Audit Committee, Board of Director Characteristics, and Earnings Management

Abstract

This study examines whether audit committee and board characteristics are related to earnings management by the firm. The motivation behind this study is the implicit assertion by the SEC, the NYSE and the NASDAQ that earnings management and poor corporate governance mechanisms are positively related. A non-linear negative relation is found between audit committee independence and earnings manipulation. Specifically, a significant relation is found only when the audit committee has less than a majority of independent directors. Surprisingly, and in contrast to the new regulations, no significant association is found between earnings management and the more stringent requirement of 100% audit committee independence.

Empirical evidence also is provided that other corporate governance characteristics are related to earnings management. Earnings management is positively related to whether the CEO sits on the board's compensation committee. It is negatively related to the CEO's shareholdings and to whether a large outside shareholder sits on the board's audit committee. These results suggest that boards structured to be more independent of the CEO may be more effective in monitoring the corporate financial accounting process.

Keywords: Audit committees, Earnings management, Corporate governance, Board of Directors

JEL Classification: G38, K22, M41, M43, M49