Outside Directors, Board Effectiveness, and Abnormal Accruals

Abstract

Corporate law holds boards of directors responsible for the financial reporting process. This raises the possibility that boards will constrain earnings management activity. This paper tests for evidence of an empirical association between board effectiveness and earnings management, as proxied by abnormal working capital accruals. We measure board effectiveness in two ways: the fraction of outside board members and the presence of an audit committee. Results indicate that when the fraction of outside board members is high, managers are less likely to make income-increasing abnormal accruals to avoid reporting earnings losses or earnings reductions. Further tests indicate that the constraining effect of outside directors is restricted to firms where the separation of ownership and control is acute. These findings are robust to the specific procedure used to estimate abnormal accruals, and persist even after controlling for the monitoring effect of alternative governance mechanisms. Our evidence is consistent with the proposition that outside directors help to ensure the integrity of financial statements by reducing earnings management activity. Conversely, we find no systematic association between abnormal accruals and the presence of an audit committee. Our results suggest that board independence, rather than the mere presence of an audit committee, is the key factor in constraining earnings management activity.

JEL Classification: M41, M43, G32, G34