Association between earnings management and properties of independent audit committee
members
S. Mitchell Williams
Singapore Management University
Contact Details:
Please Address All Correspondence To:
S.Mitchell Williams
Associate Professor of Accountancy
Singapore Management University
#05 – 11, 469 Bukit Timah Road
Singapore 259756
Phone: +65-6822-0609
Fax: +65-6822-0600
Email: mitchellw@smu.edu.sg
Key Words: Earnings management; corporate governance; audit committee; Singapore
JEL Classification: K0; G3; M4
Abstract:
This study empirically examines the association between three properties of independent audit
committee members that could impair or enhance the committee’s ability to constrain earnings
management. The three properties are: (1) presence of a ‘professional’ independent audit
committee member (hereafter ‘Pro-AC member’); (2) extent of familiarity between independent
audit committee members and the external auditor (hereafter ‘AC-External Auditor Familiarity’);
and (3) presence of an ‘interlocked’ independent director on the audit committee. Empirical
analysis is based on a sample of 465 Singapore publicly traded firm-years for 2000 – 2001. After
controlling for other possible determinants of abnormal accruals and audit committee
composition, I find the magnitude of abnormal accruals is more highly manifested amongst
Singapore publicly traded firms with audit committees comprising a ‘Pro-AC member’. Also, I
present evidence of a significant negative association between ‘AC-External Auditor Familiarity’
and the magnitude of abnormal accruals. Results do not indicate an association between ‘ACDirectorate Interlocks’ and the magnitude of earnings management. Overall, findings imply an
audit committee (i) engaging a ‘Pro-AC member’ and/or (ii) more extensive ‘AC-External
Auditor Familiarity’ is less effective in constraining earnings management. Results are robust to a
string of sensitivity tests including alternative proxies for earnings management, independent
variable and control factors.
Acknowledgements:
I appreciate the helpful comments on various versions of this paper by Greg Tower, Phil
Hancock, Stephen Courtenay, Phil Beaulieu, Michael Wright, Hussein Warsame, Duncan Green
and workshop/seminar participants at University of Calgary (Canada), Nanyang Technological
University (Singapore), Singapore Management University (Singapore), Hong Kong Polytechnic
University (Hong Kong), City University of Hong Kong (Hong Kong) and Curtin University of
Technology (Australia). I grateful acknowledge the financial support of the Wharton-SMU
Research Center and School of Accountancy, Singapore Management University. Any errors in
this paper are my own.
~ Please Do Not Quote Without Permission ~
Association between earnings management and properties of independent audit committee
members
Key Words: Earnings management; corporate governance; audit committee; Singapore
JEL Classification: K0; G3; M4
Abstract:
This study empirically examines the association between three properties of independent audit
committee members that could impair or enhance the committee’s ability to constrain earnings
management. The three properties are: (1) presence of a ‘professional’ independent audit
committee member (hereafter ‘Pro-AC member’); (2) extent of familiarity between independent
audit committee members and the external auditor (hereafter ‘AC-External Auditor Familiarity’);
and (3) presence of an ‘interlocked’ independent director on the audit committee. Empirical
analysis is based on a sample of 465 Singapore publicly traded firm-years for 2000 – 2001. After
controlling for other possible determinants of abnormal accruals and audit committee
composition, I find the magnitude of abnormal accruals is more highly manifested amongst
Singapore publicly traded firms with audit committees comprising a ‘Pro-AC member’. Also, I
present evidence of a significant negative association between ‘AC-External Auditor Familiarity’
and the magnitude of abnormal accruals. Results do not indicate an association between ‘ACDirectorate Interlocks’ and the magnitude of earnings management. Overall, findings imply an
audit committee (i) engaging a ‘Pro-AC member’ and/or (ii) more extensive ‘AC-External
Auditor Familiarity’ is less effective in constraining earnings management. Results are robust to a
string of sensitivity tests including alternative proxies for earnings management, independent
variable and control factors.
2
1.
Introduction
This study empirically examines the association between three properties of independent audit
committee members and the magnitude of abnormal accruals1 (proxy for earnings management2)
across a sample of 465 Singapore publicly traded firm-years. The three properties are: (1)
presence of a professional independent audit committee member serving on the audit committee
(hereafter ‘Pro-AC member’); (2) extent of familiarity between independent audit committee
members and the external auditor (hereafter ‘AC-External Auditor Familiarity’); and (3) presence
of ‘interlocked’ independent directors on the audit committee (hereafter ‘AC-Directorate
Interlock’). After controlling for other possible determinants of abnormal accruals and audit
committee composition, I find the magnitude of abnormal accruals is more highly manifested
amongst Singapore publicly traded firms with audit committees comprising a ‘Pro-AC member’.
Also, I present evidence of a significant negative association between ‘AC-External Auditor
Familiarity’ and the magnitude of abnormal accruals. Results do not indicate an association
between ‘AC-Directorate Interlocks’ and the magnitude of earnings management. Overall,
findings imply an audit committee (i) engaging a ‘Pro-AC member’ and/or (ii) more extensive
‘AC-External Auditor Familiarity’ is less effective in constraining earnings management.
One of the most frequently cited firm performance measures, earnings are strongly recognized for
conveying information to investors (LuCharme et al., 2003). Consistent with prior literature
1
Peasnell et al., (2000) argue two major categories of earnings management measures exist: (a) real
operating decisions such as asset sales (Black et al., 1998; Bartov, 1993) or changes in research and
development expenditure (Bushee, 1998; Bange and DeBondt, 1998); and (2) pure financial accounting
decisions such as accrual selection (McNicholas and Wilson, 1988) and accounting policy choices (Watts
and Zimmerman, 1986). As Peasnell et al., (2000, p.421) argue, costs of utilizing pure financial accounting
decisions to manage earnings are “likely to be less than the costs of resorting to sub-optimal operating
decisions to boost reported performance”. As earnings are the focus of this study, I use a proxy that best
reflects and captures corporate management’s opportunistic behavior to temporarily adjust earnings.
2
Earnings management is defined as occurring “when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some stakeholders about the underlying
economic performance of the company or to influence contractual outcomes that depend on reported
accounting numbers” (Healy and Wahlen, 1999, p. 369).
3
(e.g.Healy and Wahlen, 1999; Leuz et al., 2003), I argue incentives arising, in part, from the
conflict of interest between a firm’s insiders (i.e., corporate management) and outsiders (i.e.,
shareholders, creditors) entice corporate management to misrepresent firm performance via
earnings management. To constrain earnings management, regulators, scholars and other relevant
stakeholders stress the increasing need for sound corporate governance practices and
mechanisms. The audit committee is presently touted as a principal internal corporate governance
mechanism for constraining earnings management (Blue Ribbon Committee 1999; Corporate
Governance Committee 2001; Dey 1994; New York Stock Exchange and National Association of
Securities Dealers 1999; Securities and Exchange Commission 1999). The general undertone of
prior discussion and debate suggests independence3 is a central determinant of the audit
committee’s effectiveness when constraining earnings management. This presumption remains an
open empirical question, however, with few studies conducted. Also, data in prior research is
drawn from a single one domestic setting (e.g.Klein, 2002; Chtourou et al., 2001). It is
questionable if empirical findings based solely on United States data are readily generalizable
universally to other domestic settings. For purposes of this study I accept, in principle, the
aforementioned presumption. However, I propose properties of independent directors may
enhance (impair) audit committee independence, thereby, increasing (decreasing) the committee’s
ability to constrain earnings management.
The study provides a significant contribution to the corporate governance literature broadening
our understanding of the association between audit committee independence and earnings
management beyond the current general fixation with the proportion of independent directors on
3
. Several definitions of audit committee independence exist. One definition infers an audit committee is
independent if the majority of committee members are independent of corporate management (eg., Dechow
et al., 1996; Beasley and Salterio, 2001; Klein, 2002). Singapore regulations follow this definition Some
(eg., NASDAQ, 1999; NYSE, 1999) suggest audit committees only function independently if all members
are not influenced by management. A third, and the most common interpretation in the literature, defines of
audit committee independence to be proportional to the percentage of independent directors on this
committee (e.g., Beasley, 1996). Third study adopts the latter perception of independence.
4
the committee. Specifically, I document the first-large scale empirical analysis of the impact
fundamental properties of independent directors that enhance or compound audit committee
independence and, subsequently, the quality of earnings. Results have implications for various
parties. For example, findings infer regulators striving to improve audit committee effectiveness
may need to balance recommendations audit committees be composed of a higher proportion of
independent directors against properties of independent director available to serve this committee.
This study also makes other notable contributions. For example, I advance the international
understanding of audit committees – earnings management links. In conjunction, I provide
additional evidence determining if propositions (with their foundations in the Anglo-American
model of corporate governance and heritages in the United States or United Kingdom) for
improving corporate governance are universally applicable to other domestic settings. These
findings are important for establishing the extent to which corporate governance practices can be
harmonized across national boundaries. Finally, I contribute to the growing earnings management
literature using data lacking patterns of a priori systematic upwards or downwards earnings
management. The majority of prior earnings management research examines firms with specific
incentives for overstating earnings or committing egregious financial fraud (Beasley 1996;
DeFond and Jiambalvo 1994; Parker 2000). Using a sample without a pattern of a priori
systematic upwards or downwards earnings management assist to generalize findings across a
wider set of business conditions.
Examination of audit committees from Singapore publicly traded entities offers several
advantages. First, Singapore’s corporate governance model is generally based on the AngloAmerican model. Hypotheses with their inherent foundation developed in the United States and
United Kingdom, therefore, can be developed to encompass Singapore. Second, analysis of audit
committee issues in Singapore is both prudent and timely. Though Singapore’s underlying
corporate governance system mirrors that of various Western economies, contrasts exist. For
5
example, Singapore lacks many effective market mechanisms – such as strong take-over market
or bank centered monitoring system – to monitor corporate management. There is greater
reliance, therefore, on internal control mechanisms including audit committees. Indeed, for more
than a decade audit committees have been a prominent feature of Singapore’s corporate
governance landscape. Thus, its role is well understood and developed within the Singapore
business environment. Meanwhile, recent reforms continue to stress and strengthen the audit
committee’s role in Singapore publicly listed firms. These reforms, however, have been
implemented without the support of substantive empirical research. Third, Singapore provides a
lucrative domestic setting for empirically analyzing earnings management concerns. Leuz et al.,
(2003) report, relative to the United States, earnings management is considerably more
pronounced in Singapore.4 Finally, I am able to collect data from the vast majority of
economically significant Singapore publicly listed firms.
Empirical findings are subject to several caveats. First, earnings management is difficult to
measure. To address this concern I use several proxy measures for earnings management.
Empirical results are robust to sensitivity tests using alternative proxies. Second, though sharing a
common corporate governance infrastructure (socio-political characteristics) with various
Western (Asian) nations, the single-nation focus of this study may weaken the ability to
generalize results. Therefore, caution applies when interpreting findings within a broader
international setting. Third, I acknowledge other internal control mechanisms, that could be
complementary, may influence corporate management’s decision to manage earnings. It is
difficult to fully control for the potential impact of all other internal control mechanisms, or to
disentangle them completely from the influence of audit committee properties. Whilst I include
relevant control factors, and conduct a battery of various sensitivity tests, other endogenous
4
Leuz et al., (2003) study covers 31 nations. The United States forms the benchmark being the nation with
the lowest aggregate earnings management score. Comparatively, Singapore ranked eighth highest nation
for earnings management.
6
interactions could still exist. Finally, I examine cross-sectional associations only, not causation
relationships.
The remainder of this study is structured as follows. In Section 2 I discuss incentive underscoring
earnings management and the role of audit committees. I also develop the testable hypotheses in
this section. In Section 3 I describe research test procedures including sample selection and proxy
measures for earnings management, independent variables and control factors. Main empirical
results are outlined in Section 4. Sensitivity tests are described in Section 5. The final section
provides a summary of findings, contributions, limitations and ideas for future research.
2.
Background and Hypotheses Development
2.1
Earnings Management and Role of Audit Committees
Globally earnings are increasingly used by shareholders in contractual arrangements with
corporate management either directly (i.e., basis for awarding bonuses) or indirectly (i.e.,
reference point for activating stock option awards). Earnings also act as a pivotal element in the
formation of capital market expectations and stock price valuation. Further, capital providers rely
heavily on earnings when making lending decisions. Finally, governments and regulatory
authorities may use earnings as a triggering barometer for the development (activate) of new
(existing) anti-monopoly and other legislative regulations.
Earnings, both positive and negative, can adversely affect corporate management’s self-interests
prompting potential conflicts with outsiders. Poor earnings, for instance, may generate
unfavorable wealth consequences with bonuses reduced and stock options unrewarded. Earnings
below capital market expectations could lead a decline in a firm’s share price prompting
7
shareholders to demand management replacement.5 Finally, a history of poor earnings may harm
a manager’s reputation capital reducing potential future employment opportunities. Whilst
positive earnings enhance corporate management’s wealth, amounts perceived as excessive may
draw unwanted attention. For instance, perceived excessive positive earnings (whether in fact or
not and if unexpected) may prompt allegations of: (a) attempts to artificially influence capital
markets; (b) erroneous financial reporting practices; or (c) fraudulent behavior. If allegations
influence views of investors, shareholders and capital providers, corporate management’s
reputation capital may suffer. Also, charges of industry monopolization could evolve prompting
regulators to adjust or introduce regulations and rules aimed at improving competition and
prevent price-gouging. Extra regulatory intervention and scrutiny could negatively affect a firm’s
stock price leading to shareholder dissatisfaction and threats of corporate management change.
In summary, corporate management may be enticed by various incentives to manipulate reported
earnings either upwards or downwards. The accounting and corporate governance literatures
document different internal governance mechanisms and external market forces that can
discipline corporate management. Boards of directors are often cited as the primary internal
monitoring governance mechanism. Fama (1980, p.290), for example, argues the board of
directors is a “market-induced institution, the ultimate internal monitor of the set of contracts
called a firm, whose most important role is to scrutinize the highest decision makers within the
firm.” Whilst boards of directors are designated the overarching responsibility for monitoring
corporate management, audit committees are increasingly defined as the pivotal standing
committee accountable for overseeing the quality of a firm’s financial reporting system, including
reported earnings. The Security Exchange Commission (1999, p.1), for instance, comments an
audit committee plays “a critical role in the financial reporting system by overseeing and
monitoring management’s and the independent auditors’ participation in the financial reporting
5
Weisbach (1988), for example, finds senior management turnover increases with poor reported earnings.
8
process….audit committees can, and should, be the corporate participant best able to perform that
oversight function.” Audit committees perform other significant functions. Pincus et al., (1989),
for example, argue audit committees provide an important avenue for communication between
the external auditor and shareholders. Via regular meetings with the external auditor the audit
committee develops a greater understanding of the firm’s financial reporting process; thereby,
enhancing the quality of information provided to shareholders (Beasley and Salterio 2001; Pincus
et al. 1989). The audit committee can also act as the principal arbitrator during conflicts between
the external auditor and corporate management. Finally, audit committees play a crucial role in
the constraining earnings management. Klein (2002, p. 378), for example, comments a central
role of audit committees are “to reduce the magnitude of positive or negative abnormal accruals.”
Independence is considered a quintessential quality determining audit committee effectiveness.
Preoccupation with independence is strongly reflected in the discussions and recommendations of
various recent international corporate governance reports. Stock exchanges and regulatory
agencies internationally have adjusted regulations to emphasis a greater need for audit committee
independence. A natural conclusion of accepting the importance of independence to audit
committee effectiveness is increased independence reduces the magnitude of earnings
management (either positive or negative). Despite the significant of this assertion it is the focus of
scant empirical research. Seminal work by Klein (2002) based on a sample of 692 publicly traded
United States firm-years indicates the magnitude of abnormal accruals to “be more pronounced
for firms with audit committees comprised of less than a majority of independent directors”
(p.376). Klein (2002), however, also reports no significant difference in abnormal accruals of
firms with audit committees comprised solely of independent directors and those without.
Meanwhile, Chtourou et al., (2001) find a negative association between income increasing
earnings management and the proportion of independent directors on the audit committee. Again,
findings are based on United States data (300 firm-years).
9
In principle, I accept the assertion of a negative (positive) association between independent (nonindependent) audit committees and the magnitude of earnings management. However, I argue that
to fully understand the ramification of the aforementioned association one must extend the
analysis beyond the simply notion audit committee effectiveness is merely a function of higher
independent directors representation. I propose properties pertaining to independent directors may
intercede to enhance or impair the extent of an audit committee’s independence and its overall
effectiveness. In the following subsections I develop hypotheses to test the influences of three
audit committee properties on the magnitude of earnings management.
2.2
Presence of ‘Pro-AC Member’
Regulators, stock exchanges and other relevant institutional bodies internationally are adjusting
regulations placing more stringent requirements on firms to compose audit committees with
independent directors possessing specialized skills, and corporate governance and financial
knowledge. A by-product of new and/or additional rules stipulating specialized skills, and
corporate governance and financial knowledge is a reduction in the human-resource pool of
individuals qualified to sit on audit committees. Rapidly expanding capital markets in nations
such as Singapore place extra constrains on this human-resource pool. This is because incumbent
firms face greater competition to acquire (or retain) the servings of qualified independent
directors. A low natural population6 further perpetuates the pressure on firms. As the humanresource pool diminishes, qualified human-resource actors recognizing the constraints of firms
6
For instance, in Singapore and United States at the end of 2001there were approximately 400 and 15,000
publicly listed firms. Assuming 3 members per audit committees, the number of audit committee positions
in Singapore and United States is 1,200 and 45,000 respectively. For illustration assume 20 percent of a
nation’s overall population constitutes the human resource pool for audit committee members. Based on
this percentage the ratio of qualified individuals capable of serving on the audit committee to number of
audit committee positions is approximately 1,100:1 in the United States and 550:1 in Singapore.
10
may perceive it as greater opportunities to derive a higher proportion of their annual income from
simultaneously holding numerous boards of director and audit committee positions.7 I term
individuals devoting considerable time and effort to serving concurrently on a substantial8
number of boards of directors and audit committees as an independent director, such that these
commitments may constitute a sizeable proportion of their annual income, a ‘Pro-AC member’.
Prior empirical research does not address the impact of ‘Pro-AC member’ presence on audit
committee effectiveness and ultimately earnings management. I surmise arguments supporting
either a positive or negative association between the presence of a ‘Pro-AC member’ on the audit
committee and the magnitude of earnings management exist.
Consistent with a negative association, corporate governance advocates, regulators and scholars
argue an independent director’s effectiveness declines when serving on ‘too many’9 boards of
directors. This is because they cannot adequately discharge their fiduciary duties. Empirical
findings support this view. Core et al., (1999), for example, find a positive association between
CEO compensation and boards comprising individuals serving simultaneously on a number of
corporate boards. If, by definition, a ‘Pro-AC member’ sits on ‘too many’ boards and audit
committees their ability to effectively discharge their responsibilities is likely to be impaired.
Consequently, the capacity of an audit committee’s to constrain earnings management may
decline. Cultural dimensions and ownership structure may influence firms to focus (or assign
greater weightage) to reputation characteristics of individuals when seeking a person to serve as
an independent director on the board of directors and audit committee. For instance, in societies
7
Indeed, regulatory constraints, in conjunction with societal factors in societies (such as Singapore) with a
higher propensity for secrecy and high levels of family-owned firms, may increase the likelihood of some
individuals acting ‘full-time’ within the capacity of an independent director sitting on numerous boards of
directors and audit committees at the same time.
8
Based on NACD (1996) and Blue Ribbon Commission recommendations, a cut-off point for substantial
would be individuals holding three or more (six or more if retired) board and audit committee positions
simultaneously. For this study, however, I apply a minimum cut-off of five. See Section 3.3.
9
NACD (1996) and Blue Ribbon Commission (1999) recommendations suggest individuals sit on ‘too
many’ boards of directors if holding three or more (six or more if retired) positions simultaneously.
11
with a heightened propensity for secrecy, strong power distance relationships and/or greater
prevalence of family-owned firms, there is likely to be a greater desire to restrict information to
insiders. Thus, firms in such societies may place additional attention to identifying and appointing
individuals with a reputation for being ‘management-friendly’ as they are likely to be more
supportive of restricting information from outsiders. If having a reputation for being
‘management-friendly’ is a contributing factor for why an independent director (such as a ‘ProAC member’) serves simultaneously on a high number of boards of directors and audit
committee, this would infer the independence of these individuals (and boards of directors and
audit committees) is impaired. Finally, as a ‘Pro-AC member’ is likely to have greater experience
and knowledge of audit committee matters a firm may substitute their presence for other internal
control mechanisms. If ‘Pro-AC member’ presence merely complements other internal control
mechanism, any substitution stemming from the presence of such individuals on the audit
committee could weaken a firm’s overall internal control structure increasing the opportunities
for more expansive earning management.
I propose two lines of reasoning supporting a positive association. First, with substantial time and
effort devoted to discharging their fiduciary duties for a number of firms, opportunities for a ‘ProAC member’ derive income from alternative sources is reduced. With such a large personal
financial stake at risk, there is considerable incentive for a ‘Pro-AC member’ to ensure audit
committee independence is preserved and the committee performs its respective roles
satisfactorily (if not above expectations). This is because a ‘Pro-AC member’ would seek to
protect reputation capital, and maintain present and future directorships, and income streams.
Opportunities for earnings management, therefore, are likely to decline. Second, individuals –
such as a ‘Pro-AC member’ – with experience sitting on various boards of directors and audit
committee will naturally have more extensive intimate knowledge and understanding of corporate
governance matters, and audit committee roles and functions. Intuitively (and consistent with the
12
views of corporate governance reformists and proclamations of regulators and institutional
bodies), therefore, appointment of more experience individuals should increase the audit
committee’s overall monitoring effectiveness and ability to constrain earnings management.
As the association between ‘Pro-AC member’ presence and the magnitude of earnings
management cannot be determined a priori, I, propose the following null hypothesis:
Hypothesis 1: There is no significant difference in the magnitude of earnings management (as
measured by abnormal accruals) between firms with at least one ‘Pro-AC member’ present on the
audit committee and those without.
2.3
Level of ‘AC-External Auditor Familiarity’
The notion of familiarity is described in the prior literature as being encased within the length of
tenure between a firm and the external auditor. Length of tenure is viewed to have a positive
association with familiarity. Some corporate governance reformists and scholars argue greater
familiar resulting from longer firm-external audit links impairs auditor independence as the
chances of collusion and inadequate discharge of the external auditor’s responsibilities intensify.
It is recommended external auditors be regularly rotated. I advocate familiarity can also exist
between independent audit committee members10 and the external auditor. At a basic fundamental
level I suggest such familiarity arises when an audit firm is the same client of two different firms
with at one individual sitting simultaneously on each firm’s audit committee. I further surmise
familiarity intensifies if the partner-in-charge is also the same individual.
10
Relationships between executive directors and the external auditor are also likely to evolve. However,
these are likely to depend on different motivating factors. For instance, an executive director may be
concerned the external auditor recommends changes to a firm’s financial statements that affect bonuses.
Such financial and monetary concerns are less likely to concern independent directors. Overall, the impact
of familiarity on audit committee effectiveness is likely to be of greater when consider independent director
– external auditor relationships.
13
I propose familiarity between independent audit committee members and the external auditor
could have positive or negative implications on the audit committee’s effectiveness in
constraining earnings management. A positive influence may result because as familiarity
increases an independent audit committee member’s knowledge, understanding and appreciation
of the external auditor’s policies and practices accumulates. The independent audit committee
member is then better placed to recommend streamlining of audit committee’s procedures to
better assist the committee to focus on aspects of the financial reporting process not adequately
addressed in the external audit. By concentrating scrutiny to specific areas of risk, rather than
spreading finite resources too thinly, the audit committee will be better able to constrain earnings
management. Greater familiarity may also influence the audit committee’s role as an arbitrator
during conflicts between corporate management and the external auditor. Antle and Nalebuff
(1991) and Dye (1991) note audited financial statements are ultimately the result of negotiations
between corporate management and the incumbent auditor. Independent audit committee
members are supposedly, by definition, impartial. Nonetheless, human nature cannot be fully
discounted. Greater familiarity may heighten an independent audit committee member confidence
in the recommendations of external auditor. Thus, during conflicts an independent audit
committee member may be more inclined to support the external auditor rather than corporate
management. In giving greater support to the external auditor there is likely to be less scope for
corporate management to manage earnings.
I note above greater knowledge and understanding of the external auditor’s procedures and
practices stemming from familiarity may improve audit committee effectiveness However, the
opposite occur because additional knowledge may prompt complacency stemming from an over
confidence and appreciation of the external auditor’s abilities and coverage. Confident the
external auditor will adequate discharge their audit responsibilities, the independent audit
committee may substitute or forsake some of the own monitoring responsibilities so as to attend
14
to other firm (or even personal) matters. Under these circumstances, the risk earnings
management will remain undetected increases. Familiarity could also promote collusion. The
audit committee is in principle the body responsible for recommending which external audit firm
to appoint. An independent audit committee member of two firms with the same external auditor
may be hesitant to recommend an alternative auditor for Firm A if this prompts Firm B to
question the individual’s integrity and competence in recommending the original external auditor
be appointed to audit it (i.e., Firm B). A recommendation for a change of auditor could be
interpreted as a mark against the independent audit committee member’s reputation capital. To
avoid a fall in their reputation capital, the independent audit committee member of both firms
may implicitly collude with the external auditor to minimize the risk and reasons (such as
excessive conflict between corporate management and the external auditor) for change. By
colluding in this manner the director’s independence – and by association the audit committee –
is potentially impaired leading to greater opportunities for earnings management.
Given the opposing arguments I propose the following null hypothesis:
Hypothesis 2: There is no significant difference in the magnitude of earnings management (as
measured by abnormal accruals) between firms with greater ‘AC-External Auditor Familiarity’
and firms without ‘AC-External Auditor Familiarity’.
2.4
AC-Directorate Interlock Influences
The concept of directorate interlocks is more established in the literature. Part of a broader study
of managerial elites and corporate governance (Pettigrew, 1992; Roy, Fox and Hamilton, 1994),
directorate interlock concerns were first articulated in the United States as early as 1913 by
Brandeis. Scholarly interest and research is initially grounded in the work of Florence (1961) in
the United Kingdom and Dooley (1969) in the United States. Agency theory provides the
15
underlying theoretical underpinnings of one major stream of directorate interlock research.11
Agency theorists generally postulate possible major outcomes of directorate interlocks include the
promotion of upper-class collusion and a shift in the decision-making process of boards of
directors in favour of corporate management. In the specific context of audit committees, the
presence of an ‘interlocked’ independent director is likely to reduce the committee’s
independence. Consistent with prior literature (e.g.Core et al., 1999) I define an independent
director to be ‘interlocked’ if an executive director on the corporate board of Firm A (on which
the independent director sits) is also a member of the corporate board of Firm B (to which the
independent director is employed). Agency theorists argue that where ‘interlock’ arrangements
exist the independent director is less likely to support Firm A’s board decisions with negative
implications for the executive director’s self-interests. Reluctance arises because the executive
can influence board decisions of Firms B; thus, the interests of the independent director.
Empirical research, however, yield inconclusive findings. Core et al., (1999), for example, find
the association between directorate interlocks and CEO compensation to be positive though
statistically insignificant from zero. Findings are consistent with Hallock (1997).
Despite continued interest amongst corporate governance reformists, institutional bodies and
scholars,12 the association between ‘interlocked’ independent director presence on the audit
committee and earnings management is yet to be empirical tested. Following established agency
theory arguments I surmise ‘interlocked’ independent director presence on the audit committee
will compromise the committee’s independence. Therefore, opportunities for earnings
management are likely to increase. To test this proposition I form the following hypothesis:
11
Resource-dependence theory is the major theoretical basis of a second stream of research. Research
within this second stream focuses on the strategic value and benefit of directorate interlocks in promoting
organizational survival and success through the ability to control the flow of resources (e.g.Pfeffer and
Salancik, 1978; Mizruchi, 1982; DiMaggio and Powell, 1983). As I concentrate on contractual relationships
I confine my discussion to agency theory.
12
Blue Ribbon Committee (1999) guidelines, for example, urge firms to minimize directorate interlocks.
16
Hypothesis 3: There is a positive association between the magnitude of earnings management (as
measured by abnormal accruals) and the extent of ‘interlocked’ independent director presence on
the audit committee member.
3.
Data Description
3.1
Sample Selection
The initial sample comprises 875 firm-years representing all publicly traded entities listed on the
Singapore Stock Exchange (SGX) as of January 1, 2000 and 2001 and holding annual shareholder
meetings between April 1, 1999 and March 31, 2002.13 I eliminate 59 (2000) and 83 (2001) firmyears of new firm listings as there is insufficient details to calculate the proxy for earnings
management.14 Firm-years of delisted entities are also eliminated (13 (2000) and 25 (2001)).
Consistent with prior empirical research I remove firm-years of: (a) non-Singaporean domiciled
publicly traded entities (26 (2000) and 25 (2001)); and (b) financial industry sector entities15 (29
(2000) and 24 (2001)). I use the cross-sectional Jones (1991) regression model to calculate the
earnings management proxy. Model parameters are estimated by industry (as specified by the
SGX) classification. Consistent with prior literature (Klein 2002) I stipulate estimates be based on
a minimum of eight observations for each industry sector. Consequently, 81 firm-years (53
(2000) and 28 (2001) are excluded. Earnings management proxy calculation data is handcollected from 1999, 2000 and 2001 fiscal year annual reports. Where annual reports are
unavailable data is extracted from the Datastream Active and Research files. Data for 32 firms
(18 (2000) and 14 (2001)) could not be collected; therefore, corresponding firm-years are
13
At the start of January 1, 2000 (2001) there were 410 (465) publicly listed firms on the SGX.
Prior research suggesting a positive association between IPOs and earnings management provides
additional support for exclusion of these firm-years. Eliminating firm-years of IPOs in their initial year of
listing assists reduce the undue influence of this factor.
15
Difficulties measuring total accruals and abnormal accruals amongst financial industry sector entities
warrant such exclusion (e.g.Klein, 2002; Peasnell et al., 2000). Financial industry sectors include banks,
insurance companies, stock brokerages and financial advisor firms.
14
17
eliminated. Data for corporate governance proxy measures of the independent variables is
obtained from the Singapore Corporate Governance Intellectual Capital (CGIC) Database.
Despite its comprehensive coverage corporate governance data for 19 firm-years (15 (2000) and 4
(2001)) could not be satisfactorily determined. These firm-years are subsequently removed.
Finally, I exclude 13 outlier (>5 standard deviations from the dependent variable’s mean) firmyear (8 (2000) and 5 (2001). The final useable sample comprises 465 firm-year observations.
Table 1 Panel A summaries by year the construction of the final useable sample. An industry
breakdown is reported in Table 1 Panel B.
[Take in Table 1 About Here]
3.2
Proxy for Earnings Management
Consistent with some prior literature (DeFond and Park 1997; Klein 2002) I use both negative
and positive abnormal accruals as both can be used to conceal poor performance or save present
earnings for future use. Prior to estimating abnormal accruals I calculate total accruals (hereafter
TAC) for firm k in year t as the change in non-cash current assets less the change in operating
current liabilities less depreciation and amortization expenses. TAC is formally defined as:
TACjt = (∆CAjt - ∆Cashjt) – (∆CLjt - ∆LTDjt - ∆ITPjt) - DPAjt
(1)
Where:
TACjt = total accruals for firm k in time period t;
∆CAjt = change current assets for firm k from time period t-1 to t;
∆Cashjt = change cash balance for firm k from time period t-1 to t;
∆CLjt = change current liabilities for firm k from time period t-1 to t;
∆LTDjt = change long-term debt included in current liabilities for firm k from time period t-1 to t;
∆ITPjt = change income tax payable for firm k from time period t-1 to t; and
∆DPAjt = depreciation and amortization expense for firm k from time period t-1 to t.
18
I then decompose TAC into normal accruals (hereafter NAC) and abnormal accruals (hereafter
ACC) using the cross-sectional Jones (1991)16 model defined formally as:
TAC jk,t / TAjk,t-1 = α j,t [1/ TAjk,t-1] +βj,t [∆REVjk,t / TAjk,t-1] + γj,t [PPEjk,t / TAjk,t-1] + εjk,t
(2)
Where:
TAC jk,t = total accruals for firm k in industry j in year t;
TAjk,t-1 = are total assets for firm k in industry j at the end of year t-1;
∆REVjk,t = change net sales for firm k in industry j between years t-1 and t;
PPEjk,t = gross property, plant and equipment for firm k in industry j in the year t;
αj, βj, γj = industry specific estimated coefficients; and εj = error term.
NAC is defined as the fitted values from Equation (2) whilst ACC is the residual (i.e., the
difference between TAC and NAC). ACC is defined formally in Equation (3):
ACCij,t = TAC jk,t / TAjk,t-1 - {α j,t [1/ TAjk,t-1]+βj,t [∆REVjk,t / TAjk,t-1] + γj,t [PPEjk,t / TAjk,t-1]} (3)
Where:
αj,t βj,t γj,t are the fitted coefficients from Equation 2.
Overall, I calculate 30 industry-year combinations from the final useable sample. The maximum
number of observations for a given industry-year combination is 29 (commerce – wholesale in
2001). The mean (median) estimation portfolio size is 16 (14) observations.
Several reasons support using the cross-sectional Jones (1991) model. First, it is used regularly in
prior earning management research (Becker et al. 1998; DeFond and Jiambalvo 1994; DeFond
and Subramanyam 1998; DuCharme et al. 2000; Guidry et al. 1999; Klein 2002; Teoh et al.
1998a; Teoh et al. 1998b). Second, prior research concludes this model performs best in detecting
abnormal accruals. Bartov et al., (2000), for example, conclude it is the “only model consistently
able to detect earnings management for a sample of firms receiving audit qualifications”. Third,
Dechow et al., (1995) propose a ‘modified’ cross-sectional Jones (1991) model. Previous studies,
however, show the original and ‘modified’ cross-sectional Jones (1991) models yield almost identical
results (eg. Kothari et al., 2001; Klein, 2002). For completeness I calculate abnormal accrual estimates
using the ‘modified’ cross-sectional Jones (1991) model (see Section 6.1 – Sensitivity Analysis). I find
statistically insignificant differences. As the paper’s major objective is not test different models the main
results are reported using the original cross-sectional Jones (1991) model.
16
19
relative to the time-series Jones (1991) model, the cross-sectional variant overcomes (a) the
survivorship bias present in the times-series model and (b) eliminates the assumption parameter
estimates remain stable over time (Bartov et al. 2000; Jones 1991).17 Finally, the capital market in
Singapore is relatively small relative to the United States and the United Kingdom. It important,
therefore, to use a method that for statistical purposes maximizes sample size.
3.3
Independent Variables18
Presently, no formal definition of a ‘Pro-AC member’ exists. In developing an operational
definition I follow recent NACD (1996) and Blue Ribbon Commission (1999) guidelines as
utilized by Core et al., (1999) for direction. However, I apply a narrow definition than outlined in
the aforementioned guidelines for distinguishing someone sitting on a high number of boards of
directors. Specifically, I define a ‘Pro-AC member’ as an individual: (a) serving simultaneously
on 5 or more boards of directors as an independent director; and (b) an audit committee member
on at least 80% of those corporate boards. I feel this narrow definition is a more systematic and
concerted, better capturing individuals with a sizeable investment to being an independent
director on various corporate boards and audit committee. Also, this definition sifts out
individuals serving on multiple boards but have little or limited role in audit committee
responsibilities. The CGIC Database for ‘Pro-AC members’ in 2000 and 2001 based on the
aforementioned definition. Firm-years having corresponding audit committee upon which at least
one ‘Pro-AC member’ preside are coded one, all others zero. The dichotomous proxy is
designated ProfAC.
17
A disadvantage of the cross-sectional Jones (1991) model is it ignores to some degree the reversal of
abnormal accruals from previous periods; thus, power of empirical tests to detect earnings management
may be reduced (Peasnell et al., 2000).
18
Empirical findings for the independent variables are based on contemporaneous data. Several reasons
justify use of contemporaneous data: (1) no formal theoretical justification supporting use of
contemporaneous data versus lagged; (2) prior related research generally relies on contemporaneous data
(Klein 2002; Peasnell et al. 2000); and (3) a data review suggests audit committee and board of director
composition and structure of Singapore publicly listed firms remained stable for during the analysis period.
For completeness, however, I also perform sensitivity tests using lagged data (see Section 6.4).
20
I create a two-fold criterion for scoring ‘AC-External Auditor Familiarity’. First, I assign a value
of 1.0 for each of the following conditions met:
1. at least one independent directors on the audit committee sits simultaneously on the audit
committee of another firm as an independent director with the incumbent external auditor
for both firms being identical; and
2. Condition (1) is met and partner-in-charge of both audits same individual.
A firm-year where all conditions are satisfied receives a score of 2.0 (1.0 + 1.0), whilst those
meeting one receive a score of 1.0. Firm-years where none of the conditions are met receive a
score of 0.0. I denote this proxy measure ACAP Score.
Applying the aforementioned definition of an ‘interlocked’ independent director, I screened the
CGIC Database for all individuals meeting this criteria that serve on audit committee. I then sum
the total number of ‘interlocked’ audit committee members for each firm-year. Following Core et
al., (1999) totals are scaled by the total number of audit committee members. The resulting proxy
measure, represented as a percentage, is denoted ‘AC-Locks’.
3.4
Control Factors
Prior empirical research indicates earnings management and audit committee attributes may be
related to other confounding factors. Bartov et al., (2000) argue failure to control for confounding
factors could result in the false rejection of the null hypothesis that earnings management is
absent when the opposite is true. With regard to earnings management, prior research suggests a
negative association to political costs (Han and Wang 1998), executive directors’ ownership level
(Warfield et al. 1995), ownership structure (Rajgopal et al. 1999), auditor quality (Becker et al.
1998) and operating cash flow performance (Dechow et al. 1995). Also, previous findings suggest
21
a positive association to financial leverage (DeFond and Jiambalvo 1994) and the absolute change
in earnings from year t-1 to t (Bartov et al. 2000). In relation to audit committee features, Beasley
and Salterio (2001) and Klein (2002) report board size and the percentage of independent
directors are significantly positively influence audit committee composition. Firm size, duality,
market-to-book ratios and prior negative earnings are also found to have confounding effects on
audit committee properties. I include control factor proxy measures for the aforementioned
determinants of either earnings management or audit committee properties. Proxy measure
definitions and predicted directional relationships are summarized in Table 2.
[Take in Table 2 About Here]
4.
Results
4.1
Descriptive Statistics
The mean (median) R-squared statistic for the 30 industry-year combinations calculated using the
cross-sectional Jones (1991) model is 35.74% (18.95%). Table 3 Panel A reports descriptive
statistics for TAC, ACC and absolute ACC (hereafter Abs(ACC)) with sample means (medians)
being -0.0697 (-0.0708), -0.0012 (0.0011) and 0.0657 (0.0524) respectively. Statistical tests to
determine if the mean ACC is significantly different from zero yields a t-statistic of 0.628 (pvalue = 0.714). Across the final useable sample, 30.23% of TAC and 55.53% of ACC values are
positive. A sign test yields a p – value of 0.651 implying no systematic upward or downwards
earnings management activity. Consequently, consistent with prior research (Bartov et al. 2000;
Becker et al. 1998; Klein 2002; Warfield et al. 1995) I use Abs(ACC) as the proxy for combined
influences of income-decreasing and income-increasing earnings management.
22
Table 3 Panel B reports general descriptive data for key board of director and audit committee
composition features. Mean (median) board of director and audit committee membership is 7.10
(7.00) and 3.20 (3.00) respectively. Independent directors constitute on average 38.97% of board
of directors membership. This is lower than in Western economies such as the United States,
Canada and United Kingdom (Klein, 2002; Beasley and Salterio, 2002; Peasnell et al., 2000) but
comparable to Asian nations. Higher ownership concentration and family-owned firms in
Singapore may account, in part, for this finding. No board of directors is comprised solely of
independent directors. Furthermore, only 14.16% of the boards of directors have independent
directors in the majority.19 For audit committees, independent directors constitute on average
72.94% of the membership. All audit committees comprise a majority of independent directors;
however, only 18.24% comprise solely independent directors. Descriptive statistics of audit
committee composition is generally consistent with prior studies using data from Singapore or
Western nations20 (Beasley and Salterio 2001; Klein 2002).
[Take in Table 3 About Here]
Descriptive statistics of independent variables are shown in Table 3 Panel C. Findings show
34.30% of the final useable sample have at least one ‘Pro-AC member’ on the audit committee.
Mean (median) number of audit committee positions held by each ‘Pro-AC member’ individuals
is 5.43 (5.00). Comparatively, mean (median) number of audit committee positions held by all
individuals acting solely as an independent director and on at least one audit committee is 1.68
(1.39). The mean (median) ACAP Score for the final useable sample is 0.58 (0.00); 10.32%
receiving the maximum score of 2.0 and 37.63% scoring 1.0. The sample mean (median) of
19
Percentage of independent directors exceeded the percentage of executive directors on the boards of
directors of only 34.95% of the final useable sample.
20
Long standing legal requirements for Singapore publicly traded firms to have a majority of members
being independent of corporate management is likely to account for these similarities.
23
‘interlocked’ independent audit committee members is 4.57 (6.10). At least one ‘interlocked’
independent director is present on audit committees of 11.47% of the final useable sample.
Table 3 Panel D reports basic descriptive statistics for the control factors. Consistent with
Singapore’s social and cultural background, both executive directors’ ownership and overall
ownership concentration are generally higher than in Western economies. Mean cash flow from
operations (0.061) is slightly lower than in the United Kingdom (Peasnell et al. 2000) and United
States (Klein 2002). Sluggish economic conditions following the Asian economic crisis may, in
part, account for 17.49% of the sample firms reporting two or more years of consecutive net
losses. The mean (median) market-to-book ratio is $1.42 ($0.90). Big-Five audit firms are the
external auditor of 89.46% of the final useable sample firms. Finally, 76.35% (23.65%) of the
final useable sample firms are listed on the main board (SESDAQ) of the SGX.
4.2
Correlations
Table 4 presents Pearson pairwise correlations between the dependent variable, independent
variables and control factors.21 ProfAC and ACAP Score are positively and negatively correlated
with Abs(ACC) respectively. The correlation between AC-Locks and Abs(ACC), however, is not
significantly different from zero. Table 4 results also indicate Abs(ACC) is positively correlated
with, BoD Size (p<0.05) and Negative NI (p<0.01), and negatively correlated with Leverage
(p<0.05), Firm Size (p<0.01), Auditor (p<0.01), Ownership Concentration (p<0.01) and CFO
(p<0.01). Correlations between Abs(ACC) and (1) BoD Ind, (2) Duality, (3) ExeDirOwn, (4)
MV/BV and (5) ABS ∆NI are not significantly different from zero. There are also some significant
correlations between independent variables and control factors with values not exceeding 0.500.
Farrar and Glauber (1967) argue bivariate correlation values above 0.8 indicate harmful levels of
21
Spearman pairwise correlations are also conducted producing similar results.
24
mulitcollinearity (also see Hair et al., 1995). As a further test of multicollinearity variance
inflation factor (VIF) values are calculated (not tabulated for brevity). VIF values do not exceed
2.00, substantially below the critical value of 10.00 (Netter et al. 1989). Overall, multicollinearity
is deemed not to be a serious concern unduly affecting multiple regression analysis results.
[Take in Table 4 About Here]
4.3
Multiple Regression Results
I use multiple regression analysis to test Hypotheses 1, 2 and 3. Table 5 Panels A, B, C and D
report results of four models (denoted Model I, Model II, Model III and Model IV) based on
Equation 4. In Model I, Model II and Model III a single independent variable (ACProf, ACAP
Score and AC-Locks respectively) and all control factors are included. For Model IV, all
independent variables and control factors are included simultaneously. This strategy highlights
each independent variable’s influence in both isolation and combination. Equation 4 is defined as:
Abs(ACC)i = ai + i1ACProfi + i2 ACAP Score i + i3AC-Locksi + i4BoD Sizei - i5BoD Indi +
i6Dualityi + i7% Exe Dir Owni + i8MV/BVi + i9ABS∆NIi + i10Negative NIi + i11Leveragei i12Sizei - i13Auditori + i14Owner Coni + i15CFOi + εi (4)
Where:
i = firm-year 1 through 465;  = coefficient for variables 1 through 15; ε = model residual; and
See Table 2 for formal definitions of the dependent variable, independent variables and control factors.
Model I, Model II, Model III and Model IV are all statistically significant. Model IV explains the
most variation in Abs(ACC) (21.9%) and Model III the least (20.3%). Coefficients on ACProf are
significantly positively associated with Abs(ACC) in Model I (p<0.05) and Model IV (p<0.05). In
comparison, coefficients on ACAP Score are significantly negatively associated with Abs(ACC) in
Model II (p<0.01) and Model IV (p<0.05). For AC-Locks, coefficients are positive but not
statistically significant in both Model III and Model IV. In summary, empirical findings presented
25
in Table 5 support rejection of Hypothesis 1, 2 and 3. Specifically, findings infer ‘Pro-AC
member’ presence increases the likelihood of higher earnings management (both negative and
positive). Conversely, earnings management is less likely in firms with greater familiarity
between independent audit committee members and the external auditor. Finally, the magnitude
of earnings management is not significantly higher amongst firms with ‘interlocked’ independent
directors serving on the audit committee relative to counterparts without.
[Take in Table 5 About Here]
Empirical findings also show Abs(ACC) is significantly negatively associated with Size (p<0.01),
Auditor (p<0.01) and CFO (p<0.01) , and significantly positively associated with Negative NI
(p<0.01) for Model I, Model II, Model III and Model IV respectively. MV/BV (p<0.05) is
significantly positively associated with Abs(ACC) though only in Model II and Model IV. Owner
Con (p<0.05) is also significantly positively associated with Abs(ACC) though only in Model III .
Finally, there is no statistically significant association between Abs(ACC) and (1) Board Size; (2)
BoD Ind; (3) Duality; (4) % Exe Dir Own; (5) ABS∆NI; and (6) Leverage across all models.
5.
Sensitivity Tests
5.1
Alternative Proxies for Earnings Management
Inferences drawn in this paper are dependent on the use of abnormal residuals from the crosssectional Jones (1991) model being interpreted as a valid proxy for earnings management. I
perform additional tests to determine the robustness of these inferences. First, I re-estimate
abnormal accruals using the “modified” Jones (1991) model (change in revenue is adjusted for
changes in receivable) proposed by Dechow et al., (1995) and defined by Equation 5:
26
Abs(ACC) jk,t = TAC jk,t / TAjk,t-1 –
{α j,t [1/ TAjk,t-1] +βj,t [(∆REVjk,t - ∆RECjk,t)/ TAjk,t-1] + γj,t [PPEjk,t / TAjk,t-1] + εjk,t } (5)
Where:
∆RECjk,t = change in receivables for firm k in industry j between years t-1 and t.
Multiple regression analysis is then repeated. Table 6 Panel A reports an abbreviated summary of
findings (results for independent variable only). In general, Table 6 Panel A findings closely
mirror Table 5 results. It is noted, however, the association between Abs(ACC) and ACProf is
slightly weaker though still at p<0.05. Lack of significant discrepancies using either Jones (1991)
models is consistent with prior research (Klein 2002; Kothari et al. 2001).
[Take in Table 6 About Here]
The majority of earnings management research generally uses proxy measures for total accruals.
Peasnell et al., (2000, p.421), however, argue the working capital element of total accruals22 “is
potentially more appealing.” Following the methodology of Peasnell et al., (2000), I estimate
Abs(ACC) using two working capital proxies based on Equations 6 and 7:23
Abs(ACC) jk,t = WCAC jk,t / TAjk,t-1 –
{α j,t [1/ TAjk,t-1] +βj,t [(∆REVjk,t )/ TAjk,t-1] + γj,t [PPEjk,t / TAjk,t-1] + εjk,t }
(6)
Abs(ACC) jk,t = WCAC jk,t / TAjk,t-1 –
{α j,t [1/ TAjk,t-1] +βj,t [(∆REVjk,t - ∆RECjk,t)/ TAjk,t-1] + γj,t [PPEjk,t / TAjk,t-1] + εjk,t } (7)
Where:
WCAC jk,t = working capital accruals (∆ non-cash current assets minus ∆ current liabilities) for
firm k in industry j in year t.
22
Peasnell et al., (2000) define total accruals as working capital accruals plus depreciation; hence, working
capital accruals is total accruals less depreciation. Some researchers (such as McNichols and Wilson, 1988;
Young, 1999; Beneish, 1998) argue working capital accruals focus on more judgmental items whilst
depreciation is a poor indicator of earnings management due to is visibility and rigidity.
23
Equation 6 uses the cross-sectional Jones (1991) model and Equation 7 the “modified” Jones (1991)
model. Peasnell et al., (2000) use only the “modified” Jones (1991) model. I estimate Abs(ACC) for
working capital accruals using both models for analytical completeness.
27
Table 6 Panel B and C report an abbreviated summary of findings (results for independent
variable only) of multiple regression tests performed with Abs(ACC) estimated based on
Equations 6 and 7. Again, results are similar to Table 5. Directional signs on coefficients of
independent variables and control factors are all consistent. A noted difference, however, is the
coefficient on ACProf is significant at p<0.10 rather than p<0.05. Also, explanatory power of
regressions reported in Table 6 Panels B and C are lower than those of Table 5. Overall, findings
based on working accruals support the robustness of Table 5 findings.
5.2
Increasing-Earnings and Decreasing-Earnings Incentives
As noted above, I use Abs(ACC) as the proxy for the combined influences of income-decreasing
and income-increasing earnings management as tests show no systematic upward or downwards
earnings management activity across the sample. Nonetheless, it could be argued incomeincreasing and income-decreasing behavior is induced by different conditions and incentives that
could have different effects on factors influencing an audit committee’s effectiveness in
constraining management. Consequently, for analytical completeness, I partition the final useable
sample to perform sensitivity tests to address specific concerns related to income-increasing and
income-decreasing incentives. For partitioning I rely on the work of Kim et al., (2003). They
(Kim et al., 2003, p. 331-332) assume “managers have income-increasing (income-decreasing)
incentives if the current period’s performance relative to the benchmark performance (hereafter
current relative performance) is poor (good).” Current relative performance is defined by Kim et
al., (2003, p.332) as the difference in CFO in year-t (scaled by lagged total assets) to the median
CFO performance of samples with year-t for industry k to which a firm belongs. If a firm’s
current period CFO is better (worse) than the median for industry k a firm’s current relative
performance is classified as good (poor). I denote the two groups formed following EI/CFOg
28
(current relative performance good) and EI/CFOp (current relative performance poor). Again,
industry is based on SGX classifications.
[Take in Table 7 About Here]
If ‘AC-Pro member’ presence, heightened ‘AC-External Auditor Familiarity’ and greater ‘ACDirectorate Interlock’ levels increase audit committee effectiveness in constraining earnings
management, coefficients on ACProf, ACAP Score and AC-Locks should be positive (negative)
for the EI/CFOg (EI/CFOp) sample. Table 7 Panels A and B findings show coefficients on
ACProf are positive (negative) and statistically significant at conventional levels for regressions
using the EI/CFOg (EI/CFOp) sample. The findings imply that, relative to firms without the
presence of at least one ‘Pro-AC member’, firms with at least one ‘Pro-AC member’ are less
effective in constraining income-increasing (income-decreasing) accrual choices when corporate
management face income-increasing (income-decreasing) incentives. Coefficients on ACAP
Score, meanwhile, are negatively (positively) statistically significant at conventional levels for
regressions using the EI/CFOg (EI/CFOp) sample. Findings show heightened ‘AC-External
Auditor Familiarity’ increases audit committee effectiveness in constraining income-increasing
(income-decreasing) accrual choices when corporate management faces income-increasing
(income-decreasing) incentives. Finally, coefficients on AC-Locks are positive (positive) in
regressions using the EI/CFOg (EI/CFOp) sample. Coefficients, however, are not statistically
significant at conventional levels. Thus, presence of an ‘interlocked’ independent director does
not influence an audit committee’s ability to constrain earnings management regardless of
income-increasing or income-decreasing incentives. In conclusion, Table 7 findings provide
further supplementary empirical evidence to support inferences drawn from Table 5 results.
5.3
Alternative Proxies for Independent Variables
29
To further test robustness I construct alternative proxy measures for each independent variable. In
the case of ACProf I adjust the cut-off criteria to create two alternative proxies termed HACProf
and EHACProf. For HACProf the cut-off for the minimum number of boards of directors an
individual must sit on simultaneously is raised to seven and for EHACProf to nine.24 Again
dichotomous scaling is used to score firm-years. Regression tests based on Model I and Model IV
are then repeated for each alternative proxy. Coefficients (not tabulated for brevity) on HACProf
and EHACProf are all significantly positively associated (p<0.05) with Abs(ACC). Explanatory
power of additional regressions is marginally stronger than Table 5 findings. Overall, findings
using the alternative proxy measures HACProf and EHACProf provide additional support of a
positive association between ‘Pro-AC member’ presence and earnings management.
For ‘AC-External Auditor Familiarity’ I create three alternative proxies denoted as ACA Score,
#ACAP Links and #ACA Links. To create ACA Score I score firms based only on whether the first
condition25 specified in the scoring criteria for ACAP Score is met. This scoring approach results
in a dichotomous scale with firm-years coded one if the prescribed condition is met, otherwise
zero. To score #ACAP Links I sum the total number of links (link is defined in accordance the
definition for ‘AC-External Auditor Familiarity’) for each firm. The sum total is scaled by the
total number of independent directors on the audit committee. For #ACA Links scoring follows
the same procedure as for #ACAP Links though the definition of a link is consistent with that
employed to score ACA Score. Findings of multiple regression tests (not tabulated for brevity)
based on Model II and Model IV using the three alternative proxies is generally comparable to
Table 5 results. Two differences of any relative note are: (a) coefficients on ACAP Score are
24
Conditions that (i) the individual serves solely as an independent director and (ii) serves on at least eighty
percent of the audit committee of the corporate boards to which individual is a member still applied.
25
That is, at least one independent director on audit committee sits simultaneously on the audit committee
of another firm as an independent director and incumbent external auditor for both firms being identical.
30
significant at p<0.10 rather than p<0. 05; and (b) coefficients on ACAP Links are significant at the
p<0.01 rather than p<0.05.
Finally, I create a single alternative proxy measure for AC-Locks. Specifically, I use a
dichotomous score whereby I code all firms having at least one ‘interlocked’ independent director
on the audit committee one, otherwise zero. This alternative proxy is termed Dich: AC-Locks.
Regression analysis based on Model III and Model IV is then performed. Results (not tabulated
for brevity) are consistent with Table 5 findings though the explanatory power of regressions
using Dich: AC-Locks is slightly lower.
5.4
Other Sensitivity Tests
As noted earlier, corporate governance data is based on contemporaneous information. As a
further test of robustness I repeat the multiple regression analysis using lagged corporate
governance data. I exclude 21 firm-years from the additional tests as lagged data could not be
satisfactorily determined.26 Multiple regression tests with lagged corporate governance data yield
similar results to Table 5. A notable difference is coefficients on ACProf are significant at the
p<0.10 rather than p<0.05. Findings imply a lack of annual anomalies influencing results.
6.
Summary Remarks and Conclusions
The general undertone of this study is properties of independent audit committee members may
enhance or impair audit committee independence such that the committee’s ability to constrain
26
Elimination of 21 firm-years does not significantly alter descriptive statistics of the dependent variable
and control factors as reported in Table 3. The percentage of firms with at least one ‘Pro-AC member’
declined slightly (33.11%) whilst the mean ACAP Score is lower at 0.54. Meanwhile, mean (median)
‘interlocked’ independent audit committee membership is 4.86 (6.34). At least one ‘interlocked’
independent director serves on 13.11% of the audit committees.
31
earnings management is affected. In this study, I focus on three properties: (a) presence of a ‘ProAC member’; (b) level of ‘AC-External Auditor Familiarity’; and (c) presence of an ‘interlocked’
independent audit committee. Empirical analysis is based on a final useable sample of 465
Singapore publicly traded firm-year observations. I document evidence implying audit
committees with a ‘Pro-AC member’ are less effective in constraining opportunistic earnings
management. Conversely, audit committees having a higher level of familiarity between
independent audit committee members and the external auditor were more effective in
constraining corporate management from over-stating (under-stating) earnings through incomeincreasing (income-decreasing) accrual choices. Finally, contrary to recent promulgations by
some corporate governance advocates and institutional bodies, the presence of an ‘interlocked’
independent director did not appear to influence an audit committee’s effectiveness in
constraining earnings management. Results are robust to a string of sensitivity tests including
alternative proxies for earnings management, independent variable and control factors.
Findings have implications for numerous parties including auditors, institutional investors,
regulators, present and future board members and corporate governance reformists. For example,
findings imply a potential regulatory trade-off in balancing the need for experience on the audit
committee against individuals holding numerous audit committee positions simultaneously.
Regulators, corporate governance reformists and scholars alike argue audit committee
effectiveness is likely to be enhanced if members have more extensive corporate governance and
financial accounting knowledge and expertise. Imposition of legislation requiring firm engage the
services of individuals with such qualities will naturally reduce the available human resource
pool. Given this constraint there will be increasing opportunities for qualified individuals to serve
simultaneously, virtually within a full-time capacity, on a number of boards of directors and audit
committees. I show, however, audit committees comprising at least one individual serving
simultaneously on a high number of boards of directors and audit committees were less effective
32
in constraining earnings management. In light of these findings, regulations stipulating audit
committees be comprised of individuals with specific skills may need to be tempered or have
greater voluntary flexibility. This implication is of particular concern to regulators in nations like
Singapore with a small natural population and a large number of publicly listed firms. Also,
results have empirical implications for scholars. Specifically, findings suggest researchers
examining the influence of audit committee independence may need to control for properties of
individual independent audit committee members (such as level of familiarity with the firm’s
external auditor) that can enhance or impair independence.
Despite some caveats, this study makes several unique contributions. I provide the first largescale empirical analysis of the association between earnings management and three audit
committee properties that may enhance/impair the committee’s independence. This advances
prior understanding of audit committee – earnings management links beyond the examination of
audit committee composition with a standard fixation on the representational dichotomy between
insiders and outsiders. Also, the study helps to enrich the scope of future possible analysis of the
impact of audit committees on financial reporting processes. Further, unlike the majority of prior
earnings management – corporate governance research I analyze data from Singapore a key
capital market within Asia. Analysis of Singapore data enriches the international understanding of
corporate governance – earnings management links. Specifically, findings assist to determine if
recommendations to improve audit committee effectiveness that can assist in better constraining
earnings management can be universally applied. In addition, analysis of Singapore data allows
the opportunity to investigate in greater depth factors not as readily measurable using data from
Western economies. For instance, relative to available information in the United States and
Canada Singapore data I am able to include details related to the audit partner-in-charge. This
assists in the development of a more comprehensive proxy measure.
33
Table 1: Sample used in analysis and industry breakdown
Panel A: Sample formation
Description:
# Firms listed on SGX at start of year t
# Firms listing on SGX during year t-1
# Firms delisting from SGX during year t
# Foreign firms listed on SGX during year t
# Finance sector firms list on SGX during year t
# Firms with insufficient data to construct abnormal accruals in year t
# Firms from industry sectors without 8 observations in year t
# Firms with insufficient corporate governance data in year t
Outliers for absolute value of abnormal accruals
Final sample used
Panel B: Industry breakdown of final sample
Industry type
Commerce – Retail
Commerce – Wholesale
Construction
Finance - Banks
Finance – Finance Companies
Finance - Insurance
Hotels and Restaurants
Information Technology – Services
Manufacturing – Chemical Products
Manufacturing – Electrical
Manufacturing – Electrical Products
Manufacturing – Food and Beverage
Manufacturing – Machinery and Equipment
Manufacturing – Metal Products
Manufacturing – Other Manufacturing
Manufacturing – Petroleum Products
Manufacturing – Printing and Publishing
Manufacturing – Rubber and Plastic
Manufacturing – Transport Equipment
Multi-Industry
Other - Healthcare
Postage and Telecommunications
Properties
General Services
Storage
Transport
Total:
Firm-years
2000
2001
410
465
59
83
13
25
26
25
29
24
18
14
53
20
15
3
8
5
199
266
2000
12
26
24
Excluded
Excluded
Excluded
14
Insuff. #
Insuff. #
Insuff. #
21
10
9
12
13
Insuff. #
10
Insuff. #
Insuff. #
18
Insuff. #
Insuff. #
19
Insuff. #
Insuff. #
11
199
2001
13
26
29
Excluded
Excluded
Excluded
16
10
Insuff. #
8
25
12
11
15
15
Insuff. #
12
9
Insuff. #
20
Insuff. #
Insuff. #
21
10
Insuff. #
14
266
34
Table 2: Variable descriptions, designation and predicted direction
Variable Description
Dependent Variable
Absolute value of abnormal accruals where abnormal accruals is
measured as the difference between total accruals and expected accruals
calculated from the cross-sectional Jones model.
Independent Variable
Indicator variable with firms having a professional independent audit
committee member serving on the audit committee being scored a value
of one (1); otherwise firms are scored a value of zero (0).
Total number of interlocks between independent directors on firmi’s
audit committee and firmi’s external auditor. An interlock is formed
when an independent director sits on the audit committee of another
firm that is also client of the same external auditor firm for firmi.
Number of ‘interlocked’ independent directors (defined as occurring
when an executive director is a member of the board of directors of
which the independent director is employed) serving on the audit
committee as percentage of total audit committee membership.
Control Factors
Number of individuals serving on the board of directors
Percentage of the board of directors comprised of independent directors
Indicator variable with firms having same individual occupying the roles
of Chairperson and CEO jointly being scored a value of one (1);
otherwise firms are scored a value of zero (0).
Percentage of outstanding common shares owned by executive directors
on the board of directors.
Ratio of total market of the firm at the beginning of the year to total
book value of assets at the beginning of the year.
Absolute value of the change in a firm’s net income from year t-1 to
year t.
Indicator variable with firms having two or more consecutive years of
negative income (ending on the fiscal year prior to the shareholders’
meeting) being scored a value of one (1); otherwise firms are scored a
value of zero (0).
Ratio of a firm’s long-term debt at end of year t to total assets at the end
of year t-1.
Natural log of the book value of total assets.
Indicator variable with firms audited by a Big-Five audit firm being
scored a value of one (1); otherwise firms are scored a value of zero (0).
Percentage of outstanding common shares owned by top 20 shareholders
of the firm.
Change in operating cash flows for a firm between year t-1 and year t.
Variable
Designation
Predicted
Direction
ABS(AA)
Not Applicable
Indeterminable
ProfAC
Indeterminable
ACAP Score
Positive
AC-Locks
BoD Size
BoD Ind
Indeterminable
Negative
Positive
Duality
% Exe Dir Own
MV/BV
ABS∆NI
Indeterminable
Positive
Positive
Indeterminable
Negative NI
Leverage
Firm Size
Auditor
Owner Con
CFO
Positive
Negative
Negative
Indeterminable
Negative
35
Table 3: Descriptive statistics
Panel A: Dependent variable and related components
Variable
Mean
Std. Dev
Median
TAC
-0.0697
0.1426
-0.0708
ACC
-0.0012
0.1106
0.0011
Abs(ACC)
0.0657
0.0526
0.0524
Panel B: Basic board of director (BoD) and audit committee (AC) data
Features:
Mean/Ptgeμ
Std. Dev
Board Size
7.10
1.77
# (%) Executive Directors on BoD
2.78 (40.13)
1.47 (18.59)
# (%) Non-Executive Directors on BoD
1.60 (20.90)
1.58 (18.78)
# (%) Independent Directors on BoD
2.71 (38.97)
1.14 (13.35)
Percentage of firms having BoD with:
100% Independent Directors
0.00
N/A
Majority Independent Directors
14.16
N/A
Duality - % of sample with
29.25
N/A
Audit Committee Size
3.20
0.60
# (%) Executive Directors on AC
0.68 (21.10)
0.52 (16.48)
# (%) Non-Executive Directors on AC
0.20 (6.14)
0.45 (13.23)
# (%) Independent Directors on AC
2.32 (72.94)
0.58 (14.02)
Percentage of firms having AC with:
100% Independent Directors
18.24
N/A
Majority Independent Directors
100.00
N/A
Chairperson of BoD a Member
19.87
N/A
CEO a Member
5.83
N/A
Managing Director a Member
13.82
N/A
Panel C: Independent variables and related components
Variable
Mean/Ptgeμ
Std. Dev
ProfAC - % sample with
34.30
N/A
ProfAC – Positions Heldλ
5.43
1.90
Independent Dir. On AC – Positionsν
1.68
1.39
ACAP Score
0.58
0.67
Percentage Firms Scoring 2
10.32
N/A
Percentage Firms Scoring 1
37.63
N/A
Percentage Firms Scoring 0
52.04
N/A
AC-Locks
4.57
10.91
Panel D: Control factors (BoD Size and BoD Ind values reported above)
Variable
Mean/Ptgeμ
Std. Dev
MV/BV
1.419
2.938
% Exe Dir Own
16.068
22.057
ABS∆NI (S$‘000)
15600.0
70108.0
Negative NI (%)
17.49
N/A
Leverage
0.098
0.128
Firm Size
18.819
1.322
Total Assets (SGD$‘000)
603,016.81
2,847,377.37
Auditor (%)
89.46
N/A
Owner Con
77.08
14.19
CFO
0.061
0.205
Minimum
-0.5785
-1.5648
0.0000
Maximum
0.4241
1.6808
1.2745
% Positive
30.23
55.53
100.00
Median
7.00
3.00 (40.00)
1.00 (16.67)
2.00 (37.50)
Minimum
4.00
0.00 (0.00)
0.00 (0.00)
1.00 (11.11)
Maximum
13.00
8.00 (80.00)
7.00 (75.00)
9.00 (83.33)
N/A
N/A
N/A
3.00
1.00 (33.33)
0.00 (0.00)
2.00 (66.67)
N/A
N/A
N/A
2.00
0.00 (0.00)
0.00 (0.00)
2.00 (60.00)
N/A
N/A
N/A
7.00
2.00 (40.00)
3.00 (40.00)
4.00 (100.0)
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
Median
N/A
5.00
1.00
0.00
N/A
N/A
N/A
6.10
Minimum
N/A
4.00
1.00
0.00
N/A
N/A
N/A
0.00
Maximum
N/A
13.00
13.00
2.00
N/A
N/A
N/A
50.00
Median
0.900
4.651
3555.0
N/A
0.048
18.658
121,967.00
N/A
79.30
0.060
Minimum
-5.790
0.000
14.00
N/A
0.000
15.423
8,271.00
N/A
0.00
-0.624
Maximum
44.450
89.266
1072695
N/A
0.897
23.609
38,371,664.0
N/A
100.00
1.0195
Where: μ – for continuous variables the value shown in the mean whilst for discrete variables the percentage of the sample
meeting the defined criteria is reported; λ – total number of audit committee positions held by those designated as a ‘Pro-AC
member’ by total number of ‘Pro-AC members’; ν – mean audit committee positions held by independent directors on each firms
audit committee See Table 2 for formal descriptions of dependent and independent variables, and control factors that are all
shown in table in italics.
36
Table 4: Pearson correlation coefficient among dependent and independent variables, and control factors
Variables:
Abs(ACC)
ProfAC (1)
ACAP Score (2)
AC-Locks (3)
BoD Size (4)
BoD Ind (5)
Duality (6)
% Exe Dir Own (7)
MV/BV (8)
ABS ∆NI (9)
Negative NI (10)
Leverage (11)
Size (12)
Auditor (13)
Owner Con (14)
CFO (15)
Where:
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.163Φ
1.000
-0.187Φ
0.387Φ
1.000
0.071
0.231Φ
0.312Φ
1.000
-0.118ξ
0.065
0.138Φ
0.238Φ
1.000
0.021
0.079
0.097ξ
0.168Φ
-0.240Φ
1.000
-0.002
0.121Φ
0.033
0.133Φ
-0.161Φ
-0.022
1.000
0.022
0.034
0.007
0.047
-0.233Φ
-0.076
0.229Φ
1.000
0.058
-0.084
0.075
0.025
0.011
0.101ξ
-0.070
-0.022
1.000
-0.020
-0.014
-0.014
0.114Φ
0.062
0.021
-0.018
-0.012
0.026
1.000
0.353Φ
-0.012
-0.134Φ
-0.134Φ
-0.182Φ
0.086
-0.022
-0.044
-0.044
0.003
1.000
-0.104ξ
0.082
-0.011
-0.051
0.043
-0.017
0.073
-0.021
0.061
-0.019
-0.021
1.000
-0.292Φ
0.194Φ
0.202Φ
0.144Φ
0.479Φ
0.164Φ
-0.090
-0.282Φ
-0.016
0.071
-0.186Φ
0.233Φ
1.000
-0.140Φ
0.052
0.194Φ
0.094ξ
0.094
0.063
-0.026
0.031
0.073
0.011
-0.137Φ
0.033
0.150Φ
1.000
-0.126Φ
0.102ξ
0.074
0.064
0.061
-0.026
0.039
-0.012
0.090
0.074
-0.217Φ
-0.111
0.084
0.077
1.000
-0.156Φ
0.022
0.113Φ
0.034
0.108
0.158Φ
-0.103ξ
-0.133Φ
0.162Φ
0.134Φ
-0.137Φ
0.060
0.320Φ
0.103ξ
0.124Φ
1.000
Φ = Pearson correlation coefficient significant at the p ≤ 0.01, two-sided.
ξ = Pearson correlation coefficient significant at the p ≤ 0.05, two-sided.
See Table 2 for formal definitions of the dependent variable, independent variables and control factors.
37
Table 5: Main multiple regression results
Abs(ACC)i = ai + i1ACProfi + i2 ACAP Score i + i3AC-Locksi + i4BoD Sizei - i5BoD Indi + i6Dualityi + i7% Exe Dir Owni + i8MV/BVi + i9ABS∆NIi + i10Negative NIi
+ i11Leveragei - i12Sizei - i13Auditori + i14Owner Coni + i15CFOi + εi
Panel A – Model I
Panel B – Model II
Panel C – Model III
Panel D – Model IV
Variable
Predicted
Coefficient
Coefficient
Coefficient
Coefficient
Direction
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
Intercept
0.302 (2.871)Φ
0.305 (2.920)Φ
0.215 (1.692)
0.292 (2.698)Φ
ACProf
?
0.034 (2.571)ξ
Not Included
Not Included
0.032 (2.173)ξ
?
Not
Included
-0.036
(-3.024)Φ
Not
Included
-0.030
(-2.405)ξ
ACAP Score
AC-Locks
+
Not Included
Not Included
0.023 (1.477)
0.020 (1.202)
BoD Size
?
0.008 (1.353)
0.009 (1.513)
0.007 (1.452)
0.009 (1.510)
BoD Ind
-0.001 (-0.921)
-0.001 (-1.005)
0.000 (-0.782)
-0.001 (-1.068)
Duality
+
0.008 (0.414)
0.006 (0.328)
0.008 (0.500)
0.009 (0.475)
% Exe Dir Own
?
0.000 (-0.556)
0.000 (0.573)
0.000 (-1.235)
0.000 (-0.493)
MV/BV
+
0.005 (1.630)
0.006 (2.040)**
0.000 (0.969)
0.005 (1.846)**
ABS ∆NI
+
0.000 (0.109)
0.000 (0.077)
0.000 (-0.082)
0.000 (0.044)
Negative NI
?
0.159 (3.113)Φ
0.152 (2.813)Φ
0.141 (3.209)Φ
0.155 (2.919)Φ
Leverage
+
-0.065 (-0.980)
-0.084 (-1.273)
-0.055 (-0.952)
-0.077 (-1.159)
Size
-0.033 (-4.060)*
-0.034 (-4.147)*
-0.029 (-3.612)*
-0.032 (3.949)*
Auditor
-0.059 (-2.213)**
-0.069 (-2.560)*
-0.055 (-2.009)**
-0.068 (2.517)*
Owner Con
?
-0.001 (-1.269)
-0.001 (-1.453)
-0.003 (-1.989)ξ
-0.001 (1.296)
CFO
-0.160 (-4.137)*
-0.153 (-4.175)*
-0.154 (-4.160)*
-0.153 (-4.155)*
Adjusted R2 = 0.203
Adjusted R2 = 0.211
Adjusted R2 = 0.195
Adjusted R2 = 0.214
Model Summary
F-Statistic = 8.422*
F-Statistic = 8.649*
F-Statistic = 7.615*
F-Statistic = 8.194*
N = 465
N = 465
N = 465
N = 465
Durbin-Watson = 2.115
Durbin-Watson = 2.095
Durbin-Watson = 2.122
Durbin-Watson = 2.111
Where:
Φ = coefficient significant at the p ≤ 0.01, two-sided if directional sign indeterminable;
ξ = coefficient significant at the p ≤ 0.05, two-sided if directional sign indeterminable;
* = coefficient significant at the p ≤ 0.01, one-sided if directional sign indeterminable;
** = coefficient significant at the p ≤ 0.05, one-sided if directional sign indeterminable;
i = firm-year 1 through 465;  = coefficient for variables 1 through 15; ε = model residual; and
See Table 2 for formal definitions of the dependent variable, independent variables and control factors.
38
Table 6: Abbreviated summary sensitivity tests with alternative earnings management proxy measures
Abs(ACC)i = ai + i1ACProfi + i2 ACAP Score i + i3AC-Locksi + i4BoD Sizei - i5BoD Indi +
i6Dualityi + i7% Exe Dir Owni + i8MV/BVi + i9ABS∆NIi + i10Negative NIi + i11Leveragei i12Sizei - i13Auditori + i14Owner Coni + i15CFOi + εi
Panel A: Abs(ACC): total accruals - modified cross-sectional Jones (1991) model
Model I
Model II
Model III
Model IV
Variable
Coefficient
Coefficient
Coefficient
Coefficient
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
ACProf
0.031 (2.317)ξ
Not Included
Not Included
0.029 (2.002)ξ
Not Included
-0.034 (-2.686)Φ
Not Included
-0.032 (-2.175)ξ
ACAP Score
AC-Locks
Not Included
Not Included
0.019 (1.153)
0.015 (0.925)
2
2
2
Adj. R : 0.197
Adj. R : 0.208
Adj. R : 0.185
Adj. R2: 0.205
Model
F-Stat.: 7.923*
F-Stat.: 8.412*
F-Stat.: 6.121*
F-Stat.: 7.672*
Summary:
Panel B: Abs(ACC): working capital accruals - ‘original’ cross-sectional Jones (1991) model
Model I
Model II
Model III
Model IV
Variable
Coefficient
Coefficient
Coefficient
Coefficient
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
ACProf
0.043 (1.781)
Not Included
Not Included
0.041 (1.725)
Not Included
-0.054 (-2.732)Φ
Not Included
-0.050 (-2.437)ξ
ACAP Score
AC-Locks
Not Included
Not Included
0.022 (0.821)
0.023 (0.882)
2
2
2
Adj. R : 0.102
Adj. R : 0.111
Adj. R : 0.089
Adj. R2: 0.108
Model
F-Stat.: 4.231*
F-Stat.: 4.790*
F-Stat.: 3.883*
F-Stat.: 4.161*
Summary:
Panel C: Abs(ACC): working capital accruals – ‘modified’ cross-sectional Jones (1991) model
Model I
Model II
Model III
Model IV
Variable
Coefficient
Coefficient
Coefficient
Coefficient
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
ACProf
0.040 (1.709)
Not Included
Not Included
0.039 (1.661)
Not Included
-0.053 (-2.609)Φ
Not Included
-0.052 (-2.534)ξ
ACAP Score
AC-Locks
Not Included
Not Included
0.025 (1.016)
0.018 (0.577)
Adj. R2: 0.098
Adj. R2: 0.109
Adj. R2: 0.090
Adj. R2: 0.106
Model
F-Stat.: 4.144*
F-Stat.: 4.583*
F-Stat.: 3.975*
F-Stat.: 4.024*
Summary:
Where:
Φ = coefficient significant at the p ≤ 0.01, two-sided if directional sign indeterminable;
ξ = coefficient significant at the p ≤ 0.05, two-sided if directional sign indeterminable;
* = coefficient significant at the p ≤ 0.01, one-sided if directional sign indeterminable;
** = coefficient significant at the p ≤ 0.05, one-sided if directional sign indeterminable;
i = firm-year 1 through 465;  = coefficient for variables 1 through 15; ε = model residual; and
See Table 2 for formal definitions of the dependent variable, independent variables and control factors.
39
Table 7: Abbreviated summary sensitivity tests after sample partitioning into EI/CFOg and EI/CFOp
ACCi = ai + i1ACProfi + i2 ACAP Score i + i3AC-Locksi + i4BoD Sizei - i5BoD Indi + i6Dualityi
+ i7% Exe Dir Owni + i8MV/BVi + i9ABS∆NIi + i10Negative NIi + i11Leveragei - i12Sizei i13Auditori + i14Owner Coni + i15CFOi + εi
Panel A: EI/CFOg sample with income-decreasinng incentives (∆CFO>0) (n=208)
Model I
Model II
Model III
Model IV
Variable
Coefficient
Coefficient
Coefficient
Coefficient
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
ACProf
0.032 (2.023)**
Not Included
Not Included
0.027 (1.981)**
Not Included
-0.036 (-2.671)*
Not Included
-0.030 (-2.246)**
ACAP Score
AC-Locks
Not Included
Not Included
0.095 (1.137)
0.088 (1.061)
2
2
2
Adj. R : 0.147
Adj. R : 0.161
Adj. R : 0.135
Adj. R2: 0.155
Model
F-Stat.: 3.701*
F-Stat.: 4.141*
F-Stat.: 3.379*
F-Stat.: 3.768*
Summary:
Panel B: EI/CFOb sample with income-increasing incentives (∆CFO<0) (n=257)
Model I
Model II
Model III
Model IV
Variable
Coefficient
Coefficient
Coefficient
Coefficient
(t-statistic)
(t-statistic)
(t-statistic)
(t-statistic)
ACProf
-0.025 (-1.811)**
Not Included
Not Included
-0.021 (-1.737)**
Not Included
0.038 (3.003)*
Not Included
0.034 (2.311)**
ACAP Score
AC-Locks
Not Included
Not Included
0.089 (0.981)
0.085 (0.914)
2
2
2
Adj. R : 0.265
Adj. R : 0.274
Adj. R : 0.228
Adj. R2: 0.263
Model
F-Stat.: 6.220*
F-Stat.: 6.327*
F-Stat.: 5.104*
F-Stat.: 5.788*
Summary:
Where:
* = coefficient significant at the p ≤ 0.01, one-sided;
** = coefficient significant at the p ≤ 0.05, one-sided;
i = firm-year 1 through 208 or 257;  = coefficient for variables 1 through 15; ε = model residual; and
See Table 2 for formal definitions of the dependent variable, independent variables and control factors.
40
References:
Antle, R and B Nalebuff (1991), "Conservatism and auditor-client negotiations," Journal of Accounting
Research, 29 (1), 31-54.
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Additional References from Text:
(Peasnell et al. 2000)
(Black et al. 1998)
(Bartov 1993)
(Bushee 1998)
(Bange and De Bondt 1998)
(McNicholas and Wilson 1988)
(Watts and Zimmerman 1986)
(Healy and Wahlen 1999; Weisbach 1988)
(Fama 1980)
(Klein 2002)
(Chtourou et al. 2001)
(Antle and Nalebuff 1991)
(Dye 1991)
(Jones 1991)
(Dechow et al. 1995)
(Kothari et al. 2001)
(Hair et al. 1995)
(Farrar and Glauber 1967)
45