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JAOC 5,3

Board of directors’ governance challenges and earnings management
Ruth W. Epps
School of Business, Virginia Commonwealth University, Richmond, Virginia, USA, and

390
Received 5 February 2008 Revised 10 May 2008, 21 June 2008 Accepted 25 August 2008

Tariq H. Ismail
Faculty of Commerce, Cairo University, Cairo, Egypt
Abstract
Purpose – The purpose of this paper is to examine the relationship between corporate governance and earnings management in US context and provide further insights on the effects of board of directors’ characteristics on earnings management. Design/methodology/approach – The paper uses a sample of three groups of US firms; where firms with relatively high negative, firms with relatively high positive, and those with low levels of discretionary accruals in the year 2004 are examined. Descriptive statistics, univariate analysis, multivariate analysis, board of directors’ characteristics, and possible relationships between corporate governance variables and earnings management proxy provide the basis for discussion. Findings – Firms with annually elected boards, small size boards, 100 percent independent nominating committees, and 100 percent independent compensation committees have more negative discretionary accruals. However, firms with 75-90 percent independent board or firms with a board size of between nine and 12 have higher positive discretionary accruals. Research limitations/implications – Certain board characteristics may be the important factors associated with constraining the propensity of managers to engage in earnings management. Practical implications – Results are limited by the accuracy of the models applied to isolate discretionary accruals. Additionally, the direction diverse of discretionary accruals may differ with selecting a time series of three or more years as a base for the analysis. Originality/value – In contrast to prior literature, where board composition is defined as an insiders- or outsiders-controlled board, this paper classifies board composition into seven discrete categories, using the same seven categories employed by Institutional Shareholder Services in evaluating and assigning corporate governance quotient scores to firms. The paper’s major contributions to the existing literature are its findings that income-increasing and income-decreasing discretionary accruals have a different relationship with corporate governance practices and its expansion of the scope of corporate governance from board independence and audit committee independence to other corporate governance characteristics. This paper provides evidence that supports US regulators’ initiatives that stronger corporate governance mechanisms provide greater monitoring of the financial accounting process and may be the important factors in improving the integrity of financial reporting. Keywords Boards of directors, Compensation, Corporate governance, Earnings, United States of America Paper type Research paper

Journal of Accounting & Organizational Change Vol. 5 No. 3, 2009 pp. 390-416 q Emerald Group Publishing Limited 1832-5912 DOI 10.1108/18325910910986981

I. Introduction The subject of corporate governance is of enormous economical importance. Corporate governance addresses the ways in which stakeholders of capital to corporations assure

themselves of getting a return on their investment. Corporate governance implies an explicit responsibility for boards in the financial reporting process. In doing so, it raises the expectation that boards will constrain earnings management activity. Healy and Wahlen (1999, p. 6) define earnings management as occurring:
[. . .] when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholder about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers.

Governance and earnings management 391

One might wonder how management can manipulate earnings. Under US Generally Accepted Accounting Principles, firms use accrual accounting which focuses on the recording of the financial effects on an entity of transactions and other events and circumstances that have cash consequences for the entity in the periods in which those transactions, events, and consequences occur rather than only in the period in which cash is received or paid by the entity. The nature of accrual accounting gives managers a significant amount of discretion in determining the actual earnings a firm reports in any given period. Management has considerable control over the timing of actual expense items. They also can, to some extent, alter the timing of recognition of revenues and expenses (Teoh et al., 1998). When managers’ incentives are based on their companies’ financial performance, it may be in their self-interest to give the appearance of better performance through earnings management. Additionally, earnings management may impact investors by giving them false information. Capital markets use financial information to set security prices. Investors use financial information to decide whether to buy, sell, or hold securities. Market efficiency is based upon the information flow to capital markets. When the information is incorrect, it may not be possible for the markets to value securities correctly. Hence, earnings management may obscure real performance and lessen the ability of shareholders to make informed decisions. Teoh et al. (1998), Rangan (1998) and Dechow et al. (1996), also provide evidence that managers inflate earnings prior to seasoned equity offerings. Their results are consistent with the notion that managers seek to manage pre-issue earnings in an attempt to improve investors’ expectations about future performance. General evidence on the link between earnings management and corporate governance is provided by Cheng and Warfield (2005). They addressed the question of whether the propensity for earnings management is lower when management interest’s and owners’ interests are more closely aligned through higher managerial stock ownership. Their results confirm that earnings management is lower for firms with higher managerial ownership. The current paper explores the analysis of Cheng and Warfield (2005) further by examining whether board governance is relevant in constraining earnings management. The central issue of corporate governance is how to ensure accountability of senior managers to their stakeholders while simultaneously providing executives with the autonomy and incentives to exploit wealth producing strategies. There is a great deal of disagreement on how good or bad the existing governance mechanisms may be. For instance, Jensen and Warner (1988) and Jensen (1993) provide evidence that the US corporate governance system is deeply flawed and that a major move from the corporate form to a much more highly leverage organization is on the horizon. In contrast, Romano (2005) provides a very optimistic assessment of the US corporate governance system.

1995). While previous research suggests a relation between good governance practices and less fraudulent financial reporting (Beasley.000 þ US firms whose corporate governance practices are rated by the Institutional Shareholder Services (ISS).JAOC 5. (3) board size. The first data set consists of active Compustat companies with a December 31. and WorldCom was due in part to a weakness in their corporate governance systems as each allowed management to have an excessive concentration of power. coupled with the impossibility of writing explicit contacts on all future contingencies. consisting of four variables. consisting of six variables. financial institutions. (6) the existence and composition of a nominating committee. regulators. between shareholders and managers. the studies examining earnings management and SOX corporate governance issues are sparse and no definitive relationship has been determined. policy makers. (2) board structure. The act specifically targets corporate governance reform and has created a reporting system that now makes corporate governance more transparent to the public. congress enacted the Sarbanes-Oxley (SOX) Act on July 30. II. Hence. consisting of five variables. The second data set consists of the 6. Hypotheses development The importance of corporate governance has been a question of substantial interest to regulators. 1996). In addition. 2002. 2004 fiscal year-end. and the conclusions of the study are presented in Section V. and the media. Conflicts of interests. Tyco. Board characteristics are examined by looking at seven categories: (1) board composition. Corporate governance mechanisms are intended to mitigate . The paper extends prior research in this area by providing an extensive analysis of a broad range of board of director’s characteristics. consisting of seven variables. consisting of six variables. the development of rating schemes for corporate governance has added to its transparency. The rest of the paper is organized as follows. Section II provides hypotheses development. lead to unresolved agency problems that affect firm valuation (Hart. investors and other market participants have become increasingly aware of the need for corporations to have sound corporate governance policies and procedures.3 392 During the last decade. A major cause of the failure of corporations such as Enron. the current study expands this literature through the utilization of a study group generated from the overlap between two comprehensive data sets. In response to the corporate scandals. consisting of three variables. investors. (4) chief executive officer (CEO) and director characteristics. The main objective of the paper is to provide further evidence on the effects of the structure of the board of directors on earnings management as measured by discretionary accruals. (5) board disclosure polices. Section III presents the research model and variables. data analysis and discussion are included in Section IV. consisting of two variables. and (7) the existence and composition of a compensation committee.

They use firm-level governance data. They conclude that: first. have less severe practice of income smoothing... Gillan et al. Hartzell and Starks. Using board of directors and financial accounting data for a sample of firms listed on the Shanghai Stock Exchange and Shenzhen Stock Exchange from 2000 to 2002. as well as firms that have larger fraction of independent directors. Lai and Tam (2007) empirically examined whether independent directors serve an effective role as a corporate governance mechanism in reducing income-smoothing earnings management in China. The empirical results suggest that Chinese firms that voluntarily adopt independent directors. Lai and Tam explore whether the adoption of independent directors affects the negative relationship between the change in cash flows and accruals. Fizel and Louie (1990) found that CEO turnover is more related to internal governance structure than to firm performance. 1998. firms with good corporate governance tend to conduct less earnings management. Empirical tests demonstrate that overall governance quality is negatively related to the level of abnormal accruals and positively influences the return-earnings association. Berger et al. Niu (2006) examined the association between corporate governance mechanisms and the quality of accounting earnings. the relationship between the board size and market valuation (Yermack. Additionally. 2003. 2004). the effect of board composition has been tested in numerous studies (Barnhart et al. 1999). suggesting that entrenched management avoids long-term projects that could improve long-term stockholder value. For example. and the influence of institutional investors on executive compensation has been investigated (Karpoff et al. there is a size effect for earnings smoothing. in addition to the country-level governance data used in past studies. and the quality of earnings. CEO tenure has also been studied. 1999).. shareholders’ rights and the extent of disclosure of governance practices). Using firm-level corporate governance data for a sample of Canadian firms in the years 2001-2004. regression analysis explores the relation between corporate governance (including board composition. taken from Credit Lyonnais Security Asia. 2003). Prior research in the area of the relationship of corporate governance internal and external mechanisms and earnings management or firm performance has many directions. 1996) has been investigated. Core et al. of nine Asian countries. Governance and earnings management 393 . A central issue to corporate governance is how to ensure accountability of senior mangers to their stakeholders while simultaneously providing executives with the autonomy and incentives they need to produce wealth producing strategies. Shen and Chih (2007) studied the impacts of corporate governance on earnings management. the extent of alignment of management compensation with interests of shareholders and the strength of shareholder rights. Mangel and Singh. (1997) found that managerial entrenchment led to lower firm leverage. the relationship between boards and executive compensation has been examined (Conyon and Peck. Second. management shareholding. 1993.. the magnitude of abnormal accruals is negatively associated with the level of independence of board composition.. 1996. where the quality of earnings is measured in two ways: the accounting-based measure of earnings management and the market-based measure of earnings informativeness. In addition.agency costs by increasing the monitoring of management’s actions and limiting managers’ opportunistic behavior (Ashbaugh et al. 1998). Stockholders do not choose board members but simply ratify the choices given to them (Vafeas.

The current paper concentrates on discussing and analyzing the effects of board of directors’ characteristics on earnings management. They analyze the association between earnings management and two key aspects of corporate governance: board composition and the existence of board monitoring committees. Board size Empirical evidence suggests that efficiency is reduced by boards that are too large. Board composition Board composition variables deemed important by investors in a survey conducted by McKinsey & Company (2002) include the percentage of outside directors. Fourth. several hypotheses are developed that identify and link specific elements of governance to earnings management. stock options) and frequency of formal director evaluations.and the US-based research suggests. Nevertheless. such as profit performance or growth potential. H1 is as follows (in alternate form): H1. Osma and Noguer (2007) test whether corporate governance mechanisms promoted by best practice codes are effective in constraining earnings manipulation for a Spanish sample of quoted companies during the period 1999-2001. the existence and composition of a nomination committee affects the role of independent directors in constraining earnings manipulation. when the governance index is large. otherwise. but good corporate governance can mitigate the effect on average. firms with higher growth (lower earnings yield) are prone to engage in earnings smoothing and earnings aggressiveness. Hence.e. the percentage of independent directors. but by institutional directors. Huther (1997) identifies a negative relationship between board size and firm performance and argues that efficiency gains will result for the US firms by reducing .3 394 that is. i. as the UK.JAOC 5. The results show that board composition significantly determines earnings manipulation practices.e. The McKinsey Global Investor Opinion Survey shows that 15 percent of European institutional investors consider corporate governance as more important than a firm’s financial issues. there is a turning point for leverage effect. firms in stronger anti-director rights countries tend to exhibit stronger earnings smoothing. leverage effect exists. the main role in constraining such practices is not played by independent directors. large size firms are prone to conduct earnings smoothing. Finally. No correlation is found between the existence of an independent audit committee and earnings management measures. Finally. Hence. We hypothesize that firms with a greater proportion of independent directors will be less likely to engage in earnings management than those whose boards are staffed primarily with inside directors. Additionally. empirical studies on board composition in relation to firm performance have shown mixed results. but good corporate governance can mitigate the effect. Firms with more independent outsider boards have less discretionary accruals. However. Third. the percentage of director stockholdings (i. The results support that a highly leveraged firm with poor governance is prone to be scrutinized closely and thus finds it harder to fool the market by manipulating earnings. reverse leverage effect exists. the report indicates that 22 percent of European institutional investors are willing to pay an average premium of 19 percent for a well-governed company.

Within the theoretical governance literature. Similarly. When the CEO is also the board chairman.the size of their governing boards. Andres et al. Thus. Rahman and Ali (2006) investigate the extent of the effectiveness of monitoring functions of board of directors. Brickley et al. However. independence and size are relatively well defined. the CEO is also the chairman of the board. in contrast. 1993). (2005) analyze firms from ten countries in Western Europe and North America and find a negative relationship between firm value and size of the board directors. however. Agency theory suggests that CEO duality is bad for performance because it compromises the monitoring and control of the CEO. the monitoring effectiveness of the board is typically viewed as a function of its independence. the bank is more likely to record fewer discretionary loan loss provisions – and as a result inflate net income. is based on contradictory arguments presented by two different theories. their results do indicate that the relationship between duality and performance is contingent on the family’s ownership stake in the firm. Faleye (2003) finds that CEO duality is more likely when insider ownership is relatively large and the board is small. where abnormal working capital accruals are used as proxy for earnings management. Firms with a smaller size of board of directors have less discretionary accruals. the separation of CEO and board chairman is beneficial in terms of shareholder returns. The study also found that ethnicity (race) has no effect in mitigating earnings management. Yermack (1996) also finds that smaller boards are more efficient and that they exhibit better financial ratios. having different persons occupy the CEO and board Governance and earnings management 395 . Stewardship theory. The modernization of Malaysia and also the increase in Bumiputra ownership of national wealth may have caused the Malays to be more individualistic. audit committee and concentrated ownership in reducing earnings management among 97 firms listed on the Main Board of Bursa Malaysia over the period 2002-2003. the debate within the corporate governance framework as to whether the leadership structure consisting of the combination or the separation of the roles of the CEO and the chairman of the board contribute to or inhibit firm performance. potentially allowing for more management discretion. possibly due to the more individualistic behavior of the Bumiputra directors. (1997) report that in approximately 80 percent of US companies. In their 1997 study of earnings management at large banks. They find that duality by itself does not influence firm performance in FCPFs. argues that CEO duality may be good for performance due to the unity of command it presents. find CEO/chairman duality is significantly related to the use of discretionary loan loss provisions. This discussion leads to the development of H2: H2. When family ownership is low. Braun and Sharma (2007) examine the relationship between CEO duality and firm performance in family controlled public firms (FCPFs). The results reveal that earnings management is positively related to the size of the board of directors. CEO as chairman of the board Drawing from the findings of the corporate governance literature. size. CEO/chairman duality concentrates power in the CEO’s position. similar to their Chinese counterparts. The dual office structure also permits the CEO to effectively control information available to other board members and thus impede effective monitoring ( Jensen. The study employs the cross-sectional modified version of Jones (1991).. and leadership structure. Brickley et al.

(1999) find no evidence that independent outside directors create a more effective board. including the board of directors. for the financial year ending in 2000. whereas. thus. Bhagat and Black (1999) and Klein (1998) suggest that adding insiders to the board may enhance firm performance in some firms. the results also found a negative association between this measure and the existence of an audit committee. the audit committee.JAOC 5. Romano (2005) suggests that SOX was enacted too quickly by congress after the corporate scandals of 2000 and that empirical literature published prior to the enactment did not support the view that SOX would improve corporate governance or performance. CEO duality attracts a positive and significant relationship only when corporate performance is low. Firms with independent outside directors have less discretionary accruals. Romano suggests further that independent boards do not improve performance. stimulating increase usage of discretionary accruals to inflate income. However. (2005) investigate the role of a firm’s internal governance structure in constraining earnings management. a majority of non-executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management. Rosenstein and Wyatt (1990) argue that outside directors are selected in the interest of the shareholders. when an interaction term between industry type and CEO duality is included in the model. the following H3 is developed: H3. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. This discussion leads to the development of H4: H4. Kiel and Nicholson (2003) find a positive relationship between the proportion of insider directors and the market-based measure of firm performance. Following the above line of reasoning. Core et al. as measured by the absolute level of discretionary accruals. Inside/outside directors and board independence The question of whether or not an effective board should be comprised of a greater percentage of outside directors has been much debated. thus. Firms with separation of the role of board chairman and CEO have less discretionary accruals. the internal audit function and the choice of external auditor. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms. the impact of CEO duality on corporate performance is found to vary across industries. Based on a broad cross-sectional sample of 434 listed Australian firms. we argue that board structure may likely impact management’s willingness to manage earnings. Davidson et al. Using small increases in earnings as a measure of earnings management. Elsayed’s (2007) results indicate that CEO duality has no impact on corporate performance. Using a sample of Egyptian listed firms. .3 396 chairman positions is a useful governance control as the risk of family entrenchment increases. Bathala and Rao (1995) argue that a majority of outside directors on the board is not necessarily optimal as firms employ multiple mechanisms to control agency costs in the firm.

Governance variables All of the corporate governance characteristics of the board of directors are obtained from the ISS database for firms with financial statement year-end of December 31. The corporate governance variables are taken from the set of board characteristics variables used by ISS to determine a firm’s corporate governance index or score. audit firm. Five categories of board size taken from the ISS database are investigated. Both variables should be incorporated in formulas that express the effects of or the relationships between corporate governance and earnings managements. (1998) and Shen and Chih (2007) conclude that firm size has an impact on earnings management level.. board size. The characteristics that represent corporate governance characteristics of the board of directors are board composition. Board disclosure policies related to director characteristics are examined. we use the control variable LNSIZE. Among of these factors are firm size. taken from the ISS database. (1998) and Francis et al. Research model and variables The model that is used in the current study comprises two types of variables. For example. audit committee existence and independence) on earnings management in France. Table I summarizes the board of directors’ characteristics. Six dichotomous variables related to the nominating committee are examined and six characteristics summarized in the ISS database related to the compensation committee are investigated. board disclosure polices. auditor reputation and tenure. Becker et al. to control for this effect. Governance and earnings management 397 . Each of the corporate variables is a dichotomous variable. Control variables There are many factors that may affect the board of directors as well as the level of earnings management. In this study. Unlike annually elected boards. Piot and Janin (2007). CEO. the presence of: . nominating committee. and . (1999) reveal that firms audited by Big 6 auditors report lower levels of discretionary accruals than firms employing non-Big 6 auditors. The effects of audit firm on earnings management have inconsistent empirical results. 2004.e. where a numeric value is assigned to reflect the status of each variable. 2005). The term classified board is defined as boards whose members are elected on a staggered basis and serve a term of two to three years before coming up for election again. The discretionary accruals are estimated using the modified Jones cross-sectional model (DeFond and Subramanyam. Seven board composition variables. are employed in this study. measured as the natural log of total assets. a Big 5 auditor makes no difference regarding earnings management activities. board structure according to the ISS database includes two board structure variables which are examined in the study: classified boards and annually elected boards. 1998) with return on assets included as a control variable for performance (Kothari et al. investigate the effect of various audit quality dimensions (i. Becker et al. and capital structure. only some fraction of the board membership of a classified board would be up for election in a given year rather than the entire board membership. cash flow accruals and corporate governance variables. and compensation committee. board structure. an audit committee (but not the committee’s independence) curbs upward earnings management. The characteristics of the CEO are examined along four aspects. The main findings are.III.

IO # 90%) Board controlled by a supermajority of independent outsiders (IO . It is a dichotomous variable with a value of 1 if there is a mandatory age requirement and 0 if no disclosure DIRTERM A variable to examine the policy issue related to the disclosure of director term limits. If the chairman and CEO are not separate but there is a director. otherwise a value of 0 is assigned if there is no lead director CEOCHAIR A dichotomous variable examines the separation of chairman and CEO.7%) Board controlled by a supermajority of independent outsiders (66. then the variable has a value of 1. if the full board fulfills the nominating function. IO # 75%) Board controlled by a supermajority of independent outsiders (75 . 90%) Board has no more than 1 officer and “zero” affiliated outsiders on the board Staggered elected and serve a term of two to three years before elected again Annually elected boards Board size Board size Board size Board size Board size is is is is is less than 6 $6 and # 8 $9 and # 12 $13 and # 15 greater than 15 398 BDCOMPc BDCOMPd BDCOMPe BDCOMPf BDCOMPg Board structure BSTRUCTc BSTRUCTa Board size BDSIZEa BDSIZEb BDSIZEc BDSIZEd BDSIZEe Chief executive officer CEOSER Table I.7 .3 Governance variables Board composition BDCOMPa BDCOMPb Board controlled by insiders (insiders $ 50%) Board controlled by a majority of insiders and affiliated outsiders (I and AO $ 50%) Board controlled by a majority of independent outsiders (50 # IO # 66. The variable is assigned the value of 1. the variable is assigned a value of 1 if the former CEO is on the board and 0 if there are no former CEOs on the board CEOCHAIRDIR A dichotomous variable examines the chairman and CEO relation. the variable is assigned a value of 1 if the chairman and CEO are separate and 0 otherwise Board disclosure policies DIRAGERET A variable to examine the policy issue related to whether or not there is disclosure of a mandatory retirement age for directors.JAOC 5. it is assigned a value of 1 if the CEO serves on the boards of two or fewer public companies and 0 if the CEO serves on three or more boards of public companies CEOONBD A dichotomous variable refers to whether or not the former CEO is on the board or if there are no former CEOs on the board. The variable is a dichotomous variable with a value of 1 if term limits are disclosed and 0 if no disclosure DIRSTOCK A variable examines the issue of directors and stock ownership. otherwise the variable is 0 Nominating committee NOMCOMa Refers to who is performing the nominating function. otherwise the variable is assigned a value of 0 (continued) . The variable is assigned the value of one if all directors with more than one year of service own stock. Model variables A dichotomous variable to examine the number of boards on which the CEO serves.

if the full board fulfills the function. If affiliated outsiders are present. i. it takes a value of 1 if the auditor is a Big 4 firm. the variable is assigned a value of 1. hire their own advisors Compensation committee COMPENCOMa Refers to who is performing the compensation function. The value 1 is assigned if the compensation committee is comprised solely of independent outsiders and 0 if not COMPENCOMd Used to investigate the presence or absence of a compensation committee. otherwise the variable is assigned a value of 0 COMPENCOMb Used to denote whether or not the committee includes affiliated outsiders. hire their own advisor. Capital structure has an effect on earnings management as Piot and Janin (2007) indicated that there is a turning point for leverage effect. the variable is assigned a value of 1. The variable is assigned the value of 1. otherwise the variable is assigned a value of 0 LEV Control variable to denote the firm’s leverage. These contradictory results are considered in this study and hence we use the indicator variable BIG4AUD to control for this effect. when the governance . if necessary. If affiliated outsiders are present. if necessary. The variable is assigned a value of 1 if there is no nominating committee NOMCOMe Is used to examine the presence of insiders on the nominating committee. This variable has a value of 1 if the nominating committee is comprised solely of independent outside directors and may. The insiders’ variable is assigned the value 1 if the compensation committee includes insiders and 0 if otherwise COMPENCOMf Denotes whether the compensation committee is comprised solely of independent outside directors and the board has the authority to hire its own advisors if needed. otherwise the value of the variable is 0 NOMCOMc Refers to whether or not the nominating committee is comprised solely of independent outsiders. is measured as the natural log of total assets BIG4AUD Control variable to denote whether or not the firm’s auditor is a Big 4 firm. The variable is assigned a value of 1to denote the existence of a compensation committee and 0 if otherwise COMPENCOMe Used to examine the presence of insiders on the compensation committee.e. is measured as the ratio of total debt to total assets NOMCOMb Governance and earnings management 399 Table I. otherwise the variable is assigned a value of 0 Control variables LNSIZE Control variable to denote firm size. The variable is assigned a value of 1 if only independent outsiders are included on the nominating committee and 0 if otherwise NOMCOMd Refers to the presence or absence of a nominating committee.Governance variables Refers to whether or not the committee includes affiliated outsiders. otherwise the value of the variable is 0 COMPENCOMc Denotes whether or not the compensation committee is comprised solely of independent outsiders. This insiders’ variable is assigned the value 1 if the nominating committee includes insiders and 0 if otherwise NOMCOMf Examines whether the nominating committee is comprised solely of independent outside directors and the board has the authority to hire its own advisors. This variable has a value of 1 if the compensation committee is comprised solely of independent outside directors and may.

JAOC 5. firm’s auditor. EARNMANhp is an indicator variable for firms in the high income-increasing category. The relation between discretionary accruals and governance characteristics is examined by estimating the coefficients in the following logistic regression model (Model 1) after all corporate governance variables as well as control variables are considered. IV. leverage effect exists. Model 1: logistic regression model of earnings management: EARNMAN ¼ b0 þ b1 BDCOMPa þ b2 BDCOMPb þ b3 BDCOMPc þ b4 BDCOMPd þ b5 BDCOMPe þ b6 BDCOMPf þ b7 BDCOMPg þ b8 BSTRUCTc þ b9 BSTRUCTa þ b10 BDSIZEa þ b11 BDSIZEb þ b12 BDSIZEc þ b13 BDSIZEd þ b14 BDSIZEe þ b15 CEOSER þ b16 CEOONBD þ b17 CEOCHAIRDIR þ b18 CEOCHAIR þ b19 DIRAGERET þ b20 DIRTERM þ b21 DIRSTOCK þ b22 NOMCOMa þ b23 NOMCOMb þ b24 NOMCOMc þ b25 NOMCOMd þ b26 NOMCOMe þ b27 NOMCOMf þ b28 COMPENCOMa þ b29 COMPENCOMb þ b30 COMPEMCOMc þ b31 COMPENCOMd þ b32 COMPENCOMe þ b33 COMPENCOMf þ b34 LNSIZE þ b35 LEV þ b36 BIG4AUD þ 1 Definitions of all governance variables and control variables included in Model 1 are presented in Table I. The two definitions of earnings management. 2004 year-end and complete accrual data for 2004. ð1Þ .B. measured as the ratio of total debt to total assets. Data analysis and discussion Sample selection The study sample is based on a complete set of firms on Compustat with a December 31. Model 1. and government (SIC 9900) sectors are excluded due to their unique accounting practices which make the estimation of their discretionary accruals difficult. otherwise. EARNMANhn is an indicator variable for firms in the high income-decreasing category. and firm’s leverage.A. EARNMANhn and EARNMANhp. permit the examination of whether income-decreasing and income-increasing accruals have the same relationship with corporate governance practices or whether they have very different affects on corporate governance. Firms from regulated (Standard Industrial Classification – SIC 4000-4900). We employ three control variables in the study: firm size.3 400 index is large. two definitions of earnings management (EARNMAN) subset models can be derived based on Model 1 as: Model 1. financial (6000-9000). Using the discretionary extremes. In this study. we employ the control variable LEV to denote the company’s leverage. reverse leverage effect exists.

Descriptive statistics The information on the corporate governance variables comes from the ISS database. Baysinger and Butler’s (1985) and Byrd and Hickman’s (1992) categorization of board members is used in describing the composition of the sample firms’ boards.220 observations for the calculation of discretionary accruals. (2) the largest negative accruals (487 firms). An affiliated member is one who has some relationship with the firm or its executives. The firms are then ranked by the size of their discretionary accruals in order to stratify the sample into three groups of firms. the income-decreasing and income-increasing earnings management firms. whereas more negative discretionary accruals indicates a greater extent of downward earnings management. These requirements resulted in 3. The discretionary accruals for each firm in each of the industries are defined as the residual from the regression of total accruals on the change in revenue and the level of fixed assets subject to depreciation. and (3) small positive and negative discretionary accruals (506 firms). 126 firms with discretionary accruals in excess of the top and bottom 2 percent of all the observations are dropped to eliminate the effects of outliers because firms with very large income or cash flows from operations have been shown to bias the estimation of discretionary accruals. An insider refers to one who is employed by the firm. Table II indicates that none of the income-decreasing discretionary firms have boards controlled by a majority Governance and earnings management 401 . An outsider refers to one in which the only relationship to the firm or its executives is through the board of directors.The total accruals computation model used in this study requires an estimation of a cross-sectional regression for each industry. the study maintains the assumption that more positive discretionary accruals indicates a greater extent of earnings management upwards. We first estimate the ordinary least square regressions of total accruals on the change in sales from the previous year and on the gross level of fixed assets for firms in the same industry listed in Compustat in period t. 35 percent of these firms are controlled by a supermajority of more than 75 percent of independent outsiders. The sample used to separately estimate discretionary accruals for each of the 38 industries contains 3. As shown in the first column of Table II. By design. The descriptive statistics for the sample consisting of the two extreme earnings management groups. 88 percent of the income-decreasing discretionary firms have boards which are controlled by a majority of independent outsiders. Income-decreasing discretionary accrual firms.126 firms. Hence. Within this group.220 original firms due to missing data or having a Compustat value of zero for the firm’s previous year total assets amount. high-negative and high-positive discretionary accruals are presented in Table II. (1998) and Subramanyam (1996). Consistent with Becker et al. Table II presents a summary of descriptive statistics for the corporate governance characteristics and the control variables for the two sample groups. The specific definition for the variables appears in the Table I.126 firms after eliminating 94 of the 3. Discretionary accruals are then computed for each of the 3. the two-digit SIC codes are used and firms from industries with less than ten firms are eliminated. those with: (1) the largest positive accruals (523 firms).

332386 0.114989 0. IO # 66. IO # 75% Board controlled by a supermajority of independent outsiders 75 .177506 0. IO # 90% Board controlled by a supermajority of independent outsiders IO .528 * 1.126195 0.021032 0.28898 0.40792 0.296367 0.583162 0.04 * 1.03250 0.632 621.369024 0.15 * 391.488706 0.45174 0.349075 0.35 * 1.410.414.3 Variables 20.483002 0.001912 0.376397 0.457092 0.4 * (continued) .28666 0 0.043726 0.039.105162 0.115831 Discretionary accruals Board composition Board controlled by insiders I $ 50% Board controlled by a majority of insiders and affiliate I and AO $ 50% Board controlled by a majority of independent outsiders 50 .520.477168 0.399617 0.500386 0.96749 0.765 1.493542 0.170431 0.091778 0 0 0 0.210325 0.229979 0 0.273181 0.32 * 1.02 * 1.001912 0.307056 0.497497 0. 90% Board controlled by a supermajority of independent outsiders IO .008213 0 0.080082 0.09034 0.985626 0.424474 0.575525 0.464.68 * 1.186324 0.119148 0.494736 0.043726 0.27169 0.177506 0.7 .319337 0.79 * 21.143630 0.402 JAOC 5.554493 0.500335 0.51 * 5.494736 0.76 * 1.34 * 31. Discretionary descriptive statistics High-negative discretionary accruals (n ¼ 487) Mean SD High-positive discretionary accruals (n ¼ 523) Mean SD Test on differencea 0 924.12.7% Board controlled by a supermajority of independent outsiders 66.002053 0 0.58 * 131.045314 0 0.490288 0.421252 0. 90% Board structure Classified board Annually elected board Board size Board size is less than 6 Board size is $6 and #8 Board size is $ 9 and # 12 Board size is $13 and #15 Board size is greater than 15 Chief executive officer CEO serves on the boards of two or fewer public companies CEO is former CEO on the board Table II.431361 0.498177 0.246406 0.513347 0.

atest statistic comparing the two groups: x 2 for the dichotomous governance variables and Kruskal-Wallis for the control variables.476512 0.020533 0.Variables 0.172376 0.489488 476.433.463616 0 0.064018 0.297.120458 0.340344 0.030592 0.79 * 1.326636 0. .474278 0.155837 0.512.006160 0.43256 0.009560 0.356567 0.281010 0.248026 0.01 * 1279.878850 0.498559 0.439075 0.149870 0.248459 0.065708 0.018 827.47 * 1.001 level.07 * 716.04312 0.63 * 1.15 * 579.122846 0. n ¼ 1.37 * 1334.51 * High-negative discretionary accruals (n ¼ 487) Mean SD High-positive discretionary accruals (n ¼ 523) Mean SD Test on differencea Chairman and CEO are not separated but there is a lead director Chairman and CEO are separated Board disclosure policies All directors with more than one year of service own stock Mandatory retirement age for directors Director term limits Nominating committee Full board fulfills function Committee includes affiliated outsiders Committee comprised solely of independent outsiders No committee Committee includes insiders Committee comprised solely of independent outside directors and the board can hire its own advisor Compensation Committee Full board fulfills function Committee includes affiliated outsides Committee comprised solely of independent outsiders No committee Committee includes insiders Committee comprised solely of independent outside directors and the board can hire it own advisor Notes: *Significant at 0.170431 0.27 * 1.572895 0.09034 0.203338 0.236891 0.6 * 644.508.06 * 3.376397 0.043726 0.68833 0 0.015296 0.14196 0.12 * 1.325809 0.346959 0.203338 0.31431 0.001912 0.449.024856 0.097401 0.15 * 253.040152 0.078325 0.348861 0.1 * 763.141491 0.780114723 0.35467 0.059548 0.395793 0.004106 0.260038 0.010 Governance and earnings management 403 Table II.022944 0.652977 0.04312 0.852772 0.544147 0.13963 0.149139 0.110882 0.72 * 66.008213 0.41456 0.495166 0.193.9 * 1.196505 0.0862 0.

two-year term. of the income-increasing accrual firms have board sizes between six and eight (inclusive) members. three-year term. In an examination of board size. In contrast to the nominating committee.) and those which annually elect all members of the board. majority of the income-decreasing discretionary firms (65. Only. etc. 57. the percentage of independent outsiders is greater than 75 percent but less than or equal to 90 percent of the board’s membership.3 percent of the income-decreasing discretionary firms have classified boards and 48. Similar to the nominating committee. In 34 percent of the income-increasing firms. 8. The income-decreasing sample firms are almost evenly split between those boards which elect members with staggered year terms (one-year term. if desired. 98.6 percent of the CEOs in the income-decreasing discretionary firms serve on boards of two or fewer public companies. For 23 percent of the sample firms the former CEO currently serves on the board. in which cases.JAOC 5. A total of 121 firms (24. a majority (54. A look at the director characteristics in Table II shows 87. another 37 percent of the income-increasing firms have boards that are controlled by a supermajority of independent outsiders. The summary of the high-positive discretionary accruals in Table II for the income-increasing accrual group shows that 40 percent of the income-increasing firms have boards that are controlled by a majority of independent outsiders but the percentage of independent outsiders is less than or equal to two-thirds of the total board. However. Table II reveals that 58.3 percent of the income-decreasing discretionary firms have board sizes consisting of six to eight members.8 percent) in the income-decreasing discretionary sample group listed no nominating committee. As shown in Table II. Income-increasing discretionary accrual firms. As shown in Table II. however. Approximately. Table II shows that 21 firms or 4.6 percent of the sample firms have a mandatory retirement age policy disclosure for directors and less than 1 percent of the sample firms have a disclosure policy relating to term limits for directors.4 percent) of the sample firms list nominating committees comprised solely of independent outside directors with the authority to hire their own advisors.3 percent. while there are no firms in the sample with boards greater than 15 members.3 404 of insiders (I $ 50 per cent) or boards with any affiliated outsiders. the chairman and CEO are not separate but there . 55 percent. However. the former CEO currently serves on the board. 25 percent of the sample firms have boards with fewer than six members. A majority. Similar to the income-decreasing firms.3 percent) list compensation committees comprised solely of independent outside directors with the authority to hire their own advisors. if desired. for a majority of the income-decreasing discretionary firms. Column 3 of Table II indicates that 97 percent of the income-increasing firms’ CEOs serve on the boards of two or fewer public companies. For 21 percent of the income-increasing firms. the chairman and CEO are separate. In 11 percent of the firms the chairman and CEO are not separate but there is a lead director.8 percent have annually elected boards. 58 percent of the income-increasing firms indicate that their boards are classified. In contrast. 51. 13 percent of the income-increasing firms have a board size of less than six members. as reported by ISS.9 percent of all the directors with at least one year of service own company stock.3 percent of the income-decreasing discretionary firms listed no compensation committee. there are no income-increasing discretionary firms with boards controlled by a majority of insiders (I $ 50 per cent). Approximately. In total.

for a majority of the income-increasing accrual firms. if necessary. Both variables are significant at the 0.05. of the income-increasing firms listed nominating committees comprised solely of independent outside directors with the board having the authority to hire its own advisors. 85 percent of all the directors with at least one year of service own company stock. Unlike the 121 income-decreasing accrual firms. Only 2.5 percent have a disclosure policy related to director term limits. the summary of findings from both univariate tests indicate that when entire boards are elected annually. This finding is consistent with prior research that smaller boards are more efficient. income-decreasing discretionary accruals are lower. A look at the directors’ characteristics for the income-increasing firms reveals that 26 percent of the income-increasing firms have a disclosed mandatory age retirement policy. as opposed to staggered terms (some directors serving two-year terms and some three-year terms) and the number of directors is less than six. only 63 income-increasing firms listed no nominating committee. Ordinary least square regression is used to test the relation between the dependent variable.8 percent. in 40 percent of the income-increasing firms the chairman and CEO are separate. discretionary accruals are lower. 68. companies which elect board members on a staggering basis have a positive coefficient. In the case of directors and stock ownership. While the coefficient for board size less than six is negatively related to income-decreasing discretionary accruals and significant at the 0. more efficient with decision making and better monitors of the Governance and earnings management 405 . Annual election of board members has a negative coefficient. In contrast to the nominating committee.5 percent of the 523 income-increasing accrual firms listed no compensation committee. 78 percent. the univariate analysis of the association of income-decreasing discretionary accruals with the corporate governance characteristics for board composition and board structure indicates that only board structure has a significant correlation. Board composition. The univariate examination of income decreasing accruals indicates that board sizes between six and eight (inclusive) and between 13 and 15 members are unrelated to income-decreasing discretionary accruals. is unrelated to income-decreasing discretionary accruals. indicating that with a classified board structure income-decreasing discretionary accruals are higher. Univariate analysis. A majority. whether controlled by insiders. and high-positive discretionary accruals (EARNMANhp) (Tables are available from the authors). discretionary accruals and the independent variables. We find the coefficient for board size between nine and 12 (inclusive) to be positive and significant at 0.is a lead director. Table II indicates that eight or 1. Thus. However. indicating that a larger board size is associated with higher levels of earnings management.05 level.05 level. governance characteristics for the two accrual models – high-negative discretionary accruals (EARNMANhn). On the other hand. the compensation committee is comprised solely of independent outside directors with the board having the authority to hire its own advisors. However. However. there is a significant correlation of income-decreasing accrual with board structure. In summary. affiliated outsiders or independent outsiders. indicating that when the entire board is elected each year. These findings are consistent with the idea that smaller boards with yearly elections of each member are more accountable to stakeholders.

indicating that negative discretionary accruals are higher for companies whose nominating committee includes insiders. The coefficient of the leverage variable is negative and significant at the 0. the univariate findings of the control variables indicate that when size is observed independently. However. The coefficient of the variable is positive and significant at the 0. In summary. the proportions of affiliated outsiders or. are all unrelated to income-decreasing discretionary accruals also. respectively. However.01 and 0. A different behavior with respect to discretionary accruals is revealed by a nominating committee which includes insiders. The coefficient of the variable for the chairman and CEO are the same. The univariate analysis of the director policy disclosure characteristics.10 level. whether the committee can hire its own advisors. indicate that only the disclosure policy related to the mandatory retirement age for directors is related to income-decreasing discretionary accruals. even if there is a lead director.01 level. whether the compensation committee can hire its own advisors. The coefficient of the mandatory age retirement policy is positive and significant at the 0.01 level.01 level. the proportions of affiliated outsiders or. firm size and the employment of a “Big 4” auditor have positive coefficients and are significant at the 0. negative discretionary accruals are higher. indicating that as the more experienced directors are forced to retire. the findings show that the full board fulfilling the compensation function is unrelated to negative discretionary accruals. no nominating committee or.05 levels. the coefficient for a nominating committee comprised solely of independent outsiders is negative and significant at the 0.JAOC 5. the coefficient is positive and significant at the 0. indicating that as debt increases the ability to engage in income-decreasing earnings management is reduced. no compensation committee or.01 level. Similarly. the coefficient for a compensation committee comprised solely of independent outsiders is negative and significant at the 0. Examining the other characteristics of the CEO. The univariate regression results of the roles of the CEO and chairman and the board’s disclosure policies indicate that the dual role of the CEO is related to income-decreasing discretionary accruals.01 level. firm size is positively associated with income-decreasing . are unrelated to income-decreasing discretionary accruals as well. Additionally. the level of negative discretionary accruals increases. This finding is consistent with prior research which supports the notion that experienced directors seem to play a role in limiting earnings management. This finding indicates that when the CEO serves as chairman of the board. when there is a lead director. Results of the board’s nominating committee characteristics indicate that the full board fulfilling the nominating function is unrelated to negative discretionary accruals. insiders or. however. Similar to the nominating committee characteristics. the findings indicate that CEOs serving on the boards of two or fewer public companies and former CEO currently serving on the board are unrelated to negative discretionary accruals. These findings indicate that high-negative discretionary accrual firms are large firms and more likely to hire “Big 4” auditors. The results of the control variables. indicating that a totally independent compensation committee is associated with a reduced level of earnings management. indicating that earnings management is reduced by the presence of a nominating committee that is totally independent.3 406 company’s activities than larger boards with members elected to a two-or three-year staggered-rotation basis.

These findings indicate that high-negative discretionary accrual firms tend to have less debt. Ernst & Young. which is counterintuitive. firms with high-negative dictionary accruals and those with high-positive dictionary accruals. Test of difference between the two groups of firms. size. and PricewaterhouseCoopers. smaller firms engage in more income-increasing earnings management. Multivariate analysis. where. and Cox and Snell R 2 ¼ 70 percent. then one would expect high-negative discretionary accrual firms to have negative net income. Unlike the simple regression which indicated no significant board composition variables. we must keep in mind that this result is the single effect of leverage on earnings. However. when examining the type of auditor effect on decreasing discretionary accruals. Likewise. negative cash flows from operation and be highly leveraged. We conducted a multivariate regression analysis to take into consideration the simultaneous effects of all corporate governance variables and the control variables on earnings management. IO # 90 percent) is marginally significant at the 0. the results of the multivariate regression of the income-decreasing discretionary accrual firms indicate that the coefficient of the variable “board controlled by a supermajority of independent outsiders (IO . The supermajority independent outsider variable has a negative coefficient and is significant Governance and earnings management 407 . Income-increasing discretionary firms tend not to be audited by the “Big 4” and are likely to be highly leveraged.01 level. structure.968.000. Using a Wald test and simultaneously testing the effects of all of the corporate governance characteristics. board controlled by a supermajority of independent outsiders (75 . Table III presents the result of the omnibus tests of the coefficients and the model summary statistics for the income-decreasing discretionary accrual model (EARNMANhn). In summary. only high-negative and high-positive logistic regression models are used to test the relation between discretionary accruals and corporate governance characteristics. chairman and CEO duality and leverage. We carried out a univariate ordinary least square regressions analysis for the corporate governance characteristics and control variables results of the high-positive discretionary accrual firms (Tables are available from the authors). df ¼ 33. and board policies investigated in the current study. The univariate results of the analysis of the leverage control variable indicate that the coefficient of the variable is negative and significant at the 0.earnings management. KPMG. From the regression analysis of the high-positive discretionary accrual firms only one board governance characteristic had significant. using x 2-test for dichotomous governance variables and Kruskal-Wallis test for the control variables. as shown in prior literature involving cases of fraudulent and restated earnings studies. reveals significant association of all of the variables except the board structure variables.10 level and positively associated with income-increasing discretionary accruals. This finding indicate that income-decreasing discretionary accrual firms are more likely to hire one of the “Big 4” US accounting firms – Deloitte.05 level) association of “Big 4” auditors with decreasing earnings management. Our findings indicate that there is no meaningful direct relation between low-discretionary accrual earnings management and the effects of board composition. based upon the directional signs of the b coefficients of the high-positive discretionary accrual firms. the high-negative discretionary accrual model is highly significant with x 2 ¼ 1193. Hence. If. 90 percent)” is significant when included simultaneously with the seven variables intended to capture board composition. p ¼ 0. the results indicate a positive and significant (0.

507 223.110 2.304 3.038 20.01 level.743 16.770 1.375 0.000 0.659 0.000 * 0.443 1.185 2.729 0.228 0.968 0.975 0. 90%) Classified board Annually elected board Board size is less than 6 Board size is 6 and 8 Board size is 9 and 12 Board size is 13 and 15 Board size is greater than 15 CEO serves on the boards of two or fewer public companies Former CEO on the board Chairman and CEO are not separated but there is a director Chairman and CEO are separated Mandatory retirement age for directors Director term limits All directors with more than one year of service own stocks Full board fulfills nominating function Nominating committee includes affiliated outsiders Nominating committee comprised solely of independent outsiders No nominating committee Nominating committee includes insiders Full board fulfills compensation function Compensation committee includes affiliated outsiders Compensation committee comprised solely of independent outsiders No compensation committee Compensation committee includes insiders Compensation committee comprised solely of independent outside directors LNSIZE Leverage BIG4AUD x2 Adjusted R 2 Predicted sign None 2 2 2 2 2 þ 2 2 2 2 þ þ þ þ þ 2 þ þ 2 2 þ 2 þ 2 2 þ 2 þ þ 2 Coefficient 211.000 1.224 2.041 21.002 * 0.022 0.810 0.000 0. The model of high-negative earnings management: EARNMANhn ¼ b0 þb1 BDCOMPa þb2 BDCOMPb þb3 BDCOMPc þb4 BDCOMPd þb5 BDCOMPe þb6 BDCOMPf þb7 BDCOMPg þb8 BSTRUCTc þb9 BSTRUCTa þb10 BDSIZEa þb11 BDSIZEb þb12 BDSIZEc þb13 BDSIZEd þb14 BDSIZEe þb15 CEOSER þ b16 CEOONBD þ b17 CEOCHAIRDIR þ b18 CEOCHAIR þ b19 DIRAGERET þ b20 DIRTERM þb21 DIRSTOCK þ b22 NOMCOMa þb23 NOMCOMb þb24 NOMCOMc þb25 NOMCOMd þ b26 NOMCOMe þ b27 NOMCOMf þb28 COMPENCOMa þb29 COMPENCOMb þb30 COMPEMCOMc þ b31 COMPENCOMd þb32 COMPENCOMe þb33 COMPENCOMf þb34 LNSIZE þ b35 LEV þ b36 BIG4AUD þ 1 . IO # 90%) Board controlled by a supermajority of independent outsiders (IO .596 0.183 29.501 223.529 20.454 0.000 1.000 1.053 p-value 1. IO # 75%) Board controlled by a supermajority of independent outsiders (75 .999 1.000 1.631 19.165 20.JAOC 5.387 0.043 24.312 16.000 1.861 223.055 0.000 1.000 * 0.621 0.476 20.017 * 1.240 0.340 2.097 22.000 * 0.208 0.803 224.000 1. High-negative logistics regression results: EARNMANhn model Notes: *Significant at 0.193.3 Multiple regression results Variables Intercept Board controlled by a majority of insiders and affiliated outsiders (I and AO $ 50%) Board controlled by a majority of independent outsiders (50 # IO # 66.267 21.900 225.000 1.455 0.000 0.000 0.926 0.70 Table III.294 1.502 14.7 .000 1.047 * 408 1.247 5.779 221.672 17.7%) Board controlled by a supermajority of independent outsiders (66.504 2.329 20.

These results are consistent with the results of a similar study using UK data (Peasnell et al.009 * Governance and earnings management 409 Table IV.009 * 0.2 percent. 2005). the size variable (LNSIZE) as measured by total assets is negatively associated with decreasing income discretionary accruals. with the dependent variable. This finding can be interpreted to imply that as the seasoned. greater stock ownership by the directors leads to more efficient monitoring and a reduction in income-decreasing discretionary earnings management. The simultaneous regressions of the control variables. hence. the multivariate findings of the research indicate that the presence of income-decreasing discretionary accruals is not related to board size or CEO duality. However. The Wald-test of the simultaneous effect all of the corporate governance characteristics for the high-positive discretionary accrual model (EARNMANhp) indicate that the model is statistically significant with x 2 ¼ 90.at the 0.10 level. more highly leveraged and tend to be audited by the “Big4” US accounting firms.547 0. Control variables logistic regression results: high-negative discretionary accruals . However.000. LEVERAGE. Surprisingly. When simultaneously regressed with all of the corporate governance characteristics. In summary. The results indicate that all of the control variables are significant at the 0. Variable Firm size Firm’s leverage Firm audited by the “Big 4” x2 Adjusted R 2 Note: *Significant at 0.215.. the results of the logistic simultaneous regression of the income-decreasing discretionary accruals with the control variables indicate that the firms more likely to engage in income-decreasing discretionary accrual earnings management are smaller. BIG4AUD. unlike. The research findings also indicate that the director stock ownership governance variable is negatively related to the level of income-decreasing discretionary accruals.40. director stock ownership variable shows the strongest association of all of the significant variables.01 level and the model is significant with a x 2 ¼ 189. p ¼ 0. the unexpected negative direction found in the univariate analysis The “Big 4” variable is positively associated with income-decreasing discretionary accruals.553 0. The results lead to the rejection of both H2 and H3. p ¼ 0. more mature and experienced directors retire companies are left with less experienced directors and this tend to lead to an increase in negative discretionary accruals. decreasing discretionary accruals are shown in Table IV. LNSIZE. find that good governance is effective in reducing positive discretionary accruals but not negative.01 level Coefficient 20. and Cox and Snell R 2 ¼ 17.404 0. This finding indicates that income-decreasing discretionary accruals are reduced when boards are comprised almost entirely of independent outside directors.000. however. Perhaps. df ¼ 31. this is an indication of the agency theory at its best.172 p-value 0. there is a very strong positive association of income-decreasing discretionary accruals with board disclosure policies related to mandatory retirement for directors and director term limits. H1 is not rejected. The leverage variable is positively associated with income-decreasing discretionary accruals.000 * 0. df ¼ 3. same as in the simple regression but differing in significance.459 189. Peasnell et al.

The variable CEOCHAIRDIR which captures the characteristic that the chairman and CEO are not separated but there is a lead director is significant at the 0.05 level and positively associated with income-increasing earnings management. for income-increasing discretionary accruals CEO duality is significant and hypothesis three is rejected. Another possible explanation for the insignificant relationship between other corporate governance mechanisms (independence of board and audit committee) and earnings management is that the board of directors is seen as ineffective in discharging their monitoring duties due to management dominance over board matters. will enhanced corporate governance.01 level and negatively associated with income-increasing discretionary accruals. However. H4 is not rejected.JAOC 5. The results indicate that the variable. Surprisingly. Unlike income-decreasing discretionary accruals where the CEO duality characteristic is not significant. Table V presents the result of the omnibus tests of the coefficients and the model summary statistics for the income-increasing discretionary accrual model (EARNMANhp). Such justification may be supported by Ebrahim (2007) findings. such results could be justified based on possible explanations associated with the proxy chosen to express earnings management. The study findings indicate that income-increasing discretionary accruals are not related to the presence or composition of a nominating committee. However. The results. the findings are quite different for the compensation committee. In this case.4 percent.10 level and negatively associated with income-increasing earnings management. the results do indicate that income-increasing discretionary earnings management is reduced when CEOs serve on two or fewer public companies’ boards. the multivariate findings of the research indicate that the presence of income-increasing discretionary accruals is not related to any of the variables employed to capture board composition characteristics.01 level and positively associated with income-increasing discretionary accruals. This finding could be interpreted to imply that staggered board terms lead to a perceived unequal distribution of power by the newly elected directors. the findings do indicate that the structure of the board is significant. no compensation committee (COMPENCOMd) and compensation committee includes insiders (COMPENCOMe) are marginally significant at the 0. as he concluded that earnings management researches are sensitive to the different models suggested in literature to isolate the abnormal accruals. classified board (BDSTRUCTc) is significant at the 0. though not highly significant. accordingly. are counterintuitive implying that income-increasing discretionary accruals are . Each of the six nominating committee variables is insignificant. This perception may result in the newly elected directors following the leadership of the senior directors who may be more closely aligned with management and less effective monitors.3 410 and Cox and Snell R 2 ¼ 8. The variable CEOSER which capture whether or not the CEO serves on two or fewer public company boards is significant at the 0. However. The variables. The multivariate findings of the CEO characteristics indicate that only the CEO characteristics related to the number of public boards on which the directors serve is related to income-increasing discretionary accruals. even if there is a lead director. This finding supports the PCAOB position that limiting the number of public company boards on which a CEO may serve. This finding indicates that income-increasing earnings management is higher in situations where the CEO serves as chairman of the board.

520 2 0.865 0.864 2 24.309 0.082 p-value 1.084 Notes: *Significant at 0.452 0.258 0.973 0.000 1.310 1.000 1.293 2 21.000 0.919 0.176 2 10.464 2 0.257 0.175 2 0.000 2 0.01 level.729 2 24.456 0.444 0.347 0.206 0.648 0.138 0.800 0.668 Governance and earnings management 411 90.141 2 0.425 0.Multiple regression results Variables Interception Board controlled by a majority of insiders and affiliated outsiders Board controlled by a majority of independent outsiders Board controlled by a supermajority of independent outsiders Board controlled by a supermajority of independent outsiders Board controlled by a supermajority of independent outsiders Classified board Board size is less than 6 Board size is 6 and 8 Board size is 9 and 12 Board size is 13 and 15 CEO serves on the boards of two or fewer public companies Former CEO on the board Chairman and CEO are not separated but there is a director Chairman and CEO are separated Mandatory retirement age for directors Director term limits All directors with more than one year of service own stocks Full board fulfills nominating function Nominating committee includes affiliated outsiders Nominating committee comprised solely of independent outsiders No nominating committee Nominating committee includes insiders Nominating committee comprised solely of independent outside directors Full board fulfills compensation function Compensation committee includes affiliated outsiders Compensation committee comprised solely of independent outsiders No compensation committee Compensation committee includes insiders LNSIZE Leverage BIG4AUD x2 Adjusted R 2 Predicted sign None þ 2 2 2 2 þ 2 2 2 þ þ þ þ 2 þ þ 2 2 þ 2 þ 2 2 2 þ 2 þ þ Coefficient 23.419 2 0.059 0.953 0.023 * 0.000 1. High-positive discretionary accruals results: model EARNMANhp .636 2 0.765 0. The model of high-positive earnings management: EARNMANhp ¼ b0 þ b1 BDCOMPa þ b2 BDCOMPb þ b3 BDCOMPc þ b4 BDCOMPd þ b5 BDCOMPe þ b6 BDCOMP f þ b7 BDCOMP g þ b8 BSTRUCT c þ b9 BSTRUCTa þ b10 BDSIZE a þ b11 BDSIZEb þ b12 BDSIZEc þ b13 BDSIZEd þ b14 BDSIZEe þ b15 CEOSER þ b16 CEOONBD þ b17 CEOCHAIRDIR þ b18 CEOCHAIR þ b19 DIRAGERET þ b20 DIRTERM þ b21 DIRSTOCK þ b22 NOMCOMa þ b 23 NOMCOM b þ b24 NOMCOMc þ b25 NOMCOMd þ b 26 NOMCOM e þ b27 NOMCOMf þ b28 COMPENCOMa þ b29 COMPENCOMb þ b30 COMPEMCOMc þ b31 COMPEN COMd þ b32 COMPENCOMe þ b33 COMPENCOMf þ b34 LNSIZE þ b35 LEV þ b36 BIG4AUD þ 1 Table V.215 0.999 0.112 0.000 * 0.206 0.209 2 0.000 * 0.516 0.377 0.013 1.527 0.179 0.039 * 0.023 * 0.905 0.301 0.803 2 24.882 2 24.029 2 0.852 2 24.774 0.158 0.000 1.939 1.016 * 0.279 0.046 * 0.000 1.

662.637 2 0. The simultaneous regressions of the control variables. p ¼ 0. the role of the structure of the board of directors. Perhaps. the multivariate findings of the income-increasing discretionary control variables indicate that the larger firms. indicating that high income-increasing discretionary accruals firms are less likely to hire auditors from the “Big 4” US accounting firms.01 level Coefficient 0. In summary.013 * 0. the “Big 4” variable is not significant though it is important to note that the coefficient is negative indicating that hiring of a “Big 4” auditor tends to reduce income-increasing earnings management.3 412 reduced if management compensation decisions are made by a committee of the board members which includes insiders or at worst no board compensation committee at all. df ¼ 3. These firms tend to have less debt and though not statistically significant. and Cox and Snell R 2 ¼ 2. reduces earnings management. one can assume that these companies are not listed on the New York Stock Exchange (NYSE) or they are controlled companies exempted from the NYSE listing requirement that companies must have a compensation committee which consists entirely of independent directors.5 percent. and board disclosure policies are examined to determine the extent of their relationship to corporate earnings management as measured by the level of income-increasing and income-decreasing discretionary accruals. Additionally.662 0. The income-decreasing discretionary accruals firms are more likely to be smaller firms. directors characteristics. increasing discretionary accruals are shown in Table VI. As in the univariate analysis. as measured in terms of total assets. Conclusions This study investigates whether the earnings management activity of a firm is impacted by the firm’s corporate governance practices.000. V. The leverage variable is negatively associated with income-increasing discretionary accruals. with the dependent variable. committees structure. The results indicate that the size and leverage control variables are significant at the 0.771 Table VI. more highly leveraged and tend to hire Variable Firm size Firm’s leverage Firm audited by the “Big 4” x2 Adjusted R 2 Note: *Significant at 0. are more likely to engage in income-increasing discretionary accrual earnings management. Nevertheless. the direction of the variable indicates that the attestation process helps to reduce income-increasing earnings management. size. LNSIZE.01 level. However. LEVERAGE.173 2 0. BIG4AUD.000 * 0. Control variables logistic regression results: high-positive discretionary accruals .JAOC 5.054 25. the direction of the coefficient BIG4AUD is negative. The overall model is significant with x 2 ¼ 25. In particular. the results may imply that insiders bring a different level of knowledge and expertise to the compensation decision-making process which results in more efficient monitoring and thus. The findings of the research indicate that income-increasing and income-decreasing discretionary accruals have a different relationship with corporate governance practices. the size variable (LNSIZE) as measured by total assets is positively associated with increasing discretionary earnings management. its composition.025 p-value 0.

The findings reveal that mandatory retirement age for directors and director term limits are positively associated with income-decreasing earnings management. 90 per cent) and boards in which all directors with more than one year of service own stock. This finding may have policy implications for the PCAOB or the listing exchanges which may opt to take a position on limiting the number of public company boards on which a CEO may serve. the research findings do imply that certain board characteristics may be important factors associated with constraining the propensity of managers to engage in earnings management and this emphasizes the need of policy Governance and earnings management 413 .“Big 4” US auditors. The results of the logistic regression models suggest that there are some governance best practices and other firm characteristics associated with less earnings management. the CEO duality is very significant at the 0. the findings imply an association between the corporate governance board characteristics and earnings management and cannot be interpreted as demonstrating a causal link between board of directors and earnings management due to the endogeneity problem that plagues much of the board of directors literature. (2000) in their study on leadership structure find approximately 81 percent of their sample firms to have CEO duality. In the present study. boards where the chairman and CEO are not separated. however. It is important to note that in the current study 67 percent of the decreasing discretionary accrual firms have CEO duality. The results of the logistic regression models also suggest that some governance characteristics are associated with increasing earnings management.01 level and is positively associated with income-increasing earnings management. the direction of the coefficient BIG4AUD is negative. This finding indicates that income-increasing discretionary accruals are reduced when CEO board services are restricted to two or fewer public companies. board with no compensation committee and boards in which the compensation committee includes insiders. These firms tend to have less debt and though not statistically significant. 74 percent of the income-increasing discretionary firms have CEO duality and 26 percent of the low-discretionary accrual firms have CEO duality. Brickley et al. The variable CEOSER which captures whether or not the CEO serves on two or fewer public company boards is highly significant and negatively associated with income-increasing discretionary accruals. Specifically. are larger firms. as measured in terms of total assets. the following governance characteristics are negatively associated with income-decreasing earnings management: boards controlled by a supermajority of independent outsiders (IO . indicating that high income-increasing discretionary accruals firms are less likely to hire auditors from the “Big 4” US accounting firms. One caveat of the research must be kept in mind. Nevertheless. Income-increasing discretionary accrual firms. For the income-increasing discretionary accruals the governance characteristics positively associated with earnings management are classified board and CEO duality. These percentage are not unusual. Surprisingly. The results of this study indicate that income-increasing discretionary earnings management may be reduced when CEOs serve on two or fewer public companies’ boards. none of the significant governance characteristics have the same effects on the likelihood of income-decreasing and income-increasing discretionary accruals. The governance characteristics negatively associated with income-increasing discretionary accruals include: boards who’s CEO serves on the boards of two or fewer public companies.

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