Description
The purpose of this study is to examine the impact of recent corporate governance
reforms on the association between governance practices and earnings management.
Accounting Research Journal
An investigation of the association between corporate governance, earnings
management and the effect of governance reforms
Marion R. Hutchinson Majella Percy Leyal Erkurtoglu
Article information:
To cite this document:
Marion R. Hutchinson Majella Percy Leyal Erkurtoglu, (2008),"An investigation of the association between
corporate governance, earnings management and the effect of governance reforms", Accounting Research
J ournal, Vol. 21 Iss 3 pp. 239 - 262
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Stergios Leventis, Panagiotis Dimitropoulos, (2012),"The role of corporate governance in earnings
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Abdullah Iqbal, Norman Strong, (2010),"The effect of corporate governance on earnings management
around UK rights issues", International J ournal of Managerial Finance, Vol. 6 Iss 3 pp. 168-189 http://
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Nan Sun, Aly Salama, Khaled Hussainey, Murya Habbash, (2010),"Corporate environmental disclosure,
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Aninvestigation of the association
between corporate governance,
earnings management and the
effect of governance reforms
Marion R. Hutchinson and Majella Percy
School of Accountancy, Queensland University of Technology,
Brisbane, Australia, and
Leyal Erkurtoglu
Ernst and Young, Doha, Qatar
Abstract
Purpose – The purpose of this study is to examine the impact of recent corporate governance
reforms on the association between governance practices and earnings management.
Design/methodology/approach – This study examines the impact of corporate governance
reforms by using a ?rm?xed-effect, cross-sectional analysis of 200 ?rms listed on the Australian Stock
Exchange (ASX) for the ?nancial years ending in 2000 and 2005. This paper examines the association
between ?rms’ corporate governance practices and the quality of ?nancial reports as measured by the
magnitude of earnings management pre- and post-the governance reforms (CLERP 9 and ASX
Corporate Governance Council (CGC)).
Findings – The results of this study indicate that certain governance practices are important in
limiting earnings management. In particular, board independence and audit committee (AC)
independence, are associated with lower performance-adjusted discretionary accruals, one commonly
used measure of earnings management. However, increasing executive shareholdings provides
incentives to manage earnings.
Practical implications – This study is important to investors, academics and policy makers as it
demonstrates that governance reforms that encourage ?rms to adopt better governance practices
reduces the likelihood of earnings management.
Originality/value – There is limited research on the association between corporate governance
practices or the recent corporate governance reforms (ASX CGC Recommendations and CLERP 9) on
earnings management in Australia. This study extends the literature by demonstrating the impact of
recent corporate governance reforms on board independence, AC effectiveness and executive directors’
shareholding and the association with earnings management.
Keywords Earnings, Corporate governance, Share ownership schemes
Paper type Research paper
1. Introduction
Corporate governance controls are designed to encourage the ef?cient use of company
resources and promote accountability for the stewardship of resources used by managers
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors would like to thank the editor and an anonymous reviewer for their helpful
comments. The comments of the participants of the Paci?c Basin Finance Accounting and
Management Conference, Brisbane 2008 are also gratefully acknowledged.
Effect of
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Accounting Research Journal
Vol. 21 No. 3, 2008
pp. 239-262
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810922495
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(Sir Adrian Cadbury, 2000). The recent global spate of companies using fraudulent
accounting methods to mask declining ?nancial conditions has attracted the attention of
regulators and accountants. The US Government responded to the corporate scandals
with the Sarbanes-Oxley Act (SOX) in January 2002. The SOXis designed to reviewdated
legislative audit requirements and applies to publicly listed companies. The Australian
response to these corporate indiscretions is the Australian Stock Exchange (ASX)
Corporate Governance Best Practice Recommendations and the Corporate LawEconomic
Reform Program (Audit Reform and Corporate Disclosure) Act (known as CLERP 9).
The ASX Corporate Governance Council (CGC) released its Principles of Good
Corporate Governance (PGC) and Best Practice Recommendations (BPR) in March
2003. It includes 28 (optional) recommendations relating to ten corporate governance
principles. The adoption rate of the recommendations is very promising. The average
adoption rate for all 28 recommendations was 74 percent in 2005 (ASX, 2006). The
underlying objective of CLERP 9, which became law in Australia in 2004, is to promote
transparency, to strengthen the regulatory framework in the key areas of corporate
accountability and protection of shareholder rights. CLERP 9 introduced civil liability
in the Corporations Act for breaches of the ASX continuous disclosure requirements
and extends liability to directors and executives[1]. The civil liability assigned to board
members is designed to encourage listed companies to increase the ?nancial literacy
and independence of audit committee (AC) members.
This study is motivated bytwo considerations. First, are speci?c corporate governance
practices associated with lower levels of earnings management in 2000 or 2005? Second,
are improvements in speci?c corporate governance practices between 2000 and 2005
associated with lower levels of earnings management? We examine the impact of
corporate governance reforms by examining the association between ?rms’ corporate
governance practices and the quality of their ?nancial reports as measured by the
magnitude of earnings management (proxied by performance-adjusted current
discretional accruals (PACDA)) pre- and post-the governance reforms (CLERP 9 and
ASXCGC). The focus of our researchis onboardandACeffectiveness whichencompasses
greater board and AC independence. Given that the ASX CGC recommendations and
CLERP 9 are designed to improve the quality of ?nancial reporting, we would expect to
observe a signi?cant reduction in earnings management in ?rms that change their
corporate governance practices to comply with the recommendations.
This paper contributes to the research on corporate governance in several ways.
There is an extensive body of literature on the impact of corporate governance
practices on various outcomes, such as, ?rm performance, the value relevance of
earnings, earnings management and the impact of regulation. The vast majority of the
research examines the effects of corporate governance practices and regulations in the
USA and the UK. This notion has not been fully explored in the Australian context, a
market similar but different in certain aspects. In Australia, expected litigation costs
are relatively low and the provision of forward-looking accounting information is
voluntary. There is limited research on the association between corporate governance
practices or the recent corporate governance reforms (ASX CGC Recommendations and
CLERP 9) on earnings management in Australia.
The results of the study of the corporate governance practices of 200 Australian listed
?rms indicate that certain governance practices are important in limiting earnings
management. The results of this study demonstrate that the association between
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corporate governance practices and earnings management is only signi?cant post the
governance reforms in the year 2005. Board independence and AC independence are
negatively associated with the level of PACDA, indicating lower levels of earnings
management, while executive shareholdings are positively associated with PACDA.
However, there is no signi?cant relationship between the number of audit committee
meetings (NACM) and PACDA. Following governance reforms, board and AC
independence improved, and AC meeting frequency increased signi?cantly. However,
these changes are not necessarily associated with less earnings management. The results
of this study show that improvements in board independence are associated with
decreases inPACDA, while increasingACactivityis not associatedwithPACDA. There is
no signi?cant association with earnings management for ?rms that increased AC
independence following the governance reforms. However, it should be noted that AC
independence is signi?cantly associated with lower PACDA in 2005. There is no
signi?cant reduction in executive share ownership post the reforms and the positive and
signi?cant association between executive share ownership and PACDA remains.
2. Background and hypotheses development
According to agency theory, the separation between ownership and control may lead to
self-interested actions by managers (Jensen and Meckling, 1976). When con?icts exist
between management and stakeholders, the value of the ?rm is not maximised and the
difference between the theoretical maximumvalue of the ?rmand the actual value of the
?rm is attributed to agency costs (Palliam and Shalhoub, 2003). Prior research provides
evidence of myriad incentives that motivate managers to manage earnings, such as the
quality of the audit ?rm (Davidson III et al., 2004; Myung and Taewoo, 2004), the
distribution of ownership (Hsu and Koh, 2005; Koh, 2003), CEO’s with dual leadership
positions (Davidson et al., 2004), the adoption of International Financial Reporting
Standards (IFRS) (Tendeloo and Vanstraelen, 2005), management share ownership
(Bergstresser and Philippon, 2006), tax incentives (Dhaliwal et al., 2004) and hiring an
executive froma company’s external audit ?rm(Geiger et al., 2005). Myung and Taewoo
(2004) suggest managers adjust discretionary accruals to increase current-period
earnings before they sell their own ?rms’ shares. The majority of this research argues
that earnings manipulation is concealing the truth about earnings and has potentially
negative effects on stakeholders’ interests. This potential con?ict of interest leads to the
need to monitor managers’ behaviour in order to protect shareholders’ rights.
Corporate governance provides a framework to ensure suppliers of corporate
?nance achieve a return on their investment (Shleifer and Vishny, 1997). The board of
directors and ACs are the two main internal corporate governance mechanisms
established to monitor managers’ behaviour and also ensure the reliability of ?nancial
reporting. Extensive research has been conducted relating to the association between
earnings management and certain corporate governance practices, including board
and AC composition (Agrawal and Chadha, 2005; Beasley, 1996; Davidson et al., 2005;
Klein, 2002; Peasnell et al., 2005; Vafeas, 2005). On balance, the majority of this research
has found that the probability of earnings management is lower in companies with an
independent board or an effective AC.
In order to align agents’ incentives with interests of principals, diverse governance
mechanisms are built into the agency contracts (Fama, 1980; Fama and Jensen, 1983).
The role of regulation in this process can be explained by referring to agency theory.
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Regulation attempts to overcome information asymmetry between managers and
shareholders and protect each party’s contractual rights. Owing to incomplete
contracts, regulation (e.g. ASX CGC and CLERP 9) attempts to protect stakeholders by
mandating corporate governance practices. Regulations smooth the progress of the
efforts of contracting parties to maximise the joint gains (the contractual surplus) from
transactions (Schwartz and Scott, 2003). Changes in regulations comprise a source of
experiments (Hermalin and Weisbach, 1991) and for this reason our study examines
the impact of recent corporate governance reforms on the quality of ?nancial reporting.
Financial report preparers in Australia have recently experienced changes to their
roles and responsibilities. Some changes have arisen from the decision to adopt IFRS.
Other changes have arisen in response to events in the business environment such as
initiatives to improve auditors’ independence (Brown and Tarca, 2005). The main focus
of CLERP9 can be classi?ed into two parts: ?rst, accounting and audit reform, especially
aiming to improve the independence of auditors and emphasise the board’s
accountability for the ?nancial report; and second, enhancing corporate disclosure.
Corporate governance is no longer left to be accomplishedthrough voluntary disclosures
as CLERP 9 is enforced through a regime of rules that carry criminal penalties. The
Corporations Act enforces continuous reporting obligations on companies that are
disclosing entities, listed companies and some unlisted public companies with more than
100 shareholders, when certain material events take place regarding the company’s
operations or ?nancial position (Hanrahan et al., 2004). The Corporations Act is not only
concerned with the disclosure of information, but also with ensuring (as much as
possible) the quality of the information (Hanrahan et al., 2004). If regulation is effective
and enhanced corporate disclosure decreases the information asymmetry between
managers and shareholders, then earnings quality should improve.
2.1 Board of directors
The board of directors does not bear the major share of the wealth effects of their
decisions (Fama and Jensen, 1983) and exists to prevent management from pursuing
their personal objectives at the expense of the stakeholders (Fama, 1980). The
composition of a board plays a crucial role in corporate governance mechanisms.
The board must ensure the integrity of the corporation’s accounting and ?nancial
reporting systems. These systems include monitoring risk, ?nancial control, and
compliance with regulations. According to the New York Stock Exchange (NYSE)
Corporate Accountability and Listing Standards Committee (NYSE, 2002), an effective
board of directors should ensure the validity of the accounting choices made by
management and the ?nancial consequences of such decisions (Davidson et al., 2005).
Prior research has found that the board of directors can play an important role in
increasing the quality of ?nancial reporting. According to Beasley (1996), as the
number of independent directors on the board increases, the likelihood of ?nancial
reporting fraud decreases. Dechow et al. (1996) suggest that ?rms manipulating
earnings are more likely to have boards of directors dominated by management. The
probability of earnings manipulation is lower in companies with boards or ACs that
have an independent director with ?nancial expertise (Agrawal and Chadha, 2005).
Persons (2006) argues that the higher the independence of directors, the lower the
likelihood of non-?nancial reporting fraud (i.e. fraud against customers and
governments, and violation of regulations other than ?nancial reporting).
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Chen and Jaggi (2000) ?nd that the proportion of independent directors on corporate
boards is positively associated with the comprehensiveness of ?nancial disclosures.
Klein (2002) found a negative relationship between board independence and abnormal
accruals, a measure of earnings management. In contrast, Fama and Jensen (1983)
argue that ?rms bene?t from having insiders on the board given that senior managers
bring in expertise and improve the decision-making process. In addition, Be´dard et al.
(2004) fail to ?nd an association between the level of board independence and earnings
quality with respect to US ?rms.
The research in this area generally suggests that there is a negative association
between the level of board independence and earnings management which leads to the
following hypothesis:
H1a. There is a negative association between the level of board independence and
earnings management.
2.1.1 The effect of regulation on the association between earnings management and
the board of directors. Do corporate governance reforms and the effectiveness of the
governance mechanisms prevent management’s manipulation of earnings? In the USA,
SOX was followed by other corporate reforms such as those by the NYSE and the
National Association of Securities Dealers, and American Stock Exchange reforms. As
a result of these reforms, listed companies in the USA must have a majority of outside
independent directors (Petra, 2006).
Petra (2006), examines the actual governance structures of Enron, WorldCom, and
Global Crossing during the years of their accounting scandals. The proportions of
outside independent directors on the boards of those companies during that period
were: 50 to 55 percent for Enron Corp., 40 to 50 percent for WorldCom Inc. and 25 to
45 percent for Global Crossing Ltd Despite the presence of the outside independent
directors, these companies suffered collapses in their corporate governance systems
(Petra, 2006).
If we consider Australian examples before their collapses, the board of HIH
Insurance Limited consisted of seven directors of which ?ve were non-executive
directors (71 percent) and the board of One.Tel Limited consisted of nine directors of
which ?ve were non-executive directors (56 percent). From the previous examples of
corporate collapses, it is hard to say that new reforms will prevent the reoccurrence
of the corporate collapses and improve earnings management. If those who are
charged with governance only focus on the form, that is, the appearance of
compliance with the corporate reforms, it is be highly likely that these reforms will
not have any positive effect on the quality of ?nancial reporting. The directors need
to focus on the substance of the reforms to improve the quality of ?nancial
reporting.
If regulation does have a positive effect on board of directors’ behaviour, then we
expect that, for ?rms that change the board to be more independent, there will be a
signi?cantly negative association between the proportion of non-executive directors on
the board and earnings management. We do not expect to ?nd any signi?cant
association for ?rms that do not change their board structure, either because the board
is already dominated by independent directors, or because the practice is not
mandatory. The previous discussion leads to the following hypothesis:
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H1b. There is a negative association between board independence and earnings
management for the ?rms that increase board independence subsequent to
governance reforms.
2.2 Executive directors’ share ownership
According to agency theory, increasing the level of executive share ownership might
reduce the amount of owner/manager con?ict leading to clearer alignment of the goals of
management and shareholders (Jensen and Meckling, 1976). This goal alignment
argument suggests that ownership in the ?rm ensures managers will undertake
risk-bearing strategies that will increase share value. However, when the incentives of
managers are based on their companies’ ?nancial performance, it may be in their
self-interest to give the appearance of better performance through earnings management.
The combination of management’s discretion over reported earnings and the effect these
earnings have ontheir future wealthleads to a potential agency problem. Bergstresser and
Philippon (2006), suggest that the use of discretionary accruals in manipulating earnings
is much stronger in ?rms where the CEO’s potential total compensation is linked to the
value of stock and option holdings. Further research (Cheng and War?eld, 2005; Park and
Park, 2003; Richardson et al., 2003) suggests that managers’ equity holdings is associated
with earnings management based on the assumption that managed earnings will be
mis-priced and managers can take advantage of the mis-pricing by selling shares or
exercising options (Dechow and Schrand, 2004).
Agency theorists suggest that executive share ownership can have undesirable
risk-bearing properties and that managerial share ownership should be viewed with
caution (Beatty and Zajac, 1994). According to formal agency theory, substantial
managerial share ownership may increase the risk borne by executives. Managers are
more likely to undertake high-risk projects and manipulate earnings in order to
increase their own wealth. Therefore, increasing the level of executive directors’
ownership further erodes the independence of the board as high levels of ownership
can provide incentives for executive directors to manipulate earnings to increase their
wealth. The preceding discussion suggests that there is a positive relationship between
increasing executive directors’ share ownership and earnings management leading to
the following hypothesis:
H2a. There is a positive association between executive directors’ share ownership
and earnings management.
2.2.1 The effect of regulation on the association between the executive directors’ share
ownership and earnings management. Since enactment of CLERP 9, executive directors
(CEOs and CFOs) are required to certify to the board of directors that the ?nancial
statements are in accordance with the Corporations Act and accounting standards[2].
The penalty for directors for trading while insolvent and non-payment of debts has
increased from10 to 20 years. Executive directors’ legal responsibilities are extended in
terms of presenting the true and fair view of the companies. Under the strengthened
regulations and codes, earnings manipulation might have more serious consequences
than previously. For executive directors to increase their wealth by earnings
management is now more risky and thus earnings manipulation is not as appealing.
Under this condition, executives might reduce their ownership stake and try to ?nd
some other ways to increase their wealth. Contrary to agency theory, decreasing the
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level of executive share ownership might reduce the amount of owner/manager con?ict
(Jensen and Meckling, 1976).
If regulation does have a positive effect on the extent of share ownership of
executive directors, then we expect that, for ?rms that reduce their executive share
holdings, there will be a reduction in earnings management. Thus, there will be a
signi?cantly negative association between the executive directors’ share ownership
and discretionary accruals subsequent to the reforms. Alternatively, for ?rms where
the ownership of executive directors increased post regulation, we expect to ?nd a
positive association with earnings management. We do not expect to ?nd any
signi?cant association for ?rms that do not change their executive shareholdings,
either because the executive shareholdings are at a low level, or because the practice is
not mandatory. The previous discussion leads to the following hypothesis:
H2b. There is a positive (negative) association between increasing (decreasing) the
level of executive directors’ share ownership and earnings management
subsequent to governance reforms.
2.3 AC effectiveness and earnings management
According to agency theory, shareholders require protection because agents
(management) may not always act in the best interests of the principals
(shareholders) (Fama, 1980; Fama and Jensen, 1983; Jensen and Meckling, 1976). In
order to overcome this problem, the board undertakes an oversight role that involves
monitoring the CEO and other executive managers, approving the corporation’s
strategy, preparing the ?nancial statements and monitoring the control system(DeZoort
et al., 2002). To improve ef?ciency, the board delegates some of its responsibilities to
board committees. The ACis one of the special committees established bythe boardwith
ninety percent of Australian listed companies having an AC (Hanrahan et al., 2004).
As the AC is an extension of the full board the AC is the ultimate monitor of the ?nancial
reporting process. The primary purpose of ACs is to ensure credible ?nancial reports
(Treadway Commission, 1987). Accordingly, regulatory bodies and researchers are
interested in the features of the AC that will improve its ef?ciency. The characteristics
associated with AC effectiveness in this study are AC independence and activity.
The characteristics of the AC impact on the ef?ciency of ACs in performing their
responsibilities (Abbott et al., 2003). Despite their responsibilities, executive directors
on the ACs might still have the motivation to manipulate earnings or conceal earnings
management to hide a deteriorating ?nancial position. However, independent directors
are not likely to have incentives to manipulate earnings as their income is not reliant on
the ?rm’s performance. Accordingly, it is expected that independent ACs would play a
positive role in reducing the probability of earnings management.
However, prior researchhas foundmixed results on the associationbetweenthe level of
AC independence and earnings management. Some research has found a negative
association between AC independence and earnings management (Be´dard et al., 2004;
Klein, 2002; Peasnell et al., 2006) while other research has failed to ?nd any signi?cant
associationbetweenACindependence andearnings management (Peasnell et al., 2005; Xie
et al., 2003). Research has found that greater AC independence is associated with better
reporting quality and a reduced likelihood of fraud (McMullen and Raghundan, 1996).
Regarding, AC diligence; it is argued that inactive ACs are not likely to supervise
management effectively. Prior research and regulatory bodies suggest that ACs should
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hold a minimum of three or four meetings a year (IIA, 1991). Accordingly, it is expected
that active ACs will play a positive role in reducing the probability of earnings
management. Prior research has also found a negative association between the
frequency of AC meetings and earnings management (Klein, 2002; Xie et al., 2003).
McMullen and Raghundan (1996) suggest that increasing the frequency of AC
meetings reduces the likelihood of enforcement action by the Securities and Exchange
Commission in the USA. The preceding discussion leads to the following hypothesis:
H3a. There is a negative association between AC independence and earnings
management.
H3b. There is a negative association between AC meeting frequency and earnings
management.
2.3.1 The effect of regulation on the association between the AC effectiveness and
earnings management. Withthe issuance of the CLERP9 inAustralia, ACresponsibilities
and authority have also increased. ACs are now expected to ensure the integrity of the
?nancial reports and to be more effective in terms of their supervisory roles than
previously. However, HIH Insurance Limited and One.Tel Limited both had ACs
consisting of a majority of non-executive directors before they collapsed. In addition, the
ACmembers were meetingregularly. The UScorporate collapses of Enron, Worldcomand
Global Crossing, demonstrated governance practices of ACs with a minimum of three
members and at least 60 percent of the members were independent (Petra, 2006). That is,
these companies had the appearance of compliance with the regulations.
It is dif?cult to conclude that improvements in the ef?ciency of the AC will
de?nitely decrease earnings management. However, these improvements might still
have positive effects as suggested in previous research (Klein, 2002; Peasnell et al.,
2006; Xie et al., 2003). Braiotta and Zhou (2006) ?nd that ?rms that change their AC
structure are associated with decreased earnings management.
If regulation does have a positive effect on AC behaviour, then we expect to ?nd a
signi?cant negative association between corporate governance practices and
discretionary accruals for ?rms with more effective ACs. That is, ?rms that increase
the independence of the AC and/or increase the frequency of the AC meetings. In this
paper, both these practices are regarded as improving the effectiveness of the AC. The
previous discussion leads to the following hypothesis:
H3c. There is a negative association between AC independence and earnings
management for ?rms increasing AC independence following the governance
reforms of the ASX CGC and CLERP 9.
H3d. There is a negative association between AC meeting frequency and earnings
management for ?rms increasing the NACM following the governance
reforms of the ASX CGC and CLERP 9.
3. Research method
The present study involves a ?rm?xed-effect, cross-sectional analysis of 200 ?rms listed
on the ASX for the ?nancial year ending in 2000 and 2005. Individual models are used to
test the hypotheses. The models regress the absolute value of performance-adjusted
current discretionary accruals (PACDA) on a set of governance and control variables.
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3.1 Sample selection criteria
The sample consists of 200 listed companies selected for this research for the years
2000 and 2005 in order to make a reliable comparison of the effects of corporate
governance best practice recommendations. The original data set consisted of 388 top
500 ?rms for the year 2000. The ?nal sample of 200 ?rms is derived from the ?rms that
remained listed in 2005 and also for which annual reports are available either on the
Connect4 database, on company websites or the DatAnalysis database. Information
regarding boards of directors and AC characteristics is obtained fromdisclosures made
in company annual reports.
The years 2000 and 2005 are chosen to ascertain if corporate governance reforms
impact the corporate governance practices of ?rms. After the demise of the largest
global audit company, Arthur Andersen, in 2002, corporate governance became a much
more signi?cant issue than prior to 2002.
Two signi?cant corporate governance reforms took place between 2000 and 2005. In
2003, the CGC released the PGC and BPR although it was not mandatory to comply
with these recommendations. However, it was a crucial step to improve corporate
governance practices. In 2004, CLERP 9 became law in Australia and directors’
liabilities increased. This research investigates the impact of corporate governance
reforms on the quality of ?nancial reporting by comparing governance practices of
?rms in the years 2000 and 2005.
The following model is developed to test the hypotheses. Separate regressions are
run for each independent variable to test the association with the dependent variable,
PACDA. Finally, the complete model is tested to determine the relative signi?cance of
the governance variables on PACDA. The change model tests the association between
the changes in governance practices and PACDA:
PACDA¼a
0
þa
1
PBNEDþa
2
PANEDþa
3
NACMþa
4
EDsSHARES
þa
5
SIZEþa
6
LOSSþa
7
GROWTHþa
8
GEARINGþa
9
ROAþe
ð1Þ
PACDA ¼ a
0
þ a
1
DIFPBNED þ a
2
DIFPANED þ a
3
DIFNACM
þ a
4
DIFEDs SHARES þ a
5
SIZE þ a
6
LOSS
þ a
7
GROWTH þ a
8
GEARING þ a
9
ROA þ e
ð2Þ
Where:
Dependent variable:
PACDA ¼ absolute value of performance-adjusted current discretionary
accruals based on Kothari et al. (2005).
Independent variables:
PBNED (2) ¼ proportion of non-executive board directors to total
directors on the board.
DIFPBNED (2) ¼ difference in the proportion of non-executive board
directors calculated as the proportion of non-executive
directors on the board in 2005 less the proportion of
non-executive directors on the board in 2000.
PANED (2) ¼ percentage of non-executive directors on the AC.
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DIFPANED (2) ¼ difference in the proportion of non-executive audit
committee directors calculated as the proportion of
non-executive directors on the AC in 2005 less the
proportion of non-executive directors on the AC in 2000.
NACM (2) ¼ number of audit committee meetings per annum.
DIFFNACM (2) ¼ difference in the number of audit committee meetings
per annum in 2005 compared with 2000.
EDs SHARES (þ) ¼ the total number of ordinary shares held by the
executive directors divided by the total number of issued
ordinary shares.
DIFEDs SHARES (þ) ¼ difference in the total number of ordinary shares held by
the executive directors divided by the total number of
issued ordinary shares in 2005 compared with 2000.
Control Variables:
SIZE (þ) ¼ natural log of total assets in million dollars.
LOSS (?) ¼ dummy variable of 1 if income is , 0; 0: otherwise.
GROWTH (?) ¼ ratio of the ?rm’s market value of common equity to book value
of common equity at the beginning of the year.
GEARING (?) ¼ (Short term debt þ long term debt 2 cash)/ shareholders
equity.
ROA (?) ¼ Earnings before interest/(total assets less outside equity
interests).
3.2 Dependent variable
The dependent variable, earnings management, is proxied by PACDA. Accruals can be
decomposed into six categories based on:
.
managerial control: discretionary (unexpected or abnormal) and
non-discretionary;
.
the time period: current and long-term; and
.
performance: performance adjusted and not performance adjusted.
Persistence and permanence alone are not good indicators of earnings quality as
managers are motivated by these characteristics to present an image of themselves as
good managers. Dechow and Schrand (2004) suggest that large accruals (of either sign)
indicate volatility and low-quality earnings as accruals are likely to contain estimation
errors and the current earnings ?gure is unlikely to re?ect the company’s current
operating performance, future operating performance or measure ?rm value. Current
discretionary accruals are adjustments regarding short-term assets and liabilities.
According to recent research, current discretionary accruals are more vulnerable to
management’s earnings manipulation (Ashbaugh et al., 2003). Therefore, the analysis
is based on current discretionary accruals rather than total accruals as in prior research
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(Oei et al., 2008). Ayers et al. (2006) suggest that the positive association between
discretionary accruals and earnings intensi?es around the actual pro?t benchmark.
Given the importance of the ?rm’s growth rate (Kothari et al., 2005) in calculating
current discretionary accruals, the company’s performance is controlled for in the
model. The dependent variable is termed “PACDA.” This measure is adjusted for
performance by including a lagged return on asset (ROA). It is predicted that
improvements in corporate governance practices lead to an improvement in the quality
of the companies’ earnings ?gure, as proxied by the level of absolute discretionary
accruals. Please see the Appendix for the PACDA calculation.
3.3 Independent variables
The board’s ability to act as an effective monitoring mechanism depends on its
independence from management (Beasley, 1996; Davidson et al., 2005; Dechow et al.,
1996). Board independence is measured as the proportion of non-executive directors on
the board. The signi?cant role of non-executive directors in monitoring management is
also documented by various international and local guidelines (ASX, 2003; Cadbury
Committee, Sir Adrian Cadbury, 1992; CLERP 9, 2004; NYSE, 2002). A negative
association is expected between the proportion of non-executive directors and PACDA
(Klein, 2002). Vafeas (2005) ?nds that more appropriately structured ACs and boards
produce higher-quality earnings information.
In this study, AC effectiveness is proxied by two characteristics, independence and
activity. Prior research argues that the ability of the AC to detect earnings
manipulation is associated with the level of AC independence (Be´dard et al., 2004;
Klein, 2002; McMullen and Raghundan, 1996; Peasnell et al., 2006). Regarding AC
activity, prior research argues that the effectiveness of an AC is also dependent on the
frequency of meetings (McMullen and Raghundan, 1996). In order to ensure the
appropriateness of the ?nancial reporting process, AC members should meet regularly
(McMullen and Raghundan, 1996). Consistent with this argument, Xie et al. (2003) ?nd
that the frequency of AC meetings is negatively associated with earnings management.
We expect that the proportion of non-executive directors on the board and ACs and the
frequency of AC meetings to be negatively associated with PACDA, consistent with
prior research. We do not consider the role of the independence of the chair of the board
or the AC in earnings management in this study. As the majority of ?rms in Australia
have an independent board and/or AC chair there is little variation between ?rms
suf?cient for statistical analysis.
Agency theory indicates that executive share ownership can act as an incentive to
reduce the underlying agency problem of separation of ownership from control and
increase the welfare of the shareholders. However, a large body of literature suggests
that extensive stock ownership can motivate the executives to behave
opportunistically and in?ate stock values arti?cially by violating reporting
standards or using fraudulent reporting (Beasley, 1996; War?eld et al., 1995).
A negative relationship is expected between earnings management (PACDA) and
the proxies in this study for good corporate governance practices: PBNED, PANED,
and the NACM. However, a positive relationship is expected between earnings
management and the percentage of share ownership of executive directors, since this
practice may compromise directors’ independence.
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The changes in the governance variables between 2000 and 2005 are regressed
against PACDA to investigate the effects of recent corporate governance reforms.
A negative relationship between the governance variables and PACDA is expected for
?rms that increase the proportion of non-executive directors on board (DIFPBNED)
and the AC (DIFPANED) and the frequency of audit committee meetings (NACM).
A positive relationship is expected between the changes in executive director’s
ownership (DIFEDs SHARES) and PACDA as increases in ownership provide greater
incentives to manipulate earnings.
3.4 Control variables
Firm size affects earnings manipulation (Dechow and Dichev, 2002). Dechow and
Dichev (2002) ?nd that accrual quality is positively related to ?rm size. Since large
?rms have more stable and predictable operations and have more diversi?ed business
activities they have fewer and smaller estimation errors. Size is expected to be
negatively associated with the management of earnings as large ?rms are more likely
to report higher quality earnings, primarily due to political pressure and investors’
scrutiny (War?eld et al., 1995). Size is measured as the natural logarithm of total assets
as at June 30.
The following variables are included in the model to account for the impact on
earnings management. The direction of the relationship is not predicted due to the
con?icting results of prior research. Gearing is included as a control variable as it is
expected that debtors of highly leveraged ?rms are concerned when ?rms are
approaching ?nancial distress and are therefore more likely to monitor earnings
closely. On the other hand, ?rms with high leverage are motivated to manipulate
earnings to meet debt covenants. According to Saleh and Ahmed (2005), distressed
?rms manipulate earnings downward and managers adopt income-decreasing
accruals during debt renegotiation. Gearing is measured as the ratio of
(short –term debt þ long–term debt 2cash) to shareholders equity.
Growth opportunities of the ?rm are likely to have an impact on the quality of the
earnings ?gure. The ratio of market value of common equity to book value of common
equity is used to capture the ?rm’s growth opportunities (Smith and Watts, 1992).
Firms with low-growth opportunities have limited investment opportunities and
accordingly have high free cash ?ows and excess cash. Subsequently, managers
working for low-growth ?rms can act opportunistically by means of excessive
perquisite consumption, hiding non-optimal expenditures, misappropriation of assets
and salary enhancement (Jensen, 1986). Further, ?rms growing rapidly may have
internal control problems (Kinney and MacDaniel, 1989). Companies with high-growth
rates may have problems operating ef?cient ACs and this might exacerbate the
practice of earnings management. Growth is measured as the ratio of market
capitalisation on the last day of the company’s ?nancial year to shareholders equity per
share (Price to Book Value).
ROAs is included as a control variable as it is expected that ?rms with lower
performance tend to manipulate earnings ?gures and this should be positively
associated with earnings management. ROAs is measured as the ratio of earnings
before interest to total assets less outside equity interests.
Dechow and Dichev (2002) ?nd that accrual quality is negatively related with loss
incidence. Management is more likely to manipulate the earnings ?gure in cases of
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?nancial distress. Consistent with this argument, managers are more likely to make
income-increasing abnormal accruals to avoid reporting losses and earnings reductions
(Peasnell et al., 2005). Firms with an accounting loss are included as a dummy variable,
equal to “1” if the ?rm experienced a loss during the ?scal year and “0” otherwise.
Finally, industry effects are controlled for in the calculation of PACDA[3].
4. Results and discussion
The descriptive statistics in Table I demonstrate the following for the sample of 200
?rms in 2000 and 2005. On average, executive directors in 2005 own 5 percent (6
percent in 2000) of the total issued shares with a maximum of 67 percent (62 percent in
2000) and a minimum of zero percent. On average, 75 percent (72 percent in 2000) of the
directors on boards and 94 percent (84 percent in 2000) of the directors on ACs
are non-executive directors. There are also some companies which have no
non-executive directors on their committees and some companies with 100 percent
non-executive directors on their committees. On average, ACs in 2005 hold 3.6 (2.7 in
2000) meetings in a ?nancial year.
Individual t-tests of the differences of the means are reported in Table I to determine
the signi?cance of the differences between the years 2000 and 2005. There is a
signi?cant difference in the mean of the proportion of non-executive directors on the
board ( p ¼ 0.013) and on the AC of nearly 10 percent ( p ¼ 0.000). This result suggests
that governance reforms have been effective in increasing board and AC independence.
There are signi?cant differences in the mean of the NACM between 2000 and 2005
( p ¼ 0.00). Recent reforms are effective in increasing the NACM by nearly one extra
AC meeting per year. However, there is no signi?cant reduction in executive director
ownership between 2000 and 2005.
The Pearson’s Correlation Matrix presented in Table II shows that the
independent variables, proportion of non-executive directors on the board and AC
and NACM, are negatively associated with PACDA while executive directors’
ownership is positively correlated with PACDA. The negative correlation between
the proportion of non-executive directors on the board and AC and PACDA
supports the argument that as the number of independent directors on the board
and AC increases, the credibility of the ?nancial reporting improves (Beasley, 1996;
Be´dard et al., 2004; Chen and Jaggi, 2000; Persons, 2006). The NACM is negatively
and signi?cantly correlated with PACDA. This result supports the argument that a
more active AC is associated with less-earnings management (Xie et al., 2003; Klein,
2002; McMullen and Raghundan, 1996). The results of the Pearson’s Correlation
Matrix support the notion that executive share ownership should be viewed with
caution since it might create opportunistic incentives for managers (Beatty and
Zajac, 1994; Bergstresser and Philippon, 2006). Table II, Panel B, reports the
correlations for the differences in board and AC independence, AC meetings and
executive directors’ shareholdings.
Table III Panel A reports the results of testing the association between the
governance variables and PACDA in the year 2000, before the governance reforms,
and 2005, after the governance reforms. The results of testing H1a suggest that the
proportion of non-executive directors on the board is negatively and signi?cantly
related to PACDA in 2005. The model explains 29.3 percent of the variability in
PACDA for the year 2005, and shows that the proportion of non-executive directors is
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.
4
1
7
4
0
.
2
7
9
6
0
.
0
6
0
0
0
.
1
5
5
3
N
o
t
e
s
:
P
A
C
D
A
,
a
b
s
o
l
u
t
e
v
a
l
u
e
o
f
p
e
r
f
o
r
m
a
n
c
e
-
a
d
j
u
s
t
e
d
c
u
r
r
e
n
t
d
i
s
c
r
e
t
i
o
n
a
r
y
a
c
c
r
u
a
l
s
b
a
s
e
d
o
n
K
o
t
h
a
r
i
e
t
a
l
.
(
2
0
0
5
)
;
P
B
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
N
o
n
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
o
r
s
t
o
t
o
t
a
l
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
P
A
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
a
u
d
i
t
c
o
m
m
i
t
t
e
e
(
A
C
)
;
N
A
C
M
,
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
;
E
D
s
S
H
A
R
E
S
,
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
i
s
s
u
e
d
o
r
d
i
n
a
r
y
s
h
a
r
e
s
;
S
I
Z
E
,
n
a
t
u
r
a
l
l
o
g
o
f
t
o
t
a
l
a
s
s
e
t
s
i
n
m
i
l
l
i
o
n
d
o
l
l
a
r
s
,
L
O
S
S
,
d
u
m
m
y
v
a
r
i
a
b
l
e
a
s
:
1
:
i
n
c
o
m
e
i
s
,
0
;
0
:
o
t
h
e
r
w
i
s
e
.
G
R
O
W
T
H
,
r
a
t
i
o
o
f
t
h
e
?
r
m
’
s
m
a
r
k
e
t
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
t
o
b
o
o
k
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
a
t
t
h
e
b
e
g
i
n
n
i
n
g
o
f
t
h
e
y
e
a
r
.
G
E
A
R
I
N
G
,
ð
S
h
o
r
t
t
e
r
m
d
e
b
t
þ
l
o
n
g
t
e
r
m
d
e
b
t
2
c
a
s
h
Þ
=
s
h
a
r
e
h
o
l
d
e
r
s
e
q
u
i
t
y
;
R
O
A
,
e
a
r
n
i
n
g
s
b
e
f
o
r
e
i
n
t
e
r
e
s
t
=
ð
t
o
t
a
l
a
s
s
e
t
s
l
e
s
s
o
u
t
s
i
d
e
e
q
u
i
t
y
i
n
t
e
r
e
s
t
s
Þ
Table I.
Descriptive statistics
(N ¼ 200)
ARJ
21,3
252
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
A
C
D
A
P
B
N
E
D
E
D
s
S
H
A
R
E
S
P
A
N
E
D
N
A
C
M
L
N
S
I
Z
E
G
E
A
R
I
N
G
G
R
O
W
T
H
L
O
S
S
R
O
A
Y
e
a
r
P
a
n
e
l
A
(
N
¼
4
0
0
)
P
A
C
D
A
1
.
0
0
0
P
B
N
E
D
2
0
.
2
2
4
*
*
1
.
0
0
0
E
D
s
S
H
A
R
E
S
0
.
2
4
0
*
*
2
0
.
3
2
6
*
*
1
.
0
0
0
P
A
N
E
D
2
0
.
1
7
2
*
*
0
.
4
0
2
*
*
2
0
.
1
4
9
*
*
1
.
0
0
0
N
A
C
M
2
0
.
1
0
1
*
0
.
2
7
4
*
*
2
0
.
0
9
8
*
0
.
4
7
2
*
*
1
.
0
0
0
L
N
S
I
Z
E
2
0
.
0
6
2
0
.
1
7
4
*
*
2
0
.
2
0
3
*
*
0
.
2
2
8
*
*
0
.
3
1
6
*
*
1
.
0
0
0
G
E
A
R
I
N
G
0
.
1
1
0
*
2
0
.
0
1
5
2
0
.
0
1
8
2
0
.
0
1
5
0
.
0
1
9
0
.
1
6
6
*
*
1
.
0
0
0
G
R
O
W
T
H
0
.
1
1
0
*
2
0
.
0
4
5
2
0
.
0
1
4
0
.
0
3
0
0
.
0
3
6
2
0
.
0
3
1
0
.
0
2
4
1
.
0
0
0
L
O
S
S
0
.
0
4
6
2
0
.
0
5
4
0
.
0
0
5
2
0
.
1
2
8
*
*
2
0
.
0
8
6
*
2
0
.
4
4
1
*
*
0
.
0
6
2
0
.
0
9
8
*
1
.
0
0
0
R
O
A
2
0
.
3
4
2
*
*
0
.
1
0
5
*
2
0
.
0
5
1
0
.
1
0
5
*
0
.
0
9
5
*
0
.
4
2
3
*
*
2
0
.
0
9
4
*
2
0
.
1
1
4
*
2
0
.
5
5
1
*
*
1
.
0
0
0
Y
e
a
r
0
.
0
1
7
2
0
.
0
8
3
*
0
.
0
4
2
2
0
.
1
7
5
*
*
2
0
.
2
6
9
*
*
2
0
.
0
7
8
0
.
0
0
9
0
.
0
2
4
0
.
0
3
2
0
.
0
5
9
1
.
0
0
0
P
A
C
D
A
D
I
F
N
A
C
M
D
I
F
P
B
N
E
D
D
I
F
P
A
N
E
D
D
I
F
E
D
s
L
N
S
I
Z
E
G
E
A
R
I
N
G
G
R
O
W
T
H
L
O
S
S
R
O
A
P
a
n
e
l
B
(
N
¼
2
0
0
)
P
A
C
D
A
1
.
0
0
0
D
I
F
N
A
C
M
2
0
.
0
4
1
1
.
0
0
0
D
I
F
P
B
N
E
D
2
0
.
2
5
2
*
*
0
.
1
5
2
*
1
.
0
0
0
D
I
F
P
A
N
E
D
2
0
.
0
2
8
0
.
3
4
7
*
*
0
.
3
4
3
*
*
1
.
0
0
0
D
I
F
E
D
s
0
.
2
6
5
*
*
0
.
0
0
7
2
0
.
2
1
6
*
*
2
0
.
1
4
8
*
1
.
0
0
0
L
N
S
I
Z
E
2
0
.
0
1
7
2
0
.
0
4
8
2
0
.
0
8
7
2
0
.
0
6
2
2
0
.
0
4
1
1
.
0
0
0
G
E
A
R
I
N
G
2
0
.
0
3
0
2
0
.
0
8
6
2
0
.
0
2
1
2
0
.
0
1
6
2
0
.
0
4
3
0
.
0
9
8
1
.
0
0
0
G
R
O
W
T
H
2
0
.
0
5
1
0
.
0
6
0
0
.
0
6
3
0
.
0
1
4
0
.
0
1
2
0
.
0
4
6
0
.
1
0
5
1
.
0
0
0
L
O
S
S
0
.
1
4
5
*
2
0
.
0
0
6
0
.
0
4
4
0
.
0
4
6
2
0
.
0
1
3
2
0
.
4
9
0
*
*
0
.
1
1
2
0
.
0
0
4
1
.
0
0
0
R
O
A
2
0
.
0
2
5
2
0
.
0
4
4
2
0
.
0
9
0
2
0
.
1
1
8
*
2
0
.
0
4
3
0
.
4
6
8
*
*
2
0
.
1
3
4
*
2
0
.
0
9
7
2
0
.
5
7
2
*
*
1
.
0
0
0
N
o
t
e
s
:
C
o
r
r
e
l
a
t
i
o
n
i
s
s
i
g
n
i
?
c
a
n
t
a
t
t
h
e
*
0
.
0
5
a
n
d
*
*
0
.
0
1
l
e
v
e
l
s
(
t
w
o
-
t
a
i
l
e
d
)
,
r
e
s
p
e
c
t
i
v
e
l
y
.
P
A
C
D
A
,
a
b
s
o
l
u
t
e
v
a
l
u
e
o
f
p
e
r
f
o
r
m
a
n
c
e
-
a
d
j
u
s
t
e
d
c
u
r
r
e
n
t
d
i
s
c
r
e
t
i
o
n
a
r
y
a
c
c
r
u
a
l
s
b
a
s
e
d
o
n
K
o
t
h
a
r
i
e
t
a
l
.
(
2
0
0
5
)
;
P
B
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
N
o
n
-
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
o
r
s
t
o
t
o
t
a
l
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
P
A
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
a
u
d
i
t
c
o
m
m
i
t
t
e
e
(
A
C
)
;
N
A
C
M
,
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
.
E
D
s
S
H
A
R
E
S
,
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
i
s
s
u
e
d
o
r
d
i
n
a
r
y
s
h
a
r
e
s
;
S
I
Z
E
,
n
a
t
u
r
a
l
l
o
g
o
f
t
o
t
a
l
a
s
s
e
t
s
i
n
m
i
l
l
i
o
n
d
o
l
l
a
r
s
;
L
O
S
S
,
d
u
m
m
y
v
a
r
i
a
b
l
e
a
s
:
1
:
i
n
c
o
m
e
i
s
,
0
;
0
:
o
t
h
e
r
w
i
s
e
.
G
R
O
W
T
H
,
r
a
t
i
o
o
f
t
h
e
?
r
m
’
s
m
a
r
k
e
t
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
t
o
b
o
o
k
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
a
t
t
h
e
b
e
g
i
n
n
i
n
g
o
f
t
h
e
y
e
a
r
;
G
E
A
R
I
N
G
,
ð
s
h
o
r
t
t
e
r
m
d
e
b
t
þ
l
o
n
g
t
e
r
m
d
e
b
t
2
c
a
s
h
Þ
=
s
h
a
r
e
h
o
l
d
e
r
s
e
q
u
i
t
y
;
R
O
A
,
e
a
r
n
i
n
g
s
b
e
f
o
r
e
i
n
t
e
r
e
s
t
=
ð
t
o
t
a
l
a
s
s
e
t
s
l
e
s
s
o
u
t
s
i
d
e
e
q
u
i
t
y
i
n
t
e
r
e
s
t
s
Þ
;
Y
E
A
R
,
d
u
m
m
y
v
a
r
i
a
b
l
e
,
1
i
f
y
e
a
r
i
s
2
0
0
0
;
0
i
f
y
e
a
r
i
s
2
0
0
5
;
D
I
F
P
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
o
r
s
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
0
;
D
I
F
P
A
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
a
u
d
i
t
c
o
m
m
i
t
t
e
e
d
i
r
e
c
t
o
r
s
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
0
;
D
I
F
N
A
C
M
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
i
n
2
0
0
5
c
o
m
p
a
r
e
d
w
i
t
h
2
0
0
0
;
D
I
F
E
D
s
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
i
s
s
u
e
d
o
r
d
i
n
a
r
y
Table II.
Pearson correlation
coef?cients
Effect of
governance
reforms
253
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
o
e
f
?
c
i
e
n
t
(
t
-
s
t
a
t
i
s
t
i
c
)
V
a
r
i
a
b
l
e
H
1
a
(
2
0
0
0
)
H
1
a
(
2
0
0
5
)
H
2
a
(
2
0
0
0
)
H
2
a
(
2
0
0
5
)
H
3
a
(
2
0
0
0
)
H
3
a
(
2
0
0
5
)
H
3
c
(
2
0
0
0
)
H
3
c
(
2
0
0
5
)
F
u
l
l
M
o
d
e
l
(
2
0
0
0
)
F
u
l
l
m
o
d
e
l
(
2
0
0
5
)
P
a
n
e
l
A
C
o
n
s
t
a
n
t
?
0
.
2
5
8
(
1
.
7
2
8
)
2
0
.
0
5
1
(
2
0
.
1
3
1
)
0
.
1
7
2
(
1
.
0
9
5
)
2
0
.
6
6
4
(
2
1
.
7
5
4
)
0
.
2
3
1
(
1
.
5
4
9
)
2
0
.
0
4
1
(
2
0
.
1
0
8
)
0
.
2
4
1
(
1
.
6
0
5
)
2
0
.
4
8
9
(
2
1
.
2
3
5
)
0
.
2
3
3
(
1
.
4
3
8
)
2
0
.
2
5
7
(
2
0
.
6
3
2
)
P
B
N
E
D
2
2
0
.
0
9
4
(
2
1
.
4
4
1
)
2
0
.
6
3
4
(
2
3
.
3
4
1
)
*
*
2
0
.
1
1
0
(
2
1
.
4
5
8
)
2
0
.
2
1
8
(
2
1
.
1
0
2
)
E
D
s
S
H
A
R
E
S
þ
0
.
1
1
0
(
1
.
1
5
9
)
1
.
1
0
9
(
4
.
5
6
7
)
*
*
*
0
.
0
8
2
(
0
.
8
4
3
)
0
.
8
8
3
(
3
.
4
7
4
)
*
*
*
P
A
N
E
D
2
0
.
0
0
0
(
2
0
.
0
0
9
)
2
0
.
6
3
4
(
2
4
.
3
8
0
)
*
*
*
0
.
0
2
0
(
0
.
4
3
0
)
2
0
.
5
0
4
(
2
3
.
2
4
2
)
*
*
*
N
A
C
M
2
0
.
0
0
3
(
0
.
5
1
3
)
2
0
.
0
4
1
(
2
1
.
7
0
1
)
0
.
0
0
5
(
0
.
6
7
4
)
2
0
.
0
0
6
(
2
0
.
2
3
4
)
S
i
z
e
þ
2
.
0
0
8
(
2
1
.
0
1
1
)
0
.
0
3
1
(
1
.
6
3
0
)
2
0
.
0
0
7
(
2
0
.
9
3
2
)
0
.
0
3
6
(
1
.
9
0
0
)
*
2
0
.
0
1
0
(
2
1
.
2
9
0
)
0
.
0
3
7
(
1
.
9
6
8
)
*
2
0
.
0
1
1
(
2
1
.
4
0
9
)
0
.
0
3
7
(
1
.
7
7
2
)
2
0
.
0
0
8
(
2
0
.
9
4
7
)
0
.
0
4
8
(
2
.
4
7
1
)
*
*
G
E
A
R
I
N
G
?
0
.
0
0
2
(
0
.
1
3
8
)
0
.
0
2
8
(
1
.
2
1
5
)
0
.
0
0
3
(
0
.
2
6
0
)
0
.
0
2
4
(
1
.
0
5
5
)
0
.
0
0
3
(
0
.
2
3
7
)
0
.
0
3
1
(
1
.
3
5
1
)
0
.
0
0
4
(
0
.
2
7
9
)
0
.
0
3
0
(
1
.
2
5
4
)
0
.
0
0
3
(
0
.
2
4
5
)
0
.
0
2
4
(
1
.
1
0
6
)
G
R
O
W
T
H
?
2
0
.
0
0
4
(
2
0
.
9
5
6
)
2
0
.
0
1
7
(
2
1
.
0
8
1
)
2
0
.
0
0
3
(
2
0
.
7
9
1
)
2
0
.
0
1
8
(
2
1
.
1
9
7
)
2
0
.
0
0
3
(
2
0
.
8
0
0
)
2
0
.
0
1
6
(
2
1
.
0
2
9
)
2
0
.
0
0
3
(
2
0
.
7
9
1
)
2
0
.
0
1
6
(
2
0
.
9
7
2
)
2
0
.
0
0
4
(
2
0
.
9
6
6
)
2
0
.
0
1
3
(
2
.
8
7
5
)
L
O
S
S
?
2
0
.
0
0
7
(
2
0
.
1
8
4
)
2
0
.
2
1
7
(
2
2
.
0
4
3
)
*
2
0
.
0
0
2
(
2
0
.
0
4
2
)
2
0
.
2
1
8
(
2
2
.
1
0
7
)
*
2
0
.
0
0
3
(
2
0
.
0
8
4
)
*
*
2
0
.
2
8
9
(
2
2
.
8
0
1
)
*
*
2
0
.
0
0
2
(
2
0
.
0
6
5
)
2
0
.
2
3
9
(
2
2
.
1
9
4
)
*
2
0
.
0
0
5
(
2
0
.
1
3
2
)
2
0
.
2
1
9
(
2
2
.
1
2
3
)
*
R
O
A
?
0
.
2
3
6
(
2
.
4
2
8
)
*
2
0
.
9
7
5
(
2
6
.
9
0
2
)
*
*
*
0
.
2
4
5
(
2
.
5
2
8
)
*
*
2
1
.
0
1
8
(
2
7
.
4
9
9
)
*
*
*
0
.
2
5
8
(
2
.
6
6
3
)
*
*
2
1
.
0
2
9
(
2
7
.
5
6
2
)
*
*
*
0
.
2
6
3
(
2
.
7
0
8
)
*
*
2
1
.
0
4
0
(
2
7
.
3
0
4
)
*
*
*
0
.
2
3
3
(
2
.
3
7
2
)
*
2
0
.
9
5
9
(
2
7
.
1
5
9
)
*
*
*
F
-
v
a
l
u
e
2
.
2
9
8
*
1
3
.
3
2
0
*
*
*
2
.
1
6
8
*
1
5
.
4
8
1
*
*
*
1
.
9
3
1
1
5
.
1
0
8
*
*
*
1
.
9
7
7
1
1
.
4
7
8
*
*
*
1
.
7
1
3
1
2
.
9
0
7
*
*
*
A
d
j
u
s
t
e
d
R
2
0
.
0
3
8
0
.
2
9
3
0
.
0
3
4
0
.
3
0
4
0
.
0
2
7
0
.
2
9
8
0
.
0
2
9
0
.
2
4
0
0
.
0
3
1
0
.
3
5
0(
c
o
n
t
i
n
u
e
d
)
Table III.
Regression model:
dependent variable:
PACDA (N ¼ 200)
ARJ
21,3
254
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
o
e
f
?
c
i
e
n
t
(
t
-
s
t
a
t
i
s
t
i
c
)
P
a
n
e
l
B
V
a
r
i
a
b
l
e
H
1
b
H
2
b
H
3
b
H
3
d
F
u
l
l
c
h
a
n
g
e
m
o
d
e
l
C
o
n
s
t
a
n
t
?
2
0
.
2
4
8
(
2
0
.
5
7
4
)
2
0
.
3
4
2
(
2
0
.
7
6
6
)
2
0
.
3
3
3
(
2
0
.
7
4
6
)
2
0
.
3
0
6
(
2
0
.
7
2
3
)
D
I
F
P
B
N
E
D
2
2
0
.
6
9
7
(
2
3
.
6
5
7
)
*
*
*
2
0
.
6
2
5
(
2
3
.
1
0
5
)
*
*
*
D
I
F
E
D
s
S
H
A
R
E
S
þ
0
.
9
6
8
(
3
.
9
9
5
)
*
*
*
0
.
8
4
2
(
3
.
4
2
4
)
*
*
*
D
I
F
P
A
N
E
D
2
2
0
.
0
4
3
(
2
0
.
3
8
2
)
0
.
1
5
6
(
1
.
3
0
9
)
D
I
F
F
N
A
C
M
2
2
0
.
0
0
9
(
2
0
.
5
0
7
)
2
0
.
0
0
9
(
2
0
.
5
2
3
)
S
i
z
e
þ
0
.
0
1
3
(
0
.
6
2
6
)
0
.
0
2
0
(
0
.
9
5
5
)
0
.
0
1
8
(
0
.
7
9
7
)
0
.
0
1
7
(
0
.
7
8
5
)
0
.
0
1
6
(
0
.
7
6
8
)
G
E
A
R
I
N
G
?
2
0
.
0
2
1
(
2
0
.
7
8
5
)
2
0
.
0
1
4
(
2
0
.
5
2
4
)
2
0
.
0
1
8
(
2
0
.
6
7
4
)
2
0
.
0
1
9
(
2
0
.
7
0
7
)
2
0
.
0
0
1
7
(
2
0
.
6
5
2
)
G
R
O
W
T
H
?
2
0
.
0
0
7
(
2
0
.
4
1
7
)
2
0
.
0
1
2
(
2
0
.
6
9
2
)
2
0
.
0
1
1
(
2
0
.
6
1
9
)
2
0
.
0
1
1
(
2
0
.
5
8
7
)
2
0
.
0
0
8
(
2
0
.
4
6
1
)
L
O
S
S
?
0
.
2
7
7
(
2
.
3
6
2
)
*
*
0
.
3
0
9
(
2
.
6
5
4
)
*
*
0
.
2
8
5
(
2
.
3
5
2
)
*
0
.
2
8
4
(
2
.
3
4
2
)
*
0
.
3
0
0
(
2
.
6
1
7
)
*
*
R
O
A
?
0
.
0
6
5
(
0
.
4
1
8
)
0
.
1
3
0
(
0
.
8
3
8
)
0
.
0
9
1
(
0
.
5
6
3
)
0
.
0
9
4
(
0
.
5
8
2
)
0
.
1
1
6
(
0
.
7
5
7
)
F
-
v
a
l
u
e
3
.
3
7
7
*
*
3
.
8
2
3
*
*
1
.
0
9
9
1
.
1
1
8
3
.
7
6
8
*
*
*
A
d
j
u
s
t
e
d
R
2
0
.
0
6
7
0
.
0
7
8
0
.
0
0
3
0
.
0
0
4
0
.
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Table III.
Effect of
governance
reforms
255
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
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S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
negatively and signi?cantly associated with the PACDA with a negative coef?cient of
20.634 (t ¼ 23.341). This variable is not signi?cant in the model for the year 2000.
Prior research has produced con?icting results about the relationship between PACDA
and board independence. The results of this study demonstrate that, post-governance
changes, as the proportion of non-executive directors on the board increases, PACDA
decrease. This result supports the notion that boards of ?rms with high independence
ensure ?nancial reporting quality because they monitor managers more ef?ciently.
This result supports and strengthens the results reported by prior research (Agrawal
and Chadha, 2005; Beasley, 1996; Dechow et al., 1996; Persons, 2006). The control
variables LOSS and ROA are negatively and signi?cantly related to PACDA in the
2005 model but only ROA is signi?cant in the 2000 model.
The results of testing H2a suggests that PACDA is positively related to the
executive directors share ownership in 2005 only. The association is not signi?cant in
the year 2000. The model has an adjusted R
2
of 30.4 percent and shows that executive
directors’ share ownership is positively and signi?cantly associated with PACDA with
a coef?cient of 1.109 (t ¼ 4.567). Prior research also suggests that management
share-ownership exhibits a non-linear function (Morck et al., 1998). Increases in the
executive share ownership provides incentives for executives to act less
opportunistically and more in the interest of the ?rm, while excessive share
ownership provides managers with the voting power to pursue their own interests
(Hermalin and Weisbach, 1991). Consistent with the Morck et al. (1998) entrenchment
argument, the percentage of director share ownership was logged to test for a
non-linear relationship between the dependent and independent variables. However,
a non-linear relationship was not identi?ed. The results presented in this study support
and strengthen the results reported by other researchers who argue that executive
share ownership should be viewed with caution since it can have undesirable
risk-bearing properties and it might create incentives for managers to behave
opportunistically (Beatty and Zajac, 1994; Bergstresser and Philippon, 2006).
The two proxies for AC effectiveness, AC independence (H3a) and the frequency of
audit activity (H3c) are tested separately. The results reported in Table III Panel A
support H3a in 2005 only. The 2005 model has an adjusted R
2
of 29.8 percent and
illustrates that the proportion of non-executive directors on the AC is negatively and
signi?cantly associated with the PACDA with a coef?cient of 20.634 (t ¼ 24.380).
This variable is not signi?cant in the model for the 2000 year. This result supports the
notion that, post the governance changes, the ability of the AC to detect earnings
management is associated with the level of independence, supporting and
strengthening prior research (Be´dard et al., 2004; Klein, 2002; McMullen and
Raghundan, 1996; Peasnell et al., 2006). The control variables LOSS and ROA are
negatively and signi?cantly related to PACDA in both years. The results of testing the
second proxy for AC effectiveness, the NACM, is negatively and marginally related to
PACDA (t ¼ 21.701; p ¼ 0.091) in 2005 with an adjusted R
2
of 24 percent. The
association is not signi?cant in 2000. The results fail to support H3c. The control
variables LOSS and ROA are negatively and signi?cantly related to PACDA in 2005.
The ?rst set of regressions test whether the individual governance practices impact
earnings management. The full model tests whether board independence, executive
directors’ shareholdings, AC independence, and AC meeting frequency simultaneously
in?uence earnings management. The full model examines which of the governance
ARJ
21,3
256
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
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V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
factor(s) has the most explanatory power in predicting PACDA in 2000 and 2005.
The results of testing the full model reported in Table III Panel A, shows that two of the
corporate governance practices are signi?cantly related to PACDA in 2005 only.
The model explains 35 percent of the variability in PACDA, and demonstrates that the
proportion of non-executive directors on the AC is negatively and signi?cantly
associated with the PACDA with a coef?cient of 20.504 (t ¼ 23.242). The model also
indicates that executive directors’ share ownership is positively and signi?cantly
associated with the PACDA with a coef?cient of 0.883 (t ¼ 3.474). The control
variables ROA and LOSS are negatively and signi?cantly and SIZE is positively and
signi?cantly related to PACDA in 2005.
Table III Panel B reports the results of examining the levels of PACDA for ?rms
that change their governance practices following the governance reforms. The results
of testing H1b demonstrate that the level of PACDA is signi?cantly negative for ?rms
that increase the proportion of non-executive directors on the board with a negative
coef?cient of 20.679 (t ¼ 23.657). The model has an adjusted R
2
of 6.7 percent.
The results support the proposition that ?rms that changed their board structure
following the governance reforms have less-earnings management. The results of
testing H2b suggest that the change in the executive directors’ share ownership
remains positively and signi?cantly related to PACDA with a coef?cient of 0.968
(t ¼ 3.995). The model with an adjusted R
2
of 8 percent shows that when ?rms change
the level of executive director ownership post the reforms they have larger
discretionary accruals. The control variable, LOSS, is positively and signi?cantly
related to PACDA. The results do not support H3b and H3d that PACDA is negatively
related to changes in the proportion of non-executive directors on the AC or increases
the NACM.
The results of testing the full model of differences are reported in Table III Panel B
and suggest that changes to two of the corporate governance practices are signi?cantly
related to PACDA. The model, with an adjusted R
2
of 11.1 percent, indicates that
changes to the proportion of non-executive directors on the board is negatively and
signi?cantly associated with the PACDA with a coef?cient of 20.625 (t ¼ 23.105).
The model also shows that changes to executive directors’ share ownership is
positively and signi?cantly associated with PACDA with a coef?cient of 0.842
(t ¼ 3.424). The control variable LOSS is positively and signi?cantly related to
PACDA.
4.1 Sensitivity analysis
An additional test of the robustness of the results is performed using the pooled
sample for 2000 and 2005 including a dummy variable for year. The results
remained consistent with those reported in Table III. Further analysis of the effect
of AC meeting frequency tests the reported results. Whether the ?rm has the
recommended number of meetings rather than the maximum number of meetings is
relevant. It is not obvious that the maximum number of meetings re?ect a well
governed ?rm. When a ?rm is in crisis, the frequency of meetings is likely to
increase. As a sensitivity test, we include a dummy variable equal to 1 if the ?rm
holds up to four meetings, 0 otherwise, to consider this issue. However, the results
remain insigni?cant.
Effect of
governance
reforms
257
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
5. Conclusion
The association between ?rms’ corporate governance practices and earnings
management is examined in this study. The research involves two considerations.
First, whether speci?c corporate governance practices are associated with lower levels
of earnings management in 2000 or 2005. Second, whether improvements in speci?c
corporate governance practices between 2000 and 2005 are associated with lower levels
of earnings management. First, consistent with prior research, the research ?ndings
suggest that, both the level of board independence and AC independence improves the
quality of ?nancial reporting. In addition, the results of the study support the stream of
agency theory research that argues that increasing executive shareholdings imposes
greater risk on the agent and therefore provides the incentive to act opportunistically,
that is, to manage earnings. We failed to detect a signi?cant relationship between the
frequency of AC meetings and PACDA.
Second, the study shows that, subsequent to the reforms, board and AC
independence improved and the NACM increased signi?cantly. However, only changes
to board independence, is associated with lower levels of PACDA. Increasing the
independence or activity of the AC is not associated with PACDA. However, the
previously reported result demonstrates a signi?cantly negative association between
AC independence and PACDA, suggesting that AC independence is important in
detecting earnings management.
Complementing agency theory literature on the association between ownership and
earnings management, this research ?nds evidence that increasing executive share
ownership provides incentives to manipulate earnings regardless of governance
reforms. This result suggests that there should be limitations placed on the level of
executive director ownership to mitigate the incentives to manipulate earnings.
This study is subject to limitations. As the sample covers only two years of data, the
results may not be generalisable to different time periods. The sample is based on
companies that continue to operate from 2000 to 2005. Accordingly, delisted companies
and also bankrupt companies are not included in the sample set. Other proxies for
board and AC effectiveness, such as ?nancial literacy and responsibilities of board and
committee members, may show further signi?cant associations with earnings
management. These limitations provide fruitful avenues for future research.
Notes
1. As a consequence of CLERP 9, Subsection 232(2) of the Corporations Law was rewritten to
capture the ?duciary principles of a director and imposes both criminal and civil
consequences for a breach of that duty.
2. CLERP 9, Section 295A requires the CEO and CFO to sign a declaration stating that the
?nancial records have been properly maintained, they are prepared in accordance with
accounting standards and they present a true and fair view of the company’s ?nancial
standing. Subsequently, under Section 295(4)(e) directors must state that they have received
the ?nancial statements from the CEO and CFO and they have to provide necessary
information to ensure that ?nancial statements give a true and fair view of the ?nancial
position and performance under Sections 298 (1A) and 306 (2) (a) (b).
3. The model is estimated separately for each combination of the industry code (GICS) and year
to obtain industry-speci?c estimates of the coef?cients in the equation.
ARJ
21,3
258
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
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V
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R
S
I
T
Y
A
t
2
1
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7
2
4
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r
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2
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1
6
(
P
T
)
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Further reading
BRC (1999), Report and Recommendations of the Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees, NYSE, New York, NY.
Cooper, K. and Deo, H. (2005), “Recurring cycle of Australian corporate reforms: a never ending
story”, Journal of American Academy of Business, Vol. 17 No. 2, pp. 156-64.
Appendix. Calculation of performance-adjusted current discretionary accruals
(PACDA)
As suggested by Kothari et al. (2005) the cross-sectional PACDA are calculated by including the
lagged variable of ROA.
The parameters for calculation of expected current accruals (ECA) are estimated by using
the following equation:
TCA
it
AT
it21
¼ a
0
1
AT
it21
þ a
1
DREV
it
AT
it21
þ a
2
ðROA
it21
Þ þ 1
it
ðA1Þ
The ECA use the estimated parameters as follows:
ECA
it
AT
it21
¼ a
0
1
AT
it21
þ a
1
DREV
it
2DAR
it
AT
it21
þ a
2
ðROA
it21
Þ ðA2Þ
PACDA ¼ (A1)-(A2).
TCA ¼ total current accruals is net income (earnings before extraordinary items and
discontinued operations) plus depreciation and amortisation minus operating
cash ?ows for ?rm i in the year t.
DREV ¼ change in net revenue for ?rm i in the year t.
DAR ¼ change in accounts receivable for ?rm i in the year t.
ROA ¼ ratio of net income before extraordinary items to total assets for ?rm i in the
year t 2 1.
AT ¼ total assets for ?rm i in the year t.
e
it
¼ error term for ?rm i in year t.
PACDA ¼
TCA
it
AT
it21
2
ECA
it
AT
it21
Kothari et al. (2005) and Ashbaugh et al. (2003).
Corresponding author
Marion R. Hutchinson can be contacted at: [email protected]
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doc_856416141.pdf
The purpose of this study is to examine the impact of recent corporate governance
reforms on the association between governance practices and earnings management.
Accounting Research Journal
An investigation of the association between corporate governance, earnings
management and the effect of governance reforms
Marion R. Hutchinson Majella Percy Leyal Erkurtoglu
Article information:
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Marion R. Hutchinson Majella Percy Leyal Erkurtoglu, (2008),"An investigation of the association between
corporate governance, earnings management and the effect of governance reforms", Accounting Research
J ournal, Vol. 21 Iss 3 pp. 239 - 262
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Aninvestigation of the association
between corporate governance,
earnings management and the
effect of governance reforms
Marion R. Hutchinson and Majella Percy
School of Accountancy, Queensland University of Technology,
Brisbane, Australia, and
Leyal Erkurtoglu
Ernst and Young, Doha, Qatar
Abstract
Purpose – The purpose of this study is to examine the impact of recent corporate governance
reforms on the association between governance practices and earnings management.
Design/methodology/approach – This study examines the impact of corporate governance
reforms by using a ?rm?xed-effect, cross-sectional analysis of 200 ?rms listed on the Australian Stock
Exchange (ASX) for the ?nancial years ending in 2000 and 2005. This paper examines the association
between ?rms’ corporate governance practices and the quality of ?nancial reports as measured by the
magnitude of earnings management pre- and post-the governance reforms (CLERP 9 and ASX
Corporate Governance Council (CGC)).
Findings – The results of this study indicate that certain governance practices are important in
limiting earnings management. In particular, board independence and audit committee (AC)
independence, are associated with lower performance-adjusted discretionary accruals, one commonly
used measure of earnings management. However, increasing executive shareholdings provides
incentives to manage earnings.
Practical implications – This study is important to investors, academics and policy makers as it
demonstrates that governance reforms that encourage ?rms to adopt better governance practices
reduces the likelihood of earnings management.
Originality/value – There is limited research on the association between corporate governance
practices or the recent corporate governance reforms (ASX CGC Recommendations and CLERP 9) on
earnings management in Australia. This study extends the literature by demonstrating the impact of
recent corporate governance reforms on board independence, AC effectiveness and executive directors’
shareholding and the association with earnings management.
Keywords Earnings, Corporate governance, Share ownership schemes
Paper type Research paper
1. Introduction
Corporate governance controls are designed to encourage the ef?cient use of company
resources and promote accountability for the stewardship of resources used by managers
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors would like to thank the editor and an anonymous reviewer for their helpful
comments. The comments of the participants of the Paci?c Basin Finance Accounting and
Management Conference, Brisbane 2008 are also gratefully acknowledged.
Effect of
governance
reforms
239
Accounting Research Journal
Vol. 21 No. 3, 2008
pp. 239-262
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610810922495
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(Sir Adrian Cadbury, 2000). The recent global spate of companies using fraudulent
accounting methods to mask declining ?nancial conditions has attracted the attention of
regulators and accountants. The US Government responded to the corporate scandals
with the Sarbanes-Oxley Act (SOX) in January 2002. The SOXis designed to reviewdated
legislative audit requirements and applies to publicly listed companies. The Australian
response to these corporate indiscretions is the Australian Stock Exchange (ASX)
Corporate Governance Best Practice Recommendations and the Corporate LawEconomic
Reform Program (Audit Reform and Corporate Disclosure) Act (known as CLERP 9).
The ASX Corporate Governance Council (CGC) released its Principles of Good
Corporate Governance (PGC) and Best Practice Recommendations (BPR) in March
2003. It includes 28 (optional) recommendations relating to ten corporate governance
principles. The adoption rate of the recommendations is very promising. The average
adoption rate for all 28 recommendations was 74 percent in 2005 (ASX, 2006). The
underlying objective of CLERP 9, which became law in Australia in 2004, is to promote
transparency, to strengthen the regulatory framework in the key areas of corporate
accountability and protection of shareholder rights. CLERP 9 introduced civil liability
in the Corporations Act for breaches of the ASX continuous disclosure requirements
and extends liability to directors and executives[1]. The civil liability assigned to board
members is designed to encourage listed companies to increase the ?nancial literacy
and independence of audit committee (AC) members.
This study is motivated bytwo considerations. First, are speci?c corporate governance
practices associated with lower levels of earnings management in 2000 or 2005? Second,
are improvements in speci?c corporate governance practices between 2000 and 2005
associated with lower levels of earnings management? We examine the impact of
corporate governance reforms by examining the association between ?rms’ corporate
governance practices and the quality of their ?nancial reports as measured by the
magnitude of earnings management (proxied by performance-adjusted current
discretional accruals (PACDA)) pre- and post-the governance reforms (CLERP 9 and
ASXCGC). The focus of our researchis onboardandACeffectiveness whichencompasses
greater board and AC independence. Given that the ASX CGC recommendations and
CLERP 9 are designed to improve the quality of ?nancial reporting, we would expect to
observe a signi?cant reduction in earnings management in ?rms that change their
corporate governance practices to comply with the recommendations.
This paper contributes to the research on corporate governance in several ways.
There is an extensive body of literature on the impact of corporate governance
practices on various outcomes, such as, ?rm performance, the value relevance of
earnings, earnings management and the impact of regulation. The vast majority of the
research examines the effects of corporate governance practices and regulations in the
USA and the UK. This notion has not been fully explored in the Australian context, a
market similar but different in certain aspects. In Australia, expected litigation costs
are relatively low and the provision of forward-looking accounting information is
voluntary. There is limited research on the association between corporate governance
practices or the recent corporate governance reforms (ASX CGC Recommendations and
CLERP 9) on earnings management in Australia.
The results of the study of the corporate governance practices of 200 Australian listed
?rms indicate that certain governance practices are important in limiting earnings
management. The results of this study demonstrate that the association between
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corporate governance practices and earnings management is only signi?cant post the
governance reforms in the year 2005. Board independence and AC independence are
negatively associated with the level of PACDA, indicating lower levels of earnings
management, while executive shareholdings are positively associated with PACDA.
However, there is no signi?cant relationship between the number of audit committee
meetings (NACM) and PACDA. Following governance reforms, board and AC
independence improved, and AC meeting frequency increased signi?cantly. However,
these changes are not necessarily associated with less earnings management. The results
of this study show that improvements in board independence are associated with
decreases inPACDA, while increasingACactivityis not associatedwithPACDA. There is
no signi?cant association with earnings management for ?rms that increased AC
independence following the governance reforms. However, it should be noted that AC
independence is signi?cantly associated with lower PACDA in 2005. There is no
signi?cant reduction in executive share ownership post the reforms and the positive and
signi?cant association between executive share ownership and PACDA remains.
2. Background and hypotheses development
According to agency theory, the separation between ownership and control may lead to
self-interested actions by managers (Jensen and Meckling, 1976). When con?icts exist
between management and stakeholders, the value of the ?rm is not maximised and the
difference between the theoretical maximumvalue of the ?rmand the actual value of the
?rm is attributed to agency costs (Palliam and Shalhoub, 2003). Prior research provides
evidence of myriad incentives that motivate managers to manage earnings, such as the
quality of the audit ?rm (Davidson III et al., 2004; Myung and Taewoo, 2004), the
distribution of ownership (Hsu and Koh, 2005; Koh, 2003), CEO’s with dual leadership
positions (Davidson et al., 2004), the adoption of International Financial Reporting
Standards (IFRS) (Tendeloo and Vanstraelen, 2005), management share ownership
(Bergstresser and Philippon, 2006), tax incentives (Dhaliwal et al., 2004) and hiring an
executive froma company’s external audit ?rm(Geiger et al., 2005). Myung and Taewoo
(2004) suggest managers adjust discretionary accruals to increase current-period
earnings before they sell their own ?rms’ shares. The majority of this research argues
that earnings manipulation is concealing the truth about earnings and has potentially
negative effects on stakeholders’ interests. This potential con?ict of interest leads to the
need to monitor managers’ behaviour in order to protect shareholders’ rights.
Corporate governance provides a framework to ensure suppliers of corporate
?nance achieve a return on their investment (Shleifer and Vishny, 1997). The board of
directors and ACs are the two main internal corporate governance mechanisms
established to monitor managers’ behaviour and also ensure the reliability of ?nancial
reporting. Extensive research has been conducted relating to the association between
earnings management and certain corporate governance practices, including board
and AC composition (Agrawal and Chadha, 2005; Beasley, 1996; Davidson et al., 2005;
Klein, 2002; Peasnell et al., 2005; Vafeas, 2005). On balance, the majority of this research
has found that the probability of earnings management is lower in companies with an
independent board or an effective AC.
In order to align agents’ incentives with interests of principals, diverse governance
mechanisms are built into the agency contracts (Fama, 1980; Fama and Jensen, 1983).
The role of regulation in this process can be explained by referring to agency theory.
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Regulation attempts to overcome information asymmetry between managers and
shareholders and protect each party’s contractual rights. Owing to incomplete
contracts, regulation (e.g. ASX CGC and CLERP 9) attempts to protect stakeholders by
mandating corporate governance practices. Regulations smooth the progress of the
efforts of contracting parties to maximise the joint gains (the contractual surplus) from
transactions (Schwartz and Scott, 2003). Changes in regulations comprise a source of
experiments (Hermalin and Weisbach, 1991) and for this reason our study examines
the impact of recent corporate governance reforms on the quality of ?nancial reporting.
Financial report preparers in Australia have recently experienced changes to their
roles and responsibilities. Some changes have arisen from the decision to adopt IFRS.
Other changes have arisen in response to events in the business environment such as
initiatives to improve auditors’ independence (Brown and Tarca, 2005). The main focus
of CLERP9 can be classi?ed into two parts: ?rst, accounting and audit reform, especially
aiming to improve the independence of auditors and emphasise the board’s
accountability for the ?nancial report; and second, enhancing corporate disclosure.
Corporate governance is no longer left to be accomplishedthrough voluntary disclosures
as CLERP 9 is enforced through a regime of rules that carry criminal penalties. The
Corporations Act enforces continuous reporting obligations on companies that are
disclosing entities, listed companies and some unlisted public companies with more than
100 shareholders, when certain material events take place regarding the company’s
operations or ?nancial position (Hanrahan et al., 2004). The Corporations Act is not only
concerned with the disclosure of information, but also with ensuring (as much as
possible) the quality of the information (Hanrahan et al., 2004). If regulation is effective
and enhanced corporate disclosure decreases the information asymmetry between
managers and shareholders, then earnings quality should improve.
2.1 Board of directors
The board of directors does not bear the major share of the wealth effects of their
decisions (Fama and Jensen, 1983) and exists to prevent management from pursuing
their personal objectives at the expense of the stakeholders (Fama, 1980). The
composition of a board plays a crucial role in corporate governance mechanisms.
The board must ensure the integrity of the corporation’s accounting and ?nancial
reporting systems. These systems include monitoring risk, ?nancial control, and
compliance with regulations. According to the New York Stock Exchange (NYSE)
Corporate Accountability and Listing Standards Committee (NYSE, 2002), an effective
board of directors should ensure the validity of the accounting choices made by
management and the ?nancial consequences of such decisions (Davidson et al., 2005).
Prior research has found that the board of directors can play an important role in
increasing the quality of ?nancial reporting. According to Beasley (1996), as the
number of independent directors on the board increases, the likelihood of ?nancial
reporting fraud decreases. Dechow et al. (1996) suggest that ?rms manipulating
earnings are more likely to have boards of directors dominated by management. The
probability of earnings manipulation is lower in companies with boards or ACs that
have an independent director with ?nancial expertise (Agrawal and Chadha, 2005).
Persons (2006) argues that the higher the independence of directors, the lower the
likelihood of non-?nancial reporting fraud (i.e. fraud against customers and
governments, and violation of regulations other than ?nancial reporting).
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Chen and Jaggi (2000) ?nd that the proportion of independent directors on corporate
boards is positively associated with the comprehensiveness of ?nancial disclosures.
Klein (2002) found a negative relationship between board independence and abnormal
accruals, a measure of earnings management. In contrast, Fama and Jensen (1983)
argue that ?rms bene?t from having insiders on the board given that senior managers
bring in expertise and improve the decision-making process. In addition, Be´dard et al.
(2004) fail to ?nd an association between the level of board independence and earnings
quality with respect to US ?rms.
The research in this area generally suggests that there is a negative association
between the level of board independence and earnings management which leads to the
following hypothesis:
H1a. There is a negative association between the level of board independence and
earnings management.
2.1.1 The effect of regulation on the association between earnings management and
the board of directors. Do corporate governance reforms and the effectiveness of the
governance mechanisms prevent management’s manipulation of earnings? In the USA,
SOX was followed by other corporate reforms such as those by the NYSE and the
National Association of Securities Dealers, and American Stock Exchange reforms. As
a result of these reforms, listed companies in the USA must have a majority of outside
independent directors (Petra, 2006).
Petra (2006), examines the actual governance structures of Enron, WorldCom, and
Global Crossing during the years of their accounting scandals. The proportions of
outside independent directors on the boards of those companies during that period
were: 50 to 55 percent for Enron Corp., 40 to 50 percent for WorldCom Inc. and 25 to
45 percent for Global Crossing Ltd Despite the presence of the outside independent
directors, these companies suffered collapses in their corporate governance systems
(Petra, 2006).
If we consider Australian examples before their collapses, the board of HIH
Insurance Limited consisted of seven directors of which ?ve were non-executive
directors (71 percent) and the board of One.Tel Limited consisted of nine directors of
which ?ve were non-executive directors (56 percent). From the previous examples of
corporate collapses, it is hard to say that new reforms will prevent the reoccurrence
of the corporate collapses and improve earnings management. If those who are
charged with governance only focus on the form, that is, the appearance of
compliance with the corporate reforms, it is be highly likely that these reforms will
not have any positive effect on the quality of ?nancial reporting. The directors need
to focus on the substance of the reforms to improve the quality of ?nancial
reporting.
If regulation does have a positive effect on board of directors’ behaviour, then we
expect that, for ?rms that change the board to be more independent, there will be a
signi?cantly negative association between the proportion of non-executive directors on
the board and earnings management. We do not expect to ?nd any signi?cant
association for ?rms that do not change their board structure, either because the board
is already dominated by independent directors, or because the practice is not
mandatory. The previous discussion leads to the following hypothesis:
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H1b. There is a negative association between board independence and earnings
management for the ?rms that increase board independence subsequent to
governance reforms.
2.2 Executive directors’ share ownership
According to agency theory, increasing the level of executive share ownership might
reduce the amount of owner/manager con?ict leading to clearer alignment of the goals of
management and shareholders (Jensen and Meckling, 1976). This goal alignment
argument suggests that ownership in the ?rm ensures managers will undertake
risk-bearing strategies that will increase share value. However, when the incentives of
managers are based on their companies’ ?nancial performance, it may be in their
self-interest to give the appearance of better performance through earnings management.
The combination of management’s discretion over reported earnings and the effect these
earnings have ontheir future wealthleads to a potential agency problem. Bergstresser and
Philippon (2006), suggest that the use of discretionary accruals in manipulating earnings
is much stronger in ?rms where the CEO’s potential total compensation is linked to the
value of stock and option holdings. Further research (Cheng and War?eld, 2005; Park and
Park, 2003; Richardson et al., 2003) suggests that managers’ equity holdings is associated
with earnings management based on the assumption that managed earnings will be
mis-priced and managers can take advantage of the mis-pricing by selling shares or
exercising options (Dechow and Schrand, 2004).
Agency theorists suggest that executive share ownership can have undesirable
risk-bearing properties and that managerial share ownership should be viewed with
caution (Beatty and Zajac, 1994). According to formal agency theory, substantial
managerial share ownership may increase the risk borne by executives. Managers are
more likely to undertake high-risk projects and manipulate earnings in order to
increase their own wealth. Therefore, increasing the level of executive directors’
ownership further erodes the independence of the board as high levels of ownership
can provide incentives for executive directors to manipulate earnings to increase their
wealth. The preceding discussion suggests that there is a positive relationship between
increasing executive directors’ share ownership and earnings management leading to
the following hypothesis:
H2a. There is a positive association between executive directors’ share ownership
and earnings management.
2.2.1 The effect of regulation on the association between the executive directors’ share
ownership and earnings management. Since enactment of CLERP 9, executive directors
(CEOs and CFOs) are required to certify to the board of directors that the ?nancial
statements are in accordance with the Corporations Act and accounting standards[2].
The penalty for directors for trading while insolvent and non-payment of debts has
increased from10 to 20 years. Executive directors’ legal responsibilities are extended in
terms of presenting the true and fair view of the companies. Under the strengthened
regulations and codes, earnings manipulation might have more serious consequences
than previously. For executive directors to increase their wealth by earnings
management is now more risky and thus earnings manipulation is not as appealing.
Under this condition, executives might reduce their ownership stake and try to ?nd
some other ways to increase their wealth. Contrary to agency theory, decreasing the
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level of executive share ownership might reduce the amount of owner/manager con?ict
(Jensen and Meckling, 1976).
If regulation does have a positive effect on the extent of share ownership of
executive directors, then we expect that, for ?rms that reduce their executive share
holdings, there will be a reduction in earnings management. Thus, there will be a
signi?cantly negative association between the executive directors’ share ownership
and discretionary accruals subsequent to the reforms. Alternatively, for ?rms where
the ownership of executive directors increased post regulation, we expect to ?nd a
positive association with earnings management. We do not expect to ?nd any
signi?cant association for ?rms that do not change their executive shareholdings,
either because the executive shareholdings are at a low level, or because the practice is
not mandatory. The previous discussion leads to the following hypothesis:
H2b. There is a positive (negative) association between increasing (decreasing) the
level of executive directors’ share ownership and earnings management
subsequent to governance reforms.
2.3 AC effectiveness and earnings management
According to agency theory, shareholders require protection because agents
(management) may not always act in the best interests of the principals
(shareholders) (Fama, 1980; Fama and Jensen, 1983; Jensen and Meckling, 1976). In
order to overcome this problem, the board undertakes an oversight role that involves
monitoring the CEO and other executive managers, approving the corporation’s
strategy, preparing the ?nancial statements and monitoring the control system(DeZoort
et al., 2002). To improve ef?ciency, the board delegates some of its responsibilities to
board committees. The ACis one of the special committees established bythe boardwith
ninety percent of Australian listed companies having an AC (Hanrahan et al., 2004).
As the AC is an extension of the full board the AC is the ultimate monitor of the ?nancial
reporting process. The primary purpose of ACs is to ensure credible ?nancial reports
(Treadway Commission, 1987). Accordingly, regulatory bodies and researchers are
interested in the features of the AC that will improve its ef?ciency. The characteristics
associated with AC effectiveness in this study are AC independence and activity.
The characteristics of the AC impact on the ef?ciency of ACs in performing their
responsibilities (Abbott et al., 2003). Despite their responsibilities, executive directors
on the ACs might still have the motivation to manipulate earnings or conceal earnings
management to hide a deteriorating ?nancial position. However, independent directors
are not likely to have incentives to manipulate earnings as their income is not reliant on
the ?rm’s performance. Accordingly, it is expected that independent ACs would play a
positive role in reducing the probability of earnings management.
However, prior researchhas foundmixed results on the associationbetweenthe level of
AC independence and earnings management. Some research has found a negative
association between AC independence and earnings management (Be´dard et al., 2004;
Klein, 2002; Peasnell et al., 2006) while other research has failed to ?nd any signi?cant
associationbetweenACindependence andearnings management (Peasnell et al., 2005; Xie
et al., 2003). Research has found that greater AC independence is associated with better
reporting quality and a reduced likelihood of fraud (McMullen and Raghundan, 1996).
Regarding, AC diligence; it is argued that inactive ACs are not likely to supervise
management effectively. Prior research and regulatory bodies suggest that ACs should
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hold a minimum of three or four meetings a year (IIA, 1991). Accordingly, it is expected
that active ACs will play a positive role in reducing the probability of earnings
management. Prior research has also found a negative association between the
frequency of AC meetings and earnings management (Klein, 2002; Xie et al., 2003).
McMullen and Raghundan (1996) suggest that increasing the frequency of AC
meetings reduces the likelihood of enforcement action by the Securities and Exchange
Commission in the USA. The preceding discussion leads to the following hypothesis:
H3a. There is a negative association between AC independence and earnings
management.
H3b. There is a negative association between AC meeting frequency and earnings
management.
2.3.1 The effect of regulation on the association between the AC effectiveness and
earnings management. Withthe issuance of the CLERP9 inAustralia, ACresponsibilities
and authority have also increased. ACs are now expected to ensure the integrity of the
?nancial reports and to be more effective in terms of their supervisory roles than
previously. However, HIH Insurance Limited and One.Tel Limited both had ACs
consisting of a majority of non-executive directors before they collapsed. In addition, the
ACmembers were meetingregularly. The UScorporate collapses of Enron, Worldcomand
Global Crossing, demonstrated governance practices of ACs with a minimum of three
members and at least 60 percent of the members were independent (Petra, 2006). That is,
these companies had the appearance of compliance with the regulations.
It is dif?cult to conclude that improvements in the ef?ciency of the AC will
de?nitely decrease earnings management. However, these improvements might still
have positive effects as suggested in previous research (Klein, 2002; Peasnell et al.,
2006; Xie et al., 2003). Braiotta and Zhou (2006) ?nd that ?rms that change their AC
structure are associated with decreased earnings management.
If regulation does have a positive effect on AC behaviour, then we expect to ?nd a
signi?cant negative association between corporate governance practices and
discretionary accruals for ?rms with more effective ACs. That is, ?rms that increase
the independence of the AC and/or increase the frequency of the AC meetings. In this
paper, both these practices are regarded as improving the effectiveness of the AC. The
previous discussion leads to the following hypothesis:
H3c. There is a negative association between AC independence and earnings
management for ?rms increasing AC independence following the governance
reforms of the ASX CGC and CLERP 9.
H3d. There is a negative association between AC meeting frequency and earnings
management for ?rms increasing the NACM following the governance
reforms of the ASX CGC and CLERP 9.
3. Research method
The present study involves a ?rm?xed-effect, cross-sectional analysis of 200 ?rms listed
on the ASX for the ?nancial year ending in 2000 and 2005. Individual models are used to
test the hypotheses. The models regress the absolute value of performance-adjusted
current discretionary accruals (PACDA) on a set of governance and control variables.
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3.1 Sample selection criteria
The sample consists of 200 listed companies selected for this research for the years
2000 and 2005 in order to make a reliable comparison of the effects of corporate
governance best practice recommendations. The original data set consisted of 388 top
500 ?rms for the year 2000. The ?nal sample of 200 ?rms is derived from the ?rms that
remained listed in 2005 and also for which annual reports are available either on the
Connect4 database, on company websites or the DatAnalysis database. Information
regarding boards of directors and AC characteristics is obtained fromdisclosures made
in company annual reports.
The years 2000 and 2005 are chosen to ascertain if corporate governance reforms
impact the corporate governance practices of ?rms. After the demise of the largest
global audit company, Arthur Andersen, in 2002, corporate governance became a much
more signi?cant issue than prior to 2002.
Two signi?cant corporate governance reforms took place between 2000 and 2005. In
2003, the CGC released the PGC and BPR although it was not mandatory to comply
with these recommendations. However, it was a crucial step to improve corporate
governance practices. In 2004, CLERP 9 became law in Australia and directors’
liabilities increased. This research investigates the impact of corporate governance
reforms on the quality of ?nancial reporting by comparing governance practices of
?rms in the years 2000 and 2005.
The following model is developed to test the hypotheses. Separate regressions are
run for each independent variable to test the association with the dependent variable,
PACDA. Finally, the complete model is tested to determine the relative signi?cance of
the governance variables on PACDA. The change model tests the association between
the changes in governance practices and PACDA:
PACDA¼a
0
þa
1
PBNEDþa
2
PANEDþa
3
NACMþa
4
EDsSHARES
þa
5
SIZEþa
6
LOSSþa
7
GROWTHþa
8
GEARINGþa
9
ROAþe
ð1Þ
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0
þ a
1
DIFPBNED þ a
2
DIFPANED þ a
3
DIFNACM
þ a
4
DIFEDs SHARES þ a
5
SIZE þ a
6
LOSS
þ a
7
GROWTH þ a
8
GEARING þ a
9
ROA þ e
ð2Þ
Where:
Dependent variable:
PACDA ¼ absolute value of performance-adjusted current discretionary
accruals based on Kothari et al. (2005).
Independent variables:
PBNED (2) ¼ proportion of non-executive board directors to total
directors on the board.
DIFPBNED (2) ¼ difference in the proportion of non-executive board
directors calculated as the proportion of non-executive
directors on the board in 2005 less the proportion of
non-executive directors on the board in 2000.
PANED (2) ¼ percentage of non-executive directors on the AC.
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DIFPANED (2) ¼ difference in the proportion of non-executive audit
committee directors calculated as the proportion of
non-executive directors on the AC in 2005 less the
proportion of non-executive directors on the AC in 2000.
NACM (2) ¼ number of audit committee meetings per annum.
DIFFNACM (2) ¼ difference in the number of audit committee meetings
per annum in 2005 compared with 2000.
EDs SHARES (þ) ¼ the total number of ordinary shares held by the
executive directors divided by the total number of issued
ordinary shares.
DIFEDs SHARES (þ) ¼ difference in the total number of ordinary shares held by
the executive directors divided by the total number of
issued ordinary shares in 2005 compared with 2000.
Control Variables:
SIZE (þ) ¼ natural log of total assets in million dollars.
LOSS (?) ¼ dummy variable of 1 if income is , 0; 0: otherwise.
GROWTH (?) ¼ ratio of the ?rm’s market value of common equity to book value
of common equity at the beginning of the year.
GEARING (?) ¼ (Short term debt þ long term debt 2 cash)/ shareholders
equity.
ROA (?) ¼ Earnings before interest/(total assets less outside equity
interests).
3.2 Dependent variable
The dependent variable, earnings management, is proxied by PACDA. Accruals can be
decomposed into six categories based on:
.
managerial control: discretionary (unexpected or abnormal) and
non-discretionary;
.
the time period: current and long-term; and
.
performance: performance adjusted and not performance adjusted.
Persistence and permanence alone are not good indicators of earnings quality as
managers are motivated by these characteristics to present an image of themselves as
good managers. Dechow and Schrand (2004) suggest that large accruals (of either sign)
indicate volatility and low-quality earnings as accruals are likely to contain estimation
errors and the current earnings ?gure is unlikely to re?ect the company’s current
operating performance, future operating performance or measure ?rm value. Current
discretionary accruals are adjustments regarding short-term assets and liabilities.
According to recent research, current discretionary accruals are more vulnerable to
management’s earnings manipulation (Ashbaugh et al., 2003). Therefore, the analysis
is based on current discretionary accruals rather than total accruals as in prior research
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(Oei et al., 2008). Ayers et al. (2006) suggest that the positive association between
discretionary accruals and earnings intensi?es around the actual pro?t benchmark.
Given the importance of the ?rm’s growth rate (Kothari et al., 2005) in calculating
current discretionary accruals, the company’s performance is controlled for in the
model. The dependent variable is termed “PACDA.” This measure is adjusted for
performance by including a lagged return on asset (ROA). It is predicted that
improvements in corporate governance practices lead to an improvement in the quality
of the companies’ earnings ?gure, as proxied by the level of absolute discretionary
accruals. Please see the Appendix for the PACDA calculation.
3.3 Independent variables
The board’s ability to act as an effective monitoring mechanism depends on its
independence from management (Beasley, 1996; Davidson et al., 2005; Dechow et al.,
1996). Board independence is measured as the proportion of non-executive directors on
the board. The signi?cant role of non-executive directors in monitoring management is
also documented by various international and local guidelines (ASX, 2003; Cadbury
Committee, Sir Adrian Cadbury, 1992; CLERP 9, 2004; NYSE, 2002). A negative
association is expected between the proportion of non-executive directors and PACDA
(Klein, 2002). Vafeas (2005) ?nds that more appropriately structured ACs and boards
produce higher-quality earnings information.
In this study, AC effectiveness is proxied by two characteristics, independence and
activity. Prior research argues that the ability of the AC to detect earnings
manipulation is associated with the level of AC independence (Be´dard et al., 2004;
Klein, 2002; McMullen and Raghundan, 1996; Peasnell et al., 2006). Regarding AC
activity, prior research argues that the effectiveness of an AC is also dependent on the
frequency of meetings (McMullen and Raghundan, 1996). In order to ensure the
appropriateness of the ?nancial reporting process, AC members should meet regularly
(McMullen and Raghundan, 1996). Consistent with this argument, Xie et al. (2003) ?nd
that the frequency of AC meetings is negatively associated with earnings management.
We expect that the proportion of non-executive directors on the board and ACs and the
frequency of AC meetings to be negatively associated with PACDA, consistent with
prior research. We do not consider the role of the independence of the chair of the board
or the AC in earnings management in this study. As the majority of ?rms in Australia
have an independent board and/or AC chair there is little variation between ?rms
suf?cient for statistical analysis.
Agency theory indicates that executive share ownership can act as an incentive to
reduce the underlying agency problem of separation of ownership from control and
increase the welfare of the shareholders. However, a large body of literature suggests
that extensive stock ownership can motivate the executives to behave
opportunistically and in?ate stock values arti?cially by violating reporting
standards or using fraudulent reporting (Beasley, 1996; War?eld et al., 1995).
A negative relationship is expected between earnings management (PACDA) and
the proxies in this study for good corporate governance practices: PBNED, PANED,
and the NACM. However, a positive relationship is expected between earnings
management and the percentage of share ownership of executive directors, since this
practice may compromise directors’ independence.
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The changes in the governance variables between 2000 and 2005 are regressed
against PACDA to investigate the effects of recent corporate governance reforms.
A negative relationship between the governance variables and PACDA is expected for
?rms that increase the proportion of non-executive directors on board (DIFPBNED)
and the AC (DIFPANED) and the frequency of audit committee meetings (NACM).
A positive relationship is expected between the changes in executive director’s
ownership (DIFEDs SHARES) and PACDA as increases in ownership provide greater
incentives to manipulate earnings.
3.4 Control variables
Firm size affects earnings manipulation (Dechow and Dichev, 2002). Dechow and
Dichev (2002) ?nd that accrual quality is positively related to ?rm size. Since large
?rms have more stable and predictable operations and have more diversi?ed business
activities they have fewer and smaller estimation errors. Size is expected to be
negatively associated with the management of earnings as large ?rms are more likely
to report higher quality earnings, primarily due to political pressure and investors’
scrutiny (War?eld et al., 1995). Size is measured as the natural logarithm of total assets
as at June 30.
The following variables are included in the model to account for the impact on
earnings management. The direction of the relationship is not predicted due to the
con?icting results of prior research. Gearing is included as a control variable as it is
expected that debtors of highly leveraged ?rms are concerned when ?rms are
approaching ?nancial distress and are therefore more likely to monitor earnings
closely. On the other hand, ?rms with high leverage are motivated to manipulate
earnings to meet debt covenants. According to Saleh and Ahmed (2005), distressed
?rms manipulate earnings downward and managers adopt income-decreasing
accruals during debt renegotiation. Gearing is measured as the ratio of
(short –term debt þ long–term debt 2cash) to shareholders equity.
Growth opportunities of the ?rm are likely to have an impact on the quality of the
earnings ?gure. The ratio of market value of common equity to book value of common
equity is used to capture the ?rm’s growth opportunities (Smith and Watts, 1992).
Firms with low-growth opportunities have limited investment opportunities and
accordingly have high free cash ?ows and excess cash. Subsequently, managers
working for low-growth ?rms can act opportunistically by means of excessive
perquisite consumption, hiding non-optimal expenditures, misappropriation of assets
and salary enhancement (Jensen, 1986). Further, ?rms growing rapidly may have
internal control problems (Kinney and MacDaniel, 1989). Companies with high-growth
rates may have problems operating ef?cient ACs and this might exacerbate the
practice of earnings management. Growth is measured as the ratio of market
capitalisation on the last day of the company’s ?nancial year to shareholders equity per
share (Price to Book Value).
ROAs is included as a control variable as it is expected that ?rms with lower
performance tend to manipulate earnings ?gures and this should be positively
associated with earnings management. ROAs is measured as the ratio of earnings
before interest to total assets less outside equity interests.
Dechow and Dichev (2002) ?nd that accrual quality is negatively related with loss
incidence. Management is more likely to manipulate the earnings ?gure in cases of
ARJ
21,3
250
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
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S
I
T
Y
A
t
2
1
:
0
7
2
4
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a
n
u
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r
y
2
0
1
6
(
P
T
)
?nancial distress. Consistent with this argument, managers are more likely to make
income-increasing abnormal accruals to avoid reporting losses and earnings reductions
(Peasnell et al., 2005). Firms with an accounting loss are included as a dummy variable,
equal to “1” if the ?rm experienced a loss during the ?scal year and “0” otherwise.
Finally, industry effects are controlled for in the calculation of PACDA[3].
4. Results and discussion
The descriptive statistics in Table I demonstrate the following for the sample of 200
?rms in 2000 and 2005. On average, executive directors in 2005 own 5 percent (6
percent in 2000) of the total issued shares with a maximum of 67 percent (62 percent in
2000) and a minimum of zero percent. On average, 75 percent (72 percent in 2000) of the
directors on boards and 94 percent (84 percent in 2000) of the directors on ACs
are non-executive directors. There are also some companies which have no
non-executive directors on their committees and some companies with 100 percent
non-executive directors on their committees. On average, ACs in 2005 hold 3.6 (2.7 in
2000) meetings in a ?nancial year.
Individual t-tests of the differences of the means are reported in Table I to determine
the signi?cance of the differences between the years 2000 and 2005. There is a
signi?cant difference in the mean of the proportion of non-executive directors on the
board ( p ¼ 0.013) and on the AC of nearly 10 percent ( p ¼ 0.000). This result suggests
that governance reforms have been effective in increasing board and AC independence.
There are signi?cant differences in the mean of the NACM between 2000 and 2005
( p ¼ 0.00). Recent reforms are effective in increasing the NACM by nearly one extra
AC meeting per year. However, there is no signi?cant reduction in executive director
ownership between 2000 and 2005.
The Pearson’s Correlation Matrix presented in Table II shows that the
independent variables, proportion of non-executive directors on the board and AC
and NACM, are negatively associated with PACDA while executive directors’
ownership is positively correlated with PACDA. The negative correlation between
the proportion of non-executive directors on the board and AC and PACDA
supports the argument that as the number of independent directors on the board
and AC increases, the credibility of the ?nancial reporting improves (Beasley, 1996;
Be´dard et al., 2004; Chen and Jaggi, 2000; Persons, 2006). The NACM is negatively
and signi?cantly correlated with PACDA. This result supports the argument that a
more active AC is associated with less-earnings management (Xie et al., 2003; Klein,
2002; McMullen and Raghundan, 1996). The results of the Pearson’s Correlation
Matrix support the notion that executive share ownership should be viewed with
caution since it might create opportunistic incentives for managers (Beatty and
Zajac, 1994; Bergstresser and Philippon, 2006). Table II, Panel B, reports the
correlations for the differences in board and AC independence, AC meetings and
executive directors’ shareholdings.
Table III Panel A reports the results of testing the association between the
governance variables and PACDA in the year 2000, before the governance reforms,
and 2005, after the governance reforms. The results of testing H1a suggest that the
proportion of non-executive directors on the board is negatively and signi?cantly
related to PACDA in 2005. The model explains 29.3 percent of the variability in
PACDA for the year 2005, and shows that the proportion of non-executive directors is
Effect of
governance
reforms
251
D
o
w
n
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a
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N
o
t
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s
:
P
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a
b
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a
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t
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a
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a
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a
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s
b
a
s
e
d
o
n
K
o
t
h
a
r
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e
t
a
l
.
(
2
0
0
5
)
;
P
B
N
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D
,
p
e
r
c
e
n
t
a
g
e
o
f
N
o
n
e
x
e
c
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t
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o
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t
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a
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d
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t
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s
o
n
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e
b
o
a
r
d
;
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A
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,
p
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r
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e
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m
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(
A
C
)
;
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,
n
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s
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a
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;
E
D
s
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,
t
h
e
t
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f
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d
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n
a
r
y
s
h
a
r
e
s
;
S
I
Z
E
,
n
a
t
u
r
a
l
l
o
g
o
f
t
o
t
a
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a
s
s
e
t
s
i
n
m
i
l
l
i
o
n
d
o
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a
r
s
,
L
O
S
S
,
d
u
m
m
y
v
a
r
i
a
b
l
e
a
s
:
1
:
i
n
c
o
m
e
i
s
,
0
;
0
:
o
t
h
e
r
w
i
s
e
.
G
R
O
W
T
H
,
r
a
t
i
o
o
f
t
h
e
?
r
m
’
s
m
a
r
k
e
t
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
t
o
b
o
o
k
v
a
l
u
e
o
f
c
o
m
m
o
n
e
q
u
i
t
y
a
t
t
h
e
b
e
g
i
n
n
i
n
g
o
f
t
h
e
y
e
a
r
.
G
E
A
R
I
N
G
,
ð
S
h
o
r
t
t
e
r
m
d
e
b
t
þ
l
o
n
g
t
e
r
m
d
e
b
t
2
c
a
s
h
Þ
=
s
h
a
r
e
h
o
l
d
e
r
s
e
q
u
i
t
y
;
R
O
A
,
e
a
r
n
i
n
g
s
b
e
f
o
r
e
i
n
t
e
r
e
s
t
=
ð
t
o
t
a
l
a
s
s
e
t
s
l
e
s
s
o
u
t
s
i
d
e
e
q
u
i
t
y
i
n
t
e
r
e
s
t
s
Þ
Table I.
Descriptive statistics
(N ¼ 200)
ARJ
21,3
252
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
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Y
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N
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A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
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2
0
1
6
(
P
T
)
P
A
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A
P
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s
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A
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e
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(
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¼
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)
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0
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N
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s
:
C
o
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l
a
t
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g
n
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0
5
a
n
d
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0
1
l
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v
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l
s
(
t
w
o
-
t
a
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d
)
,
r
e
s
p
e
c
t
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l
y
.
P
A
C
D
A
,
a
b
s
o
l
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t
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v
a
l
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f
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m
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a
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u
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d
c
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t
d
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t
i
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a
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y
a
c
c
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a
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e
d
o
n
K
o
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h
a
r
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e
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a
l
.
(
2
0
0
5
)
;
P
B
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
N
o
n
-
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x
e
c
u
t
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v
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d
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r
e
c
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t
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a
l
d
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c
t
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o
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t
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e
b
o
a
r
d
;
P
A
N
E
D
,
p
e
r
c
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t
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m
m
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e
(
A
C
)
;
N
A
C
M
,
n
u
m
b
e
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o
f
a
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d
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t
c
o
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m
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E
D
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d
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a
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y
s
h
a
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s
;
S
I
Z
E
,
n
a
t
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r
a
l
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a
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m
i
l
l
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d
o
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l
a
r
s
;
L
O
S
S
,
d
u
m
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y
v
a
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a
b
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s
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1
:
i
n
c
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m
e
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s
,
0
;
0
:
o
t
h
e
r
w
i
s
e
.
G
R
O
W
T
H
,
r
a
t
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o
f
t
h
e
?
r
m
’
s
m
a
r
k
e
t
v
a
l
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f
c
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m
m
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e
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b
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k
v
a
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c
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m
m
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q
u
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A
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N
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,
ð
s
h
o
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t
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t
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l
o
n
g
t
e
r
m
d
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b
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2
c
a
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h
Þ
=
s
h
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l
d
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e
q
u
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t
y
;
R
O
A
,
e
a
r
n
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n
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s
b
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f
o
r
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i
n
t
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s
t
=
ð
t
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t
a
l
a
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t
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u
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e
s
t
s
Þ
;
Y
E
A
R
,
d
u
m
m
y
v
a
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a
b
l
e
,
1
i
f
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e
a
r
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s
2
0
0
0
;
0
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f
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e
a
r
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s
2
0
0
5
;
D
I
F
P
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
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n
t
h
e
p
r
o
p
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r
t
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o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
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c
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n
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f
n
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n
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e
c
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t
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d
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c
t
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s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
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d
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e
c
t
o
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s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
0
;
D
I
F
P
A
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
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v
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a
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d
i
t
c
o
m
m
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t
t
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d
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r
e
c
t
o
r
s
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
0
;
D
I
F
N
A
C
M
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
i
n
2
0
0
5
c
o
m
p
a
r
e
d
w
i
t
h
2
0
0
0
;
D
I
F
E
D
s
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
i
s
s
u
e
d
o
r
d
i
n
a
r
y
Table II.
Pearson correlation
coef?cients
Effect of
governance
reforms
253
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
o
e
f
?
c
i
e
n
t
(
t
-
s
t
a
t
i
s
t
i
c
)
V
a
r
i
a
b
l
e
H
1
a
(
2
0
0
0
)
H
1
a
(
2
0
0
5
)
H
2
a
(
2
0
0
0
)
H
2
a
(
2
0
0
5
)
H
3
a
(
2
0
0
0
)
H
3
a
(
2
0
0
5
)
H
3
c
(
2
0
0
0
)
H
3
c
(
2
0
0
5
)
F
u
l
l
M
o
d
e
l
(
2
0
0
0
)
F
u
l
l
m
o
d
e
l
(
2
0
0
5
)
P
a
n
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l
A
C
o
n
s
t
a
n
t
?
0
.
2
5
8
(
1
.
7
2
8
)
2
0
.
0
5
1
(
2
0
.
1
3
1
)
0
.
1
7
2
(
1
.
0
9
5
)
2
0
.
6
6
4
(
2
1
.
7
5
4
)
0
.
2
3
1
(
1
.
5
4
9
)
2
0
.
0
4
1
(
2
0
.
1
0
8
)
0
.
2
4
1
(
1
.
6
0
5
)
2
0
.
4
8
9
(
2
1
.
2
3
5
)
0
.
2
3
3
(
1
.
4
3
8
)
2
0
.
2
5
7
(
2
0
.
6
3
2
)
P
B
N
E
D
2
2
0
.
0
9
4
(
2
1
.
4
4
1
)
2
0
.
6
3
4
(
2
3
.
3
4
1
)
*
*
2
0
.
1
1
0
(
2
1
.
4
5
8
)
2
0
.
2
1
8
(
2
1
.
1
0
2
)
E
D
s
S
H
A
R
E
S
þ
0
.
1
1
0
(
1
.
1
5
9
)
1
.
1
0
9
(
4
.
5
6
7
)
*
*
*
0
.
0
8
2
(
0
.
8
4
3
)
0
.
8
8
3
(
3
.
4
7
4
)
*
*
*
P
A
N
E
D
2
0
.
0
0
0
(
2
0
.
0
0
9
)
2
0
.
6
3
4
(
2
4
.
3
8
0
)
*
*
*
0
.
0
2
0
(
0
.
4
3
0
)
2
0
.
5
0
4
(
2
3
.
2
4
2
)
*
*
*
N
A
C
M
2
0
.
0
0
3
(
0
.
5
1
3
)
2
0
.
0
4
1
(
2
1
.
7
0
1
)
0
.
0
0
5
(
0
.
6
7
4
)
2
0
.
0
0
6
(
2
0
.
2
3
4
)
S
i
z
e
þ
2
.
0
0
8
(
2
1
.
0
1
1
)
0
.
0
3
1
(
1
.
6
3
0
)
2
0
.
0
0
7
(
2
0
.
9
3
2
)
0
.
0
3
6
(
1
.
9
0
0
)
*
2
0
.
0
1
0
(
2
1
.
2
9
0
)
0
.
0
3
7
(
1
.
9
6
8
)
*
2
0
.
0
1
1
(
2
1
.
4
0
9
)
0
.
0
3
7
(
1
.
7
7
2
)
2
0
.
0
0
8
(
2
0
.
9
4
7
)
0
.
0
4
8
(
2
.
4
7
1
)
*
*
G
E
A
R
I
N
G
?
0
.
0
0
2
(
0
.
1
3
8
)
0
.
0
2
8
(
1
.
2
1
5
)
0
.
0
0
3
(
0
.
2
6
0
)
0
.
0
2
4
(
1
.
0
5
5
)
0
.
0
0
3
(
0
.
2
3
7
)
0
.
0
3
1
(
1
.
3
5
1
)
0
.
0
0
4
(
0
.
2
7
9
)
0
.
0
3
0
(
1
.
2
5
4
)
0
.
0
0
3
(
0
.
2
4
5
)
0
.
0
2
4
(
1
.
1
0
6
)
G
R
O
W
T
H
?
2
0
.
0
0
4
(
2
0
.
9
5
6
)
2
0
.
0
1
7
(
2
1
.
0
8
1
)
2
0
.
0
0
3
(
2
0
.
7
9
1
)
2
0
.
0
1
8
(
2
1
.
1
9
7
)
2
0
.
0
0
3
(
2
0
.
8
0
0
)
2
0
.
0
1
6
(
2
1
.
0
2
9
)
2
0
.
0
0
3
(
2
0
.
7
9
1
)
2
0
.
0
1
6
(
2
0
.
9
7
2
)
2
0
.
0
0
4
(
2
0
.
9
6
6
)
2
0
.
0
1
3
(
2
.
8
7
5
)
L
O
S
S
?
2
0
.
0
0
7
(
2
0
.
1
8
4
)
2
0
.
2
1
7
(
2
2
.
0
4
3
)
*
2
0
.
0
0
2
(
2
0
.
0
4
2
)
2
0
.
2
1
8
(
2
2
.
1
0
7
)
*
2
0
.
0
0
3
(
2
0
.
0
8
4
)
*
*
2
0
.
2
8
9
(
2
2
.
8
0
1
)
*
*
2
0
.
0
0
2
(
2
0
.
0
6
5
)
2
0
.
2
3
9
(
2
2
.
1
9
4
)
*
2
0
.
0
0
5
(
2
0
.
1
3
2
)
2
0
.
2
1
9
(
2
2
.
1
2
3
)
*
R
O
A
?
0
.
2
3
6
(
2
.
4
2
8
)
*
2
0
.
9
7
5
(
2
6
.
9
0
2
)
*
*
*
0
.
2
4
5
(
2
.
5
2
8
)
*
*
2
1
.
0
1
8
(
2
7
.
4
9
9
)
*
*
*
0
.
2
5
8
(
2
.
6
6
3
)
*
*
2
1
.
0
2
9
(
2
7
.
5
6
2
)
*
*
*
0
.
2
6
3
(
2
.
7
0
8
)
*
*
2
1
.
0
4
0
(
2
7
.
3
0
4
)
*
*
*
0
.
2
3
3
(
2
.
3
7
2
)
*
2
0
.
9
5
9
(
2
7
.
1
5
9
)
*
*
*
F
-
v
a
l
u
e
2
.
2
9
8
*
1
3
.
3
2
0
*
*
*
2
.
1
6
8
*
1
5
.
4
8
1
*
*
*
1
.
9
3
1
1
5
.
1
0
8
*
*
*
1
.
9
7
7
1
1
.
4
7
8
*
*
*
1
.
7
1
3
1
2
.
9
0
7
*
*
*
A
d
j
u
s
t
e
d
R
2
0
.
0
3
8
0
.
2
9
3
0
.
0
3
4
0
.
3
0
4
0
.
0
2
7
0
.
2
9
8
0
.
0
2
9
0
.
2
4
0
0
.
0
3
1
0
.
3
5
0(
c
o
n
t
i
n
u
e
d
)
Table III.
Regression model:
dependent variable:
PACDA (N ¼ 200)
ARJ
21,3
254
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
7
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
o
e
f
?
c
i
e
n
t
(
t
-
s
t
a
t
i
s
t
i
c
)
P
a
n
e
l
B
V
a
r
i
a
b
l
e
H
1
b
H
2
b
H
3
b
H
3
d
F
u
l
l
c
h
a
n
g
e
m
o
d
e
l
C
o
n
s
t
a
n
t
?
2
0
.
2
4
8
(
2
0
.
5
7
4
)
2
0
.
3
4
2
(
2
0
.
7
6
6
)
2
0
.
3
3
3
(
2
0
.
7
4
6
)
2
0
.
3
0
6
(
2
0
.
7
2
3
)
D
I
F
P
B
N
E
D
2
2
0
.
6
9
7
(
2
3
.
6
5
7
)
*
*
*
2
0
.
6
2
5
(
2
3
.
1
0
5
)
*
*
*
D
I
F
E
D
s
S
H
A
R
E
S
þ
0
.
9
6
8
(
3
.
9
9
5
)
*
*
*
0
.
8
4
2
(
3
.
4
2
4
)
*
*
*
D
I
F
P
A
N
E
D
2
2
0
.
0
4
3
(
2
0
.
3
8
2
)
0
.
1
5
6
(
1
.
3
0
9
)
D
I
F
F
N
A
C
M
2
2
0
.
0
0
9
(
2
0
.
5
0
7
)
2
0
.
0
0
9
(
2
0
.
5
2
3
)
S
i
z
e
þ
0
.
0
1
3
(
0
.
6
2
6
)
0
.
0
2
0
(
0
.
9
5
5
)
0
.
0
1
8
(
0
.
7
9
7
)
0
.
0
1
7
(
0
.
7
8
5
)
0
.
0
1
6
(
0
.
7
6
8
)
G
E
A
R
I
N
G
?
2
0
.
0
2
1
(
2
0
.
7
8
5
)
2
0
.
0
1
4
(
2
0
.
5
2
4
)
2
0
.
0
1
8
(
2
0
.
6
7
4
)
2
0
.
0
1
9
(
2
0
.
7
0
7
)
2
0
.
0
0
1
7
(
2
0
.
6
5
2
)
G
R
O
W
T
H
?
2
0
.
0
0
7
(
2
0
.
4
1
7
)
2
0
.
0
1
2
(
2
0
.
6
9
2
)
2
0
.
0
1
1
(
2
0
.
6
1
9
)
2
0
.
0
1
1
(
2
0
.
5
8
7
)
2
0
.
0
0
8
(
2
0
.
4
6
1
)
L
O
S
S
?
0
.
2
7
7
(
2
.
3
6
2
)
*
*
0
.
3
0
9
(
2
.
6
5
4
)
*
*
0
.
2
8
5
(
2
.
3
5
2
)
*
0
.
2
8
4
(
2
.
3
4
2
)
*
0
.
3
0
0
(
2
.
6
1
7
)
*
*
R
O
A
?
0
.
0
6
5
(
0
.
4
1
8
)
0
.
1
3
0
(
0
.
8
3
8
)
0
.
0
9
1
(
0
.
5
6
3
)
0
.
0
9
4
(
0
.
5
8
2
)
0
.
1
1
6
(
0
.
7
5
7
)
F
-
v
a
l
u
e
3
.
3
7
7
*
*
3
.
8
2
3
*
*
1
.
0
9
9
1
.
1
1
8
3
.
7
6
8
*
*
*
A
d
j
u
s
t
e
d
R
2
0
.
0
6
7
0
.
0
7
8
0
.
0
0
3
0
.
0
0
4
0
.
1
1
1
N
o
t
e
s
:
S
i
g
n
i
?
c
a
n
t
a
t
t
h
e
*
0
.
0
5
,
*
*
0
.
0
1
a
n
d
*
*
*
0
.
0
0
1
l
e
v
e
l
s
,
r
e
s
p
e
c
t
i
v
e
l
y
.
T
h
e
v
a
r
i
a
n
c
e
i
n
?
a
t
i
o
n
f
a
c
t
o
r
(
V
I
F
)
v
a
l
u
e
s
a
r
e
l
e
s
s
t
h
a
n
2
,
t
h
e
r
e
f
o
r
e
t
h
e
r
e
d
o
e
s
n
o
t
a
p
p
e
a
r
t
o
b
e
a
p
r
o
b
l
e
m
w
i
t
h
m
u
l
t
i
c
o
l
l
i
n
e
a
r
i
t
y
i
n
t
h
e
m
o
d
e
l
s
.
P
A
C
D
A
,
a
b
s
o
l
u
t
e
v
a
l
u
e
o
f
p
e
r
f
o
r
m
a
n
c
e
-
a
d
j
u
s
t
e
d
c
u
r
r
e
n
t
d
i
s
c
r
e
t
i
o
n
a
r
y
a
c
c
r
u
a
l
s
b
a
s
e
d
o
n
K
o
t
h
a
r
i
e
t
a
l
.
(
2
0
0
5
)
;
P
B
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
N
o
n
-
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
o
r
s
t
o
t
o
t
a
l
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
;
D
I
F
P
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
b
o
a
r
d
d
i
r
e
c
t
o
r
s
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
b
o
a
r
d
i
n
2
0
0
0
;
P
A
N
E
D
,
p
e
r
c
e
n
t
a
g
e
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
;
D
I
F
P
A
N
E
D
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
a
u
d
i
t
c
o
m
m
i
t
t
e
e
d
i
r
e
c
t
o
r
s
c
a
l
c
u
l
a
t
e
d
a
s
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
5
–
t
h
e
p
r
o
p
o
r
t
i
o
n
o
f
n
o
n
-
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
o
n
t
h
e
A
C
i
n
2
0
0
0
;
N
A
C
M
,
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
;
D
I
F
N
A
C
M
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
n
u
m
b
e
r
o
f
a
u
d
i
t
c
o
m
m
i
t
t
e
e
m
e
e
t
i
n
g
s
p
e
r
a
n
n
u
m
i
n
2
0
0
5
c
o
m
p
a
r
e
d
w
i
t
h
2
0
0
0
;
E
D
s
S
H
A
R
E
S
,
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
i
s
s
u
e
d
o
r
d
i
n
a
r
y
s
h
a
r
e
s
;
D
I
F
E
D
s
,
t
h
e
d
i
f
f
e
r
e
n
c
e
i
n
t
h
e
t
o
t
a
l
n
u
m
b
e
r
o
f
o
r
d
i
n
a
r
y
s
h
a
r
e
s
h
e
l
d
b
y
t
h
e
e
x
e
c
u
t
i
v
e
d
i
r
e
c
t
o
r
s
d
i
v
i
d
e
d
b
y
t
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Table III.
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negatively and signi?cantly associated with the PACDA with a negative coef?cient of
20.634 (t ¼ 23.341). This variable is not signi?cant in the model for the year 2000.
Prior research has produced con?icting results about the relationship between PACDA
and board independence. The results of this study demonstrate that, post-governance
changes, as the proportion of non-executive directors on the board increases, PACDA
decrease. This result supports the notion that boards of ?rms with high independence
ensure ?nancial reporting quality because they monitor managers more ef?ciently.
This result supports and strengthens the results reported by prior research (Agrawal
and Chadha, 2005; Beasley, 1996; Dechow et al., 1996; Persons, 2006). The control
variables LOSS and ROA are negatively and signi?cantly related to PACDA in the
2005 model but only ROA is signi?cant in the 2000 model.
The results of testing H2a suggests that PACDA is positively related to the
executive directors share ownership in 2005 only. The association is not signi?cant in
the year 2000. The model has an adjusted R
2
of 30.4 percent and shows that executive
directors’ share ownership is positively and signi?cantly associated with PACDA with
a coef?cient of 1.109 (t ¼ 4.567). Prior research also suggests that management
share-ownership exhibits a non-linear function (Morck et al., 1998). Increases in the
executive share ownership provides incentives for executives to act less
opportunistically and more in the interest of the ?rm, while excessive share
ownership provides managers with the voting power to pursue their own interests
(Hermalin and Weisbach, 1991). Consistent with the Morck et al. (1998) entrenchment
argument, the percentage of director share ownership was logged to test for a
non-linear relationship between the dependent and independent variables. However,
a non-linear relationship was not identi?ed. The results presented in this study support
and strengthen the results reported by other researchers who argue that executive
share ownership should be viewed with caution since it can have undesirable
risk-bearing properties and it might create incentives for managers to behave
opportunistically (Beatty and Zajac, 1994; Bergstresser and Philippon, 2006).
The two proxies for AC effectiveness, AC independence (H3a) and the frequency of
audit activity (H3c) are tested separately. The results reported in Table III Panel A
support H3a in 2005 only. The 2005 model has an adjusted R
2
of 29.8 percent and
illustrates that the proportion of non-executive directors on the AC is negatively and
signi?cantly associated with the PACDA with a coef?cient of 20.634 (t ¼ 24.380).
This variable is not signi?cant in the model for the 2000 year. This result supports the
notion that, post the governance changes, the ability of the AC to detect earnings
management is associated with the level of independence, supporting and
strengthening prior research (Be´dard et al., 2004; Klein, 2002; McMullen and
Raghundan, 1996; Peasnell et al., 2006). The control variables LOSS and ROA are
negatively and signi?cantly related to PACDA in both years. The results of testing the
second proxy for AC effectiveness, the NACM, is negatively and marginally related to
PACDA (t ¼ 21.701; p ¼ 0.091) in 2005 with an adjusted R
2
of 24 percent. The
association is not signi?cant in 2000. The results fail to support H3c. The control
variables LOSS and ROA are negatively and signi?cantly related to PACDA in 2005.
The ?rst set of regressions test whether the individual governance practices impact
earnings management. The full model tests whether board independence, executive
directors’ shareholdings, AC independence, and AC meeting frequency simultaneously
in?uence earnings management. The full model examines which of the governance
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factor(s) has the most explanatory power in predicting PACDA in 2000 and 2005.
The results of testing the full model reported in Table III Panel A, shows that two of the
corporate governance practices are signi?cantly related to PACDA in 2005 only.
The model explains 35 percent of the variability in PACDA, and demonstrates that the
proportion of non-executive directors on the AC is negatively and signi?cantly
associated with the PACDA with a coef?cient of 20.504 (t ¼ 23.242). The model also
indicates that executive directors’ share ownership is positively and signi?cantly
associated with the PACDA with a coef?cient of 0.883 (t ¼ 3.474). The control
variables ROA and LOSS are negatively and signi?cantly and SIZE is positively and
signi?cantly related to PACDA in 2005.
Table III Panel B reports the results of examining the levels of PACDA for ?rms
that change their governance practices following the governance reforms. The results
of testing H1b demonstrate that the level of PACDA is signi?cantly negative for ?rms
that increase the proportion of non-executive directors on the board with a negative
coef?cient of 20.679 (t ¼ 23.657). The model has an adjusted R
2
of 6.7 percent.
The results support the proposition that ?rms that changed their board structure
following the governance reforms have less-earnings management. The results of
testing H2b suggest that the change in the executive directors’ share ownership
remains positively and signi?cantly related to PACDA with a coef?cient of 0.968
(t ¼ 3.995). The model with an adjusted R
2
of 8 percent shows that when ?rms change
the level of executive director ownership post the reforms they have larger
discretionary accruals. The control variable, LOSS, is positively and signi?cantly
related to PACDA. The results do not support H3b and H3d that PACDA is negatively
related to changes in the proportion of non-executive directors on the AC or increases
the NACM.
The results of testing the full model of differences are reported in Table III Panel B
and suggest that changes to two of the corporate governance practices are signi?cantly
related to PACDA. The model, with an adjusted R
2
of 11.1 percent, indicates that
changes to the proportion of non-executive directors on the board is negatively and
signi?cantly associated with the PACDA with a coef?cient of 20.625 (t ¼ 23.105).
The model also shows that changes to executive directors’ share ownership is
positively and signi?cantly associated with PACDA with a coef?cient of 0.842
(t ¼ 3.424). The control variable LOSS is positively and signi?cantly related to
PACDA.
4.1 Sensitivity analysis
An additional test of the robustness of the results is performed using the pooled
sample for 2000 and 2005 including a dummy variable for year. The results
remained consistent with those reported in Table III. Further analysis of the effect
of AC meeting frequency tests the reported results. Whether the ?rm has the
recommended number of meetings rather than the maximum number of meetings is
relevant. It is not obvious that the maximum number of meetings re?ect a well
governed ?rm. When a ?rm is in crisis, the frequency of meetings is likely to
increase. As a sensitivity test, we include a dummy variable equal to 1 if the ?rm
holds up to four meetings, 0 otherwise, to consider this issue. However, the results
remain insigni?cant.
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5. Conclusion
The association between ?rms’ corporate governance practices and earnings
management is examined in this study. The research involves two considerations.
First, whether speci?c corporate governance practices are associated with lower levels
of earnings management in 2000 or 2005. Second, whether improvements in speci?c
corporate governance practices between 2000 and 2005 are associated with lower levels
of earnings management. First, consistent with prior research, the research ?ndings
suggest that, both the level of board independence and AC independence improves the
quality of ?nancial reporting. In addition, the results of the study support the stream of
agency theory research that argues that increasing executive shareholdings imposes
greater risk on the agent and therefore provides the incentive to act opportunistically,
that is, to manage earnings. We failed to detect a signi?cant relationship between the
frequency of AC meetings and PACDA.
Second, the study shows that, subsequent to the reforms, board and AC
independence improved and the NACM increased signi?cantly. However, only changes
to board independence, is associated with lower levels of PACDA. Increasing the
independence or activity of the AC is not associated with PACDA. However, the
previously reported result demonstrates a signi?cantly negative association between
AC independence and PACDA, suggesting that AC independence is important in
detecting earnings management.
Complementing agency theory literature on the association between ownership and
earnings management, this research ?nds evidence that increasing executive share
ownership provides incentives to manipulate earnings regardless of governance
reforms. This result suggests that there should be limitations placed on the level of
executive director ownership to mitigate the incentives to manipulate earnings.
This study is subject to limitations. As the sample covers only two years of data, the
results may not be generalisable to different time periods. The sample is based on
companies that continue to operate from 2000 to 2005. Accordingly, delisted companies
and also bankrupt companies are not included in the sample set. Other proxies for
board and AC effectiveness, such as ?nancial literacy and responsibilities of board and
committee members, may show further signi?cant associations with earnings
management. These limitations provide fruitful avenues for future research.
Notes
1. As a consequence of CLERP 9, Subsection 232(2) of the Corporations Law was rewritten to
capture the ?duciary principles of a director and imposes both criminal and civil
consequences for a breach of that duty.
2. CLERP 9, Section 295A requires the CEO and CFO to sign a declaration stating that the
?nancial records have been properly maintained, they are prepared in accordance with
accounting standards and they present a true and fair view of the company’s ?nancial
standing. Subsequently, under Section 295(4)(e) directors must state that they have received
the ?nancial statements from the CEO and CFO and they have to provide necessary
information to ensure that ?nancial statements give a true and fair view of the ?nancial
position and performance under Sections 298 (1A) and 306 (2) (a) (b).
3. The model is estimated separately for each combination of the industry code (GICS) and year
to obtain industry-speci?c estimates of the coef?cients in the equation.
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Effectiveness of Corporate Audit Committees, NYSE, New York, NY.
Cooper, K. and Deo, H. (2005), “Recurring cycle of Australian corporate reforms: a never ending
story”, Journal of American Academy of Business, Vol. 17 No. 2, pp. 156-64.
Appendix. Calculation of performance-adjusted current discretionary accruals
(PACDA)
As suggested by Kothari et al. (2005) the cross-sectional PACDA are calculated by including the
lagged variable of ROA.
The parameters for calculation of expected current accruals (ECA) are estimated by using
the following equation:
TCA
it
AT
it21
¼ a
0
1
AT
it21
þ a
1
DREV
it
AT
it21
þ a
2
ðROA
it21
Þ þ 1
it
ðA1Þ
The ECA use the estimated parameters as follows:
ECA
it
AT
it21
¼ a
0
1
AT
it21
þ a
1
DREV
it
2DAR
it
AT
it21
þ a
2
ðROA
it21
Þ ðA2Þ
PACDA ¼ (A1)-(A2).
TCA ¼ total current accruals is net income (earnings before extraordinary items and
discontinued operations) plus depreciation and amortisation minus operating
cash ?ows for ?rm i in the year t.
DREV ¼ change in net revenue for ?rm i in the year t.
DAR ¼ change in accounts receivable for ?rm i in the year t.
ROA ¼ ratio of net income before extraordinary items to total assets for ?rm i in the
year t 2 1.
AT ¼ total assets for ?rm i in the year t.
e
it
¼ error term for ?rm i in year t.
PACDA ¼
TCA
it
AT
it21
2
ECA
it
AT
it21
Kothari et al. (2005) and Ashbaugh et al. (2003).
Corresponding author
Marion R. Hutchinson can be contacted at: [email protected]
ARJ
21,3
262
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