Earnings Management, Corporate Governance, and True Financial

Performance

Marcia Millon Cornett*

Alan J. Marcus**
Anthony Saunders***
Hassan Tehranian****
May 2005
Revised: January 2006

The authors are grateful to Alex Fayman for his research assistance. We thank Mike Barry, Jim
Booth, Susan Chu, Richard Evans, Wayne Ferson, Edith Hotchkiss, Darren Kisgen, Gil Manzon, Jeff
Pontiff, Jun Qian, Pete Wilson, and seminar participants at Boston College, Southern Illinois
University, and University of New Orleans for helpful comments.
*College of Business and Administration, Southern Illinois University, Carbondale, IL 62901.
(618) 453-1417; mcornett@cba.siu.edu
** Wallace E. Carroll School of Business, Boston College, Chestnut Hill, MA 02467. (617) 5522767; alan.marcus@bc.edu
***Salomon Center, Stern School of Business, New York University, New York, 10020. (212) 9980711; asaunder@stern.nyu.edu
**** Wallace E. Carroll School of Business, Boston College, Chestnut Hill, MA 02467. (617) 5523944; hassan.tehranian@bc.edu

Earnings Management, Corporate Governance, and True Financial Performance

ABSTRACT

This paper addresses two questions. First, do corporate governance mechanisms that have been
shown to affect firm behavior in other contexts also affect the degree to which firms advantageously
manage their reported financial performance? Second, does past research investigating the impact of
governance structure and option-based compensation on firm performance stand up when measured
performance is adjusted for the impact of earnings management? We demonstrate that corporate
governance mechanisms effectively constrain discretion in earnings management and that the
estimated impact of governance variables on corporate performance is far stronger when discretionary
accruals are removed from reported earnings. Institutional ownership of shares, institutional investor
representation on the board of directors, and the presence of independent outside directors on the
board all reduce the use of discretionary accruals in earnings management. These factors largely
offset the impact of options compensation, which we find strongly encourages earnings management.
Earnings management strongly affects patterns of reported corporate performance. While
conventional profitability measures suggest a strong relationship between option compensation and
firm performance, profitability measures that are adjusted for the impact of discretionary accruals
show no relationship with option compensation. In contrast, the estimated impact of corporate
governance variables on firm performance more than doubles when discretionary accruals are
eliminated from measured profitability.

Earnings Management, Corporate Governance, and True Financial Performance

1. Introduction
Accountants and financial economists have recognized for years that firms use latitude in
accounting rules to manage their reported earnings in a wide variety of contexts. Healey and Wahlen
(1999) conclude in their review article on this topic that the evidence is consistent with earnings
management to window dress financial statements prior to public securities offerings, to increase
corporate managers compensation and job security, to avoid violating lending contracts, or to reduce
regulatory costs or to increase regulatory benefits. Since then, evidence of earnings management has
only mounted. For example, Cohen, Dey, and Lys (2004) find that earnings management increased
steadily from 1997 until 2002. Options and stock-based compensation emerged as a particularly
strong predictor of aggressive accounting behavior in these years (see Gao and Shrieves, 2002;
Cohen, Dey, and Lys, 2004; Bergstresser and Philippon, 2004; Cheng and Warfield, 2005).
At the extreme, earnings management has resulted in some widely-reported accounting
scandals involving Enron, Merck, WorldCom, and other major U.S. corporations. Congress
responded to the spate of corporate scandals that emerged after 2001 with the Sarbanes-Oxley Act,
passed in June 2002. Sarbanes-Oxley requires public companies to make sure their boards audit
committees have experience with applying generally accepted accounting principles (GAAP) for
estimates, accruals, and reserves.
The passage of Sarbanes-Oxley raises the question of whether corporate governance
mechanisms other than government oversight might serve to increase the quality of financial
reporting. While there is an extensive literature on opportunistic earnings management in response to
specific incentives to achieve one result or another, research looking at the impact of corporate
governance on earnings management is fairly limited. The few papers that address these issues (e.g.,
Klein, 2002 or Warfield, Wild, and Wild, 1995) focus more on the magnitude than the direction of
earnings management. Thus, they shed little light on the ability of these variables to offset the onesided incentive of management to increase reported earnings that results from stock and option-based

compensation. Moreover, the range of corporate governance variables studied in the context of
earnings management has to date been limited. In particular, these papers do not address the role of
outside investors in disciplining management. Previous research (e.g., Hartzell and Starks, 2003) has
demonstrated that such investors constrain managerial behavior.
This paper addresses two questions. First, do corporate governance mechanisms that have
been shown to affect firm behavior in other contexts also affect the degree to which firms
advantageously manage their reported financial performance? Second, does past research that finds
governance structure and option-based compensation impacts firm performance stand up when
measured performance is adjusted for the impact of earnings management? Thus, this paper reexamines the impact of incentive compensation and corporate governance on firm performance in
light of potential earnings management. We find that corporate governance variables that have been
shown to affect corporate behavior and performance in other contexts also affect firms accounting
choices. Specifically, much past research suggests that incentive-based compensation has a significant
impact on financial performance as measured by reported earnings. However, we find that once those
earnings are adjusted for discretionary accruals, the link between compensation and performance
disappears. In contrast, the estimated impact of corporate governance variables on performance more
than doubles when discretionary accruals are removed from measured profitability.
The rest of the paper is organized as follows. Section 2 briefly reviews the literature on
earnings management as it relates to our hypotheses. Section 3 discusses internal corporate
governance mechanisms shown to be important in other contexts and that might have an impact on
accounting behavior. Section 4 presents information regarding the data and methodology. Section 5
presents empirical results and Section 6 concludes the paper.
2. Earnings Management
2.1 Opportunistic Earnings Management
The opportunistic accruals-management literature largely started with Healy (1985), who
concludes that managers use accruals to strategically manipulate bonus income. For example ,

managers can defer income through accruals when an earnings target for a bonus plan cannot be
reached or when bonuses have already reached maximum levels, and can accelerate income in other
periods. Guidry, Leone, and Rock (1999) use data from businesses unit level rather than firm level
and find evidence consistent with Healeys bonus manipulation effects. Gaver, Gaver, and Austin
(1995), who study discretionary accruals rather than total accruals, also conclude that earnings are
managed, but to smooth income rather than manipulate bonuses. Finally, Holthausen, Larcker, and
Sloan (1995) also conclude that managers may use accruals to shift earnings over time with the goal
of maximizing long-term bonus income.
More recent work focuses on the use of earnings management to affect stock price, and with
it, managers wealth. For example, Sloan (1996) finds that if a firms earnings are inflated using
aggressive accruals assumptions, the market views the inflated earnings as more than cosmetic, and
the firms stock price will be affected. Teoh, Welch, and Wong (1998a, 1998b) find that firms with
more aggressive accrual policies prior to IPOs and SEOs tend to have poorer post-issuance stock price
performance than firms with less aggressive accounting policies. Their results suggest that earnings
management inflates stock prices prior to the offering. Similarly, Beneish and Vargus (2002) find that
periods of abnormally high accruals (which inflate earnings) are associated with increases in insider
sales of shares, and that after the event period, stock returns tend to be poor.
Option and restricted stock compensation is a particularly direct route by which management
can potentially increase its wealth by inflating stock prices. Indeed, considerable evidence links such
compensation to higher degrees of earnings management. Gao and Shrieves (2002), Bergstresser and
Philippon (2004), Cohen, Dey, and Lys (2004) , and Cheng and Warfield (2005) all find that the use of
discretionary accruals and earnings management is more prevalent at firms where top management
compensation is more closely tied to the value of stock in general, and options more particularly.
Burns and Kedia (2003) show that firms whose CEOs have large options positions are more likely to
file earnings restatements.
2.2 Earnings Management and Corporate Governance

The literature on the impact of corporate governance on earnings management is more sparse.
Some authors (e.g., Dechow, Sloan, Sweeney, 1996; Beasley, 1996) have investigated the relationship
between outright fraud and board characteristics. These papers, however, do not focus on the strategic
use of allowable discretion in accounting policy.
Klein (2002) shows that board characteristics such as audit committee independence predict
lower discretionary accruals. She focuses on absolute rather than signed accruals, however.
Therefore, while her measure captures the noise introduced in earnings numbers due to managerial
discretion, it does not measure systematic aggressiveness of accounting choice. Warfield, Wild, and
Wild (1995) also examine the impact of corporate governance variables on earnings management.
They find that a high level of managerial ownership is positively related to the explanatory power of
reported earnings for stock returns. They also examine the absolute value of discretionary accruals
and find that it is inversely related to managerial ownership. Like Kle in, they conclude that corporate
governance variables may affect the degree to which latitude in accounting rules affect the
informativeness of reported earnings, but do not address the degree to which governance or
compensation variables affect the average aggressiveness of accounting choice.
3. Corporate Governance and Earnings Management
Corporate governance variables have been shown in other contexts to affect firm behavior.
Such variables include institutional ownership in the firm, director and executive officer stock
ownership, board of director characteristics, CEO age and tenure, and CEO pay-for-performance
sensitivity. We discuss these next.
3.1 Institutional Ownership
McConnell and Servaes (1990), Nesbitt (1994), Smith (1996), Del Guercio and Hawkins
(1999), and Hartzell and Starks (2003) have found evidence that corporate monitoring by institutional
investors can constrain managers behavior. Large institutional investors have the opportunity,
resources, and ability to monitor, discipline, and influence managers. These papers conclude that
corporate monitoring by institutional investors can force managers to focus more on corporate

performance and less on opportunistic or self-serving behavior. If institutional ownership enhances

monitoring, it could also be associated with lower use of discretionary accruals. However, at least in
principle, it is possible that managers might feel more compelled to meet earnings goals of these
investors, and thus engage in more earnings manipulation.
3.2 Director and Executive Officer Stock and/or Option Ownership
Higher stock and/or option ownership by directors and executive officers may encourage
them to use discretionary accruals to improve the apparent performance of the firm, thereby
increasing their personal wealth. Consequently, higher stock ownership by directors and executive
officers may cause managers to use discretionary accruals to inflate reported earnings and,
consequently, board members personal wealth. Thus, stock ownership by this group would be
associated with a greater use of discretionary accruals. Stock options are particularly potent in making
managers wealth sensitive to stock price, and so may have an even greater impact on earnings
management.
3.3 Board of Director Characteristics
3.3.1 Percent of Independent Outside Directors on the Board
There is considerable literature on the impact of the composition of the board of directors
(i.e., inside versus outside directors). Boards dominated by outsiders are arguably in a better position
to monitor and control managers (Dunn, 1987). Outside directors are independent of the firms
managers, and in addition bring a greater breadth of experience to the firm (Firstenberg and Malkiel,
1980; Vance, 1983). A number of studies have linked the proportion of outside directors to financial
performance and shareholder wealth (Brickley, Coles, and Terry, 1994; Byrd and Hickman, 1992;
Subrahmanyan, Rangan, and Rosenstein, 1997; Rosenstein and Wyatt, 1990). These studies
consistently find better stock returns and operating performance when outside directors hold a
significant percentage of board seats. Consequently, if outside membership on the board enhances
monitoring, it would also be associated with lower use of discretionary accruals.
3.3.2 CEO/Chair Duality

In about 80 percent of U.S. companies, the CEO is also the chairman of the board (Brickley,
Coles and Jarrell, 1997). CEO/Chair duality concentrates power in the CEOs position, potentially
allow ing for more management discretion. The dual office structure also permits the CEO to
effectively control information available to other board members and thus impedes effective
monitoring (Jensen, 1993). Consequently, if CEO/Chair duality impedes effective monitoring, it
would also be associated with greater use of discretionary accruals.
3.3.3 Board Size
Jensen (1993) argues that small boards are more effective in monitoring a CEOs actions, as
large boards have a greater emphasis on politeness and courtesy and are therefore easier for the
CEO to control. Yermack (1996) also concludes that small boards are more effective monitors than
large boards. These studies suggest that the size of a firms board should be inversely related to
earnings management. If small boards enhance monitoring, they would also be associated with less
use of discretionary accruals.
3.4 Age and Tenure of CEO
The age and tenure of the CEO may determine his or her effectiveness in managing the firm.
Some studies suggest that top officials with little experience have limited effectiveness because it
takes time to gain an adequate understanding of the company (Bacon and Brown, 1973; Alderfer,
1986). These studies suggest that the older or the longer the tenure of the firms CEO, the greater the
understanding of the firm and its industry, and the better the performance of the firm. Consequently,
if older, more experienced CEOs enhance firm performance, they would also be associated with
lower use of discretionary accruals.
4. Data and Methodology
4.1 Discretionary Accruals
Dechow, Sloan, and Sweeney (1995) compare several models of accrual management and
conclude that the so-called modified Jones model provides the most power for detecting such
management. Bartov, Gul, and Tsui (2001) also support the use of the modified Jones model, estimated
in a cross-section using other firms in the same industry. Despite concerns about its power (Kothari,

Leone, and Wasley, 2005), it remains the most popular model for estimating accrual behavior (e.g,
Kothari, Loutskina and Nikolaev, 2005). Discretionary or abnormal accruals equal the difference
between actual and normal accruals, using a regression formula to estimate normal accruals.
The modified Jones model estimates normal accruals from the equation:1
TAjt
1
Salesjt
PPEjt
= 0
+ 1
+ 2
Assetsjt- 1
Assetsjt- 1
Assetsjt- 1
Assetsjt- 1

(1)

where:
TAjt
= Total accruals for firm j in year t,
Assetsjt = Total assets for firm j in year t (Compustat data item 6),
Salesjt = Change in sales for firm j in year t (Compustat data item 12), and
PPEjt = Property, plant, equipment for firm j in year t (Compustat data item 7)
Total accruals equal:
in current non-cash assets (Compustat data item 4 - item 1)
- in current liabilities (Compustat data item 5)
+ in long-term debt in current liabilities (Compustat data item 34)
- Depreciation (Compustat data item 14)
Discretionary accruals, DAjt , are then measured as:
TAjt
^
1
Salesjt - Receivablesjt ^ PPEjt
-
+ ^1
+ 2

(2)
0
Assetsjt- 1 Assetsjt- 1
Assetsjt- 1
Assetsjt- 1
where hats denote estimated values from regression equation (1). The inclus ion of Receivables jt
[Compustat item 151] in regression (2) is the modification of the Jones model. This variable
attempts to capture the extent to which a change in sales is in fact due to aggressive recognition of
questionable sales.2

The regression is estimated as a pooled time series-cross section for the 1993-2000 sample period including
every firm with the same 3-digit SIC code as the firm in question.
2

A criticism of the Jones model is that it may be important to control for the impact of financial performance
on accruals. Kothari, Leone, and Wasley (2005), show that (i) matching firms based on operating performance
gives the best measure of discretionary accruals, and (ii) including ROA on the right-hand side of equation (1)
improves the performance of the Jones models . In addition, McNichols (2002) points out that firms
experiencing higher growth tend to have higher accruals. We use the book-to-market ratio to measure growth
since firms with greater growth prospects are apt to have lower book-to-market ratios. Therefore, as a robustness
check on the modified Jones model, we also estimated an augmented Jones model for normal accruals as in
Cohen, Dey and Lys (2004) as follows:
TAjt
1
Salesjt
PPEjt
= 0
+ 1
+ 2
+ 3 CFROAjt + 4 BMjt
(3)
Assetsjt- 1
Assetsjt- 1
Assetsjt- 1
Assetsjt- 1
where
CFROA =

cash flow return on assets (annual earnings before interest and taxes plus depreciation
divided by total assets),

Large values of discretionary accruals are conventionally interpreted as indicative of earnings

management. Because discretionary accrua ls can be used to both increase or decrease earnings, in
some contexts (e.g., Klein, 2002 or Cohen, Dey, and Lys, 2004) the absolute value of discretionary
accruals is the appropriate measure to use to determine whether earnings management occurs.3
Bergstresser and Philippon (2004) study both signed and absolute accruals. They show that the late
1990s was characterized by a strong secular increase in accruals, suggesting a one-sided incentive to
raise reported earnings, consistent with increasing use of option compensation in that period.
As described below, our sample also is characterized by a strong bias toward positive
accruals. Accordingly, we examine the properties of the signed as well as the absolute value of
discretionary accruals. Moreover, when we examine measures of firm performance, we adjust cashflow ROA to its unmanaged value by netting out discretionary accruals. This requires that actual
discretionary accruals, not their absolute values, be deducted from reported earnings.
4.2 Other Data
The sample examined here consists of firms included in the S&P 100 Index (obtained from
Standard & Poors) as of November 1993. We use S&P 100 firms because they are among the largest
firms, representing a large share of aggregate market capitalization, and consequently command great
interest among institutional investors. Thus, these large firms enable us to test the impact of such
investors on earnings management. While institutional ownership is most prevalent in large firms
such as these, even in this group, there is considerable variation in such ownership. The sample
standard deviation of share ownership by institutional owners is 13.8 percent. Moreover, this sample
BM =

ratio of book value of common to market value of shares

These additions had no material impact on our results.

3

Over long periods of time, discretionary accruals will reverse. Strategic time -shifting of income will result
in abnormally high accruals in some periods and low accruals in others. In other contexts, however, there is a
clear presumption concerning the desired direction of earnings management: for example, when there are
incentives to increase the stock price in anticipation of options exercises. Moreover, using a time period
common to our study, Bergstresser and Philippon (2004) document a strong secular increase in accruals,
consistent with a systematic and increasing bias toward inflation of earnings rather than simple transfers of
earnings across time. We provide results on both signed and absolute discretionary accruals.

is interesting precisely because these firms are relatively stable. Prior studies have shown that
earnings management is more prevalent in poorly-performing firms (Cohen, Dey and Lys, 2004;
Kothari, Leone, Wasley, 2005) and that models of discretionary accruals are least reliable when
applied to firms with extreme financial performance (Dechow, Sloan and Sweeney, 1995). We look at
factors that influence earnings management in normal times and on the degree to which measured
performance of even blue-chip firms is affected by that management. The fact that these firms are
all free of financial distress makes the augmentation of the Jones model discussed in footnote 2 less of
an issue for our sample . This is a conservative sample-selection choice in that S&P 100 firms should
be a relatively difficult sample in which to find heavy use of discretionary accruals.
Firms that were dropped from the S&P 100 after 1993, but that remained publicly traded and
continued to operate, remain in the sample. Removing these firms would have introduced sample
selection bias as firm performance is associated with ongoing inclusion in the S&P index. However,
some firms were lost due to non-performance related events. Eleven of the 1993 S&P 100 firms
were eventually acquired by other firms over the sample period and are dropped from the sample in
the year of the merger. Another nine firms were lost by the year 2000 due to the unavailability of
proxy or institutional investor ownership data. After these adjustments to the data, we are left with a
sample of 676 firm-years. 4
Following Healy et al. (1992), who examine post-merger performance of firms, and Kothari,
Leone, and Wasley (2005), operating performance is measured as operating cash flow return on
assets, CFROA. This measure of performance is effectively independent of financial leverage. The
financial statement data needed to calculate CFROA are obtained from the Compustat database for
each year, 1993-2000.
CFROA offers several advantages over Tobins q, an alternative measure of firm
performance. While Tobins q reflects growth opportunities (and, more generally, expectations of the
4

In the regression analysis below, we trim extreme data points, eliminating the top and bottom one percent of
observations for each right-hand side variable. Therefore, the number of data points in our regressions is
reduced from 676 to 662.

firms prospects in future years) through the impact of these factors on market value, cash flow return
on assets is a more focused measure of current performance. For example, the Tobins q of a poorly
performing firm might be inflated by expectations of a premium bid in a corporate takeover.
Regressions of Tobins q on institutional ownership are more susceptible to endogeneity problems if
institutions are attracted to growth stocks or chase recent stock-market winners. These sorts of
considerations do not affect CFROA as a measure of financial performance since operating
performance is not tied to stock prices.
Both the levels and changes in CFROA may be affected by extraneous industry trends.
Therefore, we measure firm performance in each year as an industry-adjusted ROA, denoted IAROA,
i.e., as the firms cash-flow return on assets minus industry-average cash-flow return on assets in that
year. Industry-adjusted comparisons allow us to examine firm-specific performance irrespective of
any industry-wide factors that may affect CFROA. We define the industry comparison group for each
firm as all firms listed on Compustat with the same 3-digit SIC code.5 The number of firms in each
industry comparison group ranges from a min imum of 1 to a maximum of 356. Industry CFROA is
calculated as the total-asset weighted average CFROA of all firms in the industry.
Institutional investor ownership data for each year are obtained from the CDA Spectrum data
base, which compiles holdings of institutional investors from quarterly 13-f filings of institutional
investors holding more than $100 million in the equity of any firm. Institutional investors file their
holdings as the aggregate investment in each firm regardless of the number of individual fund
portfolios they manage. Our measures of institutional investor ownership follow those used in
Hartzell and Starks (2003). That is, we calculate the proportion of total institutional investor
ownership in each firm. 6

We remove all sample firms from any industry comparison groups. For example, General Motors and Ford
(both S&P 100 firms) are not included in any industry comparison groups.
6

In alternative specifications, we also investigated the impact of the leading institutional investors in each firm
by using the proportion of ownership accounted for by the top-five institutional investors. The results were
unaffected by this choice. To avoid clutter, we do not report them.

10

Finally, as discussed above, several studies have found that CEO compensation, board
composition, and director and executive officer stock ownership affect a firms performance.
Accordingly, we use proxy statements for each year to obtain director and officer stock ownership,
board size, independent outsiders on the board, 7 CEO/chair duality, CEO age, CEO tenure, and CEO
compensation (salary, bonus, options, stock grants, long-term incentive plan payouts, and other).
Table 1 presents descriptive statistics of firm financial performance during the period of
analysis. Because discretionary accruals must be reversed at some point, their average value over long
periods should be near zero. As reported in Table 1, however, the average value of discretionary
accruals for this sample is 5.21 percent of assets using the modified Jones model as the basis for
normal accruals. The average absolute value of discretionary accruals, 8.44 percent, is not
dramatically higher than the average signed values. This result is consistent with Bergstresser and
Phillipon (2004) who also find that accruals in this period spiked dramatically.
We define unmanaged earnings as reported earnings minus discretionary accruals. While
mean CFROA based on reported earnings is 18.95 percent,8 the average value of unmanaged CFROA
is only 13.75 percent using the modified Jones model to remove the impact of discretionary accruals
on reported earnings. Not surprisingly, industry-adjusted ROA is nearly zero using either of our
performance measures, 0.71 percent for reported earnings or 0.43 percent adjusting for discretionary
accruals using the Jones model. Thus, the financial performance of our sample firms is, on average,
nearly identical to that of their industries.
INSERT TABLE 1 HERE
Table 2 presents summary statistics on corporate governance variables. Institutional
ownership is significant, averaging 58.9 percent of the outstanding shares in each firm. 9 The percent

Specifically, independent outside directors are directors listed in proxy statements as managers in an
unaffiliated non-financial firm, managers of an unaffiliated bank or insurance company, retired managers of
another company, lawyers unaffiliated with the firm, and academics unaffiliated with the firm.
8

Recall that this is a cash flow ROA, which includes depreciation as well as net income in the numerator.

This is the mean value of the percentage ownership averaging across all firms in all years.

11

of shares held by this group ranges from a low of 24.9 percent to a high of 74.9 percent. In contrast,
directors and executive officers hold, on average, only 3.4 percent of the outstanding shares in their
firms. On average, 413 institutional investor firms hold stock in the sample firms.
INSERT TABLE 2 HERE
While institutional investors hold a large fraction of outstanding shares, they do not often sit
on the board of directors. On average the boards of directors seat 12.29 members, and on average,
these seats are filled by 2.29 inside directors, 1.62 affiliated outside directors, and 8.04 independent
outside directors. The average number of institutional investors on the board is 0.73 and the maximum
for this group is 4. Thus, the majority of the directors are independent outsiders (albeit not
institutional investors).
The average age of the firms CEOs is 57 years (ranging from 40 to 69) and, on average, the
CEOs have been in place for just over seven years (ranging from 2 to 37 years). These CEOs are paid
an average of $2.341 million in salary and bonus annually and hold an average of $4.065 million in
options.10 CEO compensation from all sources including options positions averages $8.342 million.
Averaging across CEOs, 37.5 percent of total compensation is composed of options.
4.3. Methodology
We estimate two broad sets of regressions. The first set treats discretionary accruals as the dependent
variable. In different specifications, we examine both signed and absolute discretionary accruals. The
explanatory variables are corporate governance variables (described above) related to institutional
ownership, management characteristics, and executive compensation. The second set of regressions
examine how financial performance relates to the same set of variables, both with and without
adjustment for discretionary accruals. The explanatory variables used in the regressions are listed in
Table 3.

10

Following Hartzell and Starks (2003), we measure option value using the dividend-adjusted Black-Scholes
formula. This is a better measure of ex ante value than option compensation given in the proxy statement,
which reflects exercises in any year. In any case, the two measures are highly correlated in our sample.

12

INSERT TABLE 3 HERE

We estimate multivariate regressions in which discretionary accruals or the firms industryadjusted ROA in each year is a function of the explanatory variables in Table 3. The observations
across firms are pooled in one regression. There are 662 observations, one for each firm-year.
The regressions that treat firm performance as the dependent variable are subject to a
potential simultaneity bias. If institutions are attracted to firms with superior performance, then a
positive association between institutional ownership and performance may be observed even if that
ownership is not directly beneficial to performance. Moreover, if operating performance and
institutional ownership are both persistent over time, lagging ownership relative to performance will
not eliminate the bias.
We employ several tools to deal with this potential problem. First and foremost, we estimate
all regressions allowing for firm fixed effects. This controls for any differences in firm-specific
average performance that might remain after industry adjustment, and allows us to identify the
marginal impact of the right-hand side variables on the dependent variable for that firm. 11
We also lag all measures of institutional ownership and institutional board membership by
one year. (Notice the lag structure embodied in Table 3.) Without the lag on institutional ownership, it
would be hard to distinguish between the hypothesis that institutional investors affect accounting
choice or cash flows versus the hypothesis that they are simply attracted to firms with more
conservative accounting or better recent performance. If institutions do affect management decisions,
they presumably would do so prior to the year of better performance, which also is consistent with the
use of a lag.12

11

As an additional check, we also estimated the financial performance regressions (Tables 5 and 6 below)
using first differences rather than firm fixed effects. The resulting estimates were essentially identical.
12

We might also have lagged explanatory variables other than those involving institutional investors.
However, endogeneity concerns are not as significant here. Board composition and membership is far less apt
to respond to perceived changes in the prospects of the firm, so, in contrast to institutional investment, there is
far less danger that it will be affected by the near-term prospects of the firm. Lagged and contemporaneous
board composition variables are essentially identical. Nevertheless, we experimented with lags on the board
membership variables, and found that such lags made virtually no difference in our regression results.

13

Industry-adjusting performance eliminates another potential source of simultaneity bias that

might exist at an industry level. Suppose for example that institutional investors prefer more stable
but lower average return industries. This preference would result in a link between average ROA and
institutional holdings. However, normalizing firm ROA by industry-average ROA eliminates any
relation between relative performance and industry characteristics.
Finally, our concerns over simultaneity are mitigated by the fact that the financial
performance of our sample does not seem to be unusual. As noted above, the mean industry-adjusted
ROA of the sample firms is virtually zero, indicating financial performance about equal to that of their
industry peer groups.
The lag on executive compensation eliminates a simpler form of reverse causality. Because
bonuses are tied to firm performance, and the value of options is linked to the stock price,
management compensation is a direct function of contemporaneous operating performance. In
contrast, using lagged compensation measures enables us to measure pay-for-performance incentive
structures uncontaminated by the impact of current performance on compensation.
5. Regression Results
Table 4 presents results on the use of discretionary accruals to manage earnings.
Discretionary accruals in this table are estimated from the modified Jones model, equation (2) above.
In regression 1, the dependent variable is discretionary accruals as a percent of assets. Regression 2
presents the same specifications except that the dependent variable is the absolute value of
discretionary accruals. The results using either measure of earnings management are highly similar.
Earnings management is significantly reduced by institutional involvement in the firm, whether that is
measured by the fraction of shares owned by all institutional investors (coefficients are - 0.0269 and
- 0.0297 in the two regressions), or by the number of institutional investors (coefficients equal
0.0247 and 0.0219). These coefficients are all significant at better than a 1 percent level.
INSERT TABLE 4 HERE

14

Board composition also significantly affects earnings management. The impact of the number
of institutional investors on the board is generally not significant, but the fraction of the board
composed of either institutional investors or of independent outside directors has a negative and
significant impact on earnings management, consistent with Klein (2002). Again, the point estimates
for the two specifications are highly consistent. The coefficients on the fraction of the board
composed of institutional investors are both about - 0.12 and those on the fraction of the board
composed of independent directors are about - 0.10. These coefficients are large enough to have a
significant economic impact. For example, using a coefficient estimate of - 0.10 for independent
directors, an increase of one (sample) standard deviation in this variable (i.e., using Table 2, an
increase in the fraction of independent outside directors of 0.147 or 14.7 percentage points) would
decrease discretionary accruals as a percentage of total assets by approximately .147 .10 = .0147, or
1.47 percentage points. Similarly, an increase of two institutional investors on a 12-member board (an
increase of 16.7 percent) would decrease discretionary accruals by approximately .167 .12 = .0200,
or 2.00 percentage points.
Table 4 also indicates that option compensation has a tremendous impact on earnings
management. The coefficient on option compensation as a fraction of total compensation is
approximately 0.14 in both specifications, with both t-statistics above 9. Using a coefficient estimate
of .14, an increase of .246 in option compensation as a fraction of total compensation (i.e., one sample
standard deviation) increases the contribution of discretionary accruals to measured ROA by .14
.246 = .0344 or 3.44 percentage points. Notice again that the impact on signed and absolute
discretionary accruals is effectively the same, suggesting that in this period, earnings management
was largely one-sided. Options compensation, which greatly accelerated in this period, seems to have
accelerated discretionary accruals. The other governance variables have little impact on discretionary
accruals. Neither board size nor any CEO characteristics such as age, tenure, or duality have a
significant impact on accruals policy. Not surprisingly, the firm fixed-effects (CUSIP) are significant
the 1% level in both regressions, with F-statistic s above 9.

15

Table 5 presents regression results of firm financial performance as a function of the same
governance and compensation variables used in the previous regressions. We measure firm
performance as industry-adjusted ROA, i.e., cash-flow ROA minus the industry mean. The cash-flow
ROA values in these regressions are based on reported earnings, i.e., without adjustment for
discretionary accruals.13
INSERT TABLE 5 HERE
The coefficient on the fraction of shares owned by all institutional investors is positive
(0.0342) and significant at the 1 percent level (t = 2.90). However, the economic impact of the
percentage of institutional ownership is relatively modest. The regression coefficient implies that an
increase of one (sample) standard deviation in institutional ownership (i.e., using Table 2, an increase
in fractional ownership of 0.138 or 13.8 percentage points) would increase industry-adjusted ROA by
only 0.0047, or 0.47 percent.
The log of the number of institutional investors holding stock in the firm is far more
influential in explaining IAROA. The coefficient on this variable is positive (0.0251), which is
significant at better than the 1 percent level (t = 2.75). Further, a one-standard deviation movement in
this variable starting from its mean value increases IAROA by 1.15 percent. These results suggest
that higher institutional investment is in fact associated with improved operating performance,
consistent with the notion that institutional ownership results in better monitoring of corporate
managers.
The coefficients on the number of institutional investors on the board and the percent of
institutional investors on the board are insignificant. However, given that so few representatives of

13

We estimated variations on this specification, for example using total option compensation in addition to
option compensation as a percent of total CEO compensation. The latter compensation variable provides
greater explanatory power, but highly similar point estimates. We also experimented with measures of
institutional ownership, for example, using total versus top-five institutional owners. Again, these two
variables seem nearly interchangeable. In light of the similarity of results across these specifications, we do
not present these variations.

16

institutional investors sit on boards of directors, it is not surprising that we find no significance for
these variables.
Notice also the coefficients on the control variables. The coefficie nt on the fractional stock
ownership of directors and executive officer are insignificant (t = 1.26). This result may reflect the
fact that our sample includes only S&P 100 firms. For these firms, it would be hard for directors and
officers to have anything but minimal fractional stock holdings in the firm (the mean for the sample is
3.4 percent). Accordingly, the insignificant regression coefficient is not entirely surprising. 14
The coefficient on the fraction of the board composed of independent outside directors is
0.1083 and is significant at the 1 percent le vel. Thus, increasing the percent of independent directors
on the board appears to result in higher IAROA. Other characteristics of the board of directors have
no significant impact on industry-adjusted performance. The coefficients on the CEO/Chair duality
dummy, board size, and CEO age and tenure are all insignificant.
The coefficients on CEO option compensation is positive, 0.1109, and highly significant (t =
8.64). Higher CEO compensation paid in the form of options seems to predict higher industryadjusted ROA. The economic impact of option-based compensation is dramatic. An increase of one
sample standard deviation in option-based compensation as a fraction of total compensation (i.e., an
increase of .246 or 24.6 percentage points) increases IAROA by .246 .1109 = .0273 or 2.73 percent.
Broadly speaking, this regression seems consistent with conventional wisdom on firm
performance. That is, performance improves with monitoring by disinterested institutional investors
and independent board members, as well as with pay-for-performance compensation, measured in this
paper by option compensation. However, recall that Table 4 shows that while earnings management
decreases with institutional monitoring, it increases with option compensation. This implies that
unmanaged performance, i.e., CFROA calculated from earnings adjusted for the impact of
discretionary accruals, will be more responsive to the monitoring variables and less responsive to the
option compensation variables.

14

This raises a general caveat concerning this study; specifically that our results may apply only to large firms.

17

Table 6 repeats the analysis of Table 5, but uses IAROA computed from unmanaged earnings
as the dependent variable. IAROA is calculated using cash-flow ROA based on reported earnings
minus discretionary accruals from the modified Jones model. The coefficient on institutional
ownership of shares, which was 0.0342 in the managed-earnings regressions (Table 5), increases to
0.0496. Similarly, the coefficient on the number of institutional investors increases from 0.0251 (tstatistic = 2.75) in Table 5 to 0.0516 (t-statistic = 3.93) in Table 6. The coefficient on the fraction of
the board composed of institutional investors, which is positive (0.0473) but insignificant in Table 5 is
now 0.1165, which is significant at better than a 1 percent level. Finally, the coefficient on
independent directors as a fraction of the board 0.2136 (t-statistic = 8.85) is double its value in the
Table 5 regression (0.1083, t-statistic = 3.17). The economic impact of these variables increases
commensurately.
INSERT TABLE 6 HERE
In stark contrast, the impact of option compensation on performance has disappeared in Table
6. The point estimate on option compensation as a fraction of total compensation, which is positive
and highly significant (0.1109, t-statistic = 8.64) in Table 5, is now negative, - 0.0137, but
insignificant (t-statistic = - 0.38). Thus, while option compensation strongly predicts profitability
using reported earnings (Table 5), its effect seems to derive wholly from the impact of such
compensation on accounting choice. Unmanaged earnings adjusted for the impact of discretionary
accruals shows no relationship to option compensation.
6. Conclusions
The analysis in this paper suggests that earnings management through the use of discretionary
accruals responds dramatically to management incentives. Earnings management is lower when there
is more monitoring of management discretion from sources such as institutional ownership of shares,
institutional representation on the board, and independent outside directors on the board. Earnings
management increases in response to the option compensation of CEOs. Our sample period is

18

characterized by a dramatic increase in accruals; both absolute values of discretionary accruals and
signed discretionary accruals show similar responses to these monitoring and incentive variables.
The results also suggest that the positive impact of option compensation on reported
profitability in this sample may have been purely cosmetic, an artifact of the more aggressive earnings
management elicited by such compensation. Once the likely impact of earnings management is
removed from profitability estimates, the relationship between performance and option compensation
disappears. Conversely, the estimates of financial performance are far more responsive to monitoring
variables when discretionary accruals are netted out from reported earnings. Therefore, the results
reinforce previous research pointing to the beneficial impact of outside monitoring, but cast doubt on
the role of pay-for-performance compensation as a means of eliciting superior performance. The
quality of reported earnings improves dramatically with monitoring, but degrades dramatically with
option compensation.

19

References
Alderfer, C.P., 1986. The invisible director on corporate boards. Harvard Business Review 64, 38-52.
Almazan, A., J. Hartzell, and L.T. Starks, 2003. Active institutional shareholders and managerial
compensation. Working paper, University of Texas at Austin.
Bacon, J., and J.K. Brown, 1973. Corporate Directorship Practices: Role, Selection and Legal Status of
the Board. The Conference Board, New York.
Bartov, Eli, Ferdinand A. Gul, and Judy S.L. Tsui, 2001, Discretionary-accrual models and audit
qualifications, Journal of Accounting and Economics 30, 421-452.
Beasley, M.S. An empirical analysis of the relation between the board of director composition
and financial statement fraud. Accounting Review 71, 443-465.
Beneish, Messod D. and M.E. Vargus, 2002. Insider trading, earnings quality, and accrual
mispricing. Accounting Review 4, 755-791.
Bergstresser, Daniel and Philippon, T. 2004. CEO incentives and earnings management.
Harvard Business School manuscript, December 2004.
Brickley, J.A., J.L. Coles, and R.L. Terry, 1994. Outside directors and the adoption of poison pills.
Journal of Financial Economics 35, 371-390.
Brickley, J.A., J.L. Coles, and G. Jarrell, 1997. Leadership structure: Separating the CEO and
Chairman of the Board. Journal of Corporate Finance 3, 189-220.
Brickley, J., R. Lease, and C. Smith, 1988. Ownership structure and voting on antitakeover
amendments. Journal of Financial Economics 20, 267-292.
Brown, W.O., and M.T. Maloney, 1999. Exit, Voice, and the Role of Corporate Directors: Evidence
from Acquisition Performance. Claremont Colleges Working Paper.
Burns, Natasha and S. Kedia, 2003. Do executive stock options generate incentives for earnings
management? Evidence from accounting restatements. Harvard Business School
manuscript.
Bryd, J., and K. Hickman, 1992. Do outside directors monitor managers? Evidence from tender offer
bids. Journal of Financial Economics 32, 195-222.
Cheng, Q. and T.D. Warfield, 2005. Equity incentives and earnings management. Accounting Review
80, 441-476.
Cohen, Daniel A., Aiyesha Dey and Thomas Z. Lys. Trends in earnings management and
informativeness of earnings announcements in the Pre- and Post-Sarbanes Oxley Periods.
Working paper, Northwestern University, November 2004.
Dechow, Patricia M., R.G. Sloan and A.P. Sweeney, 1995, Detecting earnings management,
Accounting Review 70, 193-225.

20

Dechow, Patricia M., R.G. Sloan and A.P. Sweeney, 1996, Causes and consequences of earnings
manipulaton: an analysis of firms subject to enforcement actions by the SEC,
Contemporary Accounting Research 13, 1-36.
Del Guercio, D., and J. Hawkins, 1999. The motivation and impact of pension fund activism. Journal
of Financial Economics 52, 293-340.
Dunn, D.J., 1987. Directors arent doing their jobs. Fortune (March), 117-119.
Firstenberg, P.B., and B.G. Malkiel, 1980. Why corporate boards need independent directors.
Management Review (April), 26-38.
Gaver, Jennifer, J., Kenneth M. Gaver and Jeffrey R. Austin, 1995, Additional evidence on bonus
plans and income management, Journal of Accounting and Economics 19, 3-28.
Gao, Pengjie and R.E. Shrieves, 2002. Earnings management and executive compensation: A case
of overdose of option and underdose of salary? University of Tennessee manuscript, July.
Guay, W.R., S.P. Kothari, and R.L. Watts, 1996. A market-based evaluation of discretionary
accrual models. Journal of Accounting Research 34, 83-105.
Guidry, Flora, Andrew J. Leone and Steve Rock, 1999, Earnings-bonus plans and earnings
managment, Journal of Accounting and Economics 26, 113-142.
Hartzell, Jay C. and L. T. Starks, 2003. Institutional Investors and Executive Compensation.
Journal of Finance 58, 2351-2374.
Healy, Paul, 1985, The effect of bonus schemes on accounting decisions, Journal of Accounting
and Economics 7, 85-107.
Healy, Paul M. and J.M. Wahlen, 1999, A review of the earnings management literature and its
implications for standard setting, Accounting Horizons 13, 365-383.
Holthausen, R., Larcker, D., Sloan, R., 1995. Annual bonus schemes and the manipulation of
earnings, Journal of Accounting and Economics 19, 29-74.
Jensen, M., 1993. The modern industrial revolution, exit, and the failure of internal control systems.
Journal of Finance 48, 831-880.
Jones, Jennifer, 1991. Earnings management during import relief investigations, Journal of
Accounting Research 29, 193-228.
Kaznik, R. 1999. On the association between voluntary disclosure and earnings management.
Journal of Accounting Research 37, 57-81.
Klein, April, 2002. Audit committee, board of director characteristics, and earnings management,
Journal of Accounting and Economics 33, 375-400.
Kothari, S.P., A.J. Leone, and C.E. Wasley, 2005. Performance matched discretionary accrual
measures, Journal of Accounting & Economics, forthcoming.
Kothari, S.P., E. Loutskina, and V. Nikolaev, Agency Theory of overvalued equity as an
explanation for the accrual anomaly, working paper, November 2005.
21

McConnell, J.J., and H. Servaes, 1990. Additional evidence on equity ownership and corporate value.
Journal of Financial Economics 27, 595-612.
McNichols, Maureen F. 2002. Research desing issues in earnings management studies. Journal
of Accounting and Public Policy 19, 313-345.
Nesbitt, S.L., 1994. Long-term rewards from shareholder activism: a study of the 'CalPERS effect.'
Journal of Applied Corporate Finance 6, 75-80.
Peng, Lin and Alisa Rell, 2004. Executive pay, earnings manipulation, and shareholder
litigation. unpublished manuscript, October 2004.
Rosenstien, S., and J.G. Wyatt, 1990. Outside directors, board independence, and shareholder wealth.
Journal of Financial Economics 26, 175-191.
Sloan, R. 1996. Do stock prices fully reflect information in accruals and cash flows about future
earnings? Accounting Review 71, 289-316.
Smith, M., 1996. Shareholder activism by institutional investors: Evidence from CalPERS. Journal of
Finance 51, 227-252.
Subrahmanyan, V., N. Rangan, and S. Rosenstein, 1997. The role of outside directors in bank
acquisitions. Financial Management 26, 23-36.
Teoh, S.H., I. Welch and T.J. Wong 1998a. Earnings management and the underperformance of
seasoned equity offerings. Journal of Financial Economics 50, 63-69.
Teoh, S.H., I. Welch and T.J. Wong 1998b. Earnings management and the long-run market
performance of initial public offerings. Journal of Finance 53, 1935-1974.
Warfield, Terry D., J.J. Wild, and K.L. Wild, 1995. Managerial ownership, accounting choices, and
informativeness of earnings. Journal of Accounting and Economics 20, 61-91.
Yermack, D., 1996. Higher market valuation of companies with a small board of directors. Journal of
Financial Economics 40, 185-211.

22

Table 1
Descriptive Statistics on Accruals and Average Performance
CFROA is annual operating cash flow return on assets (earnings before interest and taxes plus
depreciation over the year divided by total assets at the end of the year). Financial statement data
needed to calculate CFROA are obtained from the Compustat database for each year, 1993-2000. For
each S&P 100 firm, we classify industry comparison firms as all firms listed on Compustat with the
same 3-digit SIC code. Industry-adjusted CFROA is a sample firms CFROA in any year minus the
(total asset) weighted average industry CFROA in that year. Normal accruals are defined by equation
(1) for the modified Jones model. Discretionary accruals are residuals between actual accruals and
normal accruals predicted from the model. These statistics are based on the data included in the
regression analysis, i.e., excluding observations purged as extreme outliers. The sample size is 662.

Standard
Deviation

25th percentile 75th percentile

Variable

Mean

Median

Discretionary accruals
Assets

.0521

.0438

.0648

-.0206

.0907

Abs (Discretionary accruals)

Assets

.0844

.0727

.0637

.0089

.1204

CFROA

.1895

.1824

.0906

-.0611

.2186

Unmanaged CFROA
(from Jones model)

.1375

.1203

.0668

-.0309

.1656

Industry-adjusted CFROA

.0071

.0041

.0078

-.0063

.0138

Industry-adjusted
unmanaged CFROA

.0043

.0060

.0031

-.0059

.0107

23

Table 2
Summary Statistics on Governance and CEO Compensation Variables
Data on institutional investor ownership for the period 1993-2000 are obtained from the CDA Spectrum
data base. These data include total shares outstanding, number of shares owned by all institutional
investors, and the number of institutional investors. We use proxy statements for the sample firms for
each year 1993-2000 to collect data on the fraction of director and officer stock ownership, board size,
the fraction of independent outsiders on the board, CEO/chair duality, CEO age, CEO tenure, and CEO
compensation (salary, bonus, options, stock grants, long-term incentive plan payouts, and others).
These statistics are based on the data included in the regression analysis, i.e., excluding observations
purged as extreme outliers. The sample size is 662.

Variable

Mean

Median

Standard
Deviation

Minimum

Maximum

Fraction of shares owned by

all institutional investors

.589

.609

.138

.249

.749

Fraction director + executive

officer stock ownership

.034

.017

.042

.004

.282

412.8

359

239

91

798

Number of institutional
investors
Number of directors on board
Total

12.29

12

2.2

20

Inside directors

2.29

1.53

Affiliated outside

1.62

1.49

Independent outside

8.04

2.18

14

Institutional investors

0.73

.90

Fraction of independent
outside directors

.656

.682

.147

.174

.826

CEO age (years)

57.0

57

5.1

40

69

CEO tenure (years)

7.1

6.6

37

CEO salary and bonus

(in $ thousands)

2,341

1,824

2,019

642

15,656

CEO options
(in $ thousands)

4,065

1,642

11,528

29

187,931

CEO total
compensation
(in $ thousands)

8,342

4,763

15,196

698

219,892

Options as fraction of
total CEO compensation

.375

.359

.246

.08

.668

24

Table 3
Definitions of Regression Variables
This table lists the variable names and definitions used in the empirical analysis.

Symbol

Explanatory variable
Fraction of shares of the firm owned by all institutional investors
(lagged one year)

FIISOWN

natural log of the number of institutional investors holding stock in

firm (lagged one year)

ln(NII)

natural log of 1 + the number of institutional investors on the board

of directors (lagged one year)*

ln(NIIOB)

fraction of board of directors composed of institutional investors

(lagged one year)

FIIOB

fraction of board of directors composed of independent outside

directors

FINDDIR

fraction of shares in firm owned by directors and officers

DOSOWN

CEO/Chair duality dummy: equals 1 if the CEO is also the chair of

the board of directors, and 0 otherwise

CEOCHD

natural log of the size of the board of directors

ln(BRDSIZE)

natural log of the CEOs age

ln(CEOAGE)

natural log of the CEOs tenure

ln(CEOTEN)

natural log of value of equity

ln(SIZE)

CEO option compensation/total compensation (lagged one year)

% OPTIONS

* There are many firms with no institutional investors on the board of directors. Therefore, we
must take log of 1 plus the number of such investors. In contrast, there are many institutional
investors for each firm (median = 356), so adding 1 to that number would be irrelevant.

25

Table 4
Discretionary Accruals from Modified Jones Model for S&P 100 Firms
The dependent variable in Regression 1 is signed discretionary accruals. I n regression 2 it is the
absolute value of discretionary accruals. Discretionary accruals are defined as the difference
between actual accruals and the accruals predicted from the modified Jones model (equation 1).
Regressions are estimated as a pooled time-series cross section for S&P 100 firms, with fixed firm
effects. The sample period is 1993 2000. t-statistics are in parentheses. The number of
observations is 662.

Dependent Variable
Discretionary Accruals
as Percent of Assets
Explanatory Variable

Regression 1

Abs olute Value of Discretionary

Accruals as Percent of Assets
Regression 2

Fraction of shares
owned by all institutional investors

-0.0269
(-3.11) ***

-0.0297
(-3.45)***

ln(Number of
institutional investors)

-0.0247
(-3.42)***

-0.0219
(-3.07)***

ln(Number of institutional
investors on board)

-0.0286
(-1.62) *

-0.0243
(-1.47)

Fraction of board composed

of institutional investors

-0.1242
(-2.52) **

-0.1283
(-2.64)***

Fraction of firm owned by

directors plus executive officer

0.0931
(2.14) **

0.0809
(1.98)**

Fraction of board composed of

independent outside directors

-0.1106
(-3.46)***

-0.0997
(-2.96)***

0.0073
(1.12)

0.0048
(0.95)

-0.0042
(-0.31)

-0.0026
(-0.19)

ln(CEO age)

0.0054
(0.32)

0.0068
(0.41)

ln(CEO tenure)

0.0247
(1.27)

0.0189
(1.15)

ln(Firm size)
(lagged one year)

-0.00108
(-1.09)

-0.0011
(-1.15)

Option compensation as a fraction

of total compensation

0.1422
(9.56) ***

0.1396
(9.23)***

R-squared (adjusted)

42.5%

41.8%

CEO duality dummy

ln(Board size)

CUSIP F Value

9.42***

* Significant at better than the 10% level.

** Significant at better than the 5% level.
*** Significant at better than the 1% level

26

9.09***

Table 5
Industry-adjusted ROA as a Function of Governance and Compensation Variables
The dependent variable is industry-adjusted ROA for firm j in year t, computed from reported
earnings (i.e., without adjustment for discretionary accruals). Regressions are estimated as a pooled
time-series cross-section for S&P 100 firms, with fixed firm effects. The sample period is 1993
2000. t-statistics are in parentheses. The number of observations is 662.

Explanatory Variable
Fraction of shares owned by all
institutional investors (lagged one year)

0.0342
(2.90)***

ln(Number of institutional investors)

(lagged one year)

0.0251
(2.75)***

ln(1 + number of institutional investors

on board) (lagged one y ear)

0.0021
(0.53)

Fraction of board composed of

institutional investors (lagged one year)

0.0473
(1.01)

Fraction of firm owned by directors plus

executive officer (lagged one year)

0.0265
(1.26)

Fraction of board composed of independent

outside directors (lagged one year)

0.1083
(3.17)***

CEO duality dummy

-0.0021
(-0.56)

ln(Board size)

-0.0088
(-0.85)

ln(CEO age)
ln(CEO tenure)

0.0105
(0.84)
-0.0131
(-0.99)

ln(Firm size)
(lagged one year)

0.0010
(0.94)

Option compensation as a fraction of

total compensation (lagged one year)

0.1109
(8.64)***

R-squared (adjusted)

39.4%

CUSIP F Value

6.72***

* Significant at better than the 10% level.

** Significant at better than the 5% level.
*** Significant at better than the 1% level.

27

Table 6
Industry-adjusted Unmanaged Cash -flow Return on Assets for S&P 100 Firms
The dependent variable is industry-adjusted ROA for firm j in year t, computed from reported
earnings (i.e., without adjustment for discretionary accruals). Regressions are estimated as a pooled
time-series cross-section for S&P 100 firms, with fixed firm effects. The sample period is 1993
2000. t-statistics are in parentheses. The number of observations is 662.

Explanatory variables
Fraction of shares owned by all
institutional investors(lagged one year)

0.0496
(4.02)***

In (Number of
institutional investors) (lagged one year)

0.0516
(3.93)***

In (Number of institutional investors

on board) (lagged one year)

0.0158
(1.32)

Fraction of board composed of

institutional investors(lagged one year)

0.1165
(2.94)***

Fraction of firm owned by directors plus

executive officer(lagged one year)

0.0089
(0.51)

Fraction of board composed of independent

outside directors(lagged one year)

0.2136
(8.85)***

CEO duality dummy

-0.0127
(-0.58)

In (Board size)

-0.0096
(-0.49)

In (CEO age)

0.0128
(0.42)

In (CEO tenure)

-0.0295
(-0.87)

In (Firm size)
(lagged one year)

0.0008
(0.91)

Option compensation as a
fraction of total compensation

-0.0137
(-0.38)

R-squared (adjusted)

44.1%

CUSIP F-value

10.12***

*Significant at better than the 10% level.

** Significant at better than the 5% level.
***Significant at better than the 1% Level.

28