Earnings management and corporate governance in UK:

The role of board of directors and audit committee

Thesis Proposal by

Kang Lei

Faculty of Business Administration

National University of Singapore

CHAPTER 1

INTRODUCTION

Financial reported earnings have powerful influence on a full range of business

activities of a firm and its management decisions. The earnings could either affect

investors’ evaluation of the firm or impact contractual outcomes which are related to

financial leverage or compensation of mangers. Therefore managers have strong

intentions to adjust earnings numbers to the desirable level. The flexibility of current

accounting principles also provides managers with considerable ability to adjust

accounting earnings. The practice that the management uses judgment in financial

reporting and in structuring transaction to alter financial earnings is called “earnings

management” (Healy and Wahlen (1998)).

Although earnings management problem is not new, the recent popularity of earnings

manipulation has drawn serious attention from regulators, financial press and

academic research. For example, in a speech at NYU Center of law and business in

1998, Author Levitt, the Chairman of U.S Securities and Exchange Commissions

(SEC), said earnings management impaired the quality of financial reporting. His

comments showed serious concern of the adverse consequence of earnings

management to the US capital market. Earnings management could also be

undesirable to shareholders. When the interests of shareholders and mangers diverge,

mangers can manipulate earnings for their own purposes at the cost of shareholders’

interest. Hence how to improve the reliability and integrity of financial reporting is an

1

interesting topic for research.

Corporate governance mechanisms, board of directors and audit committee in

particular, are responsible for monitoring managers on behalf of shareholders and

overseeing financial reporting process by company law. Therefore the board of

directors and audit committee should play a role in retaining earnings management.

However, the boards of public firms are generally considered as passive entities which

are controlled by management. In an effort to improve the effectiveness of the board

and audit committee, many corporate governance reports, including Cadbury report in

UK of 1992, Toronto Stock Exchange Corporate Governance Guidelines of 1994, and

Blue Ribbon Committee Report in US of 1999, propose “best practice”

recommendations on various aspects of corporate governance. The objective of this

thesis is to empirically examine the effects of some of the best governance practices

by the board of directors and audit committees on the level of earnings management.

I study the relation between, on the one hand, the attributes of the board and audit

committee and, on the other hand, earnings management measured as discretionary

accruals. I am particularly interested in the role of non-executive directors. I examine

the effects of their proportion on board/audit committee, their competence, their

compensation scheme and the activities of board and audit committee. Discretionary

accruals are estimated using modified Jones Model. I conduct the analysis in a sample

of large publicly traded UK firms, because UK data have more variances than those of

2

U.S, and the corporate governance environment of UK is different from that of U.S in

several ways, therefore this UK study may provide some interesting results for issues

of board/audit committee monitoring.

This study could enrich the literature of relationship between board monitoring and

financial reporting by selecting UK firms for analysis. By now, most previous studies

in this field are U.S based, and a few have provided empirical evidence for UK cases.

Peasnell et al (2000a) and Peasnell et al (2000b) are two exceptions. However they

only focus on the effects of the proportion of outside directors and the existence of

audit committee on the level of earnings management. This thesis does a more

comprehensive study on various characteristics of board/audit committee, and thus

may provide more valuable information to UK accounting regulators in making

recommendations for corporate governance practice.

This study also extends the research of board effectiveness by including the

compensation of the directors as a determinant. It is possible that the directors make

different performance under different remuneration scheme, but few previous studies

have taken this financial motivation of the directors into consideration. Therefore, the

results of this study might be useful for companies to design more effective

compensation package.

Another potential contribution of this thesis is that I make additional estimation of the

3

discretionary accruals after considering some differences in accounting standards

between UK and US. Wilkins (2002) suggests that some particular country differences

in accounting environment may results in significant difference in some of the

variables in modified Jones model, however most previous UK studies ignore this

potential problem. For this thesis, one important difference for this UK study is that

revaluation of non-current assets has been banned in US since 1933, but is permitted

in UK (Company Act (CA) 85 4.31, Statement of Standard Accounting Practice

(SSAP) 19, and Financial Reporting Standard (FRS) 15). In additional test, I will

adjust modified Jones model to examine whether this difference could alter the

results.

The remainder of this paper is organized as follows: Chapter Two reviews literature of

earnings management and corporate governance, and develops hypotheses for test.

Chapter Three gives an overview of corporate governance in UK, and Chapter Four

describes the data sources and research methodology.

4

CHAPTER 2

LITERATURE AND HYPOTHESIS DEVELOPMENT

2.1 Earnings management

This is generally believed by the regulators and the public that managers manipulate

reported earnings (Levitt (1998); Loomis (1999)). A large body of academic research

has examined the existence of earnings management, in particular, around specific

corporate events in which agency problem is most likely to occur. Perry and Williams

(1994) provides evidence of managers’ manipulation of earnings in the predicted

direction in the year preceding the public announcement of management's buyout

intention. Erickson and Wang (1999) find that acquiring firms manipulate accounting

earnings upward prior to stock for stock corporate mergers. Teoh et al (1998a and

1998b) find that managers raise reported earnings before initial public offerings and

seasoned equity offerings.

Managers have various incentives to manipulate earnings. Some incentives are

provided by contractual arrangements based on accounting earnings such as bonus

plan, debt and dividend covenants, etc. For example, DeFond and Jiambalvo (1994)

find that sample firms accelerate earnings prior to lending covenants, and Holthausen,

Larcker and Sloan (1995) find that managers manipulate earnings downwards when

their bonus are at their maximum. In some cases, earnings management is motivated

by regulatory reasons. Previous studies find that managers would manipulate earnings

to circumvent industry regulations and reduce the risk of investigation by anti-trust

5

regulators (Collins et al (1995); Cahan (1992)). However, recent research has been

focus more on incentives provided by the capital market. Dechow and Skinner (2000)

suggest that accounting information such as earnings is important for capital market to

value the firm, and the increased stock market valuations and stock-based

compensation during 1990’s make managers have more incentives to manage

earnings. The results of empirical researches are generally supportive to this assertion.

Some recent studies show that firms “overstate” earnings prior to seasoned equity

offering (SEO), initial public offering (IPO) and stock for stock mergers (Teoh et al

(1998a, b); Erickson and Wang (1999)) in order to get favorable valuation by capital

markets. Moreover Perry and Williams (1994) find evidence of earnings

understatement problem prior to a management buyout.

Earnings management is different from accounting frauds which violate Generally

Accepted Accounting Principles, because the opportunities of earnings management

are inherent in the current financial reporting system. Xie et al (2003) argue that the

nature of accrual accounting gives managers considerable discretion in determining

the earnings in any given period. According to Teoh et al (1998a), within the

boundary of GAAP, managers have several sources to manipulate earnings. They can

choose an accounting method to advance or delay the recognition of revenues and

expenses, use discretionary aspects of the application of the chosen accounting

method, or adjust the timing of asset acquisitions and dispositions to alter reported

earnings.

6

Although Schipper (1989) suggests that earnings management could possibly be

beneficial by providing a means for management to convey their private information

on firm performance, there is a potential danger of wealth loss for shareholders when

the interests of mangers and shareholders conflict. Since the managers are

compensated explicitly (salary, bonus, stock option, etc) and implicitly (job security,

reputation, etc) on the firm’s earnings. Managers may conceal the true performance

by earnings management to get a higher compensation or keep their jobs at the cost of

shareholder’s interest. Moreover, the earnings management increases the information

asymmetry between managers and shareholders, thus investors may make wrong

decisions based on misleading earnings information. For example, Teoh et al (1998)

find that IPO issuers who manage earnings aggressively perform relatively bad after

IPO compared to those manage earnings conservatively and demonstrate the wealth of

outside shareholders can be harmed by earnings management.

A number of prior studies examine the existence of earnings management by

identifying a situation where earnings management is likely to occur and estimating

discretionary accruals. However, some recent papers test earnings management by

examining the distribution of reported earnings (Burgstahler and Dichev (1997);

Degeorge et al (1999); Brown (2001)). These studies find that the frequency of firms

with small positive earnings (positive earnings changes or earnings surprise) is higher

than expected, while the frequency of firms with small negative earnings (negative

7

earnings changes or earnings surprises) is less than expected. These results are

explained as the evidence of income-increasing earnings management and support the

hypothesis that managers have incentives to avoid reporting loss, earnings declines,

and earnings missing analysts’ forecasts. The reason why meeting such simple

benchmarks is so important to managers is probably due to the capital market

reaction. According to Barth et al (1999) and Skinner and Sloan (2000), failure to

meet these earnings benchmarks will cause a dramatic drop of stock price. Since the

personal wealth of top managers is tied more closely to their firms’ stock price in

form of stock-based compensation plan in recent years, it is reasonable to argue that

managers have strong incentives to manipulate earnings to avoid missing earnings

benchmarks. Thus, in this thesis, I identify the firms which are in danger of missing

some earnings benchmarks and test whether the board of directors and audit

committee could constrain earnings management behavior when managers have

strong incentives to do so. However, managers may also adjust earnings downward in

some situations. Degeorge et al (1999) argue that earnings far beyond the thresholds

will be reined in to make future earning thresholds more attainable. Therefore I will

also examine the ability of board and audit committee in reducing income-decreasing

earnings management.

2.2 The role of the board of directors

The separation of ownership and control which is inherent in the modern corporate

form of organization causes the agency problem between shareholders (the principals)

and management (the agent). This is because the ownership structure of a company is

8

highly dispersed, and shareholders generally hold more than one kind of security to

diversify their risks, therefore, no individual shareholder has enough incentives and

resources to ensure that management is acting for the shareholders’ interest. To

control this agency problem, corporate governance, according to Denis (2001),

“encompasses the set of institutional and market mechanisms that induce self-

interested managers to maximize the value of the residual cash flows of the firm on

behalf of its shareholders.”

Among the set of corporate governance mechanisms, the board of directors is often

considered the primary internal control mechanism to monitor top management, and

protect the shareholder interest. For example, Fama (1980) argues that board of

directors is a “market-induced institution, the ultimate internal monitor of the set of

contracts called a firm, whose most important role is to scrutinize the highest decision

makers within the firm”.

There is a large literature examining the relationship between board monitoring and

firm performance on various aspects such as CEO turnover, stock return, operating

performance and financial reporting quality (Weisbach (1988); Brickley (1994);

Vefeas (1999); Dechow et al (1996); Beasley (1996)). These previous papers not only

confirm that the board of directors does affect firm performance, but also find some

characteristics of the board are related to the effectiveness of the board, especially in

monitoring top managers. These characteristics are the independence of the board,

9

the competence of outside directors, outside directors’ ownership, and the activity of

the board.

Based on previous literature, Earnings management can be seen as a potential agency

cost since managers manipulate earnings to mislead shareholders and fulfill their own

interests. Therefore the board of directors which is in charge of solving the agency

conflicts between mangers and shareholders should play a role in constraining the

level of earnings management. Further more, prior similar researches of financial

reporting fraud suggest that effective board monitoring helps to maintain the

credibility of financial reports. Thus it is reasonable to hypothesize that an effective

board of directors will help to limit the earnings management. In the following

sections, I will bring forward several testable hypotheses on the relationship of the

board characteristics and earnings management.

2.2.1 Board independence from management

Fama and Jensen (1983) recognize the control function of board as the most critical

role of directors and argue that the board is not an effective device for decision control

unless it limits the decision discretion of individual top managers. Moreover, Cadbury

Report suggests that “an important aspect of effective corporate governance is the

recognition that the specific interests of the executive management and the wider

interests of the company may at times diverge”. Therefore board independence from

management is one of the important factors determining the board effectiveness and

10

monitoring ability. Hence, we expect to see the board independence has a positive

relation with the board effectiveness in limiting earnings management. However the

independence is fundamentally unobservable, I have to measure it by some proxies

developed from previous literature. One proxy is the board composition, and another

is whether the CEO is also the Chairman of the board, and the last one is the financial

dependence of outside directors.

Although the specific knowledge about the organization that the inside directors have

can make valuable contribution to decision control function of the board, the

domination by managers on the board can lead to the collusion and transfer of

stockholder wealth (Fama (1980)). Outside directors are generally considered

independent of management and more effective in protecting the interests of

shareholders when there is an agency problem. Therefore it is necessary to adding

outside directors to keep the independence of board. Moreover, Fama and Jensen

(1983) observe that outside directors have incentives to develop reputations as experts

in decision control and monitoring because the outside directors’ labor market will

price their services according to their performance.

The percentage of outside directors in the boards is increasing in practice these years

and many corporate governance reports recommend for adding outside directors ( for

example, Blue Ribbon Committee Report), and the Previous empirical studies

generally demonstrate the association between the proportion of outside directors and

11

the board effectiveness in monitoring management. Weisbach (1988) find stronger

association between performance and CEO turnover in outside-dominate boards than

inside-dominate boards. Beasley (1996) and Dechow et al (1996) document negative

relationship between outside directors and incidence of financial fraud. More

specifically, some studies find evidence that the proportion of outside directors is

negatively related to the level of earnings management (Peasnell et al (2000), Klein

(2002) and B.Xie et al (2003)). Based on theory of Fama and Jensen (1983) regarding

board composition and the results of prior studies, I make the following hypothesis:

H1: there is a negative relationship between the proportion of outside directors on the

board and the level of earnings management.

Besides the composition of outside directors on the board, the separation of roles of

the Chairman of the board and the CEO can also affect the independence of the board.

The role of the Chairman is pivotal to securing good corporate governance. Jensen

(1993) defines the function of the Chairman of the board as to run the board meetings,

oversee the process of hiring, firing, evaluating and compensating the CEO. Therefore

when the Chairman of the board and the CEO is the same person, there is a very real

danger that firm is controlled by one man, and the board is not independent from the

management. Therefore Cadbury report recommends the roles of the Chairman and

the CEO should be separate. Some empirical researches have demonstrated the

combination may affect the board effectiveness of monitoring management. For

example, Dechow et al (1996) find firms are more likely to be subject to accounting

12

enforcement actions by SEC for alleged violations of GAAP if they have the CEO

simultaneously serves as the Chair of the board. Thus I hypothesize that:

H2: the existence of combination of the CEO and the Chairman of the board is

positively related to the level of earnings management.

It is usual for outside directors to receive a fixed annual fee for their services.

However, they may also receive other forms of remuneration or reward from the

company. One remuneration form which might hurt the independence of non-

executive directors is stock option. When the directors are rewarded by large blocks

of stock option, the temptation for them is to focus on ensuring that company price is

as high as possible when the time comes for exercising the options. If the earning

figure does not come out “right”, and managers have to adjust it, the directors may not

have incentives to prevent this practice. Therefore, Cadbury report recommends non-

executive directors should not participate in share option schemes since the

independence of non-executive directors might be undesirably. Hence, I expect that:

H3: the compensation for outside directors as stock option is positively related to the

level of earnings management.

2.2.2 Competence of outside directors

2.2.2.1 Tenure of outside directors

Increasing the proportion of outside directors can not guarantee the effectiveness of

the board monitoring. Outside directors have to possess the necessary competences to

carry out their control and overseeing duties, among which the knowledge of

13

company specific affairs is particularly essential (Chtourou et al (2001)). The longer

the experience of outside directors on the board, the better knowledge of company and

their executives they will get. Therefore, outside directors may be more capable of

monitoring managers and financial reporting process if they have served the board for

long time. This assertion is supported by many previous studies. For example,

Beasley (1996) finds the likelihood of financial reporting fraud is negatively related to

the average tenure of non-executive directors. And Chtourou et al (2001) find that

average tenure of outside directors is negatively associated with level of earnings

management.

However, there is another possibility that the outside directors with longer tenure are

more likely to be entrenched with managers and thus become less effective monitors.

This speculation is consistent with National Association of Corporate Directors

(NACD) Board Guidelines 1999 which states outside directors may lose some of their

independent edge if they stay on the board too long. Xie et al (2003) also find a

positive association between average tenure of outside directors and level of earnings

management. Although the Combined Code 1998 says that a reasonably long period

on the board can give directors a deeper understanding of the company’s business,

the revised Combined Code recommends outside directors who have served more

than 9 years must be re-elected at next Annual General Meeting. I empirically test the

following hypothesis using UK samples.

H4: The relationship between the average tenure of outside directors and the level of

14

earnings management is a converted U shape.

2.2.2.2 Directorships of outside directors

The mixed results of tenure of outside directors show that tenure may not be a perfect

proxy for director’s competence. Another possible measure is the outside directorship.

As Fama and Jensen (1983) indicate that outside directors have incentive to monitor

firms effectively to seek director position in labor market, we can consider the

directorships hold by outside directors as a signal of their ability as monitors.

Empirical researches have demonstrated the positive relation between outside

directorships and quality of financial reporting. Chtourou et al (2001) find the number

of outside directorship is negatively related to the level of earnings management. Xie

et al (2003) get similar results. However, if the outside directors sit on too many

boards, they may not have enough time to perform their duties effectively. In 1995,

Authur Levitt, the Chair of SEC, said “the commitment of adequate time is an

essential requirement for directors”. NACD 1999 also suggests retired executives or

professional directors should serve on no more than six boards. However some

previous surveys suggest that the average directorship hold by UK outside directors is

relatively low (Peanell et al (1999); Cook and Leissle (2002)). Based on prior

literature, I will test the following hypothesis:

H5: The number of directorship of outside directors is negatively related to the level

of earnings management.

15

2.2.3 Ownership of outside directors

It is generally believed that the directors who hold substantial stock ownership are

more likely to fight against management to protect shareholders’ interest, because

they have their own wealth involved. For non-executive directors who hold no

position in the firm other than serving on board, Jensen (1993) asserts that holding

sizable stock ownership will provide them with better incentives to monitor

management closely. Many empirical studies lend support to this assertion. For

example, Beasley (1996) finds that the likelihood of accounting fraud is negatively

related to non-executive ownership. Consistent with these evidence, Combined Code

1998 recommends that “payment of part of a non-executive director’s remuneration

in shares can be a useful and legitimate way of aligning the director’s interest with

those of the shareholders”. Therefore I expect that:

H6: The stock ownership hold by outside directors is negatively related to the level of

earnings management.

2.2.4 Board Activity

It is generally believed that a more active board is better for shareholders’ interest,

because directors have to spend more time and energy on the company affairs in an

active board. Recently, many financial and academic publications have criticized that

directors have too little time to attend meeting regularly and this will limit their ability

to monitor management well. Conger et al (1998) also suggest that board meeting

time is an important resource for improving the effectiveness of board. Vafeas (1999)

16

empirically tests the relation between board activity, which is measured by board

meeting frequency, and the firm performance. He finds that the increase in board

meetings leads to improved firm performance, and this result suggests the frequent

board meeting can help to make up the limited director interaction time.

According to above articles, it is reasonable to get the implication that the frequent

board meetings can help to improve the board effectiveness in monitoring, and thus

have some effects in constraining earnings management. Therefore, I will test the

following hypothesis:

H7: The frequency of board meetings is negatively related to the level of earnings

management.

2.3 The role of audit committee

Since the board of directors bears diverse responsibilities to manage the business and

affairs of the corporation, it usually delegates some authorities and specific functions

to several committees which consist of subsets of board members. Therefore the

effectiveness of board monitoring is also related to the structure of the board. For

example, Klein (1998) finds that overall board composition is unrelated to firm

performance, but the composition of accounting and finance committee does impact

the performance.

As a part of the board, audit committee takes over the board function to oversee the

firm’s financial reporting process. Klein (2002) comments that “audit committee meet

17

regularly with firm’s outside auditors and internal financial managers to review the

corporation’s financial statements, audit process and internal accounting controls”.

Thus audit committee helps to alleviate the agency conflicts between the top

management and the shareholders by improving the quality of financial reporting and

reducing the information asymmetry between inside managers and outsider

shareholders.

Previous literature of audit committee and the quality of financial reporting has tended

to focus on the existence of audit committee.Wild (1996) shows that the

informativeness of a firm’s earnings report increases after the formation of an audit

committee. McMullen (1996) and Dechow et al (1996) both find that firms

committing financial fraud are less likely to have audit committees. Although these

studies suggest the existence of audit committee has a positive impact on financial

reporting, they do not investigate if the characteristics of an audit committee would

affect the quality of financial reporting.

Some recent papers explore whether the audit committee characteristics could affect

the different aspects of financial reporting process. Abbott and Parker (2000) find that

active and independent audit committees are more likely to hire an industry specialist

external auditor. Abbott et al (2002) show that financial misstatements are less likely

to occur in firms whose audit committees are independent and have at least one

financial expert. More closer to the issues of this thesis, some studies investigate the

18

relationship between audit characteristics and earnings management. Klein (2002)

finds that the independence of audit committee is negatively related to abnormal

accruals. Xie et al (2003) find that audit committee which are more independent,

meeting more frequently, and have members with corporate or financial backgrounds

are less likely to engage in earnings management. As a summary of above evidence,

the independence, member financial expertise and activity are three important

characteristics which could affect the effectiveness of audit committee in monitoring

financial reporting.

In the following sections, I will develop testable hypothesis to examine how the

characteristics of audit committee affect the level of earnings management.

2.3.1 Independence of audit committee

It is generally believed that members who are independent from management are

better monitors. Previous studies have provide plenty of evidence that an independent

audit committee is better at monitoring financial reporting and auditing process of the

firm ( e.g., Abbott and Parker (2000); Beasley et al (2000); Carcello and Neal (2000);

McMullen and Raghunandan (1996)). Moreover, some studies have examined the

negative link between the independence of audit committee and earnings management

using sample of United States (e.g., Chtourou et al (2001); Klein (2002); Xie et al

(2003)). However, the independence research of audit committee has gone beyond the

simple classification of outside and inside directors.

19

Researchers generally classify outside directors into one of the two categories:

“independent directors” and “grey directors”. Grey directors include former officers

or employees of the company or a related entity, relatives of management and

professional advisors to the company (Beasley (1996); Carcello and Neal (2000)),

while independent directors have no affiliation with the firm other than being on the

board. Previous studies have shown that the personal or economic affiliation that grey

directors have with the corporate management may impair their independence. For

example, Carcello and Neal (2000) find that the percentage of inside and grey

directors has a negative relationship with the probability that the auditor will issue a

going-concern report when the firm is experiencing financial distress. Therefore the

presence of those grey members on audit committee may impair the monitoring

effectiveness of audit committee. Aware of this problem, BRC (1999) recommends

that audit committee should be comprised only of independent directors.

The Cadbury report does not require a totally independent audit committee, but just

suggests that the membership of audit committee should be confined to non-executive

directors and majority of outside directors serving on the committee should be

independent. However the prior empirical studies have suggest possible different

performance of independent directors and grey directors, so I expect to find the audit

committees which have no insider or grey directors would be more able to restrain

earnings management than those have. Hence, I propose the following hypothesis:

20

H8: The presence of audit committee comprised solely of independent directors is

negatively related to the level of earnings management.

2.3.2 Member financial expertise

Another important variable which could affect the effectiveness of audit committee is

the member competence. Independent directors may have intentions to curb earnings

management for shareholders, but they may not be able to do so without certain level

of financial knowledge. BRC 1999 recommends that each member of audit committee

should become financially literate and at least one should have accounting or related

financial management expertise. The positive effect of audit committee members who

have financial expertise is supported by a number of empirical studies. Agrawal and

Chadha (2003) which find the incidence of independent directors with accounting or

finance background on audit committee is negatively related to the probability of

earnings restatement. McMullen and Raghunandan (1996) also find that companies

with financial reporting problems are less likely to have CPAs on the audit committee.

Cadbury report 1992 does not mention the importance of the member’s financial

expertise, but the Audit Committees Combined Code Guidance 2003 recommends

that “at least one member of the audit committee should have significant, recent and

relevant financial experience, for example as an auditor or a finance director of a

listed company. It is highly desirable for this member to have a professional

qualification from one of the professional accountancy bodies”. This change reveals

21

that the qualification of audit committee members has been realized as an important

issue for the corporate governance of UK firms.

According to US experience, member expertise can increase financial reporting and

auditing quality, decrease the probability of accounting fraud, so it is probable that the

financial expertise of audit committee members can increase their ability to detect and

constrain earnings management. Therefore I will test the following hypothesis to see

if this relationship still holds for UK cases.

H9: The financial expertise of audit committee members is negatively related to the

level of earnings management.

2.3.3 Meeting of audit committee

A common proxy for committee diligence, meeting frequency has been generally

considered as an essential component of audit committee effectiveness. Menon and

Williams (1994) note that audit committees that do not meet, or meet only a small

number of times, are unlikely to be effective monitors. In line with this argument,

NACD 2000 also recommends that “The audit committee should meet as frequently

as necessary to perform its role”. Some studies find the negative relationship between

meeting frequency and the occurrence fraudulent financial reporting (e.g., Abbott et al

(2000), Beasley et al (2000)). Some other studies, such as Abbott and Parker (2000),

link the meeting numbers with higher audit quality. In conclusion, a plenty of

empirical results support the assertion that the meeting frequency of audit committee

22

is positively associated with financial reporting quality. Since earnings management

practice impairs the integrity and transparency of financial reports by adjusting real

earnings, I can similarly propose this hypothesis:

H10: The frequency of audit committee meeting is negatively related to the level of

earnings management.

CHAPTER 3

CORPORATE GOVERNANCE IN UK

23

Similar to what has happened in US, the corporate governance issue has drawn

increasing attention from the public and regulators in UK. Although company law

holds that the board of directors is responsible for financial reporting process, the

boards of UK firms were generally considered passive entities which were controlled

by management several decades ago. A series of unexpected business failures and

high profile accounting scandals which occurred in late 1980s and early 1990s

reduced the reliability of financial reporting results and thus exposed the corporate

governance weakness of UK firms.

As a response to the weak governance of UK firms, a series of corporate governance

codes were developed through the 1990s. The Cadbury report was issued by the

committee on the Financial Aspects of Corporate Governance in 1992. The Cadbury

report contained the code of Best Practice as the criteria of good governance and

focused on the board monitoring responsibilities and highlighted the role of Non-

executive directors. Following Cadbury report, Greenbury Code was issued by the

Committee of Executive pay in 1995, and the Combined Code was released in 1998.

On 23 July 2003, the Financial Reporting Council published the final text of the

revised Combined Code which will apply to reporting years commencing on or after 1

November 2003. While companies are not under obligation to comply with the

recommendation of codes, London Stock Exchange requires all the UK-incorporated

listed firms to include a statement of compliance with the code in their annual report

and clearly explain identify and explain areas of non-compliance, thereby making

24

non-compliance a potentially costly action.

As an essential part of board, audit committee provides critical oversight on financial

reporting process. The history of audit committee is quite long in US. Since 1978,

NYSE has required all listed companies to have audit committees comprised solely of

independent directors. While in UK, the development of audit committee is relatively

slow. A report of the Accountants International Study Group in 1977 indicates that the

practice of Audit committee in UK was unusual, and the concept of audit committee

had not been generally accepted. Only 38 percent of the companies had audit

committee in 1988 according a survey by the bank of England. However the Cadbury

report (1992) highlights the importance of audit committee and recommends this

practice to all the companies as one way to improve the quality of financial reporting.

Collier (1996) shows that the audit committees had generally become more

widespread among large firms after the issue of Cadbury report 1992. By 1995,

almost 92% companies have established audit committees (Cadbury compliance

report 1995).

Although the regulators and companies of UK have made obvious effort to improve

the level of corporate governance, very limited empirical researches have been done

to examine the association between corporate governance and firm performance in

UK market. Peasnell et al (2000a and 2000b) find that board monitoring helps to

reduce the level of income-increasing earnings management. However they only

25

examine two aspects of board monitoring: the proportion of Non-executive directors

on the board and the existence of an audit committee, and thus leave the effects of

many other aspects of corporate governance unclear. Therefore the main motivation of

this paper is to fill up the lack of comprehensive examination of relation between

corporate governance and earnings management of UK companies.

Moreover, the board characteristics of UK firms have more variances compared to US

companies, and this provides a unique opportunity for research. This is probably

because that the compliance with the UK corporate governance code is voluntary, so

the companies are free to choose their own governance policy. Another possible

reason is the current Combined Code is more flexible than the requirements in US.

For example, although the Combined Code has acknowledged the importance of Non-

executive directors, it only suggests that they should constitute at least one third of the

board members, instead of majority of the board. In conclusion, the variety of UK

sample has the potential to generate some interesting results which different from

those US studies.

CHAPTER4

METHODOLOGY AND DATA SOURCE

26

4.1 Measure of earnings management

Although there is no perfect proxy for earnings management, most current studies

focus on manager’s use of discretionary accruals. Consistent with previous literature,

I estimated discretionary accruals using cross-sectional version of modified Jones

Model (e.g., Dechow et al (1995); Teoh et al (1998a and 1998b)). More specifically, I

focus on the discretionary current accruals (DCA).

There are several reasons for detecting earnings management by DCA instead of total

discretionary accruals. First, current accruals are more easily for mangers to

manipulate (Teoh et al (1998b)). Second, this measure is widely used by previous

similar researches, so it is easier for me to compare my results with theirs (e.g.,

Peasnell et al (2000b); Xie et al (2003); Park and Shin (2003)). Third, the accounting

principles for treatment of tangible fixed assets of UK are different from those of U.S,

so if I use the original modified Jones Model, the relationship between gross property

plant and equipment (PPE) and depreciation expenses may not be hold. I will address

this issue in detail in the sensitivity tests.

The model for estimating DCA is as following. First, I use the following regression

model to get the estimates of .

27

(1)

is the current accruals of firm i defined as the change of non-cash current assets

less the change of current liabilities. is the change of revenue between year t

and t-1, and is the book value of total asset of year t-1. The regression is

carried out for each industry-year combination.

Second, non-discretionary current accruals are estimated as:

(2)

Where and are OLS estimates for the coefficients in equation (1) and is

the change of net receivables.

Finally, we obtain the discretionary accruals as the remaining portion of current

accruals:

(3)

4.2 Earnings benchmarks

Several papers document managers have incentives to meet simple earnings

28

benchmarks, which include avoiding losses and earnings declines, and beating

analysts’ forecasts. This argument can be supported by Burgstahler and Dichev (1997)

and Degeorge et al (1999) which both find that small reported losses (small profit

declines) are rare, while small reported profits (small profit increases) are common,

and imply that earnings management is more pronounced when earnings are below

certain benchmarks. Thus, I examine the role of the board and audit committee in

constraining earnings management around the earnings benchmarks.

Following Park and Shin (2003) and Peasnell et al (2000b), I use two earnings

benchmarks: zero earnings and last year’s earnings. I will split the sample based on if

the pre-managed earnings (actual earnings minus the discretionary accruals) meet or

miss the target, and expect to find earnings management around targets. I expect to

find income-increasing accruals when the pre-managed earnings are below the targets,

and find income-decreasing accruals when pre-managed earnings are above the

targets. Next, I will examine the relationship between the board of directors, audit

committee and earnings management to see if they could help to decreasing the

income-increasing (income-decreasing) accruals.

4.3 Regression Analysis

To analysis the effect of the board characteristics, audit committee on earnings

management, I first construct following regression models:

Model 1: for board of directors

29

Model 2: for audit committee

According to the pre-managed earnings, I split the sample into two sub-samples, and

then run regression Model 1 and 2 in each sub-sample. Therefore, for every model,

there are four regressions. Regression a (b) is for firm-year observations that pre-

managed earnings below (above) zero, and Regression c (d) is for firm-year

observations that pre-managed earnings less than (more than) last year earnings.

4.3.1 Variables for board characteristics and audit committee

For the independent variables in Model 1, OUT is the percentage of the number of

outside directors or so called non-executive directors on the board, and IND is the

proportion of independent outside directors on the board. DUAL is a dummy variable

with value 1 if the CEO and chairman of the board is the same person and zero

otherwise. OPTION is a dummy variable with value 1 if non-executive directors

receive stock option compensation and zero otherwise. TENURE is the average years

of board services of non-executive directors. DIRSHIP is the average number of

directorships held by non-executive directors in unaffiliated firms. STKOWN is the

cumulative percentage of shares held by non-executive directors. MEET is the

number of board meetings per year. I expect OUT, IND, TENURE, DIRSHIP, MEET

and STKOWN to have negative (positive) coefficients in the regression of sub-sample

30

that pre-managed earnings below (above) earnings targets, while DUAL and OPTION

have positive (negative) coefficients.

For MODEL 2, INDAUD is a dummy variable with value 1 if the audit committee is

composed solely of independent directors. FIN is the proxy for member’s financial

expertise and also an indicator variable with value 1 if there is at least one member

has past employment experience in finance or accounting. This definition is more

restrictive than that of BRC 1999, and consists with revised combined code which

recommends one member must possess recent and relevant experience in finance.

MEETAUD is the number of meetings that the audit committee have in a year. I

expect that the INDAUD, FIN and MEETAUD will have negative (positive)

coefficients when the pre-managed earnings are below (above) earnings targets.

4.3.2 Control Variables

The above regression models control for some other dimensions of the corporate

governance and incentives for earnings management which could affect the level of

discretionary accruals. BRDSIZE is the number of directors on the board. I control

this factor because Jensen (1993) finds that a larger board is less effective and more

easily to be control by CEO. Klein (2000) also finds that board size is a determinant

of the independence of audit committee. NOM is a dummy variable with value 1 if

the nominating committee is composed of majority of independent directors. Previous

studies demonstrate this variable reflect the management power on the board, and thus

31

is related to the level of discretionary accruals (e.g., Chtourou et al (2001) and

Peasnell et al (2000)).

BLOCK is the cumulative percentage of outstanding shares hold by outside block

holders who own at least 5% of firm shares. This variable controls for the potential

monitoring from block holders on earnings management. INSTOWN is the total

percentage of outstanding shares held by institutional investors. Many papers find

that institutional investors monitor and constrain the self-serving behavior of

managers. For example, Chung et al (2003) find that large institutional shareholdings

inhibit managers from using discretionary accruals to manipulate earnings.

MANOWN is the faction of outstanding shares holding by managers. This measure is

related to discretionary accruals because it reflects the extent to which the interests of

managers are aligned with those of shareholders. As Warfield et al (1995) say,

managerial ownership is inversely related to magnitude of accounting accrual

adjustments. BIG4 is indicator variable with value 1 if the external auditor of the firm

is BIG 4 to control of the audit quality effects. Previous studies suggest that Big 5

auditors are generally more effective in deterring earnings management than other

auditors (e.g., Becker et al 1998, Kim et al (2003)).

BONUS is the average weight of bonus to total remuneration for all executives.

Maximization of bonus is a potential incentive of earnings management, and many

studies, such as Healey (1985) and Holthausen et al (1995), can provide consistent

32

empirical evidence. LEV is the financial leverage measured as the ratio of total debt to

total assets. On one hand, firms with high leverage ratio may have incentives to adjust

earnings upward to avoid debt-covenant violation. On the other hand, such firms may

under close scrutiny of lenders and are less able to do so. Therefore, the relationship

between LEV and discretionary accruals is undetermined. MBRATIO is the market to

book ratio of asset which proxy for growth opportunity of the firm. Matsumoto (2002)

argues that firms with high growth prospects have greater incentives to manipulate

earnings to avoid unfavorable market reaction to negative earnings news. SIZE is the

natural log of sales. Following previous studies, this factor is controlled as a possible

determinant of choice of discretionary accruals (e.g., Beck et al (1998), Park et al

(2003), and Peasnell et al (2000)). LOSS is a dummy variable with value 1 if the firm

has two or more previous consecutive years of losses. Matsumoto (2002) finds that

the earnings of loss firms are less value relevant and thus managers are less likely to

adjust earnings to meet targets. CFO is the cash flow from operation and this will

control for its relationship with discretionary accruals documented by Dechow et al

(1995). Finally, Year is an indicator variable control for time effects.

4.4 Sensitivity Tests

4.4.1 Alternative measure of earnings management

Some studies measure the level of earnings management by total discretionary

accruals which include the long-term accruals. As a supplementary test, I will use

Modified Jones Model to estimate total discretionary accruals. The procedures are as

33

follows;

1.

is the total accrual of firm i calculated as net income minus the cash flow from

operations. is gross property plant and equipment. The regression is carried out

for each industry-year combination to estimate and .

2. Non-discretionary accruals are estimated as:

3. The total discretionary accruals are

The above method is commonly used by previous studies. However few of them

consider the potential problem that the Jones model is developed based on U.S

accounting system, so it may not work well in UK research as it does in U.S studies

without taking UK financial reporting environment into consideration. In the

discussion of Yoon and Miller (2002), Wilkins (2002) suggests that their ignorance of

some particular differences in accounting standards between Korean and U.S that

would likely result in significant differences in some of the model variables may be

the reason why their results of earnings management of SOE firms are different from

prior U.S studies.

34

Since the Modified Jones Model considers the effects of fixed asset on discretionary

accruals, the difference between the treatment of tangible fixed asset in UK and U.S

may affect the power of this model in UK studies. In U.S, the revaluation of property,

plant and equipment is not allowed and they should be reported as historical cost

(opinion of the Accounting Principles Board (APB) 6.17), while the revaluation of

tangible fixed assets is permitted in UK (CA 85, SSAP19, FRS 15). Whittred and

Chan (1992) find that the majority of asset revaluations were taken at the last month

of the financial year. Since the gross value of fixed assets is recorded as the revalued

amount at the end of the year, while the depreciation expense for that year is

unchanged. Thus asset revaluation could possibly disrupt the relation between gross

property plant and equipment (PPE) and depreciation expenses of the period in

Modified Jones Model.

Concerning the potential problem caused by revaluation, I will do supplementary tests

to re-estimate the discretionary accruals with an alternative measure of PPE. For those

firms have revaluations of depreciable assets at the fiscal year end, I adjust the value

of PPE to the historical cost equivalents to match with the depreciation expenses. The

values of historical cost equivalents are available because CA 85 and FRS 15 require

that the historical cost equivalents (cost, cumulative provision for depreciation and

diminution in value and carrying amount) of each class of revalued assets should be

disclosed. After getting new discretionary accruals, all the multivariate regressions

35

examining the board and audit committee characteristics will be re-run to see if the

results are consistent.

4.4. 2 Lack of Independence

Since some firms may have two years observations in the sample, it is possible that

pooled OLS is biased because of unable to control the firm-fixed effect. I will control

this problem by re-run the regressions in sub-samples which constitute only one

observation per firm. However this method will suffer the reduction of sample size.

4.5 Data Sources

The empirical tests are conducted using data of U.K listed companies in fiscal year

1999 and 2002. My primary sample is the constituents of FTSE 350 index at the end

of every year. I then exclude all the financial firms (SIC codes 60-69), since it is

difficult to define accruals and discretionary accruals for financial firms. I also

exclude all regulated utilities firms (SIC codes 40-44, 46.48-49), because they have

different earnings management incentives. Accounting data will be collected from

Datastream, supplemented where necessary by annual reports. Other data including

board and audit committee characteristics, managerial ownership, block holder

ownership, and outside auditors will be hand-collected from annual reports.

36

REFERENCE

Arthur Levitt, “The Numbers Game,” remarks at New York University Center for Law and Business,

September 28, 1998

Barth,M.E., J.A.Elliott, and M.W.Finn. 1999. Market awards associated with patterns of increasing

earnings. Journal of Accounting Research 37 (Autumn), 387-413.

Beasley, M.S. 1996, An empirical analysis of the relation between the board of director composition

and financial statement fraud. The Accounting Review 71 (October): 433-465.

Beasley, M.S., J.V. Carcello, D.R. Hermanson, and P.D. Lapides,2000, Fraudulent financial reporting:

Consideration of industry traits and corporate governance mechanisms. Accounting Horizons 14, 441-

454

Blue Ribbon Committee (BRC). 1999. Report and recommendations of the Blue Ribbon Committee on

improving the effectiveness of corporate audit committees. New York Stock Exchange and National

Association of Securities Dealers (www.nyse.com).

Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal

of Accounting and Economics 24, 99-126.

Cadbury Committee, 1992. Report of the committee on the financial aspects of corporate governance.

Gee,London.

Carcello, J.V. and T.L. Neal, 2000, Audit committee composition and auditor reporting, The

37

Accounting Review 75, 453-467

Chtourou, S., Be´dard, J., Courteau, L., 2001, Corporate governance and earnings management,

Working paper, Universite´ Laval, Canada.

Collier,P.A., 1996. The rise of audit committee in UK quoted companies: a curious phenomenon.

Accounting, Business and Financial History 6 (2), 121-140.

Conger, Lawler and Finegold, 2001, Corporate Boards: strategies for adding value at the to

Dalton, D.R., Daily, C.M., Johnson, J.L., Ellstrand, A.E., 1999. Number of directors and financial

performance: a meta-analysis. Academy of Management Journal 42, 674–686.

DeAngelo, L. 1986. “Accounting Numbers as Market Valuation Substitutes: A Study of Management

Buyouts of Public Shareholders.” The Accounting Review 61, 400-420.

DeAngelo L. 1988, Managerial Competition, information cost and Corporate Governance: the use of

accounting performance measures in proxy contests, Journal of Accounting and Economics 10, 3-36

Dechow, P., Sloan, R., Sweeney, A., 1995. Detecting earnings management. The

Accounting Review 70, 193-225.

Dechow, Patricia M, Sloan, Richard G, Sweeney, Amy P, Causes and consequences of earnings

manipulations: An analysis of firms subject to enforcement actions by the SEC, Contemporary

Accounting Research. Toronto: Spring 1996. Vol. 13, Iss. 1; p. 1 (36 pages)

DeZoort .F. T and Steven E. Salterio 2001, The Effects of Corporate Governance

Experience and Financial-Reporting and Audit Knowledge on Audit Committee Members’ Judgments,

AUDITING:A Journal of Practice& Theory Vol. 20, No. 2

Degeorge, F., Patel, J., Zeckhauser, R., 1999. Earnings management to exceed thresholds.

Journal of Business 27, 1-33.

Fama, E.F., and M.C. Jensen. 1983. The separation of ownership and control. The Journal of Law and

Economics 26 (June): 301-325.

Healy, P. M. 1985. “The Effect of Bonus Schemes on Accounting Decisions.” Journal of Accounting

and Economics 7, 85-107.

Healy, P.M., Wahlen, J.M., 1998. A review of the earnings management literature and its implication

for standard setting. Harvard Working Paper.

Holthausen,R,, David F. Larcker and Richard G. Sloan,1995, Annual bonus schemes and the

manipulation of earnings, Journal of Accounting and Economics 19, 29-74

38

Jensen. M. C 1993, The modern industry revolution, exit, and the failure of internal control system,

Journal of Finance 48,831-880

Jensen, Michael C., and Murphy, Kevin J, 1990, Performance Pay and Top-Management

Incentives, Journal of Political Economy 98,225–64.

Jeong-Bon Kim, Richard Chung, Michael Firth, Auditor Conservatism, Asymmetric Monitoring and

Earnings Management, Contemporary Accounting Research, Vol 20, No 2.

Jones, J.J., 1991, Earnings management during impact relief investigations. Journal of Accounting

Research 29,193–228

Klein A ,2002, Audit committee, board of director characteristics, and earnings management, Journal of

Accounting and Economics 33, 375–400.

Matsumoto D.A. 2002, Management’s Incentives to avoid negative earnings surprises, The Accounting

Review 77, No 3, 483-514.

McMullen, Dorothy A and Raghunandan, K,1996, Enhancing audit committee effectiveness, Journal

of Accountancy (August), 79-81

McDaniel, L., R.D. Martin and L.A. Maines, 2002, Evaluating Financial Reporting Quality: The

Effects of Financial Expertise vs. Financial Literacy, The Accounting Review vol 77, 139-167

Merle Erickson and Shiing-wu Wang, 1999, Earnings management by acquiring firms in stock for

stock mergers, Journal of Accounting and Economics 27, 149-176

National Association of Corporate Directors 1999. The NACD Board Guidelines

NYSE Listed Company Manual. Updated. New York, NY: New York Stock Exchange.

Park Y.W and Hyun-Han Shin, 2003, Board composition and earnings management in Canada, Journal

of Corporate Finance, article in press

Peasnell, K.V., Pope, P.F., Young, S., 2000a, Accrual Management to meet earnings targets: UK

evidence pre- and post-Cadbury, British Accounting Review (2000) 32,415-445

Peasnell, K.V., Pope, P.F., Young, S., 2000b, Board monitoring and earnings management: Do outside

directors influence abnormal accruals? Working paper

Perry, S and T. Williams, 1994, Earnings Management preceding management buyout offers, Journal of

Accounting and Economics 18,157-179

39

Steven R. Matsunaga and Chul W. Park, 2001, The effect of missing a quarterly earnings benchmark on

the CEO’s Annual Bonus, The Accounting Review Vol 76, No 3, 313-332

Teoh, S.H., Welch, I., Wong, T.J., 1998a. Earnings management and the underperformance of seasoned

equity offerings. Journal of Financial Economics 50, 63–99.

Teoh, S.H., Welch, I., Wong, T.J., 1998b. Earnings management and the underperformance of initial

public offerings. Journal of Finance 53, 1935–1974.

Vafeas, N., 1999, Board meeting frequency and firm performance, Journal of Financial Economics 53,

113– 142

Vafeas, N., 2000, Board structure and the informativeness of Earnings, Journal of Accounting and

Public Policy 19, 139-160

Xie, Wallace N. Davidson III and Peter J. DaDalt, 2003, Earnings management and corporate

governance: the role of the board and the audit committee, Journal of Corporate Finance 9 (2003) 295–

316

40