Board Independence and Real Earnings Management: The Case of R&D Expenditure

Abstract

This paper analyses the role of boards of directors in constraining research and development (R&D) spending manipulation. Extant research on earnings management indicates that independent directors reduce accounting accruals manipulation. However, there is limited evidence on their effectiveness in limiting potentially value reducing R&D cuts motivated by short-term earnings pressures. Using a large sample of UK firms, I study whether independent boards are efficient at detecting and constraining this type of real earnings management. The results indicate that independent directors have sufficient technical knowledge to identify opportunistic reductions in R&D, and efficiently constrain opportunistic R&D spending. This evidence supports the emphasis recent policy statements have put on increasing the number of independent directors on corporate boards.

Keywords: real earnings management, board independence, R&D expenditure

JEL Classification: M41, G38