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Internal - Governance - Structures - and - Earni20161117 24677 kdtl8s With Cover Page v2
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Corporat e governance and disclosures on t he t ransit ion t o Int ernat ional Financial Report ing …
Jennifer St ewart
Audit Commit t ee Charact erist ics and Firm Performance during t he Global Financial Crisis
Keit h Duncan, Raymond McNamara
Accounting and Finance 45 (2005) 241–267
Abstract
This paper investigates the role of a firm’s internal governance structure in constrain-
ing earnings management. It is hypothesized that the practice of earnings management
is systematically related to the strength of internal corporate governance mechanisms,
including the board of directors, the audit committee, the internal audit function and
the choice of external auditor. Based on a broad cross-sectional sample of 434 listed
Australian firms, for the financial year ending in 2000, a majority of non-executive
directors on the board and on the audit committee are found to be significantly asso-
ciated with a lower likelihood of earnings management, as measured by the absolute
level of discretionary accruals. The voluntary establishment of an internal audit func-
tion and the choice of auditor are not significantly related to a reduction in the level
of discretionary accruals. Our additional analysis, using small increases in earnings
as a measure of earnings management, also found a negative association between this
measure and the existence of an audit committee.
Key words: Audit committee; Corporate governance; Earnings management; Internal
audit function
doi: 10.1111/j.1467-629x.2004.00132.x
1. Introduction
The authors acknowledge with thanks the helpful comments of two anonymous reviewers
and the Associate Editor, Professor Stephen Taylor. We also thank Christine Jubb, Ping-
Sheng Koh and participants at the 2003 Annual Conference of the Accounting and Finance
Association of Australia and New Zealand, held in Brisbane, Australia. Financial support from
the UQ Business School/KPMG Centre for Business Forensics and Queensland University of
Technology is also gratefully acknowledged.
Received 14 August 2003; accepted 29 April 2004 by Stephen Taylor (Associate Editor).
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 243
Our principal tests, using absolute discretionary accruals to measure earnings man-
agement, suggest that a lower level of earnings management is associated with the
presence of non-executive directors on the board. We also find a negative associa-
tion between earnings management and audit committees comprising a majority of
non-executives, but no relationship between earnings management and committees
comprised solely of non-executives. Our results do not support a relationship between
earnings management and the use of internal audit or the choice of a Big 5 auditor.
Additional testing, using small positive changes in earnings as an indication of earn-
ings management, suggests that audit committees are associated with this measure of
earnings management. These results have important practical implications because of
the heightened interest in corporate governance matters from governments, regulators
and standard setters.
The remainder of the paper is divided into four sections. Section 2 provides the
theoretical background for the study and develops the hypotheses. Section 3 outlines
the research method used to test the hypotheses. It also discusses the measurement
of earnings management through the estimation of discretionary accruals. Section 4
reports the present study’s results. Section 5 concludes by discussing the implications
of the research findings, highlighting potential limitations and considering future areas
for research.
The preparation and disclosure of true and fair financial information is central
to corporate governance, as it provides stakeholders with a foundation to exercise
their rights, in order to protect their interests (OECD, 1999). However, earnings
management, defined as: ‘the practice of distorting the true financial performance of
(a) company’ (SEC, 1999, p. 3), effectively weakens this monitoring mechanism as
it might conceal poor underlying performance.
The published literature has developed and empirically tested a variety of moti-
vations for earnings management to occur (Fields et al., 2001). These fall broadly
within the categories of agency costs, information asymmetries and externalities af-
fecting non-contracting parties. However, we are primarily concerned with the extent
to which certain corporate governance attributes limit the opportunity to manage
earnings, rather than specific incentives for earnings management to occur. Although
we attempt to control for two widely documented motives for earnings management;
namely, avoiding breaching debt covenants (Defond and Jiambalvo, 1991, 1994)
and avoiding political costs (Watts and Zimmerman, 1978; Jones, 1991; Jiambalvo,
1996), our approach is to examine a broad cross-section of firms rather than identify-
ing a specific subset with strong incentives to engage in earnings management. Such
subsets of firms are often context-specific (e.g. recent managerial change, hostile
takeover or new capital raising) and these contexts are likely to be endogenous to the
internal governance mechanisms we examine.
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244 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
The internal governance structure of a firm consists of the functions and processes
established to oversee and influence the actions of the firm’s management. The role
of these mechanisms in relation to financial reporting is to ensure compliance with
mandated reporting requirements and to maintain the credibility of a firm’s financial
statements (Dechow et al., 1995). The mechanisms that we examine in the present
study are the board of directors, the audit committee, the internal audit function and
the choice of external auditor.1
Fama and Jensen (1983a,b) recognize the board as the most important control
mechanism available because it forms the apex of a firm’s internal governance struc-
ture. In terms of monitoring financial discretion, an effective board of directors should
ascertain the validity of the accounting choices made by management and the financial
implications of such decisions (NYSE, 2002).
From an agency perspective, the ability of the board to act as an effective monitoring
mechanism is dependent upon its independence from management (Beasley, 1996;
Dechow et al., 1996). Board independence refers to the extent to which a board
is comprised of non-executive directors who have no relationship with the firm
beyond the role of director.2 A non-executive director is defined as a director who
is not employed in the company’s business activities and whose role is to provide
an outsider’s contribution and oversight to the board of directors (Hanrahan et al.,
2001). A non-executive director who is entirely independent from management is
expected to offer shareholders the greatest protection in monitoring management
(Baysinger and Butler, 1985). Fama and Jensen (1983a,b) posit that the superior
monitoring ability of non-executives can be attributed to the incentive to maintain
their reputations in the external labour market.
The published literature is supported by Australian and international corporate
governance guidelines, which recognize the importance of the monitoring role of
non-executive directors (AIMA, 1997, 1995; OECD, 1999; NYSE, 2002; ASX,
2003; Standards Australia International, 2003; Bosch Committee, 1995; Cadbury
Committee, 1992). These guides suggest that best practice with respect to board
1 Another mechanism is the firm’s internal control system, but companies in Australia are
not required to report on the strength of controls. We assume that external and internal au-
ditors would ensure that controls are adequate. Furthermore, earnings management by senior
management generally overrides controls that are in place.
2 According to the BRC (1999), audit committee members are independent if: (i) they, their
spouses or children do not currently work or have not worked at the organization or its affiliates
within the past 5 years; (ii) they have not received compensation from the organization or its
affiliates for work other than board service; (iii) they are not partners, shareholders or officers
of a business with which the organization has significant business.
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 245
In order to more efficiently perform their duties, boards of directors might delegate
responsibilities to board committees. In relation to monitoring the financial discretion
of management, it is the audit committee that is likely to provide shareholders with
the greatest protection in maintaining the credibility of a firm’s financial statements.
This is because of the specialized monitoring of financial reporting and audit activities
provided by the audit committee.
3 There has been a global increase in the demand for non-executives on the board because of
the requirement for audit committee members to be independent. However, it is acknowledged
that executive directors, with their in-depth knowledge of the business, also play an important
role. Hence, the key is to find the appropriate balance with regard to board composition (Klein,
2002a,b).
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246 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
4 It is recognized that other characteristics are also important indicators of an audit committee’s
effectiveness. These include the financial literacy or expertise of the committee members (Kirk
Panel, 1994; Goodwin and Yeo, 2001; Goodwin, 2003; ASX, 2003), the existence of an audit
committee charter and the number of meetings held with the external auditor (BRC, 1999).
However, as current disclosure requirements do not mandate such information, these variables
cannot be tested using publicly available information.
5 The Corporate Governance Council recommends that all members of the committee should
be non-executive directors, with a majority (including the chair) being independent. However, it
acknowledges that international practice is for all members to be independent and it encourages
companies to move towards such composition within the next 3 years (ASX, 2003).
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 247
active (Collier, 1993; Hughes, 1999) and to be of sufficient size (Cadbury Committee,
1992; CIMA, 2000). Audit committee activity has been operationalized through the
number of committee meetings held during the financial year (Chtourou et al., 2001;
Xie et al., 2001), with the expectation that the more often a committee meets, the
more likely it is to carry out its responsibilities. Studies have found that the fre-
quency of audit committee meetings is negatively associated with both earnings
management, as measured by discretionary current accruals (Xie et al., 2001), and
the likelihood of enforcement action by the SEC (McMullen and Raghundan, 1996).
With regard to size, several corporate governance reports have proposed that the
committee should consist of at least three members (BRC, 1999; NYSE, 2002; ASX,
2003).
The existence of an effective audit committee provides a firm with an added layer
of governance, which is expected to constrain earnings management behaviour. This
leads to the following hypothesis.
In addition to the audit committee, firms can voluntarily establish an internal audit
function to supplement their existing internal governance framework. If established,
this function provides firms with an assurance and consulting service, which can im-
prove the effectiveness of their risk management, control, and governance processes
(IIA, 1999). An internal audit function is also expected to facilitate the operation
and effective functioning of the audit committee, as the goals of the audit function
are closely aligned with the financial reporting oversight responsibilities of the audit
committee (Scarbrough et al., 1998; Goodwin and Yeo, 2001; Goodwin, 2003). The
formation of an internal audit function is endorsed by governance reports (NYSE,
2002) and prior literature (Collier, 1993; Goodwin and Kent, 2003) as a means of
improving internal governance processes.
Although traditionally internal audit has focused more on controls and operational
risks, there has been increasing emphasis in the professional literature on the need
to also focus on earnings management and inappropriate financial reporting (Eighme
and Cashell, 2002; Martin et al., 2002; Rezaee, 2002; Clikeman, 2003; Hala, 2003).
Sherron Watkins, former Enron vice president, believes that internal auditors should
look for warning signs such as undue pressure from senior management to meet
earnings targets and compensation arrangements that might encourage employees
to manipulate earnings in order to receive financial rewards (Hala, 2003). Clikeman
(2003) argues that internal auditors should not only be actively involved in detecting
earnings management, but that they should take a proactive approach to educating
managers and directors about the dangers of the practice. Eighme and Cashell (2002)
regard the role of internal audit in detecting earnings management as being a com-
plementary one to that of external audit. They believe that both should be actively
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3. Research design
The present study involves a cross-sectional analysis of 434 firms listed on the ASX
for the financial year ending in 2000. To test our hypotheses, we use two primary
models which regress absolute discretionary accruals on a set of governance and
control variables. The two models differ only in their measure of audit committee
independence. We also conduct additional tests, using alternative measures of both
the dependent variable and a number of independent variables.
3.1. Sample selection
Our preliminary sample of 568 firms comprised companies for which annual
reports were available either on the Connect4 database, on company websites or in
hard copy. Financial information and information pertaining to boards of directors
and audit committee characteristics were obtained from disclosures made in annual
6 For the reporting period ending in 2000, there were five main audit firms (the Big 5).
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 249
reports. However, annual report disclosure concerning the use of internal audit is
not mandatory. Therefore, this information was obtained by one of three methods.
The first method involved consulting the University of Queensland/KPMG Centre for
Business Forensics database.7 The second method involved examining annual report
disclosures.8 The final method involved directly contacting firms, which were either
not included on the database or whose annual reports made no mention of an internal
audit function.
To arrive at the final sample, exclusions were made on the basis of industry
classification and insufficient governance or financial information. For the purpose
of industry classification, the Global Industry Classification Standard (GICS) was
adopted.9 Firms were classified according to the 59 GICS industries and, consistent
with prior research, industries with less than 8 firms were eliminated. Firms in the
financial sector were also excluded because of their unique working capital structures
(Klein, 2002a) and the added layer of governance imposed through regulation (Barn-
hart et al., 1994). Those firms with missing financial or governance information were
also excluded, as were 4 firms with extreme values for discretionary accruals.10 After
these exclusions were made, the sample for the study was limited to 434 firms in 24
industries.11 Table 1 presents a breakdown of the sample according to GICS sector,
showing the broad cross-section of firms included within the sample.
The published literature has developed several tests of earnings management, in-
cluding the assessment of accounting policy changes (Healy, 1985; Sweeney, 1994),
specific accounting transactions (McNichols and Wilson, 1988), discretionary accru-
als (Jones, 1991) and small profits or small changes in earnings (Holland and Ram-
say, 2003). The present study uses discretionary accruals as the primary measure of
7 This database comprises information on 464 firms that responded to a survey sent to all firms
listed on the ASX in 2000. The survey included a question concerning the use of internal audit.
Approximately 65 per cent of the final sample was generated from this source.
8 Firms were recorded as having an internal audit function when the words ‘internal audit’ were
contained within the annual report. Approximately 20 per cent of the final sample provided
this information in their annual reports.
9 The GICS classification structure consists of 10 broad economic sectors aggregated from
23 industry groups, 59 industries and 122 sub-industries. The present study adopts the GICS
structure as it has become the new industry classification scheme of the ASX since 1 July
2002.
10 These firms had discretionary accruals divided by lagged assets of 1.5 or more and tests
revealed that they could be considered to be outliers.
11 From the original 568 firms, 48 were in industries with less than 8 firms, 58 were in the
financial sector and 24 had missing data, giving 438 firms before excluding the four outliers.
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250 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
Table 1
Analysis of sample by GICS sectors and industries
a Based
on 1218 listed entities, as of 31 March 2002.
ASX, Australian Stock Exchange; GICS, Global Industry Classification Standard.
earnings management while we also use small profits and small changes in earnings
in our additional analysis.
Earnings management research has been dominated by studies that have followed
the general discretionary accruals framework proposed by McNichols and Wilson
(1988). This framework partitions accruals into non-discretionary and discretionary
components on the assumption that a high level of discretionary accruals (DAC)
suggests that a firm is engaging in earnings management. The most frequently used
method to decompose accruals is the modified-Jones model (Dechow et al., 1995).
This model assumes that the non-discretionary component of total accruals (NDAC)
is a function of the change in revenues adjusted for the change in receivables and the
level of property, plant and equipment, which drive working capital requirements and
depreciation charges, respectively.
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where α̂j , β̂1j and β̂2j are industry-specific coefficients estimated from the following
cross-sectional regression:12
12 The adjustment for changes in receivables (i.e. modified-Jones model) is only applied to the
expectations model. To estimate the industry specific regression coefficients in equation (2),
the original Jones model is used (Dechow et al., 1995; Bartov et al., 2000).
13 All variables in the accruals expectations model (equation (2)) are scaled by lagged assets
to reduce heteroscedasticity, as it is assumed that lagged assets are positively associated with
the variance of the disturbance term (Jones, 1991).
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We control for the effect of possible confounding factors (Bartov et al., 2000)
by including in our models variables that prior studies have found to be associated
with earnings management or governance variables. To control for the existence
of concentrated shareholdings that might improve monitoring (Agrawal and Knoe-
ber, 1996; Peasnell et al., 2000), we include a variable defined as the percentage
of shares held by the largest substantial shareholder (SUBSH).15 Leverage (LEV),
14 This information is reported in the related party transactions footnote in the financial state-
ments.
15 The Corporations Act 2001 defines a substantial shareholder as one who has attained 5 per
cent or more of the total votes attached to the voting shares in the company.
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 253
measured as the ratio of total liabilities to total assets, captures the incentives to
practice earnings management when close to debt covenant violations (Beasley and
Salterio, 2001; Klein, 2002a). The absolute change in earnings has been found to be
positively associated with earnings management (Klein, 2002a) and we measure this
by the absolute change in net income between the current and prior periods scaled
by total assets (ABSCH). We include the log of total assets (SIZE) to control for
the effect of size as this has been found to be negatively associated with earnings
management and positively associated with audit committee and board independence
and the use of internal audit (Bartov et al., 2000; Klein, 2002a; Goodwin and Kent,
2003). Following Klein (2002a,b), absolute current earnings (ABSNI), measured by
the absolute value of net income before extraordinary items scaled by total assets, is
also included;16 as is the market to book ratio (MKT), measured by market capital-
ization divided by the book value of shareholders’ equity. Klein (2002b) finds this
latter variable to be related to board and audit committee independence. Finally, to
alleviate the concern that the modified Jones model provides biased estimates of dis-
cretionary accruals when firms experience extreme earnings performance (Dechow
et al., 1995), we include a control variable for extreme performance (EXTP). This
variable takes a value of 1 if the firm is within either the top or bottom 10 per cent of
the sample for performance (measured by net income divided by total assets), and 0
otherwise.
The following regression equation is adopted to test the hypotheses, with models
1 and 2 differing, as previously noted, only in their measure of audit committee
independence.
16 Klein (2002a) also tests her model using signed earnings because both Kasznik (1999) and
Kothari et al. (2001) find earnings management is related to firm performance. We repeat our
test using signed net income and obtain qualitatively similar results.
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4. Results
Table 2 provides the descriptive statistics for the variables in the model. Panel A
shows the financial variables used in the calculation of discretionary accruals, while
Panel B shows the descriptive statistics for the continuous variables in the regression
model. Panel C reports details of the dummy regression variables.
Panel A indicates that the average firm has reported total assets of $941.5m, net
income before extraordinary items of $49.8m and cash flow from operations of
$83.3m. In relation to the internal governance structures observed across the sample
firms, Panel B of the table indicates that the mean number of audit committee meetings
and the number of directors on the committee is approximately 2.5. Panel C shows
that 77 per cent of firms have a majority of non-executive directors on the board. The
same percentage of firms also maintain a division between the roles of the CEO and
chairperson. Some 83 per cent of firms report having an audit committee established,
with 64 per cent of those committees being comprised entirely of non-executive
directors and 86 per cent being comprised of a majority of non-executives. Panel C
also shows that 75 per cent of firms use a Big 5 audit firm while an internal audit
function is only present in 35 per cent of firms.
To assess the modified Jones model’s ability to discriminate between discretionary
and non-discretionary accruals, Table 3 provides a summary of the statistical prop-
erties of the model’s coefficients. The β̂1 coefficient (change in revenues) is, on
average, positive as expected, and the coefficient on β̂2 (property, plant and equip-
ment) is negative, as expected. Therefore, it appears that the model is well specified
and has produced plausible estimates for partitioning total accruals into their discre-
tionary and non-discretionary components (Bernard and Skinner, 1996). However,
the β̂1 coefficient ranges from −0.753 to 0.576, with a standard deviation of 0.255,
and a majority of the observations are negative, despite the positive mean value. The
β̂2 coefficient is similarly dispersed, ranging from −0.715 to 0.912, and a standard
deviation of 0.294.17
Table 4 reports the correlations between the variables in the regression model.18
Total assets are correlated with a number of other variables. The audit committee
variables are also highly correlated. The highest correlation for the independent
variables is between the existence of an audit committee (AC) and the size of the
audit committee (ACSIZE), with a coefficient of 0.760. Multicollinearity is, therefore,
a possible concern and this is considered under additional analysis.
17 Thelarge dispersions in the model’s coefficients highlight the imprecision of the estimates,
and as suggested by the published literature, the potential for the modified Jones model to
misclassify discretionary accruals (Bernard and Skinner, 1996).
18 SPSS calculates the exact correlation regardless of whether the variables are dummy or
continuous.
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 255
Table 2
Descriptive statistics
Total assets ($’000) 941 490 4 278 816 630 90 930 65 585 000
Net income (before 49 798 269 579 −257 600 2896 4 043 000
extraordinary items
($’000)
Cash flow from operations 83 298 455 193 −168 900 3600 6547
($’000)
Total accruals ($’000)a 0.078 1.643 −2.389 −0.029 28.476
Discretionary accrualsa −0.070 0.224 −1.031 −0.066 1.061
Board of directors
Comprised of a majority of non-executive directors (BDIND) 334 77
Independent chairperson (INDCHAIR) 334 77
Audit committee
Established (AC) 360 83
Comprised entirely of non-executives (ACIND: model 1) 230 64
Comprised of a majority of non-executives (ACIND: model 2) 310 86
Internal audit function (IAF) 152 35
Big 5 auditor 326 75
Extreme earnings performance (EXTP) 79 18
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256 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
Table 3
Descriptive statistics for estimated regression coefficients (n = 24)
T ACij t /Aij t−1 = αj [1/Aij t−1 ] + β1j [REVij t /Aij t−1 ] + β2j [PPEij t /Aij t−1 ] + εij t
a Cash-flow approach: TAC = EBXI − CFO . Where: EBXI = earnings before extraordinary items (net
t t t t
of taxes) for period t and CFO t = cash flow from operations for period t. Discretionary accruals (DAC)
are estimated by subtracting the predicted level of non-discretionary accruals (NDAC) from total accruals,
as calculated under the cash-flow approach (standardized by lagged total assets). TAC ijt = total accruals
for firm i in industry j in year t; REV ijt = change in revenue for firm i in industry j between year t − 1
and t; PPE ijt = gross property, plant and equipment for firm i in year t; A ijt −1 = total assets for firm i in
industry j at the end of the previous year; n = number of industries.
Table 5 reports the results of the two regression models. Both models are significant,
with an adjusted R2 of 0.237 and 0.239, respectively.
Recall that the ability of the board of directors to monitor the financial discretion
of management is expected to be a function of its independence, measured by board
and chairperson independence. The coefficient on the first measure (BOARDIND) is
negative and significant at p = 0.017 in model 1 and p = 0.024 in model 2. This
provides support for Hypothesis 1a that earnings management is negatively associated
with board independence. However, Hypothesis 1b is not supported as there is no
evidence of a negative relationship between an independent board chair (INDCHAIR)
and earnings management in either model. This result might be attributable to the
limited additional oversight provided by a non-executive chairperson when the board
itself is predominantly independent from management.
The second hypothesis relates to the audit committee and its role in detecting
and preventing earnings management. In model 1, we do not find any association
between the level of discretionary accruals and the existence of an audit committee
(AC), the committee’s independence (ACIND) or its effectiveness (ACMEET and
ACSIZE). Model 2, however, finds a negative association (p = 0.077) between a
reduction in earnings management and a majority of non-executives on the committee.
These results are consistent with those of Klein (2002a) who finds that a majority
of independent directors on the audit committee is related to a reduction in earnings
management, but that an entirely independent committee has no meaningful relation
with earnings management.
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Table 4
Pearson correlation matrix of independent variables (p-value, two-tailed)∗
BOARDIND 1.00
(−)
INDCHAIR 0.378 1.00
(0.000) (−)
AC 0.176 0.159 1.00
(0.000) (0.001) (−)
ACIND model 1 0.284 0.332 0.472 1.00
(0.000) (0.000) (0.000) (−)
ACIND model 2 0.342 0.350 0.685 0.688 1.00
(0.000) (0.000) (0.000) (0.000) (−)
ACMEET 0.144 0.175 0.555 0.412 0.439 1.00
(0.003) (0.000) (0.000) (0.000) (0.000) (−)
ACSIZE 0.220 0.192 0.760 0.253 0.612 0.494 1.00
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (−)
IAF 0.118 0.087 0.277 0.283 0.312 0.296 0.313 1.00
(0.014) (0.068) (0.000) (0.000) (0.000) (0.000) (.000) (−)
BIG5 0.138 0.093 0.228 0.166 0.243 0.216 0.243 0.223 1.00
(0.002) (0.052) (0.000) (0.001) (0.000) (0.000) (0.000) (0.000) (−)
SUBSH −0.083 −0.078 0.153 −0.048 0.061 0.123 0.161 0.114 0.044 1.00
(0.084) (0.104) (0.002) (0.315) (0.204) (0.011) (0.001) (0.017) (0.357) (−)
257
258
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Table 4 (cont’d)
BOARDIND INDCHAIR AC ACIND ACIND ACMEET ACSIZE IAF BIG5 SUBSH LEV ABSCH SIZE ABSNI MKT
model 1 model 2
Pearson correlations are adjusted automatically by SPSS when variables are dichotomous.
BOARDIND (board independence) = a dummy variable with a value of 1 if the board is comprised of a majority of non-executive directors, and 0 otherwise.
INDCHAIR (chairperson independence) = a dummy variable with a value of 1 if the roles of the chairperson and Chief Executive Officer are separated, and 0
otherwise. AC (audit committee) = a dummy variable with a value of 1 if the firm has an audit committee and 0 otherwise. ACIND (model 1) (audit committee
independence) = a dummy variable with a value of 1 if the audit committee is comprised solely of non-executive directors, and 0 otherwise. ACIND (model
2) (audit committee independence) = a dummy variable with a value of 1 if the audit committee is comprised of a majority of non-executive directors, and 0
otherwise. ACMEET (audit committee meetings) = the number of committee meetings held during the year. ACSIZE (audit committee size) = the number of
directors assigned to the audit committee. IAF (internal audit function) = a dummy variable with a value of 1 if the firm has an internal audit function operating
during the financial year, and 0 otherwise. BIG5 (Big 5 auditor) = a dummy variable with a value of 1 if the firm has a Big 5 audit partner, and 0 otherwise.
SUBSH (substantial shareholder) = the percentage of shares held by the largest ‘substantial shareholder’. LEV (financial leverage) = total liabilities divided
by total assets. ABSCH (absolute change in net income) = the absolute change in net income between t and t − 1 divided by total assets. SIZE (firm size) =
natural log of total assets. ABSNI (absolute net income) = the absolute net income before extraordinary items divided by total assets. MKT (market to book
ratio) = the market value of shareholders’ equity divided by the book value of equity. EXTPERF (extreme earnings performance) = a dummy variable with a
value of 1 if the firm is within the top 10 per cent or bottom 10 per cent of the sample for the performance measure (net income divided by total assets), and 0 otherwise.
R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 259
Table 5
Regression results
DAC = α + β1 BDIND + β2 INDCHAIR + β3 AC + β4 ACIND + β5 ACMEET + β6 ACSIZE + β7 IAF +
β8 BIG5 + β9 SUBSH + β10 LEV + β11 ABSCH + β12 SIZE + β13 ABSNI + β14 MKT + β15 EXTP + ε
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Several additional tests are performed to ascertain the credibility of the initial anal-
ysis. The first set of tests, comprising three iterations, repeats the regression models
with alternative definitions of board and audit committee independence. Iteration 1
uses the proportion of non-executive directors on the board as the measure of in-
dependence. The coefficient is negative and significant (p < 0.100) in both models,
supporting the relationship between board independence and earnings management.
Iteration 2 examines audit committee independence in the same manner as iteration
1, with substantively similar results to those reported. Iteration 3 attempts to refine
the measure of independence by removing those non-executive directors with related
party transactions. As a result of inadequate disclosures, our sample is reduced to 420
firms. Our results are qualitatively similar to those reported for model 1, with board
independence significant at p = 0.050. However, the measure of audit committee
independence for model 2 (a majority of independent directors on the committee) is
not significant in this iteration (p = 0.131).
We also examine the sensitivity of audit committee meetings (ACMEET) and audit
committee size (ACSIZE) to specific cut-offs. First, we substitute ACMEET with a
dummy variable taking the value of 1 if the audit committee met at least twice during
the financial year, and 0 otherwise. We then repeat the analysis with three meetings
per year as the cut-off. The coefficients are consistent with the original models. We
also apply a similar dummy variable to ACSIZE, taking a value of 1 if the audit
committee is comprised of at least three directors and 0 otherwise. However, the
results are not sensitive to this cut-off point.
Another set of tests addresses concerns relating to the high correlation coefficients
between the audit committee variables. First, we re-perform the regression analyses
19 Qualitativelysimilar results are achieved when absolute change in net income and absolute
net income are scaled by beginning total assets.
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 261
without the audit committee (AC) and audit committee meetings (ACMEET) vari-
ables. The revised models produce results qualitatively similar to the initial findings.
We also perform a factor analysis on the audit committee variables, replacing these
variables with the factor score in the regression models. The factor score is not sig-
nificant while the results for the remaining variables are substantively similar to the
primary models. These additional tests suggest that multicollinearity is not the basis
for the non-significant results reported in the primary analysis.
We also test for the possibility of interactions between audit committee indepen-
dence, audit committee size and the number of meetings by adding interaction vari-
ables to our primary models. However, none of the interaction effects are significant
and the models’ overall predictions remain substantively similar.
Table 4 shows that firm size (SIZE) is correlated with most of the other variables.
Specifically, consistent with Goodwin and Kent (2003), the correlation coefficient
between firm size and internal audit function (IAF) is 0.461 (p-value 0.000). This
correlation might confound the relationship between internal audit and earnings
management. To address this issue, and to avoid specification error by removing the
control for firm size, we re-test the regression models with only the sample firms
within the Top 500 ASX listed firms (by market capitalization). It is likely that
there is a threshold at which the perceived benefits of establishing an internal audit
function outweigh the costs of implementation. If firm size is an important factor
in determining this threshold, then the Top 500 classification might control for size,
without influencing the relationship between the internal audit function and earnings
management. The results of the regressions are consistent with the original models.
Therefore, a statistically significant relationship cannot be established between the
presence of an internal audit function and earnings management.
Final tests of robustness pertain to industry classification. To address the concern
raised in Wells (2002) that the estimation of discretionary accruals for ‘Gold’ firms
is potentially biased, because of the nature of their operations, the main regression
models are re-estimated in two ways. The first involves including a dummy variable,
taking the value of one if the firm is classified in the GICS subindustry ‘Gold’, and
zero otherwise. The second approach involves eliminating all Gold firms from the
sample. The findings from both approaches are qualitatively similar to the original
results.
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262 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
Next, we explore the possibility that firms reporting small increases in earnings or
small profits might have achieved their results by engaging in earnings management.
We plot histograms of earnings and changes in earnings, following Holland and Ram-
say (2003). Although we do not find any discontinuity with regard to small profits
or losses,20 we do find discontinuity in the distribution of small changes in earnings.
The results of a logistic regression with the dependent variable set at 1 for increases
in earnings (scaled by net assets) of less than 0.02 and 0 otherwise are reported in
Table 6. This table shows that firm size is positively associated while extreme per-
formance is negatively associated with small increases in earnings. Of interest to
the present study is the negative relation between small changes in earnings and
the existence of an audit committee. However, neither board independence nor audit
committee independence is associated with small increases in earnings. Although
these results should be interpreted with caution, they might suggest that earnings
management not captured by the discretionary accruals model is constrained by the
presence of an audit committee.
5. Conclusion
The significant negative relationship between earnings management and the pres-
ence of a board comprised of a majority of non-executive directors provides support
for Hypothesis 1a.21 The findings do not support Hypothesis 1b concerning an asso-
ciation between an independent chairperson and earnings management. With respect
to Hypothesis 2, which investigates the relation between the existence of an audit
committee and specific audit committee characteristics and earnings management,
none of the proposed variables are supported by model 1, where audit committee in-
dependence is measured as all committee members being non-executives. However,
model 2 does find support for an association between an audit committee comprising
a majority of non-executives and a reduction in earnings management.22 Our addi-
tional analysis, using small increases in earnings as a possible measure of earnings
management, finds a relation between the existence of an audit committee and the
dependent variable. Neither Hypothesis 3 relating to the internal audit function nor
Hypothesis 4 relating to the choice of a Big 5 auditor are supported in our primary
model or any of our additional testing.
The results of the present study have implications for regulators who are con-
cerned to minimize opportunities for earnings management and to improve financial
reporting quality. There are also implications for companies seeking to strengthen
20 Consequentially, logistic regressions coded 1 for firms reporting very small profits and 0
otherwise, not surprisingly fail to produce significant results at any of the accepted cut-off
points for small profits (see Holland and Ramsay, 2003).
21 Thisfinding is consistent with the results of Peasnell et al. (2000), using data from the UK
and Klein (2002a) using US data.
22 This result is also consistent with Klein (2002a).
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R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 263
Table 6
Logit regression results (dependent variable = small increases in earnings)
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264 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267
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