Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals?

Abstract

This paper examines whether the incidence of earnings management in the UK depends on board monitoring. We focus on two aspects of board monitoring: the role of outside board members and the audit committee. Results indicate that the likelihood of managers making income-increasing abnormal accruals to avoid reporting both losses and earnings reductions is negatively related to the proportion of outsiders on the board. Further tests indicate that this association is confined to firms where the separation of corporate ownership and decision control is greatest. In contrast, we find little evidence that outside directors influence income-decreasing abnormal accruals when pre-managed earnings are high. While we are unable to find evidence that the existence of an audit committee directly influences the level of earnings management (either income-increasing or income-decreasing), tests indicate that the monitoring role of outside directors in relation to income-increasing earnings management is more pronounced in cases where an audit committee exists. Our findings suggest that boards contribute towards the integrity of financial statements, as predicted by agency theory.

Keywords: Corporate governance; Boards of directors; Abnormal accruals; Earnings management

JEL Classification: M41, M43, M49, G34