Do Independent Directors Monitor Financial Reporting? Evidence from Accounting Misstatements Following Stock Exchange Listing Requirements

Abstract

A wave of accounting failures at the beginning of the century motivated the national stock exchanges to require firms to maintain a majority independent board of directors. Approximately 24% of firms were not already in compliance with the new listing requirements and so were forced to change. We investigate the causal effect of this forced increase in board independence (outside directors) on the probability of an accounting misstatement. Existing empirical studies find a negative relation between board independence and the probability of a misstatement (Beasley 1996, Dechow et al. 1996), but recent theory suggests that independent directors might be less effective monitors (Adams and Ferreira 2007, Harris and Raviv 2008). Using an instrumental variables design, we find that the forced increase in board independence increased the probability of misstatements. The findings suggest that the listing requirements had the opposite of their intended effect.

Keywords: Board Independence, Accounting Misstatement

JEL Classification: M41