Description
The purpose of this paper is to determine what aspects of board independence, in terms of
board structure and characteristics of non-executive directors (NEDs), are associated with effective
monitoring of management, as evidenced through lower levels of earnings management.
Accounting Research Journal
What makes a board independent? Australian evidence
Liyu He Sue Wright Elaine Evans Susan Crowe
Article information:
To cite this document:
Liyu He Sue Wright Elaine Evans Susan Crowe, (2009),"What makes a board independent? Australian
evidence", Accounting Research J ournal, Vol. 22 Iss 2 pp. 144 - 166
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What makes a board independent?
Australian evidence
Liyu He, Sue Wright and Elaine Evans
Faculty of Business and Economics, Macquarie University,
Sydney, Australia, and
Susan Crowe
Faculty of Science, Macquarie University, Sydney, Australia
Abstract
Purpose – The purpose of this paper is to determine what aspects of board independence, in terms of
board structure and characteristics of non-executive directors (NEDs), are associated with effective
monitoring of management, as evidenced through lower levels of earnings management.
Design/methodology/approach – This paper examines the effectiveness of board independence
requirements under the 2003 Australian Stock Exchange (ASX) Principles of Good Corporate
Governance and Best Practice Recommendations (POGCG) for a sample of 231 ?rms listed on the ASX
in the ?nancial year 2005. The associations of board composition, share ownership and compensation
of NEDs with the level of earnings management are estimated. To explore the characteristics of NEDs
that are important for effective monitoring, NEDs are separated into “grey” (af?liated) directors and
independent directors and compensation is separated into variable and ?xed components.
Findings – The results of the paper indicate a positive relation between earnings management and
share ownership of NEDs, particularly that of grey directors. There is a negative relation between
NED compensation and the level of earnings management, particularly the ?xed compensation
component for independent directors.
Practical implications – This paper is important to shareholders, academics and policy makers
because it shows the type of remuneration and ownership levels for NEDs that are consistent with
good corporate governance. NEDs are more effective monitors when independent directors are
compensated more as a ?xed amount that is not related to the ?rm’s performance. The compensation
of grey directors is not associated with the level of earnings management. On the other hand, NEDs are
less effective monitors as share ownership by grey directors increases. The share ownership of
independent directors is not associated with the level of earnings management. To ensure the
independence of the board and enhance its ability and incentives to effectively monitor management,
the paper recommends that remuneration of NEDs should be a ?xed amount, and the share ownership
of NEDs should be limited.
Originality/value – The ?ndings provide guidance as to the meaning of board independence, in
terms of the payments and returns that NEDs receive from a company. The results provide support for
recommendation 2.1 in the ASX’s POGCG that requires the majority of the board to be independent
directors. The paper highlights the need for boards to be careful when choosing and rewarding NEDs.
Keywords Financial management, Corporate governance, Boards of Directors, Australia, Best practice
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
JEL classi?cation – M41, M42, M48
This paper is funded by the Department of Accounting and Finance at Macquarie University.
The authors would like to thank Hai Wu, participants at the AFAANZ Annual Conference 2007
and the anonymous referee for their helpful comments, and Wonsil Kang, Nathan Cheung,
Chris Ihm, Sankaran Murthy and Albert Yee for assistance with data collection.
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Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 144-166
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987493
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1. Introduction
Since the introduction of the Australian Stock Exchange’s (ASX) Principles of Good
Corporate Governance and Best Practice Recommendations (POGCG) in 2003[1], there
has been increased emphasis on best practice corporate governance in Australia.
POGCG are designed to encourage companies:
[. . .] to create value, through entrepreneurialism, innovation, development and exploration,
and provide accountability and control systems commensurate with the risks involved (ASX,
2007, p. 3).
In the literature, good corporate governance is widely associated with high quality
?nancial reporting on companies’ performance and ?nancial position, which are key
determinants of its value (Vicknair et al., 1993; Beasley, 1996; Dechow et al., 1996;
Xie et al., 2003; Peasnell et al., 2005). One indicator of lower quality ?nancial reporting
is earnings management, when managers choose reporting methods and estimates that
do not adequately re?ect their ?rms’ underlying economics (Healy and Wahlen, 1999).
The presence of discretionary accruals is commonly used in the literature as a measure
of earnings management (McNichols and Wilson, 1988; Jones, 1991; Dechowet al., 1995;
Davidson et al., 2005; Hutchinson et al., 2008).
Several Australian studies document the relation between corporate governance and
earnings management. Davidson et al. (2005) ?nd that the relation between corporate
governance and earnings management was not strong in 2000, before the introduction of
POGCG. Leung et al. (2007) examine changes in this relation between 2001 and 2003,
with some evidence that corporate governance had more impact in 2003. Koh et al. (2007)
?nd some evidence of the effectiveness of board independence and audit committees
over the period 1998-2002. In the post-POGCG period, Hutchinson et al. (2008) examine
the impact on earnings management of corporate governance practices in 2005, and
changes in those attributes between 2000 and 2005. They ?nd that changes to board
independence, audit committee effectiveness and executive director’s shareholdings are
associated with earnings management.
Each of these studies measures corporate governance by a number of variables that
are assumed to re?ect distinct but complementary aspects of a company’s overall
behaviour in this regard. While this multiple measures approach has its strengths, it
precludes the close examination of the association of a single corporate governance
mechanism with earnings management. Motivated by the importance of board
independence in the guidelines of the POGCG, this paper focuses on its role as a
corporate governance mechanism for monitoring management.
This study evaluates whether the current Australian corporate reporting and
governance environment produces independent boards that are able to effectively monitor
management, suchthat earnings management is lower. Inadditiontotraditional measures
of board independence associated with board composition, it also investigates measures
that focus onthe abilityof the non-executive directors (NEDs) onthe boardtoperformtheir
oversight duties effectively: their share ownership and the type and level of their
compensation. Further, NEDs are divided into those that have an association with the
company (“grey” directors), and those that do not, and compensation is divided into ?xed
and variable components. No prior Australian study has examined these factors.
Based on a sample of 231 listed Australian ?rms in 2005, share ownership by NEDs
and grey directors in particular, is found to be associated with more earnings
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management, and total compensation of NEDs is found to be associated with
less earnings management. When total compensation is separated into ?xed and
variable components, and NEDs are separated into independent and grey directors, it is
the ?xed compensation to the independent directors that has a signi?cant association
with lower earnings management.
The paper is structured as follows. Section 2 reviews the literature. Section 3 presents
the research design, including the hypotheses to be tested in this study. Section 4
describes the process of sample collection and descriptive statistics for the data and
Section 5 presents the results of the regression analyses. The paper concludes with
a discussion of the implications of the results, limitations of the study and suggestions
for future research.
2. Literature review and hypotheses development
The concept of the invisible hand was ?rst discussed by the father of modern
economics, Adam Smith in 1766. From it, we gain the idea that individuals’ decisions
are driven by their own self-interest. In management, this self interest leads to potential
con?icts of interest (known as agency problems) when managers are asked to represent
the interests of the owners (Colley et al., 2003). One of the classic consequences of the
agency problem is earnings management.
Earnings management is any technique used by management to intentionally alter
a ?rm’s operating results for the purpose of misleading shareholders about its
underlying economic performance (Healy and Wahlen, 1999). Peasnell et al. (2005) ?nd
that when current pro?tability is low or close to three thresholds (current pro?t close to
zero; current pro?t less than previous pro?t and current pro?t is negative),
management is likely to manipulate earnings in order to secure their appointment
contracts or maximize their receivables (Peasnell et al., 2005).
The existence of earnings management creates a need for effective corporate
governance that helps to reduce the opportunities that management has to manipulate
earnings. This need is highlighted by the increasing number of corporate failures in
the last decade, such as Enron and WorldCom in the USA and HIH, One.Tel and Harris
Scarf in Australia (Neesen, 2003). It is also supported by the ?ndings of prior research
which shows that effective corporate governance is able to constrain the likelihood
of earnings manipulation (Klein, 2002; Bedard et al., 2004; Davidson et al., 2005;
Peasnell et al., 2005; Koh et al., 2007; Hutchinson et al., 2008). Taking into account the
important role of corporate governance, regulators in many countries (for example,
USA, UK and Australia) have introduced corporate regulations and guidelines,
specifying particular characteristics for corporate governance mechanisms, for the
purpose of enhancing the effectiveness of corporate governance (Neesen, 2003). In the
USA, for example, the Sarbanes-Oxley Act (SOX) was introduced in 2002, mandating
that audit committees be comprised solely of independent directors, including one
?nancial expert, as well as other accounting and auditing requirements (McClelland
and Stanton, 2004).
In Australia, the POGCG with 10 core principles (revised to eight principles in 2007)
and CLERP 9 were released in 2003 and 2004, respectively. The POGCG aims to
provide a practical guide to corporate governance for listed companies, their investors,
the wider market and the Australian community in order to restore investors’
con?dence and maintain the credibility of ?nancial reports. Companies listed on the
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ASX must provide a statement in their annual report disclosing either the extent to
which they have followed the POGCG or an explanation for why they did not. The
POGCG provide guidance as to the appropriate characteristics of corporate governance
mechanisms. For example, they recommend that a majority of the board should
be independent directors (ASX, 2007, Rec. 2.1). The focus of this paper is on the
association between earnings management and speci?c corporate governance
mechanisms related to board independence, including the independent composition
of the board, and the share ownership and compensation of NEDs.
2.1 Independent composition of the board
The monitoring role of the board of directors is important because directors represent
shareholders in assessing and evaluating managers’ performance (Fama and Jensen,
1983). To ful?l these roles, the board needs to be independent of management which
can be demonstrated by one. the structure of the board; and two. The role separation of
the Chair and the chief executive of?cer (CEO) (Rosenstein and Wyatt, 1990; John and
Senbet, 1998). Board independence is the second principle of POGCG, which includes
the following recommendations:
2.1 A majority of the board should be independent directors.
2.2 The chair should be an independent director.
2.3 The roles of chair and chief executive of?cer should not be exercised by the same
individual (ASX, 2007, Principle 2, p. 10).
In respect of board structure, the extant literature considers that the board is
independent when it is outsider-dominated (Weisbach, 1988): that is, when it consists of
at least 60 per cent of outside (non-executive) directors who are not full-time employees
and not involved in the routine business (Beasley, 1996). Fama and Jensen (1983) argue
that NEDs are more likely than executive directors to exercise objective judgement,
because they want to maintain the value of their reputations as experts in decision
making and monitoring. Further, the board is assumed to be more independent as the
number of NEDs increases (Fama, 1980; Fama and Jensen, 1983; Rosenstein and Wyatt,
1990; John and Senbet, 1998). Most of the results in the literature support the
assumption that a board with more NEDs is associated with better monitoring ability
(Dechow et al., 1996; Klein, 2002; Xie et al., 2003; Peasnell et al., 2005). Bedard et al.
(2004) is an exception to this result, failing to ?nd an association for a sample of USA
?rms in 1996. In Australia, both before and after POGCG and CLERP 9 were
introduced, Davidson et al. (2005), Koh et al. (2007) and Hutchinson et al. (2008) report
that a majority of NEDs on the board is negatively associated with the extent of
earnings management.
In relation to role separation of Chair of the Board and CEO, the literature supports
the use of chair independence as another indicator of independent board composition,
because of its usefulness for maximizing monitoring ability and minimizing power
concentration (Fama and Jensen, 1983; Boyd, 1994; Colley et al., 2003). Using US data,
Rechner and Dalton (1991) report that ?rms with chair independence perform better
than those with CEO duality. This view is also supported by corporate governance
guidelines and regulations (Cadbury Committee, 1992; SOX, 2002; ASX, 2007, Rec. 2.3,
p. 10). However, Bedard et al. (2004) and Davidson et al. (2005) fail to ?nd any
signi?cant results. Role separation is used as an alternative measure of independent
board composition in this study.
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In addition to the two measures for board independence that have been used in most
prior studies, two other measures of independent board composition are used in this
study: the average number of other board seats held by NEDs and the average period
of board service by NEDs. Prior research indicates that the number of outside
directorships is a signal of the competence of NEDs. For example, Fama and Jensen
(1983) ?nd that the managerial labor market for outside directorships rewards effective
outside directors with more than one directorship, but penalizes outside directors who
have a record of poor monitoring performance. The literature also indicates that NEDs
in a troubled ?rm are more likely than other directors to lose their other directorships
(Gilson, 1990; Gerety and Lehn, 1997). Bedard et al. (2004) report that the average
number of other directorships of NEDs is negatively associated with the level of
earnings management.
The use of average period of board service by NEDs as a measure for independent
board composition is also supported in the literature, which indicates that experience
on the company’s board enhances the NED’s understanding of the operations of the
?rm and therefore develops his or her monitoring competencies (Kosnik, 1987; Beasley,
1996; Bedard et al., 2004). However, experience may have a further effect on the
performance of directors. NED familiarity with the company would also induce
entrenchment in the long-term and lead to non-transparent decision-making.
Combining these effects, it is expected that NEDs will exercise their roles more
effectively and objectively in the early to mid stages of their period of directorship,
while in the later years of their period of board service, they will be more tolerant of
management manipulation. Accordingly, a non-linear relationship between the
average period of board service by NEDs and earnings management is predicted.
This study tests the association between independent board composition and
earnings management in Australia, using these four measures of board independence,
with the following hypotheses:
H1a. Earnings management is negatively associated with the independent
composition of the board.
H1b. Earnings management has a non-linear association with the average period of
board service by NEDs.
In summary, the impact of independent board composition on earnings management is
examined in terms of the proportion of NEDs on the board, the role separation between
the CEO and Chair, the average number of other boards that NEDs also sit on, and
average period of service by NEDs.
2.2 Share ownership of NEDs
As part of their NED compensation package, an increasing number of ?rms pay equity
compensation. The percentage of share ownership of NEDs increases as their tenure
increases (Yermack, 2004). Stakeholders support the payment of equity-based
compensation to NEDs to align their incentives and to make their views more
consistent with the views of shareholders (Perry, 2000).
In the extant literature, advocates of equity-based compensation report signi?cant
results. Patton and Baker (1987) report that a director with a sizeable stake in the ?rm
is more likely to question and challenge managements’ proposals than a director with a
low stake. Jensen (1993) argues that encouraging NEDs to hold substantial equity
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ownership in a ?rm would provide better incentives for monitoring top management.
Noe and Rebello (1996), Hermalin and Weisbach (1998) and Bedard et al. (2004) indicate
that the monitoring efforts of the board can be increased if a substantial percentage of
shares are held by NEDs. However, more recent USA research ?nds a positive
association between non-executive compensation and earnings management, drawing
the conclusion that an incentive package induces NEDs to silently agree with
managers in the practice of earnings management (Ronen et al., 2006).
The extant research in Australia regarding the association between corporate
governance and earnings management mainly focuses on the independence and
effectiveness of the board and the audit committee (Davidson et al., 2005; Koh et al., 2007;
Hutchinson et al., 2008). Only one of them investigates the impact of executive
shareholdings on the level of earnings management (Hutchinson et al., 2008) and ?nds
a positive association. The increased emphasis on the role of NEDs for the independence
and effectiveness of the board motivates an investigation of how the level of equity
ownership held by NEDs affects their monitoring of management. Although the results
are mixed inthe key relatedliterature, there are manyrelevant results supportingthe view
that a substantial percentage of outside directors’ equity ensures board effectiveness and
this is consistent with agency theory (Fama, 1980). Accordingly, a negative association
between equity ownership of outside directors and earnings management is predicted.
The mixed results regarding the relation between share ownership of NEDs and
earnings management may be a result of the treatment of NEDs as an homogenous
group. A number of studies note that the traditional classi?cation between inside and
outside directors may fail to explain the potential con?icts of interest between the
company and outside directors (Patton and Baker, 1987; Hermalin and Weisbach, 1998;
Lee et al., 1992; Vicknair et al., 1993). They agree with the classi?cation developed by
Baysinger and Butler (1985), which distinguishes between inside (executive) directors,
af?liated outside directors (grey directors), and independent directors. An independent
director is a NED who has no af?liation with the company except for the af?liation of
being a director (Beasley, 1996), whereas a grey director is a NED who has some other
af?liation with the company, such as related party transactions, substantial
shareholding in the company, as well as the af?liation of being a director (Beasley,
1996). These other af?liations may impair the independence of grey directors.
The distinction between independent directors and grey directors is tested in two
further hypotheses concerned with the association between the shareholdings of NEDs
and earnings management. In the absence of prior evidence and based on the prior
arguments, the expected relation is negative for all categories of NEDs:
H2a. Earnings management is negatively associated with the share ownership of
NEDs.
H2b/c. Earnings management is negatively associated with the share ownership of
independent/grey directors.
In summary, the impact of share ownership by NEDs on earnings management is
examined, for all NEDs, independent directors only and grey directors only.
2.3 Compensation of NEDs
Fama and Jensen (1983) argue that NEDs increase the board’s monitoring ability
because they have incentives to carry out their monitoring tasks. These incentives can
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be classi?ed as reputation incentives and ?nancial incentives. Financial incentives
include ?xed compensation received and equity held by NEDs. On the one hand,
?nancial incentives may encourage NEDs to ful?l their monitoring responsibilities
effectively and competently, while on the other hand, they may induce NEDs to tolerate
earnings manipulation undertaken by management for the purpose of retention.
The extant literature in respect of ?nancial incentives for NEDs only discusses the
outcomes of equity-based compensation (Perry, 2000; Yermack, 2004), such as bonuses,
options and other bene?ts, which may be due to the general consideration that
equity-based payment is more likely to in?uence the performance of NEDs than ?xed
compensation.
In general, NEDs receive a ?xed annual compensation instead of bonuses, which is
determined by the board or the remuneration committee, taking into account market
factors, and their commitment and responsibilities. To encourage long-term
commitment and performance, a high level of ?xed compensation is employed by
most listed companies (Yermack, 2004).
This study investigates the association between total compensation, including both
?xed and variable components and earnings management, because both types of
compensation are part of the ?nancial incentive package provided to NEDs. This study
investigates the association without sign prediction, because of the con?icting
outcomes that can be expected and the absence of prior evidence.
The total compensation to NEDs is separated into ?xed and variable components, to
facilitate comparisons with prior research into equity-based payments, and to examine
the role of ?xed payments which have not been the focus of the prior literature.
A further set of hypotheses that separate directors into independent and grey are also
tested, due to the possibility that this distinction may re?ect differential behaviour in
the face of ?nancial incentives, as discussed in the previous section:
H3a. Earnings management is associated with the annual total compensation of
NEDs.
H3b/c. Earnings management is associated with the annual ?xed/variable
compensation of NEDs.
H3d/e. Earnings management is associated with the annual variable compensation
of independent/grey directors.
H3f/g. Earnings management is associated with the annual ?xed compensation of
independent/grey directors.
In summary, the impact of compensation to NEDs on earnings management is
examined, for all NEDs, independent directors only, and grey directors only, and for all
compensation, variable compensation only and ?xed compensation only.
3. Research design
3.1 Measurement of independent variables
The measures used for each of the three corporate governance characteristics are
indicated in Table I. The construct of independent composition of the board is measured
using four variables: role separation for the CEO and the Chair of the Board (used by
Bedard et al., 2004; Davidson et al., 2005; Koh et al., 2007; Leung et al., 2007), which is a
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binary variable; and three continuous variables: the proportion of NEDs on the board,
the average number of other board seats of NEDs andthe average periodof board service
by NEDs. The latter three measures are as determined and reported by the ?rm.
Share ownership is a continuous variable, measured as the reported number of
shares owned by NEDs as a percentage of the total number of issued shares.
The construct of compensation for NEDs is also measured using a continuous variable:
their ?xed plus equity-based (variable) compensation.
NEDs were separated into grey and independent directors, by identifying which
directors are classi?ed by the ?rm as independent according to the ASX POGCG
guidelines:
An independent director is a non-executive director who is not a member of management and
who is free of any business or other relationship that could materially interfere with – or
could reasonably be perceived to materially interfere with – the independent exercise of their
judgement (ASX, 2003).
Grey directors are those who are not classi?ed as independent. As a result of the
de?nition of an independent director, a grey director may be a substantial shareholder,
may have been an executive employee, a professional advisor or consultant to the
company, may be a material supplier or customer of the company, or have a material
contractual relationship with the company.
3.2 Measurement of dependent variable
This study uses the Modi?ed Jones (M-J) model to measure discretionary accruals as a
proxy for earnings management (Jones, 1991; Dechowet al., 1995). That model has been
Hypothesis and corporate
governance characteristic Variables
Continuous
variables
Binary
indicator
variables
H1. Independent composition
of the board
Separation of roles of CEO and
Chair
CHAIR
Proportion of NEDs on the
board
INDNB
Average other board seats of
NEDs
OTHDIR
Average period of board
service by NEDs
SERVDIR
H2. Share ownership by NEDs Share ownership by NEDs OWNALL
Share ownership by grey
directors
OWNGREY
Share ownership by
independent directors
OWNIND
H3. Compensation of NEDs Total compensation of NEDs COMPTOTALL
Fixed compensation of NEDs/
grey/independent directors
COMPFIXALL
COMPFIXGREY
COMPFIXIND
Variable compensation of
NEDs/grey/independent
directors
COMPVARALL
COMPVARGREY
COMPVARIND
Table I.
Hypotheses, corporate
governance
characteristics, variables
and models
What makes
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used in prior Australian studies, for example, Davidson et al. (2005). In that model,
the level of discretionary accruals is calculated as the difference between total accruals
(pro?t after income tax less cash ?ow from operations) and non-discretionary accruals.
Non-discretionary accruals are calculated using sector-speci?c co-ef?cients in the
following model:
NDAC
ijt
¼ a
j
1
A
ijt21
þb
1j
ðDREV
ijt
2DREC
ijt
Þ
A
ijt21
þb
2j
PPE
ijt
A
ijt21
where: NDAC
ijt
– non-discretionary accruals for ?rm j in sector i at year t; A
ijt21
–
total assets for ?rm j in sector i at year t; DREV
ijt
– change in revenue for ?rm j in
sector i at year t; DREC
ijt
– change in receivables for ?rm j in sector i at year t; PPE
ijt
–
gross property, plant and equipment for ?rm j in sector i at year t.
Sector speci?c co-ef?cients are used instead of industry speci?c co-ef?cients, to
ensure that there are suf?cient ?rms in each sector to provide an accurate measure.
3.3 Control variables
Accruals management studies are known to be subject to the problem of correlated
omitted variables (Dechow et al., 1995; Bartov et al., 2000). This study controls for
several factors that have been associated with earnings management in prior
studies.
Monitoring of management by blockholders of shares is associated with reduced
levels of earnings management in prior studies (Klein, 2002). The percentage of shares
held by blockholders (BLOCK) is measured as the accumulated percentage of ordinary
shares held by shareholders not af?liated with management who hold at least 5 per cent
of shares.
DeFond and Jiambalvo (1994) show that management is more likely to overstate
earnings when the leverage ratio is close to the debt covenant violation level, and so
?nancial leverage (LEV) is included to control for this motivation to engage in earnings
management (BeasleyandSalterio, 2001; Klein, 2002; Davidsonet al., 2005; Peasnell et al.,
2005; Leung et al., 2007). It is measured as total assets divided by total liabilities.
To control for the relation between ?rm performance and earnings management
(Kasznik, 1999; Kothari et al., 2005), absolute change in earnings (ABSCH) is included.
It is measured as the absolute change in pro?t after income tax, scaled by total assets.
Larger ?rms have stronger internal control systems and stronger monitoring
mechanisms than smaller ?rms (O’Reilly et al., 1988), which may indicate that they are
more able to constrain earnings management. Bartov et al. (2000), Davidson et al.
(2005) and Peasnell et al. (2005) show that ?rm size is negatively associated with
earnings management, and positively associated with the monitoring abilities of
boards and audit committees. Firm size (SIZE) is measured as the natural logarithm of
total assets.
Management may be motivated to manage earnings if the market to book value
ratio of the ?rm is low and the ?rm is therefore a potential takeover target. By
managing earnings to the level of the market’s expectation, it is argued that the ?rm’s
market value, and therefore its market to book value ratio, can be increased. Following
Leung et al. (2007), the market to book value ratio (MKT) is included to control for this
effect. It is measured as the market capitalisation at balance date, divided by net assets.
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3.4 Models
The hypotheses are tested using a basic multiple regression model as shown below. All
variables are expected to have a linear relationship with the dependent variable
(discretionary accruals) except the average period of board service by NEDs
(SERVDIR). As explained above, a squared term of SERVDIR is included in the basic
model in expectation of a non-linear relationship between SERVDIR and DAC:
DAC ¼ a þb
1
CHAIR þb
2
INDNB þb
3
OTHDIR þb
4
SERVDIR þb
5
SERVDIR
2
þb
6
OWNALL þb
7
COMPTOTALL þb
8
BLOCK þ B
9
LEV þb
10
ABSCH
þb
11
SIZE þb
12
MKT
where: DAC – discretionary accruals; independent variables de?ned as per Table I;
control variables: BLOCK – percentage of shares held by blockholders; LEV –
?nancial leverage; ABSCH – absolute change in earnings; SIZE – ?rm size; MKT –
market to book value ratio.
To test the hypotheses that disaggregate NEDs into grey and independent directors,
and total compensation into ?xed and variable, the ownership and compensation
variables in the above models are separated into their component parts, in two stages.
First, COMPTOTALL is replaced by COMPFIXALL and COMPVARALL in the above
model. Next, OWNALL in the above model is replaced by OWNGREY and OWNIND
at the same time as COMPFIXALL and COMPVARALL are replaced by
COMPFIXGREY and COMPFIXIND and by COMPVARGREY and COMPVARIND.
4. Sample collection and data description
4.1 Sampling
An initial sample of 250 ?rms was randomly selected from the top 500 Australian ?rms
listed on the ASX in the ?nancial year 2005, excluding ?rms from the ?nancial sector.
At the time of data collection, this year was chosen as the most recent year following
the implementation of POGCG. Firms in the ?nancial sector were not included in the
sample because their accounting treatments and legal regulations differ from ?rms in
other sectors, which is consistent with prior research in this area (Barnhart et al., 1994;
Klein, 2002; Davidson et al., 2005). Due mostly to incomplete corporate governance
information, but also to incomplete ?nancial data, 19 ?rms were excluded from the 250
randomly selected ?rms. Therefore, the ?nal sample consists of 231 ?rms.
The data for this study is available from ASPECT Fin Analysis, and the ?rms’
annual reports which were accessed via ASPECT Annual Reports Online and the
?rms’ web sites.
4.2 Descriptive statistics
The 231 ?rms in the sample are drawn from nine sectors and 33 industries, as shown in
Table II. Twenty-?ve percentage of the sample is drawn from the materials sector, with
only 2 per cent of ?rms from the utilities sector. Descriptive statistics for the
independent and control variables are shown in Table III, Panels A and B.
Over 91 per cent (210/231) of ?rms separate the roles of CEO and Chair, which is
higher than that observed in other countries, and higher than the 77 per cent reported by
Davidson et al. (2005) for the year 2000, but comparable to the levels reported in Leung
What makes
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et al. (2007) for 2001 (86 per cent) and 2003 (88 per cent). The average composition of
boards of directors for this sample consists of 72 per cent NEDs. This ?gure is
comparable to those in Davidson et al. (2005), Leung et al. (2007) and Hutchinson et al.
(2008). On average, NEDs sit on 1.2 other boards, and have 5 years service on the current
board. NEDs own an average of 5.1 per cent of the company’s shares, mostly due to the
4.3 per cent ownership by grey directors, with independent directors owning only
0.5 per cent. The average total compensation paid to all NEDs is $376,000, split
between $286,000 in ?xed compensation and $90,000 in variable compensation.
Sector Industry
Industry
code
Number
in sample
Percentage
of sample
Energy Oil and Gas 101010 22 9.5
Materials Chemicals 151010 3 25.1
Construction materials 151020 6
Containers and packaging 151030 1
Metals and mining 151040 42
Paper and forest products 151050 6
Industrials Building products 201020 4 18.2
Construction and engineering 201030 11
Industrial conglomerates 201050 2
Trading companies and
distributors 201070 1
Commercial services and
supplies 202010 22
Marine 203030 1
Transportation infrastructure 203050 1
Consumer Auto Components 251010 4 13.9
discretionary Household durables 252010 3
Leisure equipment and products 252020 2
Textiles, apparel and luxury
goods 252030 2
Hotels, restaurants and leisure 253010 1
Media 254010 8
Multi-line retail 255030 2
Specialty retail 255040 10
Consumer
staples
Beverages 302010 2 4.3
Food products 302020 8
Health care Health care equipment and
supplies 351010 15 12.1
Biotechnology 352010 5
Pharmaceuticals 352020 8
Financials Real estate 404010 18 7.8
Information Internet software and services 451010 4 6.9
technology IT consulting and services 451020 3
Software electronic 451030 7
Communications equipment 452010 2
Utilities Gas utilities 551020 3 2.2
Multi-utilities and unregulated
power 551030 2
Total 231 100
Table II.
Summary of sample
by GICS sectors
and industries
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Table III.
What makes
a board
independent?
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Independent directors are paid 68 per cent of total compensation, 70 per cent of ?xed
compensation and 62 per cent of variable compensation.
Descriptive statistics for the variables used to calculate discretionary accruals using
the M-J model are shown in Table IV. The variables have the expected sign, where
applicable. Whilst the average and median discretionary accruals are quite small
(20.002 and 20.0156 per cent of total assets), the range (20.9324 to þ2.6892) indicates
that both positive and negative earnings management of larger magnitudes occur.
The results of a correlation analysis for all independent variables (Table V) reveal a
small number of positive (.0.5) and signi?cant (at 5 per cent level) associations
between the sets of variables. These do not affect the interpretation of the results. All of
these correlations are between size and compensation variables: total and ?xed
compensations for NEDs and independent directors, and all of the correlation
co-ef?cients are below 0.7. Furthermore, size is a control variable in the models, and is
not the subject of any hypotheses. Although high correlations between variables may
cause multicollinearity in the regression results, its effect would be to understate the
signi?cance of the independent variables, without impacting the explanatory power of
the overall model. So it is unlikely that multicollinearity is an issue, and even if it is, its
effect would be to bias against signi?cant ?ndings in the models.
5. Results
The results of the regression analyses are shown in Table VI, Panels A and B. Panel A
shows the results using the data that was winsorised at 1 per cent level, and Panel B
shows the results using data winsorised at 5 per cent level. The models are signi?cant
( p ¼ 0.037, 0.003, respectively) with low overall adjusted explanatory power of only 4.4
and 7.6 per cent, respectively.
Mean SD Minimum Median Maximum
Panel A: descriptive statistics for variables used in M-J model ($mill )
Name
Total assets (year t) 859.68 1,536.80 0.01 228.49 9,346.40
Total assets (year t 2 1) 701.15 1,346.30 1.98 158.29 9,037.00
Pro?ts after income tax 51.00 132.19 2652.84 51.51 1,007.10
Cash ?ow from operating activities 70.43 187.59 2426.91 15.28 1,457.90
Total accruals
a
20.0243 0.2505 21.3117 20.0368 2.7910
Non-discretionary accruals
a
20.02230 0.10987 21.16992 20.01662 0.14000
Discretionary accruals
a
20.0020 0.2227 20.9324 20.0156 2.6892
Panel B: descriptive statistics for estimated regression coef?cients (n ¼ 9)
Sector co-ef?cients
a
a co-ef?cient 0.02047 0.10537 0.24302 0.06292 0.11829
b
1
co-ef?cient 20.02571 0.06647 20.30533 20.00930 0.05999
b
2
co-ef?cient 20.2012 0.3328 21.1385 20.2237 0.2355
Notes:
a
Scaled by total assets in year t 2 1; the descriptive statistics presented are for the estimated
multiple regression equation: TAC
ijt
=A
ijt21
¼ ^ a
j
ð1=A
ijt21
Þ þ b
1j
ðDREV
ijt
=A
ijt21
Þ þ b
2j
ðPPE
ijt
=A
ijt21
Þþ
1
ijt
: where: TAC
ijt
, total accruals for ?rm i in industry j at year t; DREV
ijt
, change in revenue for ?rm i in
industryj betweenyear t 2 1andt; PPE
ijt
, gross property, plant andequipment for ?rmi inindustryj at year
t; A
ijt21
, total assets for ?rm i in industry j at year t 2 1
Table IV.
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R
0
.
3
0
1
0
.
1
8
6
0
.
0
0
0
0
.
0
0
4
S
E
R
V
D
I
R
0
.
1
3
1
0
.
0
0
6
0
.
1
1
5
0
.
0
4
7
0
.
9
2
2
0
.
0
8
0
O
W
N
A
L
L
0
.
1
0
8
0
.
0
2
3
2
0
.
0
7
0
.
2
0
1
0
.
1
0
0
0
.
7
3
0
0
.
2
6
7
0
.
0
0
2
O
W
N
I
N
D
0
.
0
5
4
0
.
0
8
4
2
0
.
0
9
2
0
.
0
6
0
.
3
3
9
0
.
4
1
2
0
.
2
0
3
0
.
1
7
8
0
.
3
4
3
0
.
0
0
0
O
W
N
G
R
E
Y
0
.
0
9
8
0
.
0
0
9
2
0
.
0
5
0
.
2
1
7
0
.
9
7
2
0
.
1
5
5
0
.
1
3
8
0
.
8
9
2
0
.
4
6
1
0
.
0
0
1
0
.
0
0
0
0
.
0
1
8
C
O
M
P
T
O
T
A
L
L
0
.
4
2
3
0
.
1
7
8
0
.
2
1
5
0
.
0
9
9
0
.
0
4
7
2
0
.
0
7
0
.
0
6
2
0
.
0
0
0
0
.
0
0
7
0
.
0
0
1
0
.
1
3
2
0
.
4
7
9
0
.
3
1
3
0
.
3
4
5
C
O
M
P
F
I
X
A
L
L
0
.
4
5
8
0
.
2
2
8
0
.
2
4
1
0
.
0
9
9
2
0
.
0
4
2
0
.
1
3
2
0
.
0
3
0
.
9
1
6
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
1
3
5
0
.
5
1
9
0
.
0
4
7
0
.
6
7
6
0
.
0
0
0
C
O
M
P
F
I
X
I
N
D
0
.
3
4
8
0
.
2
1
2
0
.
2
4
0
2
0
.
0
0
2
0
.
1
3
2
0
.
1
0
2
0
.
1
2
0
.
7
8
9
0
.
8
6
1
0
.
0
0
0
0
.
0
0
1
0
.
0
0
0
0
.
9
7
5
0
.
0
4
8
0
.
1
2
4
0
.
0
6
1
0
.
0
0
0
0
.
0
0
0
C
O
M
P
F
I
X
G
R
E
Y
0
.
3
2
8
0
.
0
8
8
0
.
0
6
2
0
.
2
0
4
0
.
1
5
5
2
0
.
0
8
0
.
1
7
2
0
.
0
4
2
0
.
4
6
3
0
.
0
0
0
0
.
1
8
2
0
.
3
5
1
0
.
0
0
2
0
.
0
1
9
0
.
2
1
1
0
.
0
0
9
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
A
L
L
0
.
1
8
5
0
.
0
1
7
0
.
0
8
0
0
.
0
5
9
0
.
1
8
1
0
.
0
7
2
0
.
1
9
1
0
.
7
2
3
0
.
3
8
5
0
.
0
0
5
0
.
7
9
5
0
.
2
2
8
0
.
3
7
5
0
.
0
0
6
0
.
2
7
3
0
.
0
0
4
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
I
N
D
0
.
1
4
9
0
.
0
4
0
0
.
1
2
1
2
0
.
0
0
0
.
0
9
1
0
.
1
4
9
0
.
0
8
4
0
.
5
7
8
0
.
3
2
6
0
.
0
2
3
0
.
5
4
8
0
.
0
6
7
0
.
9
5
2
0
.
1
6
8
0
.
0
2
3
0
.
2
0
3
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
G
R
E
Y
0
.
0
9
6
2
0
.
0
2
2
0
.
0
2
0
.
0
9
9
0
.
1
5
8
2
0
.
0
7
0
.
1
8
1
0
.
4
5
9
0
.
2
4
8
0
.
1
4
7
0
.
8
1
5
0
.
7
6
6
0
.
1
3
3
0
.
0
1
6
0
.
3
0
2
0
.
0
0
6
0
.
0
0
0
0
.
0
0
0
B
L
O
C
K
0
.
0
3
6
2
0
.
1
1
2
0
.
0
8
2
0
.
0
1
0
.
1
3
0
2
0
.
0
9
0
.
1
4
6
2
0
.
1
0
2
0
.
0
8
0
.
5
8
4
0
.
0
9
1
0
.
2
5
2
0
.
8
9
7
0
.
0
4
9
0
.
1
5
3
0
.
0
2
7
0
.
1
4
0
0
.
2
1
4
L
E
V
0
.
1
3
7
0
.
1
1
5
0
.
1
1
3
0
.
1
2
2
2
0
.
0
2
2
0
.
1
1
2
0
.
0
0
0
.
1
4
6
0
.
1
8
0
0
.
0
3
7
0
.
0
8
0
0
.
0
8
5
0
.
0
6
4
0
.
7
5
8
0
.
0
8
5
1
.
0
0
0
0
.
0
2
6
0
.
0
0
6
A
B
S
C
H
2
0
.
0
1
0
.
0
1
9
2
0
.
0
6
2
0
.
0
2
2
0
.
0
1
0
.
0
6
1
2
0
.
0
2
2
0
.
2
1
2
0
.
2
2
0
.
8
5
4
0
.
7
7
0
0
.
3
8
3
0
.
7
9
8
0
.
8
7
6
0
.
3
5
9
0
.
7
9
2
0
.
0
0
1
0
.
0
0
1
S
I
Z
E
0
.
3
0
6
0
.
2
3
8
0
.
2
7
7
0
.
0
7
5
2
0
.
1
1
2
0
.
2
6
2
0
.
0
6
0
.
6
3
9
0
.
6
8
0
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
2
5
3
0
.
0
8
4
0
.
0
0
0
0
.
3
3
6
0
.
0
0
0
0
.
0
0
0
M
K
T
2
0
.
1
1
2
0
.
1
4
2
0
.
0
5
2
0
.
0
5
0
.
0
5
3
0
.
1
7
7
2
0
.
0
2
2
0
.
1
0
2
0
.
1
0
0
.
0
8
5
0
.
0
2
8
0
.
4
1
3
0
.
4
7
5
0
.
4
2
3
0
.
0
0
7
0
.
8
0
2
0
.
1
4
8
0
.
1
2
0
(
c
o
n
t
i
n
u
e
d
)
Table V.
Correlations and p-values
for independent variables
What makes
a board
independent?
157
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
O
M
P
F
I
X
I
N
D
C
O
M
P
F
I
X
G
R
E
Y
C
O
M
P
V
A
R
A
L
L
C
O
M
P
V
A
R
I
N
D
C
O
M
P
V
A
R
G
R
E
Y
B
L
O
C
K
L
E
V
A
B
S
C
H
S
I
Z
E
C
H
A
I
R
O
T
H
D
I
R
S
E
R
V
D
I
R
O
W
N
A
L
L
O
W
N
I
N
D
O
W
N
G
R
E
Y
C
O
M
P
T
O
T
A
L
L
C
O
M
P
F
I
X
A
L
L
C
O
M
P
F
I
X
I
N
D
C
O
M
P
F
I
X
G
R
E
Y
2
0
.
0
4
0
.
5
1
8
C
O
M
P
V
A
R
A
L
L
0
.
3
3
3
0
.
1
6
8
0
.
0
0
0
0
.
0
1
0
C
O
M
P
V
A
R
I
N
D
0
.
4
2
3
2
0
.
1
1
0
.
7
7
0
0
.
0
0
0
0
.
0
9
7
0
.
0
0
0
C
O
M
P
V
A
R
G
R
E
Y
0
.
0
2
2
0
.
4
2
5
0
.
6
2
9
0
.
0
0
1
0
.
7
3
8
0
.
0
0
0
0
.
0
0
0
0
.
9
8
5
B
L
O
C
K
2
0
.
1
5
0
.
1
0
3
2
0
.
0
8
2
0
.
0
5
2
0
.
0
7
0
.
0
2
4
0
.
1
1
9
0
.
2
0
9
0
.
4
5
9
0
.
2
7
1
L
E
V
0
.
1
3
1
0
.
1
3
2
0
.
0
2
6
0
.
0
2
8
0
.
0
1
2
2
0
.
0
3
0
.
0
4
7
0
.
0
4
5
0
.
6
9
6
0
.
6
7
6
0
.
8
5
4
0
.
6
0
5
A
B
S
C
H
2
0
.
2
0
2
0
.
0
8
2
0
.
1
2
2
0
.
0
8
2
0
.
0
9
2
0
.
0
7
0
.
0
3
5
0
.
0
0
2
0
.
2
5
8
0
.
0
7
4
0
.
2
4
0
0
.
1
6
2
0
.
3
1
7
0
.
5
9
2
S
I
Z
E
0
.
6
3
1
0
.
2
4
5
0
.
2
9
8
0
.
2
6
6
0
.
1
6
4
0
.
0
1
5
0
.
2
2
3
2
0
.
4
2
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
0
1
2
0
.
8
2
3
0
.
0
0
1
0
.
0
0
0
M
K
T
2
0
.
0
4
2
0
.
1
4
2
0
.
0
4
2
0
.
0
2
2
0
.
0
5
0
.
0
1
8
2
0
.
2
4
0
.
1
3
7
2
0
.
3
4
0
.
5
6
6
0
.
0
3
2
0
.
5
2
0
0
.
7
9
9
0
.
4
4
8
0
.
7
8
6
0
.
0
0
0
0
.
0
3
7
0
.
0
0
0
N
o
t
e
:
V
a
r
i
a
b
l
e
n
a
m
e
s
a
s
p
e
r
T
a
b
l
e
I
Table V.
ARJ
22,2
158
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
a
n
e
l
A
:
1
p
e
r
c
e
n
t
w
i
n
s
o
r
i
s
e
d
d
a
t
a
P
a
n
e
l
B
:
5
p
e
r
c
e
n
t
w
i
n
s
o
r
i
s
e
d
d
a
t
a
V
a
r
i
a
b
l
e
s
P
r
e
d
i
c
t
i
o
n
M
o
d
e
l
1
M
o
d
e
l
2
M
o
d
e
l
3
M
o
d
e
l
1
M
o
d
e
l
2
M
o
d
e
l
3
I
n
t
e
r
c
e
p
t
2
0
.
1
0
7
(
2
0
.
7
1
)
2
0
.
1
1
6
(
2
0
.
7
4
)
2
0
.
1
2
3
(
2
0
.
7
5
)
2
0
.
1
1
5
(
2
0
.
9
7
)
2
0
.
1
4
1
(
2
1
.
1
3
)
2
0
.
1
5
0
(
2
1
.
1
7
)
C
H
A
I
R
H
1
(
2
)
2
0
.
0
1
5
(
2
0
.
4
9
)
2
0
.
0
1
5
(
2
0
.
4
6
)
2
0
.
0
1
3
(
2
0
.
4
1
)
2
0
.
0
1
0
(
2
0
.
4
4
)
2
0
.
0
0
8
(
2
0
.
3
6
)
2
0
.
0
0
7
(
2
0
.
2
9
)
I
N
D
N
B
H
1
(
2
)
0
.
0
6
8
(
1
.
1
4
)
0
.
0
7
0
(
1
.
1
5
)
0
.
0
7
5
(
1
.
2
0
)
0
.
0
8
3
(
1
.
8
2
)
*
0
.
0
8
9
(
1
.
9
1
)
*
0
.
0
9
6
(
2
.
0
2
)
*
*
O
T
H
E
R
D
I
R
H
1
(
2
)
0
.
0
0
8
(
0
.
7
4
)
0
.
0
0
8
(
0
.
7
3
)
0
.
0
0
7
(
0
.
6
2
)
0
.
0
0
5
(
0
.
6
0
)
0
.
0
0
5
(
0
.
5
5
)
0
.
0
0
3
(
0
.
3
9
)
S
E
R
V
D
I
R
H
1
(
2
)
0
.
0
2
0
(
2
.
6
3
)
*
*
*
0
.
0
2
0
(
2
.
5
7
)
*
*
*
0
.
0
2
0
(
2
.
4
6
)
*
*
0
.
0
1
8
(
3
.
0
1
)
*
*
*
0
.
0
1
7
(
2
.
9
0
)
*
*
*
0
.
0
1
8
(
2
.
9
2
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;
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;
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:
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a
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;
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,
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r
m
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z
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;
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T
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a
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b
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k
v
a
l
u
e
r
a
t
i
o
Table VI.
Multiple regression
results
What makes
a board
independent?
159
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
5.1 Independent composition of the board
H1a states that earnings management is negatively associated with the independent
composition of the board, where independent composition is measured as separation of
the roles of CEO and Chair, the proportion of NEDs on the board, and the average other
board seats of NEDs. H1b states that earnings management has a non-linear
association with the average period of board service by NEDs.
Panel A shows that only one of the measures, the average board service by NEDs, is
signi?cant. Both the measure and its square are signi?cant: the measure has a positive
co-ef?cient (0.020, p ¼ 0.009) and the square has a negative co-ef?cient (20.002,
p ¼ 0.004). The sign of the squared term dominates the effect of average board service
on earnings management, and its negative co-ef?cient indicates that the relationship
between earnings management and the average period of board service by NEDs is an
inverse “U” shaped curve. This is consistent with the expectation that familiarity with
the ?rm and its operations can enhance NEDs’ ability to monitor management in the
short-term but does not detect or prevent earnings management in the long run.
In Panel B, there is reduced impact of potential outliers on the results. Two measures
of independent composition of the board are signi?cant: the proportion of NEDs on the
board, and average board service by NEDs (both the measure and its square, as in
Panel A). The proportion of NEDs has a positive co-ef?cient and is signi?cant at 10 per
cent level (0.083, p ¼ 0.071). This indicates that a greater proportion of NEDs is weakly
associated with a higher level of earnings management, which is contrary to the ?ndings
of other studies of this phenomenon, and also contrary to the rationale behind corporate
governance guidelines. This ?nding is interpreted cautiously, as its effect may be
confounded by the effect of other measures of board independence, and also by results
pertaining to the impact of grey directors on earnings management. Again, the measure
of average board service and its square are both signi?cant: the measure again has a
positive co-ef?cient (0.018, p ¼ 0.003) and the square has a negative co-ef?cient (20.001,
p ¼ 0.002). The similarity of this result with that reported in Panel A con?rms the
robustness of this result. Sensitivity tests of the effect of omitting the square of this
measure (not reported) do not affect the signi?cance or signs of other explanatory
variables, but reduce the overall explanatory power of the model.
Overall, the results of this study provide limited support for H1b.
5.2 Share ownership on NEDs
H2 states that earnings management is negatively associated with the share ownership
of NEDs. This is tested for all NEDs, and then for NEDs disaggregated into
independent and grey directors.
The co-ef?cient for aggregate share ownership of NEDs is positive and signi?cant
in both Panels A and B (0.215, p ¼ 0.005; 0.251, p ¼ 0.000). This indicates that a higher
level of share ownership by NEDs is associated with a higher level of earnings
management. Similar results are found in other versions of the basic model, when
compensation of NEDs is disaggregated, which con?rms the robustness of this result.
It appears that directors with this level of ownership do not make effective monitors of
management, which is contrary to the theory that an ownership stake in the ?rm aligns
the incentives of directors to those of shareholders. The prior literature was divided
on this issue, with some results indicating a positive effect for corporate governance
ARJ
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from directors’ shareholdings, and other indicating a negative effect. In Australia,
Hutchinson et al. (2008) ?nd a similar positive association for executive directors.
But which type of NED is driving the positive relation in this paper? Recall that grey
directors’ average shareholding is 4.3 per cent compared to independent directors’
average shareholding of 0.5 per cent. When NEDs are disaggregated into independent
and grey directors, the share ownership of independent directors is not signi?cantly
associated with earnings management. In contrast, that of grey directors is signi?cantly
positively associated with earnings management across both versions of the data (Panel
A: 0.211, p ¼ 0.013; Panel B: 0.252, p ¼ 0.001). This result clearly indicates that it is the
higher level of share ownership by grey directors that is associated with a higher level of
earnings management.
Overall, the results of this study do not support H2, ?nding instead that there are
signi?cant positive associations between earnings management and share ownership
of NEDs, and earnings management and share ownership of grey directors.
5.3 Compensation of NEDs
H3 states that earnings management is associated with total compensation of NEDs.
This is tested for total compensation and all NEDs, and then compensation is
disaggregated into variable and ?xed compensation, for independent and grey directors.
The co-ef?cient for total compensation to all NEDs is negative and statistically
signi?cant in both Panels A and B (20.000, p ¼ 0.017; 20.000, p ¼ 0.003). The low
co-ef?cient does not indicate little economic signi?cance, because compensation is
measured in dollars, and earnings management (non-discretionary accruals) is de?ated
by total assets[2]. The co-ef?cients are both 20.00000009. This result indicates that a
higher level of compensation for NEDs is associated with lower earnings management.
This result is consistent with prior research in the USA which ?nds that NEDs who
have substantial equity ownership (and therefore equity-based payments) are more likely
to monitor and constrain earnings management (Bedard et al., 2004). However, this
comparison to other results highlights the potential con?ict between the results for H2,
which ?nd that share ownership by NEDs is not conducive to effective monitoring of
management, and this result, which ?nds that total compensationof NEDs is conducive to
effective monitoring. Disaggregating total compensation resolves this potential con?ict.
First, total compensation is disaggregated into ?xed and variable compensation.
Across Panels A and B, it is clear that it is ?xed compensation which is associated with
earnings management. Fixed compensation has negative and signi?cant co-ef?cients
(20.000, p ¼ 0.072; 20.000, p ¼ 0.011), whereas the co-ef?cients for variable
compensation are not signi?cant.
Second, ?xed and variable compensations to NEDs as a whole are disaggregated by
independent and grey directors. Unsurprisingly, disaggregating variable
compensation by type of director does not produce any signi?cant associations.
Fixed compensation of independent directors is signi?cantly and negatively associated
with earnings management, whereas ?xed compensation of grey directors is not
signi?cant. The co-ef?cients are still very small, but not equal to zero (20.00000010;
20.00000014). The results indicate that a higher level of ?xed compensation to
independent directors is associated with lower earnings management.
Recall that 72 per cent of NEDs are independent, and that 69 per cent of
total compensation is paid to independent directors. Further, ?xed compensation is
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76 per cent of total compensation. The allocation of total, ?xed and variable
compensations is roughly the same between all NEDs, independent and grey directors.
The ?xed compensation of independent directors, which is the only signi?cant variable
when total compensation is fully disaggregated, is 53 per cent of that total.
Overall, in relation to H3, the results of this study indicate that earnings
management is negatively associated with total compensation of NEDs, and in
particular this result holds for ?xed rather than variable compensation, and for ?xed
compensation of independent directors rather than that of grey directors.
After conducting these disaggregated analyses, the potential con?ict between the
results for H2 and H3 can be resolved. Effective monitoring of management, which is
assumed to be linked to lower earnings management, is promoted when the share
ownership of grey directors is lower, and when the ?xed compensation of independent
directors is higher.
Grey directors by de?nition are closely associated with the company. This study
shows that the extent to which that association is by way of share ownership works
against the interests of shareholders. Their total reward from their shareholding is not
fully re?ected in their variable compensation, because that would also include capital
gains on the sale of shares, for example. This total reward appears to motivate grey
directors to not closely or effectively monitor management, resulting in higher levels of
earnings management.
In contrast, independent directors are not closely associated with the company. This
study shows that the more ?xed compensation they receive, the more closely they
monitor management, which reduces the level of earnings management. Because they
do not have any substantial shareholding, they are motivated to act in ways that
promote the interests of shareholders.
6. Summary and conclusions
6.1 Summary
This study has investigated the effectiveness of corporate governance guidelines in
Australia, by focusing on a single corporate governance factor, board independence.
It analyses whether measures of board independence, including board structure and
characteristics of NEDs, are associated with effective monitoring of management, as
evidenced through lower levels of earnings management.
Contrary to the hypothesis, the results of testing H1a indicates weak support for a
negative association between the proportion of NEDs on the board and earnings
management. They also indicate support for a signi?cant non-linear relation between
earnings management and the average period of board service by NEDs. Whilst
earnings management decreases with the average period of NED board service in the
lower end of the range, as board service increases, it is associated with increased
earnings management. This is consistent with the expectation that whilst at ?rst
increased service enhances NEDs’ ability to monitor management, too long a period on
the board entrenches the NED in ways that are not in shareholders’ best interests.
Although H2 predicts a negative association between earnings management and
the share ownership of NEDs, the results indicate a positive relation that can be
attributed to the share ownership of grey directors. These results suggest that grey
directors with substantial shareholdings do not act independently of management.
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They provide support for the ASX’s de?nition of independent directors, and suggest
the similarly tight de?nitions should apply in other jurisdictions.
Finally, testing of H3 supports a negative association between NED compensation
and the level of earnings management, a ?nding that can be attributed to the ?xed
compensation for independent directors. This study shows that the more ?xed
compensation they receive, the more closely they monitor management, which reduces
the level of earnings management. Because independent directors do not have any
substantial shareholding, they are motivated to act in ways that promote the interests
of shareholders.
This study provides practical guidance regarding the tenure, type of remuneration
and ownership levels for NEDs that are consistent with good corporate governance.
NEDs are more effective monitors in the earlier years of their board service, and when
they are compensated more as a ?xed amount that is not related to the ?rm’s
performance. On the other hand, NEDs are less effective monitors as their board service
lengthens past the average term and as share ownership increases. To ensure the
independence of the board and enhance its ability and incentives to effectively monitor
management, the paper recommends ?rst, that the terms of NEDs be ?xed, say at less
than the current average level which is ?ve years; second, that remuneration of NEDs
should be a ?xed amount; and third, the share ownership of NEDs should be limited.
6.2 Limitations and suggestions for further research
A limitation of this study is that the measure of earnings management used may not
adequately capture the underlying construct. Recent papers (Dechow et al., 2003;
Coulton et al., 2005; Francis et al., 2005) have re?ned the ways in which earnings
management can be measured. In addition, incorporating alternative measures of
earnings management into future studies will provide further valuable insights.
A limitation of examining one corporate governance characteristic (board
independence) in a study such as this is the lower explanatory power of the models
compared to studies that include a number of corporate governance variables.
Unreported analyses that include other corporate governance variables, such as audit
committee characteristics, have higher explanatory power.
Notes
1. POGCG were updated in 2007.
2. The use of de?ators for compensation, such as total assets, led to potential problems with
multicollinearity.
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About the authors
Liyu He is an Associate Lecturer in Accounting at Macquarie University, Sydney, Australia. Her
research interests are in corporate governance, earnings management and fair value. She is
currently undertaking a PhD at Macquarie University examining the implications of adopting
fair value accounting in the agricultural sector.
Sue Wright is an Associate Professor in Accounting at Macquarie University, Sydney,
Australia. Her research interests are in corporate governance, business valuation and analysis
and capital markets. Her PhD which was undertaken at Macquarie University examined the
comparative information content of accounting and share price for Australian banks 1960-1990,
drawing on her industry experience working for the Reserve Bank of Australia in policy areas
related to bank supervision and reporting. Sue Wright is the corresponding author and can be
contacted at: [email protected]
Elaine Evans is currently an Associate Professor in Accounting at Macquarie University,
Sydney, Australia. She has held academic positions in accounting at the University of Western
Sydney and ANU, and in health services accounting at the University of New South Wales.
Her current research interests include ?nancial reporting in Australia under IFRS, corporate
governance, the interface between academic education and professional training for accountants,
the accounting profession in Australia and the integration of graduate attributes into the
accounting curriculum.
Susan Crowe is a Lecturer in Statistics at Macquarie University, Sydney, Australia. Her
research interests are in the application of statistical techniques and recent projects include
collaborations with colleagues in accounting and ?nance areas. She has been recognised by
Macquarie University as an outstanding teacher.
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This article has been cited by:
1. Victoria J. Clout, Larelle Chapple, Nilan Gandhi. 2013. The impact of auditor independence regulations
on established and emerging firms. Accounting Research Journal 26:2, 88-108. [Abstract] [Full Text] [PDF]
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doc_720867806.pdf
The purpose of this paper is to determine what aspects of board independence, in terms of
board structure and characteristics of non-executive directors (NEDs), are associated with effective
monitoring of management, as evidenced through lower levels of earnings management.
Accounting Research Journal
What makes a board independent? Australian evidence
Liyu He Sue Wright Elaine Evans Susan Crowe
Article information:
To cite this document:
Liyu He Sue Wright Elaine Evans Susan Crowe, (2009),"What makes a board independent? Australian
evidence", Accounting Research J ournal, Vol. 22 Iss 2 pp. 144 - 166
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What makes a board independent?
Australian evidence
Liyu He, Sue Wright and Elaine Evans
Faculty of Business and Economics, Macquarie University,
Sydney, Australia, and
Susan Crowe
Faculty of Science, Macquarie University, Sydney, Australia
Abstract
Purpose – The purpose of this paper is to determine what aspects of board independence, in terms of
board structure and characteristics of non-executive directors (NEDs), are associated with effective
monitoring of management, as evidenced through lower levels of earnings management.
Design/methodology/approach – This paper examines the effectiveness of board independence
requirements under the 2003 Australian Stock Exchange (ASX) Principles of Good Corporate
Governance and Best Practice Recommendations (POGCG) for a sample of 231 ?rms listed on the ASX
in the ?nancial year 2005. The associations of board composition, share ownership and compensation
of NEDs with the level of earnings management are estimated. To explore the characteristics of NEDs
that are important for effective monitoring, NEDs are separated into “grey” (af?liated) directors and
independent directors and compensation is separated into variable and ?xed components.
Findings – The results of the paper indicate a positive relation between earnings management and
share ownership of NEDs, particularly that of grey directors. There is a negative relation between
NED compensation and the level of earnings management, particularly the ?xed compensation
component for independent directors.
Practical implications – This paper is important to shareholders, academics and policy makers
because it shows the type of remuneration and ownership levels for NEDs that are consistent with
good corporate governance. NEDs are more effective monitors when independent directors are
compensated more as a ?xed amount that is not related to the ?rm’s performance. The compensation
of grey directors is not associated with the level of earnings management. On the other hand, NEDs are
less effective monitors as share ownership by grey directors increases. The share ownership of
independent directors is not associated with the level of earnings management. To ensure the
independence of the board and enhance its ability and incentives to effectively monitor management,
the paper recommends that remuneration of NEDs should be a ?xed amount, and the share ownership
of NEDs should be limited.
Originality/value – The ?ndings provide guidance as to the meaning of board independence, in
terms of the payments and returns that NEDs receive from a company. The results provide support for
recommendation 2.1 in the ASX’s POGCG that requires the majority of the board to be independent
directors. The paper highlights the need for boards to be careful when choosing and rewarding NEDs.
Keywords Financial management, Corporate governance, Boards of Directors, Australia, Best practice
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
JEL classi?cation – M41, M42, M48
This paper is funded by the Department of Accounting and Finance at Macquarie University.
The authors would like to thank Hai Wu, participants at the AFAANZ Annual Conference 2007
and the anonymous referee for their helpful comments, and Wonsil Kang, Nathan Cheung,
Chris Ihm, Sankaran Murthy and Albert Yee for assistance with data collection.
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Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 144-166
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987493
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1. Introduction
Since the introduction of the Australian Stock Exchange’s (ASX) Principles of Good
Corporate Governance and Best Practice Recommendations (POGCG) in 2003[1], there
has been increased emphasis on best practice corporate governance in Australia.
POGCG are designed to encourage companies:
[. . .] to create value, through entrepreneurialism, innovation, development and exploration,
and provide accountability and control systems commensurate with the risks involved (ASX,
2007, p. 3).
In the literature, good corporate governance is widely associated with high quality
?nancial reporting on companies’ performance and ?nancial position, which are key
determinants of its value (Vicknair et al., 1993; Beasley, 1996; Dechow et al., 1996;
Xie et al., 2003; Peasnell et al., 2005). One indicator of lower quality ?nancial reporting
is earnings management, when managers choose reporting methods and estimates that
do not adequately re?ect their ?rms’ underlying economics (Healy and Wahlen, 1999).
The presence of discretionary accruals is commonly used in the literature as a measure
of earnings management (McNichols and Wilson, 1988; Jones, 1991; Dechowet al., 1995;
Davidson et al., 2005; Hutchinson et al., 2008).
Several Australian studies document the relation between corporate governance and
earnings management. Davidson et al. (2005) ?nd that the relation between corporate
governance and earnings management was not strong in 2000, before the introduction of
POGCG. Leung et al. (2007) examine changes in this relation between 2001 and 2003,
with some evidence that corporate governance had more impact in 2003. Koh et al. (2007)
?nd some evidence of the effectiveness of board independence and audit committees
over the period 1998-2002. In the post-POGCG period, Hutchinson et al. (2008) examine
the impact on earnings management of corporate governance practices in 2005, and
changes in those attributes between 2000 and 2005. They ?nd that changes to board
independence, audit committee effectiveness and executive director’s shareholdings are
associated with earnings management.
Each of these studies measures corporate governance by a number of variables that
are assumed to re?ect distinct but complementary aspects of a company’s overall
behaviour in this regard. While this multiple measures approach has its strengths, it
precludes the close examination of the association of a single corporate governance
mechanism with earnings management. Motivated by the importance of board
independence in the guidelines of the POGCG, this paper focuses on its role as a
corporate governance mechanism for monitoring management.
This study evaluates whether the current Australian corporate reporting and
governance environment produces independent boards that are able to effectively monitor
management, suchthat earnings management is lower. Inadditiontotraditional measures
of board independence associated with board composition, it also investigates measures
that focus onthe abilityof the non-executive directors (NEDs) onthe boardtoperformtheir
oversight duties effectively: their share ownership and the type and level of their
compensation. Further, NEDs are divided into those that have an association with the
company (“grey” directors), and those that do not, and compensation is divided into ?xed
and variable components. No prior Australian study has examined these factors.
Based on a sample of 231 listed Australian ?rms in 2005, share ownership by NEDs
and grey directors in particular, is found to be associated with more earnings
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management, and total compensation of NEDs is found to be associated with
less earnings management. When total compensation is separated into ?xed and
variable components, and NEDs are separated into independent and grey directors, it is
the ?xed compensation to the independent directors that has a signi?cant association
with lower earnings management.
The paper is structured as follows. Section 2 reviews the literature. Section 3 presents
the research design, including the hypotheses to be tested in this study. Section 4
describes the process of sample collection and descriptive statistics for the data and
Section 5 presents the results of the regression analyses. The paper concludes with
a discussion of the implications of the results, limitations of the study and suggestions
for future research.
2. Literature review and hypotheses development
The concept of the invisible hand was ?rst discussed by the father of modern
economics, Adam Smith in 1766. From it, we gain the idea that individuals’ decisions
are driven by their own self-interest. In management, this self interest leads to potential
con?icts of interest (known as agency problems) when managers are asked to represent
the interests of the owners (Colley et al., 2003). One of the classic consequences of the
agency problem is earnings management.
Earnings management is any technique used by management to intentionally alter
a ?rm’s operating results for the purpose of misleading shareholders about its
underlying economic performance (Healy and Wahlen, 1999). Peasnell et al. (2005) ?nd
that when current pro?tability is low or close to three thresholds (current pro?t close to
zero; current pro?t less than previous pro?t and current pro?t is negative),
management is likely to manipulate earnings in order to secure their appointment
contracts or maximize their receivables (Peasnell et al., 2005).
The existence of earnings management creates a need for effective corporate
governance that helps to reduce the opportunities that management has to manipulate
earnings. This need is highlighted by the increasing number of corporate failures in
the last decade, such as Enron and WorldCom in the USA and HIH, One.Tel and Harris
Scarf in Australia (Neesen, 2003). It is also supported by the ?ndings of prior research
which shows that effective corporate governance is able to constrain the likelihood
of earnings manipulation (Klein, 2002; Bedard et al., 2004; Davidson et al., 2005;
Peasnell et al., 2005; Koh et al., 2007; Hutchinson et al., 2008). Taking into account the
important role of corporate governance, regulators in many countries (for example,
USA, UK and Australia) have introduced corporate regulations and guidelines,
specifying particular characteristics for corporate governance mechanisms, for the
purpose of enhancing the effectiveness of corporate governance (Neesen, 2003). In the
USA, for example, the Sarbanes-Oxley Act (SOX) was introduced in 2002, mandating
that audit committees be comprised solely of independent directors, including one
?nancial expert, as well as other accounting and auditing requirements (McClelland
and Stanton, 2004).
In Australia, the POGCG with 10 core principles (revised to eight principles in 2007)
and CLERP 9 were released in 2003 and 2004, respectively. The POGCG aims to
provide a practical guide to corporate governance for listed companies, their investors,
the wider market and the Australian community in order to restore investors’
con?dence and maintain the credibility of ?nancial reports. Companies listed on the
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ASX must provide a statement in their annual report disclosing either the extent to
which they have followed the POGCG or an explanation for why they did not. The
POGCG provide guidance as to the appropriate characteristics of corporate governance
mechanisms. For example, they recommend that a majority of the board should
be independent directors (ASX, 2007, Rec. 2.1). The focus of this paper is on the
association between earnings management and speci?c corporate governance
mechanisms related to board independence, including the independent composition
of the board, and the share ownership and compensation of NEDs.
2.1 Independent composition of the board
The monitoring role of the board of directors is important because directors represent
shareholders in assessing and evaluating managers’ performance (Fama and Jensen,
1983). To ful?l these roles, the board needs to be independent of management which
can be demonstrated by one. the structure of the board; and two. The role separation of
the Chair and the chief executive of?cer (CEO) (Rosenstein and Wyatt, 1990; John and
Senbet, 1998). Board independence is the second principle of POGCG, which includes
the following recommendations:
2.1 A majority of the board should be independent directors.
2.2 The chair should be an independent director.
2.3 The roles of chair and chief executive of?cer should not be exercised by the same
individual (ASX, 2007, Principle 2, p. 10).
In respect of board structure, the extant literature considers that the board is
independent when it is outsider-dominated (Weisbach, 1988): that is, when it consists of
at least 60 per cent of outside (non-executive) directors who are not full-time employees
and not involved in the routine business (Beasley, 1996). Fama and Jensen (1983) argue
that NEDs are more likely than executive directors to exercise objective judgement,
because they want to maintain the value of their reputations as experts in decision
making and monitoring. Further, the board is assumed to be more independent as the
number of NEDs increases (Fama, 1980; Fama and Jensen, 1983; Rosenstein and Wyatt,
1990; John and Senbet, 1998). Most of the results in the literature support the
assumption that a board with more NEDs is associated with better monitoring ability
(Dechow et al., 1996; Klein, 2002; Xie et al., 2003; Peasnell et al., 2005). Bedard et al.
(2004) is an exception to this result, failing to ?nd an association for a sample of USA
?rms in 1996. In Australia, both before and after POGCG and CLERP 9 were
introduced, Davidson et al. (2005), Koh et al. (2007) and Hutchinson et al. (2008) report
that a majority of NEDs on the board is negatively associated with the extent of
earnings management.
In relation to role separation of Chair of the Board and CEO, the literature supports
the use of chair independence as another indicator of independent board composition,
because of its usefulness for maximizing monitoring ability and minimizing power
concentration (Fama and Jensen, 1983; Boyd, 1994; Colley et al., 2003). Using US data,
Rechner and Dalton (1991) report that ?rms with chair independence perform better
than those with CEO duality. This view is also supported by corporate governance
guidelines and regulations (Cadbury Committee, 1992; SOX, 2002; ASX, 2007, Rec. 2.3,
p. 10). However, Bedard et al. (2004) and Davidson et al. (2005) fail to ?nd any
signi?cant results. Role separation is used as an alternative measure of independent
board composition in this study.
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In addition to the two measures for board independence that have been used in most
prior studies, two other measures of independent board composition are used in this
study: the average number of other board seats held by NEDs and the average period
of board service by NEDs. Prior research indicates that the number of outside
directorships is a signal of the competence of NEDs. For example, Fama and Jensen
(1983) ?nd that the managerial labor market for outside directorships rewards effective
outside directors with more than one directorship, but penalizes outside directors who
have a record of poor monitoring performance. The literature also indicates that NEDs
in a troubled ?rm are more likely than other directors to lose their other directorships
(Gilson, 1990; Gerety and Lehn, 1997). Bedard et al. (2004) report that the average
number of other directorships of NEDs is negatively associated with the level of
earnings management.
The use of average period of board service by NEDs as a measure for independent
board composition is also supported in the literature, which indicates that experience
on the company’s board enhances the NED’s understanding of the operations of the
?rm and therefore develops his or her monitoring competencies (Kosnik, 1987; Beasley,
1996; Bedard et al., 2004). However, experience may have a further effect on the
performance of directors. NED familiarity with the company would also induce
entrenchment in the long-term and lead to non-transparent decision-making.
Combining these effects, it is expected that NEDs will exercise their roles more
effectively and objectively in the early to mid stages of their period of directorship,
while in the later years of their period of board service, they will be more tolerant of
management manipulation. Accordingly, a non-linear relationship between the
average period of board service by NEDs and earnings management is predicted.
This study tests the association between independent board composition and
earnings management in Australia, using these four measures of board independence,
with the following hypotheses:
H1a. Earnings management is negatively associated with the independent
composition of the board.
H1b. Earnings management has a non-linear association with the average period of
board service by NEDs.
In summary, the impact of independent board composition on earnings management is
examined in terms of the proportion of NEDs on the board, the role separation between
the CEO and Chair, the average number of other boards that NEDs also sit on, and
average period of service by NEDs.
2.2 Share ownership of NEDs
As part of their NED compensation package, an increasing number of ?rms pay equity
compensation. The percentage of share ownership of NEDs increases as their tenure
increases (Yermack, 2004). Stakeholders support the payment of equity-based
compensation to NEDs to align their incentives and to make their views more
consistent with the views of shareholders (Perry, 2000).
In the extant literature, advocates of equity-based compensation report signi?cant
results. Patton and Baker (1987) report that a director with a sizeable stake in the ?rm
is more likely to question and challenge managements’ proposals than a director with a
low stake. Jensen (1993) argues that encouraging NEDs to hold substantial equity
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ownership in a ?rm would provide better incentives for monitoring top management.
Noe and Rebello (1996), Hermalin and Weisbach (1998) and Bedard et al. (2004) indicate
that the monitoring efforts of the board can be increased if a substantial percentage of
shares are held by NEDs. However, more recent USA research ?nds a positive
association between non-executive compensation and earnings management, drawing
the conclusion that an incentive package induces NEDs to silently agree with
managers in the practice of earnings management (Ronen et al., 2006).
The extant research in Australia regarding the association between corporate
governance and earnings management mainly focuses on the independence and
effectiveness of the board and the audit committee (Davidson et al., 2005; Koh et al., 2007;
Hutchinson et al., 2008). Only one of them investigates the impact of executive
shareholdings on the level of earnings management (Hutchinson et al., 2008) and ?nds
a positive association. The increased emphasis on the role of NEDs for the independence
and effectiveness of the board motivates an investigation of how the level of equity
ownership held by NEDs affects their monitoring of management. Although the results
are mixed inthe key relatedliterature, there are manyrelevant results supportingthe view
that a substantial percentage of outside directors’ equity ensures board effectiveness and
this is consistent with agency theory (Fama, 1980). Accordingly, a negative association
between equity ownership of outside directors and earnings management is predicted.
The mixed results regarding the relation between share ownership of NEDs and
earnings management may be a result of the treatment of NEDs as an homogenous
group. A number of studies note that the traditional classi?cation between inside and
outside directors may fail to explain the potential con?icts of interest between the
company and outside directors (Patton and Baker, 1987; Hermalin and Weisbach, 1998;
Lee et al., 1992; Vicknair et al., 1993). They agree with the classi?cation developed by
Baysinger and Butler (1985), which distinguishes between inside (executive) directors,
af?liated outside directors (grey directors), and independent directors. An independent
director is a NED who has no af?liation with the company except for the af?liation of
being a director (Beasley, 1996), whereas a grey director is a NED who has some other
af?liation with the company, such as related party transactions, substantial
shareholding in the company, as well as the af?liation of being a director (Beasley,
1996). These other af?liations may impair the independence of grey directors.
The distinction between independent directors and grey directors is tested in two
further hypotheses concerned with the association between the shareholdings of NEDs
and earnings management. In the absence of prior evidence and based on the prior
arguments, the expected relation is negative for all categories of NEDs:
H2a. Earnings management is negatively associated with the share ownership of
NEDs.
H2b/c. Earnings management is negatively associated with the share ownership of
independent/grey directors.
In summary, the impact of share ownership by NEDs on earnings management is
examined, for all NEDs, independent directors only and grey directors only.
2.3 Compensation of NEDs
Fama and Jensen (1983) argue that NEDs increase the board’s monitoring ability
because they have incentives to carry out their monitoring tasks. These incentives can
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be classi?ed as reputation incentives and ?nancial incentives. Financial incentives
include ?xed compensation received and equity held by NEDs. On the one hand,
?nancial incentives may encourage NEDs to ful?l their monitoring responsibilities
effectively and competently, while on the other hand, they may induce NEDs to tolerate
earnings manipulation undertaken by management for the purpose of retention.
The extant literature in respect of ?nancial incentives for NEDs only discusses the
outcomes of equity-based compensation (Perry, 2000; Yermack, 2004), such as bonuses,
options and other bene?ts, which may be due to the general consideration that
equity-based payment is more likely to in?uence the performance of NEDs than ?xed
compensation.
In general, NEDs receive a ?xed annual compensation instead of bonuses, which is
determined by the board or the remuneration committee, taking into account market
factors, and their commitment and responsibilities. To encourage long-term
commitment and performance, a high level of ?xed compensation is employed by
most listed companies (Yermack, 2004).
This study investigates the association between total compensation, including both
?xed and variable components and earnings management, because both types of
compensation are part of the ?nancial incentive package provided to NEDs. This study
investigates the association without sign prediction, because of the con?icting
outcomes that can be expected and the absence of prior evidence.
The total compensation to NEDs is separated into ?xed and variable components, to
facilitate comparisons with prior research into equity-based payments, and to examine
the role of ?xed payments which have not been the focus of the prior literature.
A further set of hypotheses that separate directors into independent and grey are also
tested, due to the possibility that this distinction may re?ect differential behaviour in
the face of ?nancial incentives, as discussed in the previous section:
H3a. Earnings management is associated with the annual total compensation of
NEDs.
H3b/c. Earnings management is associated with the annual ?xed/variable
compensation of NEDs.
H3d/e. Earnings management is associated with the annual variable compensation
of independent/grey directors.
H3f/g. Earnings management is associated with the annual ?xed compensation of
independent/grey directors.
In summary, the impact of compensation to NEDs on earnings management is
examined, for all NEDs, independent directors only, and grey directors only, and for all
compensation, variable compensation only and ?xed compensation only.
3. Research design
3.1 Measurement of independent variables
The measures used for each of the three corporate governance characteristics are
indicated in Table I. The construct of independent composition of the board is measured
using four variables: role separation for the CEO and the Chair of the Board (used by
Bedard et al., 2004; Davidson et al., 2005; Koh et al., 2007; Leung et al., 2007), which is a
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binary variable; and three continuous variables: the proportion of NEDs on the board,
the average number of other board seats of NEDs andthe average periodof board service
by NEDs. The latter three measures are as determined and reported by the ?rm.
Share ownership is a continuous variable, measured as the reported number of
shares owned by NEDs as a percentage of the total number of issued shares.
The construct of compensation for NEDs is also measured using a continuous variable:
their ?xed plus equity-based (variable) compensation.
NEDs were separated into grey and independent directors, by identifying which
directors are classi?ed by the ?rm as independent according to the ASX POGCG
guidelines:
An independent director is a non-executive director who is not a member of management and
who is free of any business or other relationship that could materially interfere with – or
could reasonably be perceived to materially interfere with – the independent exercise of their
judgement (ASX, 2003).
Grey directors are those who are not classi?ed as independent. As a result of the
de?nition of an independent director, a grey director may be a substantial shareholder,
may have been an executive employee, a professional advisor or consultant to the
company, may be a material supplier or customer of the company, or have a material
contractual relationship with the company.
3.2 Measurement of dependent variable
This study uses the Modi?ed Jones (M-J) model to measure discretionary accruals as a
proxy for earnings management (Jones, 1991; Dechowet al., 1995). That model has been
Hypothesis and corporate
governance characteristic Variables
Continuous
variables
Binary
indicator
variables
H1. Independent composition
of the board
Separation of roles of CEO and
Chair
CHAIR
Proportion of NEDs on the
board
INDNB
Average other board seats of
NEDs
OTHDIR
Average period of board
service by NEDs
SERVDIR
H2. Share ownership by NEDs Share ownership by NEDs OWNALL
Share ownership by grey
directors
OWNGREY
Share ownership by
independent directors
OWNIND
H3. Compensation of NEDs Total compensation of NEDs COMPTOTALL
Fixed compensation of NEDs/
grey/independent directors
COMPFIXALL
COMPFIXGREY
COMPFIXIND
Variable compensation of
NEDs/grey/independent
directors
COMPVARALL
COMPVARGREY
COMPVARIND
Table I.
Hypotheses, corporate
governance
characteristics, variables
and models
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used in prior Australian studies, for example, Davidson et al. (2005). In that model,
the level of discretionary accruals is calculated as the difference between total accruals
(pro?t after income tax less cash ?ow from operations) and non-discretionary accruals.
Non-discretionary accruals are calculated using sector-speci?c co-ef?cients in the
following model:
NDAC
ijt
¼ a
j
1
A
ijt21
þb
1j
ðDREV
ijt
2DREC
ijt
Þ
A
ijt21
þb
2j
PPE
ijt
A
ijt21
where: NDAC
ijt
– non-discretionary accruals for ?rm j in sector i at year t; A
ijt21
–
total assets for ?rm j in sector i at year t; DREV
ijt
– change in revenue for ?rm j in
sector i at year t; DREC
ijt
– change in receivables for ?rm j in sector i at year t; PPE
ijt
–
gross property, plant and equipment for ?rm j in sector i at year t.
Sector speci?c co-ef?cients are used instead of industry speci?c co-ef?cients, to
ensure that there are suf?cient ?rms in each sector to provide an accurate measure.
3.3 Control variables
Accruals management studies are known to be subject to the problem of correlated
omitted variables (Dechow et al., 1995; Bartov et al., 2000). This study controls for
several factors that have been associated with earnings management in prior
studies.
Monitoring of management by blockholders of shares is associated with reduced
levels of earnings management in prior studies (Klein, 2002). The percentage of shares
held by blockholders (BLOCK) is measured as the accumulated percentage of ordinary
shares held by shareholders not af?liated with management who hold at least 5 per cent
of shares.
DeFond and Jiambalvo (1994) show that management is more likely to overstate
earnings when the leverage ratio is close to the debt covenant violation level, and so
?nancial leverage (LEV) is included to control for this motivation to engage in earnings
management (BeasleyandSalterio, 2001; Klein, 2002; Davidsonet al., 2005; Peasnell et al.,
2005; Leung et al., 2007). It is measured as total assets divided by total liabilities.
To control for the relation between ?rm performance and earnings management
(Kasznik, 1999; Kothari et al., 2005), absolute change in earnings (ABSCH) is included.
It is measured as the absolute change in pro?t after income tax, scaled by total assets.
Larger ?rms have stronger internal control systems and stronger monitoring
mechanisms than smaller ?rms (O’Reilly et al., 1988), which may indicate that they are
more able to constrain earnings management. Bartov et al. (2000), Davidson et al.
(2005) and Peasnell et al. (2005) show that ?rm size is negatively associated with
earnings management, and positively associated with the monitoring abilities of
boards and audit committees. Firm size (SIZE) is measured as the natural logarithm of
total assets.
Management may be motivated to manage earnings if the market to book value
ratio of the ?rm is low and the ?rm is therefore a potential takeover target. By
managing earnings to the level of the market’s expectation, it is argued that the ?rm’s
market value, and therefore its market to book value ratio, can be increased. Following
Leung et al. (2007), the market to book value ratio (MKT) is included to control for this
effect. It is measured as the market capitalisation at balance date, divided by net assets.
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3.4 Models
The hypotheses are tested using a basic multiple regression model as shown below. All
variables are expected to have a linear relationship with the dependent variable
(discretionary accruals) except the average period of board service by NEDs
(SERVDIR). As explained above, a squared term of SERVDIR is included in the basic
model in expectation of a non-linear relationship between SERVDIR and DAC:
DAC ¼ a þb
1
CHAIR þb
2
INDNB þb
3
OTHDIR þb
4
SERVDIR þb
5
SERVDIR
2
þb
6
OWNALL þb
7
COMPTOTALL þb
8
BLOCK þ B
9
LEV þb
10
ABSCH
þb
11
SIZE þb
12
MKT
where: DAC – discretionary accruals; independent variables de?ned as per Table I;
control variables: BLOCK – percentage of shares held by blockholders; LEV –
?nancial leverage; ABSCH – absolute change in earnings; SIZE – ?rm size; MKT –
market to book value ratio.
To test the hypotheses that disaggregate NEDs into grey and independent directors,
and total compensation into ?xed and variable, the ownership and compensation
variables in the above models are separated into their component parts, in two stages.
First, COMPTOTALL is replaced by COMPFIXALL and COMPVARALL in the above
model. Next, OWNALL in the above model is replaced by OWNGREY and OWNIND
at the same time as COMPFIXALL and COMPVARALL are replaced by
COMPFIXGREY and COMPFIXIND and by COMPVARGREY and COMPVARIND.
4. Sample collection and data description
4.1 Sampling
An initial sample of 250 ?rms was randomly selected from the top 500 Australian ?rms
listed on the ASX in the ?nancial year 2005, excluding ?rms from the ?nancial sector.
At the time of data collection, this year was chosen as the most recent year following
the implementation of POGCG. Firms in the ?nancial sector were not included in the
sample because their accounting treatments and legal regulations differ from ?rms in
other sectors, which is consistent with prior research in this area (Barnhart et al., 1994;
Klein, 2002; Davidson et al., 2005). Due mostly to incomplete corporate governance
information, but also to incomplete ?nancial data, 19 ?rms were excluded from the 250
randomly selected ?rms. Therefore, the ?nal sample consists of 231 ?rms.
The data for this study is available from ASPECT Fin Analysis, and the ?rms’
annual reports which were accessed via ASPECT Annual Reports Online and the
?rms’ web sites.
4.2 Descriptive statistics
The 231 ?rms in the sample are drawn from nine sectors and 33 industries, as shown in
Table II. Twenty-?ve percentage of the sample is drawn from the materials sector, with
only 2 per cent of ?rms from the utilities sector. Descriptive statistics for the
independent and control variables are shown in Table III, Panels A and B.
Over 91 per cent (210/231) of ?rms separate the roles of CEO and Chair, which is
higher than that observed in other countries, and higher than the 77 per cent reported by
Davidson et al. (2005) for the year 2000, but comparable to the levels reported in Leung
What makes
a board
independent?
153
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et al. (2007) for 2001 (86 per cent) and 2003 (88 per cent). The average composition of
boards of directors for this sample consists of 72 per cent NEDs. This ?gure is
comparable to those in Davidson et al. (2005), Leung et al. (2007) and Hutchinson et al.
(2008). On average, NEDs sit on 1.2 other boards, and have 5 years service on the current
board. NEDs own an average of 5.1 per cent of the company’s shares, mostly due to the
4.3 per cent ownership by grey directors, with independent directors owning only
0.5 per cent. The average total compensation paid to all NEDs is $376,000, split
between $286,000 in ?xed compensation and $90,000 in variable compensation.
Sector Industry
Industry
code
Number
in sample
Percentage
of sample
Energy Oil and Gas 101010 22 9.5
Materials Chemicals 151010 3 25.1
Construction materials 151020 6
Containers and packaging 151030 1
Metals and mining 151040 42
Paper and forest products 151050 6
Industrials Building products 201020 4 18.2
Construction and engineering 201030 11
Industrial conglomerates 201050 2
Trading companies and
distributors 201070 1
Commercial services and
supplies 202010 22
Marine 203030 1
Transportation infrastructure 203050 1
Consumer Auto Components 251010 4 13.9
discretionary Household durables 252010 3
Leisure equipment and products 252020 2
Textiles, apparel and luxury
goods 252030 2
Hotels, restaurants and leisure 253010 1
Media 254010 8
Multi-line retail 255030 2
Specialty retail 255040 10
Consumer
staples
Beverages 302010 2 4.3
Food products 302020 8
Health care Health care equipment and
supplies 351010 15 12.1
Biotechnology 352010 5
Pharmaceuticals 352020 8
Financials Real estate 404010 18 7.8
Information Internet software and services 451010 4 6.9
technology IT consulting and services 451020 3
Software electronic 451030 7
Communications equipment 452010 2
Utilities Gas utilities 551020 3 2.2
Multi-utilities and unregulated
power 551030 2
Total 231 100
Table II.
Summary of sample
by GICS sectors
and industries
ARJ
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Table III.
What makes
a board
independent?
155
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Independent directors are paid 68 per cent of total compensation, 70 per cent of ?xed
compensation and 62 per cent of variable compensation.
Descriptive statistics for the variables used to calculate discretionary accruals using
the M-J model are shown in Table IV. The variables have the expected sign, where
applicable. Whilst the average and median discretionary accruals are quite small
(20.002 and 20.0156 per cent of total assets), the range (20.9324 to þ2.6892) indicates
that both positive and negative earnings management of larger magnitudes occur.
The results of a correlation analysis for all independent variables (Table V) reveal a
small number of positive (.0.5) and signi?cant (at 5 per cent level) associations
between the sets of variables. These do not affect the interpretation of the results. All of
these correlations are between size and compensation variables: total and ?xed
compensations for NEDs and independent directors, and all of the correlation
co-ef?cients are below 0.7. Furthermore, size is a control variable in the models, and is
not the subject of any hypotheses. Although high correlations between variables may
cause multicollinearity in the regression results, its effect would be to understate the
signi?cance of the independent variables, without impacting the explanatory power of
the overall model. So it is unlikely that multicollinearity is an issue, and even if it is, its
effect would be to bias against signi?cant ?ndings in the models.
5. Results
The results of the regression analyses are shown in Table VI, Panels A and B. Panel A
shows the results using the data that was winsorised at 1 per cent level, and Panel B
shows the results using data winsorised at 5 per cent level. The models are signi?cant
( p ¼ 0.037, 0.003, respectively) with low overall adjusted explanatory power of only 4.4
and 7.6 per cent, respectively.
Mean SD Minimum Median Maximum
Panel A: descriptive statistics for variables used in M-J model ($mill )
Name
Total assets (year t) 859.68 1,536.80 0.01 228.49 9,346.40
Total assets (year t 2 1) 701.15 1,346.30 1.98 158.29 9,037.00
Pro?ts after income tax 51.00 132.19 2652.84 51.51 1,007.10
Cash ?ow from operating activities 70.43 187.59 2426.91 15.28 1,457.90
Total accruals
a
20.0243 0.2505 21.3117 20.0368 2.7910
Non-discretionary accruals
a
20.02230 0.10987 21.16992 20.01662 0.14000
Discretionary accruals
a
20.0020 0.2227 20.9324 20.0156 2.6892
Panel B: descriptive statistics for estimated regression coef?cients (n ¼ 9)
Sector co-ef?cients
a
a co-ef?cient 0.02047 0.10537 0.24302 0.06292 0.11829
b
1
co-ef?cient 20.02571 0.06647 20.30533 20.00930 0.05999
b
2
co-ef?cient 20.2012 0.3328 21.1385 20.2237 0.2355
Notes:
a
Scaled by total assets in year t 2 1; the descriptive statistics presented are for the estimated
multiple regression equation: TAC
ijt
=A
ijt21
¼ ^ a
j
ð1=A
ijt21
Þ þ b
1j
ðDREV
ijt
=A
ijt21
Þ þ b
2j
ðPPE
ijt
=A
ijt21
Þþ
1
ijt
: where: TAC
ijt
, total accruals for ?rm i in industry j at year t; DREV
ijt
, change in revenue for ?rm i in
industryj betweenyear t 2 1andt; PPE
ijt
, gross property, plant andequipment for ?rmi inindustryj at year
t; A
ijt21
, total assets for ?rm i in industry j at year t 2 1
Table IV.
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D
0
.
3
4
8
0
.
2
1
2
0
.
2
4
0
2
0
.
0
0
2
0
.
1
3
2
0
.
1
0
2
0
.
1
2
0
.
7
8
9
0
.
8
6
1
0
.
0
0
0
0
.
0
0
1
0
.
0
0
0
0
.
9
7
5
0
.
0
4
8
0
.
1
2
4
0
.
0
6
1
0
.
0
0
0
0
.
0
0
0
C
O
M
P
F
I
X
G
R
E
Y
0
.
3
2
8
0
.
0
8
8
0
.
0
6
2
0
.
2
0
4
0
.
1
5
5
2
0
.
0
8
0
.
1
7
2
0
.
0
4
2
0
.
4
6
3
0
.
0
0
0
0
.
1
8
2
0
.
3
5
1
0
.
0
0
2
0
.
0
1
9
0
.
2
1
1
0
.
0
0
9
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
A
L
L
0
.
1
8
5
0
.
0
1
7
0
.
0
8
0
0
.
0
5
9
0
.
1
8
1
0
.
0
7
2
0
.
1
9
1
0
.
7
2
3
0
.
3
8
5
0
.
0
0
5
0
.
7
9
5
0
.
2
2
8
0
.
3
7
5
0
.
0
0
6
0
.
2
7
3
0
.
0
0
4
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
I
N
D
0
.
1
4
9
0
.
0
4
0
0
.
1
2
1
2
0
.
0
0
0
.
0
9
1
0
.
1
4
9
0
.
0
8
4
0
.
5
7
8
0
.
3
2
6
0
.
0
2
3
0
.
5
4
8
0
.
0
6
7
0
.
9
5
2
0
.
1
6
8
0
.
0
2
3
0
.
2
0
3
0
.
0
0
0
0
.
0
0
0
C
O
M
P
V
A
R
G
R
E
Y
0
.
0
9
6
2
0
.
0
2
2
0
.
0
2
0
.
0
9
9
0
.
1
5
8
2
0
.
0
7
0
.
1
8
1
0
.
4
5
9
0
.
2
4
8
0
.
1
4
7
0
.
8
1
5
0
.
7
6
6
0
.
1
3
3
0
.
0
1
6
0
.
3
0
2
0
.
0
0
6
0
.
0
0
0
0
.
0
0
0
B
L
O
C
K
0
.
0
3
6
2
0
.
1
1
2
0
.
0
8
2
0
.
0
1
0
.
1
3
0
2
0
.
0
9
0
.
1
4
6
2
0
.
1
0
2
0
.
0
8
0
.
5
8
4
0
.
0
9
1
0
.
2
5
2
0
.
8
9
7
0
.
0
4
9
0
.
1
5
3
0
.
0
2
7
0
.
1
4
0
0
.
2
1
4
L
E
V
0
.
1
3
7
0
.
1
1
5
0
.
1
1
3
0
.
1
2
2
2
0
.
0
2
2
0
.
1
1
2
0
.
0
0
0
.
1
4
6
0
.
1
8
0
0
.
0
3
7
0
.
0
8
0
0
.
0
8
5
0
.
0
6
4
0
.
7
5
8
0
.
0
8
5
1
.
0
0
0
0
.
0
2
6
0
.
0
0
6
A
B
S
C
H
2
0
.
0
1
0
.
0
1
9
2
0
.
0
6
2
0
.
0
2
2
0
.
0
1
0
.
0
6
1
2
0
.
0
2
2
0
.
2
1
2
0
.
2
2
0
.
8
5
4
0
.
7
7
0
0
.
3
8
3
0
.
7
9
8
0
.
8
7
6
0
.
3
5
9
0
.
7
9
2
0
.
0
0
1
0
.
0
0
1
S
I
Z
E
0
.
3
0
6
0
.
2
3
8
0
.
2
7
7
0
.
0
7
5
2
0
.
1
1
2
0
.
2
6
2
0
.
0
6
0
.
6
3
9
0
.
6
8
0
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
2
5
3
0
.
0
8
4
0
.
0
0
0
0
.
3
3
6
0
.
0
0
0
0
.
0
0
0
M
K
T
2
0
.
1
1
2
0
.
1
4
2
0
.
0
5
2
0
.
0
5
0
.
0
5
3
0
.
1
7
7
2
0
.
0
2
2
0
.
1
0
2
0
.
1
0
0
.
0
8
5
0
.
0
2
8
0
.
4
1
3
0
.
4
7
5
0
.
4
2
3
0
.
0
0
7
0
.
8
0
2
0
.
1
4
8
0
.
1
2
0
(
c
o
n
t
i
n
u
e
d
)
Table V.
Correlations and p-values
for independent variables
What makes
a board
independent?
157
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
C
O
M
P
F
I
X
I
N
D
C
O
M
P
F
I
X
G
R
E
Y
C
O
M
P
V
A
R
A
L
L
C
O
M
P
V
A
R
I
N
D
C
O
M
P
V
A
R
G
R
E
Y
B
L
O
C
K
L
E
V
A
B
S
C
H
S
I
Z
E
C
H
A
I
R
O
T
H
D
I
R
S
E
R
V
D
I
R
O
W
N
A
L
L
O
W
N
I
N
D
O
W
N
G
R
E
Y
C
O
M
P
T
O
T
A
L
L
C
O
M
P
F
I
X
A
L
L
C
O
M
P
F
I
X
I
N
D
C
O
M
P
F
I
X
G
R
E
Y
2
0
.
0
4
0
.
5
1
8
C
O
M
P
V
A
R
A
L
L
0
.
3
3
3
0
.
1
6
8
0
.
0
0
0
0
.
0
1
0
C
O
M
P
V
A
R
I
N
D
0
.
4
2
3
2
0
.
1
1
0
.
7
7
0
0
.
0
0
0
0
.
0
9
7
0
.
0
0
0
C
O
M
P
V
A
R
G
R
E
Y
0
.
0
2
2
0
.
4
2
5
0
.
6
2
9
0
.
0
0
1
0
.
7
3
8
0
.
0
0
0
0
.
0
0
0
0
.
9
8
5
B
L
O
C
K
2
0
.
1
5
0
.
1
0
3
2
0
.
0
8
2
0
.
0
5
2
0
.
0
7
0
.
0
2
4
0
.
1
1
9
0
.
2
0
9
0
.
4
5
9
0
.
2
7
1
L
E
V
0
.
1
3
1
0
.
1
3
2
0
.
0
2
6
0
.
0
2
8
0
.
0
1
2
2
0
.
0
3
0
.
0
4
7
0
.
0
4
5
0
.
6
9
6
0
.
6
7
6
0
.
8
5
4
0
.
6
0
5
A
B
S
C
H
2
0
.
2
0
2
0
.
0
8
2
0
.
1
2
2
0
.
0
8
2
0
.
0
9
2
0
.
0
7
0
.
0
3
5
0
.
0
0
2
0
.
2
5
8
0
.
0
7
4
0
.
2
4
0
0
.
1
6
2
0
.
3
1
7
0
.
5
9
2
S
I
Z
E
0
.
6
3
1
0
.
2
4
5
0
.
2
9
8
0
.
2
6
6
0
.
1
6
4
0
.
0
1
5
0
.
2
2
3
2
0
.
4
2
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
0
0
0
0
.
0
1
2
0
.
8
2
3
0
.
0
0
1
0
.
0
0
0
M
K
T
2
0
.
0
4
2
0
.
1
4
2
0
.
0
4
2
0
.
0
2
2
0
.
0
5
0
.
0
1
8
2
0
.
2
4
0
.
1
3
7
2
0
.
3
4
0
.
5
6
6
0
.
0
3
2
0
.
5
2
0
0
.
7
9
9
0
.
4
4
8
0
.
7
8
6
0
.
0
0
0
0
.
0
3
7
0
.
0
0
0
N
o
t
e
:
V
a
r
i
a
b
l
e
n
a
m
e
s
a
s
p
e
r
T
a
b
l
e
I
Table V.
ARJ
22,2
158
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
P
a
n
e
l
A
:
1
p
e
r
c
e
n
t
w
i
n
s
o
r
i
s
e
d
d
a
t
a
P
a
n
e
l
B
:
5
p
e
r
c
e
n
t
w
i
n
s
o
r
i
s
e
d
d
a
t
a
V
a
r
i
a
b
l
e
s
P
r
e
d
i
c
t
i
o
n
M
o
d
e
l
1
M
o
d
e
l
2
M
o
d
e
l
3
M
o
d
e
l
1
M
o
d
e
l
2
M
o
d
e
l
3
I
n
t
e
r
c
e
p
t
2
0
.
1
0
7
(
2
0
.
7
1
)
2
0
.
1
1
6
(
2
0
.
7
4
)
2
0
.
1
2
3
(
2
0
.
7
5
)
2
0
.
1
1
5
(
2
0
.
9
7
)
2
0
.
1
4
1
(
2
1
.
1
3
)
2
0
.
1
5
0
(
2
1
.
1
7
)
C
H
A
I
R
H
1
(
2
)
2
0
.
0
1
5
(
2
0
.
4
9
)
2
0
.
0
1
5
(
2
0
.
4
6
)
2
0
.
0
1
3
(
2
0
.
4
1
)
2
0
.
0
1
0
(
2
0
.
4
4
)
2
0
.
0
0
8
(
2
0
.
3
6
)
2
0
.
0
0
7
(
2
0
.
2
9
)
I
N
D
N
B
H
1
(
2
)
0
.
0
6
8
(
1
.
1
4
)
0
.
0
7
0
(
1
.
1
5
)
0
.
0
7
5
(
1
.
2
0
)
0
.
0
8
3
(
1
.
8
2
)
*
0
.
0
8
9
(
1
.
9
1
)
*
0
.
0
9
6
(
2
.
0
2
)
*
*
O
T
H
E
R
D
I
R
H
1
(
2
)
0
.
0
0
8
(
0
.
7
4
)
0
.
0
0
8
(
0
.
7
3
)
0
.
0
0
7
(
0
.
6
2
)
0
.
0
0
5
(
0
.
6
0
)
0
.
0
0
5
(
0
.
5
5
)
0
.
0
0
3
(
0
.
3
9
)
S
E
R
V
D
I
R
H
1
(
2
)
0
.
0
2
0
(
2
.
6
3
)
*
*
*
0
.
0
2
0
(
2
.
5
7
)
*
*
*
0
.
0
2
0
(
2
.
4
6
)
*
*
0
.
0
1
8
(
3
.
0
1
)
*
*
*
0
.
0
1
7
(
2
.
9
0
)
*
*
*
0
.
0
1
8
(
2
.
9
2
)
*
*
*
S
E
R
V
D
I
R
2
H
1
(
s
i
g
)
2
0
.
0
0
2
(
2
2
.
8
8
)
*
*
*
2
0
.
0
0
2
(
2
2
.
8
0
)
*
*
*
2
0
.
0
0
2
(
2
2
.
6
3
)
*
*
*
2
0
.
0
0
1
(
2
3
.
1
2
)
*
*
*
2
0
.
0
0
1
(
2
2
.
9
9
)
*
*
*
2
0
.
0
0
1
(
2
2
.
9
8
)
*
*
*
O
W
N
A
L
L
H
2
(
2
)
0
.
2
1
5
(
2
.
8
5
)
*
*
*
0
.
2
1
2
(
2
.
7
2
)
*
*
*
0
.
2
5
1
(
3
.
8
0
)
*
*
*
0
.
2
4
2
(
3
.
6
1
)
*
*
*
O
W
N
G
R
E
Y
H
2
(
2
)
0
.
2
1
1
(
2
.
5
2
)
*
*
0
.
2
5
2
(
3
.
4
4
)
†
O
W
N
I
N
D
H
2
(
2
)
0
.
2
4
7
(
0
.
3
9
)
0
.
2
3
3
(
0
.
3
1
)
C
O
M
P
T
O
T
A
L
L
H
3
(
s
i
g
)
2
0
.
0
0
0
(
2
2
.
4
1
)
*
*
2
0
.
0
0
0
(
2
3
.
0
1
)
*
*
*
C
O
M
P
F
I
X
A
L
L
H
3
(
s
i
g
)
2
0
.
0
0
0
(
2
1
.
8
0
)
*
2
0
.
0
0
0
(
2
2
.
5
7
)
*
*
*
C
O
M
P
F
I
X
G
R
E
Y
H
3
(
s
i
g
)
H
3
(
s
i
g
)
2
0
.
0
0
0
(
2
1
.
0
3
)
2
0
.
0
0
0
(
2
1
.
1
6
)
C
O
M
P
F
I
X
I
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;
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a
t
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o
Table VI.
Multiple regression
results
What makes
a board
independent?
159
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
5.1 Independent composition of the board
H1a states that earnings management is negatively associated with the independent
composition of the board, where independent composition is measured as separation of
the roles of CEO and Chair, the proportion of NEDs on the board, and the average other
board seats of NEDs. H1b states that earnings management has a non-linear
association with the average period of board service by NEDs.
Panel A shows that only one of the measures, the average board service by NEDs, is
signi?cant. Both the measure and its square are signi?cant: the measure has a positive
co-ef?cient (0.020, p ¼ 0.009) and the square has a negative co-ef?cient (20.002,
p ¼ 0.004). The sign of the squared term dominates the effect of average board service
on earnings management, and its negative co-ef?cient indicates that the relationship
between earnings management and the average period of board service by NEDs is an
inverse “U” shaped curve. This is consistent with the expectation that familiarity with
the ?rm and its operations can enhance NEDs’ ability to monitor management in the
short-term but does not detect or prevent earnings management in the long run.
In Panel B, there is reduced impact of potential outliers on the results. Two measures
of independent composition of the board are signi?cant: the proportion of NEDs on the
board, and average board service by NEDs (both the measure and its square, as in
Panel A). The proportion of NEDs has a positive co-ef?cient and is signi?cant at 10 per
cent level (0.083, p ¼ 0.071). This indicates that a greater proportion of NEDs is weakly
associated with a higher level of earnings management, which is contrary to the ?ndings
of other studies of this phenomenon, and also contrary to the rationale behind corporate
governance guidelines. This ?nding is interpreted cautiously, as its effect may be
confounded by the effect of other measures of board independence, and also by results
pertaining to the impact of grey directors on earnings management. Again, the measure
of average board service and its square are both signi?cant: the measure again has a
positive co-ef?cient (0.018, p ¼ 0.003) and the square has a negative co-ef?cient (20.001,
p ¼ 0.002). The similarity of this result with that reported in Panel A con?rms the
robustness of this result. Sensitivity tests of the effect of omitting the square of this
measure (not reported) do not affect the signi?cance or signs of other explanatory
variables, but reduce the overall explanatory power of the model.
Overall, the results of this study provide limited support for H1b.
5.2 Share ownership on NEDs
H2 states that earnings management is negatively associated with the share ownership
of NEDs. This is tested for all NEDs, and then for NEDs disaggregated into
independent and grey directors.
The co-ef?cient for aggregate share ownership of NEDs is positive and signi?cant
in both Panels A and B (0.215, p ¼ 0.005; 0.251, p ¼ 0.000). This indicates that a higher
level of share ownership by NEDs is associated with a higher level of earnings
management. Similar results are found in other versions of the basic model, when
compensation of NEDs is disaggregated, which con?rms the robustness of this result.
It appears that directors with this level of ownership do not make effective monitors of
management, which is contrary to the theory that an ownership stake in the ?rm aligns
the incentives of directors to those of shareholders. The prior literature was divided
on this issue, with some results indicating a positive effect for corporate governance
ARJ
22,2
160
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
2
1
:
0
8
2
4
J
a
n
u
a
r
y
2
0
1
6
(
P
T
)
from directors’ shareholdings, and other indicating a negative effect. In Australia,
Hutchinson et al. (2008) ?nd a similar positive association for executive directors.
But which type of NED is driving the positive relation in this paper? Recall that grey
directors’ average shareholding is 4.3 per cent compared to independent directors’
average shareholding of 0.5 per cent. When NEDs are disaggregated into independent
and grey directors, the share ownership of independent directors is not signi?cantly
associated with earnings management. In contrast, that of grey directors is signi?cantly
positively associated with earnings management across both versions of the data (Panel
A: 0.211, p ¼ 0.013; Panel B: 0.252, p ¼ 0.001). This result clearly indicates that it is the
higher level of share ownership by grey directors that is associated with a higher level of
earnings management.
Overall, the results of this study do not support H2, ?nding instead that there are
signi?cant positive associations between earnings management and share ownership
of NEDs, and earnings management and share ownership of grey directors.
5.3 Compensation of NEDs
H3 states that earnings management is associated with total compensation of NEDs.
This is tested for total compensation and all NEDs, and then compensation is
disaggregated into variable and ?xed compensation, for independent and grey directors.
The co-ef?cient for total compensation to all NEDs is negative and statistically
signi?cant in both Panels A and B (20.000, p ¼ 0.017; 20.000, p ¼ 0.003). The low
co-ef?cient does not indicate little economic signi?cance, because compensation is
measured in dollars, and earnings management (non-discretionary accruals) is de?ated
by total assets[2]. The co-ef?cients are both 20.00000009. This result indicates that a
higher level of compensation for NEDs is associated with lower earnings management.
This result is consistent with prior research in the USA which ?nds that NEDs who
have substantial equity ownership (and therefore equity-based payments) are more likely
to monitor and constrain earnings management (Bedard et al., 2004). However, this
comparison to other results highlights the potential con?ict between the results for H2,
which ?nd that share ownership by NEDs is not conducive to effective monitoring of
management, and this result, which ?nds that total compensationof NEDs is conducive to
effective monitoring. Disaggregating total compensation resolves this potential con?ict.
First, total compensation is disaggregated into ?xed and variable compensation.
Across Panels A and B, it is clear that it is ?xed compensation which is associated with
earnings management. Fixed compensation has negative and signi?cant co-ef?cients
(20.000, p ¼ 0.072; 20.000, p ¼ 0.011), whereas the co-ef?cients for variable
compensation are not signi?cant.
Second, ?xed and variable compensations to NEDs as a whole are disaggregated by
independent and grey directors. Unsurprisingly, disaggregating variable
compensation by type of director does not produce any signi?cant associations.
Fixed compensation of independent directors is signi?cantly and negatively associated
with earnings management, whereas ?xed compensation of grey directors is not
signi?cant. The co-ef?cients are still very small, but not equal to zero (20.00000010;
20.00000014). The results indicate that a higher level of ?xed compensation to
independent directors is associated with lower earnings management.
Recall that 72 per cent of NEDs are independent, and that 69 per cent of
total compensation is paid to independent directors. Further, ?xed compensation is
What makes
a board
independent?
161
D
o
w
n
l
o
a
d
e
d
b
y
P
O
N
D
I
C
H
E
R
R
Y
U
N
I
V
E
R
S
I
T
Y
A
t
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76 per cent of total compensation. The allocation of total, ?xed and variable
compensations is roughly the same between all NEDs, independent and grey directors.
The ?xed compensation of independent directors, which is the only signi?cant variable
when total compensation is fully disaggregated, is 53 per cent of that total.
Overall, in relation to H3, the results of this study indicate that earnings
management is negatively associated with total compensation of NEDs, and in
particular this result holds for ?xed rather than variable compensation, and for ?xed
compensation of independent directors rather than that of grey directors.
After conducting these disaggregated analyses, the potential con?ict between the
results for H2 and H3 can be resolved. Effective monitoring of management, which is
assumed to be linked to lower earnings management, is promoted when the share
ownership of grey directors is lower, and when the ?xed compensation of independent
directors is higher.
Grey directors by de?nition are closely associated with the company. This study
shows that the extent to which that association is by way of share ownership works
against the interests of shareholders. Their total reward from their shareholding is not
fully re?ected in their variable compensation, because that would also include capital
gains on the sale of shares, for example. This total reward appears to motivate grey
directors to not closely or effectively monitor management, resulting in higher levels of
earnings management.
In contrast, independent directors are not closely associated with the company. This
study shows that the more ?xed compensation they receive, the more closely they
monitor management, which reduces the level of earnings management. Because they
do not have any substantial shareholding, they are motivated to act in ways that
promote the interests of shareholders.
6. Summary and conclusions
6.1 Summary
This study has investigated the effectiveness of corporate governance guidelines in
Australia, by focusing on a single corporate governance factor, board independence.
It analyses whether measures of board independence, including board structure and
characteristics of NEDs, are associated with effective monitoring of management, as
evidenced through lower levels of earnings management.
Contrary to the hypothesis, the results of testing H1a indicates weak support for a
negative association between the proportion of NEDs on the board and earnings
management. They also indicate support for a signi?cant non-linear relation between
earnings management and the average period of board service by NEDs. Whilst
earnings management decreases with the average period of NED board service in the
lower end of the range, as board service increases, it is associated with increased
earnings management. This is consistent with the expectation that whilst at ?rst
increased service enhances NEDs’ ability to monitor management, too long a period on
the board entrenches the NED in ways that are not in shareholders’ best interests.
Although H2 predicts a negative association between earnings management and
the share ownership of NEDs, the results indicate a positive relation that can be
attributed to the share ownership of grey directors. These results suggest that grey
directors with substantial shareholdings do not act independently of management.
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They provide support for the ASX’s de?nition of independent directors, and suggest
the similarly tight de?nitions should apply in other jurisdictions.
Finally, testing of H3 supports a negative association between NED compensation
and the level of earnings management, a ?nding that can be attributed to the ?xed
compensation for independent directors. This study shows that the more ?xed
compensation they receive, the more closely they monitor management, which reduces
the level of earnings management. Because independent directors do not have any
substantial shareholding, they are motivated to act in ways that promote the interests
of shareholders.
This study provides practical guidance regarding the tenure, type of remuneration
and ownership levels for NEDs that are consistent with good corporate governance.
NEDs are more effective monitors in the earlier years of their board service, and when
they are compensated more as a ?xed amount that is not related to the ?rm’s
performance. On the other hand, NEDs are less effective monitors as their board service
lengthens past the average term and as share ownership increases. To ensure the
independence of the board and enhance its ability and incentives to effectively monitor
management, the paper recommends ?rst, that the terms of NEDs be ?xed, say at less
than the current average level which is ?ve years; second, that remuneration of NEDs
should be a ?xed amount; and third, the share ownership of NEDs should be limited.
6.2 Limitations and suggestions for further research
A limitation of this study is that the measure of earnings management used may not
adequately capture the underlying construct. Recent papers (Dechow et al., 2003;
Coulton et al., 2005; Francis et al., 2005) have re?ned the ways in which earnings
management can be measured. In addition, incorporating alternative measures of
earnings management into future studies will provide further valuable insights.
A limitation of examining one corporate governance characteristic (board
independence) in a study such as this is the lower explanatory power of the models
compared to studies that include a number of corporate governance variables.
Unreported analyses that include other corporate governance variables, such as audit
committee characteristics, have higher explanatory power.
Notes
1. POGCG were updated in 2007.
2. The use of de?ators for compensation, such as total assets, led to potential problems with
multicollinearity.
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About the authors
Liyu He is an Associate Lecturer in Accounting at Macquarie University, Sydney, Australia. Her
research interests are in corporate governance, earnings management and fair value. She is
currently undertaking a PhD at Macquarie University examining the implications of adopting
fair value accounting in the agricultural sector.
Sue Wright is an Associate Professor in Accounting at Macquarie University, Sydney,
Australia. Her research interests are in corporate governance, business valuation and analysis
and capital markets. Her PhD which was undertaken at Macquarie University examined the
comparative information content of accounting and share price for Australian banks 1960-1990,
drawing on her industry experience working for the Reserve Bank of Australia in policy areas
related to bank supervision and reporting. Sue Wright is the corresponding author and can be
contacted at: [email protected]
Elaine Evans is currently an Associate Professor in Accounting at Macquarie University,
Sydney, Australia. She has held academic positions in accounting at the University of Western
Sydney and ANU, and in health services accounting at the University of New South Wales.
Her current research interests include ?nancial reporting in Australia under IFRS, corporate
governance, the interface between academic education and professional training for accountants,
the accounting profession in Australia and the integration of graduate attributes into the
accounting curriculum.
Susan Crowe is a Lecturer in Statistics at Macquarie University, Sydney, Australia. Her
research interests are in the application of statistical techniques and recent projects include
collaborations with colleagues in accounting and ?nance areas. She has been recognised by
Macquarie University as an outstanding teacher.
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
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This article has been cited by:
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