characteristics related to the number of public boards on which the directors serve is related to income-increasing discretionary accruals, accordingly, H4 is not rejected. The variable CEOSER which capture whether or not the CEO serves on two or fewer public company boards is signicant at the 0.01 level and negatively associated with income-increasing discretionary accruals. This nding supports the PCAOB position that limiting the number of public company boards on which a CEO may serve, will enhanced corporate governance. In this case, the results do indicate that income-increasing discretionary earnings management is reduced when CEOs serve on two or fewer public companies boards. However, such results could be justied based on possible explanations associated with the proxy chosen to express earnings management. Such justication may be supported by Ebrahim (2007) ndings; as he concluded that earnings management researches are sensitive to the different models suggested in literature to isolate the abnormal accruals. Another possible explanation for the insignicant relationship between other corporate governance mechanisms (independence of board and audit committee) and earnings management is that the board of directors is seen as ineffective in discharging their monitoring duties due to management dominance over board matters. Unlike income-decreasing discretionary accruals where the CEO duality characteristic is not signicant, for income-increasing discretionary accruals CEO duality is signicant and hypothesis three is rejected. The variable CEOCHAIRDIR which captures the characteristic that the chairman and CEO are not separated but there is a lead director is signicant at the 0.01 level and positively associated with income-increasing discretionary accruals. This nding indicates that income-increasing earnings management is higher in situations where the CEO serves as chairman of the board, even if there is a lead director. The study ndings indicate that income-increasing discretionary accruals are not related to the presence or composition of a nominating committee. Each of the six nominating committee variables is insignicant. However, the ndings are quite different for the compensation committee. The variables, no compensation committee (COMPENCOMd) and compensation committee includes insiders (COMPENCOMe) are marginally signicant at the 0.10 level and negatively associated with income-increasing earnings management. The results, though not highly signicant, are counterintuitive implying that income-increasing discretionary accruals are
Multiple regression results Variables Interception Board controlled by a majority of insiders and afliated outsiders Board controlled by a majority of independent outsiders Board controlled by a supermajority of independent outsiders Board controlled by a supermajority of independent outsiders Board controlled by a supermajority of independent outsiders Classied board Board size is less than 6 Board size is 6 and 8 Board size is 9 and 12 Board size is 13 and 15 CEO serves on the boards of two or fewer public companies Former CEO on the board Chairman and CEO are not separated but there is a director Chairman and CEO are separated Mandatory retirement age for directors Director term limits All directors with more than one year of service own stocks Full board fullls nominating function Nominating committee includes afliated outsiders Nominating committee comprised solely of independent outsiders No nominating committee Nominating committee includes insiders Nominating committee comprised solely of independent outside directors Full board fullls compensation function Compensation committee includes afliated outsiders Compensation committee comprised solely of independent outsiders No compensation committee Compensation committee includes insiders LNSIZE Leverage BIG4AUD x2 Adjusted R 2
Predicted sign None 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Coefcient 23.852 2 24.803 2 24.864 2 24.729 2 24.882 2 24.258 0.310 1.013 1.112 0.939 1.419 2 0.800 0.206 0.464 2 0.158 0.138 0.029 2 0.209 2 0.765 0.206 0.516 0.059 0.179 0.293 2 21.175 2 0.141 2 0.520 2 0.636 2 0.444 0.176 2 10.000 2 0.082
p-value 1.000 1.000 1.000 1.000 1.000 1.000 0.023 * 0.425 0.377 0.456 0.301 0.023 * 0.257 0.016 * 0.347 0.452 0.953 0.279 0.648 0.905 0.774 0.973 0.919 0.865 0.999 0.527 0.309 0.046 * 0.039 * 0.000 * 0.000 * 0.668
90.215 0.084
Notes: *Signicant at 0.01 level. The model of high-positive earnings management: EARNMANhp b0 b1 BDCOMPa b2 BDCOMPb b3 BDCOMPc b4 BDCOMPd b5 BDCOMPe b6 BDCOMP f b7 BDCOMP g b8 BSTRUCT c b9 BSTRUCTa b10 BDSIZE a b11 BDSIZEb b12 BDSIZEc b13 BDSIZEd b14 BDSIZEe b15 CEOSER b16 CEOONBD b17 CEOCHAIRDIR b18 CEOCHAIR b19 DIRAGERET b20 DIRTERM b21 DIRSTOCK b22 NOMCOMa b 23 NOMCOM b b24 NOMCOMc b25 NOMCOMd b 26 NOMCOM e b27 NOMCOMf b28 COMPENCOMa b29 COMPENCOMb b30 COMPEMCOMc b31 COMPEN COMd b32 COMPENCOMe b33 COMPENCOMf b34 LNSIZE b35 LEV b36 BIG4AUD 1
Table V. High-positive discretionary accruals results: model EARNMANhp
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reduced if management compensation decisions are made by a committee of the board members which includes insiders or at worst no board compensation committee at all. Perhaps, the results may imply that insiders bring a different level of knowledge and expertise to the compensation decision-making process which results in more efcient monitoring and thus, reduces earnings management. Additionally, one can assume that these companies are not listed on the New York Stock Exchange (NYSE) or they are controlled companies exempted from the NYSE listing requirement that companies must have a compensation committee which consists entirely of independent directors. The simultaneous regressions of the control variables, LNSIZE, LEVERAGE, BIG4AUD, with the dependent variable, increasing discretionary accruals are shown in Table VI. The results indicate that the size and leverage control variables are signicant at the 0.01 level. The overall model is signicant with x 2 25.662, df 3, p 0.000, and Cox and Snell R 2 2.5 percent. The leverage variable is negatively associated with income-increasing discretionary accruals. However, the size variable (LNSIZE) as measured by total assets is positively associated with increasing discretionary earnings management. As in the univariate analysis, the Big 4 variable is not signicant though it is important to note that the coefcient is negative indicating that hiring of a Big 4 auditor tends to reduce income-increasing earnings management. In summary, the multivariate ndings of the income-increasing discretionary control variables indicate that the larger rms, as measured in terms of total assets, are more likely to engage in income-increasing discretionary accrual earnings management. These rms tend to have less debt and though not statistically signicant, the direction of the coefcient BIG4AUD is negative, indicating that high income-increasing discretionary accruals rms are less likely to hire auditors from the Big 4 US accounting rms. Nevertheless, the direction of the variable indicates that the attestation process helps to reduce income-increasing earnings management. V. Conclusions This study investigates whether the earnings management activity of a rm is impacted by the rms corporate governance practices. In particular, the role of the structure of the board of directors, its composition, size, committees structure, directors characteristics, and board disclosure policies are examined to determine the extent of their relationship to corporate earnings management as measured by the level of income-increasing and income-decreasing discretionary accruals. The ndings of the research indicate that income-increasing and income-decreasing discretionary accruals have a different relationship with corporate governance practices. The income-decreasing discretionary accruals rms are more likely to be smaller rms, more highly leveraged and tend to hire
Variable Firm size Firms leverage Firm audited by the Big 4 x2 Adjusted R 2 Note: *Signicant at 0.01 level Coefcient 0.173 2 0.637 2 0.054 25.662 0.025 p-value 0.000 * 0.013 * 0.771
Table VI. Control variables logistic regression results: high-positive discretionary accruals
Big 4 US auditors. Income-increasing discretionary accrual rms, however, are larger rms, as measured in terms of total assets. These rms tend to have less debt and though not statistically signicant, the direction of the coefcient BIG4AUD is negative, indicating that high income-increasing discretionary accruals rms are less likely to hire auditors from the Big 4 US accounting rms. The results of the logistic regression models suggest that there are some governance best practices and other rm characteristics associated with less earnings management. Surprisingly, none of the signicant governance characteristics have the same effects on the likelihood of income-decreasing and income-increasing discretionary accruals. Specically, the following governance characteristics are negatively associated with income-decreasing earnings management: boards controlled by a supermajority of independent outsiders (IO . 90 per cent) and boards in which all directors with more than one year of service own stock. The governance characteristics negatively associated with income-increasing discretionary accruals include: boards whos CEO serves on the boards of two or fewer public companies, board with no compensation committee and boards in which the compensation committee includes insiders. The variable CEOSER which captures whether or not the CEO serves on two or fewer public company boards is highly signicant and negatively associated with income-increasing discretionary accruals. This nding indicates that income-increasing discretionary accruals are reduced when CEO board services are restricted to two or fewer public companies. This nding may have policy implications for the PCAOB or the listing exchanges which may opt to take a position on limiting the number of public company boards on which a CEO may serve. The results of this study indicate that income-increasing discretionary earnings management may be reduced when CEOs serve on two or fewer public companies boards. The results of the logistic regression models also suggest that some governance characteristics are associated with increasing earnings management. The ndings reveal that mandatory retirement age for directors and director term limits are positively associated with income-decreasing earnings management. For the income-increasing discretionary accruals the governance characteristics positively associated with earnings management are classied board and CEO duality, boards where the chairman and CEO are not separated. It is important to note that in the current study 67 percent of the decreasing discretionary accrual rms have CEO duality; 74 percent of the income-increasing discretionary rms have CEO duality and 26 percent of the low-discretionary accrual rms have CEO duality. These percentage are not unusual, Brickley et al. (2000) in their study on leadership structure nd approximately 81 percent of their sample rms to have CEO duality. In the present study, the CEO duality is very signicant at the 0.01 level and is positively associated with income-increasing earnings management. One caveat of the research must be kept in mind; the ndings imply an association between the corporate governance board characteristics and earnings management and cannot be interpreted as demonstrating a causal link between board of directors and earnings management due to the endogeneity problem that plagues much of the board of directors literature. Nevertheless, the research ndings do imply that certain board characteristics may be important factors associated with constraining the propensity of managers to engage in earnings management and this emphasizes the need of policy
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setters for more effective corporate governance mechanisms that provide greater maintaining of nancial accounting processes to ensure integrity of nancial reporting. However, there is a need for further research to consider the time lag between discretionary accruals and earnings management, as positive or negative discretionary accruals reverse in the future, not necessarily in the following year, but most likely in two years ahead as managers cannot manage upward or downward indenitely, hence, an average of three years of analysis may produce different results. A second caveat must be kept in mind; the corporate governance variables, such as board composition, structure, and/or policies may change annually and averaging these variables over a period of three years may be very challenging.
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Board of directors governance challenges and earnings management

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Table I. Model variables

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Predicted sign None 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

Table III. High-negative logistics regression results: EARNMANhn model

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Predicted sign None 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

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Table V. High-positive discretionary accruals results: model EARNMANhp

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