Review of Accounting and Finance

Earnings management and board activity: an additional

evidence Ahmed Ebrahim
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Ahmed Ebrahim, (2007),"Earnings management and board activity: an additional evidence", Review
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Review of Accounting and Finance
Vol. 6 No. 1, 2007
pp. 42-58
# Emerald Group Publishing
Limited 1475-7702
DOI 10.1108/14757700710725458
The current issue and full text archive of this journal is
available at www.emeraldinsight.com/1475-7702.htm
Earnings management and board
activity: an additional evidence
Ahmed Ebrahim
School of Business, SUNY New Paltz, NY, USA
Abstract
Purpose – The purpose of this paper is to examine the relation between earnings management
behavior and the activity of both the board and audit committee.
Design/methodology/approach – Different models to isolate abnormal accruals as a proxy for
earnings management are applied to a sample of manufacturing companies.
Findings – Earnings management is negatively related to both board and audit committee
independence. Such negative relation is stronger when the audit committee is more active. However,
this result is not valid for the board activity.
Research limitations/implications – Results are limited by the accuracy of the models applied to
isolate abnormal accruals.
Practical implications – Results may have implications for corporate governance regulations such
as board composition, audit committee composition, and their activity.
Originality/value – Results of earnings management research are sensitive to the different models
suggested in literature to isolate the abnormal accruals.
Keywords Earnings, Corporate governance
Paper type Research paper
1. Introduction
The recent collapse of some large companies resulting partially from accounting
manipulation has raised serious questions about the effectiveness of different
monitoring devices presumed to protect investors’ interests and control managerial
opportunistic behavior. These monitoring devices include different corporate
governance factors such as independent directors on corporate boards, independence
of the audit committee, and other factors that may affect sharing of power inside the
board and, therefore, the quality of corporate governance structure and its
effectiveness to protect shareholders’ interests.
Because of the lack of a comprehensive corporate governance theory in current
literature, such concept is looked at as a generic concept that is clarified by its
components. In addition to the composition of the board and its committees, such
corporate governance factors may also include CEO-chairman duality (the two positions
held by the same person), CEO tenure, and board size. The institutional ownership in the
company is also thought to proxy for monitoring devices that may help align the interests
of both managers and shareholders, and is expected to reduce opportunistic behavior by
managers, in addition to the independent audit process conducted by outsider auditors.
Fama and Jensen (1983) argued that the role of the board of directors is to protect
shareholder interests by monitoring the firm’s management team. An important factor
that may affect the board’s ability to monitor the firm’s managers is its composition
and the percentage of independent directors on the board. In the agency theory
framework, outside directors have an incentive to avoid colluding with managers
because the value of independent directors’ human capital is partially determined by
the effectiveness of their monitoring performance (Fama, 1980; Fama and Jensen,
1983). If they do not adequately monitor managers, the value of their human capital
as outside directors may diminish. Therefore, outside directors are widely believed to
 protect the interests of shareholders more effectively. Fama (1980) argues that the Earnings
inclusion of outside directors as professional referees improves the likelihood the management and
board will achieve its control function, and lowers the probability of top management
colluding with other board members against the shareholders interests. board activity
On the other hand, it is argued that the monitoring role of independent directors
will be less effective when those directors are overcommitted in terms of the number
of directorships they hold in different companies because directors who hold too
many directorships may not have enough time for close monitoring attention for
43
management (Lipton and Lorsch, 1992). However, Li and Ang (2000) reported
evidence that the mere number of outside directorships does not affect the director’s
performance in monitoring management especially in situations that require the
director’s expertise.
In addition, according to the Blue Ribbon Committee Report, audit committee
serves as an ‘‘ultimate monitor’’ of the financial reporting system. The committee
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selects the outside auditor and questions management, external auditors, and internal
auditors to determine whether they are acting in the best interest of the company. One
of the primary functions of the audit committee is to safeguard the independence of
the external auditor. Given the strong economic or personal affiliation of inside
directors with the company or its management, audit committees that have a majority
of affiliated directors will be more likely to side with management in any disputes
with the auditor.
However, Menon and Williams (1994) argue that, for the audit committee to be
effective, it is not enough to be independent but it must also be active and vigilant. They
used the number of audit committee meetings as a proxy for the committee activity and
found that those audit committees that do not meet or meet less frequently are less likely
to perform their monitoring function properly. Menon and Williams (1994) reported that
as the proportion of outside directors on the board increases, firms seem more likely to
exclude officers from audit committees, and that these committees become more active.
On the other hand, the results regarding the general board activity are not equally
consistent. For example, Lipton and Lorsch (1992) argue that boards that meet frequently
are more likely to perform their duties diligently. However, Jensen (1993) pointed out that
board meetings are not necessary useful because, given their limited time, they cannot be
used for meaningful exchange of ideas among directors or with managers.
The main objective of this paper is to provide additional evidence on the effect of
activity of both the board of directors and its audit committee on earnings
management behavior as measured by abnormal accruals. The paper extends prior
literature in this area by using different discretionary accrual measures recently
suggested, using a sample including both large and small firms, testing interactions
between director independence and meeting frequency, and using additional
conditioning variables in empirical models including institutional ownership and
external audit quality.

2. Prior research and paper hypotheses

Prior accounting research has examined the relationship of different corporate governance
factors to different financial reporting issues including financial reporting misstatements,
fraud, and earnings management (Beasley, 1996; Dechow et al., 1996). Prior research
also examined the effect of audit committee independence on the outside auditor choice
(Abbott et al., 2000), and on external auditor’s effectiveness and financial reporting
quality (Ng and Tan, 2003; Carcello and Neal, 2003).
 RAF Klein (2002b) used a sample of 692 large publicly traded S&P 500 companies and
6,1 found that firms with boards and/or audit committees composed of less than a majority of
independent directors are more likely to have larger abnormal accruals. However, Klein
(2002b) did not find an evidence of a systematic relation between an all-independent audit
committee and abnormal accruals. Xie et al. (2003) used a small sample of 282 firm-year
observations and reported that earnings management is significantly negatively related to
the percentage of outside directors on board and audit committee, and board and
44 committee number of meetings. Xie et al. (2003) tested the effect of board variables and
audit committee variables in separate regressions. In addition to using much larger sample,
and different models to measure earnings management, this paper examines the board and
audit committee variables within a general framework of monitoring mechanisms that
includes corporate governance factors in addition to institutional ownership and audit
quality. This study also tests the interactions between both the board and audit committee
independence and their activity.
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Beasley et al. (2000) found that fraud companies have less frequency of audit
committee meetings. However, Uzun et al. (2004) did not find significant relation
between financial reporting fraud and the meeting frequency of board and audit
committee. Uzun et al. (2004) used 133 matched pairs of companies and found that
the number of independent directors on board and its audit committee is negatively
related to corporate fraud. They also reported insignificant relation between fraud and
institutional ownership in the firm.
Finally, Bedard et al. (2004) used a sample of companies with extreme measures
of earnings management and found significant negative relation between measures of
earnings management and the all-independent audit committees. However, they found
no significant relation between earnings management and audit committee activity as
measured by annual meetings. Bedard et al. (2004) recommended using a random
sample that includes also small companies rather than only using a sample of
companies with extreme earnings management behavior. They also recommended
testing these relations using measures of current accruals in addition to total accruals
as a proxy for earnings management.
As stated above, this paper extends prior literature by using different measures of
abnormal accruals and larger sample that includes both big and small companies,
testing the interaction between both board and audit committee independence and
their activity, and examining the effect of other corporate governance factors and
monitoring devices including the institutional ownership. This paper also measures
the audit committee independence by dummy variable for all-independent
committees. This measurement of the audit committee independence variable is more
consistent with the recent SEC and stock exchanges regulations that require listed
companies to have audit committees composed entirely of independent directors.
Based on the above arguments and different findings, this study examines the
following hypothesis regarding the association between board independence and
earnings management:
H1. Earnings management is negatively related to the percentage of independent
directors on the board. This negative relation will be higher (more significant)
for more active boards.
The study also argues that such monitoring function of audit committee regarding the
financial reporting process will be even more effective in cases of active and more
vigilant audit committees that meet more frequently. Therefore, the study expects that
 earnings management will be even less likely in these cases and tests the following Earnings
hypothesis:
management and
H2. Earnings management is negatively related to the independence of the audit board activity
committee. This negative relation will be higher (more significant) for more
active committees

3. Research design 45
Earnings management measure
The vast majority of recent earnings management literature has used abnormal accruals
(or discretionary accruals, DA) as a proxy for earnings management. Therefore, this study
uses abnormal accruals to measure earnings management and applies different models
recently suggested in the literature to isolate this part of total accruals.
Different models have been developed to isolate abnormal accruals (see Dechow
2016 (PT)

et al., 1995, for more details of these models). Based on Jones (1991) model, the
normal accruals in the event period are estimated as shown in equation (1):

NDAi ¼ ð1=Ai 1Þ þ 1ð REVi Þ þ 2ðPPEi Þ ð1Þ

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where REVi , is the change in revenues measured as revenues in year less revenues in
year 1 scaled by total assets at 1; PPEi , is the gross property plant and equipment in
year scaled by total assets at 1; Ai 1, is the total assets at 1; , 1, 2, are estimated
parameters.
In this model, the parameters , 1, and 2 are estimated by applying the following
model in equation (2) in the estimation period either as a time-series model for each
firm using at least eight firm-year observations, or a cross-section model using
observations in the same two-digit SIC code:

TAit ¼ ðAit 1Þ þ 1ð REVit Þ þ 2ðPPEitÞ þ " ð2Þ

where TA is the total accruals scaled by lagged total assets.

The Jones (1991) model assumes all revenues are non-discretionary. However,
Dechow et al. (1995) argued that earnings could be managed through the abnormal
revenues by recording these revenues at year end when cash has not yet been
received. This will affect total accruals through the increase in receivables. Therefore,
Dechow et al. (1995) suggested that when estimating the normal accruals in the event
period using Jones model, we need to deduct the change in receivables – which is
assumed to be discretionary – from the total change in revenues in the event period.
Based on this modification of the Jones model, equation (1) that estimates normal
accruals in the event period will be as follows:

NDAi ¼ ð1=Ai 1Þ þ 1ð REVi RECi Þ þ 2ðPPEi Þ ð3Þ

where RECi is the change in receivables in the event period as measured by net
receivables in year less net receivables in year 1 scaled by total assets at year
1. Dechow et al. (1995) found that this modified Jones model is relatively more
powerful in detecting the abnormal accruals than the original Jones model and other
models suggested in accounting literature. In addition, most of the previous research
on abnormal accruals used the cross-sectional version of this modified model
including Barton (2001) and Heninger (2001).
 RAF Because this study does not examine a specific event, and consistent with Kothari
6,1 (2005) and Kasznik (1999), I also deduct the receivables change from the revenues
change in estimating the coefficients. Therefore, this study estimates the abnormal
accruals based on the modified Jones model by the residuals of the following cross-
sectional regression using all COMPUSTAT companies within the same two-digit
industry SIC code to estimate the parameters:
46 TAit ¼ ðAit 1Þ þ 1ð REVit RECit Þ þ 2ðPPEitÞ þ " ð4Þ

Total accruals (TAit) are measured by the difference between income before extraordinary
items (NIit) and net cash flows from operating activities (CFOit) as follows:

TAit ¼ NIit CFOit

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The study follows the direct method and uses cash flows from operating activities to
compute total accruals to eliminate any potential measurement errors when using the
balance sheet items to compute total accruals indirectly (Collins and Hribar, 2000).
Kothari (2005) argue that the DA as estimated by both Jones and modified Jones
models illustrated above may result in severe measurement error in DA when these
models do not control for the prior performance of the company. They suggested
different techniques to control for prior performance such as adding a prior
performance measure like the return on assets of the previous year (ROA it 1) as an
additional regressor to the cross-sectional model in equation (4) above, or by using
the portfolio performance adjusted DA by adjusting the DA estimate from equation
(4) using a matching portfolio based on industry and previous performance. Under
this approach, the adjusted portfolio matched DA (DAP it) will be equal to:

DAPit ¼ DAit MedianðDAptÞ ð5Þ

where DAit is the DA for company i in year t as estimated from equation (4) above,
and DApt is the DA as estimated from equation (4) above for all firms in portfolio p
to which company i belongs.
In this study, portfolios are designed using quartiles of companies within the same two-
digit SIC codes based on the return on assets of all COMPUSTAT companies with this
SIC code in previous year (ROAt 1). In other words, I applied this portfolio adjusted
approach as follows: (a) estimate the DA for each sample firm-year observation as shown
in equation (4) above, (b) estimate the DA for all COMPUSTAT firms in this year within
the same two-digit SIC code using equation (4) above, (c) arrange all COMPUSTAT firms
in this year within the same two-digit SIC code based on ROAt 1, design quartile
portfolios, and take the median DA for each portfolio, and (d) compute the firm’s portfolio
adjusted DA as shown in equation (5) above. This approach is similar to that applied by
Ashbaugh et al. (2003) except for using quartiles instead of deciles in constructing the
portfolios to maintain enough number of observations within each portfolio.
In addition to applying the above models of estimating DA (modified Jones, adding
ROAt 1 as an additional regressor, and the portfolio adjusted approach) using total
accruals (TAit), this study also applies the same models using only the current accruals
(CAit) instead of total accruals. Becker et al. (1998) suggest that management may have
the most discretion over current accruals and, therefore, abnormal current accruals may be
a better proxy for earnings management. Thus, some recent papers (Ashbaugh et al.,
2003) focused on the abnormal current accruals by applying the above equations
 after eliminating PPEi from explanatory variables in the model, and using current Earnings
accruals as dependent variable instead of total accruals. Consistent with Ashbaugh et management and
al. (2003), this study measures current accruals by net income before extraordinary
items plus depreciation and amortization minus operating cash flows, scaled by the board activity
beginning of year total assets.
Because this study doesn’t examine any particular event and focuses on the
magnitude rather than direction of earnings management, I use the absolute value of
different measures of DA as a dependent variable. Examples of recent studies that
47
used this measure include Klein (2002b) and Chung and Kallapur (2003).
The study tests the above hypotheses by estimating the following models both with
and without the control variables:

Model 1 : jDAit j ¼ þ 1INDit þ 2AUDCOMit þ 3BDMit þ 4ADMit þ "

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Model 2 : jDAit j ¼ þ 1INDit þ 2AUDCOMit þ 3BDMit þ 4ADMit

XN
þ jCVj þ "
j¼1

Model 3 : jDAit j ¼ þ 1INDit þ 2AUDCOMit þ 3BDMit INDit

þ 4ADMit AUDCOMit þ "
Model 4 : jDAit j ¼ þ 1INDit þ 2AUDCOMit þ 3BDMit INDit þ 4ADMit
N
þ þ
AUDCOMit X
jCVj "
j¼1

where:
|DA|: the absolute value of different measures of abnormal accruals as measured
by different models illustrated above,
IND: the percent of independent directors on the board as measured by number
of independent directors divided by number of board members,
AUDCOM: a dummy variable for the audit committee independence that takes 1 if all
the audit committee members are independent and 0 otherwise,
BDM: the number of meetings of the board of directors during the year. The
regression analysis uses an indicator variable that takes 1 if the number of
meeting is equal to or above the sample median, and 0 otherwise.
ADM: the number of meetings of the audit committee during the year. The
regression analysis uses an indicator variable that takes 1 if the number of
meeting is equal to or above the sample median, and 0 otherwise.
CV: Refers to the other control variables examined in the study as explained in
results tables.

4. Sample and results

The sample used in this study includes all manufacturing firms (SIC codes from 2,000 to
3,999) as listed in COMPUSTAT files in 2002 with fiscal year ends at 31 December after
excluding the American Depository Receipts (ADR) firms. The reason of including only
the firms with December fiscal year end is to facilitate combining the data from the
different sources used. ADR firms are also excluded because of their special reporting
 RAF requirements. To increase variability in the board and audit committee independence
6,1 measures, and because data about corporate governance factors was manually
collected, the study is using a two years period of 1999 and 2000 before the new
changes in audit committees composition introduced by stock exchanges and the SEC
were effective. For any firm to be included in the sample, this firm must have the data
items required to apply different DA models illustrated above available in
COMPUSTAT files. The information about board directors and other information
48 necessary to measure the corporate governance variables are manually compiled from
the original proxy statements as filed by the firm and the same information as
included in compact disclosure database. The data about institutional ownership and
insiders’ ownership was obtained from the compact disclosure database.
Table I includes a description of the sample selection and sample composition by
each two-digit SIC code. Companies in SIC code 21 were excluded because of the
insufficient number of observations (only six observations) to run the cross-sectional
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DA models. The coefficients of the cross-sectional DA models were estimated using

all COMPUSTAT companies within the same two-digit SIC code (i.e. including other
firms whose fiscal year end is not 31 December). The number of observations used to
estimate coefficients in different cross-sectional models ranged from a minimum of
21 observations (SIC 31) to a maximum of 474 observations (SIC 36).
Table II shows descriptive statistics of study variables including the different
measures of DA for the pooled data, while Table III shows the correlation coefficients

Year Year
SIC Code title 1999 2000 Total

20 Food and kindred products 37 40 77

22 Textile mill products 13 12 25
23 Apparel and other finished products made from fabrics and
similar materials 17 17 34
24 Lumber and wood products, except furniture 15 15 30
25 Furniture and fixtures 12 12 24
26 Paper and allied products 34 31 65
27 Printing, publishing, and allied industries 35 36 71
28 Chemicals and allied products 258 273 531
29 Petroleum refining and related industries 15 15 30
30 Rubber and miscellaneous plastics products 36 37 73
31 Leather and leather products 10 11 21
32 Stone, clay, glass, and concrete products 16 17 33
33 Primary metal industries 43 44 87
34 Fabricated metal products, except machinery, and
transportation equipment 44 50 94
35 Industrial and commercial machinery and computer
equipment 149 162 311
36 Electronic and other electrical equipment and components,
except computer equipment 168 184 352
37 Transportation equipment 55 52 107
38 Measuring, analyzing, and controlling instruments;
photographic, medical and optical goods; watches and clocks 154 171 325
39 Miscellaneous manufacturing industries 35 35 70
Table I. Total 1,146 1,214 2,360
Sample distribution by
year and industrya Note: aSIC code 21 does not have enough observations to apply the DA models
 Variable Mean Median Standard deviation Earnings
management and
Signed abnormal accruals
DATP 0.0114 0.0000 0.25971
board activity
DACP 0.0096 0.0003 0.24125
DATR 0.0341 0.0169 0.27608
DACR 0.0325 0.0161 0.25803
DATMJ 0.0428 0.0442 0.27401
DACMJ 0.0352 0.0405 0.25204
49
Absolute value of abnormal accruals
ADATP 0.1195 0.0600 0.23086
ADACP 0.1056 0.0519 0.21710
ADATR 0.1343 0.0664 0.24361
ADACR 0.1262 0.0644 0.22737
ADATMJ 0.1457 0.0890 0.23594
ADACMJ 0.1292 0.0780 0.21922
Corporate governance variables
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CEOTEN 7.86 6.00 7.10

LEADER 0.70 1.00 0.46
BSIZE 7.67 7.00 2.46
IND 0.65 0.67 0.17
AUDCOM 0.74 1.00 0.44
BDM 6.66 6.00 3.17
ADM 2.98 3.00 1.84
Ownership variables
INDOWN 2.00 0.36 5.50
INSTOWN 35.76 32.08 27.92
INSDOWN 16.10 7.03 29.10
Other variable
AUD 0.86 1.00 0.34
ANLST 4.22 2.00 6.06
FSIZE 2.21 2.13 0.96
AUDTEN 0.77 1.00 0.42
MBK 6.43 2.04 32.74

Notes: DATP: the total abnormal accruals estimated using the modified Jones model minus the median total
abnormal accruals of the portfolio this company belongs to. Portfolios are designed within the same two-digit SIC
codes using quartiles based on ROAt 1; DACP: the current abnormal accruals estimated using the modified Jones
model minus the median current abnormal accruals of the portfolio this company belongs to. Portfolios are
designed within the same two-digit SIC codes using quartiles based on ROAt 1; DATR: the total abnormal
accruals estimated using the modified Jones model after adding ROAt 1 as an estimation variable; DACR: the
current abnormal accruals estimated using the modified Jones model after adding ROA t 1 as an estimation
variable; DATMJ: the total abnormal accruals estimated using the modified Jones model; DACMJ: the current
abnormal accruals estimated using the modified Jones model, All the above variables with A at the beginning
indicate the absolute value of these same measures; CEOTEN: the CEO tenure measured by the number of years
for the CEO in his/her position as CEO; LEADER: a dummy variable for the board leadership style. It takes 1 if
the CEO holds the board chairman position, and 0 otherwise; BSIZE: the board size measured by the number of
directors on the board at the end of the year; IND: the number of independent directors on the board divided by the
board size; AUDCOM: a dummy variable for the audit committee independence. It takes the value 1 if all the
members on the audit committee are independent directors, and 0 otherwise; BDM: the number of meetings of the
board of directors during the year; ADM: the number of meetings of the audit committee during the year;
INDOWN: the percent of company’s stocks owned by independent directors on the board measured as a
percentage point by the number of stocks owned by them divided by the total number of shares outstanding;
INSTOWN: the percentage of company’s stocks owned by financial institutions; AUD: dummy variable for the
external audit quality. It takes the value 1 if the company’s auditor is one of the big auditing companies, and 0
otherwise; INSDOWN: the percent of insiders ownership of the company’s stock; ANLST: the number of analysts
who follow the company measured by the numbers of EPS estimations for the next year in I/B/E/S; FSIZE: the
company size measured by the 10-base logarithm of total assets; AUDTEN: the auditor tenure measured by a
dummy variable that takes the value 1 if the client-auditor relation has started on or before year t 3 and 0 Table II.
otherwise; MBK: the market to book ratio Descriptive statistics
 RAF ADATP ADACP ADATR ADACR ADATMJ ADACMJ
6,1
CEOTEN 0.001 0.011 0.004 0.002 0.015 0.002
(0.975) (0.580) (0.834) (0.920) (0.468) (0.938)
LEADER 0.000 0.004 0.011 0.008 0.013 0.005
(1.00) (0.862) (0.577) (0.684) (0.536) (0.812)
BSIZE 0.152* 0.147* 0.159* 0.152* 0.125* 0.127*
50 (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
IND 0.112* 0.111* 0.109* 0.099* 0.096* 0.093*
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
AUDCOM 0.060* 0.072* 0.060* 0.058* 0.046** 0.051**
(0.003) (0.000) (0.004) (0.005) (0.026) (0.013)
BDM 0.017 0.026 0.010 0.023 0.005 0.016
(0.399) (0.208) (0.614) (0.267) (0.790) (0.448)
ADM 0.060* 0.066* 0.078* 0.080* 0.038*** 0.045**
(0.004) (0.001) (0.000) (0.000) (0.062) (0.030)
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INDOWN 0.003 0.001 0.002 0.001 0.007 0.001

(0.876) (0.951) (0.929) (0.953) (0.733) (0.964)
INSTOWN 0.141* 0.142* 0.154* 0.145* 0.110* 0.106*
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
AUD 0.077* 0.078* 0.083* 0.072* 0.059* 0.055*
(0.000) (0.000) (0.000) (0.001) (0.004) (0.007)
INSDOWN 0.029 0.025 0.028 0.020 0.025 0.022
(0.162) (0.220) (0.170) (0.331) (0.223) (0.293)
FSIZE 0.197* 0.205* 0.227* 0.221* 0.154* 0.160*
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
AUDTEN 0.014 0.024 0.012 0.017 0.020 0.030
(0.497) (0.246) (0.561) (0.417) (0.331) (0.140)
MBK 0.033 0.042** 0.075* 0.079* 0.028 0.034***
Table III. (0.104) (0.043) (0.000) (0.000) (0.172) (0.097)
Correlation of the
absolute value of Notes: Pearson correlation coefficients between different measures of the absolute value of abnormal
abnormal accruals accruals and the explanatory variables; *significant at less than 1% level; **significant at less than
measures with 5% level; ***significant at less than 10% level; variable definitions are as mentioned in Table II
explanatory variables

between the absolute value of different measures of abnormal accruals and both the
explanatory variables and control variables of the study. Table II shows that about 70
per cent; of the sample’s firm year observations have CEO duality, and that on
average 65 per cent of the board directors are independent. In 74 per cent of the firm-
year observations, the audit committee was composed entirely of independent
directors. The table also shows an average board size of 7.67 members and an average
CEO tenure of 7.86 year[1]. Consistent with the results of previous papers and the
general notion that big auditing firms dominate the audit market, about 86 per cent of
the sample firm-year observations have a big auditing company serving as an auditor.
Table III shows that the absolute value of all measures of DA has a negative and
significant correlation coefficient with board independence, audit committee
independence, institutional ownership, and audit quality. All the DA measures are
significantly negatively related to the audit committee activity indicator. However, the
board activity indicator has an insignificant correlation with all DA measures.
Table IV shows the results of independent sample t-tests of equality of means of
samples of the same measures of abnormal accruals based on both the board
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ADATP ADATR ADATMJ

Variable Mean SD t-value Mean SD t-value Mean SD t-value

Total ADA
IND >= 0.67 0.0943 0.16721 5.009* 0.1066 0.18505 5.212* 0.1232 0.17480 4.372*
<0.67 0.1417 0.27325 0.1587 0.28337 0.1656 0.27758
AUDCOM 1 0.1112 0.24100 2.930* 0.1256 0.24917 2.922* 0.1393 0.24799 2.235**
0 0.1429 0.19747 0.1590 0.22541 0.1640 0.19665
BDM >= 6 0.1177 0.25361 0.453 0.1310 0.25992 0.783 0.1447 0.25590 0.239
<6 0.1220 0.19468 0.1389 0.21878 0.1471 0.20485
ADM >=3 0.1106 0.25581 2.070** 0.1192 0.25757 3.341* 0.1418 0.26166 0.892
<3 0.1304 0.19549 0.1528 0.22402 0.1505 0.19988
Current ADA
ADACP ADACR ADACMJ
IND >= 0.67 0.0828 0.15663 4.827* 0.1024 0.17492 4.800* 0.1089 0.16276 4.238*
<0.67 0.1258 0.25742 0.1473 0.26350 0.1471 0.25780
AUDCOM 1 0.0964 0.22530 3.493* 0.1184 0.23336 2.823* 0.1226 0.22897 2.486**
0 0.1319 0.18952 0.1485 0.20791 0.1481 0.18757
BDM >= 6 0.1073 0.24551 0.449 0.1259 0.25037 0.087 0.1306 0.24650 0.360
<6 0.1032 0.16957 0.1267 0.19066 0.1273 0.17407
ADM >= 3 0.0960 0.24418 2.380** 0.1122 0.24382 3.327* 0.1242 0.24830 1.225
<3 0.1174 0.17770 0.1435 0.20415 0.1353 0.17701

Notes: *Significant at less than 1 per cent level; **significant at less than 5 per cent level; ***significant at less than 10 per cent level; variable definitions are
as mentioned in Table II
of abnormal accruals
of the absolute value
differences in means
t-test results for

anagementEarnings
activityboardandm
Table IV.

51
 RAF independence, audit committee independence, and their activity variables. These samples
6,1 were designed using the two categories in case of dummy explanatory variables, or the
median in case of other scale variables. The results presented in Table IV support our
expectations in hypotheses H1, H2 regarding the effect of both board independence and
audit committee independence on earnings management measures. The results show that
the means of the absolute value of all measures of DA are significantly lower in sub-
samples of firm-year observations with percentage of independent board directors above
52 the median and with all independent audit committees. The results in Table IV also show
that the means of DA measures are significantly lower for firm-year observations with
audit committees that meet frequently during the year (at least three times). However, the
table shows insignificant differences in DA means of sub samples based on the whole
board activity.
The multivariate regression analysis in Table V has excluded the firm size variable
because it introduces a high level of multicollinearity into the analysis that makes the
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tests’ coefficients and their statistical power unreliable. The firm size variable is
significantly correlated with other explanatory variables at less than 1 per cent
significance level and, by including it in the regression analysis, it seriously increases
its variance inflation factor. To avoid the effect of outlier observations in the
dependent variable, all the multivariate regression analysis in this study is conducted
after excluding observations for which the signed measure of abnormal accruals used
in the analysis as dependent variable is beyond three standard deviations around the
mean of that signed measure.
The results in Table V show that the percent of independent director on the board
(IND) is negatively related to all DA measures and is significant in most of these
measures. The AUDCOM variable is negatively related to most of the DA measures
although it is significant only in model 1 using ADACP as a dependent variable.
Consistent with our expectation in H2, the coefficients of the ADM indicator variable
and its interaction with the AUDCOM variable before including other control
variables (models 1 and 3) are negative and significant in all the models except those
that use the modified Jones model measures of DA as a dependent variable. This
result indicates that the monitoring function of the independent audit committee is
even more effective when this committee is more active. However, this significant
negative relation disappears once we include other control variables in the analysis.
One explanation of this result is that the independence of the audit committee is
actually derived by the board size. Table V shows a consistent significant negative
relation between the board size (BSIZE) and all measures of DA. One explanation of
this result is that large boards increase the expertise diversity in the board including
financial reporting expertise. Large boards also increase the representation of
independent directors and, therefore, the probability of having the audit committee
composed of totally independent directors. Both Beasley and Salterio (2001) and
Klein (2002a) argued that limited board size will also limit the number of independent
directors available to serve on the audit committee, and reported evidence that audit
committee independence increases with the board size.
Inconsistent with our expectations in H2, the coefficients of both the BDM indicator
variable and its interaction with IND variable are positive and significant in most of the
models especially after including other control variables. One explanation of this result is
that the number of board meetings is an indication of the board’s reaction to urgent
business or performance circumstances rather than an indication of the board’s activity in
terms of conducting its monitoring function of the financial reporting process of the
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ADATP ADATR ADATMJ

Variable Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4

Total ADA
Constant 0.182* 0.226* 0.175* 0.232* 0.211* 0.256* 0.199* 0.260* 0.197* 0.228* 0.194* 0.236*
(16.837) (15.034) (16.119) (15.126) (15.619) (13.623) (14.627) (13.593) (16.387) (13.494) (16.076) (13.685)
IND 0.131* 0.057** 0.130* 0.068** 0.109* 0.033 0.107* 0.041 0.113* 0.060** 0.113* 0.068**
( 5.395) ( 2.236) ( 5.103) ( 2.557) ( 4.497) ( 1.306) ( 4.195) ( 1.529) ( 4.629) ( 2.313) ( 4.377) ( 2.532)
AUDCOM 0.020 0.002 0.005 0.006 0.021 0.002 0.008 0.002 0.003 0.010 0.002 0.007
( 0.839) ( 0.075) (0.194) ( 0.219) ( 0.881) ( 0.088) (0.299) ( 0.068) ( 0.142) (0.405) (0.067) ( 0.252)
BDM 0.006 0.032 0.011 0.024 0.009 0.021
( 0.281) (1.501) ( 0.537) (1.116) ( 0.416) (0.950)
ADM 0.046** 0.022 0.073* 0.006 0.008 0.042***
( 2.156) (0.998) ( 3.399) ( 0.278) ( 0.381) (1.866)
IND BDM 0.000 0.043*** 0.015 0.025 0.003 0.030
(0.003) (1.862) ( 0.670) (1.102) (0.111) (1.294)
AUDCOM ADM 0.003** 0.008 0.070* 0.001 0.012 0.039
( 2.427) (0.330) ( 2.816) ( 0.045) ( 0.493) (1.496)
TENURE 0.017 0.017 0.006 0.006 0.008 0.009
( 0.791) ( 0.785) ( 0.260) ( 0.269) (0.380) (0.397)
LEADER 0.004 0.004 0.022 0.022 0.009 0.009
( 0.164) ( 0.193) ( 1.002) ( 1.011) (0.412) (0.394)
BSIZE 0.135* 0.134* 0.116* 0.118* 0.098* 0.097*
( 5.829) ( 5.783) ( 5.038) ( 5.093) ( 4.165) ( 4.147)
INDOWN 0.019 0.019 0.021 0.021 0.016 0.016
( 0.911) ( 0.901) ( 1.033) ( 1.010) ( 0.771) ( 0.768)
INST 0.137* 0.135* 0.142* 0.143* 0.100* 0.099*
( 5.494) ( 5.425) ( 5.678) ( 5.732) ( 3.925) ( 3.885)
INSD 0.026 0.026 0.027 0.027 0.018 0.017
( 1.219) ( 1.199) ( 1.283) ( 1.292) ( 0.818) ( 0.798)
AUD 0.048** 0.046** 0.048** 0.048** 0.029 0.026
( 2.150) ( 2.052) ( 2.154) ( 2.153) ( 1.257) ( 1.145)
AUDTENURE 0.001 0.001 0.007 0.007 0.018 0.018
(0.056) (0.036) (0.345) (0.337) ( 0.838) ( 0.854)
MBK 0.051** 0.051** 0.103* 0.103* 0.042** 0.042**
(2.560) (2.533) (5.125) (5.136) (2.054) (2.038)
(Continued)

Regression analysis
TableV.
 activityboardandm
anagementEarnings
53
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Table V.

4
5
F
A
R
1
,
6
ADATP ADATR ADATMJ
Variable Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4 Model 1 Model 2 Model 3 Model 4

Current ADA
Constant 0.158* 0.204* 0.155* 0.212* 0.185* 0.228* 0.176* 0.233* 0.170* 0.209*** 0.168* 0.217*
(17.480) (16.248) (16.988) (16.619) (15.744) (13.994) (14.859) (14.070) (17.332) (15.254) (17.070) (15.513)
IND 0.127* 0.050** 0.138* 0.072* 0.096* 0.020 0.101* 0.033 0.110* 0.051** 0.115* 0.065**
( 5.273) ( 1.968) ( 5.436) ( 2.733) ( 3.972) ( 0.800) ( 3.935) ( 1.254) ( 4.517) ( 1.972) ( 4.493) ( 2.414)
AUDCOM 0.049** 0.029 0.015 0.027 0.027 0.008 0.008 0.003 0.018 0.005 0.004 0.013
( 2.105) ( 1.278) ( 0.567) ( 1.062) ( 1.141) ( 0.358) (0.296) ( 0.112) ( 0.775) ( 0.198) ( 0.145) ( 0.525)
BDM 0.033 0.073* 0.009 0.043** 0.014 0.043**
(1.553) (3.457) (0.419) (2.020) (0.681) (2.001)
ADM 0.076* 0.001 0.089*** 0.020 0.032 0.024
( 3.535) (0.055) ( 4.130) ( 0.920) ( 1.465) (1.068)
IND BDM 0.039*** 0.084* 0.006 0.046** 0.019 0.052**
(1.693) (3.714) (0.247) (2.010) (0.803) (2.233)
AUDCOM ADM 0.086* 0.008 0.085* 0.014 0.036 0.020
( 3.470) ( 0.327) ( 3.426) ( 0.551) ( 1.442) (0.797)
TENURE 0.041*** 0.041*** 0.011 0.012 0.016 0.016
( 1.889) ( 1.907) ( 0.515) ( 0.532) ( 0.715) ( 0.717)
LEADER 0.011 0.010 0.022 0.022 0.001 0.000
(0.509) (0.462) ( 0.984) ( 1.002) (0.030) (0.002)
BSIZE 0.136* 0.136* 0.122* 0.124* 0.118* 0.118*
( 5.941) ( 5.972) ( 5.303) ( 5.403) ( 5.040) ( 5.050)
INDOWN 0.014 0.013 0.017 0.017 0.002 0.002
( 0.691) ( 0.641) ( 0.845) ( 0.803) ( 0.113) ( 0.089)
INST 0.162* 0.161* 0.148* 0.150* 0.100* 0.099*
( 6.565) ( 6.544) ( 5.955) ( 6.042) ( 3.943) ( 3.916)
INSD 0.037*** 0.037*** 0.039*** 0.040*** 0.025 0.024
( 1.753) ( 1.750) ( 1.851) ( 1.868) ( 1.148) ( 1.138)
AUD 0.054** 0.051** 0.035 0.035 0.026 0.024
( 2.419) ( 2.315) ( 1.585) ( 1.590) ( 1.158) ( 1.049)
AUDTENURE 0.021 0.022 0.007 0.007 0.044** 0.044**
( 1.027) ( 1.062) ( 0.318) ( 0.330) ( 2.106) ( 2.130)
MBK 0.072* 0.072* 0.118* 0.118* 0.058* 0.058*
(3.630) (3.620) (5.879) (5.896) (2.862) (2.853)
Notes: *Significant at less than 1 per cent level; **significant at less than 5 per cent level; ***significant at less than 10 per cent level; variable definitions are as mentioned in
Table II
 firm. As suggested by Vafeas (1999), one way boards react to poor performance and/or Earnings
challenging business circumstances is by increasing the frequency of board meetings.
management and
Table V shows a consistent and significant negative relation between all DA measures
and the institutional holdings (INSTOWN) in the firm. Prior research indicated that board activity
institutional investors focus more on the long term value of the stocks they hold in their
portfolios rather than the short term performance (Bushee, 1998; Baysinger et al., 1991).
Research also indicated that institutional investors are more motivated to acquire financial
information and they have more capacities to analyze such information. Financial
55
institutions are also considered to be more sophisticated investors and have better access
to financial information about the companies in their portfolios than individual investors
(El-Gazzar, 1998; Bartov et al., 2000). Therefore, the institutional ownership in the firm
is considered to be an additional monitoring mechanism of its financial reporting process.
This result is also consistent with the results of both Richardson (2000), who reported a
positive relation between earnings management and information asymmetry, and Utama
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and Cready (1997), who found that information asymmetry decreases with higher levels of
institutional ownership. The regression analysis in Table V also shows a negative
coefficient for the audit quality (AUD) variable, which is significant in most of the
models. This result indicates that earnings management is less likely in companies audited
by a big auditing firm and is consistent with the argument that big auditing firms are
expected to be more independent and provide a higher-quality audit process (DeAngelo,
1981). This result is also consistent with prior research that found evidence that clients of
big auditing firms have lower amounts of estimated DA. (Becker et al., 1998; Francis et
al., 1999)
Consistent with Myers et al. (2003), the results in Table V show some evidence
that long auditor’s tenure is related to relatively lower levels of DA especially in the
models using current accruals as a dependent variable although the results are not
significant for all the cases. Table V also shows a negative coefficient for the insider
ownership variable (INSDOWN), which is significant only in some current DA
measures. This result is consistent with Warfield et al. (1995) who reported the same
negative relation using different models to isolate abnormal accruals.
The multivariate regression in Table V also shows a negative relation between the
CEO tenure variable (CEOTEN) and different measures of DA, and that this negative
coefficient is significant only in the models using ADACP as a dependent variable.
This result is consistent with one argument about the CEO tenure effect that long
CEO tenure may indicate lower levels of agency problems (Hermalin and Weisback,
1991) and, therefore, fewer incentives for managers to manipulate reported numbers.
The results in Table V show no evidence of a systematic or significant relation
between measures of DA and stock ownership of independent directors on the board
(INDOWN), or CEO duality (LEADER) variables. This result is consistent with
Beasley (1996) who reported no significant relation between the likelihood of
financial statements fraud and CEO duality.

5. Summary and conclusion

This study used a sample of manufacturing firms in the years 1999 and 2000 to test
the effect of the interaction between board and audit committee independence and
their activity on earnings management behavior. The paper hypothesized that both
independent boards and audit committees will be more effective in monitoring the
financial reporting process of the firm when they are more active and meet more
frequently during the year and, therefore, the paper expected the negative relation
 RAF between earnings management and both board and audit committee independence to
6,1 be mediated by their activity. The paper examined this relation within a general
framework that also includes other corporate governance factors suggested in
previous literature to affect the monitoring role of the board and the audit committee
such as stock ownership of independent directors on the board, CEO tenure, CEO
duality, and board size. The study also examines the effect of the institutional
ownership in the firm, and the quality of external auditing.
56 The study applies different models suggested in accounting literature to isolate the
abnormal accruals as a proxy for earnings management. These models include those
suggested to control for previous performance of the firm such as the portfolio-adjusted
techniques, in addition to the traditional modified Jones model. These models were
applied for both total and current accruals. The results indicate that the absolute value of
abnormal accruals is negatively related to the per cent of independent directors on the
board and the audit committee independence. The results also support the expectation that
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abnormal accruals are even much lower when independent audit committees are more
active. Although the results show significant negative relation between abnormal accruals
and board independence, they do not show any evidence that this relation is mediated by
the board activity. The results show consistent and significant negative relation between
measures of earnings management and both institutional ownership in the firm and quality
of its outside audit. However, The results do not show evidence of any systematic relation
between the earnings management proxy and CEO duality, or stock ownership of
independent directors in the board.
The value of this paper’s results is limited to the accuracy of the models applied to
isolate abnormal accruals. Although the study applies different techniques suggested
in the literature to improve the measurement of abnormal accruals, the accuracy of the
results will depend on how these models successfully estimate abnormal accruals
without error. The classification of independent directors in this study depends
basically on the information about those directors and their transactions with and
relationships to the firm and its officers as disclosed in the proxy statements submitted
to the SEC. Therefore, the results of the study will be limited by the omission of any
significant information about firm’s directors in its proxy statements. The
generalization of the results is limited by the two years used in the study.
Further research can replicate this study after the new corporate governance
requirements under the Sarbanes-Oxley act come into effect and examine any change
in results. In addition, future research can investigate the effect of these different
monitoring devices on managing earnings using some specific accounting items in a
particular industry. For example, research can investigate the potential effect of these
variables on managing earnings using the provision of bad debts in the banking
industry. Further research can also try to develop a more robust theory of corporate
governance that explains the composition of the board and its committees and serves
as guidance for empirical research.

Note
1. In all the following regression analysis, the variable CEOTEN was truncated at 20 years
to avoid any effect of outlier observations.

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Corresponding author
Ahmed Ebrahim can be contacted at: ebrahima@newpaltz.edu

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