A UDITING: A JOURNAL OF PRACTICE & THEORY Vol. 23, No. 2 September 2004 pp. 13-35
The Effect of Audit Committee Expertise, Independence, and Activity on
Aggressive Earnings Management
Jean Bedard, Sonda Marrakchi Chtourou, and Lucie Courteau
SUMMARY: This study investigates whether the expertise, independence, and activities of a firm’s audit committee have an effect on the quaiity of its pubiiciy released financial information. In particular, we examine the relationship between audit committee charac- teristics and the extent of corporate earnings management as measured by the level of Income-increasing and income-decreasing abnormal accruals. Using two groups of U.S. firms, one with relatively high and one with relatively low levels of abnormal accruals in the year 1996, we find a significant association between earnings management and audit committee governance practices.
We find that aggressive earnings management is negatively associated with the financial and governance expertise of audit committee members, with indicators of independence, and with the presence of a clear mandate defining the responsibilities of the committee. The association is similar for both income-increasing and income-de- creasing earnings management, suggesting that audit committee members are con- cerned with both types of earnings management and do not exhibit an asymmetric loss function similar to that of auditors.
Keywords: audit committee; financial expertise; earnings management; abnormal accruals.
Data Availability: The data used is from public sources identified in the manuscript.
INTRODUCTION
C oncems about earnings management (e.g., Levitt 1998) and recent high-profile accounting scandals have led most of the investing community to call for more effective audit commit- tees as a mean to improve the quality of financial statements (e.g.. Blue Ribbon Committee
[BRC] 1999; Securities and Exchange Commission [SEC] 2000). In response to these calls, regula- tors have adopted regulations on the functioning of audit committees in a number of areas including the expertise of their members, their independence, and their activities. The latest example of such
Jean Bedard is Professor at Universite Laval. Sonda Marrakchi Chlourou is Assistant Professor at the Faculle des Sciences Economiques et de Gestion de Sfax, and Lucie Courteau is Associate Professor at the Free University of Bozen-Bolzano.
We thank Mark DcFond {associale editor), the two anonymous reviewers, Ann Gaeremynck, as well as the accounting workshop participants at Katholieke Unlversiteit Leuven, Universite Laval, Universite Pierre Mendes-France, Universiti Montesqieu, Universitcit Maastricht, and the participants at the Auditing .Section Midyear Meetings for their comments. We acknowledge the financial support of the Social Sciences and Humanities Research Council of Canada.
Submitted: July 2002 Accepted: November 2003
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14 Bedard. Chtourou, and Courteau
regulation in the U.S., the Sarbanes-Oxley Act of 2002 (hereafter SOX), requires that at least one audit committee member have financial expertise, that all the members be independent from the firm’s management, and that the committee oversee the accounting and financial reporting processes as well as the audit of the financial statements.
While prior research on actual fraudulent financial reporting deficiencies provides evidence that is generally consistent with the assertion that some of the practices recommended or required by regulatorsareassociated with lower likelihood of fraud (Beasley l996;AbbottetaI. 2004), there are questions as to whether they also reduce less spectacular forms of earnings management. Klein (2002) provides some evidence on this issue. In her examination of the association between audit committee independence and earnings management for a sample of S&P 500 firms, she finds a significant association between abnormal accruals and the presence of a majority of independent directors on the committee, but “no meaningful relation between abnormal accruals and having an audit committee comprised solely of independent directors” (Klein 2002, 389). Thus, evidence is needed on the possible effects on earnings management of SOX requirements (financial expertise, 100 percent of independent members, and oversight) and of other audit committee best practices.
We investigate the relation between, on the one hand, the audit committee’s expertise (financial, governance, and firm-specific expertise), independence, and activities and, on the other hand, ag- gressive earnings management on a sample of 300 U.S. firms. The sample is composed of three groups, one with aggressive income-increasing earnings management, one with aggressive income- decreasing earnings management, and a third group of firms with low levels of earnings management in the year 1996. Earnings management is measured as abnormal accruals estimated with a cross- sectional version of the Jones (1991) model.
Controlling for specific motivations that firms may have to manage earnings, and for alternative control mechanisms, as well as for variables that have been found to affect the reliability of abnormal accruals measurement, we test whether recommended governance practices for audit committees are associated with a lower likelihood that the firm be in one of the groups with high levels of earnings management. A 1996 sample has the advantage of allowing us to examine firms that voluntarily adopted the best governance practices before some of them were mandated by stock exchanges in December 1999. Thus, we can test the effectiveness of these practices on a cross-section of firms during the same period and increase the power of our tests by limiting the symbolic display of conformity associated with mandatory rules (Kalbers and Fogarty 1998).
Our results suggest that an audit committee whose members have more expertise is more effective in constraining earning management. Specifically, we find that the presence of at least one member with financial expertise, which is now required by SOX, is associated with a lower likeli- hood of aggressive earnings management, and so is the level of governance expertise in the commit- tee. The association between the level of firm-specific expertise and the probability of earnings management, however, is significant only for income-decreasing accruals.
Regarding independence, our results generally support the SOX requirement that all members of the audit committee be independent. Contrary to Klein (2002) whose fmdings suggest that the critical threshold for the number of independent directors on the audit committee is 50 percent rather than 100 percent, we find no significant effect for a committee composed of 50-99 percent indepen- dent members, but a significant reduction in the likelihood of aggressive earnings management when 100 percent of the members are independent. We also find that the percentage of stock options that can be exercised in the short term by independent audit committee members is associated with a higher likelihood of aggressive earnings management. This result provides some support for the U.K. Combined Code (Financial Reporting Council [FRC] 2003) provision that the remuneration of outside directors should not include stock options.
Two aspects of the audit committee’s activity, its size and the frequency of its meetings, do not seem to affect the likelihood of aggressive earnings management. For the third aspect of committee
Auditing: A Journal of Practice & Theory, September 2004
The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 15
activity, the responsibility of overseeing both the financial reporting and the audit processes, we find a significantly negative association with the likelihood of aggressive earnings management. This last result lends support to the SOX requirement that the role of the audit committee include the oversight of both fmancial reporting and the audit process.
While most studies of earnings management consider either only income-increasing accruals or the magnitude of accruals irrespective of their direction, we examine negative (income-decreasing) and positive (income-increasing) earnings management separately. We find that except for the audit committee oversight responsibilities, the effects are not statistically different between the two groups of firms. This suggests that audit committee members are concerned with both income-increasing and income-decreasing earnings management and do not exhibit an asymmetric loss function (Antle and Nalebuff 1991).
Our results are subject to the inherent limitations of our measure of earnings management. Abnormal accruals are subject to measurement errors that can lead to erroneous inference if the measurement error is correlated with the audit committee characteristics (Klein 2002; Kothari et al. forthcoming). While we control for possibly omitted variables that are found in prior literature to affect the reliability of the measure of abnormal accruals, there is always a possibility that our results are caused by measurement error.
This paper contributes to the literature on the association between audit committee characteris- tics and earnings management in three ways. First, while most studies on audit committees focus on the independence of committee members, we also examine their expertise and the extent of their oversight mandate, two aspects that are emphasized in the Sarbanes-Oxley Act of 2002. Second, we examine separately firms that, in 1996, showed evidence of income-increasing and income-decreas- ing earnings management. Firms often claim that income-decreasing abnormal accruals are indica- tive of conservative reporting behavior and Nelson et al. (2002) find that auditors are more likely to require adjustments to positive than negative accruals. Our results contradict both as we find almost no significant difference in the association of committee characteristics with the two types of earn- ings management. Third, our sample includes finns of various sizes. While Klein (2002) studies a sample of firms from the S&P 500 for 1992 and 1993 (an average of 346 firms per year), our sample includes 300 firms of different sizes for 1996. Our sample firms’ median assets are $51 million whereas Klein’s (2002) smallest firm has assets of $179 million. Since the audit committee require- ments apply to firms of all sizes, our sample allows us to test the effect of these requirements on smaller firms, which have also been found to be more prone to earnings management,
Overall, our results lend support to the assumptions underlying the SOX requirements that both expertise and independence are important characteristics for an audit committee to effectively moni- tor the financial reporting and audit processes. They can be used by other regulators that are contemplating similar rules. For example, in Canada the proposed rules on audit committees require that all members of the committee be independent, but does not require financial expertise (Ontario Securities Commission [OSC] 2003).
The remainder of the paper is organized as follow. The next section provides the motivation for the predicted association between audit committee characteristics and earnings management. The third section discusses sample selection and research design. Results are presented in the fourth section and conclusions in the last section.
THE ROLE OFTHE AUDIT COMMITTEE IN MITIGATING EARNINGS MANAGEMENT
Earnings Management Earnings management generally implies a “purposeful intervention in the external financial
reporting process, with the intent of obtaining some private gain” (Schipper 1989, 92). Although management may intervene in the process to signal private information and make the financial
Auditing: A Journal of Practice & Theory, September 2004
16 Bedard. Chtourou, and Courteau
reports more informative for users, we concentrate on the negative aspect of earnings management, i.e., “to mislead stakeholders (or some class of stakeholders) about the underlying economic perfor- mance of the firm” (Healy and Wahlen 1999,368).
The audit committee’s primary role is to help ensure “high quality financial reporting” (PricewaterhouseCoopers 1999, 7). As indicated by the BRC (1999, 7), the audit committee is the “ultimate monitor of the [fmancial reporting] process.” The committee may reduce opportunistic earnings management by “evaluating the competence and in
