Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals? K.V. PEASNELL, P.F. POPE AND S. YOUNG* Abstract: This paper examines whether the incidence of earnings manage- ment by UK firms depends on board monitoring. We focus on two aspects of board monitoring: the role of outside board members and the audit commit- tee. Results indicate that the likelihood of managers making income-increasing abnormal accruals to avoid reporting losses and earnings reductions is negatively related to the proportion of outsiders on the board. We also find that the chance of abnormal accruals being large enough to turn a loss into a profit or to ensure that profit does not decline is significantly lower for firms with a high proportion of outside board members. In contrast, we find little evidence that outside directors influence income-decreasing abnormal accruals when pre-managed earnings are high. We find no evidence that the presence of an audit committee directly affects the extent of income-increasing manipulations to meet or exceed these thresholds. Neither do audit commit- tees appear to have a direct effect on the degree of downward manipulation, when pre-managed earnings exceed thresholds by a large margin. Our find- ings suggest that boards contribute towards the integrity of financial state- ments, as predicted by agency theory. Keywords: corporate governance, boards of directors, abnormal accruals, earnings management * The authors are from Lancaster University. They gratefully acknowledge the helpful comments of the anonymous referee and those of Steve Lim, Gilad Livne, Scott Richardson, Lakshmanan Shivakumar, Judy Tsui, and seminar participants at Bristol, U.C. Dublin, Dundee, Glasgow, Lancaster, London Business School, University of Science and Technology, Hong Kong, Feng Chia University, Taiwan, Stockholm, the Scottish Institute for Research in Investment and Finance, the 2000 Annual Meeting of the European Finance Association and the 2001 Annual Conference of the British Accounting Association. Financial support was provided by the Research Board of the Institute of Chartered Accountants in England and Wales, The Leverhulme Trust, and the Economic and Social Research Council (contract No. H53627500497). (Paper received June 2004, revised and accepted November 2004) Address for correspondence: Ken Peasnell, Management School, Lancaster University, Lancaster LA1 4YX, UK. e-mail: k.peasnell@lancaster.ac.uk Journal of Business Finance & Accounting, 32(7) & (8), S eptember/October 2005, 0306-686X # Blackwell Publishing Ltd. 2005, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 1311 1. INTRODUCTION Boards of directors are widely believed to play an important role in corporate governance, particularly in monitoring top management (Fama and Jensen, 1983). The governance debate emphasises the distinctive contribution that outside directors can make in helping to ensure that managers act in the interests of outside stockholders (Fama, 1980; and Fama and Jensen, 1983). Prior US research indicates that outside directors influ- ence a wide range of board decisions, including CEO removal (Weisbach, 1988), negotiation of tender offer bids (Byrd and Hickman, 1992) and resistance to greenmail payments (Kosnik, 1987). In this paper, we test whether the influence of outside directors extends to the financial reporting process. In particu- lar, we examine whether the incidence of earnings management depends on board monitoring. Studies that examine the relation between board monitoring and financial reporting have mostly focused on blatant viola- tions of Generally Accepted Accounting Principles (GAAP). For example, Beasley (1996) reports that the incidence of financial statement fraud in the US is lower for firms where the propor- tion of outside directors is relatively high. Dechow et al. (1996) report similar findings for firms subject to SEC accounting enforcement actions. These studies provide evidence of a link between gross violations of accounting standards and board structure. However, whether this link extends to more subtle accruals-based earnings management permissible within GAAP remains an unresolved issue that this paper seeks to address. Opportunities for earnings management arise because of flexibility permitted by GAAP. The purpose of this paper is to investigate whether boards actively monitor and take actions that reduce the incidence of earnings management when the incentives for manipulations are high. Our tests focus on situa- tions where performance is either poor (in which case the incentive will be to manage earnings upwards), or exceptionally good (in which case the incentive will be to manage earnings downwards). We use abnormal working capital accruals to proxy for earn- ings management. Our focus is on two dimensions of board monitoring in the UK: the proportion of outside directors and 1312 PEASNELL, POPE AND YOUNG # Blackwell Publishing Ltd 2005 the presence of an audit committee. The UK provides an inter- esting experimental setting for investigating these issues since there is greater variation in outside director representation on boards in the UK than in the US (Peasnell et al., 1999) and audit committees are not mandatory. Our results show that when pre- managed earnings are negative or below last year’s reported earnings, abnormal working capital accruals are less positive if the proportion of outsiders on the board is relatively high. Furthermore, we find that the chance of abnormal accruals being sufficiently large as to result in reported earnings exceed- ing the thresholds is significantly lower for firms with a high proportion of outside board members. Our findings are consis- tent with the prediction that outside directors contribute towards the integrity of financial statements. However, boards appear only to intervene in the case of income-increasing earn- ings management: we find little evidence that outside directors are associated with income-decreasing accruals when the incen- tives to manipulate earnings downwards might be deemed to be strong. Finally, we find that the mere presence or absence of an audit committee has no measurable impact on earnings man- agement. While audit committees are voluntary in the UK, 84% of the companies in our sample had set up such a committee, which might account for this null result. The next section reviews the literature on the monitoring role of boards of directors and develops our hypotheses. Section 3 presents the methods used to identify earnings management and explains the research design. The data and sample are described in Section 4. Section 5 presents the empirical results. Our conclusions appear in Section 6. 2. HYPOTHESIS DEVELOPMENT (i) Governance and Earnings Management Schipper (1989) defines earnings management as purposeful intervention in the external financial reporting process, with a view to obtaining private gain for shareholders or managers. Shareholders will gain when earnings management is used to signal managers’ private information (Healy and Palepu, 1995), to avoid costly debt re-contracting or to reduce political costs BOARD MONITORING AND EARNINGS MANAGEMENT 1313 # Blackwell Publishing Ltd 2005 (Watts and Zimmerman, 1986). Managers can also use earnings management to extract rents from shareholders. Such gains could take the form of increased compensation (Healy, 1985; and Holthausen et al., 1995) or reduced likelihood of dismissal when performance is low (Weisbach, 1988). We focus on the role of corporate governance in constraining earnings management. Two measures of board monitoring that have been widely used in the literature are the proportion of board members classified as outside directors (e.g., Vicknair et al., 1993) and whether the board has an audit committee (e.g., Pincus et al., 1989; C ollier, 1993; and Collier and Gregory, 1999 ). The gov ernance literature emphasises the role of outside directors in resolving agen cy problems between managers and shareholders through the creation of appropriate employment contracts and the subsequent monitoring of manage- rial behaviour. Fama (1980) and Fama and Jensen (1983) argue that outside directors have incentives to be effective monitors in order to m aintain the value of t heir reputational capital. Prior US research generally supports the predic tion that bo ard effectiveness in protectin g shareho lders’ wealth is a positive function of the proportion of outsiders o n t he board (Weisbach, 1988 ; Rosenstein and Wyatt, 1990; Byrd and Hickman, 1992; Brickley et al., 1994; and McWilliams and Sen, 1997). 1 The effectiveness of the board’s monitoring activities might also depend on how the board is structured and organized. Boards often delegate work on important tasks to standing committees reporting directly to the main board (Klein, 1998). The board committee responsible for financial reporting is the audit committee, if one exists. The audit committee has specific responsibility for the production of financial statements, and usually for communicating with the external auditor. Audit committees are not mandatory in the UK, although listed firms 1 The board’s effectiveness at monitoring the financial reporting process will depend on the ability of outside directors to understand earnings management methods. Although the level of accounting expertise, and hence monitoring effectiveness, will vary across boards, there are at least two reasons for having confidence in outside directors’ general ability in this regard. First, outside directors often have a financial background. For example, Peasnell et al. (1999) report that over a quarter of all UK board members are professionally qualified accountants. Second, outside directors frequently hold senior management positions in other large corporations. As such, they are likely to be familiar with financial reporting from a senior management perspective. 1314 PEASNELL, POPE AND YOUNG # Blackwell Publishing Ltd 2005 are encouraged to form them (Collier, 1993; and Collier and Gregory, 1999). 2 However, the creation of an audit committee does not absolve the full board from its financial reporting responsibilities. The full board will often have other reasons to consider financial reporting issues, because accounting numbers figure prominently in such matters as determining management compensation, reviews of operating results and making invest- ment decisions. The incremental monitoring contribution of an audit committee is an empirical issue on which this study aims to shed light. The preceding discussion takes the perspective that earnings management is undesirable because it is costly to shareholders. However, signalling-based motivations for earnings management need to be considered as well. Earnings management will benefit shareholders if managers use accounting discretion to signal private information about future performance. Subramanyam (1996) shows that, in the US, discretionary accruals predict future profitability and dividend changes, suggesting that man- agers do use their discretion to improve the informativeness of earnings. In such circumstances, shareholders will not expect boards to constrain earnings management. We therefore start our empirical analysis by considering whether signalling can explain discretionary accruals behaviour, before investigating the monitoring roles of the board and the audit committee. (ii) Earnings Management Relative to Thresholds Recent evidence suggests that the incidence of earnings manage- ment is particularly pronounced when earnings fall below certain thresholds. Three thresholds have been considered in the litera- ture: avoiding reporting a loss; reporting a growth in profits; and meeting the analysts’ consensus forecast. Burgstahler and Dichev (1997) and Degeorge et al. (1999) find that there is a higher-than- expected frequency of firms in the US with slightly positive 2 Collier (1993) provides evidence on the factors affecting the formation of audit committees in the UK prior to the governance recommendations set out in the Cadbury Report (1992). Since the London Stock Exchange’s decision to adopt the Cadbury recommendations on board composition and audit committee formation, the number of firms with such committees has increased dramatically. However, unlike in the US, firms still have the option not to form an audit committee. As we show later in the paper, a minority of firms exercise their option not to form an audit committee. BOARD MONITORING AND EARNINGS MANAGEMENT 1315 # Blackwell Publishing Ltd 2005 reported earnings (and earnings changes) and a lower-than- expected frequency of firms with slightly negative reported earn- ings (and earnings changes). The same pattern has been observed in the UK (Gore et al., 2002). Such discontinuities in the distribu- tions are consistent with managers trying to beat the benchmarks in question. 3 A key issue is how managers decide which bench- mark to try to beat when the benchmarks conflict. Degeorge et al. (1999) report that there appears to be a hierarchy to the bench- marks, with firms behaving as if reporting a profit is of most importance, followed by reporting growth in earnings, with meet- ing analysts’ forecasts mattering only if the other two thresholds have been met. We focus on avoiding losses and declines in profit benchmarks since as well as being more important, we are able to include in our analysis the many firms for which consensus fore- casts are not available, and thereby to achieve more powerful tests. There are a number of possible reasons for such threshold- targeting earnings management b ehaviour. One possibility is that capital market participants’ implicit contracts with manage- ment are defined in terms of these simple thresholds. For example, there is considerable anecdotal evidence of share- holders increasing their monitoring activities when a loss or a decline in earnings is reported, with significant knock-on costs for man agemen t in the f or m of reduced compensatio n and an increased probability of d ismissal. Consistent with this view, US research reveals that firms subject to shareholder activism tend to be characteri sed by poor earnings performance (Karpoff, 1998). Another r eason might be the fear that failing to meet a threshold will result in a large decline in stock price. 4 Whatever, the reason, Dechow et al. (2000) report that a ttempts by US firms to avoid reporting losses and earnings declines appear to be driven by managers’ desires to opportunisti cal ly delay reporting poor performance. Thus, if board monitoring is associated with earnings management, we expect that our 3 Other factors might play a role as well. For example, Beaver et al. (2003) show that, in the US, the asymmetric treatment of income taxes and special items for profit and loss firms can account for about two-thirds of the discontinuity in the distribution of earnings. 4 For example, Skinner and Sloan (2002) have found that growth stocks in the US tend to exhibit an asymmetrically large negative price response to negative earnings surprises. 1316 PEASNELL, POPE AND YOUNG # Blackwell Publishing Ltd 2005 ability to detect such a relation will be greatest close to threshold points. Consequently, we condition our empirical tests on the proximity of pre-managed earnings to zero earnings and zero change in earnings. We predict that board monitoring will constrain income-increasing earnings management when pre- managed earnings undershoot these thresholds. The preceding discussion focuses on the link between board monitoring and the incidence of income-increasing earnings management. Earnings management, however, is not restricted solely to income-increasing behaviour. Prior research indicates that, under certain conditions, managers engage in income- decreasing earnings management. For example, Degeorge et al. (1999) find that managers appear systematically to manipulate reported earnings downwards when pre-managed earnings exceed threshold earnings by a substantial amount. 5 Similarly, Healy (1985), Gaver et al. (1995) and Holthausen et al. (1995) report evidence of income-decreasing accounting choices by US firms when managers’ accounting-based bonuses are at their maximum. There are several plausible explanations for these income-decreasing accounting choices. One possibility is that managers prefer to shift abnormal positive earnings forward in time in order to make the thresholds easier to cross and targets easier to meet in the future. Another possibility is that managers are reluctant to report large gains because of fears that it will result in increased earnings-based performance tar- gets for them in the future. If downward manipulation imposes significant costs on external parties, boards should be as con- cerned with income-decreasing manipulations as they are with income-increasing ones. Therefore, we also test whether board monitoring is negatively associated with income-decreasing earnings management when pre-managed earnings exceed these thresholds by a large margin. 5 The big bath hypothesis predicts income-decreasing earnings management when pre- managed earnings fall well below the threshold. We have examined the issue of big bath accrual choices for our sample. Untabulated results provide no indication that our below-target firms were engaged in big bath accounting. One reason might be that the incidence of big baths is dependent on other factors, such as whether or not there has been a change in management. This is an issue that falls outside the scope of our study and is therefore an aspect of earnings management that we do not investigate any further in this paper. BOARD MONITORING AND EARNINGS MANAGEMENT 1317 # Blackwell Publishing Ltd 2005 Our empirical tests explicitly examine both upward a nd downward manipulations. However, we anticipate that boards will have asymmetric loss functions with respect to earnings management because the penalties a ssoci ated with overst ating earnings (e.g., loss of reputation) are likely to exceed the costs of unde rstat ing earnings. This lead s us to co njec tur e that the incentives for b oards to monitor income-increasing earnings management are greater than those to monitor income- decreasing earnings management. Whether this is the case remainsanempiricalissueonwhichweaimtoshedlightin this paper. (iii) The Intervening Effect of Managerial Share Ownership The need for board monitoring depends on the extent to which managers’ interests diverge from t hose of shareholders and other investors. We expect share ownership by managers to lead to a closer alignment of interests. US research has found that manage- rial own ership is a ssociated with l ower levels of earnings man age- ment (Dhaliwal et al., 1982; and Warfield et al., 1995). Also, there is evidence in both the US and the UK of a negative association between m anagerial share o wnership a nd both the proportion o f outside board members (Weisbach, 1988; and Peasnell et al., 2003) and the presence of an audit committee (Pincus et al., 1989 ; and Collier, 1993). This prior research suggests that the demand for board monitoring declines with managerial ownership and that managerial ownership interacts wi th board monitoring of earnings management. More precisely, we hypothe size that the constraining association betwee n earnings manag ement and (i) the prop ortion of outsid e directors and (ii) the existence of an audit committee will be more pronounced when th e lev el of manage rial share o wner- ship is low. 3. METHODOLOGY (i) Measuring Earnings Management Manipulation of operating accruals is likely to be a favored instrument for opportunistic earnings management because 1318 PEASNELL, POPE AND YOUNG # Blackwell Publishing Ltd 2005 they generally have no direct cash flow consequences 6 and are relatively difficult to detect. A more costly method to manipulate earnings is by changing the way the firm does business. The firm could, for example, boost reported profit by cutting back on advertising and research and development (Bushee, 1998). There are many more possibilities: selling assets it would other- wise keep (Bartov, 1993; and Poitras et al., 2002); cutting back on staff development and essential equipment maintenance; channel stuffing; the list is almost endless. All such actions are costly, in the sense that they have negative effects on the firm’s future cash flows. Such manipulations reduce the value of the firm and as such are more costly than mere accounting manip- ulations. We therefore expect that the manipulation of accruals will be the instrument chosen first, before management resorts to more costly ones involving real changes in investment and operating activities. We focus only on the accounting manipulations. We use abnormal accruals as our proxy for earnings manage- ment. 7 Several methods have been proposed in the literature for separating operating accruals into abnormal (or dis- cretionary) and normal (or non-discretionary) components. (See Dechow et al., 1995, for a review of these models.) The most frequently used methods are the Jones (1991) model and the modified-Jones model (Dechow et al. 1995). Both methods involve estimating parameters for normal accrual activity by regressing a measure of accounting accruals on proxies for normal business activity. These estimated normal accrual para- meters are then combined with event-period data to generate estimated unexpected accrual activity. We estimate abnormal accruals using the modified-Jones (m- J) model. Dechow et al. (1995) present evidence that the m-J model is more powerful at detecting sales-based manipulations 6 Accruals can have tax effects, but these are likely to be of second-order importance in the UK, given that financial reporting and tax accounting are governed by different measurement rules. 7 Accruals-based measures are theoretically appealing because they aggregate into a single measure the net effect of numerous recognition and measurement decisions, thereby capturing the portfolio nature of income determination (Watts and Zimmerman, 1990). Moreover, to the extent that boards treat earnings from operations and cash from operations as key indicators, a simple comparison of the two numbers will provide them with direct insight into the aggregate effect of operating accruals. BOARD MONITORING AND EARNINGS MANAGEMENT 1319 # Blackwell Publishing Ltd 2005 than the original Jones (1991) model. 8 We estimate the m-J model on a cross-sectional basis in order to maximize our sam- ple size and to avoid the survivorship bias problem inherent in the use of a firm-specific time-series approach (Becker et al., 1998; and DeFond and Subramanyam, 1998). In contrast to prior studies that model total operating accruals, we focus spe- cifically on the working capital component. Prior studies have generally defined total operating accruals as working capital accruals plus a key long-term accrual, depreciation. We ignore the long-term component of total accruals, for several reasons. As Beneish (1998) points out, depreciation offers limited poten- tial as a tool for systematic earnings management since changes in depreciation policy cannot be made very frequently without attracting adverse attention from the auditor or investors. However, this is not the case with some other long-term accruals, such as defined benefit pension obligations and certain environmental liabilities where the amounts are very sensitive to key assumptions. Nevertheless, we follow prior practice and exclude these non-depreciation long-term accruals from our analysis because of their very complexity. No prior study has included long-term accruals other than depreciation. Lacking a model of what drives those other long-term accruals, it is diffi- cult to distinguish between normal and abnormal long-term accruals. The power of our tests will be adversely affected by this omission. The m-J model parameters are estimated with the following cross-sectional OLS regression: WC it TA i;tÀ1 ¼ ! 0 1 TA i;tÀ1  þ ! 1 ÁREV it TA i;tÀ1  þ  i ; ð1Þ 8 A number of different models have been developed to measure abnormal accruals. An example is the margin model developed in Peasnell et al. (2000) that formally links sales, accruals related to transactions with customers and suppliers, and operating profit. Simulations by Peasnell et al. (2000) indicate that the Jones and modified-Jones models are likely to be better at detecting revenue and bad debt manipulations than the margin model, whereas the margin model is better at detecting non-bad debt expense manip- ulations. Since we have no priors as to what form earnings management might take, to aid comparability with related prior research, we have focused on the more familiar modified-Jones model. We have also replicated many of our key tests using the margin model, with essentially the same results. 1320 PEASNELL, POPE AND YOUNG # Blackwell Publishing Ltd 2005 [...]... value of one if one-period-ahead pre-managed earnings (proxied by cash flow from operations) exceeds current period reported earnings and zero otherwise b All probability values are for two-tailed tests AA is current period abnormal accruals scaled by beginning-of-period total assets, estimated using the m-J model NA is current period normal accruals scaled by beginning-of-period total assets, measured... Chairman and CEO are combined and zero otherwise AUD is an indicator variable taking the value of one if the firm has a Big 5 auditor and zero otherwise REL is an indicator variable taking the value of one if earnings before abnormal accruals, scaled by beginning-of-period total assets, are less than industry median scaled reported earnings and zero otherwise All values are measured at fiscal year-end,... difference between total working capital accruals and AA CFO is current period operating cash flow scaled by beginning-of-period total assets The control variables are as follows DUAL is an indicator of CEO power, set equal to one if the roles of chairman and chief executive are combined, and zero otherwise BRDSIZE is the number of directors and serves as a measure of board effectiveness BRDOWN is the... (i) A Signalling Explanation As explained in sub-section 2(ii), before considering whether board monitoring influences the extent of earnings management, we must first establish that such earnings management is not in shareholders’ interests If managers are using their accounting discretion to signal private information about future # Blackwell Publishing Ltd 2005 BOARD MONITORING AND EARNINGS MANAGEMENT. .. MANAGEMENT 1327 earnings performance, then it is unclear why boards should seek to prevent such behaviour We therefore present evidence on the extent to which abnormal accrual activity is attributable to signalling If a signalling rationale explains abnormal accrual activity, then we would expect to observe a positive association between current period abnormal accruals and future earnings changes... appropriate to proceed as though abnormal accruals are potentially costly to market participants (ii) Board Monitoring Equation (3) provides our basic model for capturing the impact of board monitoring on abnormal accrual activity We consider two versions of the model, M1 and M2 M1 includes only our test variables OUT and AC, together with the indicator variables BELOW and HIGH and their interactions with... of auditor quality and is set equal to one if the firm has a Big 5 auditor, and zero otherwise LEV is the ratio of total debt to total assets and is included to pick up debt contracting motivations for earnings management (DeFond and Jiambalvo, 1994) REL is the firm’s earnings relative to that of the industry and is included to control for income smoothing (DeFond and Park, 1997) LEV and REL are controls... income-decreasing manipulations In addition to examining the impact of board composition on earnings management, models M1 and M2 also throw light on # Blackwell Publishing Ltd 2005 1330 PEASNELL, POPE AND YOUNG Table 3 OLS Regressions of Abnormal Accruals on Below-threshold and High Premanaged Earnings, Allowing for the Intervening Effects of Board Monitoringa AA it ¼0 þ ... variable takes the value of one if our proxy for oneperiod-ahead pre-managed earnings is higher than reported earnings in the current period and zero otherwise:   probðPMEtþ1 > EARNt Þ log probðPMEtþ1 EARNt Þ ¼ 0 þ 1 CFOt þ 2 NA t þ 3 AA t : ð4Þ In addition to abnormal accruals, the set of explanatory variables also includes measures of current period operating cash flow and normal accruals Separate regressions... inside directors and proxies for the congruence of interests of shareholders and management We use two indicators of the monitoring activities of important shareholders: INSTOWN is the # Blackwell Publishing Ltd 2005 BOARD MONITORING AND EARNINGS MANAGEMENT 1329 proportion of share owned by institutional investors; BLOCK is set equal to one if an external shareholder owns more than 10% of the shares, and . Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals? K.V. PEASNELL, P.F. POPE AND S. YOUNG* Abstract: This paper examines whether the incidence of earnings. earn- ings and zero otherwise. b All probability values are for two-tailed tests. AA is current period abnormal accruals scaled by beginning-of-period total assets, estimated using the m-J model. NA. period normal accruals scaled by beginning-of-period total assets, meas- ured as the difference between total working capital accruals and AA. CFO is current period operating cash flow scaled by