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Quality
Does board governance improve of accounting
the quality of accounting earnings? earnings
Raghavan J. Iyengar and Judy Land
School of Business, North Carolina Central University, Durham, 49
North Carolina, USA, and
Ernest M. Zampelli
Department of Business and Economics,
The Catholic University of America, Washington, DC, USA

Abstract
Purpose – The purpose of this paper is to examine the contention that a strengthening of corporate
governance mechanisms would result in the improved relevance and reliability of financial statements.
Design/methodology/approach – Using pooled ordinary least squares regression, the paper
analyse the quality of reported earnings for a sample of firms over the 1998-2002 time period.
Findings – The findings show negative and statistically significant associations between reported
earnings quality and the proportion of CEO incentive pay and firm’s growth opportunities. It is also
found that earnings quality is positively and significantly related to the existence of an orderly CEO
transition process. However, board independence does not seem to be associated with earnings quality.
Research limitations/implications – Since the sample of firms is from the 1998 to 2002 period,
consistent with the paper’s motivation, the results may not generalize to the more recent time period.
Practical implications – The results provide support for the argument that the current structure of
executive pay does adversely impact the quality of reported earnings and hence provides a rationale
for closer scrutiny of executive pay by regulatory bodies. Additionally, the findings suggest that the
emphasis on board independence as an effective monitoring device may be misplaced.
Originality/value – Unlike prior studies, the paper’s hypotheses are derived from an explicit agency
theoretic optimization model of managerial decision making. The paper uses the Ball and Shivakumar
model for estimating abnormal accruals unlike previous analyses that relied more heavily on the Jones
model. The paper also adds to past studies of the relationship between corporate governance and
earnings quality and the role of executive compensation.
Keywords Earnings, Corporate governance, Accounting, Financial reporting
Paper type Research paper

1. Introduction
The high-profile corporate accounting scandals occurring earlier in this decade,
particularly Enron and WorldCom, precipitated intense debate regarding the
relationship between corporate governance practices and the integrity, reliability, and
credibility of corporate financial reporting. Moreover, they constituted the raison d’etre
for the Sarbanes-Oxley Act (SOX) of 2002 (hereafter referred to as SOX) which
mandated a number of changes in corporate governance practices aimed at

The authors gratefully acknowledge the helpful comments from Augustine Duru, Javad Kargar,
Accounting Research Journal
Robert Moffie, and Samuel Kotz, an anonymous referee and the editors Marion Hutchinson and Vol. 23 No. 1, 2010
Gavin Nicholson. Research assistance of Julius Bradshaw and Sarika Ramakrishnan is pp. 49-68
q Emerald Group Publishing Limited
appreciated. Raghavan Iyengar and Judy Land acknowledge summer research grant received 1030-9616
from North Carolina Central University. DOI 10.1108/10309611011060524
ARJ strengthening the oversight and monitoring capabilities of corporate boards of
23,1 directors, thereby, reducing the likelihood of future accounting scandals. For example,
the act mandated that audit committees be comprised entirely of independent directors
and that firms be restricted in their purchases of nonauditing services from their
auditors[1]. This study empirically tests these notions by using a sample of pre-2003
firms, the period on which these assumptions are based.
50 Prior academic research has provided mixed evidence on the relationship between
corporate governance practices and board characteristics and the integrity and
reliability of corporate financial reporting[2]. Beasley (1996), Dechow et al. (1996) and
more recently, Uzun et al. (2004) find that firms with boards comprised of more outside
and independent directors are less likely to commit corporate fraud but find no
significant effects for board size, frequency of board meetings, or frequency of audit
committee meetings. Agrawal and Chadha (2005) analyse the relationship between
governance characteristics and the probability of serious accounting problems, as
gauged by earnings restatements, and find no significant impact of board independence
nor audit committee independence on the probability of restatement. Boards and audit
committees with independent directors possessing financial expertise, however, are
found to significantly lower the probability of restatements. Abbott et al. (2004) finds
that all-independent audit committees, audit committees with members having
financial expertise, and the frequency of audit committee meetings have significant
negative effects on the likelihood of financial restatements. Their results also indicate
that firms with larger boards are more likely to restate earnings.
A number of studies have examined the relationship between corporate governance
and earnings quality (management), as measured by abnormal (discretionary) accruals.
Chtourou et al. (2001) provides evidence that earnings management is less likely in
firms with audit committees having higher percentages of independent non-executive
directors who are not managers in other firms, audit committees with at least one
member with financial expertise, and audit committees comprised of only independent
directors that meet at least twice per year. The authors also find that larger boards are
associated with less earnings management. Klein (2002) reports statistically significant
negative relationships between both board and audit committee independence and
abnormal accruals but no significant relationship between all-independent audit
committees and abnormal accruals. Consistent with these results, Xie et al. (2003) report
that earnings management is less likely to occur in companies with boards that include
both independent outside directors and directors with corporate experience, boards that
are larger, audit committees that are comprised of corporate members and investment
bankers, and audit committees that meet more often. Davidson et al. (2005) also find a
statistically significant negative linkage between board independence and discre-
tionary accruals, but little else. Results from Peasnell et al. (2005) indicate a statistically
significant negative relationship between income-increasing abnormal accruals and the
proportion of outsiders on the board of directors but offer little evidence of linkages
between audit committee characteristics and abnormal accruals.
It seems that the literature has reached consensus on one general issue – corporate
governance and board of director characteristics have implications for the quality of
financial reporting. It remains unclear, however, exactly which governance mechanisms
and board characteristics influence financial reporting quality and exactly why they do
so. This provides the fundamental motivation for this study in which we too focus on the
relationship between governance and earnings quality as measured by discretionary Quality
accruals. The paper’s contribution is threefold. First, unlike prior studies, our hypotheses of accounting
are derived from an explicit, albeit simple, and agency theoretic optimization model of
managerial decision making. The comparative statics provide the direct links between earnings
the theoretical model and independent variables employed in its econometric counterpart.
Second, previous analyses have relied largely on the modified Jones (1991)[3] model to
estimate abnormal (discretionary) accruals. Ball and Shivakumar (2006), however, 51
demonstrated that such linear accruals models “by omitting the loss recognition asymmetry,
exhibit substantial attenuation bias and offer a comparatively poor specification of the
accounting accrual process (Ball and Shivakumar (2006, p. 207).” They go on to show that:
[. . .] that nonlinear accruals models incorporating the asymmetry in gain and loss recognition
(timelier loss recognition, or conditional conservatism) offer a substantial specification
improvement, explaining substantially more variation in accruals than equivalent linear
specifications.
Consequently, in this study, we have chosen to use abnormal accruals estimated from
the models developed by Ball and Shivakumar (2006). Third, this paper adds to past
studies of the relationship between corporate governance and earnings quality as
proxied by abnormal (discretionary) accruals and the role of executive compensation
(Bergstresser and Philippon, 2006; Meek et al., 2007). Executive bonuses, stock options,
etc. are regularly indicted as major reasons for the use of overly aggressive and zealous
accounting practices and past studies using alternative proxies for earnings quality
have incorporated some version of CEO compensation into their models. For these
reasons together with our analytical results, CEO incentive pay is afforded an
important role in the discretionary accruals process.
The paper’s major findings include:
.
a significant negative association between earnings quality and managers’
incentive pay;
.
a significant negative association between earnings quality and a firm’s growth
prospects; and
.
a significant positive association between earnings quality and the existence of
an orderly succession policy.

We find no statistical evidence of a significant association between earnings quality

and board and audit committee independence. The main results remain unchanged for
a battery of robustness tests.
The remainder of the paper is structured as follows. Section 2 presents the agency
theoretic optimization model, the relevant comparative statics, and the hypotheses to
be tested. The abnormal accruals measures used as proxies for earnings quality along
with the explanatory variables of the econometric model are discussed in Section 3.
The sample, its selection, and the descriptive statistics for all major variables are
discussed in Section 4. Section 5 presents the empirical results and discusses their
implications. Summary and concluding remarks are offered in Section 6.

2. A simple model of managerial decision making

Our theoretical model is a simplified version and an extension of the model developed by
Feltham and Xie (1994). We assume a risk averse manager (the agent) who expends
ARJ effort in performing two activities, Activities 1 and 2. Shareholders (the principal) do not
23,1 observe the manager’s effort levels, e1 and e2, respectively, and thus face an incentive
problem that is addressed by an incentive compensation contract. Since e1 and e2 are
unobservable, the compensation contract is based on a reported performance measure, y.
The first activity is productive as it is aimed entirely at improving y for the sake of
increasing the shareholders’ payoff. The second activity is “window dressing” aimed
52 only at increasing the measure of performance to the benefit of the manager with no
additional benefit to shareholders. The relationship between y and the activity levels is
assumed to be linear and given by:
y ¼ m1 e1 þ m2 e2 þ 1 ð1Þ
2


where mi is the marginal productivity of ei and 1~ N 0; s 1 represents the stochastic
component of the performance measure. The manager’s wage, w, is assumed to be a
linear function of y represented by:
w ¼ w0 þ n y ¼ w0 þ n ðm1 e1 þ m2 e2 þ 1Þ ð2Þ
where w0 is a fixed payment and n is the pay-performance sensitivity. The direct cost to
the agent of exerting effort is assumed to be quadratic and given by:
1 1
Cðe1 ; e2 Þ ¼ e21 þ e22 ð3Þ
2 2
The manager assumes, however, that a penalty will likely be imposed by the principal if
the “window dressing” activity is discovered. The penalty is assumed to be proportional
to m2 e2 and equal to tm2 e2 where 0 , t , 1. The manager estimates a non-zero
probability of detection at 0 , r , 1. Augmenting equation (3) by the expected penalty,
we have:
1 1
Cðe1 ; e2 Þ ¼ e21 þ e22 þ rtm2 e2 ð4Þ
2 2
The manager is assumed to choose e1 and e2 to maximize the objective function
w 2 Cðe1 ; e2 Þ. The solutions to the first order conditions are easily shown to be:

e*1 ¼ nm1 e*2 ¼ ðn 2 rtÞm2 ð5Þ

From equation (5), we see that the comparative statics for e*2 are sensible. In particular, the
optimal
  level
 of window
 dressing effort is increasing in the pay-performance
 sensitivity

*
›e2 =›n . 0 , and with the marginal productivity of effort *
›e2 =›m2 . 0 , for
ðn 2 rtÞ . 0; and declining in the probability of detection and in the penalty proportion:

›e*2 ›e*2
, 0 and , 0:
›r ›t
Simply stated, the comparative statics suggest that increases in the sensitivity of
managerial compensation to firm performance will engender more effort to
opportunistically manipulate firm performance measures as will a bigger marginal payoff
from such manipulation. In contrast, closer and more effective monitoring of managerial
actions and/or a higher penalty for managerial misconduct will reduce such effort.
2.1 Hypotheses development Quality
Based on the above theoretical model of managerial decision making, we focus on four of accounting
specific issues that may be associated with the quality of reported corporate earnings.
Incentive pay. Extant academic literature seems to suggest that as the proportion of earnings
managers’ at-risk pay to total pay increases, managers have an incentive to manipulate
their firms’ reported earnings. Bergstresser and Philippon (2006) document that if
CEO’s potential total compensation is more closely tied to the value of stock and option 53
holdings they have a greater incentive to use of discretionary accruals to manage
reported earnings. Sloan (1996) and Collins and Hribar (2000) have shown that
managers manipulate reported earnings to affect stock prices thereby increasing their
wealth through the use of stock options or other forms of incentive compensation. More
recently, Cheng and Warfield (2005) found that managers with substantial equity
incentives in the form of stock compensation and ownership are motivated to manage
earnings in order to sell shares in the future. Ke (2005) argues that CEOs with high
incentives are more likely to manage earnings to produce a string of consecutive
earnings increases. Two recent studies (Cornett et al., 2008; Meek et al., 2007) document
a positive association between equity incentives and discretionary accruals. It seems
then that the preponderance of evidence suggests that as managers’ wealth becomes
more sensitive to stock prices and earnings, managers are more inclined to manipulate
earnings thereby reducing the quality of reported earnings. In terms of our model
above, as pay-performance sensitivity
 increases
 the effort expended on window
dressing would also increase ›e*2 =›n . 0 . Consequently, we posit that as the
proportion of incentive pay increases, managers may be more inclined to manipulate
the performance through abnormal accruals thus diluting the quality of earnings.
We predict a negative association between the incentive pay and earnings quality:
H1. There is a negative relation between the proportion of incentive pay-to-total
pay and earnings quality.
Growth. Lee et al. (2006) demonstrate that higher growth firms are more likely to
manage earnings. Abarbanell and Lehavy (2003) document that firms with higher
growth opportunities have stronger incentives to meet or beat analysts’ forecast of
earnings. Additionally, there is considerable evidence from prior research including
Clinch (1991), Gaver and Gaver (1993), Anderson et al. (2000) and Ittner et al. (2002),
that CEO incentive pay is higher in firms with more growth opportunities and that
firms with higher growth opportunities are also likely to have strong incentives to meet
earnings targets, Skinner and Sloan (2002). Since higher growth firms may offer a
bigger marginal payoff to managers from earnings manipulation, managers may be
more
  likely to expend
 greater effort to opportunistically manipulate firm performance
›e*2 =›m2 . 0 . This leads to the following hypothesis:
H2. There is a negative relation between the firm’s growth prospects and earnings
quality.
Board independence. Board members are deemed to be independent if they are not
employees of the company or its auditors and do not have any material relationship
with the company[4]. Prior research finds that board independence is linked to both the
quality of financial information and executive actions (Dechow et al., 1996; Klein, 2002).
ARJ Since financial statements are reviewed by the board of directors before its release,
23,1 we explore whether stronger monitoring of managerial actions and/or a higher penalty
for managerial misconduct will curb managerial effort to window-dress. Since our
theoretical model suggests that the optimal level of window-dressing effort declines
with the probability of detection and the penalty proportion:
›e*2 ›e*2
54 , 0 and , 0;
›r ›t
we posit the following hypothesis:
H3. There is a positive relation between board independence and earnings quality.
Orderly succession. The success of a firm depends not only on the current management
team but also on its management transition plans and procedures. The sudden death or
departure of a CEO in the absence of adequate replacement and transition plans can
substantially undermine stockholder confidence as well as the financial viability of an
otherwise profitable company. In contrast, a written and orderly succession policy for
managers creates an image of firm stability and instills confidence in the firm’s
management. The presence of orderly transition by design implies the existence of
appropriate retirement policies. We envisage that firms with orderly transition
processes are also likely to have in place good internal controls for financial record
keeping. Kanagaretnam et al. (2007) find that the quality of corporate governance,
which includes a variable for retirement policy, is significantly negatively related to
information asymmetry around earnings announcements. In terms of our theoretical
model an orderly transition would imply effective monitoring of managers by the
board of directors. This suggests that earnings quality should be higher in firms where
there is a managerial retirement policy in place:
H4. There is a positive relationship between the existence of a managerial
retirement policy and earnings quality.

3. Model for earnings quality, theoretical background, and hypotheses

3.1 Earnings quality
To examine the influence of incentive pay, growth, board independence, and retirement
policy have any influence on earnings quality, we incorporate two alternate definitions of
earnings quality. Schipper and Vincent (2003) summarize much of the literature on
earnings quality. Since there are various ways to capture the levels of earnings
management for firms in our sample, we include several proxies for the level of accounting
quality. In this study, we use abnormal accruals measures to determine the level of
earnings management. We multiply the absolute value of accruals by negative one so that
smaller values, values closer to zero represent higher quality of earnings and larger
accruals (values further away from zero) are indicative of a lower quality of earnings. The
two proxies are based on abnormal accruals model for earnings management introduced
by Ball and Shivakumar (2006; henceforth B&S). We estimate abnormal accruals using
the following models: the model by B&S (MODQ1), and a modified B&S (MODQ2) model.
The alternate measures of earnings quality are defined as[5]:
MODQ1 ¼ the absolute value of the residuals obtained from the following equation
(B&S, 2006) multiplied by 2 1:
TA it DREVit GPPEit CFit CFit Quality
¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit þ a5 *DCFit * þ 1it
Ait21 Ait21 Ait21 Ait21 Ait21 of accounting
ð6Þ earnings
where TAit is total accruals for firm i in year t, DREVit is the change in firm i’s total
revenue from t 2 1 to t, GPPEit is the gross acquisition cost of property, plant, and
equipment for firm i in year t, Ait2 1 is the value of average total assets for firm i in year 55
t 2 1, CFit is the level of cash flow for firm i and DCFit is a dummy variable that is
equal to 1 if CFit is negative and 0 otherwise:
MODQ2 ¼ the absolute value of the residuals obtained from the following modified
equation (Dechow et al., 1995; B&S, 2006) multiplied by 2 1.
 
TAit DREVit 2 DRECit GPPEit CFit
¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit
Ait21 Ait21 Ait21 Ait21
ð7Þ
CFit
þ a5 * DCFit * þ 1it
Ait21
For both of the measures, the absolute value of the residuals is multiplied by minus one
so that smaller (larger) values of abnormal or discretionary accruals indicate higher
(lower) earnings quality.
It should be noted that the original model advanced by Jones (1991) as well as B&S
did not contain an intercept term, since the intercept was also deflated by lagged
assets. But, it is by no means clear that total accruals would be zero if all independent
variables are zero. Peasnell et al. (2000) use a modified Jones model with an intercept
and explain that the intercept is not deflated because:
First, there is no theoretical reason for forcing the regression through the origin [. . .]. Second,
regressions estimated with the constant suppressed preclude an analysis of the goodness-of-fit
of the models because the associated R-square values are unreliable [. . .]” (p. 316, fn. 12).
In accordance with these arguments, we follow Peasnell et al. (2000) and include an
intercept in each of the two accrual models.

3.2 An econometric model of earnings quality

To test the association between incentive pay, growth, board independence, and
retirement policy on one hand and earnings quality on the other, we use the following
regression model (after controlling for other factors identified by current literature):
MODQ ¼ a0 þ a1 INCPAY þ a2 MKBK þ a3 PCTINDBD þ a4 RETPLY
þ a5 BDSIZE þ a6 MEETINGS þ a7 DUAL þ a8 MKVAL ð8Þ
þ a9 FIN þ a10 OWN þ a11 LOCK þ 1
where:

MODQ ¼ one of the two alternate measures of earnings quality (MODQ1,

MODQ2), defined earlier.
INCPAY ¼ the percentage of CEO incentive pay to total pay, where incentive
pay is defined as “bonus” and total pay is salary plus bonus plus
ARJ other annual plus other restricted stock grants plus long-term
23,1 incentive payouts plus value of stock options granted plus all other.
Total pay is TDC1 in ExecuComp parlance.
MKBK ¼ market-to-book ratio of common equity[6].
PCTINDBD ¼ the percentage of board members who are independent.
56 RETPLY ¼ a dummy variable equal to one if the firm has a retirement policy
and zero otherwise.
BDSIZE ¼ the total number of members on the corporate board.
MEETINGS ¼ the number of board meetings held in a year.
DUAL ¼ a dummy variable equal to one if the firm’s CEO is also the chair of
the board, and equal to zero otherwise.
MKVAL ¼ the natural logarithm of the firm’s market value at the end of the
year.
FIN ¼ a dummy variable equal to one if a member of the board has other
financial relationships in the firm and zero otherwise.
OWN ¼ stocks held by directors as a percentage of firm’s outstanding
equity.
LOCK ¼ dummy variable equal to one if any of the following hold:
.
the CEO serves on the board committee that makes his compensation decisions;
or
.
the CEO serves on the board (and possibly compensation committee) of another
company that has an executive officer serving on the compensation committee of
the CEO’s company, or the CEO serves on the compensation committee of another
company that has an executive officer serving on the board (and possibly
compensation committee) of the CEO’s company.

3.3 Control variables

We include most of the governance variables that are available in the Investor
Responsibility Research Center (IRRC) database as control variables. The estimating
equation includes other control variables such as BDSIZE (the total number of
members on the corporate board), MEETINGS (the number of board meetings held in
one year), DUAL (dummy variable equal to one if the firm’s CEO is also the chair of the
board, and equal to zero otherwise), MKVAL (firm size as measured by the natural log
of the firm’s market value at the end of the year), FIN (board members having other
financial stake in the business), OWN (percentage of stock owned by directors), and
LOCK (executives interlocking relationship).
Board size (BDSIZE). Yermack (1996) demonstrates that smaller boards are effective
in improving firm performance and Vafeas (2000) finds that smaller boards (with a
minimum of five board members) result in higher earnings response coefficients when
analysing the informativeness of earnings. Beasley (1996) finds board size to be
positively related to financial statement fraud. However, others like Xie et al. (2003) and
Klein (2002) argue that larger boards are better able to effectively monitor a firm because Quality
of the greater likelihood of independent directors with corporate or financial expertise of accounting
and experience. Xie et al. (2003) also finds that larger boards are associated with lower
discretionary accruals. Thus, far, board size has often been identified as a significant earnings
determinant of earnings management/quality but the direction of its impact remains
unresolved.
Number of board meetings (MEETINGS). Vafeas (1999) questions the importance of 57
board activity, and conjectures that boards are more active in the presence of problems,
implying that increased board meetings are a response to poor firm performance rather
than an indicator of pro-active behavior. Consistent with the argument in Vafeas (1999)
and Chtourou et al. (2001) find higher levels of earnings management in firms with
larger number of board meetings. In contrast, other studies including Xie et al. (2003)
and Bowen et al. (2008) find that when boards meet more often earnings management is
lower. The number of board meetings has been shown to be significantly associated
with earnings management/quality, although the direction is uncertain.
CEO duality (DUAL). Poor corporate governance has commonly been linked to CEO
duality, where the firm’s CEO also serving as the chair of its board of directors.
According to Fama and Jensen (1983) and Jensen (1993), CEO duality violates the rubric
of the separation of decision control and decision management, thus impeding a board’s
ability to monitor the CEO effectively. In contrast, Stoeberl and Sherony (1985) and
Anderson and Anthony (1986) argue that a dual structure creates greater stability and
fosters better communication while Brickley et al. (1997) asserts that a non-dual structure
results in higher information, agency, and incentive costs. A recent study by Iyengar and
Zampelli (2009) examines the issue of duality and firm performance from an endogenous
theory of governance. They conclude that firm’s selection of the dual governance
structure is not consistent with either comparative advantage or the objective of
maximizing firm performance. The literature on duality has not yet provided compelling
evidence one way or the other, but we include it as a control variable in our analysis.
Firm size (MKVAL). Large firms are closely monitored by the firm and its various
stakeholders, and as firm size increases there is much greater media and public scrutiny.
It has been found that information provided by large firms is impounded in stock prices
in greater proportion than for small firms prior to earnings announcements (Atiase,
1985), and that the larger the firm, the higher the analyst following (Dempsey, 1989).
A recent article by Christensen et al. (2004) find that there is a positive relationship
between firm size and the information content of earnings announcements. We therefore
posit a positive effect of firm size on earnings quality.
Otherfin (FIN). The “FIN” variable is a dummy variable that captures the extent to
which an outside director has a family, business, and/or financial relationship with the
company. Since this variable may reduce the ability of a board member to be independent,
we predict that the existence of this relationship will reduce the effectiveness of the board
and will be associated with reduced earnings quality.
Ownership (OWN). Any analysis of board governance cannot ignore the role of
managerial equity ownership. As directors of a firm hold higher percentages of a firm’s
outstanding equity, they are more likely to have interests that are aligned with the
shareholders and more likely to effectively monitor the firm (Jensen and Meckling, 1976).
Consequently, we predict a positive relationship between director ownership and the
ARJ quality of reported earnings. The variable “OWN” measures the percentage of stock held
23,1 by directors of the firm as a fraction of the firm’s outstanding equity.
Interlock (LOCK). The LOCK variable measures the extent to which a CEO has
influence over his own compensation, either by serving the board committee which
makes decisions effecting compensation or having a relationship with an individual
serving the committee making compensation decisions. Since this variable reduces the
58 level of independence that the board has on any decisions relating to compensation, we
predict that this will have a negative relationship with earnings quality.

4. Research design
4.1 Sample selection
To compile the sample of firms, we began with the population of firms in the IRRC
database for the period 1998-2002. We restricted the sample to pre-SOX by limiting the
data from 1998 to 2002. Proponents of SOX believed that certain board characteristics
(for instance, board independence) were crucial to preventing accounting practices that
diminish the integrity of financial reporting. Since we wish to examine if the priors are
supported by empirical evidence we exclude 2003 or later data. This initial sample
consisted of 4,819 firm-year observations. From this population, we deleted
623 observations with insufficient governance data in the IRRC database. From this, we
dropped 162 and 152 observations for lack of financial data and compensation data in the
Compustat and ExecuComp databases, respectively. We then proceeded to delete
198 observations because there were insufficient observations to compute the firm-specific
residuals and consequently, the accounting quality measures (minimum eight year data
required for each firm) in Compustat database. We then winsorize the data by discarding
the extreme outliers (observations in the top and bottom 0.5 percent of each of the
variables). This process eliminated another 133 observations. Table I provides details of
how the selection criteria resulted in a final sample of 3,551 firm-year observations.

4.2 Descriptive statistics

Table II presents the distribution of our sample by industry and mean values of main
variables in our study. The industry distribution of our sample is similar to prior
studies using comparable sample evidence (Frankel et al., 2002; Whisenant et al., 2003).
Industry membership is defined by the four digit SIC code, and our sample includes

Number of firm-years

Number of non-financial, non-utility, firm year observations from IRRC

database for the sample period 4,819
Less: firm-years
(1) with insufficient data in IRRC for all the governance variables (623)
(2) with insufficient financial data in Compustat database (162)
(3) with insufficient executive compensation data in ExeCucomp database (152)
(4) with insufficient observations to obtain firm-specific residuals and
consequently the accounting quality measures (minimum eight
observations required for each firm to run firm-specific regression) (198)
Table I. (5) with extreme outliers (observations in the top and bottom 0.5 percent of
Selection of sample of each of the variables) (133)
firm-years 1998-2002 Number of firm-year observations in the final sample 3,551
 No. INCPAY MKBK PCTINDBD BDSIZE MEETINGS DUAL MKVAL RETPLY FIN OWN LOCK MODQ1 MODQ2

Mining/construct 73 0.77 1.94 64.67 10.34 7.29 0.70 7.01 0.42 0.16 1.51 0 20.0586 20.0565
Food 123 0.75 7.16 60.08 10.90 6.54 0.75 8.36 0.32 0.46 6.77 0.008 20.0371 20.0384
Textiles/printing 335 0.63 3.39 63.26 9.76 6.35 0.70 7.01 0.32 0.32 3.99 0.003 20.0355 20.0353
Chemicals 165 0.73 4.17 70.74 10.23 7.55 0.77 7.63 0.41 0.16 2.35 0 20.0298 20.0300
Pharmaceuticals 151 0.78 6.57 62.38 9.28 7.65 0.68 8.34 0.23 0.25 2.90 0 20.0690 20.0639
Extractive 171 0.76 2.07 62.59 9.37 6.86 0.68 7.56 0.19 0.28 1.60 0.006 20.0360 20.0373
Durables 1,024 0.67 3.12 66.86 9.06 6.76 0.64 7.05 0.23 0.22 3.34 0.003 20.0492 20.0487
Computers 555 0.76 4.42 62.65 7.46 7.56 0.61 7.58 0.10 0.24 4.04 0 20.0790 20.0766
Retail 473 0.66 2.81 60.51 9.51 6.28 0.63 7.29 0.19 0.29 4.65 0.002 20.0344 20.0340
Services 274 0.65 4.17 59.30 8.68 6.61 0.66 7.05 0.12 0.32 7.66 0 20.0409 20.0408
Transportation 184 0.69 2.50 57.84 10.02 6.59 0.76 7.67 0.24 0.40 7.45 0 20.0296 20.0294
Other 23 0.74 4.15 69.18 11.22 8.91 0.83 8.63 0 0.26 3.53 0 20.0351 20.0353
Overall 3,551 0.70 3.62 63.48 9.14 6.87 0.66 7.35 0.22 0.27 4.17 0.002 20.0479 20.0472
Notes: Industry membership is determined by SIC code as follows: mining and construction (1000-1999, excluding 1300-1399), food (2000-2111), textiles and
printing/publishing (2200-2799), chemicals (2800-2824, 2840-2899), pharmaceuticals (2830-2836), extractive (2900-2999, 1300-1399), durable manufacturers (3000-
3999, excluding 3570-3579 and 3670-3679), computers (7370-7379, 3570-3579, 3670-3679), transportation (4000-4799), retail (5000-5999), services (7000-8999),
excluding 7370-7379), and others (000-0999, 9000-9999). Financial services (6000-6999) firms and utilities (4900-4999) are excluded from the sample. This
classification is followed in the prior accounting literature
Source: Whisenant et al. (2003)
earnings
of accounting
Quality

explanatory variables
industries and mean
(1998-2002) across
Distribution of firm-years

values of main
59

Table II.
ARJ a variety of industries. In addition, our sample does include a higher percentage of
23,1 firms from the “Durables” industry, and we address this issue in the sensitivity
analysis section of the paper.
Table II reports the means of all variables. In general, the mean values are similar
across models and industries. On average, firms in the computer industry are associated
with the lowest quality of earnings for both models, while the highest levels of earnings
60 quality are reported by chemicals and transportation industries. On average, companies
in the food industry are the largest in terms of market value, exhibit the highest growth
(MKBK) and are managed by the largest corporate boards. Firms in the pharmaceutical
industry have the largest percentage of incentive pay, are second highest in growth
opportunities, and have the largest number of board meetings. Firms in the mining/
construction industry also appear to have large percentage of incentive pay and are
likely to have a dual CEO structure and a managerial retirement policy. At the opposite
end of the spectrum are firms in computer industry, which have the smallest board, are
least likely to have a dual CEO structure, and also less likely to have a managerial
retirement policy in place.
The correlations of the main variables are reported in Table III. The Pearson
correlation coefficients provide some evidence of the direction of the results. Consistent
with predictions, both of the earnings quality measures, MODQ1 and MODQ2, are
significantly correlated with firm growth, MKBK, at the 5 percent level. The earnings
quality measures are also significantly positively correlated with RETPLY and BDSIZE.
Earnings quality is negatively correlated with INCPAY, although the correlation is
insignificant. Other variables that are significantly correlated to earnings quality are
MKVAL, and MEETINGS. One of the earnings quality measures, MODQ1, is positively
correlated with PCTINDBD and DUAL, but only moderately so, at the 10 percent
significance level.

5. Results
5.1 Main results
Table IV presents the results of the pooled OLS estimation of equations (1) and (2) with
MODQ1 and MODQ2 as respective dependent variables. Panel A reports the results for
the entire sample. It is obvious from Table II that a substantial portion of our sample is
from one industry, namely “Durables”. Thus, the clustering effect of durables industry
cannot be ignored. To rectify this situation, we deleted all observations from this
industry and re-ran the model, the results of which are reported in Panel B of Table IV.
Parameter estimates are given along with the corresponding p-values. Standard
significance levels of one and 5 percent are used for the statistical inference. In both
specifications, the coefficients on INCPAY, the measure of incentive pay, are negative
and significant at the 1 percent level, consistent with our H1 that manager at-risk pay is
negatively related to earnings quality. The coefficients on MKBK are also negative and
statistically significant (at the 5 percent level), indicating that firms’ growth
opportunities are negatively related to earnings quality, consistent with hypothesis H2.
Tests of hypothesis H3 show that the coefficient on PCTINDBD is positive as
expected but not significantly different from zero in either specification. The results
provide no evidence of an association between board independence and earnings quality,
hence hypothesis H3 is rejected. The estimated coefficient on retirement policy,
RETPLY is consistently positive and significant across the alternate specifications,
 MODQ1 MODQ2 INCPAY MKBK PCTINDBD BDSIZE MEETINGS DUAL MKVAL RETPLY FIN OWN LOCK

MODQ1 1.000
MODQ2 0.996 (0.000) 1.000
INCPAY 20.170 (0.310) 20.018 (0.282) 1.000
MKBK 20.316 (0.059) 20.033 (0.047) 0.150 (0.000) 1.000
PCTINDBD 0.030 (0.071) 0.028 (0.101) 0.180 (0.000) 0.044 (0.009) 1.000
BDSIZE 0.115 (0.000) 0.109 (0.000) 0.175 (0.000) 0.073 (0.000) 0.098 (0.000) 1.000
MEETINGS 20.097 (0.000) 20.095 (0.000) 0.075 (0.000) 0.009 (0.590) 0.113 (0.000) 0.083 (0.000) 1.000
DUAL 0.0277 (0.098) 0.025 (0.140) 0.065 (0.000) 0.017 (0.299) 0.138 (0.000) 0.064 (0.000) 20.030 (0.070) 1.000
MKVAL 0.052 (0.002) 0.047 (0.005) 0.451 (0.000) 0.339 (0.000) 0.109 (0.000) 0.434 (0.000) 0.099 (0.000) 0.146 (0.000) 1.000
RETPLY 0.066 (0.000) 0.062 (0.000) 0.174 (0.000) 0.069 (0.000) 0.284 (0.000) 0.268 (0.000) 0.110 (0.000) 0.132 (0.000) 0.264 (0.000) 1.000
FIN 20.025 (0.134) 20.025 (0.140) 20.008 (0.605) 20.227 (0.177) 20.333 (0.000) 0.094 (0.000) 0.002 (0.896) 2 0.024 (0.149) 0.013 (0.451) 2 0.094 (0.000) 1.000
OWN 20.005 (0.747) 20.005 (0.747) 20.213 (0.000) 20.039 (0.019) 20.242 (0.000) 20.138 (0.000) 20.128 (0.000) 0.128 (0.000) 20.139 (0.000) 2 0.153 (0.000) 0.040 (0.017) 1.000
LOCK 0.003 (0.852) 0.003 (0.870) 0.006 (0.725) 20.007 (0.660) 20.007 (0.661) 0.000 (0.996) 0.002 (0.907) 0.005 (0.782) 0.000 (0.993) 2 0.008 (0.630) 20.013 (0.454) 20.015 (0.358) 1.000

Notes: Variable definitions: INCPAY is the percentage of bonus to total CEO compensation including stock options granted. MKBK is market-to-book ratio of common equity. PCTINDBD is the percentage of board
members who are independent. BDSIZE is the total number of members on the corporate board. MEETINGS is the number of board meetings held in a year. DUAL is a dummy variable equal to one if the firm’s CEO is
also the chair of the board, and equal to zero otherwise. MKVAL is the natural logarithm of the firm’s market value at the end of the year. RETPLY is a dummy variable equal to one if the firm has a retirement policy and
zero otherwise. FIN is a dummy variable equal to one if a member of the board has other financial relationships and zero otherwise. OWN is stocks held by directors as a percentage of firm’s outstanding equity and zero
otherwise. LOCK is a dummy variable equal to one if any of the following hold: (a) the CEO serves on the board committee that makes his compensation decisions or (b) the CEO serves on the board (and possibly
compensation committee) of another company that has an executive officer serving on the compensation committee of the CEO’s company, or the CEO serves on the compensation committee of another company that has
an executive officer serving on the board (and possibly compensation committee) of the CEO’s company; p-values in parentheses

correlation coefficients
earnings
of accounting
Quality

Correlation table: Pearson

Table III.
61
ARJ
Panel A (full sample) Panel B (durable industry exluded)
23,1 MODQ1 MODQ2 MODQ1 MODQ2
Dependent
variable Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

Intercept 2 0.0663 * * 0.000 2 0.0626 * * 0.000 2 0.0685 * * 0.000 2 0.0638 * * 0.000

INCPAY 2 0.0181 * * 0.010 2 0.0173 * 0.012 2 0.0185 * 0.025 2 0.0174 * 0.031
62 MKBK 2 0.0007 * 0.014 2 0.0007 * 0.019 2 0.0009 * * 0.000 2 0.0009 * * 0.000
PCTINDBD 0.0001 0.261 0.0001 0.326 0.0001 0.306 0.0001 0.362
RETPLY 0.0091 * * 0.004 0.0086 * * 0.006 0.0079 * * 0.002 0.0077 * * 0.002
BDSIZE 0.0037 * * 0.000 0.0035 * * 0.000 0.0025 * * 0.000 0.0023 * * 0.000
MEETINGS 2 0.0034 * * 0.001 2 0.0033 * * 0.001 2 0.0031 * * 0.010 2 0.0030 * * 0.010
DUAL 0.0013 0.683 0.0010 0.751 0.0030 0.383 0.0025 0.464
MKVAL 0.0023 0.153 0.0021 0.193 0.0038 * * 0.005 0.0034 * * 0.010
FIN 2 0.0055 0.111 2 0.0054 0.117 2 0.0048 0.197 2 0.0047 0.213
OWN 2 0.0000 0.951 2 0.0000 0.900 2 0.0001 0.719 2 0.0001 0.720
LOCK 0.0066 0.521 0.0057 0.625 0.0044 0.748 0.0024 0.888
Sample size 3,551 3,551 2,527 2,527
F-value 8.19 * * 0.000 7.13 * * 0.000 6.57 * * 0.000 6.02 * * 0.000
Adjusted R 2 0.0320 0.0298 0.0411 0.0378
Notes: Significance at: *5 and * *1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 firm-year observations
Model:
MODQ ¼ a0 þ a1INCPAY þ a2MKBK þ a3PCTINDBD þ a4RETPLY þ a5BDSIZE
þ a6MEETINGS þ a7DUAL þ a8MKVAL þ a9FIN þ a10OWN þ a11LOCK þ 1
where
MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):

TAit DREVit GPPEit CFit CFit

¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit þ a5 * DCFit * þ 1it ð6Þ
Ait21 Ait21 Ait21 Ait21 Ait21
where TAit is total accruals for firm i in year t, DREVit is the change in i’s total revenue from t 2 1 to t, GPPEit is
the gross acquisition cost of property, plant, and equipment for firm i in year t, Ait2 1 is the value of average total
assets for firm i in year t 2 1, CFit is the level of cash flow for firm i in year t and DCFit is a dummy variable that
is equal to 1 if CFit is negative and 0 otherwise.
Table IV.
Results of pooled OLS MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modified
regression with earnings equation (Dechow et al., 1995; B&S, 2006):
quality (MODQ1 and  
MODQ2) as the TAit DREVit 2 DRECit GPPEit CFit CFit
¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit þ a5 * DCFit * þ 1it ð7Þ
dependent variable Ait21 Ait21 Ait21 Ait21 Ait21

supporting hypothesis H4. Other results are that the coefficient on BDSIZE is positive
and significant at the 1 percent level, an indication that the larger executive board is
better able to monitor the firm, consistent with findings in Xie et al. (2003). In addition, the
coefficient on MEETINGS is negative and significant at the 1 percent level, supporting
the argument that increased board meetings are related to increased earnings
management. This is consistent with findings of Vafeas (1999) and Chtourou et al. (2001).
The estimated coefficients DUAL, OWN, LOCK, and FIN are insignificant
suggesting that none of these variables are important in determining earnings quality.
The parameter estimate of MKVAL, a measure of firm size, is positive and significant
only when the durable industry is excluded from the analysis.
5.2 Robustness tests Quality
A number of alternative forms of the model were estimated to determine the robustness of accounting
of the paper’s overall results. For each alternative specification, the model was estimated
in accordance with the pooled least squares that generated Table IV. First, we expand the earnings
set of explanatory variables to include a dummy variable for the presence or absence of
staggered boards (STGBD) and a dummy variable for the presence or absence of
cumulative voting (CUMVTG) feature. Staggered boards are those where a fraction 63
(usually a third) of the board members get re-elected periodically (usually every third
year) as opposed to unitary boards where all board members are elected periodically.
There are two contradictory effects of staggered boards on earnings management. The
agency perspective view argues that entrenched managers are likely to divert
shareholder wealth to themselves (Faleye, 2007; Shleifer and Vishny, 1997), which in turn
increases the potential of earnings management. In contrast, executives in staggered
boards may be less inclined to manage earnings, since their own position within the firm
is somewhat more secure (Zhao and Chen, 2008). Hence, we do not predict, a priori, the
impact of STGBD on earnings quality. A firm with CUMVTG enables even relatively
small shareholders to have a say in the management of the firm. A firm without
CUMVTG is more likely to advance the interests of majority shareholders at the expense
of minority interests. The predicted impact of CUMVTG on earnings quality is a priori
positive. Table V, Panel A reports the results with the inclusion of STGBD and
CUMVTG. However, the inclusion of these variables did not affect the results of our
study. INCPAY and MKBK were negatively associated with earnings quality ( p-values
of 0.010 and 0.012) while independent board is not associated with earnings quality
( p-values of 0.389 and 0.458). Furthermore, the coefficients on RETPLY are positive and
significant with p-values close to zero for both specifications of earnings quality
(MODQ1 and MODQ2). The results are consistent with H1 that manager at-risk pay is
negatively related to earnings quality but do not provide us with any evidence of
association between board independence and earnings quality and hence do not support
our H3. The results suggest that there is a positive association between retirement policy
and earnings quality (H4) and a negative association between the MKBK and earnings
quality (H2).
Finally, we examine alternative specification of the board independence variable.
We define board independence by replacing PCTINDBD by the percentage of
independent board members of the audit committee (PCTINDAD). Table V, Panel B
presents the results with PCTNDBD replaced by PCTINDAD. Once again all of the
prior results hold with the estimated coefficients not significant for PCTINDAD
( p-values of 0.608 and 0.464); negative and significant for INCPAY ( p-values of 0.014
and 0.017); negative and significant for MKBK ( p-values of 0.015 and 0.020); and
positive and significant for RETPLY ( p-values of 0.002 and 0.003).
In sum, the sensitivity tests broadly support our conjecture that there is a negative
relation between the proportion of incentive pay-to-total pay and firm’s growth on the
one hand and earnings quality on the other. We also find a positive association
between retirement policy and earnings quality on the other. At the same time, we find
no association between board independence and earnings quality.
6. Summary and conclusion
The SOX was enacted in 2002 on the implicit assumption that strengthening corporate
governance mechanisms would result in improved relevance and reliability of financial
ARJ
MODQ1 MODQ2 MODQ1 MODQ2
23,1 Dependent
variable Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

Intercept 2 0.0698 * * 0.000 2 0.0685 * * 0.000 2 0.0587 * * 0.000 2 0.0544 * * 0.000

INCPAY 2 0.0180 * * 0.010 2 0.0172 * 0.012 2 0.0174 * 0.014 2 0.0166 * 0.017
MKBK 2 0.0007 * 0.014 2 0.0007 * 0.021 2 0.0007 * 0.015 2 0.0007 * * 0.020
64 PCTINDBD 0.0001 0.389 0.0001 0.458
PCTINDAD 2 0.0000 0.608 2 0.0000 0.464
RETPLY 0.0089 * * 0.005 0.0084 * * 0.008 0.0098 * * 0.002 0.0093 * * 0.003
BDSIZE 0.0035 * * 0.000 0.0033 * * 0.000 0.0037 * * 0.000 0.0035 * * 0.000
MEETINGS 2 0.0034 * * 0.001 2 0.0033 * * 0.001 2 0.0033 * * 0.001 2 0.0032 * * 0.001
DUAL 0.0025 0.740 0.0080 0.805 0.0018 0.571 0.0014 0.639
MKVAL 0.0025 0.132 0.0022 0.169 0.0022 0.169 0.0020 0.212
FIN 2 0.0053 0.122 2 0.0053 0.127 2 0.0068 0.039 2 0.0068 * 0.041
OWN 2 0.0000 0.961 2 0.0000 0.9799 2 0.0000 0.766 2 0.0000 0.726
LOCK 0.0079 0.450 0.0069 0.558 0.0056 0.602 0.0045 0.710
STGBD 0.0077 * * 0.010 0.0072 * 0.016
CUMVTG 0.0038 0.299 0.0033 0.359
Sample size 3,551 3,551 3,551 3,551
F-value 7.61 * * 0.000 6.63 * * 0.000 7.93 * * 0.000 6.93 * * 0.000
Adjusted R 2 0.0339 0.0314 0.0318 0.0297
Notes: Significance at: *5 and * *1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 firm-year observations
Model:
MODQ ¼ a0 þ a1INCPAY þ a2MKBK þ a3PCTINDBD þ a4RETPLY þ a5BDSIZE
Table V. þ a6MEETINGS þ a7DUAL þ a8MKVAL þ a9FIN þ a10OWN þ a11LOCK þ 1
Results of pooled OLS where
regression with earnings MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):
quality (MODQ1 and
MODQ2) as the TAit DREVit GPPEit CFit CFit
¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit þ a5 * DCFit * þ 1it ð6Þ
dependent variable Ait21 Ait21 Ait21 Ait21 Ait21
additional control
where TAit is total accruals for firm i in year t, DREVit is the change in i’s total revenue from t 2 1 to t, GPPEit
variables STGBD and is the gross acquisition cost of property, plant, and equipment for firm i in year t, Ait2 1 is the value of average
CUMVTG included and total assets for firm i in year t 2 1, CFit is the level of cash flow for firm i in year t and DCFit is a dummy
replaced PCTINDBD variable that is equal to 1 if CFit is negative and 0 otherwise.
(percentage of MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modified
independent board) by equation (Dechow et al., 1995; B&S, 2006):
PCTINDAD (percentage  
of independent audit TAit DREVit 2 DRECit GPPEit CFit CFit
¼ a0 þ a1 þ a2 þ a3 þ a4 DCFit þ a5 * DCFit * þ 1it ð7Þ
committee) Ait21 Ait21 Ait21 Ait21 Ait21

statements. This study investigates whether such an assumption is well-founded.

It documents how certain governance mechanisms and managers’ at-risk pay affect the
quality of reported earnings. In line with our predictions, we find that earnings quality is
higher for firms where managerial at-risk pay is low as a proportion of total pay and for
firms with lesser growth prospects. The existence of a smooth transition by way of an
established managerial retirement policy has a positive association with earnings
quality. Contrary to our expectations, we find no evidence of an association between
board independence and earnings quality. It is possible that our measure of board
independence may not be fully capturing independence, as it is also highly correlated
with other variables, and other variables might be considered for future research.
Our results provide support for the argument that the current structure of executive pay Quality
does adversely impact the quality of reported earnings and hence provides a rationale for of accounting
possible closer scrutiny by regulatory bodies. From a theoretical perspective, our
analysis suggests that more needs to be done on how compensation contracts can be earnings
structured so as to align interests of managers and shareholders while also reducing the
incentive for managing earnings. The focus, however, on board independence as critical
for effective monitoring seems to be misplaced. Future research could examine this issue 65
in greater detail.

Notes
1. See Romano (2005) for a more complete list of SOX governance initiatives.
2. For a rather extensive review of this literature, see Cohen et al. (2004).
3. This is a version of the Jones (1991) model that accounts for changes in revenues over and
above changes in receivables.
4. As per New York Stock Exchange rules “independence” requires that the director cannot
have been an employee for the past five years and cannot have been an employee of the
company’s auditor for the past five years. A director also cannot have an immediate family
member who has met any of these disqualifications.
5. The original Jones model, upon which the B&S model is based, does not contain an intercept
term, since the intercept was also deflated by lagged assets. It is by no means clear that total
accruals would be zero if the independent variables are also zero. We have therefore
corrected this, by including an intercept in each of the models.
6. Market-to-book is used as a proxy for the firm’s growth prospects in accounting and finance
literature (Gaver and Gaver, 1993).

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Corresponding author
Raghavan J. Iyengar can be contacted at: riyengar@nccu.edu

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