vafeas - 2005 - audit committees, boards, and the quality of reported earnings

Results from logistic regressions suggest that measures of audit committee and board structure are related to earnings quality in a manner that is generally consistent with the predictio

Audit Committees, Boards, and the

NIKOS VAFEAS, University of Cyprus

Abstract

I use data on 252 U.S firms between 1994 and 2000 to study the relationship between audit committees and boards of directors with financial reporting quality I initially document several changes in committee and board profile during the sample period Results from logistic regressions suggest that measures of audit committee and board structure are related

to earnings quality in a manner that is generally consistent with the predictions of agency theory This study contributes to extant knowledge by employing different earnings quality measures from prior studies, and by expanding the range of audit committee attributes deemed important in determining audit committee performance.

Keywords Audit committee; Board of directors; Earnings quality

JEL Descriptors G30, G38

Comités de vérification, conseils d’administration

et qualité des résultats publiés Condensé

Compte tenu du nombre croissant de scandales touchant l’information financière, le rôle des comités de vérification dans la gouvernance d’entreprise a fait l’objet d’un débat nourri chez les responsables de l’élaboration des politiques, les gestionnaires, les investisseurs et les uni- versitaires Au cours des vingt dernières années, ce débat a engendré une série de rapports sur la gouvernance d’entreprise, prescrivant les structures souhaitables des comités de vérifica- tion, dont le plus récent est l’œuvre du Blue Ribbon Committee (BRC) Tous ces rapports s’articulent essentiellement autour d’un thème central : la possibilité pour les sociétés d’accroître la qualité de leurs états financiers en améliorant la structure et le fonctionnement

de leurs comités de vérification En outre, puisque la qualité des comités de vérification est fondamentalement liée à celle des conseils d’administration d’entreprise dont ils sont issus, les responsables de l’élaboration de politiques et les universitaires confèrent également à la structure du conseil d’administration une importance déterminante dans la qualité des états financiers.

* Accepted by Michel Magnan I have benefited from numerous useful comments and suggestions

by Michel Magnan (associate editor), and two anonymous reviewers Thanks also are due to Irene Karamanou for providing valuable input on a programming issue, Maria Christodoulou for competent research assistance, and First Call Corporation, a Thompson Financial Company, for pro- viding forecast financial data This project was partly funded by a University of Cyprus research grant.

1094 Contemporary Accounting Research

La simple observation semble indiquer que les comités de vérification et les conseils d’administration présentent une grande variété transversale de structures et de modes de fonctionnement Compte tenu de cette variété, la nature de la relation entre les structures du comité de vérification et du conseil d’administration et la qualité des résultats publiés (qualité des résultats dans la suite) est un sujet de recherche primordial dont les répercussions sur les politiques sont évidentes Les données empiriques à cet égard confirment, pour la plupart, le point de vue selon lequel les comités de vérification et les conseils d’administration structurés

de manière plus appropriée produisent de l’information de meilleure qualité en ce qui a trait aux résultats Les chercheurs précédents ont démontré l’existence d’un lien entre les structures des conseils d’administration et des comités de vérification et les mesures de la qualité des résultats fondées sur la comptabilité d’exercice, les retraitements des états financiers et les propriétés des prévisions de résultats de la direction.

La présente étude élargit ce champ de recherche en traitant du lien entre les attributs des comités de vérification et des conseils d’administration et deux variables substituts de la qualité des résultats : la probabilité que les sociétés évitent un fléchissement des résultats et

la probabilité qu’elles préviennent des résultats négatifs inattendus L’étude enrichit les naissances existantes de différentes façons Premièrement, elle puise dans un bassin de recherche qui évolue à grands pas dans le domaine de la finance et qui met en lumière d’importantes différences dans les motivations, la capacité et la volonté des administrateurs externes de surveiller la direction Le thème sous-jacent à ce champ de recherche veut qu’il soit trop simpliste de cibler l’indépendance des administrateurs et que d’autres facteurs puissent être liés à la performance d’un administrateur externe en matière de surveillance, notamment les incitatifs au rendement sous forme d’actions, les fonctions assumées au sein

con-de conseils d’administration d’autres sociétés, la durée con-de l’appartenance au conseil nistration, et les responsabilités dans d’autres comités L’auteur avance l’existence d’un lien entre ces caractéristiques des administrateurs et la performance des comités de vérification,

d’admi-et il procède à l’examen empirique de leur relation avec la qualité des résultats.

Deuxièmement, l’auteur s’abstient d’employer les mesures fondées sur les régularisations inhabituelles utilisées dans les travaux précédents — et auxquelles peuvent être associées des perturbations — en ayant recours aux faibles hausses des résultats et aux rendements négatifs inattendus pour évaluer la qualité des résultats La qualité des résultats étant une notion difficile à cerner et aucune mesure ne s’étant véritablement démarquée par sa supé- riorité, l’adoption d’une autre perspective méthodologique pour définir la qualité des résultats,

et pour produire des données complémentaires et corroboratives relativement à la question étudiée, est un autre aspect de l’intérêt que présente l’étude Enfin, l’auteur emploie un échantillon constant de données, qui s’échelonnent sur sept ans, grâce auquel il peut analyser les questions pertinentes sur une période plus longue Les données étant structurées sous forme d’échantillon constant, l’auteur soumet également à des tests les changements dans la gouvernance qui réduisent les risques d’omission de variables souvent présents dans les tests transversaux L’étude des tendances chronologiques est également importante, car le débat sur la gouvernance d’entreprise et les réformes politiques qui en ont résulté dans les années 1990 ont entraîné d’importants changements dans les conseils d’administration et les comités de vérification d’entreprise L’échantillon de l’auteur, qui couvre la majorité des années 1990, fait abstraction de l’hypothèse selon laquelle les structures de gouvernance restent inchangées dans le temps.

Audit Committees, Boards, and the Quality of Reported Earnings 1095Les deux variables substituts de la qualité des résultats utilisées comme variables dépendantes dans la présente étude permettent de déceler les faibles hausses des résultats et les résultats inattendus Les caractéristiques du comité de vérification et du conseil d’admi- nistration retenues par l’auteur sont les suivantes : pourcentage des membres du comité ayant un lien avec l’entreprise ; pourcentage des membres du comité assumant des fonctions

de cadres dans d’autres sociétés ouvertes ; pourcentage des membres du comité siégeant aussi à un autre comité de vérification ; taille du comité de vérification ; nombre de réunions (annuelles) du comité de vérification ; fraction cumulative des actions ordinaires de l’entre- prise détenues par les membres du comité ; durée moyenne (en années) de l’appartenance des membres du comité au conseil d’administration ; nombre moyen de sièges occupés par les membres du comité dans d’autres conseils d’administration ; nombre moyen d’autres comités du conseil auxquels siègent les membres du comité de vérification ; pourcentage des actions ordinaires de l’entreprise détenues par l’ensemble des cadres et des administra- teurs ; pourcentage d’administrateurs externes ; taille du conseil d’administration Enfin, le modèle englobe des contrơles relatifs aux pertes, au risque de litiges, à la taille de la société, aux actionnaires institutionnels et à la croissance de la société.

L’échantillon initial de l’auteur est constitué de sociétés figurant au palmarès Fortune 500

de 1995 Les institutions financières et les sociétés de services publics sont retirées de l’échantillon du fait que le régime réglementaire particulier auquel elles sont soumises est susceptible d’influer sur le rơle des systèmes d’information financière dans le processus de gouvernance d’entreprise Les sociétés à l’égard desquelles les données relatives à la gouver- nance et les données financières sont insuffisantes sont également retirées L’échantillon définitif se compose de 1 621 observations relatives à 252 sociétés, pour la période 1994–2000 L’auteur estime deux équations de régression logistique qui relient la probabilité des deux mesures de la qualité des résultats aux structures du comité de vérification et du conseil d’administration Pour tenir compte de la possibilité que les caractéristiques du comité de vérification et les pratiques de gestion du résultat soient en corrélation pour chaque société dans le temps, l’auteur adapte aux données un modèle des effets aléatoires Ce dernier est estimé à partir de la totalité des 1 621 observations relatives aux 252 sociétés de l’échantillon Les résultats de l’analyse semblent indiquer que les structures des comités de vérification

et des conseils d’administration ont beaucoup évolué entre 1994 et 2000 Les conseils d’administration de sociétés sont maintenant de taille plus restreinte et sont plus indépendants Les comités de vérification sont aussi plus indépendants et plus actifs, et ils comptent davantage de cadres et d’administrateurs siégeant aussi à un autre comité de vérification Le total des actions de la société détenues par les membres du comité a également augmenté sensiblement Cette transformation cadre généralement avec les pressions venant de la presse financière et les recommandations du BRC Fait intéressant, la majorité de ces change- ments ont précédé les recommandations du BRC, ce qui donne à penser que maintes sociétés ont réagi par anticipation, peut-être pour détourner l’attention malvenue du public de la qualité

de leur information financière et pour éviter les cỏts politiques qu’aurait occasionnés cet intérêt.

L’auteur recense donc les liens qui existent entre les structures des comités de vérification

et des conseils d’administration et les faibles hausses des résultats de même que la prévention des résultats négatifs, les deux variables substituts de la qualité des résultats Ses observations découlent de régressions logistiques multivariées expliquant la probabilité de faibles hausses

1096 Contemporary Accounting Research

des résultats et de la prévention des résultats négatifs Des régressions des changements observés dans les conseils d’administration et les comités de vérification sur les indicateurs de qualité des résultats livrent d’autres données probantes à cet égard En somme, la présente étude met au jour des récurrences empiriques qui élargissent l’éventail des explications relatives aux modalités de l’influence exercée par les comités de vérification et les conseils d’administration sur la qualité de l’information financière Les facteurs tels que l’actionnariat des membres du comité de vérification, les fonctions assumées au sein d’autres comités et, à plus faible échelle, la durée de l’appartenance et les sièges occupés dans d’autres conseils d’administration semblent jouer un certain rôle dans l’explication de la qualité des résultats Les conclusions de l’étude quant aux faibles hausses des résultats sont conformes à celles des travaux précédents Les membres du comité de vérification ayant un lien avec l’entreprise sont associés à une qualité des résultats inférieure ; les membres du comité assumant des fonctions de cadres dans d’autres sociétés protègent la direction plus que les actionnaires ; et la fréquence des réunions du comité est associée à une qualité des résultats supérieure L’auteur note, en outre, que le fait que des membres du comité siègent aussi à un autre comité de vérification est associé à une moindre occurrence de faibles hausses des résultats Les observations relatives à la prévention des résultats négatifs inattendus se com- parent plus modérément aux conclusions des travaux précédents, puisqu’elles indiquent que l’augmentation des incitatifs au rendement sous forme d’actions et la durée de l’apparte- nance au conseil d’administration sont associées à une qualité des résultats inférieure Dans leur ensemble, ces constatations pourraient être utiles aux responsables de l’élaboration des politiques qui envisagent des réformes de la gouvernance, aux gestionnaires et aux action- naires qui s’intéressent à l’amélioration de la qualité des états financiers, et aux chercheurs qui étudient la gouvernance d’entreprise et la qualité des résultats.

Enfin, les conclusions de l’auteur paraissent indiquer qu’en général, au sens usuel, les comités de vérification et les conseils d’administration d’entreprise dont les structures et le fonctionnement sont appropriés peuvent contribuer à l’amélioration de la qualité de l’infor- mation financière Les comités de vérification subissent actuellement d’autres changements d’importance, par suite des nouvelles règles adoptées par la SEC et les Bourses de valeurs L’incidence à long terme de ces changements sur la qualité des états financiers des sociétés est une question qui mérite de retenir l’attention des chercheurs dans les années à venir.

1 Introduction

Amid a growing number of financial reporting scandals, the role of audit committees

in corporate governance has been the topic of an active debate among policymakers,managers, investors, and academics Over the past 20 years, this debate fueled aseries of corporate governance reports prescribing desirable audit committee struc-tures, the most recent by the Blue Ribbon Committee (BRC 1999).1 The maintheme running through these reports is that firms can improve the quality of theirfinancial statements by structuring and operating their audit committees moreappropriately Moreover, given that the quality of the audit committee is funda-mentally linked to the quality of the corporate board from which the committeeoriginates, policymakers and academics have also posited board structure as adeterminant of financial statement quality (e.g., Pagano, Schwartz, Wagner, andMarinelli 2002)

Audit Committees, Boards, and the Quality of Reported Earnings 1097Casual observation suggests that there is wide cross-sectional variation in theway audit committees and boards are structured and operate Given such variation,the nature of the relation between audit committee and board structures and earn-ings quality is a fundamental research question with clear policy implications Theempirical evidence addressing this question has been mostly consistent with theview that more appropriately structured audit committees and boards produceearnings information of higher quality Klein (2002), Xie, Davidson, and DaDalt(2003), and Bédard, Chtourou, and Courteau (2004) draw on BRC recommenda-tions addressing director independence and financial knowledge to document alink between board and audit committee structures with accruals-based measures

of earnings quality Abbott, Parker, and Peters (2004) similarly link audit tee characteristics to financial restatements, and Larcker and Richardson (2004)find that corporate governance characteristics mitigate the relation between nonauditfees and accruals Finally, Karamanou and Vafeas (2005) document a relationbetween board and audit committee structures with the properties of managementearnings forecasts

commit-The present study extends this line of work by addressing the link betweenaudit committee and board attributes with two alternative earnings quality proxies:the likelihood that firms avoid an earnings decline and the likelihood that firms avoid

a negative earnings surprise This study adds to extant knowledge in the followingways First, it draws on a rapidly evolving body of research from the finance litera-ture that illuminates important differences in the incentives, ability, and will-ingness of outside directors to monitor management (e.g., Ferris, Jagannathan, andPritchard 2003; Yermack 2004; Perry and Peyer, 2005) The underlying theme ofthis line of work is that a focus on director independence is overly simplistic, andthat additional factors may be related to an outside director’s monitoring perform-ance, such as the director’s equity incentives, board seats in other corporations,length of board tenure, and other committee responsibilities In this paper I propose alink between these director characteristics and audit committee performance,empirically examining their relation to earnings quality

Second, this paper abstracts from the potentially noisy based measures used in prior studies by relying on small earnings increases andnegative earnings surprises to measure earnings quality Given that earnings qualityhas been an elusive concept to pin down, and that no single measure has emerged

abnormal-accruals-as definitively superior to others, using an alternative methodological perspective tocapture earnings quality and to provide complementary and confirmatory evidence

of the issue is also a potential contribution of this study (In a similar spirit, recentstudies by Leuz, Nanda, and Wysocki 2003 and Lang, Raedy, and Yetman 2003 use

a variety of measures, in addition to accruals, to capture earnings quality.) Finally,this paper employs a seven-year panel of data that allows me to study the relevantissues over a longer time period Given the panel structure of the data, I also per-form tests of changes in governance that reduce the likelihood of omitted-variablesproblems that are often present in cross-sectional tests The study of trends overtime is also important because the corporate governance debate and resulting pol-icy reforms of the 1990s have induced notable changes in corporate boards and

1098 Contemporary Accounting Research

audit committees My sample, covering most of the 1990s, abstracts from theassumption that governance structures remain unchanged through time Next, Idevelop the study’s research proposition

The remainder of this paper is organized as follows Section 2 lays out theresearch proposition I describe the measures of audit committee effectiveness andboard structure in section 3 The data and methodology are discussed in section 4and the results in section 5 Section 6 presents the summary and conclusion

2 Research proposition

Corporate boards in general, and audit committees in particular, are responsible formonitoring the information contained in financial reports As suggested earlier,differences in board and audit committee structures across firms, coupled with dif-ferent levels of effectiveness of the various governance structures, suggest that thequality of board monitoring over financial reports is likely to vary across firms.Evidence addressing this notion empirically has clear policy implications Out ofequilibrium, evidence of higher earnings quality in firms with properly structuredand functioning audit committees would justify policy efforts by those arguing thatuniform committee structures be mandated In contrast, lack of such evidencewould be more consistent with an efficient contracting view of the firm, suggestingthat reform may lead to monitoring that is redundant and costly because firms canchoose an optimal mix of control mechanisms on their own

Motivated by these policy concerns, and building on earlier work, the presentstudy addresses the link between audit committee structure and audit committeefunctioning with the quality of reported earnings empirically Given that auditcommittees are the principal liaison between management and auditors and arechiefly responsible for reporting on earnings quality to the board of directors, Iexpect that their monitoring performance should partly determine the extent ofearnings manipulation by managers Moreover, the quality of the audit committee

is fundamentally linked to the quality of the corporate board because all audit mittee members are also members of the board, and are appointed by the boarditself, while audit committee decisions have to be ratified by the board as a whole.Accordingly, I also hypothesize that well-structured and functioning corporateboards are associated with improved financial reporting quality

com-To study the link between boards and audit committees with earnings quality,this paper considers two complementary measures of earnings quality, followingFrankel, Johnson, and Nelson 2002 and Ashbaugh, LaFond, and Mayhew 2003.First, it focuses on the tendency of firms to manage earnings so as to avoid reporting

a negative earnings change by isolating all firm-years with a marginally positiveearnings change This measure is based on prior evidence (e.g., Burgstahler andEames 2003) that there is a discontinuity in the distribution of earnings changesaround zero, suggesting that firms that report marginally positive earnings changes arelikely trying to avoid reporting bad news to the market The second measure isbased on work by Matsumoto 2002, who suggests that firms try to meet analystexpectations benchmarks in order to avoid negative earnings surprises, apparently

by managing earnings These earnings quality measures have two potential

Audit Committees, Boards, and the Quality of Reported Earnings 1099advantages over accruals-based measures: they are likely to be less noisy andincorporate the effect of cash flow manipulation Extending this work, I suggestthat the likelihood that a firm will report earnings of poor quality in order to avoid

an earnings decline or a negative earnings surprise will be inversely related to theeffectiveness of its audit committee and board of directors

RESEARCH PROPOSITION The likelihood of reporting a marginal earnings increase or artificially avoiding a negative earnings surprise will be lower

in firms with properly structured audit committees and boards of directors.

3 Measures of audit committee and board structure

To measure audit committee effectiveness, I initially draw on the BRC dations to suggest a set of five audit committee characteristics that are likely to berelated to audit committee performance I then expand this set by examining therole of four additional audit committee characteristics and three general govern-ance characteristics that are likely to be associated with earnings quality

recommen-Audit committee characteristics highlighted by the Blue Ribbon Committee

Monitoring the financial reporting process and ensuring high-quality financialstatements is one of the prime tasks bestowed on corporate boards in general, andindependent outside directors in particular In line with this, the BRC report and priorevidence suggest that the presence of inside directors on the audit committee islikely to be related to poorer financial reporting choices (Klein 2002; Bédard et al.2004), because insiders often have incentives to tolerate a lower quality of reportedearnings I therefore expect lower earnings quality in committees with insiderparticipation

Second, the BRC recommends that all committee members be financially literate,and that at least one be a financial expert Empirical evidence by DeZoort 1998,Xie et al 2003, and Bédard et al 2004 is consistent with the notion that committeemember financial expertise enhances audit committee performance Following Beasleyand Salterio 2001, I suggest that business executives and directors who serve onthe audit committee of another firm are likely to be financially knowledgeable,given that such knowledge is normally necessary for appointment to such positions.Conversely, it is possible that business executives are more likely to identify with,and thus befriend, management who underperform their monitoring role (DeZoortand Salterio 2001) Thus, ex ante, the link between earnings quality and businessexecutives is undetermined, whereas a positive relation is expected between earn-ings quality and committee members with experience in other audit committees

A third potential determinant of audit committee performance is committeesize Ex ante, adding more directors to a committee is likely to have a nonlineareffect on committee performance Initially, adding more members to the commit-tee enhances performance because there are more people on whom to draw Whencommittees grow too large, performance declines because of process losses anddiffusion of responsibility Reflecting concerns about understaffed committees, theBRC (1999) suggests that audit committees should have at least three members, to

1100 Contemporary Accounting Research

ensure a minimum required knowledge base and a lower likelihood that the mittee as a whole will be “handled” by management Xie et al (2003) find aninsignificant relation between audit committee size and discretionary accruals.Given somewhat mixed predictions, I tentatively expect a positive relation betweenearnings quality and audit committee size

com-An important objective for audit committees is to provide their members withsufficient time to carry out their duties Vafeas (1999) suggests that board meetings

in general are a credible measure of board activity Focusing on audit committees inparticular, Menon and Williams (1994) and Xie et al (2003) suggest that meetingsare a reasonable proxy for committee effectiveness In its sample audit committeecharter, the BRC (1999) suggests that committees should hold at least four meetingsper year Accordingly, I expect that audit committees that meet more frequentlyalso operate better, thereby leading to a higher quality of reported earnings

Additional audit committee characteristics

One implicit assumption underlying research on audit committees to date has beenthat the monitoring performance of financially knowledgeable outside directors ismore or less uniform Committee members are assumed to perform similarly to oneanother provided that they are outsiders and have the financial knowledge to copewith the demands of audit committee service The BRC report (1999) reinforces thisview Such research, however, can be enriched by a growing body of evidence fromthe finance literature highlighting other important differences among directors Thisevidence suggests that, in addition to affiliation and knowledge, director perform-ance is likely to be related to equity incentives, total board seats, other committeeservice, and length of tenure on the board (e.g., Ferris et al 2003; Yermack 2004;Perry and Peyer 2005) Drawing on this work, I posit the notion that these directorcharacteristics, detailed below, will also be significant in evaluating audit commit-tees and explaining differences in performance across committee member directorsand, ultimately, differences in performance across audit committees

The first such characteristic is audit committee member equity ownership Toalign the interests of shareholders and outside directors, who are themselves agents

of shareholders, firms routinely grant equity to outside directors Yermack (2004)finds that director equity awards are made systematically, consistent with the predic-tions of agency theory Moreover, there is growing evidence that outside directorswho own more equity in the firm protect shareholder interests more effectively (forexample, by reducing the likelihood of fraud litigation; see Ferris et al 2003) Inthe context of audit committees, higher equity ownership by committee members

is likely to reduce the danger of these directors colluding with management tomanipulate earnings (for example, to inflate executive pay) because such collusionwould ultimately harm their own interests as well I therefore expect that thegreater the fraction of equity that audit committee members own, the greater will

be their motivation to monitor the financial reporting process more effectively, thusproviding earnings information of higher quality

Second, director performance may be related to length of tenure on the board.There are two competing views on the impact of director tenure lengths on audit

Audit Committees, Boards, and the Quality of Reported Earnings 1101committee effectiveness More seasoned directors gain more experience and betterknowledge about the firm’s operations and thus are able to exercise more effectivedecision control on management’s financial reporting choices than are junior, lessexperienced directors In contrast, excessively lengthy board service might com-promise independence because senior directors may be more likely to befriendmanagement (Vafeas 2003), becoming less critical of the quality of its financialreports (Beasley 1996) Yermack (2004) does not find a link between outside direc-tor turnover with either director tenure length or audit committee membership.Given conflicting predictions, the link between earnings quality and director tenurelength is addressed empirically.

The market for directorships provides corporate directors with a powerfulincentive to perform their duties well The more board seats directors hold, themore sensitive to reputation effects they are likely to be (e.g., Yermack 2004).News of poor audit committee performance, as conveyed by a financial reportingscandal, is likely to stigmatize the overseeing audit committee members, damagingtheir reputation and ability to acquire additional board seats Furthermore, Ferris et

al (2003) do not find any evidence that holding more board seats compromises thedirectors’ monitoring performance in any way Consistent with this finding, Perryand Peyer (2005) find that outside directorships by an executive enhance a firm’svalue I thus expect a positive relation between the average number of directorshipsheld by audit committee members and earnings quality

Finally, additional committee service may have a bearing on director ance in the audit committee More committee service provides directors withgreater knowledge of the firm’s affairs and more experience in monitoring manage-ment Furthermore, appointment to a committee may signal a director’s ability tomonitor management Vafeas (1999) finds that firms that operate more board com-mittees also have more active and, presumably, more effective boards Also, direc-tors who hold additional board seats, and thus have a greater reputation capital,serve at least as much as other directors in board committees (Ferris et al 2003).Thus, I tentatively expect a positive relation between the number of other com-mittee memberships held by audit committee members and audit committee per-formance, as captured by earnings quality

perform-General governance characteristics

The fraction of shares owned by officers and directors as a group reflects the tives the management team has to protect the interests of shareholders Warfield,Wild, and Wild (1995) find that higher managerial ownership is associated with agreater information content of earnings, presumably because manager-shareholderssecure better financial information for investors I similarly expect that a greaterfraction of insider ownership will be associated with higher earnings quality.Second, there is a vast body of literature suggesting that a greater proportion

incen-of outsiders serving on corporate boards is associated with improved board toring over shareholders Consistent with this notion, Beasley (1996), Dechow,Sloan, and Sweeney (1996), and Klein (2002) find that a higher representation ofoutside directors on the board is associated with higher financial reporting quality

moni-1102 Contemporary Accounting Research

I similarly expect the degree of board independence to be positively related toearnings quality

Finally, larger boards have been found to be associated with lower firm valuebecause of the higher coordination costs and process losses they face (Yermack1996) I also expect that larger boards make the monitoring process more difficult,thereby leading to financial reports of lower quality, and hypothesize that earningsquality is lower for firms with larger boards of directors

4 Data and methodology

The data

My initial sample comprises firms that are listed in the 1995 Fortune 500 survey.Financial institutions (Standard Industrial Classification [SIC] codes 6000–6999)and utilities (SIC codes 4900 – 4999) are deleted from the sample, because theirspecial regulatory environment is likely to influence the role of financial reportingsystems in the corporate governance process Also deleted are firms with no elec-tronic filings with the Securities and Exchange Commission (SEC) between 1994and 2000, firms for which COMPUSTAT provides insufficient financial data for

1995, and foreign firms This leaves a final sample of 252 firms

I extend the sample period one year before 1995 and five years forward, creating

a seven-year panel of data from 1994 to 2000 Firms are allowed to exit the panel

as they merge, go private or bankrupt, or otherwise cease to exist in their initialform, thereby limiting the effects of survivorship bias Thus, the sample comprises

an unbalanced panel of data over a seven-year period, ranging from 252 firms in

1995 to 182 firms in 2000, with a total of 1,621 firm-year observations

Information on audit committee and board structures is collected from theelectronic filings of proxy statements with the SEC in EDGAR for each firm andeach year Financial information for each firm is collected from COMPUSTAT.Information on institutional holdings is collected from Compact Disclosure.Finally, information on analyst forecasts and on corresponding actual earnings pershare (EPS) figures is collected from Institutional Brokers Estimate System (I/B/E/S).The two earnings quality proxies used as dependent variables in this studycapture small earnings increases and earnings surprises The audit committee andboard characteristics employed are: percentage of committee insiders, percentage

of active business executives, percentage of members with other audit committee experience, audit committee size, audit committee meetings,2stock ownership of committee members, mean tenure per committee member, mean directorships per committee member, mean committee memberships per committee member,3inside ownership, percentage of board outsiders, and board size Finally, the modelincludes five control variables that are considered by both Frankel et al 2002 andAshbaugh et al 2003: a loss dummy; a litigation risk dummy; firm size, proxied by

equity capitalization; institutional holdings; and firm growth, proxied by the to-book ratio (See the appendix for detailed definitions of the variables.)

market-Audit Committees, Boards, and the Quality of Reported Earnings 1103

Methodology

In sum, I estimate two logistic regression equations that link the likelihood of low

earnings quality, approximated by the likelihood of a small earnings increase and

the likelihood of meeting or just beating analyst expectations, respectively, using

the following model:

P (low earnings quality)=α0+α1insiders+α2executives+α3expertise+α4size

+α5meetings+ β1ln(stock) +β2tenure

+β3directorships+β4committees

+γ1inside ownership+γ2board outsiders

+γ3board size+δ1loss+δ2litigation

+δ3ln(equity cap.) +δ4institutions

+δ5market-to-book+ u

To account for the possibility that audit committee characteristics and

earnings-management practices are correlated for each firm through time, I fit a

random-effects model to the data (or, more accurately, a random-intercepts model because

the intercept is the only random parameter) To this end I use the GLIMMIX macro

in SAS (see Wolfinger and McConnell 1993 for the theory behind this macro, and

Littell, Milliken, Stroup, and Wolfinger 1996 for a description of the macro) The

random-effects model illuminates how between-firm variation in boards and audit

committees helps to explain poor earnings quality More specifically, the

random-effects model assumes that the slope coefficients are constant, while the intercept

varies over individual firms and over time Also, the model assumes that the firm

and time effects are random variables, and that they are uncorrelated with the

model’s independent (governance and control) variables Finally, the model assumes

that the number of sample firm-years is sufficiently large Given the small number

of years examined here, the empirical models in this paper employ a random effect

for firms but fixed effects for time (year dummies) The models are estimated using

the full sample of 1,621 observations for 252 firms

Table 1 provides a summary of the expected relations among each of the audit

committee, board, and control variables to the likelihood of avoiding reporting a

small earnings increase or a negative earnings surprise Ex ante, each relation is

denoted as positive (+), negative (−), or undetermined (?)

5 Results

The trend in audit committee and board characteristics

between 1994 and 2000

To understand the trends in audit committee structure and activity and board

struc-ture for my sample firms, in Table 2 I trace their audit committee and board profile

for the period 1994–2000 First, I observe a decline in the relative number of

insid-ers serving on the committee, from 3.69 percent in 1994 to 1.86 percent in 2000

(t =−2.33; p < 0.03), in line with committees becoming more independent of

man-agement’s influence through time The largest decline occurs in the last sample

1104 Contemporary Accounting Research

T Expected relations between e

Audit Committees, Boards, and the Quality of Reported Earnings 1105year, from 3.18 percent to 1.86 percent Furthermore, there is a substantial increase

in the percentage of active business executives serving on the audit committee (t = 4.13; p < 0.01) and in the level of audit committee activity as approximated by

committee meetings (t = 2.87; p < 0.01) Finally, committees have not changedmeaningfully in size over the sample period.4 In general, these findings are consist-ent with the recommendations of the Blue Ribbon Committee, emphasizing theneed for more independent, informed, and active audit committees Furthermore,the timing of these changes suggests many firms acted in anticipation of the BRCrecommendations, because such changes precede the issuance of the BRC report.Notably, the median fraction of common stock owned by all audit committeemembers together increased steadily and significantly over the sample period, from

0.017 percent in 1994 to 0.039 percent in 2000 (Wilcoxon z = 3.41; p < 0.01) Thisfinding reflects the recent trend for more stock-based pay for corporate directors.(Nevertheless, average ownership declined slightly during the sample period, as

indicated by the t-statistic, because of the undue influence of a few extreme

obser-vations.) Third, the percentage of outside directors serving on boards increasedsteadily over the sample period, from 75.1 percent in 1994 to 80.3 percent in 2000

(t = 4.81; p < 0.01), consistent with public pressures for more independent boards

of directors Also, boards have shrunk modestly in size, from 11.7 directors in

1994 to 11.3 directors in 2000 (t =−1.89; p < 0.07), consistent with concerns thatlarger boards are less effective monitors of management Finally, firms report asmall earnings increase and a small positive earnings surprise in about 25 percent

of the sample years

The relationship between audit committees and boards with the likelihood of small earnings increases and avoidance of negative earnings surprises

Table 3 presents Pearson (Spearman) pair-wise correlations above (below) the onal among the governance and earnings quality variables In general, it appearsthat board and audit committee measures are positively correlated, and are thuscomplements in monitoring management, whereas ownership concentration is neg-atively correlated to effective boards and audit committees, and is thus a substitutefor these mechanisms in monitoring management

diag-Next, I estimate the relation among audit committee structure and activity,board structure, and control variables to the likelihood of low earnings quality in amultivariate logistic regression model The model is estimated twice, employingsmall earnings increases and negative surprise avoidance as the dependent vari-able, respectively Table 4 presents the results Importantly, each of the models inTable 4 is jointly significant at the 0.001 level, as signified by the Pearson χ2 statistic.Results from the model on small earnings increases suggest that a greaternumber of insiders on audit committees increases the likelihood of lower earningsquality This finding is consistent with Klein 2002 and BRC 1999, and suggeststhat the pressures exerted on policymakers and top management teams to makeaudit committees more independent are justified The results are very similar when

I introduce a dummy that is set to 1 for audit committees with no insiders, and 0otherwise

1106 Contemporary Accounting Research

T The trend in audit committee and board characteristics for 252 sample fi

Audit Committees, Boards, and the Quality of Reported Earnings 1107