Explain what factors the auditors should have considered in assessing the fraud at The North Face. Did Deloitte meet its ethical and professional responsibilities when

A UDITING: A JOURNAL OF PRACTICE & THEORY Vol. 23, No. 2 September 2004 pp. 13-35

The Effect of Audit Committee Expertise, Independence, and Activity on

Aggressive Earnings Management

Jean Bedard, Sonda Marrakchi Chtourou, and Lucie Courteau

SUMMARY: This study investigates whether the expertise, independence, and activities of a firm's audit committee have an effect on the quaiity of its pubiiciy released financial information. In particular, we examine the relationship between audit committee charac- teristics and the extent of corporate earnings management as measured by the level of Income-increasing and income-decreasing abnormal accruals. Using two groups of U.S. firms, one with relatively high and one with relatively low levels of abnormal accruals in the year 1996, we find a significant association between earnings management and audit committee governance practices.

We find that aggressive earnings management is negatively associated with the financial and governance expertise of audit committee members, with indicators of independence, and with the presence of a clear mandate defining the responsibilities of the committee. The association is similar for both income-increasing and income-de- creasing earnings management, suggesting that audit committee members are con- cerned with both types of earnings management and do not exhibit an asymmetric loss function similar to that of auditors.

Keywords: audit committee; financial expertise; earnings management; abnormal accruals.

Data Availability: The data used is from public sources identified in the manuscript.

INTRODUCTION

C oncems about earnings management (e.g., Levitt 1998) and recent high-profile accounting scandals have led most of the investing community to call for more effective audit commit- tees as a mean to improve the quality of financial statements (e.g.. Blue Ribbon Committee

[BRC] 1999; Securities and Exchange Commission [SEC] 2000). In response to these calls, regula- tors have adopted regulations on the functioning of audit committees in a number of areas including the expertise of their members, their independence, and their activities. The latest example of such

Jean Bedard is Professor at Universite Laval. Sonda Marrakchi Chlourou is Assistant Professor at the Faculle des Sciences Economiques et de Gestion de Sfax, and Lucie Courteau is Associate Professor at the Free University of Bozen-Bolzano.

We thank Mark DcFond {associale editor), the two anonymous reviewers, Ann Gaeremynck, as well as the accounting workshop participants at Katholieke Unlversiteit Leuven, Universite Laval, Universite Pierre Mendes-France, Universiti Montesqieu, Universitcit Maastricht, and the participants at the Auditing .Section Midyear Meetings for their comments. We acknowledge the financial support of the Social Sciences and Humanities Research Council of Canada.

Submitted: July 2002 Accepted: November 2003

13

14 Bedard. Chtourou, and Courteau

regulation in the U.S., the Sarbanes-Oxley Act of 2002 (hereafter SOX), requires that at least one audit committee member have financial expertise, that all the members be independent from the firm's management, and that the committee oversee the accounting and financial reporting processes as well as the audit of the financial statements.

While prior research on actual fraudulent financial reporting deficiencies provides evidence that is generally consistent with the assertion that some of the practices recommended or required by regulatorsareassociated with lower likelihood of fraud (Beasley l996;AbbottetaI. 2004), there are questions as to whether they also reduce less spectacular forms of earnings management. Klein (2002) provides some evidence on this issue. In her examination of the association between audit committee independence and earnings management for a sample of S&P 500 firms, she finds a significant association between abnormal accruals and the presence of a majority of independent directors on the committee, but "no meaningful relation between abnormal accruals and having an audit committee comprised solely of independent directors" (Klein 2002, 389). Thus, evidence is needed on the possible effects on earnings management of SOX requirements (financial expertise, 100 percent of independent members, and oversight) and of other audit committee best practices.

We investigate the relation between, on the one hand, the audit committee's expertise (financial, governance, and firm-specific expertise), independence, and activities and, on the other hand, ag- gressive earnings management on a sample of 300 U.S. firms. The sample is composed of three groups, one with aggressive income-increasing earnings management, one with aggressive income- decreasing earnings management, and a third group of firms with low levels of earnings management in the year 1996. Earnings management is measured as abnormal accruals estimated with a cross- sectional version of the Jones (1991) model.

Controlling for specific motivations that firms may have to manage earnings, and for alternative control mechanisms, as well as for variables that have been found to affect the reliability of abnormal accruals measurement, we test whether recommended governance practices for audit committees are associated with a lower likelihood that the firm be in one of the groups with high levels of earnings management. A 1996 sample has the advantage of allowing us to examine firms that voluntarily adopted the best governance practices before some of them were mandated by stock exchanges in December 1999. Thus, we can test the effectiveness of these practices on a cross-section of firms during the same period and increase the power of our tests by limiting the symbolic display of conformity associated with mandatory rules (Kalbers and Fogarty 1998).

Our results suggest that an audit committee whose members have more expertise is more effective in constraining earning management. Specifically, we find that the presence of at least one member with financial expertise, which is now required by SOX, is associated with a lower likeli- hood of aggressive earnings management, and so is the level of governance expertise in the commit- tee. The association between the level of firm-specific expertise and the probability of earnings management, however, is significant only for income-decreasing accruals.

Regarding independence, our results generally support the SOX requirement that all members of the audit committee be independent. Contrary to Klein (2002) whose fmdings suggest that the critical threshold for the number of independent directors on the audit committee is 50 percent rather than 100 percent, we find no significant effect for a committee composed of 50-99 percent indepen- dent members, but a significant reduction in the likelihood of aggressive earnings management when 100 percent of the members are independent. We also find that the percentage of stock options that can be exercised in the short term by independent audit committee members is associated with a higher likelihood of aggressive earnings management. This result provides some support for the U.K. Combined Code (Financial Reporting Council [FRC] 2003) provision that the remuneration of outside directors should not include stock options.

Two aspects of the audit committee's activity, its size and the frequency of its meetings, do not seem to affect the likelihood of aggressive earnings management. For the third aspect of committee

Auditing: A Journal of Practice & Theory, September 2004

The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 15

activity, the responsibility of overseeing both the financial reporting and the audit processes, we find a significantly negative association with the likelihood of aggressive earnings management. This last result lends support to the SOX requirement that the role of the audit committee include the oversight of both fmancial reporting and the audit process.

While most studies of earnings management consider either only income-increasing accruals or the magnitude of accruals irrespective of their direction, we examine negative (income-decreasing) and positive (income-increasing) earnings management separately. We find that except for the audit committee oversight responsibilities, the effects are not statistically different between the two groups of firms. This suggests that audit committee members are concerned with both income-increasing and income-decreasing earnings management and do not exhibit an asymmetric loss function (Antle and Nalebuff 1991).

Our results are subject to the inherent limitations of our measure of earnings management. Abnormal accruals are subject to measurement errors that can lead to erroneous inference if the measurement error is correlated with the audit committee characteristics (Klein 2002; Kothari et al. forthcoming). While we control for possibly omitted variables that are found in prior literature to affect the reliability of the measure of abnormal accruals, there is always a possibility that our results are caused by measurement error.

This paper contributes to the literature on the association between audit committee characteris- tics and earnings management in three ways. First, while most studies on audit committees focus on the independence of committee members, we also examine their expertise and the extent of their oversight mandate, two aspects that are emphasized in the Sarbanes-Oxley Act of 2002. Second, we examine separately firms that, in 1996, showed evidence of income-increasing and income-decreas- ing earnings management. Firms often claim that income-decreasing abnormal accruals are indica- tive of conservative reporting behavior and Nelson et al. (2002) find that auditors are more likely to require adjustments to positive than negative accruals. Our results contradict both as we find almost no significant difference in the association of committee characteristics with the two types of earn- ings management. Third, our sample includes finns of various sizes. While Klein (2002) studies a sample of firms from the S&P 500 for 1992 and 1993 (an average of 346 firms per year), our sample includes 300 firms of different sizes for 1996. Our sample firms' median assets are $51 million whereas Klein's (2002) smallest firm has assets of $179 million. Since the audit committee require- ments apply to firms of all sizes, our sample allows us to test the effect of these requirements on smaller firms, which have also been found to be more prone to earnings management,

Overall, our results lend support to the assumptions underlying the SOX requirements that both expertise and independence are important characteristics for an audit committee to effectively moni- tor the financial reporting and audit processes. They can be used by other regulators that are contemplating similar rules. For example, in Canada the proposed rules on audit committees require that all members of the committee be independent, but does not require financial expertise (Ontario Securities Commission [OSC] 2003).

The remainder of the paper is organized as follow. The next section provides the motivation for the predicted association between audit committee characteristics and earnings management. The third section discusses sample selection and research design. Results are presented in the fourth section and conclusions in the last section.

THE ROLE OFTHE AUDIT COMMITTEE IN MITIGATING EARNINGS MANAGEMENT

Earnings Management Earnings management generally implies a "purposeful intervention in the external financial

reporting process, with the intent of obtaining some private gain" (Schipper 1989, 92). Although management may intervene in the process to signal private information and make the financial

Auditing: A Journal of Practice & Theory, September 2004

16 Bedard. Chtourou, and Courteau

reports more informative for users, we concentrate on the negative aspect of earnings management, i.e., "to mislead stakeholders (or some class of stakeholders) about the underlying economic perfor- mance of the firm" (Healy and Wahlen 1999,368).

The audit committee's primary role is to help ensure "high quality financial reporting" (PricewaterhouseCoopers 1999, 7). As indicated by the BRC (1999, 7), the audit committee is the "ultimate monitor of the [fmancial reporting] process." The committee may reduce opportunistic earnings management by "evaluating the competence and independence of the external auditors," by engaging in proactive discussions with company management and outside auditors regarding key accounting judgments, and by probing "to find out the nature and extent of issues that management and the auditors gave considerable attention to" as well as "the outcome of these discussions" (Herdman 2002).

The literature concerning audit committees suggests three main categories of factors that might affect their capacity in reducing earning management; the expertise of the members, and the indepen- dence and activity level of the committee. Therefore we test the following three hypotheses:

H I : Firms with expert audit committee members are less likely to engage in aggressive earnings management.

H2: Firms with an independent audit committee are less likely to engage in aggressive earnings management.

H3: Firms with an active audit committee are less likely to engage in aggressive earnings management.

We consider income-decreasing abnormal accruals separately because they are frequently used by managers. For example, a survey by Nelson et al. (2002) indicates that 31 percent of the earnings management attempts are income-decreasing compared to 53 percent that are income-increasing. Managers have various motivations to reduce earnings. They may want to reduce the value of the stocks prior to a management buyout (Perry and Williams 1994), to reduce the risk of adverse political consequences (Cahan 1992; Jones 1991; Key 1997), or simply to create opportunities to increase income in future periods (Levitt 1998). For example, the SEC (2003a) alleges that Xerox created "cushion" reserves that it used when necessary to pump up its earnings by nearly $500 million in order to meet earnings targets. It is also true that the accruals used in one year to increase earnings must be reversed in the following years, decreasing the earnings by the same amount.

Generally, previous research suggests that auditors try to constrain earnings management to a greater extent if it is income-increasing than if it is income-decreasing. For example. Nelson et al. (2002) find that auditors' adjustment rate for income-increasing earnings management attempts is higher than for income-decreasing attempts and Francis and Krishnan (1999) find that high income- increasing accruals are more likely to result in auditor reporting conservatism. This greater attention to income-increasing earnings management may be associated with professionally mandated skepti- cism (Braun 2001) and auditors' perception that litigation is more likely to occur when income is overstated (Myers et al. 2003). In their study of auditor tenure, however, Myers et al. (2003) find that if an auditor remains longer with a firm, then he or she is more likely to restrict management from making extreme reporting decisions, both income-increasing and income-decreasing.

As in the case of auditors, it is possible that the audit committee restrains income-increasing to a greater extent than income-decreasing earnings management because the members have an asym- metric loss fiinction: the likelihood of attracting media attention or being sued could be higher in cases of income-increasing earnings management.

H4: The effect of audit committee characteristics is larger for income-increasing than for income-decreasing earnings management.

Auditing: A Journal of Practice & Theory, September 2004

The Effect of Audit Committee Expertise, Independence, and Activity on Earnings Management 17

Audit Committee Expertise In order to fulfill their responsibilities for monitoring internal control and financial reporting,

audit committee members should possess the necessary expertise. We examine three aspects of their expertise: financial, governance, and firm-specific expertise.

First, based on the requirement by Section 407 of SOX, we investigate the effect of the presence of at least one member with financial expertise. There is some empirical evidence that this require- ment is effective for extreme events such as SEC violations and earnings restatement (e.g., McMullen and Raghunandan 1996). While there is some experimental evidence that financial expertise is associated with a higher likelihood that the committee support the auditor in an auditor-corporate management dispute (DeZoort and Salterio 2001), greater focus on concerns that are critical for the quality of financial reporting, and more structured discussion on reporting quality (McDaniels et al. 2002), to our knowledge there is no empirical evidence on the effectiveness of this requirement in preventing less spectacular cases of earnings management.

Several authors suggest that the managerial labor market for outside directorships provides an incentive to monitor effectively by rewarding effective outside directors with additional positions as directors and disciplining those who have a record of poor monitoring performance {Fama and Jensen 1983; Milgrom and Roberts 1992). For example, outside directors of firms charged with accounting and disclosure violations by the SEC are more likely than others to lose their other directorships (Gerety and Lehn 1997). Additional directorships not only signal outside directors' competence to the managerial labor market, but it also helps them to acquire governance expertise and to gain knowledge of best board practices. On the other hand, if the number of other director- ships is too large, then it may reduce the time the director can devote to the particular firm, thus decreasing the committee's governing effectiveness (Morck et al. 1988; Beasley 1996). Conse- quently, additional directorships may improve effectiveness up to a point, but beyond that point, the committee may be penalized because of the time and effort absorbed by other directorships.

The experience of independent directors on the company's board allows them to develop their monitoring competencies while providing them with some firm-specific expertise such as knowledge of the company's operations and its executive directors. Thus, as their experience increases, they become more effective at overseeing the firm's financial reporting process. On the other hand, over time the audit committee members may become more complacent, offsetting the knowledge effect. Previous research results support the knowledge effect. For example, Kosnik (1987) finds that the longer the average tenure of outside directors, the more likely the company is to resist greenmail payments and Beasley (1996) finds that the likelihood of financial reporting fraud is a decreasing function of the average tenure of outside directors.

Audit Committee Independence To fulfill its oversight role and protect the interest of shareholders, the audit committee must be

independent of the firm's management. We consider two aspects of Independence: the number of nonrelated outside members and whether these members participate in the firm's stock option plans.

Section 301 of SOX requires that all members of the audit committee be independent. Several studies find an association between the proportion of nonrelated outside directors on the audit committee and some indicators of reporting quality such as the probability of SEC enforcement action (Wright 1996) and the size of abnormal accruals (Klein 2002). Klein (2002) however, finds that it is the presence of a majority of independent directors on the committee, rather than 100 percent, that seems to have a significant effect on the level of abnormal accruals. To provide evidence on this issue, we examine the effect of both thresholds (50 percent and 100 percent) on the committee's effectiveness in monitoring the level of earnings management.

Stock option schemes may compromise committee members' independence. While executive stock options are designed to align the manager's interests with those of the shareholders, they

Auditing: A Journal of Practice & Theory. September 2004

18 Bedard, Chtourou, and Courteau

sometimes have the opposite effect. For example, Safdar (2003) finds that executives manage discretionary accruals prior to exercising substantial portions of their outstanding stock options. Even if no research has examined the effect of stock options in the specific case of outside directors, the U.K. Combined Code on Corporate Governance (FRC 2003) states that their remuneration should not include stock options. We believe that such a practice is even more important for audit committee members because it is their duty to monitor the quality of the financial reports. Hence, we expect that outside directors with options that can be exercised currently or in the short run are less effective in curtailing income-increasing earnings management, especially If the options are in-the- money or at-the-money (i.e., the current stock price is higher than or equal to the exercise price of the options). However, even if they can be exercised in the short term, Huddart and Lang (1996) show that options are not necessarily exercised soon after their vesting date. If that is the case or if the options are out-of-the-money, then it may be in the interest of committee members to allow income- decreasing accruals in order to accumulate reserves to be used in subsequent years, when an increase in eartiings would enhance the value of the options.

Audit Committee Activity

Expertise and independence will not result in effectiveness unless the committee is active. We examine three aspects of its level of activity: the duties it has to perform, the frequency of its meetings, and its size. The duties of an audit committee can be classified into three categories (Verschoor 1993; Wolnizer 1995): oversight of the financial statements, of the external audit, and of the internal control system (including internal auditing). We focus on the first two because they are the most relevant for income management. SOX (U.S. House of Representatives 2002, Section 2) states that the purpose of an audit committee is to oversee the accounting and financial reporting processes of the company as well as the audit of its financial statements. Furthermore, the BRC (1999) recommends that the responsibilities should be memorialized in a formal charter approved by the board of directors. A formal charter not only provides guidance to members as to their duties, but it is also a source of power for the audit committee. Kalbers and Fogarty (1993) find that a formal written charter establishing its responsibilities plays an important role in the power of the audit committee and that its perceived effectiveness is significantly related to this concept of power.

The second dimension of committee activity we examine is the frequency of its meetings. An audit committee eager to carry out its functions of control must maintain a constant level of activity (National Commission on Fraudulent Financial Reporting [NCFFR] 1987) and best practices sug- gest three or four meetings a year (Cadbury Committee 1992; KPMG 1999). McMullen and Raghunandan (1996) show that the audit committees of firms that are facing SEC enforcement actions or restating their quarterly reports are less likely to have frequent meetings. The committees of only 23 percent of their problem companies met more than twice a year compared to 40 percent for the other firms. Abbott et al. (2004) find similar results in a more recent sample.

As indicated by the BRC (1999, 26) "Because of the audit committee's responsibilities and the complex nature of the accounting and financial matters reviewed, the committee merits significant director resources […] in terms of the number of directors dedicated to [it]." Best practices suggest at least three members (Cadbury Committee 1992; BRC 1999), which provides the necessary strength and diversity of expertise and views to ensure appropriate monitoring. The benefit of additional members, however, must be weighed against the incremental cost of poorer communication and decision making associated with larger groups (Steiner 1972; Hackman 1990). The objective is to have a committee not so large as to become unwieldy, but large enough to ensure effective monitor- ing. In general, it is recommended to limit the size of the committee to five (Arthur Andersen 1998) or six members (National Association of Corporate Directors [NACD] 2000). While limited, the evidence suggests that size may matter. For example, Archambeault and DeZoort (2001) find a significantly negative relationship between committee size and suspicious auditor switches, but Abbott et al. (2004) find no significant association between size and earnings misstatements.

Auditing: A Journal of Practice & Theory, September 2004

The Effect of Audit Commillee Expertise, Independence, and Activity on Earnings Management 19

RESEARCH DESIGN The objective of this study is to determine whether good audit committee practices reduce the

likelihood of earnings management as measured by abnormal accruals. Our sample is drawn from the population of U.S. firms whose financial data appear on Compustat in 1996. From this population, we identify the 100 firms with the highest income-increasing abnormal accruals, the 100 firms with the highest income-decreasing abnormal accruals, and the 100 with the lowest abnormal accruals. We categorize the first two groups as using "aggressive earnings management" (AEM) and the third group as having "low earnings management" (LEM). Several studies indicate that all existing models measure abnormal accruals with error (for example, Dechow et at. 1995). By including only firms with high and low abnormal accruals in the sample, we seek to improve the power of our tests by mitigating the measurement error problem.'

Abnormal Accruals Estimation Our sample is based on the complete set of firms on Compustat with a December 31,1996 year-

end and complete accruals data for 1996. We exclude firms from the regulated {SIC 4000 to 4900), financial (SIC 6000 to 6900), and government (SIC 9900) sectors because their special accounting practices make the estimation of their abnormal accruals difficult. The abnormal component of total accruals is estimated with the modified Jones (1991) cross-sectional model (DeFond and Jiambalvo 1994; Francis et al. 1999; Becker et al. 1998). This requires the estimation of a cross-sectional regression for each industry (two-digit SIC codes), so we eliminate industries with less than ten firms. These requirements leave 3,947 observations for the calculation of abnormal accruals.

Abnormal accruals {AbnAccruals) for each firm / in industry^ are defined as the residual from the regression of total accruals (the difference between cash from operations and net income) on two factors that explain nondiscretionary accruals, the change in revenue and the level of fixed assets subject to depreciation. All variables are defiated by total opening assets to reduce heteroscedasticity.

AbnAccruals,^, ^ TAC,^JA,^,_,-{a^ (IM,^, _,) + p,^ (AV?£,y^,,_,) + 3,^ {PPE^/A,^, _,)] (1)

where: AbnAccruals = abnormal accruals for firm / from industryy in year /;

= total accruals for firm / from industryy' in year t; ^ total assets for firm i from industryy' at the end of year /-I (Compustat item 6);

^ change in net sales for firm / from industryy' between years /-I and / (Compustat item 12);

= gross property, plant, and equipment for firm / from industryy' in year / (Compustat item 8);

ct, /3, ./^j = industry-specific estimated coefficients from the following cross-sectional re- gression:

(2)

Consistent with DeFond and Park (1997) and Subramanyam (1996) we drop 438 firms with extreme earnings and cash fiows from operation (in excess of the top and bottom 2 percent of all observations) and 58 outliers.^ The sample used to estimate Equation (2) separately for each of the 39 industries that meet our requirements contains 3,451 firms. Abnormal accruals are then computed for each firm from Equation (1).

Panel A of Table 1 reports descriptive statistics for the entire sample of 3,451 firms. The average

Focusing on extremes (top and botlom deciles) may render our estimates of abnormal accruals vulnerable to the bias caused by extreme cash flows and earnings. We control for this possible bias with a regression approach, including both cash flows and earnings as control variables in the regression models, and with Kasznik's (1999) matched-portfolio approach. Firms with very large earnings or cash flows from operations have been shown to bias the estimation of discretionary accruals. For detecting outliers, we use three criteria: Cook's distance, Studentized residuals, and hat matrix An observa- tion is excluded from the sample as an outlier if it fails two out of these three tests.

Auditing: A Journal of Practice & Theory, September 2004

20 Bedard. Chtourou, and Courteau

(median) abnormal accrual is 0.000 (0.017) and 58 percent of the firms have positive abnormal accruals. The average (median) current earnings and cash fiows from operations relative to opening total assets are -0.099 (0.031) and -0.029 (0.062), respectively Compared to Klein (2002), the population we use to estimate the abnormal accruals includes smaller firms (with median asset of $82 million whereas Klein's smallest firm has assets of $179 million), with lower profitability (Klein's average [median] earnings deflated by opening assets are 0.056 [0048]) and generating lower levels of cash flows from operations for each dollar of opening assets (Klein's sample firms have average [median] ofO.II7 [0.107]).

While we take precautions (e.g., dropping outliers and firms with extreme earnings and cash fiows) to avoid known bias in the estimation of abnormal accruals, the possibility of measurement error is always an issue in studies using the modified Jones model to measure discretionary accruals in tests of earnings management. As noted by Klein (2002) any proxy for abnormal accruals yields biased metrics if the measurement error in the proxy is correlated with omitted variables. Prior studies suggest that the measurement error is correlated with current earnings, previous year's earnings, changes in earnings, current cash flows from operations, changes in cash fiows, changes in total accruals, firm size, and previous year's return on assets (Kasznik 1999; Jeter and Shivakumar 1999; Klein 2002; Kothari et al. forthcoming).

Panel B of Table I repo

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