Background
In December 1999, NYSE and NASDAQ instituted changes in audit committees’ requirements. The changes required firms to have audit committees, consisting of no less than three directors, independent from the management and the company.
These requirements were a response to damaging “earning management” by firms.
In her study “Audit committee, board of director characteristics, and earnings management” (2002), April Klein, a professor of accounting at New York University Stern School of Business, evaluates these changes and makes the argument that audit committee and board characteristics correlate to the earnings management by the firm.
Methodology
To prove her theory, Klein decided to examine how variations on audit committee and board independence affected the level of abnormal accruals (expenses or revenues that happened, but haven’t been recorded in the accounts), which are often in positive relation to earning management.
Throughout the paper, Klein tests the idea that an independent audit committee is the most productive at supervising a firm’s accounting process. She has also noted how existing empirical evidence suggested that board independence had a positive impact on firm performance and negative on financial fraud.
Participants
To test these ideas and how they correlate to the levels of abnormal accruals, Klein analyzed a sample of 692 publicly traded American firms-years. This batch consisted of non-US firms, banking and insurance firms, missing data on audit committees, missing compustat, and the outlier for the absolute value of abnormal accrual.
Procedure
To achieve this, she used the methods advocated by Ron Kasznik and Eli Bartov, who previously wrote on control when estimating accruals, and its importance for the earning process. She used Kasznik’s matched-portfolio technique to analyze the data and asserted that the more independent the boards and audit committees are, the smaller are the AAACs. She also determined that optimal option for firms was to maintain audit committees where 51% of directors were independent, but the higher the percent of independent directors, the smaller is the level of AAACs.
With this data at hand, and by cross-comparing it with data about the changes in accruals caused by shifts in the audit committee independence, Klein was able to confirm the negative connection between board and committee insider-outsider ratio and the changes in abnormal adjusted accruals.
Results
By establishing first the direct link between earning management and abnormal adjusted accruals, and then negative relation between AAACs and independence of boards of directors and audit committees, April Klein confirmed the NASDAQ, SEC, and NYSE assertion that decreasing the percentage of independent directors can lead to a reduction in quality of firm governing mechanisms and earning management. On the other hand, her studies showed that a solely independent board does not affect earning management that much.
Implications
There are several conclusions that can be inferred from this. The first one confirms the thesis of Klein’s study that by using outside directors and committee members a company can improve its standing. The second one implies that use of only in-house executives inherently leads to transparency issues. The final one suggests that large trade companies, for which high accruals and natural, are less likely to maintain independent boards and directors. While the results have proven to be quite robust, more research will be required before better techniques of dealing with earning management, and abnormal accruals can be developed.
Works Cited
Klein, April. “Audit Committee, Board of Director Characteristics, and Earnings Management.” Journal of Accounting and Economics 33.3 (2002): 375-400. Web.