Journal of Accounting and Economics 33 (2002) 375–400

Audit committee, board of director characteristics, and earnings management$
April Klein*
Stern School of Business, New York University, New York, NY 10012-1118, USA Received 20 October 2000; received in revised form 2 February 2002

Abstract This study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process. r 2002 Elsevier Science B.V. All rights reserved.
JEL classification: K0; G3; M4 Keywords: Earnings management; Corporate governance; Audit committee; Board of directors

1. Introduction In December 1999, the NYSE and NASDAQ modified their requirements for audit committees. Under the new standards, firms must maintain audit committees with at least three directors, ‘‘all of whom have no relationship to the company that
I would like to acknowledge the helpful comments of S.P. Kothari (the editor), an anonymous referee, Eli Bartov, James Doona, Lee-Seok Hwang, Jayanthi Krishnan, Carol Marquardt and the participants at the Temple University and NYU workshops. The Ross Institute of the Stern School of Business provided financial support. *Corresponding author. Tel.: +1-212-998-0014; fax: +1-212-995-4004. E-mail address: aklein@stern.nyu.edu (A. Klein). 0165-4101/02/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 5 - 4 1 0 1 ( 0 2 ) 0 0 0 5 9 - 9
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A. Klein / Journal of Accounting and Economics 33 (2002) 375–400

may interfere with the exercise of their independence from management and the company’’ (NYSE Listing Guide, Section 303.01(B)(2)(a)). These new requirements respond to the SEC’s call for improving the effectiveness of corporate audit committees in overseeing the financial reporting process. One specific area of concern to the SEC is inappropriate ‘‘earnings management’’ by the firm defined as ‘‘the practice of distorting the true financial performance of the company’’.1 The common thread running through the SEC and stock exchange proposals is an implicit positive connection between earnings management and non-independent audit committees. Yet no study to date explicitly tests this assertion. The purpose of this paper is to undertake such a study. Using a sample of 692 publicly traded U.S. firm-years, I examine whether the magnitude of abnormal accruals (the proxy for earnings management) is related to audit committee independence. After controlling for other determinants of abnormal accruals and audit committee composition, I find the magnitude of abnormal accruals to be more pronounced for firms with audit committees comprised of less than a majority of independent directors. I also find a negative association between abnormal accruals and the percent of outside directors on the audit committee. However, and contrary to the SEC’s intent, no difference in abnormal accruals is found between firms with and without wholly independent committees. Given that the audit committee’s effectiveness is embedded within the larger corporate governess process, I also investigate whether abnormal accruals are related to other board characteristics. I find significantly negative associations between abnormal accruals and the percent of outside directors on the board, and for whether the board is comprised of less than a majority of outside directors. These results are harmonious to the audit committee findings given that the audit committee reports to the board and that its members come from the full board. I also examine whether changes in board or audit committee independence are accompanied by changes in the level of abnormal accruals. The results dovetail with the cross-sectional findings. Firms that change their boards and/or audit committees from majority-independent to minority-independent have significantly larger " increases in abnormal accruals vis-a-vis their counterparts. These findings support the hypothesis that earnings management is negatively related to independent boards and audit committees, but can also be a reflection of a period of increasing uncertainty. The uniqueness of this paper versus other papers relating board characteristics to earnings management is that while previous papers either examine firms committing egregious financial fraud (e.g., Dechow et al., 1996 and Beasley, 1996) or firms with incentives to overstate earnings (e.g., DeFond and Jiambalvo, 1994; Teoh et al., 1998a, b; Parker, 2000), I conduct my analyses on a sample of large, publicly traded U.S. firms which a priori have no systematic upwards or downwards earnings
See SEC Chairman Arthur Levitt’s Address to NYU Center for Law and Business on September 28, 1998, the SEC’s proposed rule 32-41987 published on October 8, 1999, and the final rule on audit committee disclosure dated January 10, 2000 for use and definition of earnings management by the SEC. All three can be found on www.sec.gov.
1

2. Bartov et al.S. U. This paper also contributes to the growing literature on measuring abnormal accruals. Section 6 contains cross-sectional analyses. Section 303. Section 9 concludes. my results lend support to the exchanges’ and SEC’s assertions that for all large U. Section 4 details the sample selection criteria and contains descriptive statistics of the data. However. This problem is exacerbated if the measurement error is correlated with the partitioning variable (e. NYSE and NASDAQ rules for audit committees Prior to December 1999.01(B)(2)(a). AMEX. Thus. foreign companies are excluded if their audit committee structure abides by the country’s rules. the SEC adopted new rules to improve disclosures related to the functioning of corporate audit committees. (2000) and Kothari et al. independent audit committees and boards are better able to monitor the earnings process.. they show that not controlling for reversals of prior years’ accruals or growth patterns in earnings results in measurement error in abnormal accruals. To be listed on the NYSE. listed companies were required or encouraged to maintain audit committees with a majority or all members being ‘‘independent’’ of management. no definition of independence was given. ‘‘all of whom have no relationship to the company that may interfere with the exercise of their independence from management and the company’’. Section 2 discusses the stock exchange rules for audit committee composition. In December 1999 the NYSE and NASDAQ modified their requirements by mandating listed companies to maintain audit committees with at least three directors. 34-42232 and 34-42233.2 Simultaneously. Kasznik (1999). Section 3 develops the hypotheses about the expected associations between corporate governance mechanisms and earnings management. Section 5 discusses the methodologies and econometric issues related to creating the adjusted abnormal accruals.3 Excluded from the audit committee are See NYSE Listing Guide.A. the stock exchanges and NASDAQ rules for audit committee composition were vague at best. firms must have at least $100 million of revenues. ‘‘Adopting Rules Regarding Disclosure by Audit Committees. audit committee or board independence).S. NASDAQ Market Listing Requirements Section 4310(c)(26)(B). (2001) demonstrate the importance of controlling for the firm’s earnings process when measuring abnormal accruals. See also SEC Release Numbers 34-42231. 3 See Release Number 34-42266. which can lead to erroneous inferences. The methods used throughout this paper address these issues and suggest the necessity of using a matched-portfolio (or firm) technique as advocated by these authors. Including Discussions with Auditors Regarding Financial Statements’’. The results in section 8 support the inferences made throughout the paper. Section 7 has the empirical results surrounding the associations between changes in board or audit committee composition and changes in adjusted abnormal accruals. 2 . Large. Specifically. Klein / Journal of Accounting and Economics 33 (2002) 375–400 377 management.g. traded companies. For the NYSE. For the NASDAQ. companies with revenues less than $25 million are excluded. ‘‘Adopting Changes to Listing Requirements for the NASD. and NYSE Regarding Audit Committees’’.

are not steadfast. 3. the NASDAQ excludes any director who accepts nondirector compensation from the firm in excess of $60.000 or whose employer receives at least $200. The maintained hypothesis throughout this paper is that an independent audit committee is best able to serve as an active overseer of the financial accounting process. I predict that audit committee independence will be negatively related to earnings management. or are immediate family members of an executive officer. in a negotiated final financial report. confirm that many reported earnings numbers are negotiated. If the board determines that the independence of the director is not compromised by the business relationship. Although much emphasis has been put on the audit committee’s role in preventing fraudulent accounting statements (i. They present evidence consistent with this assertion for a sample of firms experiencing auditor changes. audit process. Magee and Tseng (1990). Equivalently. Nelson et al. NASDAQ Rule 4310(c)(26)(B)(ii) allows the board under ‘‘limited circumstances’’ to appoint any non-current employee or family member to the audit committee. malfeasance of management or the outside auditor). Corporate governance mechanisms and monitoring the firm’s financial reporting process 3. former employees within the last 3 years.e. In addition. using survey data. then that director may serve on the board’s audit committee.000 in any of the past 3 years. NYSE Section 303. . more likely. It meets regularly with the firm’s outside auditors and internal financial managers to review the corporation’s financial statements. and Antle and Nalebuff (1991) argue that legitimate differences of opinion may exist between management and outside auditors in how to best apply GAAP. Overall.378 A.. (2000). Klein / Journal of Accounting and Economics 33 (2002) 375–400 directors who are current employees. The role of board audit committees in resolving conflicts between management and outside auditors The audit committee primary oversees the firm’s financial reporting process. DeFond and Subramanyam (1998) postulate that client litigation risk may result in auditors preferring more conservative accounting choices than management for clients they perceive to be more risky. prior research suggests that the audit committee’s role as arbiter between the two parties is to weigh and broker divergent views of both parties to produce ultimately a balanced. however. Antle and Nalebuff (1991) conclude that these differences result either in the auditor being dismissed or. more accurate report.01(B)(3)(b) gives the board broader discretion in appointing directors with business relationships to the firm. These rules. Dye (1991). its role is to reduce the magnitude of positive or negative abnormal accruals. firms may maintain audit committees that are not 100% independent. Thus. and internal accounting controls. have cross compensation committee links.1.

g. 1932. CEO shareholdings Warfield et al. and Nagar et al. If the CEO manages earnings to increase his overall compensation. relationship investing is often achieved by giving a large non-management shareholder or one of his representatives a seat on the board of directors. Weisbach. Thus.4. 1988). Sample selection Data about boards and board audit committees are hand-collected from SEC-filed proxy statements. 1992 and 1993 with annual shareholder meetings between July 1. Byrd and Hickman.. interventionist role in the firm’s economic processes. For large U. no a priori prediction is made. The initial sample contains all firm-years listed on the S&P 500 as of March 31. Board independence Several papers present evidence suggesting that effective governance and firm performance increase with board independence (for example. 4. In a similar vein. 1996).A. 3. (1995) find a negative relation between managerial stockholdings and the absolute value of abnormal accruals.. I predict a negative relation between earnings management and the incidence of at least one large (e. at least 5% shareholdings) outside director on the board’s audit committee. see Brickley et al.S. Relationship investing Relationship investing encompasses all situations in which a large blockholder takes an active. Morck et al. I test the assertion that a board’s relative independence from management is negatively related to earnings manipulation. Aboody and Kasznik (2000) and Yermack (1997) show that CEOs manage investors’ earnings expectations downward prior to scheduled stock option award to increase the value of their awards. Beasley. However. 1976). 1991 . companies. Healy (1985) presents evidence that CEOs manage earnings to maximize their bonuses. Others document a negative link between outside directors and the incidence of financial fraud (see Dechow et al. (1988). 3. (2000) present evidence that a firm’s discretionary disclosure of accounting data is related to the form of the CEO’s compensation.1.. 1992. 1996. Klein / Journal of Accounting and Economics 33 (2002) 375–400 379 3.3. Being on the boards’ audit committees gives these investors the opportunity to monitor the firm’s financial reporting process. 1994. Data description 4.2. and McConnell and Servaes (1990) find a positive relation between Tobin’s Q and inside director shareholdings. Jensen and Meckling. They interpret their results as being consistent with managerial shareholdings acting as a disciplining mechanism (Berle and Means. then there will be a positive relation between CEO shareholdings and earnings management.

Compustat provides the earnings.000. First.380 A. One hundred and eighty firm-years are eliminated due to insufficient Compustat or CRSP data. and other financial data needed to construct the abnormal accruals. consulting fees and other joint ventures. Second. Item 404(b) delineates the transactions as payments in return for services or property. I eliminate 28 firm-years for firms domiciled outside the U. One technique ranks all Compustat firms into percentiles by the 10-year standard Item 404(a) of Regulation S–K of the 1934 Securities and Exchange Act defines significant business transactions as any transaction between firm and director (or his/her place of business) that exceeds $60.S. ‘‘significant business relations’’ with the firm and number of shares held. all inferences in the paper are limited by the particular time period and sample selection. 4 . I use a cross-sectional Jones regression model to estimate the unadjusted abnormal accruals for each sample firm. CRSP and Compustat provide data for many of the independent variables. 1993. cash flows from operations. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 1 Sample used in analyses Firm-years Initial S&P 500 Sample for 1992–1993 Non-US firms Banking firms (four-digit SIC code: 6000–6199) Insurance firms (four-digit SIC code: 6300–6411) Missing data on audit committees Missing Compustat or CRSP data Outlier for absolute value of abnormal accrual Final sample 1000 (28) (53) (36) (4) (180) (7) 692 and June 30. If such a committee exists. Thus. outside legal counseling. Four firm-years are eliminated due to missing information about their audit committees. investment banking. Schedule 14A (the proxy statement) requires firms to disclose each director’s name. nominee or executive officer. firms are required to disclose its functions and responsibilities. The model’s parameters are estimated by industry and I require each firm-year to have at least eight observations with the same two-digit SIC code. its members. business experience during the last 5 years. Table 1 summarizes how the final sample is constructed. significant current or proposed transactions with management. The deletions arise primarily from two sources. and the number of times the committee met during the last fiscal year.4 Schedule 14A (Item 7(e)(1)) requires firms to state whether they have a standing audit committee. family relationships between any director. significant indebtedness. other current directorships. I use variants of Kasznik’s (1999) matched-portfolio technique to adjust the firm’s abnormal accrual for effects that are correlated with board and/or audit committee independence. I also exclude 53 banks (SIC codes: 6000 to 6199) and 36 insurance companies (SIC codes: 6300–6411) because it is difficult to define accruals and abnormal accruals for financial services firms.

Adjusted abnormal accruals Any test of earnings management is a joint test of (1) earnings management and (2) the expected accruals model used. On average. or affiliated (‘‘gray’’) with the firm. Outsiders have no ties to the firm beyond being a board member. I remove seven abnormal accrual outliers. outsiders. 4. relatives of the CEO. Guay et al. Brickley et al. or are on interlocking boards as defined by Item 402(j)(3)(ii) of Regulation S–X. 7 Bernard and Skinner (1996). each sample firm must have 11 years of Compustat data. (2001) contain excellent discussions of this issue. 1992. (1995). More importantly. 5. (2000).. and Kothari et al. 6 Many papers use the terms discretionary and non-discretionary accruals for expected and abnormal accruals.A. each being more than 5 standard deviations from the mean.4% of audit committees are comprised of outside directors only and 86.2. 1994). Klein / Journal of Accounting and Economics 33 (2002) 375–400 381 deviation of past total accruals and requires each sample firm-year to have an appropriate matched-portfolio for the adjustment. Dechow and Skinner (2000).5 In contrast. affiliated directors are past employees. Weisbach. if the omitted variable is associated with the independent variable of interest or is within a non-random sample.8% of the firms in the sample have boards in which the majority of directors are independent of management. Kasznik (1999). or have significant transactions and/or business relationships with the firm as defined by Items 404(a) and (b) of Regulation S–X. In total. and the NASDAQ required domestic listed firms to have a minimum of two ‘‘outside’’ or ‘‘independent’’ directors on their boards. ending in 1991 or in 1992.g. 5 .7% have a majority of independent directors. I employ Kasznik’s (1999) matched-portfolio technique. (1996).6 Acceptance or rejection of the null hypothesis of no earnings management cannot be disentangled from the key methodological issue of how well the chosen expected accruals model separates total accruals into its unexpected (abnormal) and expected components. these requirements yield 692 observations. Guay et al. Kasznik (1999) and Kothari et al.4% of board members and 79. (1996). the NYSE. 73. I classify directors as insiders. Finally. AMEX. 43. While no firm has a completely independent board. Insiders are current employees of the company.7 Moreover. Table 2 reports data on board and audit committee composition. Thus. Byrd and Hickman.. Bartov et al. then well-specified tests must include an adjustment for the omitted variable. In 1992 and today. 1988. Consistent with the NYSE and NASDAQ listing requirements. and Kothari et al. Dechow et al. (2001) show that any proxy for abnormal accruals yields biased metrics if measurement error in the proxy is correlated with omitted variables. (2001) control for the correlated variable by using a matched-firm or portfolio technique to adjust the abnormal accruals. 58.6% of audit committee members are outsiders. Corporate governance characteristics Consistent with prior research (e.

Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 2 Descriptive corporate governance data Whole board Percentage of directors who are Insidersa (%) Outsidersb Affiliatesc Percentage of firms with 100% outside directors (%) Majority of outside directors 22. The changes in revenues and PPE are used to control for expected (i.t is the change in net sales [Compustat item #12]. Industries with less than eight observations are dropped from the sample.4 19.e.tÀ1 Š þ ejk. They conclude that the cross-sectional original Jones model is the only model consistently able to detect earnings management for a sample of firms receiving audit qualifications.tÀ1 are total assets [Compustat item #6].4 79. 1998. TAjk. 1994.tÀ1 ¼ aj. Dechow et al. 1998. DuCharme et al.t ½PPEjk..1 Audit committee 1. b Outsiders have no affiliation with the company beyond for being directors. Becker et al.t is gross property. 8 Other papers using this model include DeFond and Jiambalvo. economic-based) components in total accruals.382 A. 1998. 2001. (1995) and Guay et al. . c Affiliates are former employees.t ½DREVjk.5 58.. Subramanyam. 9 Bartov et al.tÀ1 Š þ gj. 1992 and 1993 with annual shareholder meetings between July 1. plant and equipment [Compustat item #7]. Peasnall et al. DeFond and Subramanyam.tÀ1 Š þ bj.9 I use all firms on Compustat having the same two-digit SIC code for the firm-year. DREVjk. 1993.t =TAjk. and PPEjk. b.. or have significant transactions and/or business relationships with the firm as defined by Items 404(a) and (b) of Regulation S–X. The number of firms used in each industry model ranges from 8 to 315.. a Insiders are current employees of the company. In total. 114 twodigit industry regressions for the 2-year period are estimated. Guidry et al.t =TAjk. (2000) test the efficacy of the unadjusted cross-sectional Jones model vis-" -vis other crossa sectional and time-series expected accruals models. 1996.6 19. I begin by estimating a cross-sectional variant of the Jones (1991) expected accruals model for all firms k in industry j for year t:8 The model is ACCRjk.t . (1996) contrast the time-series Jones and modified Jones time-series models with other time-series models and conclude that the Jones models perform the best in detecting abnormal accruals..7 Sample is for 692 US firms-years with audit committees listed on the S&P 500 as of March 31. 1991 and June 30.4 86. relatives of the CEO.t are total accruals for firm k in industry j in year t [Compustat item #18-Compustat item #304]. ð1Þ where ACCRjk. board interlocks. 1999.. 1998a. Teoh et al.t =TAjk.t ½1=TAjk.0 0 73.8 43.

Abs is the absolute value.298 À0.057 0.80 11 0.077 0.tÀ1 Š þ gj.t ¼ ACCRij.t =TAij.107 8.004 (À0. dev.064 0. (2). Testing for whether the mean abnormal accrual is different from zero yields a t-statistic of 0. 0.139 10 0.281 0. g Assets are total assets (Compustat item # 6). the difference between total accruals and estimated expected accruals.056 0.126 179 1.189 Median Minimum Maximum 1.79 0. . deflated by lagged total assets (Compustat item #6). e Net Income is net income before extraordinary items (Compustat item #18) deflated by lagged total assets (Compustat item # 6).001 0.t ½PPEij. and gj.576 84 0.177 À0. c Total accruals are the difference between net income before extraordinary items (Compustat item #18) and cash flows from operations (Compustat item #308).588 Std.050 0. bj.065 0.047 À0. (1).173 0. for each firm-year ij.tÀ1 faj..tÀ1 Š þ bj.059 À0. Table 3 reports descriptive statistics for the entire sample.001 0.035 0. See Eq.003).352 3.001 0.075 0.0002 À2.t ½DREVij. 1992 and 1993 with annual shareholder meetings between July 1.003 À1.00003 1.886 100 0.t .001 À0.014 0. (1).59).048 0. I calculate the unadjusted abnormal accrual defined as AACij. 1993.190 À0.4053 100 1. 1991 and June 30. Forty-eight percent Table 3 Descriptive statistics on accruals.t =TAij.077 0.004 0.061 0. e. t in the S&P 500 sample. and abnormal accruals Variable Abnormal accruals (AAC) Unadjusteda p-value Abs(AAC) Unadjusteda p-value Adjusted for s(total accruals)b p-value Total accrualsc Abs(total accruals)c Non-discretionary accrualsd Net incomee Operating cash flowsf Assetsg (in $millions) Mean 0.17 À0. b Adjusted abnormal accruals is the unadjusted Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms matched by the same standard deviation of the firms’ past 10 years’ total accruals.A.145 0.89 %Positive 48 À0.54 (p-value=0.t =TAij. a Unadjusted abnormal accruals (AAC) are the accruals prediction error.t1 Šg.067 0.429 100 Sample is for 692 US firms-years with audit committees listed on the S&P 500 as of March 31.405 0.425 0. ð2Þ where aj.013 À0.g.117 0.t . f Operating cash flows is from the cash flows statement (Compustat item #308) deflated by lagged total assets (Compustat item # 6).t ½1=TAij.838 100 À0. Klein / Journal of Accounting and Economics 33 (2002) 375–400 383 Next.483 97 174. The average (median) abnormal accrual is 0.960 21.t are the fitted coefficients from Eq. d Non-discretionary accruals are estimated for each firm-year as the expected value of accruals based on Eq.

.01) (0.09 À0.01) (0.01) (0.07) (0. I use the unsigned (absolute value of) abnormal accruals as a proxy for the unadjusted combined effect of incomeincreasing and income-decreasing earnings management.i Abs(TA) 0. Nelson et al.11) (0.06 À0.01) (0. Bartov et al.01) (0.00 0. 1998.06 0. adjusted abnormal accruals (AAAC)c.01) (0..03) (0.01) (0.05 0.18) (0. with possible correlated variables Variable s(TA) Abs(earnings)d Abs(earningstÀ1 ) Earnings Abs(Dearnings) Abs(DCFO)e Abs(DTA) Debtf Log(Assets) a. abnormal Accruals (AAC)b.13 0.15 0.40) (0.26 0.11 0.00 0. Because of this quality.43. The adjustment for each sample firm is the median absolute value of the AAC for a portfolio of firms matched by a variable that is correlated with both the absolute value of abnormal accruals and board and/or audit committee independence.33 À0.04) (0.07 À0. I use Kasznik’s (1999) matched-portfolio method to adjust the absolute value of the AAC.19 À0.99) (0.03) (0.20 À0..74) .07 À0.13) (0. Klein / Journal of Accounting and Economics 33 (2002) 375–400 of the abnormal accruals are positive.17 À0.01) (0.13 0. no evidence of systematic upward or downward earnings management activity is detected.01) (0.09 À0. a sign test yields a p-value of 0.01 (0.01) Panel B: Spearman correlations of percentages of outside directors on audit committee (%Audout) and boards (%Outsiders on board) with possible correlated variables Variable s(TA)i Abs(earnings) Abs(earningstÀ1 ) Earnings Abs(Dearnings) Abs(DCFO) Abs(DTA) Debt Log(Assets) MV/BVj Negative incomek %Audoutg À0.18 0.40) (0.08) (0. As Table 4.01) (0.03 À0.01 0.13 À0.01) (0. audit committee independence and board independence are correlated at Table 4 Spearman correlations (p-value in parenthesis) Panel A: Spearman correlations of absolute values of total accruals (TA)a.01 0.11) (0.18 À0. Other earnings management studies using this measure are Warfield et al.07 0.01) (0.17) (0.73) (0.01) (0.17) (0.06 À0.53) (0. Thus.03 À0.08 À0.01) (0.384 A.05 À0. 2000.11) (0. Becker et al.01) (0. Panels A and B illustrate the absolute value of abnormal accruals.93) (0.83) Abs(AAC) 0. Next.01) (0.05 À0.01 (0. 2000).01) (0.19 0.10) (0.16 0. 1999.05) %Outsiders on boardh À0.05) (0.27 0.06 0.80) (0.01) (0.02 0.10 À0.07 (0.22 (0.20 0. This finding most likely is due to the S&P 500 being a relatively random sample with respect to earnings management incentives (see Healy and Wahlen.08 À0.01) (0.01) (0.01) (0.11 0. 1995.08 À0.01) (0.01) (0.15 (0.20 0.14 À0.20 À0.14 À0..01) AAAC À0.

26 (0.04) (0. g %Audout is the percent of outside directors on the audit committee.01 or 0. k Negative income is equal to one if the firm has two past years of negative income before extraordinary items and zero otherwise.07 0.01) (0. (2001). Total accruals are deflated by lagged total assets. d Earnings and earningstÀ1 are net income before extraordinary items deflated by lagged total assets for the current and lagged year. respectively. The positive correlations between the absolute value of current abnormal accruals and the earnings numbers are congruent to Kothari et al.01) 0. j MV/BV is the market value of common equity divided by the book value of total common equity. b AAC are abnormal accruals measured as the difference between total accruals and expected accruals using the cross-sectional Jones model (Eq. The negative associations between the earnings numbers and board or audit committee independence are similar to results reported by Hermalin and Weisbach (1991) and Klein (2002).01) (0. Each earnings variable controls for the firm’s inherent accruals or earnings process and is consistent with Kothari et al. e CFO is cash flows from operations deflated by lagged total assets.21 0.01) (0.09 0.01) 0.01) (0.38 (0.23 0. i s(TA) is the standard deviation of total accruals for the 10 years prior to the current year. and total accruals Abs(earnings) Abs(earningtÀ1 ) Earnings s(TA) 0.10 The positive correlation between the standard deviation of past total accruals and the absolute value of current abnormal accruals signifies that firms with extreme accruals inherent in their business are more likely to have high discretionary accruals.01) (0.20 0.01) 0.13 0.09 À0.01) 0.08 0. and at the 0. Abs is the absolute value the 0.01 level with the standard deviation of past total accruals. and Kasznik’s (1999) findings that this period’s AAC is related to last period return on assets.01) Abs(earnings) Abs(earningstÀ1 ) Earnings Abs(Dearnings) Abs(DCFO) a 385 Abs(Dearnings) Abs(DCFO) Abs(DTA) 0. In particular. The negative correlation between this variable and board (audit committee) independence supports Hermalin and Weisbach’s (1998) prediction that firms with past extreme accruals are less likely to have an independent board.23 (0. cash flows.01) Total accruals are net income before extraordinary items minus cash flows from operations.01) (0. each variable allows for this period’s earnings to take into account reversals of prior year accruals or growth trends in earnings.71 (0.01) (0.01) (0.02) (0. c AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms match on the standard deviation of past total accruals.04 0. f Debt is long-term debt deflated by lagged total assets.01) 0.24 0.20 (0.01) 0. Dechow et al.A. (1995). (1)). h %Outsiders on board is the percent of outside directors on the board. the absolute value of current earnings.04 level for the level of current earnings.16 0. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 4 (continued) Panel C: Correlations among earnings.06) (0.37 (0.73 (0. 10 .82 (0.01) 0. and the absolute value of last period’s earnings. (2001) assertion that this period’s AAC is associated with the firm’s earnings process.21 0.11 (0.24) (0.

013) than the unadjusted Abs(AAC) (mean=0.077.014 (À0.p ¼ AbsðAACij.37 to 0. Cross-sectional analyses 6. Panel A shows. audit committees can function independently if and only if all members are free from managerial influence. and p is the percentile ranking of the Compustat firms’ standard deviation of total accruals. However.p Þ À Median AbsðAACÞt. Tobin’s Q for Hermalin and Weisbach) and board independence may not be linear. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Initially. median=0. this definition is not feasible for the entire board. This is not a trivial exercise as the following discussion illustrates.g.t. This is a common definition used in the academic literature (e. A second path is to follow the NASDAQ and NYSE’s guidelines and consider an audit committee independent only if all members are outside directors. I use three definitions of independence. I compute the standard deviation of total accruals for the 10 years prior to 1991 or 1992 for all Compustat firms with non-missing data and assign them to percentiles based on their ordered rank. Each sample firm is matched by the percentile. AAAC is insignificantly correlated with the standard deviation of past total accruals (r ¼ À0:01. much of the measurement error due to these factors is removed. and current earnings (r ¼ 0:00. .386 A.1. The first is to interpret audit or board independence as the percentage of outside directors on the audit committee or on the board.e. Finally. p-value=0.82.t.. ð3Þ where AbsðAACij.t. p-value=0. as Hermalin and Weisbach (1991) show. Under this definition.035). I match by the standard deviation of total accruals. the correlations among these variables range from 0. and the AAAC is computed using Eq. One issue is determining independence. p-value=0. the relation between economic outcomes (i.73).40).p Þ is the absolute value of the abnormal accrual for firm-year ij. As Table 4. 6. Median AbsðAACÞt. as shown in Table 3..p is the median absolute value of the abnormal accruals for a portfolio of Compustat firms. To get the percentile rankings. p ¼ 0:99). The adjusted abnormal accrual for sample firm-year ij. I compute each sample firm’s standard deviation of total accruals for the 10 years prior to 1991 or prior to 1992.p . Each Compustat percentile for 1991 contains approximately 87 firms. Thus. the AAAC has a lower mean (median) of 0. Note too from Panel C. the absolute value of past earnings (r ¼ À0:00. Beasley.t is AAACij. the absolute value of current earnings (r ¼ 0:03. for 1992 each percentile has approximately 90 firms. 1996). Since no boards are comprised solely of outside directors.t. (3). Similarly.93). Defining audit committee and board independence The maintained hypothesis is that more independent audit committees and/or boards are associated with smaller AAACs. suggesting that the variables capture much of the same processes. p.

Multivariate models This section uses multivariate models relating board characteristics to abnormal accruals. I estimate the ‘‘regression’’ coefficients by maximum likelihood using a Newton–Raphson algorithm on a lognormal-dependent variable.11 As predicted. Table 5 presents coefficients for the univariate models..A. I obtain significantly negative coefficients for both board definitions and for the 51% audit committee independence definition. Klein / Journal of Accounting and Economics 33 (2002) 375–400 387 A third definition of board or audit committee independence is for a majority of members to be independent of management. To check the sensitivity of the findings. To achieve this. The differences among definitions. 11 . Taken as a whole. 6. for example. define a board as being inside-dominated if at least 50% of board members are firm officers. these results suggest that a majority outside membership may be a critical threshold for deriving a meaningful relation between director independence and the absolute value of the adjusted abnormal accruals. can influence how firms structure their boards. Accordingly. The rationale behind this metric is that majority rule dominates board and committee actions. using the 51% (majority) definition may be a desirable alternative to many firms. under 10 directors) are better performers. I control for other factors that may be related to the absolute value of Pearson and Spearman correlations present similar results to the regression models. The exchange rules suggest that effective monitoring requires boards to maintain audit committees with independent directors only. I re-estimate models using cutoffs of 40% and 60%. one-tailed tests are reported except for that variable. the coefficients on the 100% audit committee independence definition. Examination of its distribution reveals that its shape is approximately lognormal. 2002). In contrast. Only the coefficient on the 60% cutoff of outside directors is significant at the 0. Yermack (1996) argues and shows that firms with smaller boards (i. Thus. the percent of outsiders on the audit committee. Yet. Since there are sign predictions for all of the variables except %CEO shareholdings. which has a weaker relation (po0:10) than those presented in Table 5. Fama and Jensen (1983) and Klein (1998) articulate that firms benefit greatly by having insiders on the board since top managers bring in expertise about the organization to the board’s top-level decision making apparatus. These papers suggest that it may be costly for companies to maintain 100% independent audit committees.e. Univariate models The dependent variable is the AAAC. firms need to recruit independent directors and may have to increase board size (Klein.10 level or better. particularly between the 100% and 51% rules. Dechow et al. the incidence of a large blockholder on the audit committee and the percent of common equity owned by the CEO are insignificantly different from zero. (1996). The most statistically significant coefficients are for the 51% board and audit committee cutoff levels.3.2. 6. The one exception is Aud51%.

past negative earnings (two or more previous consecutive years). Previous studies suggest that the absolute change in the previous year’s income before extraordinary items divided by total assets.01 (0. Panel A shows.21) 5%Block..05)n %Audoutf 0.27) %CEO sharesh 0.09 (10.09) À0.50)n À0..06 (2. Dechow et al.388 A.08 (50. Bartov et al. As the last column of Table 4. and political costs (log of beginning year’s assets) are negatively related to earnings management (see Warfield et al.01 level. and financial leverage (total debt divided by total assets) are positively associated with earnings management. As Bartov et al. h %CEO shares is the percentage of common equity owned by the CEO. Panel B.13)n À0. 1994. on aud. failure to control for confounding factors may result in falsely rejecting the null hypothesis of no abnormal accruals when in fact the null is true. is an indicator if an outside 5% blockholder sits on the board’s audit committee.01 (0. From Table 4.08 (36..93)n À0. 1991 and June 30.36) Aud51%e 0. 1995.07 (9.27) Coefficient (w2 -Values) Sample is for 692 US firms-years with audit committees listed on the S&P 500 as of March 31. on aud. The parameters are estimated by maximum likelihood using a Newton–Raphson algorithm. and zero otherwise.14 (48. 1995. f %Audout is the percentage of outsiders on the firm’s audit committee.36)n %Outc 0. comm.g 0.17 (36. Becker et al. 1998. DeFond and Jiambalvo. and firm size (log of beginning year’s assets).. d Aud100% takes on the value of one if the firm’s audit committee has outside directors only. a AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms match on the standard deviation of past total accruals. 1993. The dependent variable is modeled as a lognormal distribution.70)n 0.72)n Aud100%d 0.85)n À0. n Significant at the 0. comm. 1992 and 1993 with annual shareholder meetings between July 1..73)n 0.14 (6. b Bd51% takes on the value of one if the firm’s board has at least a majority of outside directors. abnormal accruals or board/audit committee independence. and zero otherwise. Dechow et al. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 5 Univariate models of absolute values of adjusted abnormal accruals (AAACs)a on corporate governance explanatory variables Explanatory Bd51%b variable Intercept 0.11 (2. c %Out is the percentage of outsiders on the firm’s board. g 5%Block. e Aud51% takes on the value of one if the firm’s audit committee has at least a majority of outside directors. %Outsiders on the board is significantly correlated with firm assets and . we see that %Audout is significantly correlated with these three variables.31 (1. 1996. AAAC is significantly correlated at the 0. (2000) show.01 level with the absolute value of the change in earnings and with the log of firm assets. Klein (2002) reports that audit committee and board independence are significantly related to market-to-book ratios. 2000).15 (13.09 (71. and zero otherwise.

Table 6 contains the multivariate results. contrary to the intentions of the new guidelines promulgated by the exchanges.07) Model 4 0.01 level to whether the board or its audit committee has a majority of independent directors. %Outsiders is also significantly correlated with debt.09 (2.08 (12.01 (6.18)nnn 0.40) À0.01 levels.39 (1.11)nnn À0.70)nn Model 5 0.38) À0.54 (4.01 (7. but not to negative income.58) 0.09 (2.31) 0.38 (1. respectively. AAACs are negatively related at the 0.10 (6.59 (5.A.71 (7.97) 0. cross-sectionally.06) À0.37) À0.84)n 0.12 (2.57)nn Bd51%b %Outc Aud100%d Aud51%e %Audoutf 5%Blockholder on audit comm.11 (2.59)nnn À0.84)n 0.47)nnn 0.01 (5.003n (0.11 (2.10 (3.56)n 0.68)n 0.01 (7.09 (1.08)nn 0.21 (0.65 (6.47) Model 2 0. there appears to be no meaningful relation between abnormal accruals and having an audit committee comprised solely of independent directors.04)n 0.10 (2.07)nnn 0. NIk ? .87) 0.03 (0.g %CEO sharesh — ? MV/BVi ? Abs(DNI)j + Neg.96)nn 0.10 and 0.89)nnn À0.52)nnn 0. the coefficients on the percentages of outsiders on the board or audit committee are significantly negative at the 0.14 (3.89)n — — — — — À0. However.61)nnn 0.66 (6.08 (1.20)nn 0.03) À0.12 (18.44) 0.17) Model 3 0.16 (4.13) 0. The associations between earnings management and having a 5% outside blockholder on the audit committee or CEO shareholdings are unclear since the coefficients for the former variable are significantly negative for three models only and the coefficients for the latter variable are significantly positive for two Table 6 Multivariate models of absolute values of adjusted abnormal accruals (AAACs)a on Board and Audit Committee Composition (parameter estimates and w2 -Values) Predicted sign Intercept Model 1 0. board and audit committee compositions are related to abnormal accruals.09 (2. In addition. Klein / Journal of Accounting and Economics 33 (2002) 375–400 389 the market-to-book ratio.14 (3.01 (4.47 (3. Thus.29)nnn 0.48 (2.01)nn 0.09 (2.12 (2.

18 (6. specifications only.01 (1. and zero otherwise. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 6 (continued) Predicted sign Debt l Model 1 0. on audit comm.09) Model 2 0. Finally.01 (0.21)nnn À0. c %Out is the percentage of outsiders on the firm’s board. 1991 and June 30. i MV/BV is the market value of the total firm over book value of assets. and zero otherwise. .43)nnn À0.10.390 A. m Log(Assets) is the natural log of the book value of assets.19 (7. ending on the fiscal year prior to the shareholders’ meeting.01 (1. l Debt is long-term debt divided by last year’s assets. The parameters are estimated by maximum likelihood using a Newton–Raphson algorithm.11) + Log(Assets)m — Sample is for 692 US firms-years with audit committees listed on the S&P 500 as of March 31.01 (1. b Bd51% takes on the value of one if the firm’s board has at least a majority of outside directors.74) Model 3 0.25)nnn À0.19 (6. nn Significant at the 0.01 (1. d Aud100% takes on the value of one if the firm’s audit committee has outside directors only. j Abs(DNI) is the absolute value of the change in net income between years t À 1 and t: k Neg. is an indicator if the firm had two or more consecutive years of negative income. there is no evidence of a systematic association between having an all-independent audit committee and abnormal accruals. NI. f %Audout is the percentage of outsiders on the firm’s audit committee. n Significant at the 0. the control factors.96) Model 5 0. firms with boards and/or audit committees composed of less than a majority of independent directors are more likely to have larger AAACs than their counterparts. are significantly different from zero. the results indicate that after holding other factors constant. g 5%Block. e Aud51% takes on the value of one if the firm’s audit committee has at least a majority of outside directors. Summary In summary.05. 1992 and 1993 with annual shareholder meetings between July 1. 6. The dependent variable is modeled as a lognormal distribution. is an indicator if an outside 5% blockholder sits on the board’s audit committee. a AAAC is the absolute value of adjusted abnormal accruals measured as Abs(AAC) minus the Median Abs(AAC) for a portfolio of firms match on the standard deviation of past total accruals. with the exceptions of negative income and the log of assets.67)nnn À0. A negative relation exists between AAACs and the percent of independent directors on the board and/or audit committee.01.15 (4. measured at the beginning of the fiscal year.22 (9.31)nn À0. nnn Significant at the 0. In contrast. and zero otherwise. h %CEO shares is the percentage of common equity owned by the CEO.40) Model 4 0. 1993.4.

This phenomenon will bias my results away from the hypothesis of a negative relation between adjusted abnormal returns and board (audit committee) independence. 49 had a reduction in board independence. The z-test does not assume normality and tests for differences between medians. The t-test assumes normal distributions and tests for differences between means. 2002). 48 also had an increase in board independence. For these firms. Seventy-eight firms had a decrease in audit committee independence between 1992 and 1993. significant at the 0. I determine whether the change in the level of abnormal accruals is statistically different for firms experiencing changes in their board (audit committee) structures as compared to firms not experiencing the changes.A.001 for other firms.051 mean increase in abnormal adjusted accruals. I examine changes in AAACs around changes in board independence. Greater independence is associated with a positive number. I identify 339 firms having the required data for both 1992 and 1993. The alternative hypothesis is that boards (audit committees) moving towards more (less) independence will be accompanied by a decrease (increase) in abnormal accruals. When appropriate. The 116 firms that reduced its percentage of outsiders on the board experienced a 0. In the betweensample tests. 15 had an increase in board independence. Since audit committee independence is related also to board independence (Klein. First. Klein / Journal of Accounting and Economics 33 (2002) 375–400 391 7. there is a significant relation between changes in board independence and changes in audit committee independence. In this section. Changes in abnormal adjusted accruals and changes in board and audit committee composition Regressions using cross-sectional data describe associations between abnormal adjusted accruals and board and audit committee composition. DAAAC is defined as the AAAC for 1993 minus the AAAC for 1992. I scrutinize more directly the link between board and audit committee composition and earnings management by testing whether the level of abnormal adjusted accruals changes when board or audit committee structure changes. As one would expect. A positive number indicates an increase in the level of abnormal accruals. 9 had a decrease in board independence. and 9 had no change in board independence over the same 2 years.45.01 level. 12 . and 14 had no change in board independence over the same 2 years. The change in board or audit composition is the percent of outside directors on the board (audit committee) in 1993 minus the percent of outside directors on the board (audit committee) in 1992. compared to a decrease of 0. adjustments to the denominator are made to accommodate statistical differences in variances between samples. Sixty-six firms had an increase in audit committee independence between 1992 and 1993. the Spearman correlation coefficient between the two variables is 0. Panel A of Table 7 presents the between-sample tests. Weisbach’s (1988) findings suggest that a positive relation between the change in adjusted abnormal returns and audit committee independence may arise due to economic events. The 24 firms whose boards moved from a majority of outsiders to less than a majority of outsiders Weisbach (1988) finds that poorly performing firms are more likely to change their boards towards more independence. One-sided tests are performed. For the sample. For these firms.12 Both between-sample tests and regression analyses are used. and as Klein (2002) shows.

000 0.10 À1.83 À1.010 0.049 À0.79n 109 67 9 18 NoChg #> median 60 102 160 151 z-stat 133 116 19 24 206 223 320 315 1.06nn 0. Audit committee composition Increase in Audoutc Decrease in Audout To 100% Audout To o100% Audout To >51% Audout To o51% Audout 0.015 0.55nnn À0.74n 30 41 9 18 4 2 139 128 160 151 165 167 0.002 N t-Statistic for difference between means z-Statistic for difference between medians Chg #> median 0.44n À2. To o51% Out.014 0.92nn .021 À0.051 À0.016 0.79 0.86n À1. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 7 Changes in adjusted abnormal accruals (DAAAC) following changes in board and audit committee composition for all firms in sample with two years of data (N ¼ 339) Panel A: Mean changes in adjusted abnormal accruals (DAAAC)a Change in %Outside directors on board or audit committee Mean DAAAC Board composition Increase in %Out.020 0.035 À0.b Decrease in %Out.60n À0. To >51% Out.89nn 1.025 0.91nn 1.083 0.392 A.59n 0.006 0.68 À0.002 0.161 N No change or opposite change in %Outside directors on board or audit committee Mean DAAAC 0.82 À1.001 273 261 316 311 333 329 1.22 À2.55 1.131 66 78 23 28 6 10 0.015 0.06 À1.57 À1.007 0.

61nn Coefficient (t-statistic) 0. a AAAC is the absolute value of adjusted abnormal accruals measured as abs(AAC) minus the median abs(AAC) for a portfolio of firms match on the standard deviation of past total accruals.01 (0.99) A.Panel B: Regression of DAAAC on changes in board or audit committee composition Variable Intercept Predicted sign Coefficient (t-statistic) 0. b %Out is the percentage of outside directors on the board c %Audout is the percentage of outside directors on the audit committee 393 . Klein / Journal of Accounting and Economics 33 (2002) 375–400 D%Out D%Audout — Adjusted R2 F -value n nn Significant at the 0.13 (À0.01 (1. nnn Significant at the 0.10 level.95 0.00 0.01 level. Significant at the 0.16 (À2.15)b 0.97) À0.21) — À0.01 4.05 level.

The 10 firms whose audit committees shifted from a majority of outsiders to a less than a majority of outsiders had a 0.001 for other firms.t =TAjk. only the change in audit committee independence yields a statistically significant tstatistic.t .t À DRECjk.t .t from their original model (Eq. Adjusting the Jones model for extreme accruals inherent in each firm’s business (e. Additional tests This paper uses an abnormal adjusted residual from the cross-sectional Jones model as its measure of abnormal accruals..1. In this section.131 average increase in abnormal accruals.394 A.t =TAj. Next.002 increase for other firms. (1) of this paper) and use .t ½1=TAjk. Summary In summary.t .t =TAjk.t ¼ ACCRjk. compared to an average increase of 0. the results indicate that firms with boards and/or audit committees that move from majority-independent to a minority-independent structures experience large increases in AAACs in the year of the change compared to their counterparts.g. bj. 8. 8. Both partitions produce statistically significant differences in means and medians. and gj. In Panel B.t ½DREVjk. The coefficients on each variable are negative as expected. revenue changes are adjusted for DRECjk.1. I perform other tests to ensure further that the inferences drawn thus far are valid. (1995) calculate aj. As do other papers in the literature. I regress the change in AAAC on changes in board or audit committee independence.049. Again. against an average increase of 0. it is important to take reasonable steps to ensure the metric is measuring abnormal accruals and not other firm characteristics included in the model. the standard deviation of past total accruals) is one mechanism. Firms moving from a wholly independent audit committee to a lesser independent committee produce an average increase in abnormal adjusted accruals of 0. (1995) propose a ‘‘modified’’ Jones model in which AACjk. However. the change in receivables for year t: Dechow et al. Since the results of my study depend on this measure.tÀ1 À faj. Modified cross-sectional Jones model Dechow et al. Klein / Journal of Accounting and Economics 33 (2002) 375–400 had a 0.010 for other firms. this measure is interpreted as being a proxy for earnings management. I examine changes in audit committee independence.tÀ1 Šg: ð4Þ The modification is that in the expected accruals model.161 average increase in abnormal adjusted accruals. 7.t ½PPEj.tÀ1 Š þ gj. against a 0. both classifications yield statistically different means and medians.tÀ1 Š þ bj.

Using the unsigned (absolute) values preserves the research design.. (2001) find the same result for last year’s net earnings. Thus. it can be argued each is surrogating for aspects of the firm’s earnings process. in Panel A. The univariate and multivariate results with specification are almost identical to those presented in Tables 5–7. all three variables are highly correlated with the conditioning variable used thus far. (2001) follow this methodology. the parameter estimates and statistical significant levels are qualitatively the same whether I match by the past standard deviation of total accruals or the level of earnings. (1) to include the adjustment for receivables.g. the correlation between this year’s and last year’s abnormal earnings is 0. Table 8 contains the parameter estimates and w2 -values for the univariate and multivariate procedures. Other papers. e. Thus. Panel A has the results on matching by the absolute value of current earnings. Kothari et al. Kothari et al.73 and the correlation between this year’s signed and unsigned earnings is 0. Further. I present the range of parameter estimates and w2 -values over the five regressions.82. Both univariate and multivariate tests akin to Tables 5 and 6 are conducted with the newly calculated dependent variables. the standard deviation of past total accruals. Since 5%Blockholder on audit committee and %CEO shares are included in each multivariate regression. Using Eq. As Table 4. Kasznik (1999).t . (3). the coefficients on Aud51% are À0. As Table 8 illustrates. (2) the absolute value of last year’s earnings. (2000) and Kothari et al. For the multivariate process.. (2001) also find statistically insignificant differences between using the Jones and modified-Jones cross-sectional models. I follow the same methodology described in Section 5 and calculate an AAAC for each firm-year. and (3) this year’s signed earnings.e. The procedure to compute the AAAC is the same as described in section 5. (2001) show to be untrue for firms that a priori have incentives to manage earnings. an assumption that Kasznik (1999) and Kothari et al. Bartov et al. I match firms by both signed and unsigned earnings. Panel B contains the results on matching by the absolute value of last year’s earnings.096 (p ¼ 0:01) and –0. Klein / Journal of Accounting and Economics 33 (2002) 375–400 395 these estimates in Eq. Adjustment for current or past abnormal earnings Kasznik (1999) finds that measurement error for the signed abnormal accrual of the cross-sectional Jones model is positively related to net earnings. bj.t by modifying Eq. it assumes that the degree of earnings manipulation is unaffected by firm performance (net earnings). i. For example. To control for the possibility that my results reflect these omitted correlated variables. re-estimate aj. 8. the same independent variables are included.2. The difference is that the Abs(AAC) is adjusted by the Median Abs(AAC) for differently matched portfolios. However. Panel C matches by the current signed earnings.t .A. and gj. The matchings are based on (1) the absolute value of this year’s earnings. (4) as my measure of abnormal accruals. I use both specifications. Panel C shows. I adjust the unsigned abnormal accruals by the median value of the unsigned abnormal accrual for three matched portfolios of Compustat firms.120 (p ¼ 0:01) for the unsigned current .

8.54)n À0.08) À0. In contrast.61)nn 5%Blockholder on audit comm.121 (5. À0.127 (22.084 (14.67)e .71.21)n (À0.136 (3. The regression is the unadjusted Abs(AAC) on the independent variables included in Table 6 alongside the standard deviation of total accruals. the matched-portfolio method does not impose restrictions these restrictions.076 (11.85)n (À0. 3. 4.080 (3.102. Klein / Journal of Accounting and Economics 33 (2002) 375–400 " earnings-matched univariate and multivariate models vis-a-vis À0. 3.14) Panel B: Matching by absolute value of last year’s earnings Board51% À0.288 (1. the unsigned levels of current or last year’s earnings.71)n %Out À0.008 (0.01) for the standard deviation-matched models in Tables 5 and 6. the overall results are robust to whether I match by the standard deviation of total accruals.392 (2.068 (9.120 (19.084 (2.17)n %Audout À0.093.078 (3. respectively. or the signed level of current earnings. the coefficients on Aud51% are À0.01) Aud51% À0.43)nn %CEO sharesc 0.16) À0.280.24)e (0.118 (9.501)d (0.41)n %Audout À0.76)nn %CEO sharesc 0.124 (2. Regression approach A second method for controlling for omitted correlated variables is to include them as separate regressors (see Bartov et al.36)nn Aud100% À0. 3. The advantage to using this technique over the matched-portfolio approach is that mismatching on the conditioning variable introduces noise into the dependent variable. the absolute value of this year’s earnings or the absolute value of last year’s earnings.127. with a fixed coefficient on the conditioning variable. À0.07) À0.006 (0.110 (7.002 (0.c À0.34)e (0.095 and À0.27)n À0.51) À0.21)n À0. The disadvantage to the regression approach over the matched-portfolio approach is that the former imposes a cross-sectionally linear relation.150)d (2.23)e Panel A: Matching by absolute value of current earnings Board51% À0.3.09 and À0. À0.222. 2000).396 A.06)n À0. which weakens the power of the independent variables. In Panel C.067 (9.094 (2.78)nnn 0. Table 8 Parameter estimates and chi-square values for board independence and audit committee independence for univariate and multivariate models in which the AAACs are calculated by matching portfolios of current or past earnings Variable Univariate procedurea Multivariate procedureb À0.61)nn Aud100% 0.66.124..0. the coefficients on Aud51% are À0.12 (p ¼ |:01.77)nn c 5%Blockholder on audit comm.04.095 (11.096 (11.02) Aud51% À0.144)d (1.28)n %Out À0.557)d (1.07. respectively. 0. 0.000 (0.101 and À0. Thus. In Panel B.123(5.

c %CEO sharesc n nn 397 Univariate procedurea À0.144)d (1.080 (13.04)e (0. one is significant at the 0. nnn Significant at the 0.05 level and two are not significant at the 0.07) À0.10 level.10 level.05 level and one is not significant at the 0.005 (0. I estimate three regressions on the abnormal unadjusted AACs (untabulated). For %CEO shares. and %Audout. 5%Blockholder on audit committee is included as an independent variable in the multivariate regressions alongside Board51%.100 À0.76)nn (2. one is significant at the 0. a Univariate procedure is the maximum likelihood estimates of the abnormal earnings-adjusted accruals on the independent variable.97. the coefficients and significance levels on the audit and board independence variables remain qualitatively the same. For %CEO shares. %Out. À0.10 level. Aud100%.124 (20.01 and 0.073 À0. c 5%Blockholder on audit committee and %CEO shares are used singularly in the univariate procedures. two chi-square values are significant at the 0.05 level.76)nnn (2.10 level. three chi-Square values are significant at the 0. A second difference is that the coefficient on firm assets is .10 level.088 À0.02)n À0. two are significant at the 0. one chi-square values is significant at the 0.34)n (À0. Each regression includes one of the three correlated variables. two chi-square values are significant at the 0.10 level.05 level and one is not significant at the 0. In Panel C: For 5%Blockholder on audit committee. They are included alongside the board or audit committee independence variable in the multivariate procedures.05 level and one is not significant at the 0.10 level. 3.10 level.82. one chi-square values is significant at the 0. The regression results with these specifications exhibit many similarities to those reported in Tables 5 and 6.10 level. For %CEO shares. the parameter estimates on 5%Blockholder on audit committee range between À0. b Multivariate procedure is the maximum likelihood estimates of the abnormal earnings-adjusted accruals on the independent variable and the other variables in Table 6.093 and À0. three chi-Square values are significant at the 0.121 0. e This is the range of chi-square values over the five multivariate procedures. Specifically. Aud51%. d This is the range of parameter estimates over the five multivariate procedures.112 (8.A.10 level. respectively.088 (2.10 level. In Panel B: For 5%Blockholder on audit committee.68)nn (0. two are significant at the 0. For example.02) for the regression approach. 0.43)n (3. Significant at the 0.267.34) Multivariate procedureb À0.30) À0. one is significant at the 0. I do not include two or all three together because of the high degree of co-linearity among the variables. In Panel A: for 5%Blockholder on audit committee.10 level and three are not significant at the 0.095. One difference is that the coefficient on whether a large blockholder sits on the audit committee is significantly negative (p-values between 0.05 level and three are not significant at the 0.79)n (4.93)n À0.101 À0. Klein / Journal of Accounting and Economics 33 (2002) 375–400 Table 8 (continued) Variable Panel C: Matching by this year’s earnings Board51% %Out Aud100% Aud51% %Audout 5%Blockholder on audit comm.01 level.411 (11.03) (12.10 level. For the regressions on current-earnings adjusted AACs.534)d (0. 4.83)e Significant at the 0.144.004 À0.

Thus. CEO on compensation committee equals one if the CEO sits on the compensation or if the board has no compensation committee. suggesting no relation between this variable and earnings management. In addition. Thus. the main result that abnormal accruals are related to board and audit committee independence remains robust to this technique. Nevertheless. firms. I test if earnings management is positively related to whether the CEO sits on these committees by including two indicators into the regression analysis performed in Table 6 (untabulated). Most significantly. 8. This interpretation suggests that the exchange rules are reasonable. strong results are found when either the board or the audit committee has less than a majority of independent directors. and zero otherwise. 2000) and Shivdasani and Yermack (1999) demonstrate a negative association between board independence and whether the CEO sits on the board’s nominating or executive compensation committee. 9. Cross-sectional negative associations are found between board or audit committee independence and abnormal accruals. a negative relation exists between audit committee or board independence and earnings management for all large traded U.4. The motivation behind this study is the implicit assertion by the SEC. This finding is consistent with Aboody and Kasznik’s (2000) and Yermack’s (1997) research showing that CEOs manage investors’ expectations on earnings downwards prior to the issuance of stock option awards. (2001) show. no significant cross-sectional association is found between earnings management and the more stringent requirement of 100% audit committee independence. I find that firms changing their board or audit committee from having a majority to a minority of outside directors experience large increases in AAACs relative to their counterparts. CEO on nominating committee equals one if the CEO sits on the nominating committee or if the board has no nominating committee. consistent with the SEC’s and the exchanges’ concerns.S. suggesting a positive relation between earnings management and whether the CEO sits on this committee. In contrast. Contravene to the new regulations. disparate approaches can produce different inferences.01 level for the regression approach. the coefficient on CEO on compensation committee is significantly different from zero at conventional levels. . as Kothari et al. The coefficient on CEO on nominating committee is insignificantly different from zero. although maintaining a wholly independent audit committee may not be necessary.398 A. CEO on board nominating committee or executive compensation committee Klein (1998. A generous interpretation is that. Summary and conclusions This study examines whether audit committee and board characteristics are related to earnings management by the firm. Klein / Journal of Accounting and Economics 33 (2002) 375–400 significantly negative at the 0. The implications of this study depend on one’s view of how accurately the AAAC measures earnings management. the NYSE and the NASDAQ that earnings management and poor corporate governance mechanisms are positively related.

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