Earnings management and corporate governance in UK:
The role of board of directors and audit committee
Thesis Proposal by
Kang Lei
Faculty of Business Administration
National University of Singapore
CHAPTER 1
INTRODUCTION
Financial reported earnings have powerful influence on a full range of business
activities of a firm and its management decisions. The earnings could either affect
investors’ evaluation of the firm or impact contractual outcomes which are related to
financial leverage or compensation of mangers. Therefore managers have strong
intentions to adjust earnings numbers to the desirable level. The flexibility of current
accounting principles also provides managers with considerable ability to adjust
accounting earnings. The practice that the management uses judgment in financial
reporting and in structuring transaction to alter financial earnings is called “earnings
management” (Healy and Wahlen (1998)).
Although earnings management problem is not new, the recent popularity of earnings
manipulation has drawn serious attention from regulators, financial press and
academic research. For example, in a speech at NYU Center of law and business in
1998, Author Levitt, the Chairman of U.S Securities and Exchange Commissions
(SEC), said earnings management impaired the quality of financial reporting. His
comments showed serious concern of the adverse consequence of earnings
management to the US capital market. Earnings management could also be
undesirable to shareholders. When the interests of shareholders and mangers diverge,
mangers can manipulate earnings for their own purposes at the cost of shareholders’
interest. Hence how to improve the reliability and integrity of financial reporting is an
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interesting topic for research.
Corporate governance mechanisms, board of directors and audit committee in
particular, are responsible for monitoring managers on behalf of shareholders and
overseeing financial reporting process by company law. Therefore the board of
directors and audit committee should play a role in retaining earnings management.
However, the boards of public firms are generally considered as passive entities which
are controlled by management. In an effort to improve the effectiveness of the board
and audit committee, many corporate governance reports, including Cadbury report in
UK of 1992, Toronto Stock Exchange Corporate Governance Guidelines of 1994, and
Blue Ribbon Committee Report in US of 1999, propose “best practice”
recommendations on various aspects of corporate governance. The objective of this
thesis is to empirically examine the effects of some of the best governance practices
by the board of directors and audit committees on the level of earnings management.
I study the relation between, on the one hand, the attributes of the board and audit
committee and, on the other hand, earnings management measured as discretionary
accruals. I am particularly interested in the role of non-executive directors. I examine
the effects of their proportion on board/audit committee, their competence, their
compensation scheme and the activities of board and audit committee. Discretionary
accruals are estimated using modified Jones Model. I conduct the analysis in a sample
of large publicly traded UK firms, because UK data have more variances than those of
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U.S, and the corporate governance environment of UK is different from that of U.S in
several ways, therefore this UK study may provide some interesting results for issues
of board/audit committee monitoring.
This study could enrich the literature of relationship between board monitoring and
financial reporting by selecting UK firms for analysis. By now, most previous studies
in this field are U.S based, and a few have provided empirical evidence for UK cases.
Peasnell et al (2000a) and Peasnell et al (2000b) are two exceptions. However they
only focus on the effects of the proportion of outside directors and the existence of
audit committee on the level of earnings management. This thesis does a more
comprehensive study on various characteristics of board/audit committee, and thus
may provide more valuable information to UK accounting regulators in making
recommendations for corporate governance practice.
This study also extends the research of board effectiveness by including the
compensation of the directors as a determinant. It is possible that the directors make
different performance under different remuneration scheme, but few previous studies
have taken this financial motivation of the directors into consideration. Therefore, the
results of this study might be useful for companies to design more effective
compensation package.
Another potential contribution of this thesis is that I make additional estimation of the
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discretionary accruals after considering some differences in accounting standards
between UK and US. Wilkins (2002) suggests that some particular country differences
in accounting environment may results in significant difference in some of the
variables in modified Jones model, however most previous UK studies ignore this
potential problem. For this thesis, one important difference for this UK study is that
revaluation of non-current assets has been banned in US since 1933, but is permitted
in UK (Company Act (CA) 85 4.31, Statement of Standard Accounting Practice
(SSAP) 19, and Financial Reporting Standard (FRS) 15). In additional test, I will
adjust modified Jones model to examine whether this difference could alter the results.
The remainder of this paper is organized as follows: Chapter Two reviews literature of
earnings management and corporate governance, and develops hypotheses for test.
Chapter Three gives an overview of corporate governance in UK, and Chapter Four
describes the data sources and research methodology.
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CHAPTER 2
LITERATURE AND HYPOTHESIS DEVELOPMENT
2.1 Earnings management
This is generally believed by the regulators and the public that managers manipulate
reported earnings (Levitt (1998); Loomis (1999)). A large body of academic research
has examined the existence of earnings management, in particular, around specific
corporate events in which agency problem is most likely to occur. Perry and Williams
(1994) provides evidence of managers’ manipulation of earnings in the predicted
direction in the year preceding the public announcement of management's buyout
intention. Erickson and Wang (1999) find that acquiring firms manipulate accounting
earnings upward prior to stock for stock corporate mergers. Teoh et al (1998a and
1998b) find that managers raise reported earnings before initial public offerings and
seasoned equity offerings.
Managers have various incentives to manipulate earnings. Some incentives are
provided by contractual arrangements based on accounting earnings such as bonus
plan, debt and dividend covenants, etc. For example, DeFond and Jiambalvo (1994)
find that sample firms accelerate earnings prior to lending covenants, and Holthausen,
Larcker and Sloan (1995) find that managers manipulate earnings downwards when
their bonus are at their maximum. In some cases, earnings management is motivated
by regulatory reasons. Previous studies find that managers would manipulate earnings
to circumvent industry regulations and reduce the risk of investigation by anti-trust
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regulators (Collins et al (1995); Cahan (1992)). However, recent research has been
focus more on incentives provided by the capital market. Dechow and Skinner (2000)
suggest that accounting information such as earnings is important for capital market to
value the firm, and the increased stock market valuations and stock-based
compensation during 1990’s make managers have more incentives to manage earnings.
The results of empirical researches are generally supportive to this assertion. Some
recent studies show that firms “overstate” earnings prior to seasoned equity offering
(SEO), initial public offering (IPO) and stock for stock mergers (Teoh et al (1998a, b);
Erickson and Wang (1999)) in order to get favorable valuation by capital markets.
Moreover Perry and Williams (1994) find evidence of earnings understatement
problem prior to a management buyout.
Earnings management is different from accounting frauds which violate Generally
Accepted Accounting Principles, because the opportunities of earnings management
are inherent in the current financial reporting system. Xie et al (2003) argue that the
nature of accrual accounting gives managers considerable discretion in determining
the earnings in any given period. According to Teoh et al (1998a), within the
boundary of GAAP, managers have several sources to manipulate earnings. They can
choose an accounting method to advance or delay the recognition of revenues and
expenses, use discretionary aspects of the application of the chosen accounting
method, or adjust the timing of asset acquisitions and dispositions to alter reported
earnings.
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Although Schipper (1989) suggests that earnings management could possibly be
beneficial by providing a means for management to convey their private information
on firm performance, there is a potential danger of wealth loss for shareholders when
the interests of mangers and shareholders conflict. Since the managers are
compensated explicitly (salary, bonus, stock option, etc) and implicitly (job security,
reputation, etc) on the firm’s earnings. Managers may conceal the true performance by
earnings management to get a higher compensation or keep their jobs at the cost of
shareholder’s interest. Moreover, the earnings management increases the information
asymmetry between managers and shareholders, thus investors may make wrong
decisions based on misleading earnings information. For example, Teoh et al (1998)
find that IPO issuers who manage earnings aggressively perform relatively bad after
IPO compared to those manage earnings conservatively and demonstrate the wealth of
outside shareholders can be harmed by earnings management.
A number of prior studies examine the existence of earnings management by
identifying a situation where earnings management is likely to occur and estimating
discretionary accruals. However, some recent papers test earnings management by
examining the distribution of reported earnings (Burgstahler and Dichev (1997);
Degeorge et al (1999); Brown (2001)). These studies find that the frequency of firms
with small positive earnings (positive earnings changes or earnings surprise) is higher
than expected, while the frequency of firms with small negative earnings (negative
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earnings changes or earnings surprises) is less than expected. These results are
explained as the evidence of income-increasing earnings management and support the
hypothesis that managers have incentives to avoid reporting loss, earnings declines,
and earnings missing analysts’ forecasts. The reason why meeting such simple
benchmarks is so important to managers is probably due to the capital market reaction.
According to Barth et al (1999) and Skinner and Sloan (2000), failure to meet these
earnings benchmarks will cause a dramatic drop of stock price. Since the personal
wealth of top managers is tied more closely to their firms’ stock price in form of
stock-based compensation plan in recent years, it is reasonable to argue that managers
have strong incentives to manipulate earnings to avoid missing earnings benchmarks.
Thus, in this thesis, I identify the firms which are in danger of missing some earnings
benchmarks and test whether the board of directors and audit committee could
constrain earnings management behavior when managers have strong incentives to do
so. However, managers may also adjust earnings downward in some situations.
Degeorge et al (1999) argue that earnings far beyond the thresholds will be reined in
to make future earning thresholds more attainable. Therefore I will also examine the
ability of board and audit committee in reducing income-decreasing earnings
management.
2.2 The role of the board of directors
The separation of ownership and control which is inherent in the modern corporate
form of organization causes the agency problem between shareholders (the principals)
and management (the agent). This is because the ownership structure of a company is
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highly dispersed, and shareholders generally hold more than one kind of security to
diversify their risks, therefore, no individual shareholder has enough incentives and
resources to ensure that management is acting for the shareholders’ interest. To
control this agency problem, corporate governance, according to Denis (2001),
“encompasses the set of institutional and market mechanisms that induce selfinterested managers to maximize the value of the residual cash flows of the firm on
behalf of its shareholders.”
Among the set of corporate governance mechanisms, the board of directors is often
considered the primary internal control mechanism to monitor top management, and
protect the shareholder interest. For example, Fama (1980) argues that 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”.
There is a large literature examining the relationship between board monitoring and
firm performance on various aspects such as CEO turnover, stock return, operating
performance and financial reporting quality (Weisbach (1988); Brickley (1994);
Vefeas (1999); Dechow et al (1996); Beasley (1996)). These previous papers not only
confirm that the board of directors does affect firm performance, but also find some
characteristics of the board are related to the effectiveness of the board, especially in
monitoring top managers. These characteristics are the independence of the board,
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the competence of outside directors, outside directors’ ownership, and the activity of
the board.
Based on previous literature, Earnings management can be seen as a potential agency
cost since managers manipulate earnings to mislead shareholders and fulfill their own
interests. Therefore the board of directors which is in charge of solving the agency
conflicts between mangers and shareholders should play a role in constraining the
level of earnings management. Further more, prior similar researches of financial
reporting fraud suggest that effective board monitoring helps to maintain the
credibility of financial reports. Thus it is reasonable to hypothesize that an effective
board of directors will help to limit the earnings management. In the following
sections, I will bring forward several testable hypotheses on the relationship of the
board characteristics and earnings management.
2.2.1 Board independence from management
Fama and Jensen (1983) recognize the control function of board as the most critical
role of directors and argue that the board is not an effective device for decision control
unless it limits the decision discretion of individual top managers. Moreover, Cadbury
Report suggests that “an important aspect of effective corporate governance is the
recognition that the specific interests of the executive management and the wider
interests of the company may at times diverge”. Therefore board independence from
management is one of the important factors determining the board effectiveness and
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monitoring ability. Hence, we expect to see the board independence has a positive
relation with the board effectiveness in limiting earnings management. However the
independence is fundamentally unobservable, I have to measure it by some proxies
developed from previous literature. One proxy is the board composition, and another
is whether the CEO is also the Chairman of the board, and the last one is the financial
dependence of outside directors.
Although the specific knowledge about the organization that the inside directors have
can make valuable contribution to decision control function of the board, the
domination by managers on the board can lead to the collusion and transfer of
stockholder wealth (Fama (1980)). Outside directors are generally considered
independent of management and more effective in protecting the interests of
shareholders when there is an agency problem. Therefore it is necessary to adding
outside directors to keep the independence of board. Moreover, Fama and Jensen
(1983) observe that outside directors have incentives to develop reputations as experts
in decision control and monitoring because the outside directors’ labor market will
price their services according to their performance.
The percentage of outside directors in the boards is increasing in practice these years
and many corporate governance reports recommend for adding outside directors ( for
example, Blue Ribbon Committee Report), and the Previous empirical studies
generally demonstrate the association between the proportion of outside directors and
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the board effectiveness in monitoring management. Weisbach (1988) find stronger
association between performance and CEO turnover in outside-dominate boards than
inside-dominate boards. Beasley (1996) and Dechow et al (1996) document negative
relationship between outside directors and incidence of financial fraud. More
specifically, some studies find evidence that the proportion of outside directors is
negatively related to the level of earnings management (Peasnell et al (2000), Klein
(2002) and B.Xie et al (2003)). Based on theory of Fama and Jensen (1983) regarding
board composition and the results of prior studies, I make the following hypothesis:
H1: there is a negative relationship between the proportion of outside directors on the
board and the level of earnings management.
Besides the composition of outside directors on the board, the separation of roles of
the Chairman of the board and the CEO can also affect the independence of the board.
The role of the Chairman is pivotal to securing good corporate governance. Jensen
(1993) defines the function of the Chairman of the board as to run the board meetings,
oversee the process of hiring, firing, evaluating and compensating the CEO. Therefore
when the Chairman of the board and the CEO is the same person, there is a very real
danger that firm is controlled by one man, and the board is not independent from the
management. Therefore Cadbury report recommends the roles of the Chairman and
the CEO should be separate. Some empirical researches have demonstrated the
combination may affect the board effectiveness of monitoring management. For
example, Dechow et al (1996) find firms are more likely to be subject to accounting
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enforcement actions by SEC for alleged violations of GAAP if they have the CEO
simultaneously serves as the Chair of the board. Thus I hypothesize that:
H2: the existence of combination of the CEO and the Chairman of the board is
positively related to the level of earnings management.
It is usual for outside directors to receive a fixed annual fee for their services.
However, they may also receive other forms of remuneration or reward from the
company. One remuneration form which might hurt the independence of nonexecutive directors is stock option. When the directors are rewarded by large blocks
of stock option, the temptation for them is to focus on ensuring that company price is
as high as possible when the time comes for exercising the options. If the earning
figure does not come out “right”, and managers have to adjust it, the directors may not
have incentives to prevent this practice. Therefore, Cadbury report recommends nonexecutive directors should not participate in share option schemes since the
independence of non-executive directors might be undesirably. Hence, I expect that:
H3: the compensation for outside directors as stock option is positively related to the
level of earnings management.
2.2.2 Competence of outside directors
2.2.2.1 Tenure of outside directors
Increasing the proportion of outside directors can not guarantee the effectiveness of
the board monitoring. Outside directors have to possess the necessary competences to
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carry out their control and overseeing duties, among which the knowledge of
company specific affairs is particularly essential (Chtourou et al (2001)). The longer
the experience of outside directors on the board, the better knowledge of company and
their executives they will get. Therefore, outside directors may be more capable of
monitoring managers and financial reporting process if they have served the board for
long time. This assertion is supported by many previous studies. For example,
Beasley (1996) finds the likelihood of financial reporting fraud is negatively related to
the average tenure of non-executive directors. And Chtourou et al (2001) find that
average tenure of outside directors is negatively associated with level of earnings
management.
However, there is another possibility that the outside directors with longer tenure are
more likely to be entrenched with managers and thus become less effective monitors.
This speculation is consistent with National Association of Corporate Directors
(NACD) Board Guidelines 1999 which states outside directors may lose some of their
independent edge if they stay on the board too long. Xie et al (2003) also find a
positive association between average tenure of outside directors and level of earnings
management. Although the Combined Code 1998 says that a reasonably long period
on the board can give directors a deeper understanding of the company’s business,
the revised Combined Code recommends outside directors who have served more
than 9 years must be re-elected at next Annual General Meeting. I empirically test the
following hypothesis using UK samples.
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H4: The relationship between the average tenure of outside directors and the level of
earnings management is a converted U shape.
2.2.2.2 Directorships of outside directors
The mixed results of tenure of outside directors show that tenure may not be a perfect
proxy for director’s competence. Another possible measure is the outside directorship.
As Fama and Jensen (1983) indicate that outside directors have incentive to monitor
firms effectively to seek director position in labor market, we can consider the
directorships hold by outside directors as a signal of their ability as monitors.
Empirical researches have demonstrated the positive relation between outside
directorships and quality of financial reporting. Chtourou et al (2001) find the number
of outside directorship is negatively related to the level of earnings management. Xie
et al (2003) get similar results. However, if the outside directors sit on too many
boards, they may not have enough time to perform their duties effectively. In 1995,
Authur Levitt, the Chair of SEC, said “the commitment of adequate time is an
essential requirement for directors”. NACD 1999 also suggests retired executives or
professional directors should serve on no more than six boards. However some
previous surveys suggest that the average directorship hold by UK outside directors is
relatively low (Peanell et al (1999); Cook and Leissle (2002)). Based on prior
literature, I will test the following hypothesis:
H5: The number of directorship of outside directors is negatively related to the level
of earnings management.
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2.2.3 Ownership of outside directors
It is generally believed that the directors who hold substantial stock ownership are
more likely to fight against management to protect shareholders’ interest, because
they have their own wealth involved. For non-executive directors who hold no
position in the firm other than serving on board, Jensen (1993) asserts that holding
sizable stock ownership will provide them with better incentives to monitor
management closely. Many empirical studies lend support to this assertion. For
example, Beasley (1996) finds that the likelihood of accounting fraud is negatively
related to non-executive ownership. Consistent with these evidence, Combined Code
1998 recommends that “payment of part of a non-executive director’s remuneration
in shares can be a useful and legitimate way of aligning the director’s interest with
those of the shareholders”. Therefore I expect that:
H6: The stock ownership hold by outside directors is negatively related to the level of
earnings management.
2.2.4 Board Activity
It is generally believed that a more active board is better for shareholders’ interest,
because directors have to spend more time and energy on the company affairs in an
active board. Recently, many financial and academic publications have criticized that
directors have too little time to attend meeting regularly and this will limit their ability
to monitor management well. Conger et al (1998) also suggest that board meeting
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time is an important resource for improving the effectiveness of board. Vafeas (1999)
empirically tests the relation between board activity, which is measured by board
meeting frequency, and the firm performance. He finds that the increase in board
meetings leads to improved firm performance, and this result suggests the frequent
board meeting can help to make up the limited director interaction time.
According to above articles, it is reasonable to get the implication that the frequent
board meetings can help to improve the board effectiveness in monitoring, and thus
have some effects in constraining earnings management. Therefore, I will test the
following hypothesis:
H7: The frequency of board meetings is negatively related to the level of earnings
management.
2.3 The role of audit committee
Since the board of directors bears diverse responsibilities to manage the business and
affairs of the corporation, it usually delegates some authorities and specific functions
to several committees which consist of subsets of board members. Therefore the
effectiveness of board monitoring is also related to the structure of the board. For
example, Klein (1998) finds that overall board composition is unrelated to firm
performance, but the composition of accounting and finance committee does impact
the performance.
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As a part of the board, audit committee takes over the board function to oversee the
firm’s financial reporting process. Klein (2002) comments that “audit committee meet
regularly with firm’s outside auditors and internal financial managers to review the
corporation’s financial statements, audit process and internal accounting controls”.
Thus audit committee helps to alleviate the agency conflicts between the top
management and the shareholders by improving the quality of financial reporting and
reducing the information asymmetry between inside managers and outsider
shareholders.
Previous literature of audit committee and the quality of financial reporting has tended
to focus on the existence of audit committee.Wild (1996) shows that the
informativeness of a firm’s earnings report increases after the formation of an audit
committee. McMullen (1996) and Dechow et al (1996) both find that firms
committing financial fraud are less likely to have audit committees. Although these
studies suggest the existence of audit committee has a positive impact on financial
reporting, they do not investigate if the characteristics of an audit committee would
affect the quality of financial reporting.
Some recent papers explore whether the audit committee characteristics could affect
the different aspects of financial reporting process. Abbott and Parker (2000) find that
active and independent audit committees are more likely to hire an industry specialist
external auditor. Abbott et al (2002) show that financial misstatements are less likely
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to occur in firms whose audit committees are independent and have at least one
financial expert. More closer to the issues of this thesis, some studies investigate the
relationship between audit characteristics and earnings management. Klein (2002)
finds that the independence of audit committee is negatively related to abnormal
accruals. Xie et al (2003) find that audit committee which are more independent,
meeting more frequently, and have members with corporate or financial backgrounds
are less likely to engage in earnings management. As a summary of above evidence,
the independence, member financial expertise and activity are three important
characteristics which could affect the effectiveness of audit committee in monitoring
financial reporting.
In the following sections, I will develop testable hypothesis to examine how the
characteristics of audit committee affect the level of earnings management.
2.3.1 Independence of audit committee
It is generally believed that members who are independent from management are
better monitors. Previous studies have provide plenty of evidence that an independent
audit committee is better at monitoring financial reporting and auditing process of the
firm ( e.g., Abbott and Parker (2000); Beasley et al (2000); Carcello and Neal (2000);
McMullen and Raghunandan (1996)). Moreover, some studies have examined the
negative link between the independence of audit committee and earnings management
using sample of United States (e.g., Chtourou et al (2001); Klein (2002); Xie et al
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(2003)). However, the independence research of audit committee has gone beyond the
simple classification of outside and inside directors.
Researchers generally classify outside directors into one of the two categories:
“independent directors” and “grey directors”. Grey directors include former officers
or employees of the company or a related entity, relatives of management and
professional advisors to the company (Beasley (1996); Carcello and Neal (2000)),
while independent directors have no affiliation with the firm other than being on the
board. Previous studies have shown that the personal or economic affiliation that grey
directors have with the corporate management may impair their independence. For
example, Carcello and Neal (2000) find that the percentage of inside and grey
directors has a negative relationship with the probability that the auditor will issue a
going-concern report when the firm is experiencing financial distress. Therefore the
presence of those grey members on audit committee may impair the monitoring
effectiveness of audit committee. Aware of this problem, BRC (1999) recommends
that audit committee should be comprised only of independent directors.
The Cadbury report does not require a totally independent audit committee, but just
suggests that the membership of audit committee should be confined to non-executive
directors and majority of outside directors serving on the committee should be
independent. However the prior empirical studies have suggest possible different
performance of independent directors and grey directors, so I expect to find the audit
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committees which have no insider or grey directors would be more able to restrain
earnings management than those have. Hence, I propose the following hypothesis:
H8: The presence of audit committee comprised solely of independent directors is
negatively related to the level of earnings management.
2.3.2 Member financial expertise
Another important variable which could affect the effectiveness of audit committee is
the member competence. Independent directors may have intentions to curb earnings
management for shareholders, but they may not be able to do so without certain level
of financial knowledge. BRC 1999 recommends that each member of audit committee
should become financially literate and at least one should have accounting or related
financial management expertise. The positive effect of audit committee members who
have financial expertise is supported by a number of empirical studies. Agrawal and
Chadha (2003) which find the incidence of independent directors with accounting or
finance background on audit committee is negatively related to the probability of
earnings restatement. McMullen and Raghunandan (1996) also find that companies
with financial reporting problems are less likely to have CPAs on the audit committee.
Cadbury report 1992 does not mention the importance of the member’s financial
expertise, but the Audit Committees Combined Code Guidance 2003 recommends
that “at least one member of the audit committee should have significant, recent and
relevant financial experience, for example as an auditor or a finance director of a
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listed company. It is highly desirable for this member to have a professional
qualification from one of the professional accountancy bodies”. This change reveals
that the qualification of audit committee members has been realized as an important
issue for the corporate governance of UK firms.
According to US experience, member expertise can increase financial reporting and
auditing quality, decrease the probability of accounting fraud, so it is probable that the
financial expertise of audit committee members can increase their ability to detect and
constrain earnings management. Therefore I will test the following hypothesis to see
if this relationship still holds for UK cases.
H9: The financial expertise of audit committee members is negatively related to the
level of earnings management.
2.3.3 Meeting of audit committee
A common proxy for committee diligence, meeting frequency has been generally
considered as an essential component of audit committee effectiveness. Menon and
Williams (1994) note that audit committees that do not meet, or meet only a small
number of times, are unlikely to be effective monitors. In line with this argument,
NACD 2000 also recommends that “The audit committee should meet as frequently
as necessary to perform its role”. Some studies find the negative relationship between
meeting frequency and the occurrence fraudulent financial reporting (e.g., Abbott et al
(2000), Beasley et al (2000)). Some other studies, such as Abbott and Parker (2000),
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link the meeting numbers with higher audit quality. In conclusion, a plenty of
empirical results support the assertion that the meeting frequency of audit committee
is positively associated with financial reporting quality. Since earnings management
practice impairs the integrity and transparency of financial reports by adjusting real
earnings, I can similarly propose this hypothesis:
H10: The frequency of audit committee meeting is negatively related to the level of
earnings management.
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CHAPTER 3
CORPORATE GOVERNANCE IN UK
Similar to what has happened in US, the corporate governance issue has drawn
increasing attention from the public and regulators in UK. Although company law
holds that the board of directors is responsible for financial reporting process, the
boards of UK firms were generally considered passive entities which were controlled
by management several decades ago. A series of unexpected business failures and
high profile accounting scandals which occurred in late 1980s and early 1990s
reduced the reliability of financial reporting results and thus exposed the corporate
governance weakness of UK firms.
As a response to the weak governance of UK firms, a series of corporate governance
codes were developed through the 1990s. The Cadbury report was issued by the
committee on the Financial Aspects of Corporate Governance in 1992. The Cadbury
report contained the code of Best Practice as the criteria of good governance and
focused on the board monitoring responsibilities and highlighted the role of Nonexecutive directors. Following Cadbury report, Greenbury Code was issued by the
Committee of Executive pay in 1995, and the Combined Code was released in 1998.
On 23 July 2003, the Financial Reporting Council published the final text of the
revised Combined Code which will apply to reporting years commencing on or after 1
November 2003. While companies are not under obligation to comply with the
recommendation of codes, London Stock Exchange requires all the UK-incorporated
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listed firms to include a statement of compliance with the code in their annual report
and clearly explain identify and explain areas of non-compliance, thereby making
non-compliance a potentially costly action.
As an essential part of board, audit committee provides critical oversight on financial
reporting process. The history of audit committee is quite long in US. Since 1978,
NYSE has required all listed companies to have audit committees comprised solely of
independent directors. While in UK, the development of audit committee is relatively
slow. A report of the Accountants International Study Group in 1977 indicates that the
practice of Audit committee in UK was unusual, and the concept of audit committee
had not been generally accepted. Only 38 percent of the companies had audit
committee in 1988 according a survey by the bank of England. However the Cadbury
report (1992) highlights the importance of audit committee and recommends this
practice to all the companies as one way to improve the quality of financial reporting.
Collier (1996) shows that the audit committees had generally become more
widespread among large firms after the issue of Cadbury report 1992. By 1995,
almost 92% companies have established audit committees (Cadbury compliance
report 1995).
Although the regulators and companies of UK have made obvious effort to improve
the level of corporate governance, very limited empirical researches have been done
to examine the association between corporate governance and firm performance in
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UK market. Peasnell et al (2000a and 2000b) find that board monitoring helps to
reduce the level of income-increasing earnings management. However they only
examine two aspects of board monitoring: the proportion of Non-executive directors
on the board and the existence of an audit committee, and thus leave the effects of
many other aspects of corporate governance unclear. Therefore the main motivation of
this paper is to fill up the lack of comprehensive examination of relation between
corporate governance and earnings management of UK companies.
Moreover, the board characteristics of UK firms have more variances compared to US
companies, and this provides a unique opportunity for research. This is probably
because that the compliance with the UK corporate governance code is voluntary, so
the companies are free to choose their own governance policy. Another possible
reason is the current Combined Code is more flexible than the requirements in US.
For example, although the Combined Code has acknowledged the importance of Nonexecutive directors, it only suggests that they should constitute at least one third of the
board members, instead of majority of the board. In conclusion, the variety of UK
sample has the potential to generate some interesting results which different from
those US studies.
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CHAPTER4
METHODOLOGY AND DATA SOURCE
4.1 Measure of earnings management
Although there is no perfect proxy for earnings management, most current studies
focus on manager’s use of discretionary accruals. Consistent with previous literature,
I estimated discretionary accruals using cross-sectional version of modified Jones
Model (e.g., Dechow et al (1995); Teoh et al (1998a and 1998b)). More specifically, I
focus on the discretionary current accruals (DCA).
There are several reasons for detecting earnings management by DCA instead of total
discretionary accruals. First, current accruals are more easily for mangers to
manipulate (Teoh et al (1998b)). Second, this measure is widely used by previous
similar researches, so it is easier for me to compare my results with theirs (e.g.,
Peasnell et al (2000b); Xie et al (2003); Park and Shin (2003)). Third, the accounting
principles for treatment of tangible fixed assets of UK are different from those of U.S,
so if I use the original modified Jones Model, the relationship between gross property
plant and equipment (PPE) and depreciation expenses may not be hold. I will address
this issue in detail in the sensitivity tests.
The model for estimating DCA is as following. First, I use the following regression
model to get the estimates of 1 , 2 .

CAi ,t
1
 1 
 TA
TAi ,t 1
i ,t 1


 REVi ,t
  2

 TA
i ,t 1



   i ,t


- 27 -
(1)
CAi ,t is the current accruals of firm i defined as the change of non-cash current assets
less the change of current liabilities. REVi ,t is the change of revenue between year t
and t-1, and TAi ,t 1 is the book value of total asset of year t-1. The regression is
carried out for each industry-year combination.
Second, non-discretionary current accruals are estimated as:

1
NDCAi ,t  ˆ1 
 TA
i ,t 1


 REVi ,t  REC i ,t
  ˆ 2 


TAi ,t 1






(2)
Where ̂1 and ̂ 2 are OLS estimates for the coefficients in equation (1) and REC i ,t is
the change of net receivables.
Finally, we obtain the discretionary accruals as the remaining portion of current
accruals:
DCAi ,t 
CAi ,t
TAi ,t 1
 NDCAi ,t
(3)
4.2 Earnings benchmarks
Several papers document managers have incentives to meet simple earnings
benchmarks, which include avoiding losses and earnings declines, and beating
analysts’ forecasts. This argument can be supported by Burgstahler and Dichev (1997)
and Degeorge et al (1999) which both find that small reported losses (small profit
declines) are rare, while small reported profits (small profit increases) are common,
and imply that earnings management is more pronounced when earnings are below
certain benchmarks. Thus, I examine the role of the board and audit committee in
- 28 -
constraining earnings management around the earnings benchmarks.
Following Park and Shin (2003) and Peasnell et al (2000b), I use two earnings
benchmarks: zero earnings and last year’s earnings. I will split the sample based on if
the pre-managed earnings (actual earnings minus the discretionary accruals) meet or
miss the target, and expect to find earnings management around targets. I expect to
find income-increasing accruals when the pre-managed earnings are below the targets,
and find income-decreasing accruals when pre-managed earnings are above the
targets. Next, I will examine the relationship between the board of directors, audit
committee and earnings management to see if they could help to decreasing the
income-increasing (income-decreasing) accruals.
4.3 Regression Analysis
To analysis the effect of the board characteristics, audit committee on earnings
management, I first construct following regression models:
Model 1: for board of directors
DCA   0  1OUT ( IND)   2 DUAL   3OPTION   4TENURE   5 (TENURE ) 2   6 DIRSHIP
  7 STKOWN   8 MEET    i controls  
Model 2: for audit committee
DCA  0  1INDAUD   2 FIN  3MEETAUD   i controls  
According to the pre-managed earnings, I split the sample into two sub-samples, and
then run regression Model 1 and 2 in each sub-sample. Therefore, for every model,
there are four regressions. Regression a (b) is for firm-year observations that pre-
- 29 -
managed earnings below (above) zero, and Regression c (d) is for firm-year
observations that pre-managed earnings less than (more than) last year earnings.
4.3.1 Variables for board characteristics and audit committee
For the independent variables in Model 1, OUT is the percentage of the number of
outside directors or so called non-executive directors on the board, and IND is the
proportion of independent outside directors on the board. DUAL is a dummy variable
with value 1 if the CEO and chairman of the board is the same person and zero
otherwise. OPTION is a dummy variable with value 1 if non-executive directors
receive stock option compensation and zero otherwise. TENURE is the average years
of board services of non-executive directors. DIRSHIP is the average number of
directorships held by non-executive directors in unaffiliated firms. STKOWN is the
cumulative percentage of shares held by non-executive directors. MEET is the
number of board meetings per year. I expect OUT, IND, TENURE, DIRSHIP, MEET
and STKOWN to have negative (positive) coefficients in the regression of sub-sample
that pre-managed earnings below (above) earnings targets, while DUAL and OPTION
have positive (negative) coefficients.
For MODEL 2, INDAUD is a dummy variable with value 1 if the audit committee is
composed solely of independent directors. FIN is the proxy for member’s financial
expertise and also an indicator variable with value 1 if there is at least one member
has past employment experience in finance or accounting. This definition is more
- 30 -
restrictive than that of BRC 1999, and consists with revised combined code which
recommends one member must possess recent and relevant experience in finance.
MEETAUD is the number of meetings that the audit committee have in a year. I
expect that the INDAUD, FIN and MEETAUD will have negative (positive)
coefficients when the pre-managed earnings are below (above) earnings targets.
4.3.2 Control Variables
The above regression models control for some other dimensions of the corporate
governance and incentives for earnings management which could affect the level of
discretionary accruals. BRDSIZE is the number of directors on the board. I control
this factor because Jensen (1993) finds that a larger board is less effective and more
easily to be control by CEO. Klein (2000) also finds that board size is a determinant
of the independence of audit committee. NOM is a dummy variable with value 1 if
the nominating committee is composed of majority of independent directors. Previous
studies demonstrate this variable reflect the management power on the board, and thus
is related to the level of discretionary accruals (e.g., Chtourou et al (2001) and
Peasnell et al (2000)).
BLOCK is the cumulative percentage of outstanding shares hold by outside block
holders who own at least 5% of firm shares. This variable controls for the potential
monitoring from block holders on earnings management. INSTOWN is the total
percentage of outstanding shares held by institutional investors. Many papers find
- 31 -
that institutional investors monitor and constrain the self-serving behavior of
managers. For example, Chung et al (2003) find that large institutional shareholdings
inhibit managers from using discretionary accruals to manipulate earnings.
MANOWN is the faction of outstanding shares holding by managers. This measure is
related to discretionary accruals because it reflects the extent to which the interests of
managers are aligned with those of shareholders. As Warfield et al (1995) say,
managerial ownership is inversely related to magnitude of accounting accrual
adjustments. BIG4 is indicator variable with value 1 if the external auditor of the firm
is BIG 4 to control of the audit quality effects. Previous studies suggest that Big 5
auditors are generally more effective in deterring earnings management than other
auditors (e.g., Becker et al 1998, Kim et al (2003)).
BONUS is the average weight of bonus to total remuneration for all executives.
Maximization of bonus is a potential incentive of earnings management, and many
studies, such as Healey (1985) and Holthausen et al (1995), can provide consistent
empirical evidence. LEV is the financial leverage measured as the ratio of total debt to
total assets. On one hand, firms with high leverage ratio may have incentives to adjust
earnings upward to avoid debt-covenant violation. On the other hand, such firms may
under close scrutiny of lenders and are less able to do so. Therefore, the relationship
between LEV and discretionary accruals is undetermined. MBRATIO is the market to
book ratio of asset which proxy for growth opportunity of the firm. Matsumoto (2002)
argues that firms with high growth prospects have greater incentives to manipulate
- 32 -
earnings to avoid unfavorable market reaction to negative earnings news. SIZE is the
natural log of sales. Following previous studies, this factor is controlled as a possible
determinant of choice of discretionary accruals (e.g., Beck et al (1998), Park et al
(2003), and Peasnell et al (2000)). LOSS is a dummy variable with value 1 if the firm
has two or more previous consecutive years of losses. Matsumoto (2002) finds that
the earnings of loss firms are less value relevant and thus managers are less likely to
adjust earnings to meet targets. CFO is the cash flow from operation and this will
control for its relationship with discretionary accruals documented by Dechow et al
(1995). Finally, Year is an indicator variable control for time effects.
4.4 Sensitivity Tests
4.4.1 Alternative measure of earnings management
Some studies measure the level of earnings management by total discretionary
accruals which include the long-term accruals. As a supplementary test, I will use
Modified Jones Model to estimate total discretionary accruals. The procedures are as
follows;
1.
TACi ,t
TAi ,t 1
 1 
 REVi ,t
 2
 1 

 TA
i ,t 1
 TAi ,t 1 


 PPEi ,t
  3

 TA

 i ,t 1

   i ,t


TACi ,t is the total accrual of firm i calculated as net income minus the cash flow from
operations. PPEi ,t is gross property plant and equipment. The regression is carried out
for each industry-year combination to estimate 1 , 2 and  3 .
2. Non-discretionary accruals are estimated as:
- 33 -
 1 
 REVi ,t  RECi ,t 
 PPEi ,t 
  ˆ 2 
  ˆ3 

NDAi ,t  ˆ1 



 TA 
TAi ,t 1
 TAi ,t 1 


 i ,t 1 
3. The total discretionary accruals are DAi ,t 
TACi ,t
TAi ,t 1
 NDAi ,t
The above method is commonly used by previous studies. However few of them
consider the potential problem that the Jones model is developed based on U.S
accounting system, so it may not work well in UK research as it does in U.S studies
without taking UK financial reporting environment into consideration. In the
discussion of Yoon and Miller (2002), Wilkins (2002) suggests that their ignorance of
some particular differences in accounting standards between Korean and U.S that
would likely result in significant differences in some of the model variables may be
the reason why their results of earnings management of SOE firms are different from
prior U.S studies.
Since the Modified Jones Model considers the effects of fixed asset on discretionary
accruals, the difference between the treatment of tangible fixed asset in UK and U.S
may affect the power of this model in UK studies. In U.S, the revaluation of property,
plant and equipment is not allowed and they should be reported as historical cost
(opinion of the Accounting Principles Board (APB) 6.17), while the revaluation of
tangible fixed assets is permitted in UK (CA 85, SSAP19, FRS 15). Whittred and
Chan (1992) find that the majority of asset revaluations were taken at the last month
of the financial year. Since the gross value of fixed assets is recorded as the revalued
amount at the end of the year, while the depreciation expense for that year is
- 34 -
unchanged. Thus asset revaluation could possibly disrupt the relation between gross
property plant and equipment (PPE) and depreciation expenses of the period in
Modified Jones Model.
Concerning the potential problem caused by revaluation, I will do supplementary tests
to re-estimate the discretionary accruals with an alternative measure of PPE. For those
firms have revaluations of depreciable assets at the fiscal year end, I adjust the value
of PPE to the historical cost equivalents to match with the depreciation expenses. The
values of historical cost equivalents are available because CA 85 and FRS 15 require
that the historical cost equivalents (cost, cumulative provision for depreciation and
diminution in value and carrying amount) of each class of revalued assets should be
disclosed. After getting new discretionary accruals, all the multivariate regressions
examining the board and audit committee characteristics will be re-run to see if the
results are consistent.
4.4. 2 Lack of Independence
Since some firms may have two years observations in the sample, it is possible that
pooled OLS is biased because of unable to control the firm-fixed effect. I will control
this problem by re-run the regressions in sub-samples which constitute only one
observation per firm. However this method will suffer the reduction of sample size.
- 35 -
4.5 Data Sources
The empirical tests are conducted using data of U.K listed companies in fiscal year
1999 and 2002. My primary sample is the constituents of FTSE 350 index at the end
of every year. I then exclude all the financial firms (SIC codes 60-69), since it is
difficult to define accruals and discretionary accruals for financial firms. I also
exclude all regulated utilities firms (SIC codes 40-44, 46.48-49), because they have
different earnings management incentives. Accounting data will be collected from
Datastream, supplemented where necessary by annual reports. Other data including
board and audit committee characteristics, managerial ownership, block holder
ownership, and outside auditors will be hand-collected from annual reports.
- 36 -
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