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The purpose of this paper is to examine the contention that a strengthening of corporate
governance mechanisms would result in the improved relevance and reliability of financial statements.
Accounting Research Journal
Does board governance improve the quality of accounting earnings?
Raghavan J . Iyengar J udy Land Ernest M. Zampelli
Article information:
To cite this document:
Raghavan J . Iyengar J udy Land Ernest M. Zampelli, (2010),"Does board governance improve the quality of
accounting earnings?", Accounting Research J ournal, Vol. 23 Iss 1 pp. 49 - 68
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Does board governance improve
the quality of accounting earnings?
Raghavan J. Iyengar and Judy Land
School of Business, North Carolina Central University, Durham,
North Carolina, USA, and
Ernest M. Zampelli
Department of Business and Economics,
The Catholic University of America, Washington, DC, USA
Abstract
Purpose – The purpose of this paper is to examine the contention that a strengthening of corporate
governance mechanisms would result in the improved relevance and reliability of ?nancial statements.
Design/methodology/approach – Using pooled ordinary least squares regression, the paper
analyse the quality of reported earnings for a sample of ?rms over the 1998-2002 time period.
Findings – The ?ndings show negative and statistically signi?cant associations between reported
earnings quality and the proportion of CEO incentive pay and ?rm’s growth opportunities. It is also
found that earnings quality is positively and signi?cantly related to the existence of an orderly CEO
transition process. However, board independence does not seemto be associated with earnings quality.
Research limitations/implications – Since the sample of ?rms is from the 1998 to 2002 period,
consistent with the paper’s motivation, the results may not generalize to the more recent time period.
Practical implications – The results provide support for the argument that the current structure of
executive pay does adversely impact the quality of reported earnings and hence provides a rationale
for closer scrutiny of executive pay by regulatory bodies. Additionally, the ?ndings suggest that the
emphasis on board independence as an effective monitoring device may be misplaced.
Originality/value – Unlike prior studies, the paper’s hypotheses are derived from an explicit agency
theoretic optimization model of managerial decision making. The paper uses the Ball and Shivakumar
model for estimating abnormal accruals unlike previous analyses that relied more heavily on the Jones
model. The paper also adds to past studies of the relationship between corporate governance and
earnings quality and the role of executive compensation.
Keywords Earnings, Corporate governance, Accounting, Financial reporting
Paper type Research paper
1. Introduction
The high-pro?le corporate accounting scandals occurring earlier in this decade,
particularly Enron and WorldCom, precipitated intense debate regarding the
relationship between corporate governance practices and the integrity, reliability, and
credibility of corporate ?nancial reporting. Moreover, they constituted the raison d’etre
for the Sarbanes-Oxley Act (SOX) of 2002 (hereafter referred to as SOX) which
mandated a number of changes in corporate governance practices aimed at
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors gratefully acknowledge the helpful comments from Augustine Duru, Javad Kargar,
Robert Mof?e, and Samuel Kotz, an anonymous referee and the editors Marion Hutchinson and
Gavin Nicholson. Research assistance of Julius Bradshaw and Sarika Ramakrishnan is
appreciated. Raghavan Iyengar and Judy Land acknowledge summer research grant received
from North Carolina Central University.
Quality
of accounting
earnings
49
Accounting Research Journal
Vol. 23 No. 1, 2010
pp. 49-68
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611011060524
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strengthening the oversight and monitoring capabilities of corporate boards of
directors, thereby, reducing the likelihood of future accounting scandals. For example,
the act mandated that audit committees be comprised entirely of independent directors
and that ?rms be restricted in their purchases of nonauditing services from their
auditors[1]. This study empirically tests these notions by using a sample of pre-2003
?rms, the period on which these assumptions are based.
Prior academic research has provided mixed evidence on the relationship between
corporate governance practices and board characteristics and the integrity and
reliability of corporate ?nancial reporting[2]. Beasley (1996), Dechow et al. (1996) and
more recently, Uzun et al. (2004) ?nd that ?rms with boards comprised of more outside
and independent directors are less likely to commit corporate fraud but ?nd no
signi?cant effects for board size, frequency of board meetings, or frequency of audit
committee meetings. Agrawal and Chadha (2005) analyse the relationship between
governance characteristics and the probability of serious accounting problems, as
gauged by earnings restatements, and ?nd no signi?cant impact of board independence
nor audit committee independence on the probability of restatement. Boards and audit
committees with independent directors possessing ?nancial expertise, however, are
found to signi?cantly lower the probability of restatements. Abbott et al. (2004) ?nds
that all-independent audit committees, audit committees with members having
?nancial expertise, and the frequency of audit committee meetings have signi?cant
negative effects on the likelihood of ?nancial restatements. Their results also indicate
that ?rms with larger boards are more likely to restate earnings.
A number of studies have examined the relationship between corporate governance
and earnings quality (management), as measured by abnormal (discretionary) accruals.
Chtourou et al. (2001) provides evidence that earnings management is less likely in
?rms with audit committees having higher percentages of independent non-executive
directors who are not managers in other ?rms, audit committees with at least one
member with ?nancial expertise, and audit committees comprised of only independent
directors that meet at least twice per year. The authors also ?nd that larger boards are
associated with less earnings management. Klein (2002) reports statistically signi?cant
negative relationships between both board and audit committee independence and
abnormal accruals but no signi?cant relationship between all-independent audit
committees and abnormal accruals. Consistent with these results, Xie et al. (2003) report
that earnings management is less likely to occur in companies with boards that include
both independent outside directors and directors with corporate experience, boards that
are larger, audit committees that are comprised of corporate members and investment
bankers, and audit committees that meet more often. Davidson et al. (2005) also ?nd a
statistically signi?cant negative linkage between board independence and discre-
tionary accruals, but little else. Results from Peasnell et al. (2005) indicate a statistically
signi?cant negative relationship between income-increasing abnormal accruals and the
proportion of outsiders on the board of directors but offer little evidence of linkages
between audit committee characteristics and abnormal accruals.
It seems that the literature has reached consensus on one general issue – corporate
governance and board of director characteristics have implications for the quality of
?nancial reporting. It remains unclear, however, exactly which governance mechanisms
and board characteristics in?uence ?nancial reporting quality and exactly why they do
so. This provides the fundamental motivation for this study in which we too focus on the
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relationship between governance and earnings quality as measured by discretionary
accruals. The paper’s contribution is threefold. First, unlike prior studies, our hypotheses
are derived from an explicit, albeit simple, and agency theoretic optimization model of
managerial decision making. The comparative statics provide the direct links between
the theoretical model and independent variables employed in its econometric counterpart.
Second, previous analyses have relied largely on the modi?ed Jones (1991)[3] model to
estimate abnormal (discretionary) accruals. Ball and Shivakumar (2006), however,
demonstrated that such linear accruals models “by omitting the loss recognition asymmetry,
exhibit substantial attenuation bias and offer a comparatively poor speci?cation of the
accounting accrual process (Ball and Shivakumar (2006, p. 207).” They go on to show that:
[. . .] that nonlinear accruals models incorporating the asymmetry in gain and loss recognition
(timelier loss recognition, or conditional conservatism) offer a substantial speci?cation
improvement, explaining substantially more variation in accruals than equivalent linear
speci?cations.
Consequently, in this study, we have chosen to use abnormal accruals estimated from
the models developed by Ball and Shivakumar (2006). Third, this paper adds to past
studies of the relationship between corporate governance and earnings quality as
proxied by abnormal (discretionary) accruals and the role of executive compensation
(Bergstresser and Philippon, 2006; Meek et al., 2007). Executive bonuses, stock options,
etc. are regularly indicted as major reasons for the use of overly aggressive and zealous
accounting practices and past studies using alternative proxies for earnings quality
have incorporated some version of CEO compensation into their models. For these
reasons together with our analytical results, CEO incentive pay is afforded an
important role in the discretionary accruals process.
The paper’s major ?ndings include:
.
a signi?cant negative association between earnings quality and managers’
incentive pay;
.
a signi?cant negative association between earnings quality and a ?rm’s growth
prospects; and
.
a signi?cant positive association between earnings quality and the existence of
an orderly succession policy.
We ?nd no statistical evidence of a signi?cant association between earnings quality
and board and audit committee independence. The main results remain unchanged for
a battery of robustness tests.
The remainder of the paper is structured as follows. Section 2 presents the agency
theoretic optimization model, the relevant comparative statics, and the hypotheses to
be tested. The abnormal accruals measures used as proxies for earnings quality along
with the explanatory variables of the econometric model are discussed in Section 3.
The sample, its selection, and the descriptive statistics for all major variables are
discussed in Section 4. Section 5 presents the empirical results and discusses their
implications. Summary and concluding remarks are offered in Section 6.
2. A simple model of managerial decision making
Our theoretical model is a simpli?ed version and an extension of the model developed by
Feltham and Xie (1994). We assume a risk averse manager (the agent) who expends
Quality
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effort in performing two activities, Activities 1 and 2. Shareholders (the principal) do not
observe the manager’s effort levels, e
1
and e
2
, respectively, and thus face an incentive
problem that is addressed by an incentive compensation contract. Since e
1
and e
2
are
unobservable, the compensation contract is based on a reported performance measure, y.
The ?rst activity is productive as it is aimed entirely at improving y for the sake of
increasing the shareholders’ payoff. The second activity is “window dressing” aimed
only at increasing the measure of performance to the bene?t of the manager with no
additional bene?t to shareholders. The relationship between y and the activity levels is
assumed to be linear and given by:
y ¼ m
1
e
1
þ m
2
e
2
þ 1 ð1Þ
where m
i
is the marginal productivity of e
i
and ~ 1 N 0; s
2
1
À Á
represents the stochastic
component of the performance measure. The manager’s wage, w, is assumed to be a
linear function of y represented by:
w ¼ w
0
þ n y ¼ w
0
þ n ðm
1
e
1
þ m
2
e
2
þ 1Þ ð2Þ
where w
0
is a ?xed payment and n is the pay-performance sensitivity. The direct cost to
the agent of exerting effort is assumed to be quadratic and given by:
Cðe
1
; e
2
Þ ¼
1
2
e
2
1
þ
1
2
e
2
2
ð3Þ
The manager assumes, however, that a penalty will likely be imposed by the principal if
the “windowdressing” activity is discovered. The penalty is assumed to be proportional
to m
2
e
2
and equal to tm
2
e
2
where 0 , t , 1. The manager estimates a non-zero
probability of detection at 0 , r , 1. Augmenting equation (3) by the expected penalty,
we have:
Cðe
1
; e
2
Þ ¼
1
2
e
2
1
þ
1
2
e
2
2
þ rtm
2
e
2
ð4Þ
The manager is assumed to choose e
1
and e
2
to maximize the objective function
w 2Cðe
1
; e
2
Þ. The solutions to the ?rst order conditions are easily shown to be:
e
*
1
¼ nm
1
e
*
2
¼ ðn 2rtÞm
2
ð5Þ
Fromequation (5), we see that the comparative statics for e
*
2
are sensible. In particular, the
optimal level of window dressing effort is increasing in the pay-performance sensitivity
›e
*
2
=›n
. 0
, and with the marginal productivity of effort ›e
*
2
=›m
2
. 0
, for
ðn 2rtÞ . 0; and declining in the probability of detection and in the penalty proportion:
›e
*
2
›r
, 0 and
›e
*
2
›t
, 0:
Simply stated, the comparative statics suggest that increases in the sensitivity of
managerial compensation to ?rm performance will engender more effort to
opportunistically manipulate ?rmperformance measures as will a bigger marginal payoff
from such manipulation. In contrast, closer and more effective monitoring of managerial
actions and/or a higher penalty for managerial misconduct will reduce such effort.
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2.1 Hypotheses development
Based on the above theoretical model of managerial decision making, we focus on four
speci?c issues that may be associated with the quality of reported corporate earnings.
Incentive pay. Extant academic literature seems to suggest that as the proportion of
managers’ at-risk pay to total pay increases, managers have an incentive to manipulate
their ?rms’ reported earnings. Bergstresser and Philippon (2006) document that if
CEO’s potential total compensation is more closely tied to the value of stock and option
holdings they have a greater incentive to use of discretionary accruals to manage
reported earnings. Sloan (1996) and Collins and Hribar (2000) have shown that
managers manipulate reported earnings to affect stock prices thereby increasing their
wealth through the use of stock options or other forms of incentive compensation. More
recently, Cheng and War?eld (2005) found that managers with substantial equity
incentives in the form of stock compensation and ownership are motivated to manage
earnings in order to sell shares in the future. Ke (2005) argues that CEOs with high
incentives are more likely to manage earnings to produce a string of consecutive
earnings increases. Two recent studies (Cornett et al., 2008; Meek et al., 2007) document
a positive association between equity incentives and discretionary accruals. It seems
then that the preponderance of evidence suggests that as managers’ wealth becomes
more sensitive to stock prices and earnings, managers are more inclined to manipulate
earnings thereby reducing the quality of reported earnings. In terms of our model
above, as pay-performance sensitivity increases the effort expended on window
dressing would also increase ›e
*
2
=›n
. 0
. Consequently, we posit that as the
proportion of incentive pay increases, managers may be more inclined to manipulate
the performance through abnormal accruals thus diluting the quality of earnings.
We predict a negative association between the incentive pay and earnings quality:
H1. There is a negative relation between the proportion of incentive pay-to-total
pay and earnings quality.
Growth. Lee et al. (2006) demonstrate that higher growth ?rms are more likely to
manage earnings. Abarbanell and Lehavy (2003) document that ?rms with higher
growth opportunities have stronger incentives to meet or beat analysts’ forecast of
earnings. Additionally, there is considerable evidence from prior research including
Clinch (1991), Gaver and Gaver (1993), Anderson et al. (2000) and Ittner et al. (2002),
that CEO incentive pay is higher in ?rms with more growth opportunities and that
?rms with higher growth opportunities are also likely to have strong incentives to meet
earnings targets, Skinner and Sloan (2002). Since higher growth ?rms may offer a
bigger marginal payoff to managers from earnings manipulation, managers may be
more likely to expend greater effort to opportunistically manipulate ?rm performance
›e
*
2
=›m
2
. 0
. This leads to the following hypothesis:
H2. There is a negative relation between the ?rm’s growth prospects and earnings
quality.
Board independence. Board members are deemed to be independent if they are not
employees of the company or its auditors and do not have any material relationship
with the company[4]. Prior research ?nds that board independence is linked to both the
quality of ?nancial information and executive actions (Dechow et al., 1996; Klein, 2002).
Quality
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Since ?nancial statements are reviewed by the board of directors before its release,
we explore whether stronger monitoring of managerial actions and/or a higher penalty
for managerial misconduct will curb managerial effort to window-dress. Since our
theoretical model suggests that the optimal level of window-dressing effort declines
with the probability of detection and the penalty proportion:
›e
*
2
›r
, 0 and
›e
*
2
›t
, 0;
we posit the following hypothesis:
H3. There is a positive relation between board independence and earnings quality.
Orderly succession. The success of a ?rm depends not only on the current management
team but also on its management transition plans and procedures. The sudden death or
departure of a CEO in the absence of adequate replacement and transition plans can
substantially undermine stockholder con?dence as well as the ?nancial viability of an
otherwise pro?table company. In contrast, a written and orderly succession policy for
managers creates an image of ?rm stability and instills con?dence in the ?rm’s
management. The presence of orderly transition by design implies the existence of
appropriate retirement policies. We envisage that ?rms with orderly transition
processes are also likely to have in place good internal controls for ?nancial record
keeping. Kanagaretnam et al. (2007) ?nd that the quality of corporate governance,
which includes a variable for retirement policy, is signi?cantly negatively related to
information asymmetry around earnings announcements. In terms of our theoretical
model an orderly transition would imply effective monitoring of managers by the
board of directors. This suggests that earnings quality should be higher in ?rms where
there is a managerial retirement policy in place:
H4. There is a positive relationship between the existence of a managerial
retirement policy and earnings quality.
3. Model for earnings quality, theoretical background, and hypotheses
3.1 Earnings quality
To examine the in?uence of incentive pay, growth, board independence, and retirement
policy have any in?uence on earnings quality, we incorporate two alternate de?nitions of
earnings quality. Schipper and Vincent (2003) summarize much of the literature on
earnings quality. Since there are various ways to capture the levels of earnings
management for ?rms inour sample, we include several proxies for the level of accounting
quality. In this study, we use abnormal accruals measures to determine the level of
earnings management. We multiply the absolute value of accruals by negative one so that
smaller values, values closer to zero represent higher quality of earnings and larger
accruals (values further away fromzero) are indicative of a lower quality of earnings. The
two proxies are based on abnormal accruals model for earnings management introduced
by Ball and Shivakumar (2006; henceforth B&S). We estimate abnormal accruals using
the following models: the model by B&S (MODQ1), and a modi?ed B&S (MODQ2) model.
The alternate measures of earnings quality are de?ned as[5]:
MODQ1 ¼ the absolute value of the residuals obtained from the following equation
(B&S, 2006) multiplied by 21:
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TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5*
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in ?rm i’s total
revenue from t 2 1 to t, GPPE
it
is the gross acquisition cost of property, plant, and
equipment for ?rm i in year t, A
it21
is the value of average total assets for ?rm i in year
t 2 1, CF
it
is the level of cash ?ow for ?rm i and DCF
it
is a dummy variable that is
equal to 1 if CF
it
is negative and 0 otherwise:
MODQ2 ¼ the absolute value of the residuals obtained from the following modi?ed
equation (Dechow et al., 1995; B&S, 2006) multiplied by 21.
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
For both of the measures, the absolute value of the residuals is multiplied by minus one
so that smaller (larger) values of abnormal or discretionary accruals indicate higher
(lower) earnings quality.
It should be noted that the original model advanced by Jones (1991) as well as B&S
did not contain an intercept term, since the intercept was also de?ated by lagged
assets. But, it is by no means clear that total accruals would be zero if all independent
variables are zero. Peasnell et al. (2000) use a modi?ed Jones model with an intercept
and explain that the intercept is not de?ated because:
First, there is no theoretical reason for forcing the regression through the origin [. . .]. Second,
regressions estimated with the constant suppressed preclude an analysis of the goodness-of-?t
of the models because the associated R-square values are unreliable [. . .]” (p. 316, fn. 12).
In accordance with these arguments, we follow Peasnell et al. (2000) and include an
intercept in each of the two accrual models.
3.2 An econometric model of earnings quality
To test the association between incentive pay, growth, board independence, and
retirement policy on one hand and earnings quality on the other, we use the following
regression model (after controlling for other factors identi?ed by current literature):
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY
þ a
5
BDSIZE þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL
þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
ð8Þ
where:
MODQ ¼ one of the two alternate measures of earnings quality (MODQ1,
MODQ2), de?ned earlier.
INCPAY ¼ the percentage of CEO incentive pay to total pay, where incentive
pay is de?ned as “bonus” and total pay is salary plus bonus plus
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other annual plus other restricted stock grants plus long-term
incentive payouts plus value of stock options granted plus all other.
Total pay is TDC1 in ExecuComp parlance.
MKBK ¼ market-to-book ratio of common equity[6].
PCTINDBD ¼ the percentage of board members who are independent.
RETPLY ¼ a dummy variable equal to one if the ?rm has a retirement policy
and zero otherwise.
BDSIZE ¼ the total number of members on the corporate board.
MEETINGS ¼ the number of board meetings held in a year.
DUAL ¼ a dummy variable equal to one if the ?rm’s CEO is also the chair of
the board, and equal to zero otherwise.
MKVAL ¼ the natural logarithm of the ?rm’s market value at the end of the
year.
FIN ¼ a dummy variable equal to one if a member of the board has other
?nancial relationships in the ?rm and zero otherwise.
OWN ¼ stocks held by directors as a percentage of ?rm’s outstanding
equity.
LOCK ¼ dummy variable equal to one if any of the following hold:
.
the CEO serves on the board committee that makes his compensation decisions;
or
.
the CEO serves on the board (and possibly compensation committee) of another
company that has an executive of?cer serving on the compensation committee of
the CEO’s company, or the CEOserves on the compensation committee of another
company that has an executive of?cer serving on the board (and possibly
compensation committee) of the CEO’s company.
3.3 Control variables
We include most of the governance variables that are available in the Investor
Responsibility Research Center (IRRC) database as control variables. The estimating
equation includes other control variables such as BDSIZE (the total number of
members on the corporate board), MEETINGS (the number of board meetings held in
one year), DUAL (dummy variable equal to one if the ?rm’s CEO is also the chair of the
board, and equal to zero otherwise), MKVAL (?rm size as measured by the natural log
of the ?rm’s market value at the end of the year), FIN (board members having other
?nancial stake in the business), OWN (percentage of stock owned by directors), and
LOCK (executives interlocking relationship).
Board size (BDSIZE). Yermack (1996) demonstrates that smaller boards are effective
in improving ?rm performance and Vafeas (2000) ?nds that smaller boards (with a
minimum of ?ve board members) result in higher earnings response coef?cients when
analysing the informativeness of earnings. Beasley (1996) ?nds board size to be
positively related to ?nancial statement fraud. However, others like Xie et al. (2003) and
ARJ
23,1
56
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(
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Klein (2002) argue that larger boards are better able to effectively monitor a ?rmbecause
of the greater likelihood of independent directors with corporate or ?nancial expertise
and experience. Xie et al. (2003) also ?nds that larger boards are associated with lower
discretionary accruals. Thus, far, board size has often been identi?ed as a signi?cant
determinant of earnings management/quality but the direction of its impact remains
unresolved.
Number of board meetings (MEETINGS). Vafeas (1999) questions the importance of
board activity, and conjectures that boards are more active in the presence of problems,
implying that increased board meetings are a response to poor ?rm performance rather
than an indicator of pro-active behavior. Consistent with the argument in Vafeas (1999)
and Chtourou et al. (2001) ?nd higher levels of earnings management in ?rms with
larger number of board meetings. In contrast, other studies including Xie et al. (2003)
and Bowen et al. (2008) ?nd that when boards meet more often earnings management is
lower. The number of board meetings has been shown to be signi?cantly associated
with earnings management/quality, although the direction is uncertain.
CEO duality (DUAL). Poor corporate governance has commonly been linked to CEO
duality, where the ?rm’s CEO also serving as the chair of its board of directors.
According to Fama and Jensen (1983) and Jensen (1993), CEOduality violates the rubric
of the separation of decision control and decision management, thus impeding a board’s
ability to monitor the CEO effectively. In contrast, Stoeberl and Sherony (1985) and
Anderson and Anthony (1986) argue that a dual structure creates greater stability and
fosters better communication while Brickleyet al. (1997) asserts that a non-dual structure
results in higher information, agency, and incentive costs. Arecent study by Iyengar and
Zampelli (2009) examines the issue of duality and ?rmperformance froman endogenous
theory of governance. They conclude that ?rm’s selection of the dual governance
structure is not consistent with either comparative advantage or the objective of
maximizing ?rmperformance. The literature on duality has not yet provided compelling
evidence one way or the other, but we include it as a control variable in our analysis.
Firm size (MKVAL). Large ?rms are closely monitored by the ?rm and its various
stakeholders, and as ?rmsize increases there is much greater media and public scrutiny.
It has been found that information provided by large ?rms is impounded in stock prices
in greater proportion than for small ?rms prior to earnings announcements (Atiase,
1985), and that the larger the ?rm, the higher the analyst following (Dempsey, 1989).
A recent article by Christensen et al. (2004) ?nd that there is a positive relationship
between ?rmsize and the information content of earnings announcements. We therefore
posit a positive effect of ?rm size on earnings quality.
Other?n (FIN). The “FIN” variable is a dummy variable that captures the extent to
which an outside director has a family, business, and/or ?nancial relationship with the
company. Since this variable may reduce the ability of a board member to be independent,
we predict that the existence of this relationship will reduce the effectiveness of the board
and will be associated with reduced earnings quality.
Ownership (OWN). Any analysis of board governance cannot ignore the role of
managerial equity ownership. As directors of a ?rm hold higher percentages of a ?rm’s
outstanding equity, they are more likely to have interests that are aligned with the
shareholders and more likely to effectively monitor the ?rm( Jensen and Meckling, 1976).
Consequently, we predict a positive relationship between director ownership and the
Quality
of accounting
earnings
57
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(
P
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)
quality of reported earnings. The variable “OWN” measures the percentage of stock held
by directors of the ?rm as a fraction of the ?rm’s outstanding equity.
Interlock (LOCK). The LOCK variable measures the extent to which a CEO has
in?uence over his own compensation, either by serving the board committee which
makes decisions effecting compensation or having a relationship with an individual
serving the committee making compensation decisions. Since this variable reduces the
level of independence that the board has on any decisions relating to compensation, we
predict that this will have a negative relationship with earnings quality.
4. Research design
4.1 Sample selection
To compile the sample of ?rms, we began with the population of ?rms in the IRRC
database for the period 1998-2002. We restricted the sample to pre-SOX by limiting the
data from 1998 to 2002. Proponents of SOX believed that certain board characteristics
(for instance, board independence) were crucial to preventing accounting practices that
diminish the integrity of ?nancial reporting. Since we wish to examine if the priors are
supported by empirical evidence we exclude 2003 or later data. This initial sample
consisted of 4,819 ?rm-year observations. From this population, we deleted
623 observations with insuf?cient governance data in the IRRC database. From this, we
dropped 162 and 152 observations for lack of ?nancial data and compensation data in the
Compustat and ExecuComp databases, respectively. We then proceeded to delete
198 observations because there were insuf?cient observations tocompute the ?rm-speci?c
residuals and consequently, the accounting quality measures (minimum eight year data
required for each ?rm) in Compustat database. We then winsorize the data by discarding
the extreme outliers (observations in the top and bottom 0.5 percent of each of the
variables). This process eliminated another 133 observations. Table I provides details of
how the selection criteria resulted in a ?nal sample of 3,551 ?rm-year observations.
4.2 Descriptive statistics
Table II presents the distribution of our sample by industry and mean values of main
variables in our study. The industry distribution of our sample is similar to prior
studies using comparable sample evidence (Frankel et al., 2002; Whisenant et al., 2003).
Industry membership is de?ned by the four digit SIC code, and our sample includes
Number of ?rm-years
Number of non-?nancial, non-utility, ?rm year observations from IRRC
database for the sample period 4,819
Less: ?rm-years
(1) with insuf?cient data in IRRC for all the governance variables (623)
(2) with insuf?cient ?nancial data in Compustat database (162)
(3) with insuf?cient executive compensation data in ExeCucomp database (152)
(4) with insuf?cient observations to obtain ?rm-speci?c residuals and
consequently the accounting quality measures (minimum eight
observations required for each ?rm to run ?rm-speci?c regression) (198)
(5) with extreme outliers (observations in the top and bottom 0.5 percent of
each of the variables) (133)
Number of ?rm-year observations in the ?nal sample 3,551
Table I.
Selection of sample of
?rm-years 1998-2002
ARJ
23,1
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:
W
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.
(
2
0
0
3
)
Table II.
Distribution of ?rm-years
(1998-2002) across
industries and mean
values of main
explanatory variables
Quality
of accounting
earnings
59
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(
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)
a variety of industries. In addition, our sample does include a higher percentage of
?rms from the “Durables” industry, and we address this issue in the sensitivity
analysis section of the paper.
Table II reports the means of all variables. In general, the mean values are similar
across models and industries. On average, ?rms in the computer industry are associated
with the lowest quality of earnings for both models, while the highest levels of earnings
quality are reported by chemicals and transportation industries. On average, companies
in the food industry are the largest in terms of market value, exhibit the highest growth
(MKBK) and are managed by the largest corporate boards. Firms in the pharmaceutical
industry have the largest percentage of incentive pay, are second highest in growth
opportunities, and have the largest number of board meetings. Firms in the mining/
construction industry also appear to have large percentage of incentive pay and are
likely to have a dual CEO structure and a managerial retirement policy. At the opposite
end of the spectrum are ?rms in computer industry, which have the smallest board, are
least likely to have a dual CEO structure, and also less likely to have a managerial
retirement policy in place.
The correlations of the main variables are reported in Table III. The Pearson
correlation coef?cients provide some evidence of the direction of the results. Consistent
with predictions, both of the earnings quality measures, MODQ1 and MODQ2, are
signi?cantly correlated with ?rm growth, MKBK, at the 5 percent level. The earnings
qualitymeasures are also signi?cantly positively correlatedwith RETPLYand BDSIZE.
Earnings quality is negatively correlated with INCPAY, although the correlation is
insigni?cant. Other variables that are signi?cantly correlated to earnings quality are
MKVAL, and MEETINGS. One of the earnings quality measures, MODQ1, is positively
correlated with PCTINDBD and DUAL, but only moderately so, at the 10 percent
signi?cance level.
5. Results
5.1 Main results
Table IV presents the results of the pooled OLS estimation of equations (1) and (2) with
MODQ1 and MODQ2 as respective dependent variables. Panel A reports the results for
the entire sample. It is obvious from Table II that a substantial portion of our sample is
from one industry, namely “Durables”. Thus, the clustering effect of durables industry
cannot be ignored. To rectify this situation, we deleted all observations from this
industry and re-ran the model, the results of which are reported in Panel B of Table IV.
Parameter estimates are given along with the corresponding p-values. Standard
signi?cance levels of one and 5 percent are used for the statistical inference. In both
speci?cations, the coef?cients on INCPAY, the measure of incentive pay, are negative
and signi?cant at the 1 percent level, consistent with our H1 that manager at-risk pay is
negatively related to earnings quality. The coef?cients on MKBK are also negative and
statistically signi?cant (at the 5 percent level), indicating that ?rms’ growth
opportunities are negatively related to earnings quality, consistent with hypothesis H2.
Tests of hypothesis H3 show that the coef?cient on PCTINDBD is positive as
expected but not signi?cantly different from zero in either speci?cation. The results
provide no evidence of anassociation between board independence andearnings quality,
hence hypothesis H3 is rejected. The estimated coef?cient on retirement policy,
RETPLY is consistently positive and signi?cant across the alternate speci?cations,
ARJ
23,1
60
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Table III.
Correlation table: Pearson
correlation coef?cients
Quality
of accounting
earnings
61
D
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(
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supporting hypothesis H4. Other results are that the coef?cient on BDSIZE is positive
and signi?cant at the 1 percent level, an indication that the larger executive board is
better able to monitor the ?rm, consistent with?ndings inXie et al. (2003). Inaddition, the
coef?cient on MEETINGS is negative and signi?cant at the 1 percent level, supporting
the argument that increased board meetings are related to increased earnings
management. This is consistent with ?ndings of Vafeas (1999) and Chtourou et al. (2001).
The estimated coef?cients DUAL, OWN, LOCK, and FIN are insigni?cant
suggesting that none of these variables are important in determining earnings quality.
The parameter estimate of MKVAL, a measure of ?rm size, is positive and signi?cant
only when the durable industry is excluded from the analysis.
Panel A (full sample) Panel B (durable industry exluded)
MODQ1 MODQ2 MODQ1 MODQ2
Dependent
variable Coef?cient p-value Coef?cient p-value Coef?cient p-value Coef?cient p-value
Intercept 20.0663
* *
0.000 20.0626
* *
0.000 20.0685
* *
0.000 20.0638
* *
0.000
INCPAY 20.0181
* *
0.010 20.0173
*
0.012 20.0185
*
0.025 20.0174
*
0.031
MKBK 20.0007
*
0.014 20.0007
*
0.019 20.0009
* *
0.000 20.0009
* *
0.000
PCTINDBD 0.0001 0.261 0.0001 0.326 0.0001 0.306 0.0001 0.362
RETPLY 0.0091
* *
0.004 0.0086
* *
0.006 0.0079
* *
0.002 0.0077
* *
0.002
BDSIZE 0.0037
* *
0.000 0.0035
* *
0.000 0.0025
* *
0.000 0.0023
* *
0.000
MEETINGS 20.0034
* *
0.001 20.0033
* *
0.001 20.0031
* *
0.010 20.0030
* *
0.010
DUAL 0.0013 0.683 0.0010 0.751 0.0030 0.383 0.0025 0.464
MKVAL 0.0023 0.153 0.0021 0.193 0.0038
* *
0.005 0.0034
* *
0.010
FIN 20.0055 0.111 20.0054 0.117 20.0048 0.197 20.0047 0.213
OWN 20.0000 0.951 20.0000 0.900 20.0001 0.719 20.0001 0.720
LOCK 0.0066 0.521 0.0057 0.625 0.0044 0.748 0.0024 0.888
Sample size 3,551 3,551 2,527 2,527
F-value 8.19
* *
0.000 7.13
* *
0.000 6.57
* *
0.000 6.02
* *
0.000
Adjusted R
2
0.0320 0.0298 0.0411 0.0378
Notes: Signi?cance at:
*
5 and
* *
1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 ?rm-year observations
Model:
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY þ a
5
BDSIZE
þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
where
MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5*
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in i’s total revenue from t 2 1 to t, GPPE
it
is
the gross acquisition cost of property, plant, and equipment for ?rm i in year t, A
it21
is the value of average total
assets for ?rm i in year t 2 1, CF
it
is the level of cash ?ow for ?rm i in year t and DCF
it
is a dummy variable that
is equal to 1 if CF
it
is negative and 0 otherwise.
MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modi?ed
equation (Dechow et al., 1995; B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
Table IV.
Results of pooled OLS
regression with earnings
quality (MODQ1 and
MODQ2) as the
dependent variable
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5.2 Robustness tests
A number of alternative forms of the model were estimated to determine the robustness
of the paper’s overall results. For each alternative speci?cation, the model was estimated
inaccordance withthe pooled least squares that generated Table IV. First, we expandthe
set of explanatory variables to include a dummy variable for the presence or absence of
staggered boards (STGBD) and a dummy variable for the presence or absence of
cumulative voting (CUMVTG) feature. Staggered boards are those where a fraction
(usually a third) of the board members get re-elected periodically (usually every third
year) as opposed to unitary boards where all board members are elected periodically.
There are two contradictory effects of staggered boards on earnings management. The
agency perspective view argues that entrenched managers are likely to divert
shareholder wealthto themselves (Faleye, 2007; Shleifer andVishny, 1997), whichinturn
increases the potential of earnings management. In contrast, executives in staggered
boards may be less inclined to manage earnings, since their own position within the ?rm
is somewhat more secure (Zhao and Chen, 2008). Hence, we do not predict, a priori, the
impact of STGBD on earnings quality. A ?rm with CUMVTG enables even relatively
small shareholders to have a say in the management of the ?rm. A ?rm without
CUMVTGis more likely to advance the interests of majority shareholders at the expense
of minority interests. The predicted impact of CUMVTG on earnings quality is a priori
positive. Table V, Panel A reports the results with the inclusion of STGBD and
CUMVTG. However, the inclusion of these variables did not affect the results of our
study. INCPAY and MKBK were negatively associated with earnings quality ( p-values
of 0.010 and 0.012) while independent board is not associated with earnings quality
( p-values of 0.389 and 0.458). Furthermore, the coef?cients on RETPLYare positive and
signi?cant with p-values close to zero for both speci?cations of earnings quality
(MODQ1 and MODQ2). The results are consistent with H1 that manager at-risk pay is
negatively related to earnings quality but do not provide us with any evidence of
association between board independence and earnings quality and hence do not support
our H3. The results suggest that there is a positive association between retirement policy
and earnings quality (H4) and a negative association between the MKBK and earnings
quality (H2).
Finally, we examine alternative speci?cation of the board independence variable.
We de?ne board independence by replacing PCTINDBD by the percentage of
independent board members of the audit committee (PCTINDAD). Table V, Panel B
presents the results with PCTNDBD replaced by PCTINDAD. Once again all of the
prior results hold with the estimated coef?cients not signi?cant for PCTINDAD
( p-values of 0.608 and 0.464); negative and signi?cant for INCPAY ( p-values of 0.014
and 0.017); negative and signi?cant for MKBK ( p-values of 0.015 and 0.020); and
positive and signi?cant for RETPLY ( p-values of 0.002 and 0.003).
In sum, the sensitivity tests broadly support our conjecture that there is a negative
relation between the proportion of incentive pay-to-total pay and ?rm’s growth on the
one hand and earnings quality on the other. We also ?nd a positive association
between retirement policy and earnings quality on the other. At the same time, we ?nd
no association between board independence and earnings quality.
6. Summary and conclusion
The SOX was enacted in 2002 on the implicit assumption that strengthening corporate
governance mechanisms would result in improved relevance and reliability of ?nancial
Quality
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statements. This study investigates whether such an assumption is well-founded.
It documents how certain governance mechanisms and managers’ at-risk pay affect the
quality of reported earnings. In line with our predictions, we ?nd that earnings quality is
higher for ?rms where managerial at-risk pay is lowas a proportion of total pay and for
?rms with lesser growth prospects. The existence of a smooth transition by way of an
established managerial retirement policy has a positive association with earnings
quality. Contrary to our expectations, we ?nd no evidence of an association between
board independence and earnings quality. It is possible that our measure of board
independence may not be fully capturing independence, as it is also highly correlated
with other variables, and other variables might be considered for future research.
MODQ1 MODQ2 MODQ1 MODQ2
Dependent
variable Coef?cient p-value Coef?cient p-value Coef?cient p-value Coef?cient p-value
Intercept 20.0698
* *
0.000 20.0685
* *
0.000 20.0587
* *
0.000 20.0544
* *
0.000
INCPAY 20.0180
* *
0.010 20.0172
*
0.012 20.0174
*
0.014 20.0166
*
0.017
MKBK 20.0007
*
0.014 20.0007
*
0.021 20.0007
*
0.015 20.0007
* *
0.020
PCTINDBD 0.0001 0.389 0.0001 0.458
PCTINDAD 20.0000 0.608 20.0000 0.464
RETPLY 0.0089
* *
0.005 0.0084
* *
0.008 0.0098
* *
0.002 0.0093
* *
0.003
BDSIZE 0.0035
* *
0.000 0.0033
* *
0.000 0.0037
* *
0.000 0.0035
* *
0.000
MEETINGS 20.0034
* *
0.001 20.0033
* *
0.001 20.0033
* *
0.001 20.0032
* *
0.001
DUAL 0.0025 0.740 0.0080 0.805 0.0018 0.571 0.0014 0.639
MKVAL 0.0025 0.132 0.0022 0.169 0.0022 0.169 0.0020 0.212
FIN 20.0053 0.122 20.0053 0.127 20.0068 0.039 20.0068
*
0.041
OWN 20.0000 0.961 20.0000 0.9799 20.0000 0.766 20.0000 0.726
LOCK 0.0079 0.450 0.0069 0.558 0.0056 0.602 0.0045 0.710
STGBD 0.0077
* *
0.010 0.0072
*
0.016
CUMVTG 0.0038 0.299 0.0033 0.359
Sample size 3,551 3,551 3,551 3,551
F-value 7.61
* *
0.000 6.63
* *
0.000 7.93
* *
0.000 6.93
* *
0.000
Adjusted R
2
0.0339 0.0314 0.0318 0.0297
Notes: Signi?cance at:
*
5 and
* *
1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 ?rm-year observations
Model:
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY þ a
5
BDSIZE
þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
where
MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in i’s total revenue from t 2 1 to t, GPPE
it
is the gross acquisition cost of property, plant, and equipment for ?rm i in year t, A
it21
is the value of average
total assets for ?rm i in year t 2 1, CF
it
is the level of cash ?ow for ?rm i in year t and DCF
it
is a dummy
variable that is equal to 1 if CF
it
is negative and 0 otherwise.
MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modi?ed
equation (Dechow et al., 1995; B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
Table V.
Results of pooled OLS
regression with earnings
quality (MODQ1 and
MODQ2) as the
dependent variable
additional control
variables STGBD and
CUMVTG included and
replaced PCTINDBD
(percentage of
independent board) by
PCTINDAD (percentage
of independent audit
committee)
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Our results provide support for the argument that the current structure of executive pay
does adversely impact the qualityof reported earnings and hence provides a rationale for
possible closer scrutiny by regulatory bodies. From a theoretical perspective, our
analysis suggests that more needs to be done on how compensation contracts can be
structured so as to align interests of managers and shareholders while also reducing the
incentive for managing earnings. The focus, however, on board independence as critical
for effective monitoring seems to be misplaced. Future research could examine this issue
in greater detail.
Notes
1. See Romano (2005) for a more complete list of SOX governance initiatives.
2. For a rather extensive review of this literature, see Cohen et al. (2004).
3. This is a version of the Jones (1991) model that accounts for changes in revenues over and
above changes in receivables.
4. As per New York Stock Exchange rules “independence” requires that the director cannot
have been an employee for the past ?ve years and cannot have been an employee of the
company’s auditor for the past ?ve years. A director also cannot have an immediate family
member who has met any of these disquali?cations.
5. The original Jones model, upon which the B&S model is based, does not contain an intercept
term, since the intercept was also de?ated by lagged assets. It is by no means clear that total
accruals would be zero if the independent variables are also zero. We have therefore
corrected this, by including an intercept in each of the models.
6. Market-to-book is used as a proxy for the ?rm’s growth prospects in accounting and ?nance
literature (Gaver and Gaver, 1993).
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Xie, B., Davidson, W.N. III and DaDalt, P.J. (2003), “Earnings management and corporate
governance: the roles of the board and the audit committee”, Journal of Corporate Finance,
Vol. 9, pp. 295-316.
Yermack, D. (1996), “Higher market valuation of companies with a small board of directors”,
Journal of Financial Economics, Vol. 40 No. 2, pp. 185-276.
Zhao, Y. and Chen, K.H. (2008), “Staggered boards and earnings management”, The Accounting
Review, Vol. 83 No. 5, pp. 1347-81.
Corresponding author
Raghavan J. Iyengar can be contacted at: [email protected]
ARJ
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doc_391400981.pdf
The purpose of this paper is to examine the contention that a strengthening of corporate
governance mechanisms would result in the improved relevance and reliability of financial statements.
Accounting Research Journal
Does board governance improve the quality of accounting earnings?
Raghavan J . Iyengar J udy Land Ernest M. Zampelli
Article information:
To cite this document:
Raghavan J . Iyengar J udy Land Ernest M. Zampelli, (2010),"Does board governance improve the quality of
accounting earnings?", Accounting Research J ournal, Vol. 23 Iss 1 pp. 49 - 68
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J ui-Chin Chang, Huey-Lian Sun, (2010),"Does the disclosure of corporate governance structures
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Does board governance improve
the quality of accounting earnings?
Raghavan J. Iyengar and Judy Land
School of Business, North Carolina Central University, Durham,
North Carolina, USA, and
Ernest M. Zampelli
Department of Business and Economics,
The Catholic University of America, Washington, DC, USA
Abstract
Purpose – The purpose of this paper is to examine the contention that a strengthening of corporate
governance mechanisms would result in the improved relevance and reliability of ?nancial statements.
Design/methodology/approach – Using pooled ordinary least squares regression, the paper
analyse the quality of reported earnings for a sample of ?rms over the 1998-2002 time period.
Findings – The ?ndings show negative and statistically signi?cant associations between reported
earnings quality and the proportion of CEO incentive pay and ?rm’s growth opportunities. It is also
found that earnings quality is positively and signi?cantly related to the existence of an orderly CEO
transition process. However, board independence does not seemto be associated with earnings quality.
Research limitations/implications – Since the sample of ?rms is from the 1998 to 2002 period,
consistent with the paper’s motivation, the results may not generalize to the more recent time period.
Practical implications – The results provide support for the argument that the current structure of
executive pay does adversely impact the quality of reported earnings and hence provides a rationale
for closer scrutiny of executive pay by regulatory bodies. Additionally, the ?ndings suggest that the
emphasis on board independence as an effective monitoring device may be misplaced.
Originality/value – Unlike prior studies, the paper’s hypotheses are derived from an explicit agency
theoretic optimization model of managerial decision making. The paper uses the Ball and Shivakumar
model for estimating abnormal accruals unlike previous analyses that relied more heavily on the Jones
model. The paper also adds to past studies of the relationship between corporate governance and
earnings quality and the role of executive compensation.
Keywords Earnings, Corporate governance, Accounting, Financial reporting
Paper type Research paper
1. Introduction
The high-pro?le corporate accounting scandals occurring earlier in this decade,
particularly Enron and WorldCom, precipitated intense debate regarding the
relationship between corporate governance practices and the integrity, reliability, and
credibility of corporate ?nancial reporting. Moreover, they constituted the raison d’etre
for the Sarbanes-Oxley Act (SOX) of 2002 (hereafter referred to as SOX) which
mandated a number of changes in corporate governance practices aimed at
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
The authors gratefully acknowledge the helpful comments from Augustine Duru, Javad Kargar,
Robert Mof?e, and Samuel Kotz, an anonymous referee and the editors Marion Hutchinson and
Gavin Nicholson. Research assistance of Julius Bradshaw and Sarika Ramakrishnan is
appreciated. Raghavan Iyengar and Judy Land acknowledge summer research grant received
from North Carolina Central University.
Quality
of accounting
earnings
49
Accounting Research Journal
Vol. 23 No. 1, 2010
pp. 49-68
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309611011060524
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strengthening the oversight and monitoring capabilities of corporate boards of
directors, thereby, reducing the likelihood of future accounting scandals. For example,
the act mandated that audit committees be comprised entirely of independent directors
and that ?rms be restricted in their purchases of nonauditing services from their
auditors[1]. This study empirically tests these notions by using a sample of pre-2003
?rms, the period on which these assumptions are based.
Prior academic research has provided mixed evidence on the relationship between
corporate governance practices and board characteristics and the integrity and
reliability of corporate ?nancial reporting[2]. Beasley (1996), Dechow et al. (1996) and
more recently, Uzun et al. (2004) ?nd that ?rms with boards comprised of more outside
and independent directors are less likely to commit corporate fraud but ?nd no
signi?cant effects for board size, frequency of board meetings, or frequency of audit
committee meetings. Agrawal and Chadha (2005) analyse the relationship between
governance characteristics and the probability of serious accounting problems, as
gauged by earnings restatements, and ?nd no signi?cant impact of board independence
nor audit committee independence on the probability of restatement. Boards and audit
committees with independent directors possessing ?nancial expertise, however, are
found to signi?cantly lower the probability of restatements. Abbott et al. (2004) ?nds
that all-independent audit committees, audit committees with members having
?nancial expertise, and the frequency of audit committee meetings have signi?cant
negative effects on the likelihood of ?nancial restatements. Their results also indicate
that ?rms with larger boards are more likely to restate earnings.
A number of studies have examined the relationship between corporate governance
and earnings quality (management), as measured by abnormal (discretionary) accruals.
Chtourou et al. (2001) provides evidence that earnings management is less likely in
?rms with audit committees having higher percentages of independent non-executive
directors who are not managers in other ?rms, audit committees with at least one
member with ?nancial expertise, and audit committees comprised of only independent
directors that meet at least twice per year. The authors also ?nd that larger boards are
associated with less earnings management. Klein (2002) reports statistically signi?cant
negative relationships between both board and audit committee independence and
abnormal accruals but no signi?cant relationship between all-independent audit
committees and abnormal accruals. Consistent with these results, Xie et al. (2003) report
that earnings management is less likely to occur in companies with boards that include
both independent outside directors and directors with corporate experience, boards that
are larger, audit committees that are comprised of corporate members and investment
bankers, and audit committees that meet more often. Davidson et al. (2005) also ?nd a
statistically signi?cant negative linkage between board independence and discre-
tionary accruals, but little else. Results from Peasnell et al. (2005) indicate a statistically
signi?cant negative relationship between income-increasing abnormal accruals and the
proportion of outsiders on the board of directors but offer little evidence of linkages
between audit committee characteristics and abnormal accruals.
It seems that the literature has reached consensus on one general issue – corporate
governance and board of director characteristics have implications for the quality of
?nancial reporting. It remains unclear, however, exactly which governance mechanisms
and board characteristics in?uence ?nancial reporting quality and exactly why they do
so. This provides the fundamental motivation for this study in which we too focus on the
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relationship between governance and earnings quality as measured by discretionary
accruals. The paper’s contribution is threefold. First, unlike prior studies, our hypotheses
are derived from an explicit, albeit simple, and agency theoretic optimization model of
managerial decision making. The comparative statics provide the direct links between
the theoretical model and independent variables employed in its econometric counterpart.
Second, previous analyses have relied largely on the modi?ed Jones (1991)[3] model to
estimate abnormal (discretionary) accruals. Ball and Shivakumar (2006), however,
demonstrated that such linear accruals models “by omitting the loss recognition asymmetry,
exhibit substantial attenuation bias and offer a comparatively poor speci?cation of the
accounting accrual process (Ball and Shivakumar (2006, p. 207).” They go on to show that:
[. . .] that nonlinear accruals models incorporating the asymmetry in gain and loss recognition
(timelier loss recognition, or conditional conservatism) offer a substantial speci?cation
improvement, explaining substantially more variation in accruals than equivalent linear
speci?cations.
Consequently, in this study, we have chosen to use abnormal accruals estimated from
the models developed by Ball and Shivakumar (2006). Third, this paper adds to past
studies of the relationship between corporate governance and earnings quality as
proxied by abnormal (discretionary) accruals and the role of executive compensation
(Bergstresser and Philippon, 2006; Meek et al., 2007). Executive bonuses, stock options,
etc. are regularly indicted as major reasons for the use of overly aggressive and zealous
accounting practices and past studies using alternative proxies for earnings quality
have incorporated some version of CEO compensation into their models. For these
reasons together with our analytical results, CEO incentive pay is afforded an
important role in the discretionary accruals process.
The paper’s major ?ndings include:
.
a signi?cant negative association between earnings quality and managers’
incentive pay;
.
a signi?cant negative association between earnings quality and a ?rm’s growth
prospects; and
.
a signi?cant positive association between earnings quality and the existence of
an orderly succession policy.
We ?nd no statistical evidence of a signi?cant association between earnings quality
and board and audit committee independence. The main results remain unchanged for
a battery of robustness tests.
The remainder of the paper is structured as follows. Section 2 presents the agency
theoretic optimization model, the relevant comparative statics, and the hypotheses to
be tested. The abnormal accruals measures used as proxies for earnings quality along
with the explanatory variables of the econometric model are discussed in Section 3.
The sample, its selection, and the descriptive statistics for all major variables are
discussed in Section 4. Section 5 presents the empirical results and discusses their
implications. Summary and concluding remarks are offered in Section 6.
2. A simple model of managerial decision making
Our theoretical model is a simpli?ed version and an extension of the model developed by
Feltham and Xie (1994). We assume a risk averse manager (the agent) who expends
Quality
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effort in performing two activities, Activities 1 and 2. Shareholders (the principal) do not
observe the manager’s effort levels, e
1
and e
2
, respectively, and thus face an incentive
problem that is addressed by an incentive compensation contract. Since e
1
and e
2
are
unobservable, the compensation contract is based on a reported performance measure, y.
The ?rst activity is productive as it is aimed entirely at improving y for the sake of
increasing the shareholders’ payoff. The second activity is “window dressing” aimed
only at increasing the measure of performance to the bene?t of the manager with no
additional bene?t to shareholders. The relationship between y and the activity levels is
assumed to be linear and given by:
y ¼ m
1
e
1
þ m
2
e
2
þ 1 ð1Þ
where m
i
is the marginal productivity of e
i
and ~ 1 N 0; s
2
1
À Á
represents the stochastic
component of the performance measure. The manager’s wage, w, is assumed to be a
linear function of y represented by:
w ¼ w
0
þ n y ¼ w
0
þ n ðm
1
e
1
þ m
2
e
2
þ 1Þ ð2Þ
where w
0
is a ?xed payment and n is the pay-performance sensitivity. The direct cost to
the agent of exerting effort is assumed to be quadratic and given by:
Cðe
1
; e
2
Þ ¼
1
2
e
2
1
þ
1
2
e
2
2
ð3Þ
The manager assumes, however, that a penalty will likely be imposed by the principal if
the “windowdressing” activity is discovered. The penalty is assumed to be proportional
to m
2
e
2
and equal to tm
2
e
2
where 0 , t , 1. The manager estimates a non-zero
probability of detection at 0 , r , 1. Augmenting equation (3) by the expected penalty,
we have:
Cðe
1
; e
2
Þ ¼
1
2
e
2
1
þ
1
2
e
2
2
þ rtm
2
e
2
ð4Þ
The manager is assumed to choose e
1
and e
2
to maximize the objective function
w 2Cðe
1
; e
2
Þ. The solutions to the ?rst order conditions are easily shown to be:
e
*
1
¼ nm
1
e
*
2
¼ ðn 2rtÞm
2
ð5Þ
Fromequation (5), we see that the comparative statics for e
*
2
are sensible. In particular, the
optimal level of window dressing effort is increasing in the pay-performance sensitivity
›e
*
2
=›n
. 0
, and with the marginal productivity of effort ›e
*
2
=›m
2
. 0
, for
ðn 2rtÞ . 0; and declining in the probability of detection and in the penalty proportion:
›e
*
2
›r
, 0 and
›e
*
2
›t
, 0:
Simply stated, the comparative statics suggest that increases in the sensitivity of
managerial compensation to ?rm performance will engender more effort to
opportunistically manipulate ?rmperformance measures as will a bigger marginal payoff
from such manipulation. In contrast, closer and more effective monitoring of managerial
actions and/or a higher penalty for managerial misconduct will reduce such effort.
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2.1 Hypotheses development
Based on the above theoretical model of managerial decision making, we focus on four
speci?c issues that may be associated with the quality of reported corporate earnings.
Incentive pay. Extant academic literature seems to suggest that as the proportion of
managers’ at-risk pay to total pay increases, managers have an incentive to manipulate
their ?rms’ reported earnings. Bergstresser and Philippon (2006) document that if
CEO’s potential total compensation is more closely tied to the value of stock and option
holdings they have a greater incentive to use of discretionary accruals to manage
reported earnings. Sloan (1996) and Collins and Hribar (2000) have shown that
managers manipulate reported earnings to affect stock prices thereby increasing their
wealth through the use of stock options or other forms of incentive compensation. More
recently, Cheng and War?eld (2005) found that managers with substantial equity
incentives in the form of stock compensation and ownership are motivated to manage
earnings in order to sell shares in the future. Ke (2005) argues that CEOs with high
incentives are more likely to manage earnings to produce a string of consecutive
earnings increases. Two recent studies (Cornett et al., 2008; Meek et al., 2007) document
a positive association between equity incentives and discretionary accruals. It seems
then that the preponderance of evidence suggests that as managers’ wealth becomes
more sensitive to stock prices and earnings, managers are more inclined to manipulate
earnings thereby reducing the quality of reported earnings. In terms of our model
above, as pay-performance sensitivity increases the effort expended on window
dressing would also increase ›e
*
2
=›n
. 0
. Consequently, we posit that as the
proportion of incentive pay increases, managers may be more inclined to manipulate
the performance through abnormal accruals thus diluting the quality of earnings.
We predict a negative association between the incentive pay and earnings quality:
H1. There is a negative relation between the proportion of incentive pay-to-total
pay and earnings quality.
Growth. Lee et al. (2006) demonstrate that higher growth ?rms are more likely to
manage earnings. Abarbanell and Lehavy (2003) document that ?rms with higher
growth opportunities have stronger incentives to meet or beat analysts’ forecast of
earnings. Additionally, there is considerable evidence from prior research including
Clinch (1991), Gaver and Gaver (1993), Anderson et al. (2000) and Ittner et al. (2002),
that CEO incentive pay is higher in ?rms with more growth opportunities and that
?rms with higher growth opportunities are also likely to have strong incentives to meet
earnings targets, Skinner and Sloan (2002). Since higher growth ?rms may offer a
bigger marginal payoff to managers from earnings manipulation, managers may be
more likely to expend greater effort to opportunistically manipulate ?rm performance
›e
*
2
=›m
2
. 0
. This leads to the following hypothesis:
H2. There is a negative relation between the ?rm’s growth prospects and earnings
quality.
Board independence. Board members are deemed to be independent if they are not
employees of the company or its auditors and do not have any material relationship
with the company[4]. Prior research ?nds that board independence is linked to both the
quality of ?nancial information and executive actions (Dechow et al., 1996; Klein, 2002).
Quality
of accounting
earnings
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Since ?nancial statements are reviewed by the board of directors before its release,
we explore whether stronger monitoring of managerial actions and/or a higher penalty
for managerial misconduct will curb managerial effort to window-dress. Since our
theoretical model suggests that the optimal level of window-dressing effort declines
with the probability of detection and the penalty proportion:
›e
*
2
›r
, 0 and
›e
*
2
›t
, 0;
we posit the following hypothesis:
H3. There is a positive relation between board independence and earnings quality.
Orderly succession. The success of a ?rm depends not only on the current management
team but also on its management transition plans and procedures. The sudden death or
departure of a CEO in the absence of adequate replacement and transition plans can
substantially undermine stockholder con?dence as well as the ?nancial viability of an
otherwise pro?table company. In contrast, a written and orderly succession policy for
managers creates an image of ?rm stability and instills con?dence in the ?rm’s
management. The presence of orderly transition by design implies the existence of
appropriate retirement policies. We envisage that ?rms with orderly transition
processes are also likely to have in place good internal controls for ?nancial record
keeping. Kanagaretnam et al. (2007) ?nd that the quality of corporate governance,
which includes a variable for retirement policy, is signi?cantly negatively related to
information asymmetry around earnings announcements. In terms of our theoretical
model an orderly transition would imply effective monitoring of managers by the
board of directors. This suggests that earnings quality should be higher in ?rms where
there is a managerial retirement policy in place:
H4. There is a positive relationship between the existence of a managerial
retirement policy and earnings quality.
3. Model for earnings quality, theoretical background, and hypotheses
3.1 Earnings quality
To examine the in?uence of incentive pay, growth, board independence, and retirement
policy have any in?uence on earnings quality, we incorporate two alternate de?nitions of
earnings quality. Schipper and Vincent (2003) summarize much of the literature on
earnings quality. Since there are various ways to capture the levels of earnings
management for ?rms inour sample, we include several proxies for the level of accounting
quality. In this study, we use abnormal accruals measures to determine the level of
earnings management. We multiply the absolute value of accruals by negative one so that
smaller values, values closer to zero represent higher quality of earnings and larger
accruals (values further away fromzero) are indicative of a lower quality of earnings. The
two proxies are based on abnormal accruals model for earnings management introduced
by Ball and Shivakumar (2006; henceforth B&S). We estimate abnormal accruals using
the following models: the model by B&S (MODQ1), and a modi?ed B&S (MODQ2) model.
The alternate measures of earnings quality are de?ned as[5]:
MODQ1 ¼ the absolute value of the residuals obtained from the following equation
(B&S, 2006) multiplied by 21:
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TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5*
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in ?rm i’s total
revenue from t 2 1 to t, GPPE
it
is the gross acquisition cost of property, plant, and
equipment for ?rm i in year t, A
it21
is the value of average total assets for ?rm i in year
t 2 1, CF
it
is the level of cash ?ow for ?rm i and DCF
it
is a dummy variable that is
equal to 1 if CF
it
is negative and 0 otherwise:
MODQ2 ¼ the absolute value of the residuals obtained from the following modi?ed
equation (Dechow et al., 1995; B&S, 2006) multiplied by 21.
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
For both of the measures, the absolute value of the residuals is multiplied by minus one
so that smaller (larger) values of abnormal or discretionary accruals indicate higher
(lower) earnings quality.
It should be noted that the original model advanced by Jones (1991) as well as B&S
did not contain an intercept term, since the intercept was also de?ated by lagged
assets. But, it is by no means clear that total accruals would be zero if all independent
variables are zero. Peasnell et al. (2000) use a modi?ed Jones model with an intercept
and explain that the intercept is not de?ated because:
First, there is no theoretical reason for forcing the regression through the origin [. . .]. Second,
regressions estimated with the constant suppressed preclude an analysis of the goodness-of-?t
of the models because the associated R-square values are unreliable [. . .]” (p. 316, fn. 12).
In accordance with these arguments, we follow Peasnell et al. (2000) and include an
intercept in each of the two accrual models.
3.2 An econometric model of earnings quality
To test the association between incentive pay, growth, board independence, and
retirement policy on one hand and earnings quality on the other, we use the following
regression model (after controlling for other factors identi?ed by current literature):
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY
þ a
5
BDSIZE þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL
þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
ð8Þ
where:
MODQ ¼ one of the two alternate measures of earnings quality (MODQ1,
MODQ2), de?ned earlier.
INCPAY ¼ the percentage of CEO incentive pay to total pay, where incentive
pay is de?ned as “bonus” and total pay is salary plus bonus plus
Quality
of accounting
earnings
55
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2
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a
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2
0
1
6
(
P
T
)
other annual plus other restricted stock grants plus long-term
incentive payouts plus value of stock options granted plus all other.
Total pay is TDC1 in ExecuComp parlance.
MKBK ¼ market-to-book ratio of common equity[6].
PCTINDBD ¼ the percentage of board members who are independent.
RETPLY ¼ a dummy variable equal to one if the ?rm has a retirement policy
and zero otherwise.
BDSIZE ¼ the total number of members on the corporate board.
MEETINGS ¼ the number of board meetings held in a year.
DUAL ¼ a dummy variable equal to one if the ?rm’s CEO is also the chair of
the board, and equal to zero otherwise.
MKVAL ¼ the natural logarithm of the ?rm’s market value at the end of the
year.
FIN ¼ a dummy variable equal to one if a member of the board has other
?nancial relationships in the ?rm and zero otherwise.
OWN ¼ stocks held by directors as a percentage of ?rm’s outstanding
equity.
LOCK ¼ dummy variable equal to one if any of the following hold:
.
the CEO serves on the board committee that makes his compensation decisions;
or
.
the CEO serves on the board (and possibly compensation committee) of another
company that has an executive of?cer serving on the compensation committee of
the CEO’s company, or the CEOserves on the compensation committee of another
company that has an executive of?cer serving on the board (and possibly
compensation committee) of the CEO’s company.
3.3 Control variables
We include most of the governance variables that are available in the Investor
Responsibility Research Center (IRRC) database as control variables. The estimating
equation includes other control variables such as BDSIZE (the total number of
members on the corporate board), MEETINGS (the number of board meetings held in
one year), DUAL (dummy variable equal to one if the ?rm’s CEO is also the chair of the
board, and equal to zero otherwise), MKVAL (?rm size as measured by the natural log
of the ?rm’s market value at the end of the year), FIN (board members having other
?nancial stake in the business), OWN (percentage of stock owned by directors), and
LOCK (executives interlocking relationship).
Board size (BDSIZE). Yermack (1996) demonstrates that smaller boards are effective
in improving ?rm performance and Vafeas (2000) ?nds that smaller boards (with a
minimum of ?ve board members) result in higher earnings response coef?cients when
analysing the informativeness of earnings. Beasley (1996) ?nds board size to be
positively related to ?nancial statement fraud. However, others like Xie et al. (2003) and
ARJ
23,1
56
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A
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2
1
:
1
0
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
Klein (2002) argue that larger boards are better able to effectively monitor a ?rmbecause
of the greater likelihood of independent directors with corporate or ?nancial expertise
and experience. Xie et al. (2003) also ?nds that larger boards are associated with lower
discretionary accruals. Thus, far, board size has often been identi?ed as a signi?cant
determinant of earnings management/quality but the direction of its impact remains
unresolved.
Number of board meetings (MEETINGS). Vafeas (1999) questions the importance of
board activity, and conjectures that boards are more active in the presence of problems,
implying that increased board meetings are a response to poor ?rm performance rather
than an indicator of pro-active behavior. Consistent with the argument in Vafeas (1999)
and Chtourou et al. (2001) ?nd higher levels of earnings management in ?rms with
larger number of board meetings. In contrast, other studies including Xie et al. (2003)
and Bowen et al. (2008) ?nd that when boards meet more often earnings management is
lower. The number of board meetings has been shown to be signi?cantly associated
with earnings management/quality, although the direction is uncertain.
CEO duality (DUAL). Poor corporate governance has commonly been linked to CEO
duality, where the ?rm’s CEO also serving as the chair of its board of directors.
According to Fama and Jensen (1983) and Jensen (1993), CEOduality violates the rubric
of the separation of decision control and decision management, thus impeding a board’s
ability to monitor the CEO effectively. In contrast, Stoeberl and Sherony (1985) and
Anderson and Anthony (1986) argue that a dual structure creates greater stability and
fosters better communication while Brickleyet al. (1997) asserts that a non-dual structure
results in higher information, agency, and incentive costs. Arecent study by Iyengar and
Zampelli (2009) examines the issue of duality and ?rmperformance froman endogenous
theory of governance. They conclude that ?rm’s selection of the dual governance
structure is not consistent with either comparative advantage or the objective of
maximizing ?rmperformance. The literature on duality has not yet provided compelling
evidence one way or the other, but we include it as a control variable in our analysis.
Firm size (MKVAL). Large ?rms are closely monitored by the ?rm and its various
stakeholders, and as ?rmsize increases there is much greater media and public scrutiny.
It has been found that information provided by large ?rms is impounded in stock prices
in greater proportion than for small ?rms prior to earnings announcements (Atiase,
1985), and that the larger the ?rm, the higher the analyst following (Dempsey, 1989).
A recent article by Christensen et al. (2004) ?nd that there is a positive relationship
between ?rmsize and the information content of earnings announcements. We therefore
posit a positive effect of ?rm size on earnings quality.
Other?n (FIN). The “FIN” variable is a dummy variable that captures the extent to
which an outside director has a family, business, and/or ?nancial relationship with the
company. Since this variable may reduce the ability of a board member to be independent,
we predict that the existence of this relationship will reduce the effectiveness of the board
and will be associated with reduced earnings quality.
Ownership (OWN). Any analysis of board governance cannot ignore the role of
managerial equity ownership. As directors of a ?rm hold higher percentages of a ?rm’s
outstanding equity, they are more likely to have interests that are aligned with the
shareholders and more likely to effectively monitor the ?rm( Jensen and Meckling, 1976).
Consequently, we predict a positive relationship between director ownership and the
Quality
of accounting
earnings
57
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U
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I
T
Y
A
t
2
1
:
1
0
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
quality of reported earnings. The variable “OWN” measures the percentage of stock held
by directors of the ?rm as a fraction of the ?rm’s outstanding equity.
Interlock (LOCK). The LOCK variable measures the extent to which a CEO has
in?uence over his own compensation, either by serving the board committee which
makes decisions effecting compensation or having a relationship with an individual
serving the committee making compensation decisions. Since this variable reduces the
level of independence that the board has on any decisions relating to compensation, we
predict that this will have a negative relationship with earnings quality.
4. Research design
4.1 Sample selection
To compile the sample of ?rms, we began with the population of ?rms in the IRRC
database for the period 1998-2002. We restricted the sample to pre-SOX by limiting the
data from 1998 to 2002. Proponents of SOX believed that certain board characteristics
(for instance, board independence) were crucial to preventing accounting practices that
diminish the integrity of ?nancial reporting. Since we wish to examine if the priors are
supported by empirical evidence we exclude 2003 or later data. This initial sample
consisted of 4,819 ?rm-year observations. From this population, we deleted
623 observations with insuf?cient governance data in the IRRC database. From this, we
dropped 162 and 152 observations for lack of ?nancial data and compensation data in the
Compustat and ExecuComp databases, respectively. We then proceeded to delete
198 observations because there were insuf?cient observations tocompute the ?rm-speci?c
residuals and consequently, the accounting quality measures (minimum eight year data
required for each ?rm) in Compustat database. We then winsorize the data by discarding
the extreme outliers (observations in the top and bottom 0.5 percent of each of the
variables). This process eliminated another 133 observations. Table I provides details of
how the selection criteria resulted in a ?nal sample of 3,551 ?rm-year observations.
4.2 Descriptive statistics
Table II presents the distribution of our sample by industry and mean values of main
variables in our study. The industry distribution of our sample is similar to prior
studies using comparable sample evidence (Frankel et al., 2002; Whisenant et al., 2003).
Industry membership is de?ned by the four digit SIC code, and our sample includes
Number of ?rm-years
Number of non-?nancial, non-utility, ?rm year observations from IRRC
database for the sample period 4,819
Less: ?rm-years
(1) with insuf?cient data in IRRC for all the governance variables (623)
(2) with insuf?cient ?nancial data in Compustat database (162)
(3) with insuf?cient executive compensation data in ExeCucomp database (152)
(4) with insuf?cient observations to obtain ?rm-speci?c residuals and
consequently the accounting quality measures (minimum eight
observations required for each ?rm to run ?rm-speci?c regression) (198)
(5) with extreme outliers (observations in the top and bottom 0.5 percent of
each of the variables) (133)
Number of ?rm-year observations in the ?nal sample 3,551
Table I.
Selection of sample of
?rm-years 1998-2002
ARJ
23,1
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.
F
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:
W
h
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a
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t
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a
l
.
(
2
0
0
3
)
Table II.
Distribution of ?rm-years
(1998-2002) across
industries and mean
values of main
explanatory variables
Quality
of accounting
earnings
59
D
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P
O
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D
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t
2
1
:
1
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2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
a variety of industries. In addition, our sample does include a higher percentage of
?rms from the “Durables” industry, and we address this issue in the sensitivity
analysis section of the paper.
Table II reports the means of all variables. In general, the mean values are similar
across models and industries. On average, ?rms in the computer industry are associated
with the lowest quality of earnings for both models, while the highest levels of earnings
quality are reported by chemicals and transportation industries. On average, companies
in the food industry are the largest in terms of market value, exhibit the highest growth
(MKBK) and are managed by the largest corporate boards. Firms in the pharmaceutical
industry have the largest percentage of incentive pay, are second highest in growth
opportunities, and have the largest number of board meetings. Firms in the mining/
construction industry also appear to have large percentage of incentive pay and are
likely to have a dual CEO structure and a managerial retirement policy. At the opposite
end of the spectrum are ?rms in computer industry, which have the smallest board, are
least likely to have a dual CEO structure, and also less likely to have a managerial
retirement policy in place.
The correlations of the main variables are reported in Table III. The Pearson
correlation coef?cients provide some evidence of the direction of the results. Consistent
with predictions, both of the earnings quality measures, MODQ1 and MODQ2, are
signi?cantly correlated with ?rm growth, MKBK, at the 5 percent level. The earnings
qualitymeasures are also signi?cantly positively correlatedwith RETPLYand BDSIZE.
Earnings quality is negatively correlated with INCPAY, although the correlation is
insigni?cant. Other variables that are signi?cantly correlated to earnings quality are
MKVAL, and MEETINGS. One of the earnings quality measures, MODQ1, is positively
correlated with PCTINDBD and DUAL, but only moderately so, at the 10 percent
signi?cance level.
5. Results
5.1 Main results
Table IV presents the results of the pooled OLS estimation of equations (1) and (2) with
MODQ1 and MODQ2 as respective dependent variables. Panel A reports the results for
the entire sample. It is obvious from Table II that a substantial portion of our sample is
from one industry, namely “Durables”. Thus, the clustering effect of durables industry
cannot be ignored. To rectify this situation, we deleted all observations from this
industry and re-ran the model, the results of which are reported in Panel B of Table IV.
Parameter estimates are given along with the corresponding p-values. Standard
signi?cance levels of one and 5 percent are used for the statistical inference. In both
speci?cations, the coef?cients on INCPAY, the measure of incentive pay, are negative
and signi?cant at the 1 percent level, consistent with our H1 that manager at-risk pay is
negatively related to earnings quality. The coef?cients on MKBK are also negative and
statistically signi?cant (at the 5 percent level), indicating that ?rms’ growth
opportunities are negatively related to earnings quality, consistent with hypothesis H2.
Tests of hypothesis H3 show that the coef?cient on PCTINDBD is positive as
expected but not signi?cantly different from zero in either speci?cation. The results
provide no evidence of anassociation between board independence andearnings quality,
hence hypothesis H3 is rejected. The estimated coef?cient on retirement policy,
RETPLY is consistently positive and signi?cant across the alternate speci?cations,
ARJ
23,1
60
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s
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s
Table III.
Correlation table: Pearson
correlation coef?cients
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supporting hypothesis H4. Other results are that the coef?cient on BDSIZE is positive
and signi?cant at the 1 percent level, an indication that the larger executive board is
better able to monitor the ?rm, consistent with?ndings inXie et al. (2003). Inaddition, the
coef?cient on MEETINGS is negative and signi?cant at the 1 percent level, supporting
the argument that increased board meetings are related to increased earnings
management. This is consistent with ?ndings of Vafeas (1999) and Chtourou et al. (2001).
The estimated coef?cients DUAL, OWN, LOCK, and FIN are insigni?cant
suggesting that none of these variables are important in determining earnings quality.
The parameter estimate of MKVAL, a measure of ?rm size, is positive and signi?cant
only when the durable industry is excluded from the analysis.
Panel A (full sample) Panel B (durable industry exluded)
MODQ1 MODQ2 MODQ1 MODQ2
Dependent
variable Coef?cient p-value Coef?cient p-value Coef?cient p-value Coef?cient p-value
Intercept 20.0663
* *
0.000 20.0626
* *
0.000 20.0685
* *
0.000 20.0638
* *
0.000
INCPAY 20.0181
* *
0.010 20.0173
*
0.012 20.0185
*
0.025 20.0174
*
0.031
MKBK 20.0007
*
0.014 20.0007
*
0.019 20.0009
* *
0.000 20.0009
* *
0.000
PCTINDBD 0.0001 0.261 0.0001 0.326 0.0001 0.306 0.0001 0.362
RETPLY 0.0091
* *
0.004 0.0086
* *
0.006 0.0079
* *
0.002 0.0077
* *
0.002
BDSIZE 0.0037
* *
0.000 0.0035
* *
0.000 0.0025
* *
0.000 0.0023
* *
0.000
MEETINGS 20.0034
* *
0.001 20.0033
* *
0.001 20.0031
* *
0.010 20.0030
* *
0.010
DUAL 0.0013 0.683 0.0010 0.751 0.0030 0.383 0.0025 0.464
MKVAL 0.0023 0.153 0.0021 0.193 0.0038
* *
0.005 0.0034
* *
0.010
FIN 20.0055 0.111 20.0054 0.117 20.0048 0.197 20.0047 0.213
OWN 20.0000 0.951 20.0000 0.900 20.0001 0.719 20.0001 0.720
LOCK 0.0066 0.521 0.0057 0.625 0.0044 0.748 0.0024 0.888
Sample size 3,551 3,551 2,527 2,527
F-value 8.19
* *
0.000 7.13
* *
0.000 6.57
* *
0.000 6.02
* *
0.000
Adjusted R
2
0.0320 0.0298 0.0411 0.0378
Notes: Signi?cance at:
*
5 and
* *
1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 ?rm-year observations
Model:
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY þ a
5
BDSIZE
þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
where
MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5*
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in i’s total revenue from t 2 1 to t, GPPE
it
is
the gross acquisition cost of property, plant, and equipment for ?rm i in year t, A
it21
is the value of average total
assets for ?rm i in year t 2 1, CF
it
is the level of cash ?ow for ?rm i in year t and DCF
it
is a dummy variable that
is equal to 1 if CF
it
is negative and 0 otherwise.
MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modi?ed
equation (Dechow et al., 1995; B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
Table IV.
Results of pooled OLS
regression with earnings
quality (MODQ1 and
MODQ2) as the
dependent variable
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5.2 Robustness tests
A number of alternative forms of the model were estimated to determine the robustness
of the paper’s overall results. For each alternative speci?cation, the model was estimated
inaccordance withthe pooled least squares that generated Table IV. First, we expandthe
set of explanatory variables to include a dummy variable for the presence or absence of
staggered boards (STGBD) and a dummy variable for the presence or absence of
cumulative voting (CUMVTG) feature. Staggered boards are those where a fraction
(usually a third) of the board members get re-elected periodically (usually every third
year) as opposed to unitary boards where all board members are elected periodically.
There are two contradictory effects of staggered boards on earnings management. The
agency perspective view argues that entrenched managers are likely to divert
shareholder wealthto themselves (Faleye, 2007; Shleifer andVishny, 1997), whichinturn
increases the potential of earnings management. In contrast, executives in staggered
boards may be less inclined to manage earnings, since their own position within the ?rm
is somewhat more secure (Zhao and Chen, 2008). Hence, we do not predict, a priori, the
impact of STGBD on earnings quality. A ?rm with CUMVTG enables even relatively
small shareholders to have a say in the management of the ?rm. A ?rm without
CUMVTGis more likely to advance the interests of majority shareholders at the expense
of minority interests. The predicted impact of CUMVTG on earnings quality is a priori
positive. Table V, Panel A reports the results with the inclusion of STGBD and
CUMVTG. However, the inclusion of these variables did not affect the results of our
study. INCPAY and MKBK were negatively associated with earnings quality ( p-values
of 0.010 and 0.012) while independent board is not associated with earnings quality
( p-values of 0.389 and 0.458). Furthermore, the coef?cients on RETPLYare positive and
signi?cant with p-values close to zero for both speci?cations of earnings quality
(MODQ1 and MODQ2). The results are consistent with H1 that manager at-risk pay is
negatively related to earnings quality but do not provide us with any evidence of
association between board independence and earnings quality and hence do not support
our H3. The results suggest that there is a positive association between retirement policy
and earnings quality (H4) and a negative association between the MKBK and earnings
quality (H2).
Finally, we examine alternative speci?cation of the board independence variable.
We de?ne board independence by replacing PCTINDBD by the percentage of
independent board members of the audit committee (PCTINDAD). Table V, Panel B
presents the results with PCTNDBD replaced by PCTINDAD. Once again all of the
prior results hold with the estimated coef?cients not signi?cant for PCTINDAD
( p-values of 0.608 and 0.464); negative and signi?cant for INCPAY ( p-values of 0.014
and 0.017); negative and signi?cant for MKBK ( p-values of 0.015 and 0.020); and
positive and signi?cant for RETPLY ( p-values of 0.002 and 0.003).
In sum, the sensitivity tests broadly support our conjecture that there is a negative
relation between the proportion of incentive pay-to-total pay and ?rm’s growth on the
one hand and earnings quality on the other. We also ?nd a positive association
between retirement policy and earnings quality on the other. At the same time, we ?nd
no association between board independence and earnings quality.
6. Summary and conclusion
The SOX was enacted in 2002 on the implicit assumption that strengthening corporate
governance mechanisms would result in improved relevance and reliability of ?nancial
Quality
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statements. This study investigates whether such an assumption is well-founded.
It documents how certain governance mechanisms and managers’ at-risk pay affect the
quality of reported earnings. In line with our predictions, we ?nd that earnings quality is
higher for ?rms where managerial at-risk pay is lowas a proportion of total pay and for
?rms with lesser growth prospects. The existence of a smooth transition by way of an
established managerial retirement policy has a positive association with earnings
quality. Contrary to our expectations, we ?nd no evidence of an association between
board independence and earnings quality. It is possible that our measure of board
independence may not be fully capturing independence, as it is also highly correlated
with other variables, and other variables might be considered for future research.
MODQ1 MODQ2 MODQ1 MODQ2
Dependent
variable Coef?cient p-value Coef?cient p-value Coef?cient p-value Coef?cient p-value
Intercept 20.0698
* *
0.000 20.0685
* *
0.000 20.0587
* *
0.000 20.0544
* *
0.000
INCPAY 20.0180
* *
0.010 20.0172
*
0.012 20.0174
*
0.014 20.0166
*
0.017
MKBK 20.0007
*
0.014 20.0007
*
0.021 20.0007
*
0.015 20.0007
* *
0.020
PCTINDBD 0.0001 0.389 0.0001 0.458
PCTINDAD 20.0000 0.608 20.0000 0.464
RETPLY 0.0089
* *
0.005 0.0084
* *
0.008 0.0098
* *
0.002 0.0093
* *
0.003
BDSIZE 0.0035
* *
0.000 0.0033
* *
0.000 0.0037
* *
0.000 0.0035
* *
0.000
MEETINGS 20.0034
* *
0.001 20.0033
* *
0.001 20.0033
* *
0.001 20.0032
* *
0.001
DUAL 0.0025 0.740 0.0080 0.805 0.0018 0.571 0.0014 0.639
MKVAL 0.0025 0.132 0.0022 0.169 0.0022 0.169 0.0020 0.212
FIN 20.0053 0.122 20.0053 0.127 20.0068 0.039 20.0068
*
0.041
OWN 20.0000 0.961 20.0000 0.9799 20.0000 0.766 20.0000 0.726
LOCK 0.0079 0.450 0.0069 0.558 0.0056 0.602 0.0045 0.710
STGBD 0.0077
* *
0.010 0.0072
*
0.016
CUMVTG 0.0038 0.299 0.0033 0.359
Sample size 3,551 3,551 3,551 3,551
F-value 7.61
* *
0.000 6.63
* *
0.000 7.93
* *
0.000 6.93
* *
0.000
Adjusted R
2
0.0339 0.0314 0.0318 0.0297
Notes: Signi?cance at:
*
5 and
* *
1 percent levels, respectively, for a two-tailed test; the table reports the
regression results of earnings quality on governance variables; sample consists of 3,551 ?rm-year observations
Model:
MODQ ¼ a
0
þ a
1
INCPAY þ a
2
MKBK þ a
3
PCTINDBD þ a
4
RETPLY þ a
5
BDSIZE
þ a
6
MEETINGS þ a
7
DUAL þ a
8
MKVAL þ a
9
FIN þ a
10
OWN þ a
11
LOCK þ 1
where
MODQ1 ¼ minus one times the absolute value of the residuals obtained from the estimation of the
equation (see B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð6Þ
where TA
it
is total accruals for ?rm i in year t, DREV
it
is the change in i’s total revenue from t 2 1 to t, GPPE
it
is the gross acquisition cost of property, plant, and equipment for ?rm i in year t, A
it21
is the value of average
total assets for ?rm i in year t 2 1, CF
it
is the level of cash ?ow for ?rm i in year t and DCF
it
is a dummy
variable that is equal to 1 if CF
it
is negative and 0 otherwise.
MODQ2 ¼ minus one times the absolute value of the residuals obtained from the estimation of the modi?ed
equation (Dechow et al., 1995; B&S, 2006):
TA
it
A
it21
¼ a
0
þ a
1
DREV
it
2DREC
it
A
it21
þ a
2
GPPE
it
A
it21
þ a
3
CF
it
A
it21
þ a
4
DCF
it
þ a
5 *
DCF
it *
CF
it
A
it21
þ 1
it
ð7Þ
Table V.
Results of pooled OLS
regression with earnings
quality (MODQ1 and
MODQ2) as the
dependent variable
additional control
variables STGBD and
CUMVTG included and
replaced PCTINDBD
(percentage of
independent board) by
PCTINDAD (percentage
of independent audit
committee)
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Our results provide support for the argument that the current structure of executive pay
does adversely impact the qualityof reported earnings and hence provides a rationale for
possible closer scrutiny by regulatory bodies. From a theoretical perspective, our
analysis suggests that more needs to be done on how compensation contracts can be
structured so as to align interests of managers and shareholders while also reducing the
incentive for managing earnings. The focus, however, on board independence as critical
for effective monitoring seems to be misplaced. Future research could examine this issue
in greater detail.
Notes
1. See Romano (2005) for a more complete list of SOX governance initiatives.
2. For a rather extensive review of this literature, see Cohen et al. (2004).
3. This is a version of the Jones (1991) model that accounts for changes in revenues over and
above changes in receivables.
4. As per New York Stock Exchange rules “independence” requires that the director cannot
have been an employee for the past ?ve years and cannot have been an employee of the
company’s auditor for the past ?ve years. A director also cannot have an immediate family
member who has met any of these disquali?cations.
5. The original Jones model, upon which the B&S model is based, does not contain an intercept
term, since the intercept was also de?ated by lagged assets. It is by no means clear that total
accruals would be zero if the independent variables are also zero. We have therefore
corrected this, by including an intercept in each of the models.
6. Market-to-book is used as a proxy for the ?rm’s growth prospects in accounting and ?nance
literature (Gaver and Gaver, 1993).
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Corresponding author
Raghavan J. Iyengar can be contacted at: [email protected]
ARJ
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