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Board of Directors and Opportunistic Earnings Management:

Evidence from India

Jayati Sarkar
Indira Gandhi Institute of Development Research,
Film City Road, Goregaon (E),
Mumbai - 400 065, INDIA

Subrata Sarkar
Indira Gandhi Institute of Development Research,
Film City Road, Goregaon (E),
Mumbai - 400 065, INDIA

Kaustav Sen
Lubin School of Business,
Pace University, One Pace Plaza,
New York, NY 10038, USA

April 1, 2006

In this paper we investigate the impact of board characteristics on opportunistic earnings

management in the context of a large emerging economy, India. While the role of company
boards in earnings management has been examined in developed markets setting, particularly
the US and UK, understanding their effectiveness in emerging markets like India is particularly
important due to differences that exist in the structure of business organizations across these
markets. Using a sample of 500 large Indian firms, we analyze the effect of board independence
on earnings management as has been the focus of most existing studies, and extend the existing
literature by including characteristics of directors that proxy for the quality of both inside and
outside directors that are likely to impinge on the effectiveness of boards in curbing earnings
manipulation. Our results indicate that it is not board independence per se, but rather board
quality that is important for earnings management. Our results show that diligent boards are
associated with lower earnings manipulation, while boards that have large number of multiple
directors exhibit higher earnings management. With respect to inside directors, our results
indicate that CEO-duality and presence of controlling shareholders on the board increases
earnings management. We also find that domestic institutional owners, one of our key control
variables, mitigate earnings management and acts as a compensating control mechanism to the
presence of controlling shareholders on corporate boards.
1. Introduction
In recent years a major thrust of corporate governance reforms worldwide has been to make
corporate boards of publicly held corporations structurally and operationally more effective in
mitigating agency costs between shareholders and managers. One manifestation of such agency
costs, as is widely discussed in the accounting and finance literature, is opportunistic earnings
management whereby the true financial performance of a company is distorted by managers for
private gains (Klein, 2002). Corporate governance codes around the world, in drawing out the
procedures for improving the quality of financial statements, have emphasized the fiduciary role
of the board of directors in curbing opportunistic earnings manipulation and in ensuring that
earnings figures convey true information about firm operations (Young, 2000).
Several empirical studies with respect to widely held corporations in the UK and US
show that company boards influence earnings manipulation and the quality of financial
statements, and that the extent of such influence depends on board characteristics. In particular,
studies have shown that independent boards reduce earnings manipulations by managers (see for
example, Beasley, 1996; Dechow et al., 1996; Peasnell et al., 2000, 2001; Klein, 2002; Xie et al.,
2003). Some of these studies have also considered the role of audit committees that are vested
particularly with the responsibility of monitoring the financial reporting by corporates. These
studies have found that the level of earnings management is inversely related to the extent of
audit committee independence ( see for example, Klein, 2002; Xie et al., 2003).
The objective of this paper is to empirically analyze the relationship between board
characteristics and earnings management with respect to India the second largest emerging
economy after China. A survey of the existing literature on the role of board of directors in
earnings management reveals that much of this literature has originated in the context of agency
problems in widely held corporations in developed countries and relatively little is known on
this issue with regard to developing and emerging economies.1 Yet cross-country evidence
shows that the phenomenon of obscuring a firms true underlying performance, which
Bhattacharya et al. (2003) term as earnings opacity, is ubiquitous in developed and developing
countries alike. In fact data on earnings opacity, a component of which is accounted for by
opportunistic earnings management, reveals that compared to their developed country

Bushman and Smith (2001) in their survey of financial accounting and corporate governance observe that most
governance research focuses on the US and that this has been mainly on account of availability of relevant data.

counterparts, opacity in developing and emerging economies are on the average higher. Given
the increasing integration of equity markets worldwide and the growing relevance of emerging
economies for foreign institutional investors and foreign direct investment, poor earnings quality
and weak governance mechanisms in such economies can adversely affect the extent of financial
integration. As Bhattacharya et al. (2003) find, the US home bias increases when earnings
management increases in the other country. The East Asian crisis too has demonstrated how
weak legal institutions for corporate governance and low accounting disclosure quality were key
factors in exacerbating the stock market collapse during the East Asian crisis (Johnson et al.,
2000; Mitton 2002).
While in many emerging economies including India, corporate governance initiatives
have focused in improving the quality of financial reporting and in creating independent boards
that are in line with the best practices adopted in countries with Anglo-Saxon based systems of
governance, notably the US and UK, there is little in the way of evidence to assess whether,
consistent with the expectations of regulators, company boards have been effective in curbing
earnings manipulation by management. Differences exist in accounting and auditing practices,
quality of enforcement, investor protection as well as the ownership and control structures of
firms in emerging markets from those in developed markets. Thus, it is not a priori evident
whether conclusions arrived at with respect to the role of corporate governance in mitigating
earnings management in developed market economies would be equally relevant in case of
emerging economies like India. Understanding what specific attributes contribute to the
effectiveness of these mechanisms, individually as well as jointly, in reducing opportunistic
earnings management in an emerging market setting will not only enhance the growing literature
of the role corporate governance on financial reporting, but will have policy implications given
the increasing importance of India as a destination for equity and foreign direct investment.
Using a sample of 500 large Indian companies for the financial year 2002-03, we analyze
the extent to which board characteristics matter in earnings management. As has been the case
with most of the existing studies with respect to the US and UK that focus on board
characteristics and earnings management, we address the question of whether independent
boards reduce earnings management. Additionally, we seek to extend the existing literature by
including characteristics of directors that proxy for the quality of both inside and outside
directors on the board and are likely to impinge on the effectiveness of boards in curbing

earnings manipulation. Specifically, we consider four such characteristics, namely (i) the
busyness of independent directors, i.e., the number of multiple directorships held by them (ii)
the diligence of such directors measured in terms of their attendance of board meetings during
the year2 (iii) the presence of controlling shareholders as inside directors on the board, and (iv)
the presence of CEO duality . As several recent empirical analyses have concluded, the extent to
which independent directors on a board are effective in monitoring, can critically depend on the
busyness of these directors as also their ability to participate in board meetings.3 While multiple
directorships can imply erosion of the commitment by independent directors to be able to
monitor a firm effectively, the existing theoretical literature highlights some potential benefits
from such directorships. In the presence of well functioning market for outside directors, the
number of multiple directorships can signal a directors reputation and serve as a proxy for high
director quality (Fama, 1980, Fama and Jensen, 1983). Thus, having directors on board with
multiple directorships can lead to better monitoring and constrain opportunistic earnings
management. The net effect of busyness on earnings management would therefore depend on
the relative strengths of the over-commitment and quality effects associated with multiple
directorships. Several studies on multiple directorships and firm performance in the context of
developed and emerging economies have shown that busyness of directors can matter in the
ability of independent directors to monitor, although the evidence is somewhat mixed (Ferris et
al. 2003; Fich and Shivdasani, 2004; Harris and Shimizu, 2004; Sarkar and Sarkar, 2005).
The rationale for including the diligence measure under (ii) lies in the conventional
wisdom that the most commonly shared problem faced by directors is lack of sufficient time to
discharge their professional responsibilities, and thereby compromise on their decision making
quality and ability to provide useful advice (Lipton and Lorsch, 1992). Thus, multiple
directorships of directors, while being a necessary condition for weak monitoring, is not a
sufficient condition. Only when multiple directorships lead to over-commitment will it have an
adverse effect on monitoring capabilities. One of the manifestations of over-commitment by
busy directors would be their reduced ability to attend board meetings, company Annual General
Meetings (AGMs) and different board committee meetings, the forums in which outside
directors can formally participate and demand accountability from management.

These terms are largely in consonance with those defined in Carcello et al., (2002).
See for example, Ferris et al. (2003) in the context of US and Sarkar and Sarkar (2005) in the context of India.

The question under (iii) of whether controlling shareholders on boards matter with
respect to earnings management is relevant particularly in view of the fact that in family owned
corporations that widely prevail in countries such as India, boards are typically dominated by
family members who enjoy substantial ownership and control and who often hold top executive
positions with the objective of controlling the firm (Carney and Gadajlovic, 2002; Gomes-Mejia
et al., 2003). Existing literature highlights the incentives of the controlling shareholders of such
corporations in engaging in tunneling and propping activities (see for example, Bertrand et al.,
2003; Friedman et al., 2003). The incentives for earnings management by the controlling
shareholders cum directors in such corporations primarily stem from their need to camouflage
their private benefits of control (Fan and Wong 2002) and to provide cover for their
expropriation of minority investors.
Finally, the issue of CEO duality and earnings management under (iv) needs careful
analysis. As the literature on CEO duality and corporate governance highlights, agency
problems could be higher when a CEO also holds the position of the Chairman of a board.
There is little by way of evidence on CEO duality and earnings management. and the evidence
on the relation between CEO duality and firm performance is mixed. While some studies find
that CEO duality enhances performance in large firms (Brickley, Coles and Jarrell, 1996), others
document higher performance of firms where the positions of CEO and Chairman are split (Pi
and Timme, 1993; Baliga, Moyer and Rao, 1996). CEO duality essentially weakens the
independence of the monitoring role from the executive decision making. A weaker control
system indicates opportunistic earnings management can increase.4

Using a sample of five hundred large Indian firms, our results indicate that it is not board
independence per se, but rather board quality that is important for earnings management. Our
results show that diligent boards are associated with lower earnings manipulation, while boards
that have large number of multiple directors exhibit higher earnings management. With respect
to inside directors, our results indicate that CEO-duality and presence of controlling shareholders
on the board increases earnings management. We also find that domestic institutional owners,

Tsui, Jaggi and Gul (2001) investigate the relation between CEO duality, audit fees and growth opportunities. In
the absence of CEO duality, they argue that since control risk is lower, auditors have to spend lower effort and
indeed find audit fees to be lower. However, this reduction of audit fees in absence of CEO duality becomes weaker
in the case of firms with high growth opportunities, because of the existence of discretionary investments and
measurement problems associated with future assets.

one of our key control variables, mitigate earnings management and acts as a compensating
control mechanism to the presence of controlling shareholders on corporate boards.

The rest of the paper is organized as follows. Section 2 discusses the background literature on
corporate governance and earnings management. The empirical model and hypotheses are
presented in Section 3. Section 4 reports the empirical findings and Section 5 discusses some
important robustness checks. Section 6 concludes the paper.

2. Background Literature
Corporate governance can be broadly classified into internal and external mechanisms
(Denis and McConnell, 2003). Internal mechanisms are those related to board structure,
executive compensation, and ownership structure and monitoring by large shareholders. External
mechanisms relate to the market for corporate control i.e. the takeover market and the
shareholder protection offered by the legal system in which the business operates. The threat of a
takeover and the subsequent change in control can motivate management to keep firm value
high, so that the value gap is not attractive enough to make it vulnerable to a takeover. However,
external mechanisms may not be effective in emerging markets either because the legal system
does not offer much protection or because a market for corporate control does not exist due to
the prevalent ownership styles e.g. existence of business groups.
In widely held corporations with separation of ownership and control, the primary
objective of governance mechanisms, both internal and external, is to align the interests of
managers with that of shareholders. Managers undertake earnings management for several
reasons, including capital markets, contracting and regulatory motivations (see Healy and
Wahlen, 1999 for a review)5. For example, Healy (1985) provides a compensation-based
rationale for earnings management.6 McNichols and Wilson (1988) find evidence of earnings
management by managers in the case of estimating bad debt provisions for firms with extreme
earnings. Burgstahler and Dichev (1997) provide a transaction-cost-based reasoning (due to
The need to manipulate accounting numbers to serve the self interests of insiders arise due to a variety of reasons,
such as the use of accounting information in incentive-based compensation contracts for managers (Watts and
Zimmerman, 1986; Watts, 1977), the use of accounting based covenants in debt contracts (Smith and Warner, 1979;
Leftwich, 1983) and the need to meet analysts expectation and management forecasts about firm performance
(Burgstahler and Eames, 1998; Degeorge et al., 1999).
Accounting numbers have been extensively and explicitly used in major executive compensation contracts in the
US See for example Murphy 1998.

scrutiny and renegotiations) for loss avoidance by income-increasing discretionary accruals.
Burgstahler and Eames (2003) find that firms manage earnings to meet analyst forecasts. Teoh,
Welch and Wong (1988a and 1988b) and Teoh, Wong and Rao (1998) find existence of
opportunistic earnings management during initial and seasoned public offerings. Bushman and
Smith (2001) provide an exhaustive review of the role of publicly reported financial accounting
information in the governance processes of corporations.
Several papers in particular have examined relation between earnings quality and specific
internal corporate governance mechanisms. Bushman et al. (2004) finds that earnings timeliness
is negatively related to ownership concentration, executive compensation and reputation of
outside directors. However, board size and percentage of inside directors do not affect earnings
timeliness. DeFond and Subramanyam (1998), Bartov, Gul and Tsui (2001), Frankel, Johnson
and Nelson (2002), Larcker and Richardson (2004) examine the relation between auditor
independence and earnings management. In general, these papers find that lack of audit
independence is associated with earnings management. Balsam (1998) finds that cash
compensation to CEOs is associated with discretionary accruals. Baker, Collins and Reitenga
(2003) find that managers opportunistically manage earnings relative to the award date when
compensated with stock options. Gul, Chen and Tsui (2003) find higher managerial ownership
reduces the positive association between discretionary accruals and audit fees, thus indicating
that it is used to communicate value relevant information.
Focusing specifically on the impact of board characteristics on the incentives to manage
earnings, one finds that corporate governance codes around the world emphasize the fiduciary
role of the board of directors in curbing opportunistic earnings manipulation and in ensuring that
earnings figures convey true information about firm operations (Young, 2000). In this regard, the
existing literature largely supports the contention that board structure matters in earnings
management; independence of the board of directors as well as the independence of audit
committees which are created with a subset of directors on the board with the primary
responsibility of monitoring the financial reporting process of a firm, are found to constrain
earnings management This broad consensus with respect to the effectiveness of independent
boards in earnings management stands in contrast to the absence of any clear cut agreement

regarding the role of independent boards in corporate governance in general, and firm
performance in particular.7
Using a sample of 92 US firms under SEC investigation for manipulating earnings,
Dechow et al. (1996) find that firms with higher proportion of independent directors, smaller
boards, and with an audit committee have lower earnings manipulation. In a similar vein,
Beasley (1996) demonstrates for a sample of 75 fraudulent US firms along with a control sample
of 75 other firms that firms with higher proportion of independent directors are less likely to
commit frauds. Studies with respect to UK largely mirror the findings in US. Peasnell et al.
(2000) in their empirical analysis of the effect of the recommendations of the Cadbury
Committee Report on a large sample of UK firms find that non-executive directors had become
more efficient in constraining earnings management practices in firms adopting the Committees
recommendations. Further, Peasnell et al. (2001) also provide evidence of independent directors
reducing earnings manipulation and their effectiveness in doing so increasing when the board
appoints an audit committee.
Studies have also explicitly considered the role of audit committees in earnings
management (Klein, 2002; Xie et al., 2003) and have found that the level of earnings
management is inversely related to the extent of audit committee independence. While Klein, in
her study of US firms find that independent audit committees have a constraining effect on
earnings manipulation particularly when a majority of directors are independent, Xie et al.
(2003) find that more active rather than independent audit committees reduce the extent of
earnings management. Both studies also support the hypotheses that boards with a higher
proportion of independent directors are more effective in constraining earnings manipulation.
As mentioned earlier, the literature on board structure and earnings management for
emerging economies like India is scant. The nascent earnings literature that does exist with
respect to emerging economies has largely analyzed the relationship between earnings

While some studies find that more independent boards impact positively on discrete tasks such as hiring and firing
of chief executive officers (Weisbach, 1988), response to hostile takeovers (Brickley et al., 1994; Byrd and
Hickman, 1992) and determining CEO compensation (Core et al., 1999), the majority of studies, predominantly in
the context of US, find little support for the hypothesis that more independent boards lead to better firm
performance (see for example, Bhagat and Black, 2002; Hermalin and Weisbach, 1991). As Dahya and McConnell
(2003) comment, the outside director mania across a large cross-section of countries and the presumption that
outside directors matter rests more on faith than on evidence.

management and ownership and control structures.8 The focus of a few studies which have
examined the role of boards in corporate governance in emerging economies has been almost
entirely on the relationship between board characteristics and firm performance: Peng (2004) in
the context of China; Yeh and Woidtke (1998) in the case of Taiwan; Sarkar and Sarkar (2005)
in the case of India. The study by Peng (2004) provides evidence of a positive effect of
independent directors on firm performance for a sample of listed Chinese firms when
performance is measured in terms of sales growth, but of no impact if performance measured as
return on equity. Results similar in spirit to the Chinese study are reported with respect to a
sample of Taiwanese firms (Yeh and Woidtke, 1998); companies with boards dominated by
members affiliated with the controlling family do worse than companies where board is
dominated by non-affiliated members. Finally, an empirical analysis of the effect of boards
dominated by independent directors with multiple appointments in large Indian companies
(Sarkar and Sarkar, 2005) reveals that firm value is positively affected when a majority of
independent directors on company boards sit on three or more boards, with no significant
relation found below this threshold. Independent directors with multiple positions are also found
to attend more board meetings and are more likely to be present in companys annual general

3. Empirical Estimation
3.1 Sample
The sample for our analysis consists of 500 top private sector companies listed in the
Bombay Stock Exchange and covers the financial year 2003. These companies accounted for
about 90 percent of market capitalization as on March 2003. Both domestic and foreign private
sector companies are represented in the sample, with domestic companies further classified into
those belonging to business groups (group-affiliated) and those which are non-affiliated
(standalones). Of the 500 companies, sixty eight per cent (388) of the sample companies are
group affiliated, and the rest being non-affiliated or standalone firms.
The data for our analysis is sourced from the Prowess database created by the Center for
Monitoring the Indian economy (CMIE). PROWESS is a comprehensive database containing

See for example, Kim and Yi (2005) for Korea, Liu and Lu (2004) and (Jian and Wong, 2003) in the case of

good time series information (from 1990 onwards) on a large number of companies (about
8000). This database has formed the basis of several recent empirical studies on the Indian
corporate sector (see for example, Bertrand, Mehta and Mullainathan, 2002; Khanna and Palepu,
2000a; Sarkar and Sarkar, 2000). We utilize the corporate governance (CG) reports contained in
the Prowess database to collate the details of board membership by directors.
According to Clause 49 of the Listing Agreement that came into effect from February
2000, all listed companies in India are required to file a CG report disclosing the details of board
functioning. This report contains among other things, (i) the name of each director and his/her
type, namely promoter director (founding family shareholder), executive (inside) director, non-
executive affiliated (gray) director, non-executive independent (outside) director, nominee
director of financial institutions, (ii) the number of directorships and committee memberships
held by the director in other listed companies, (iii) the number of board meetings held by the
company in the financial year and dates on which they were held, (iv) the attendance record of
each director at the board meetings and in particular at the Annual General Meeting (AGM), and
(v) audit committee information relating to its size, number of independent directors and the
number of committee meetings held. Companies are required to file the CG report every quarter
so that four such reports are available for a typical financial year. To pick our sample we ranked
the private sector companies in terms of their sales in 2003 and then selected the first 500
companies for which the CG report was available for the year 2003.
In addition to the data on director characteristics we need information on financial
performance, equity ownership by major shareholders, stock market variables, and other firm
characteristics for our analysis. These data were sourced from the financial statements and stock
price data of the companies contained in the Prowess database.

3.2. Empirical Model and Variables

We examine the effect of board independence and directorial characteristics that proxy
for board quality on earnings management using a specification is similar to that in existing
studies on corporate governance and earnings management (see for example Klein, 2002, Xie et
al., 2003), namely,

Opportunistic earnings management = f (board independence, director characteristics, control
variables) + error

3.2.1 Dependent Variable: Opportunistic Earnings Management

The literature on the role of earnings and accounting numbers on capital market
participants is quite exhaustive. Researchers have looked at a variety of measures to examine
various issues related to quality of earnings.9 Earnings management can be accomplished by the
choice of accounting methods and by the assumptions and estimates used in computing the
accruals. Generally Accepted Accounting Principles (GAAP) requires disclosure of the
accounting methods used for computing the reported earnings. If motivations for earnings
management are due to capital market, contracting or regulatory considerations, then managers
have to use methods that cannot be easily unraveled by the investors. Thus this method of
choosing the accounting methods cannot be employed easily to opportunistically manage
earnings. Instead, it is easier to manage earnings using assumptions and estimates needed for
computing the accruals. The efficacy of the assumptions and estimates cannot be determined in
the absence of private information known only to the managers. Therefore, discretionary accruals
cannot be observed by investors and is therefore the preferred choice of managers acting
opportunistically. Healy and Wahlen (1999) present a similar rationale and in fact, define
earnings management as being essentially opportunistic.
Opportunistic earnings management is manifested by the estimates and judgments made
in reporting accruals. Change in total accruals over time can represent the extent of earnings
management if we assume that some portion of accruals is non-manipulated and constant over
time. However, as suggested by Jones (1991), the non-manipulated accruals may not be constant
over time and be driven by some accounting fundamentals (such as revenues adjusted for
receivables; property, plant and equipment). In this approach, opportunistic earnings
management is captured by the residuals from a regression of total accruals on accounting

Schipper and Vincent (2003) identify four broad classes of measures developed to examine earnings quality: based
on time-series properties of earnings, based on relation between income, accruals and cash, based on qualitative
concepts of the accounting standards and those based on implementation considerations.

fundamentals, referred to as discretionary accruals. We use the Jones approach to estimate
discretionary accruals as developed by Jones (1991).
We first compute the total accruals for firm i in year t as:
TA it = (CA it CL it Cash it + STD it Dep it ) (1)

where CA it is the change in current assets, CL it is the change in current liabilities, Cash it is

the change in cash and cash equivalents, STD it is the change in debt in current liabilities, Depit

is depreciation and Ait is the total assets.

In order to compute the discretionary and non-discretionary component of the total
accruals, we obtain the parameter estimates of the Jones (1991) model:
TA it / A i ,t 1 = 1 (1 / A i ,t 1 ) + 2 (REVit ) / A i ,t 1 + 3 (PPE it ) / A i ,t 1 + it (2)

where TAit is the total accruals computed as in equation (1) above, REVit is the change in

revenues, PPEit is the change in property, plant and equipment and it is the error term.
The parameters for equation (2) are estimated for each year and industry using cross-
sectional data. Using the product code provided for each firm in the Prowess database, we
classify the sample into 23 different industry groups. To ensure we have representative parameter
estimates, we require that at least 10 firms that are listed in the Bombay Stock Exchange exist for
each industry in each year.
Discretionary accruals are then calculated as
DA= TA it / A i ,t 1 [ 1 (1 / A i ,t 1 ) + 2 (REVit ) / A i ,t 1 + 3 (PPE it ) / A i ,t 1 ] (3)

where 1 2 , 3 are the estimates from equation (2). As in the literature, we consider the absolute
measure of discretionary accruals as a proxy for the extent of opportunistic earnings
Further modifications to estimating discretionary accruals have been suggested in the
literature. Kasznik (1999) suggests controlling for return on assets in estimation of discretionary
accruals whereas Kothari, Leone and Wasley (2005) suggest adjusting firm level discretionary
accruals by that of a performance matched portfolio. The last two measures control for firm
performance and have been developed since it is believed that earnings management is related to
firm performance.
We use the Jones measure rather than a performance adjusted discretionary accruals
measure primarily for two reasons. This measure has been used extensively in the literature and

draws from the fundamental accounting numbers10. While firm performance may be the primary
motive for earnings management for firms with diversified ownership structures as in the case of
developed markets like US, UK and Canada, the dynamics may be quite different for emerging
economies with different corporate ownership structures. Very often, cross-holdings and
behavior of group affiliated companies in emerging economies makes the case of individual firm
performance as the primary motive for earnings management tenuous.
We compute both the signed and absolute values of discretionary accruals in our
examination of earnings management. Nelson et al. 2002 suggest that income-increasing
(positive) discretionary accruals are likely to be more opportunistic and that auditors are more
likely to require adjustments to positive rather than negative accruals. However, Bedard et al.
(2004) argue that aggressive earnings management includes both positive and negative
discretionary accruals. For example, in periods of high earnings, the existence of a bonus cap
motivates managers to generate negative discretionary accruals. Managers might keep current
high earnings for potential future low earnings periods as per the cookie jar hypothesis.
Further, managers can take big baths to generate negative discretionary accruals in periods of
negative earnings so that the future turnaround looks impressive. Given all these reasons for
creating negative discretionary accruals to opportunistically manage earnings, the absolute value
of discretionary accrual might be a more appropriate measure of earnings management than the
raw discretionary accrual.

3.2.2 Variables of Interest: Board Independence and Director Characteristics

In order to analyze the governance role of company boards in earnings management, as
discussed earlier, our main variables of interest are (i) the extent to which independent directors
are present on the board (ii) the extent to which boards comprise of busy independent directors
(iii) the extent to which independent directors are diligent in their duties (iv) whether controlling
shareholders are inside directors on the board and (v) whether the CEO of the board is also the
chairman. While (ii) and (iii) proxy for the quality of monitoring by independent directors, (iv)
and (v) capture the conflict of interest of inside directors and proxy for the quality of monitoring
by them.

The Jones measure has been modified by Dechow et al. (1995), where the changes in revenues are adjusted by the
change in receivables. Our results are robust to the modified Jones measure and are discussed in a later section.

Under (i), as is the standard approach in existing studies, we use two measures of board
independence, one the proportion of independent directors on the board, and alternatively, a
dummy variable which takes the value one if a the firm has a board constituting of a majority of
independent directors and zero otherwise. Listing regulations in India formalized in 2000 and
instituted by the capital market regulator, the Securities and Exchange Board of India (SEBI)
require that boards of listed companies should have no less than half of its board comprised of
non-executive directors with the additional provision that one-third of the board must have
independent directors if the chairman is non-executive and at least half of the board to comprise
of independent directors if the chairman is an executive (Box 1). Similar to existing studies, the
maintained hypothesis in our study is that board independence is negatively associated with
earnings management.
With regard to the measure of busyness under (ii), we use a dummy variable which
equals one if a firm has at least one independent director with three or more directorships, and
zero otherwise. By doing so, we apply the most conservative definition of busyness that is in line
with the rule of thumb used to define busyness with respect to several US studies. This rule of
thumb largely follows the recommendation of the Council of Institutional Investors in the US
(see Ferris et al., 2003). Notwithstanding the fact that the limits set on multiple directorships for
independent directors is set at a much higher level of twenty, we set a relatively low threshold of
busyness of a board in our analysis to examine whether the ability to monitor earnings
manipulation is affected even when the benchmark of developed countries are applied. As
discussed in the introduction, since multiple directorships can potentially have both positive and
negative effects on monitoring, we are unable to predict the direction of the relationship between
busyness and earnings manipulation a priori.
With regard to the diligence measure under (iii) of the extent to which independent
directors attend board meetings, we use the standard measure of the average percentage of board
meetings attended by the independent directors on the board (see Carcello et al., 2002 and Sarkar
and Sarkar, 2005). In line with the discussion in Section 2, we hypothesize that such over-
commitment, as manifested in a lower number of meetings attended, will have a positive effect
on opportunistic earnings management.

With respect to (iv), as argued above, the presence of controlling shareholders on

company boards can have a positive effect on opportunistic earnings manipulation given that

earnings management provides a channel for expropriation. In order to examine the influence of
controlling shareholders on company boards, we, however, we examine the ex promoter-
independent boards where no inside director on the board is a promoter. Interpreting through
the lens of corporate governance, we predict that firms which have no promoters as inside
directors will have lower earnings manipulation as expropriation through earnings manipulation
by inside directors will be absent in such firms. Thus we define a dummy variable which takes
the value one if a firm has a promoter-independent board and zero otherwise.
Finally, we take account of CEO duality under (v) in terms of a dummy variable which
takes the value of one if the CEO of the firm is also the Chairman of the board and zero
otherwise. Similar to the presence of controlling shareholders on the board, the presence of a
Chairman-cum-CEO also implies influence by an insider on the board. However, the situation is
slightly different, since as a CEO, there are compensation related motives. If compensation was
only in terms of equity grants which did not have any vesting period, then the dynamics would
be similar to those of a controlling shareholder. On the other hand, if there is performance bonus
involved, then the preferences for income-increasing and income-decreasing earnings
management may not replicate those of a controlling shareholder. In addition, any limit on the
amount of bonus that can be earned during a given year also makes it difficult to come up with a
priori expectation about the direction of earnings management.11

3.2.3 Control Variables

While we are interested in examining how board independence and director
characteristics can influence the extent of earnings management, there are other firm level factors
that can influence earnings management and which need to be controlled for in the estimations.
Earlier studies have found that the absolute change in a firms prior years earnings (Absearnch)
as well as financial leverage (Debt) are positively related to earnings management, whereas
political costs, captured by a firms size (size) is negatively related to earnings management
(Warfield et al. 1995; Dechow et al. 1995; DeFond and Jiambalvo, 1994; Becker et al., 1998;
Dechow et al. 1996; Bartov et al. 2000). Market-to-book ratios (mbvr), negative earnings in the

Another layer of complexity is possible if the Chairman-cum-CEO is a promoter. Such Chairman-CEOs perhaps
behave like any other controlling shareholder regarding earnings management.

past (Negearn) and firm size have been related to board independence (Klein, 2002). We
include these five variables as controls in our opportunistic earnings regression.

In line with recent findings that ownership by institutional investors is positively related
to recent earnings performance and recent positive performance (Del Guerico, 1996; Lang and
McNichols, 1997; Chung et al., 2002), we also consider equity holdings by institutional investors
in a firm as a control variable. Using discretionary accounting accruals as the measure of
earnings management, Chung et al. (2002) for instance find that the presence of large
institutional shareholders constrain opportunistic earnings management for US companies during
1988-1996. Similar evidence is found in Mitra (2002) for a sample of 386 firms listed in the New
York Stock Exchange between 1991 and 1998. The inclusion of the ownership of institutional
investors as a factor influencing earnings management is particularly relevant for an emerging
economy like India given the increasing role that such investors have played in the governance
of coporations in these economies. While several studies have focused on the governance role of
institutional investors in emerging economies (Khanna and Palepu, 2000; Xu and Wang, 1997)
most of these analyze their effect with respect to firm performance, their effect on earnings
management and in ensuring the credibility of accounting numbers remains an open question
which we seek to address in our analysis. In controlling for institutional investors, we consider
two variables, one equity holdings by domestic institutional investors (Iinst_share), and second,
equity holdings by foreign institutional investors (Fii_share).
While the control variables mentioned above have been used in studies dealing with data
from the US or similar developed markets (see for example Klein, 2002), we have to control for
characteristics unique to countries like India where business groups dominate. Cross holdings by
promoter groups or families and interlocking boards or directorates makes it important to control
for group affiliated companies. We use a dummy variable, Group, to capture this firm attribute.
The list of variables and their definitions are summarized in Table 1.

----Insert Table 1 about here---

4. Empirical Results
4.1 Summary Statistics
As mentioned in Section 3.1, our sample consists of the largest 500 firms in terms of
sales that trade in the Bombay Stock Exchange, accounting for about 90 percent of the market
capitalization. Summary measures of variables of interest are presented in Table 2.
----Insert Table 2 about here---
Opportunistic earnings management is captured by the amount of discretionary accruals a
firm recognizes. We notice that the mean value of signed discretionary accruals for the sample is
quite low, about 1 percent of the lagged total assets. However, further investigation indicates that
about 57 percent of the sample generates positive discretionary accruals and the rest generate
negative discretionary accruals. For each of these groups, the mean value is about 8 percent of
lagged total assets. Thus a look at the partitioned sample or the absolute values gives us a better
idea of the extent of opportunistic earnings management. The value of discretionary accruals
ranges from a minimum of -39 percent to a maximum of +42 percent of lagged total assets.
Quite a few variables have been used to measure the characteristics of the board of
directors. During the year 2002-03, about 54 percent of the directors in these 500 firms are
independent, with about 260 firms (52 percent) having a majority of independent directors on
their board. However, about 465 firms (93 percent) have busy independent directors i.e. at least
one independent director having 3 or more directorships. We find that independent directors
attended about 70 percent of the board meetings. About 150 firms (30 percent) have a promoter
as an executive director. We are interested in examining the quality of the board and its
independence from promoter influence; so we use a dummy variable (No_ prom_execdir) which
indicates if a board has no promoters as executive directors. Table 2 also indicates that about 115
firms (23 percent) have a problem of CEO duality, with the same person serving as the managing
director as well as the chairman of the board.
Examination of the ownership structure of the sample gives some interesting insights.
About 43 percent of the equity of these firms is owned by promoters, with a maximum value of
98 percent. Banks, financial institutions and insurance companies own about 7.5 percent of the
equity, with mutual funds owning about 3 percent. Thus the Indian institutional investors own
about 10 percent, with a maximum value of 66 percent. The ownership by foreign institutional
investors is relatively lower, about 2 percent, with a maximum of 43 percent.

About 340 firms (68 percent) are affiliated to a business group.12 Firm size is measured as
a log of total assets and has a mean value of 5.92m INR, varying from a minimum of 3.20 to a
maximum of 11.06. With a standard deviation of 1, this shows that there is enough variation in
the size of the firms. The mean value of leverage (measured as total borrowing to total assets) is
0.32, with a maximum value of 0.79. The mean market to book value ratio is 1.12. The mean
absolute value of the change in earnings per share is 10 (INR per share), with a median value of
4. The indicator variable for negative earnings shows that about 22 percent of the firms did have
losses in both of the last two years. While the firms in this sample represent those with the
largest sales in the Indian market place, the descriptive values in Table 2 confirm that there is
reasonable variation in the underlying firm characteristics to make it representative of the

4.2 Board Characteristics and Earnings Management

Boards with a majority of independent directors are expected to implement a higher
standard of corporate governance. However, board independence is only one of the board
characteristics of the corporate governance environment of a firm. Diligence of the independent
directors, influence of promoters as well as of the CEO on the board are some other board
characteristics that warrant examination as well, particularly in the context of curbing earnings
If the independent directors are busy with other directorships, then they devote less
attention to the firm in question, reducing the level of corporate governance. Thus a board
composed of busy independent directors may not be as effective. Furthermore, the diligence of
these independent directors can be measured by the percentage of board meetings they have
attended. We expect that the presence of diligent independent directors will reduce the amount of
opportunistic earnings management. Influence on the board from a promoter or a CEO can be
self-serving and not in the interest of the outside shareholder. So we expect that the absence of
influence from promoters leads to lower earnings management. In a similar vein, we expect
boards where the CEO (or managing director) is not the chairman of the board will exhibit lower
earnings management. So to summarize, we expect opportunistic earnings management to

The Prowess database defines a business group as a set of companies which have the same set of controlling
owners, referred to as promoters under the Indian Securities Law. The promoters are usually the founding family
members, their relatives, and other companies controlled by them.

decrease when (i) boards are independent, (ii) the directors are less busy, (iii) the directors are
more diligent, (iv) promoters cannot influence the board and (v) when boards are not influenced
by promoters or CEOs.
--- Insert Table 3 about here ---

We use the absolute value of discretionary accruals to measure the amount of

opportunistic earnings management. Furthermore, we use two alternative measures for board
independence. The first is an indicator variable denoting if the majority of the directors are
independent. The second is a continuous measure using the percentage of directors who are
independent. We consider 4 separate regression models to examine the effect of board
characteristics on the absolute value of discretionary accruals. In models 1 and 2, we examine the
impact of independence, busyness and diligence. In models 3 and 4, we examine the impact of
independence, busyness, diligence and both types of influences. Models 1 and 3 use the indicator
variable to measure board independence, whereas models 2 and 4 use the continuous variable.
From the results of models 1 and 2, we find that neither definition of board independence has a
significant influence on opportunistic earnings management. However, we find board busyness
increases earnings management and the results are significant around the 6 percent level.
Furthermore, we also find that diligence of the independent directors reduce earnings
management and is significant around the 3 percent level. Examining the results of models 3 and
4, we find in addition to the earlier results, the absence of promoter influence on the board
reduces earnings management, which is significant at less than 10 percent. All of these results
are in line with our expectations. However, we find that in the presence of CEO influence on the
board, earnings management reduces, significant at around 8 percent. This is contrary to our
expectation. However, this result occurs because the absolute discretionary accruals measure
blurs the different responses by the CEO to influence earnings management when a firm is
conservative vs. aggressive in its financial reporting. We get an insight into the reason for such a
result when we split the discretionary accruals into positive and negative subgroups, presented
later in Table 5. There we find that only when firms follow conservative reporting (essentially
negative discretionary accruals), the presence of the CEO on the board make the reporting less
conservative. If the firm was reporting aggressively, the presence of the CEO on the board does
not reduce the aggressiveness.

In summary, we find that it is not overall board independence but rather the presence of
diligent independent directors that reduces the extent of opportunistic earnings management by a
firm. We also find that when independent directors are busy, they are not effective in reducing
earnings management. Finally the influence of a promoter or the CEO on the board increases the
extent of earnings management. These results are interesting since it essentially says that several
dimensions of board characteristics are important for improving the financial reporting
environment and curbing earnings management. A board that looks good on the surface but does
not exert effort (as would be the case when the board is independent, but not diligent) would be
ineffective. Influence by self-interested parties, such as the CEO or a promoter can override any
benefits of having an independent board. We thus conclude that board effectiveness in improving
financial reporting depends on the quality of the independent directors (diligence and lack of
busyness) but not on the number of independent directors on the board itself; further, the absence
of external influence improves the board effectiveness as well.

4.3 Effect of Control Variables

We discuss the effects of the control variables on earnings management in this section.
Firms with high market to book ratio show greater opportunistic earnings management. In
addition, the absolute earnings change also increases opportunistic earnings management.
Further, neither the size nor the loss dummy has any effect on the absolute discretionary
accruals. All of these results concur with the results in Klein (2002). However, her results
indicate that debt increases opportunistic earnings management, which we are unable to confirm
from our results.
--- Insert Table 4 about here ---

In addition to the variables used in Klein (2002), since we are examining an emerging
market setting where the business environment and institutions are different, we control for the
effect of business group affiliation and institutional ownership. We find that business group
affiliation does not have an effect on earnings management. As mentioned earlier, we consider
two categories of institutional investors, domestic and foreign. We saw in table 2 that the mean
value of domestic institutional investor ownership is larger than their foreign counterparts.
Model 1 in table 4 presents the effect of domestic institutional ownership in the presence of

board of director characteristics, viz. independence, busyness, diligence and influence. The board
characteristics continue to be significant as earlier. In addition, we find that domestic
institutional ownership reduces opportunistic earnings management, significant at 10 percent.
Instead of domestic institutional ownership, model 2 considers foreign institutional ownership;
although it reduces absolute discretionary accruals, but we find that it is not significant. Model 3
considers both domestic and foreign institutional ownerships and we find that the results from
models 1 and 2 are unchanged. Based on these results, it may be possible that powerful
institutional shareholders can act as a compensating control mechanism to mitigate the influence
of controlling (promoter) shareholders on the effectiveness of the board. We examine this issue
in the next section.

4.4 Relation between Promoter-Independent Boards and Institutional Investors

Our result that domestic institutional ownership reduces opportunistic earnings
management together with the result of an adverse effect of promoter-director on discretionary
accruals suggest that there could be a possible conflict of interest between outside investors and
controlling shareholders. Anderson and Reeb (2003; 2004) argue in the context of family owned
firms in the US, when families have substantial control in a firm, the presence of large external
investors can mitigate the agency costs between controlling shareholders and outside
shareholders. Further, if outside shareholders choose to act as coalition, it would be all the more
difficult for controlling shareholders to expropriate minority shareholders. Using Canadian data,
Park and Shin (2004) find that when active institutional investors have representation on the
board, earning management is reduced. Representation from financial intermediaries on the
board also reduces earnings management. Applying this line of reasoning to family controlled
corporations in emerging economies, and given the emphasis in the literature on the inter-
relationships between controlling outside blockholders and board effectiveness, one can argue
that if one of the channels of expropriation of controlling shareholders is through executive
positions on the board, the presence of institutional investors can constrain the ability of the
entrenched controlling insider to expropriate through manipulating earnings. Conversely, boards
which are independent from family control in terms of the absence of a controlling shareholder
as an insider and institutional investors can act as substitute mechanisms in reducing earnings

manipulation. We seek to address this issue in the context of analyzing the joint effect of board
characteristics and institutional investors on earnings management.
To estimate the joint effect of institutional investors and promoters on company boards,
we interact domestic institutional ownership and independence of board from promoter influence
in model 4 of Table 4. We find this joint effect term to increase opportunistic earnings
management, significant at 10 percent. In view of the fact that individually both of these factors
reduce absolute discretionary accruals, this result indicates that these two governance
mechanisms act as substitutes in reducing opportunistic earnings management.
A little more discussion is in order in this regard. A firm can implement various
mechanisms to improve the corporate governance structure. For an outsider, it is often very
difficult to assess whether there is an adequate level of governance for any firm. The reason why
this assessment is difficult is because very often it is not clear how the coexistence of alternative
forms of governance contributes to improving the environment. For the outside investor or
regulator it is important to understand if the relation between the alternative mechanisms is one
of complements or substitutes. A bulk of the literature on corporate governance has examined the
impact of one or two mechanisms on firm value, stock returns or earnings management. But very
few have examined to nature of the joint-relation between two alternative mechanisms. Cremers
and Nair (2003) find that external and internal governance mechanism act as complements in
determining stock price returns.13 Our contribution in this respect is that we examine how the
interaction between two alternative internal governance mechanisms can affect earnings
management and find that they substitute each other. This has implications for regulators not
only for developing new policies, but also in their enforcement decisions e.g. the standards for
determining board effectiveness can be lower when there are institutional investor ownership is
large enough to compensate for that. Investors are also impacted by this additional insight. A
substitute relationship increases the set of firms that they can consider for investing, whereas a
complementary relation yields a smaller set of investment choices.
--- Insert Table 5 about here ---
We gain further insight into this by examining the effect of promoter influence and
institutional investors on signed discretionary accruals. The first column in Table 5 presents the

External governance is measured by the absence of anti-takeover devices a firm has at its disposal and internal
governance by the percent owned by public pension funds or large blockholders.

raw DA results. We find that while promoter independent boards reduce earnings management,
the value is not statistically significant. Domestic institutional investors significantly reduce
earnings management at 2 percent and the substitution effect is significant at 10 percent. In the
second column, firms with positive discretionary accruals confirm all of the earlier results i.e.
both promoter independent boards and institutional ownership reduce earnings management; in
conjunction, they act as substitutes. However, in the third column, where we examine firms only
with negative discretionary accruals, neither promoter influence nor institutional ownership is
significant; the interaction term is also not significant. From this additional analysis, we conclude
that a promoter presence on the board does not always lead to increased earnings management
(as in the case of firms with negative discretionary accruals). But if the promoter does influence
the level of earnings management of a firm, as in the case of those with positive discretionary
accruals, then domestic institutional ownership can act as a compensating control to mitigate the

4.5 CEO Duality influence on earnings management: Further analysis

Another element of conflict of interest is if the CEO of the firm also serves as the
chairman of the board of directors. This phenomenon is not just restricted to emerging market
economies. Such dual chairman-CEOs often yield considerable power over the operations and
evaluation (or governance) of the firm. Their power to control can often lead to self-interested
decision making at the expense of the outsider investor.
In section 4.2, we saw the effect of a chairman-CEO on the absolute value of
discretionary accruals: it decreased significantly in the presence of such a dual CEO role. This
was counterintuitive since we expect a dual CEO to actually increase earnings due to bonus and
other compensation considerations. Since the absolute measure captures both income increasing
as well as income decreasing earnings management, we examined the signed measures in Table
5. To get a complete understanding, we also investigate the positive and negative discretionary
accruals firms separately. From the first column of Table 5 we notice that the presence of a
chairman-CEO increases the raw DA, significant at the 5 percent level. This agrees with our
expectations. However, from the second column, it appears that for positive DA firms, contrary
to our expectations, the dual role is reducing the income increasing earnings, although not
statistically significant.

The third column indicates that for negative DA firms, the dual chairman-CEO role is
significantly increasing income-increasing earnings management, significant at 1 percent. We
also find that board diligence as measured by percentage of meetings attended by independent
directors (meeting_attend_indepdir) also results in income-increasing earnings management, also
significant at 1 percent.14 While the reasons for the chairman-CEO and the diligent independent
board member to push for income increasing accounting choices may be different, it is important
to understand which of these effects are stronger and dominates the other. In the last column of
Table 5, we introduce an interaction term to capture any additional insight available. The results
show that diligence of the independent board director and presence of chairman-CEO act as
substitutes in reducing negative discretionary accruals, with a slope of -0.0013 significant at 1
percent. We also notice that there is a large increase in the coefficient of associated with CEO
duality (chairmd) from 0.0459 to 0.1326 in the presence of the interaction term.
The results from the last column in Table 5 imply that while the marginal effect of board
diligence is positive for companies with separation of the CEO and the chairmans position, this
marginal effect is negative (0.0009 - 0.0013) for companies exhibiting CEO-duality. In contrast,
the marginal effect of CEO-duality (which is estimated by 0.1326 -
0.0013*meeting_attend_indepdir) is always positive15, although the effect decreases as boards
become more diligent. Essentially, what we conclude is that in the presence of chairman-CEO,
the diligent board wants to report conservatively. We can only speculate that these may be driven
by the alternative motives for the two parties (reputation for the independent director and
compensation for the chairman-CEO). The independent director may realize the CEOs
inclinations and thus acts to counter that effect. We draw two conclusions from this analysis:
first, board diligence is useful in reducing income-decreasing opportunistic earnings
management when the CEO is not the chairman of the board; second, the presence of chairman-
CEO is always effective in deterring income-decreasing opportunistic earnings management. In
other words, in the absence of a chairman-CEO, investors should look for a diligent board as a
compensating control.

What this means is if firms are relatively conservative in arriving at their earnings figure, the dual chairman-CEO
influences the firm to engage in income-increasing accounting estimates. So does the diligent independent boar
members. While both appear to reduce the amount of earnings management for these negative DA firms, they may
be caused by different motives (e.g. reputation for the director and bonus for the chairman-CEO).
For the marginal effect to be zero, diligence by independent board member (meeting_attend_indepdir) has to take
the value of 0.1326/0.0013 =101 percent.

5. Robustness Checks
We did a number of robustness tests to ensure that our results are not driven by our
choice of variables. Instead of using the Jones approach to measure for discretionary accruals, we
used the modified Jones approach, as suggested by Dechow et al. (1995). The modified Jones
model is developed by assuming that it is easier to exercise discretion over credit sales than cash
sales. Thus discretionary accruals are estimated after adjusting for change in receivables. Our
results remain virtually unchanged with the use of this alternative measure of earnings
measurement. Board independence measured either by percentage of independent directors or
majority independent board remains insignificant in all regressions with very high p-values (0.22
to 0.43). Director diligence measured by percentage of board meeting attended is always
significant with slightly lower p-values (0.03 in all regressions). Likewise, promoter-
independent-boards always exhibit lower earnings management (with p-values between 0.05 and
0.08) while CEO-duality is significant in all regressions (p-values between 0.05 and 0.08).
Finally, the coefficient of foreign ownership is never significant (p-values between 0.43 and
0.48) while share ownership by institutional investors is highly significant (with p-value 0.00) in
all regressions). The interaction with promoter-independent-board and institutional shareholding
is significant at the seven percent level. The only change is the slightly reduced significance of
the busyness variable with p-values between 0.11 and 0.15 compared to between 0.08 and 0.12
with the Jones measure.
We also examined if the results change using an alternative set of control variables.
Warfield, Wild and Wild (1995) examine the relation between managerial ownership and
discretionary accruals adjustment. The control variables used in that study include size measured
as the log of the market value of equity, systematic risk of the firm (firms beta), leverage
measured as the ratio of total debt to total assets, growth measured as the market-to-book ratio of
equity, earnings variability during the last sixteen quarters and earnings persistence measured as
the first-order autocorrelation over the last sixteen quarters. Again, all our results remain robust.
In fact, p-values of most coefficients decline by two to four percentage points. With respect to
the control variables themselves, size and debt remain insignificant with similar p-values, while
market-to-book-ratio is always significant at lower than the five percent level. With respect to
the three new control variables, beta and earnings persistence are not significant in any of the

regressions (with p-values around 0.70 and 0.50, respectively) while earnings variability exhibits
a strong correlation with discretionary accruals with a p-value of 0.01 in all regressions.
We also ensured that our results were not driven by properties of the data. First, standard
errors of all coefficients have been calculated using Whites correction for heteroskedasticity.
Accordingly, the test statistics used to infer the significance of the coefficients are consistent. We
also examined if outliers were driving our results by inspecting the extreme observations, the top
and bottom five values of the discretionary accruals variable. We found these observations to be
within three standard deviations of the mean suggesting that our results were not unduly
influenced by extreme observations.
Finally, we examined if our results are sensitive to the set of firms considered for
estimating the parameters of Jones model of total accruals (equation 2). We have used the
universe of all listed firms in Bombay Stock Exchange that are available in the Prowess database
to estimate the above equation. However, since our exploration of earnings management is
restricted to large firms, we re-estimated the parameters of Jones model based on only the top
1000 firms listed on the Exchange. The new set of parameters lead to similar estimates of
discretionary accruals for our sample firms and our results remain robust.

6. Conclusion
This paper examined the role of board characteristics in mitigating opportunistic earnings
management by managers and promoters of firms. Opportunistic earnings management is
motivated by self-serving interests of the parties involved, including compensation benefits,
wealth transfers and rent extraction opportunities. In this paper, we focus primarily on
governance mechanisms that are associated with an entire gamut of board and director
characteristics. Earlier studies have considered board independence to determine how effective it
is in governing the firm. In this study, we consider a much richer set of board attributes to
understand how they mitigate the earnings management process.
Our sample consists of a sample of large firms in India, which together represent around
ninety percent of the total market capitalization of the country. Using a sample from an emerging
economy serves several purposes. It helps us test whether the mechanisms that are effective in a
developed market are also effective in an emerging market. Further, we are also able to
understand any nuances that exist in this context in comparison to a developed market. Investors,

particularly the international ones, can use these results to determine how to evaluate firms for
effective governance since a different set of factors may be at play in different markets.
We consider the discretionary accruals of a firm to represent the extent of opportunistic
earnings management. Our estimate of discretionary accruals is based on the Jones (1986)
model. Four different characteristics of the board of directors are examined. Independence is
measured using two ways: the percentage of independent directors on the board and a variable to
indicate if the majority of the directors are independent. Busyness is measured by a variable that
indicates if there is at least one independent director who has three or more directorships. Board
diligence is measured by the percentage of board meetings attended by independent directors.
Influence on the board by promoters and chief executive officer is also examined. We use a
variable to indicate if a promoter serves as an executive director and another variable to indicate
if the chief executive officer is also the chairman of the board.
Our results indicate that board independence by itself does not reduce absolute
discretionary accruals. We also find that if a board has busy directors, then absolute discretionary
accruals increase. Diligent directors do a good job of reducing absolute discretionary accruals.
The influence of promoters on the board increases absolute discretionary accruals. We find that
the raw rather than the absolute discretionary accruals increase significantly in the presence of a
CEO-chairman and thus conclude that chief executive officer who serves as chairman of the
board is always interested in increasing earnings, not necessarily smoothing them.
We find that in the presence of the various board characteristics, the presence of Indian
institutional investors reduce the amount of absolute discretionary accruals. Foreign institutional
investors do not have any effect. Furthermore, we find that the interaction between board and
domestic institutional ownership yield interesting insights. We find that board independence
from promoter influence and Indian institutional ownership are substitutes. In other words, at the
margin, high levels of both types of governance increases absolute discretionary accruals. This is
evidence of the fact that if there is a weakness in one governance mechanism, which in our case
is the ability of a promoter-independent board to monitor earnings, the strength of the other
governance mechanism, namely the monitoring undertaken by domestic institutional investors,
can compensate for the weakness. The idea of compensating controls is an important one, in
particular because increasing all the governance levels can unnecessarily increase costs without
adding value beyond a certain point. Our research complements the existing literature on the

influence of individual corporate governance mechanisms as well as those that have examined a
comprehensive set of measures (using factor scores) on earnings management.


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Table 1: List of Variables and Definitions

Variable name Definition

Abs_DA Absolute discretionary accruals. Calculated using Jones (1991) model.

Raw_DA Raw or discretionary accruals. Calculated using Jones (1991) model.
Positive_DA Positive discretionary accruals. Calculated using Jones (1991) model.
Negative_DA Negative discretionary accruals. Calculated using Jones (1991) model.
Percent_indepdir Percentage of independent directors on the board. Calculated as number
of independent directors divided by board size, multiplied by 100.
Maj_ indep_ board Majority independent board. Dummy variable. Equals one if percentage
of independent director exceeds 50.
Has_busy_indepdir Dummy variable. Equals one if the board has at least one independent
director with three or more directorships.
Meeting_attend_indepdir Percentage of board meetings attended by independent directors.
Calculated as mean of percentage of board meetings in the year attended
by all independent directors of the board.
No_ prom_execdir Dummy variable. Equals one if promoters or controlling shareholders are
not present as executive directors on the board.
Chairmd Dummy variable. Equals one if the same person holds the position of
Chairman and Managing Director of the corporation.
Prom_share Promoters share. Percentage of common stock owned by
promoters/controlling shareholders.
Bfi_share Banks, financial institutions and insurance companies share. Percentage
of common stock owned by banks, financial institutions and insurance
Muf_share Mutual funds share. Percentage of common stock owned by domestic
mutual funds.
Iinst_share Indian institutions share. Total of Bfi_share + Muf_share.
Fii_share Foreign institutional investors share. Percentage of common stock owned
by foreign institutional investors.
Group Dummy variable. Equals one if the corporation is affiliated to a business
Size Log of total assets.
Debt Financial leverage. Calculated as total borrowing divided by total assets.
Mbvr Market to book value ratio. Market value of equity plus book value of
debt divided by book value of equity.
Absearnch Absolute earnings change. Calculated as the absolute value of the change
in earnings per share between the current year and the previous year.
Negearn Negative earning. Dummy variable. Equals one if the firm had two or
more consecutive years of negative earnings per share, ending on the
fiscal year prior to the current year.

Table 2: Summary Statistics

Variable N Mean Median Min Max

Abs_DA 485 0.08 0.06 0.00 0.42
Raw_DA 485 0.01 0.01 -0.39 0.42
Positive_DA 275 0.08 0.06 0.00 0.42
Negative_DA 210 -0.08 -0.06 -0.39 0.00
Percent_indepdir 500 54.16 54.55 8.33 100.00
Maj_ indep_ board 500 0.52 1.00 0.00 1.00
Has_busy_indepdir 500 0.93 1.00 0.00 1.00
Meeting_attend_indepdir 488 69.39 70.00 12.50 100.00
No_ prom_execdir 500 0.70 1.00 0.00 1.00
Chairmd 500 0.23 0.00 0.00 1.00
Prom_share 500 42.84 45.33 0.00 98.90
Bfi_share 500 7.42 4.35 0.00 50.64
Muf_share 500 2.95 1.18 0.00 19.54
Iinst_share 500 10.37 7.49 0.00 66.31
Fii_share 500 1.86 0.00 0.00 43.02
Group 500 0.68 1.00 0.00 1.00
Size 500 5.92 5.81 3.20 11.06
Debt 500 0.32 0.34 0.00 0.79
Mbvr 500 1.12 0.55 0.02 66.88
Absearnch 489 10.00 4.02 0.01 432.40
Negearn 484 0.22 0.00 0.00 1.00

Table 3: Effect of Board Characteristics on Discretionary Accruals

Explanatory Variables Model 1 Model 2 Model 3 Model 4

Intercept 0.0883*** 0.0861*** 0.1008*** 0.0969***

(0.0048) (0.0085) (0.0022) (0.0048)
Maj_ indep_ board 0.0041 0.0045
(0.5289) (0.4775)
Percent_indepdir 0.0001 0.0001
(0.6937) (0.5140)
Has_busy_indepdir 0.0209* 0.0210* 0.0212* 0.0210*
(0.0870) (0.0892) (0.0779) (0.0843)
Meeting_attend_indepdir -0.0004** -0.0004** -0.0004** -0.0004**
(0.0354) (0.0326) (0.0418) (0.0408)
No_ prom_execdir -0.0147** -0.0149**
(0.0514) (0.0525)
Chairmd -0.0137* -0.0138*
(0.0681) (0.0621)
Group -0.0020 -0.0016 -0.0032 -0.0031
(0.7952) (0.8268) (0.6670) (0.6721)
Size -0.0031 -0.0031 -0.0029 -0.0028
(0.2663) (0.2819) (0.3117) (0.3288)
Debt 0.0302 0.0300 0.0290 0.0284
(0.1155) (0.1237) (0.1415) (0.1536)
Mbvr 0.0009** 0.0009** 0.0009** 0.0009**
(0.0325) (0.0385) (0.0373) (0.0416)
Absearnch 0.0002** 0.0002** 0.0002*** 0.0002***
(0.0360) (0.0306) (0.0149) (0.0148)
Negearn -0.0036 -0.0037 -0.0030 -0.0030
(0.5958) (0.5846) (0.6611) (0.6581)

Industry dummies Yes Yes Yes Yes

No. of observations 454 454 454 454
R2 0.15 0.15 0.16 0.16
F 3.35 3.34 3.36 3.35
(<0.0001) (<0.0001) (<0.0001) (<0.0001)

Notes: P-values in parenthesis. ***, **, * denote the co-efficient is significant at the 1 percent, 5 percent, and 10
percent level respectively.

Table 4: Effect of Board Characteristics Model and Ownership on Discretionary Accruals

Explanatory Variables Model 1 Model 2 Model 3 Model 4

Intercept 0.0850*** 0.0948*** 0.0822** 0.0848**

(0.0145) (0.0070) (0.0195) (0.0169)
Percent_indepdir 0.0002 0.0001 0.0002 0.0002
(0.2773) (0.5181) (0.2797) (0.3141)
Has_busy_indepdir 0.0193* 0.0201* 0.0184 0.0216*
(0.1014) (0.0983) (0.1249) (0.0758)
Meeting_attend_indepdir -0.0004** -0.0004** -0.0004** -0.0003**
(0.0471) (0.0384) (0.0444) (0.0496)
No_ prom_execdir -0.0135* -0.0153** -0.0139* -0.0237**
(0.0732) (0.0467) (0.0651) (0.0209)
Chairmd -0.0150** -0.0138* -0.0149** -0.0140**
(0.0387) (0.0646) (0.0406) (0.0552)
Iinst_share -0.0009*** -.0009*** -0.0016***
(0.0095) (0.0093) (0.0020)
No_ prom_execdir Iinst_share 0.0010*
Fii_share -0.0006 -0.0006 -0.0006
(0.3695) (0.3581) (0.3823)
Group -0.0031 -0.0031 -0.0031 -0.0026
(0.6699) (0.6718) (0.6695) (0.7387)
Size 0.0003 -0.0019 0.0012 0.0009
(0.9173) (0.5565) (0.7182) (0.7908)
Debt 0.0285 0.0256 0.0257 0.0257
(0.1536) (0.2119) (0.2132) (0.2075)
Mbvr 0.0010** 0.0010** 0.0011** 0.0011**
(0.0331) (0.0217) (0.0165) (0.0179)
Absearnch 0.0002*** 0.0002** 0.0002*** 0.0002**
(0.0142) (0.0155) (0.0146) (0.0189)
Negearn -0.0030 -0.0032 -0.0032 -0.0023
(0.6579) (.6356) (0.6353) (0.7314)

Industry dummies Yes Yes Yes Yes

No. of observations 455 455 455 455
R2 0.18 0.17 0.18 0.18
F 3.52 3.24 3.41 3.38
(<0.0001) (<0.0001) (<0.0001) (<0.0001)

Notes: P-values in parenthesis. ***, **, * denote the co-efficient is significant at the 1 percent, 5 percent, and 10
percent level respectively.

Table 5: Effect of Board Characteristics and Ownership on Discretionary Accruals:
Raw, Positive and Negative Discretionary Accruals

Explanatory Variables Raw_DA Pos_DA Neg_DA Neg_DA

Intercept -0.0758* 0.0482 -0.1830*** -0.2113***

(0.0980) (0.2492) (<0.0001) (<0.0001)
Percent_indepdir 0.0003 0.0001 0.0001 -0.0001
(0.1543) (0.5982) (0.9089) (0.8711)
Has_busy_indepdir -0.0069 0.0233 -0.0150 -0.0209
(0.6523) (0.1497) (0.3297) (0.1942)
Meeting_attend_indepdir 0.0001 -0.0003 0.0006*** 0.0009***
(0.5440) (0.1584) (0.0074) (0.0005)
No_ prom_execdir -0.0180 -0.0313** 0.0037 0.0077
(0.1988) (0.0240) (0.8132) (0.6171)
Chairmd 0.0196** -0.0005 0.0459*** 0.1326***
(0.0325) (0.9629) (<0.0001) (<0.0001)
Chairmd Meeting_attend_indepdir -0.0013***
Iinst_s -0.0018** -0.0023*** 0.0001 0.0003
(0.0204) (0.0052) (0.9548) ((0.7197)
No_ prom_execdir Iinst_share 0.0014* 0.0018** 0.0007 0.0004
(0.0934) (0.0543) (0.4584) (0.6433)
Fii_share -0.0007 -0.0004 0.0007 0.0006
(0.4576) (0.7086) (0.3733) (0.4575)
Group -0.0010 -0.0054 0.0106 0.0102
(0.9136) (0.5361) (0.3677) (0.3860)
Size 0.0066 0.0035 0.0017 0.0030
(0.1665) (0.4715) (0.7256) (0.5510)
Debt 0.0141 0.0193 -0.0022 0.0005
(0.5888) (0.5214) (0.9380) (0.9843)
Mbvr -0.0027*** -0.0018 -0.0014*** -0.0013***
(<0.0001) (0.5407) (0.0002) (0.0003)
Absearnch -0.0004*** 0.0002 -0.0004*** -0.0003***
(<0.0001) (0.6757) (<0.0001) (0.0002)
Negearn -0.0082 -0.0100 0.0012 0.0012
(0.3879) (0.3094) (0.8903) (.8907)

Industry dummies Yes Yes Yes Yes

No. of observations 455 254 201 201
R2 0.36 0.24 0.35 0.37
F 8.59 2.73 3.33 3.46
(<0.0001) (<0.0001) (<0.0001) (<0.0001)

Notes: P-values in parenthesis. ***, **, * denote the co-efficient is significant at the 1%, 5%, and 10% level