Do Directors Serving on Multiple Audit Committees Independently Monitor or Help Promote Earnings-Management by Firms? Identifying Vigilant vs. Compliant Directors

Abstract

Most research in accounting and finance assumes that outside directors who obtain multiple board memberships do so by cultivating reputations as vigilant directors who are capable and committed to monitoring management. We investigate an alternative perspective that there exists an active labor market for compliant directors who are not capable of and/or not committed to monitoring management. We divide outside directors who serve on audit committees into vigilant versus compliant directors based on whether their contracts with external auditors provide stronger versus weaker incentives to monitor managements’ financial reporting. We predict and find that each additional audit committee membership is associated with higher levels of income-increasing earnings management, but only for compliant directors. Also, as predicted, CFOs’ equity incentives to manage earnings amplifies the positive association between additional audit committee memberships and higher levels of earnings management, again only for compliant directors. These findings highlight the importance of questioning the vigilance of outside directors and of controlling for their incentives when conducting future governance research.

Keywords: Corporate governance, Outside directors, Multiple directorships, Earnings quality, Restatements, Director independence