Audit Committee Characteristics and Audit Quality

Transcription

1 Audit Committee Characteristics and Audit Quality Master Thesis Name: Roos Hageman Student nr.: Date: MSc Accountancy & Control, variant Accountancy Amsterdam Business School Faculty of Economics and Business, University of Amsterdam Supervisor: Dr. J.J.F. van Raak

2 Abstract After the big accounting scandals the Sarbanes-Oxley act (SOX) was introduced by the Securities and Exchange commission (SEC) in This American law intensified the role of audit committees. SOX developed strict rules about the composition and other requirements for members of an audit committee. At the same time the members were given more responsibilities and authority. These strict rules and the increased role of audit committees must lead to more effectiveness. The assumption is that if an audit committee is effective the audit quality will be high. This study explores whether the independence, financial expertise, size and activity of a firm s audit committee have influence on audit quality. In particular, this master thesis examines the relation between audit committee characteristics and the level of earnings management or the likelihood that an auditor will issue a going-concern report. An additional test has been done to investigate whether the audit committee activity is a result of proactive or reactive behavior. Using 2 samples of US firms, the 200 largest firms to test for earnings management and 200 most financial distressed firms to test the likelihood of receiving a going-concern opinion. The findings of this master thesis show no significant relations, therefore there is no evidence supporting the hypotheses. My hypotheses suggested that a large and active audit committee which consists of independent members and a financial expert will lead to higher audit quality. Higher audit quality is expressed by a lower level of earnings management and a higher likelihood that an auditor will issue a going-concern opinion. However, there cannot be concluded that there is an association between audit committee characteristics and audit quality. 2

3 Table of contents 1. Introduction p Background p Summary of results p Contribution p Structure p Literature review and hypotheses development p Audit committee p Definition p Theoretical foundation p Role and responsibilities p Audit quality p Definition p Earnings management as measure for audit quality p The likelihood that the auditor will issue a going- p. 10 concern report as measure for audit quality 2.3 Audit committee characteristics p Audit committee independence p Financial expert p Audit committee size p Audit committee activity p Research Design p Research method p Estimating discretionary accruals p Regression models p Control variables p Sample and data collection p Results and Analysis p Descriptive statistics p T-test mean difference p Correlation matrix p Relation between earnings management and audit committee p. 31 characteristics 4.5 Relation between the likelihood of receiving a going-concern p. 33 report and audit committee characteristics 4.6 Additional test audit committee activity p Conclusion and Limitations p Conclusion p Limitations and Future Research p Reference list p. 41 3

4 1. Introduction After the big accounting scandals the Sarbanes-Oxley act (SOX) was introduced by the Securities and Exchange commission (SEC) in This American law intensified the role of audit committees. According to SOX an audit committee is established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer, and audits of the financial statements of the issuer (SOX, section 2, definitions, number 3a) was the first year when audit committees were recommended by the New York Stock Exchange (NYSE). The recommendation by the SEC for public companies to establish audit committees followed in The responsibilities and authority of audit committees increased and intensified with two regulatory reforms in the area of corporate governance. The first reform is the 1999 Blue Ribbon Committee's (BRC) Report and Recommendations on Improving the Effectiveness of Corporate Audit Committees (BRC, 1999). The most impact, however, had the second reform. In 2002 the Corporate and Criminal Fraud Accountability Act, in other words the Sarbanes-Oxley Act (Vera-Munoz, 2005, p. 116), was introduced. SOX developed strict rules about the composition and other requirements for members of an audit committee. At the same time they were given more responsibilities and authority. The new audit committee rules in SOX are: (1) all firms must have an audit committee that is composed entirely of members that are independent of management; (2) the firm must state whether the audit committee contains a so-called financial expert and if not why not; (3) the audit committee is responsible for appointing the outside auditor; (4) the firm must provide outside counsel and other advisors that the audit committee deems necessary to fulfill its duties; (5) the audit committee must implement procedures to receive and investigate employee complaints about accounting policies and practices; and (6) the audit committee must approve the purchase of nonaudit services that are not specifically prohibited by SOX (Defond and Francis, 2005, p ). These strict rules and the increased role of audit committees must lead to more effectiveness. The assumption is that if an audit committee is effective the audit quality will be high. 1.1 Background Audit quality in relation to audit characteristics is measured in prior literature mostly by the level of discretionary accruals (earnings management). Bédard et al. (2004) examine whether the expertise, independence, and activities of a firm s audit committee have an effect on the level of aggressive earnings management. They conclude that aggressive earnings management is negatively associated with expertise, independence and not (or at least partly) with the activity of the audit committee. Ghosh et al. (2010) have different 4

5 outcomes. They investigate whether audit committee characteristics (composition, size, activity, expertise, ownership, and tenure) are associated with earnings management before and after SOX. They conclude that earnings management does not vary with audit committee composition, expertise, and ownership. In contrast to audit committee size, activity, and tenure, which are associated with earnings management. An interesting finding of Gosh et al. (2010) is that the strength of the association is remarkably weaker for the pre- SOX period in comparison with the years after SOX was introduced. So the results of the mentioned academic research are mixed about which characteristics of an audit committee are associated with earnings management. Other ways to measure audit quality in relation with audit committee characteristics are the likelihood of receiving going-concern opinion, the likelihood of financial restatements and accounting conservatism. Carcello and Neal (2000) found a positive relation between audit committee independence and the likelihood that the auditor will issue a going-concern report. Abbott et al. (2004) found that independence, presence of at least one member with financial expertise and activity level of the audit committee is negatively associated with the occurrence of restatements. The findings of Krishnan and Visvanathan (2008) show that accounting conservatism is positively and significantly correlated with conservatism (except for one measure of conservatism). As prior research shows, the relationship between characteristics and audit quality has been examined in different settings, different combinations of characteristics and different measures for audit quality. Most of the prior research focused on the two pillars of SOX about audit committee, 100 percent independent members and the presence of a financial expert. In 1999 the BRC made also important recommendations about the size and activity of audit committees. These characteristics were not included in SOX. While size and activity are also important aspects that influence the functioning of the board of directors. Board of directors and the audit committee have both a monitoring function and have to safeguard the financial reporting process (Ghosh et al., 2010). The relation between the functioning of the board of directors and their size and activity has been researched more extensively. For example Beasley (1996) concludes that fraudulent financial reporting is more likely when the size of the board increases. Although these are two different committees (board of directors and audit committees) they have both a monitoring function and they influence each other. So I would expect that size and activity will also be an important factor in the composition of an audit committee. There has been very few research on the relation between all these 4 characteristics (independence, financial expert, size and activity) on audit quality. So I would like to fulfill this gap in the academic accounting literature. Moreover, I am going to measure audit quality in two different ways: The level of earnings 5

6 management and the likelihood that the auditor will issue a going-concern report. This will help in providing a more convincing conclusion. The research question of this master thesis: What is the effect of 4 characteristics (independence, financial knowledge, size, activity) of an audit committee on audit quality? 1.2 Summary of results The findings of this master thesis show no significant relations, therefore there is no evidence supporting the hypotheses. My hypotheses suggested that a large and active audit committee which consists of independent members and a financial expert will lead to higher audit quality. Higher audit quality is expressed by a lower level of earnings management and a higher likelihood that an auditor will issue a going-concern opinion. However, there cannot be concluded that there is an association between audit committee characteristics and audit quality. 1.3 Contribution There is an extensive body of research after 2002, when SOX was introduced, which examined the increased independence in general in relation with increased audit quality. Also the effect of more independent audit committee members on audit quality has been researched. And the effect of the required financial expert in audit committees on the audit quality has been tested a couple of times. These two characteristics of an audit committee (independence, presence of a financial expert) are very clear mentioned in SOX. The members of the audit committee have to be fully independent and at least one member has to be classified as a financial expert according the definition of SEC. In SOX nothing has been said about the size and activity of an audit committee. While according to Defond and Francis (2005, p. 22) these are also important aspects to improve the effectiveness of audit committees. And maybe because they are not (or at least not explicitly and clear) mentioned in SOX, there has been less research done about these aspects of audit committees. Anderson et al. (2004) state that larger audit committees improve the financial reporting quality. And Abbott et al. (2004) conclude that more active audit committees are associated with less fraud (combined with independence of audit committee members). I want to explore these characteristics further. But I recognize that independence and financial knowledge are also very important characteristics of an audit committee in relation with audit quality. So I would like to examine if a more independent, financial competent, larger and active audit 6

7 committee is more effective ( in terms of audit quality). I will use two measures for audit quality. The first one, which is used a lot in prior research, is the level of earnings management. To build stronger evidence, I am going to use also as measure for audit quality the likelihood that the auditor will issue a going-concern report. From a societal point of view research that examines the effectiveness of audit committee is important. Because there will be assumed that an effective audit committee will lead to high financial reporting quality. High audit quality ensures reliable information for investors, shareholders, stakeholders and other interested parties. Reliable information improves decision making and efficiency. So my research could help regulators to define and become more specific about the composition of the audit committee. 1.4 Structure This thesis is structured as follows. Section 2 discusses prior literature that will lead to the development and formulation of the hypotheses. The research methodology will be described in section 3. The results will be presented and analyzed In section 4. And finally, section 5 will provide the conclusion, limitations and suggestions for future research. 7

8 2. Literature review and hypotheses development 2.1 Audit committee Definition An audit committee is defined by SOX (2002) as follows: An audit committee is established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer, and audits of the financial statements of the issuer (SOX, section 2, definitions, number 3a). According to the Blue Ribbon Committee (BRC, 1999) the audit committee is the ultimate monitor in the financial reporting process. Therefore Mangena and Pike (2005) argue that the audit committee can be seen as one of the most important elements in the corporate governance process and the primary decision-making body that has to monitor and enhance the quality of the financial reporting process. Together with the board of directors, the audit committee has an oversight role Theoretical foundation The most common economic theory according audit committees and corporate governance in general is the agency theory (Beasley et al., 2009). The agency theory (Jensen and Meckling, 1976) states that an audit committee exist because they have to monitor management. Otherwise the agents (the managers) may act in their personal interest and not in the best interest of the principals (shareholders and stakeholders etc.). So according to the agency theory the members of an audit committee are objective and independent, monitor management and have to prevent opportunistic behavior of the managers Role and responsibilities of an audit committee The role and responsibilities of audit committees have increased more and more over time. Especially after the introduction of the Sarbanes Oxley Act in SOX increased the responsibilities and authority of audit committees. It also increased the requirements and criteria to become a member of an audit committee. In response, the existing bodies proposed new rules and regulations to strengthen audit committees. Some of the (new) tasks for audit committees according the SEC and the US stock exchange are the responsibility to 8

9 pre-approving audit and non-audit services, overseeing the auditor engagement and compensation, and provide procedures to receive, retain, and treat the complaints of employees (Vera-Munoz, 2005). Off course, the main (and traditional) task of the audit committee is to oversee the financial reporting process (Krishnan and Visvanathan, 2008). 2.2 Audit quality Definition Audit quality has been defined mostly in prior research in line with the findings of DeAngelo (1981). She states that the quality of audit services is defined to be the market-assessed joint probability that a given auditor will both (a) discover a breach in the client's accounting system, and (b) report the breach. The probability that a given auditor will discover a breach depends on the auditor's technological capabilities, the audit procedures employed on a given audit, the extent of sampling, etc. The conditional probability of reporting a discovered breach is a measure of an auditor's independence from a given client. So according to the definition of DeAngelo (1981) depends audit quality on the ability of the auditor to detect material misstatements (how competent he is) and the independence of the auditor Earnings management as measure for audit quality The compensation of managers is usually based on the reported earnings. According to the agency theory, managers are trying to maximize their own wealth. So they act in their personal interest (Jensen and Meckling, 1976). Managers have the incentive to manipulate the reported earnings in order to maximize their compensation and/or bonus. There is high audit quality if the auditor has the ability to detect material misstatements (DeAngelo, 1981). Manipulation of the reported earnings can be seen as a material misstatement. So if the auditor is capable of detecting all the material misstatements, there is no earnings management. This suggest that the level of earnings management is a good measure for audit quality. And an effective audit committee could help the auditor in performing his profession in the best way. 9

10 2.2.3 The likelihood that an auditor will issue a going-concern report as measure for audit quality Receiving a going-concern opinion could be harmful for a company. This can lead for instance to a decline in stock price or it can be more difficult to raise debt capital. Thus management has an incentive to pressure the auditor not to issue a going-concern report. And if an auditor does issue a going-concern report it can affect the auditor. Consequences could be switching auditors, fee pressure or less purchased non audit services. Carcello and Neal (2000) view the issuance of a going-concern as the outcome of an often contentious negotiation among management, the auditor and the audit committee. The decision to issue a going-concern report is one of the most difficult audit tasks (Carcello and Neal, 2000). The audit committee, however, could help the (external) auditor by reducing the pressure of management on the auditor. The audit committee should support the auditor when there is a conflict. If this is the case the auditor could carry out his profession in the right way. This will lead to high financial reporting quality. So if an auditor is free to issue a going-concern report when he thinks it is necessary then the audit quality is assumed to be higher, because it reflects than the real situation of the company Audit committee characteristics In the following paragraph the characteristics of the audit committee will be discussed. These characteristics will be described in relation with audit quality. I will start with independence of the audit committee member. This part will be followed by the presence of an financial expert at the audit committee. Then the size of an audit committee will be discussed. And finally, the activity of an audit committee Audit committee independence SOX (2002) requires that all members of an audit committee must be independent. The belief that audit committees have to be independent is not new, but the fact that the audit committee have to be 100 percent independent without any exceptions can be called new. The Blue Ribbon Committee (BRC,1999) already recommended that all the members have to be independent. As mentioned before, in the past exceptions were possible. If appropriate, the board was allowed to appoint inside directors. This approach was based on research 10

11 from the board of directors. Inside directors have important firm-specific knowledge and insiders (instead of outsiders) have greater incentives to improve the performance of the firm (Rosenstein and Wyatt, 1997). The suggestion that in some settings the board of directors benefits from having non-independent directors, does not immediately imply that this also holds for audit committees (Defond and Francis, 2005). Bédard et al. (2004) show that their results support the SOX requirement that the audit committee must be 100 percent independent. They find a significant reduction in the likelihood of aggressive earnings management when all the members of the audit committee are independent. They have also investigated whether the critical threshold is not 100 percent but between the 50 and 99 percent. This would indicate that for instance an inside director has a positive influence on audit quality. But Bédard et al. (2005) did not find any significant effect. Abbott et al. (2004) come to the same conclusion after measuring audit quality with the occurrence of restatements. There is a negative association between audit committee independence and the occurrence of restatements. Further there is an inverse relation between the likelihood of receiving a going-concern report and the percentage of non-independent directors on the audit committee (Carcello and Neal, 2000). This indicates that the probability is very low that an auditor will issue a going-concern report if there are non-independent members on the audit committee. Also Mangena and Pike (2005) have consistent results. Their results show a negative and significant association between shareholding of an audit committee member and interim disclosure. So these studies all support the requirement of SOX. On the other hand Gosh et al. (2010) conclude that earnings management does not vary with the percentage of outside directors on audit committees. Independent members do not better monitor the financial reporting process. So these results are not consistent with the claim of SOX that the audit committee has to be 100 percent independent. Overall, prior research shows that independent audit committee members help in ensuring audit quality and contribute to financial statement user reliance on the financial reporting process (Jamil & Nelson, 2011). Also the independence of an audit committee reduces the likelihood of financial misstatements. So audit committee independence is associated with more successful monitoring of management (Abott et al. (2004). This leads to the suggestion that independent audit committees will be more effective in controlling the level of earnings management and it will be more likely that an auditor will issue a going-concern report. H1a: Independent audit committees are negatively associated with earnings management. 11

12 H1b: Independent audit committees are positively associated with the likelihood that an auditor will issue a going-concern report Financial expert SOX (2002, Section 407) requires the presence of at least one member of the audit committee with financial expertise. This requirement of SOX is just as the independence requirement for audit committees not new (Defond and Francis, 2005). The Blue Ribbon Committee (RBC, 1999) made already recommendations about this concept. But the rules from SOX are stricter and there is less discretion possible. Thus according to SOX there has to be an financial expert on the audit committee and if there is not, an explanation is required. This rule is quite straight forward. The only difficulty is how to define a financial expert. SOX gives no clear definition whether an audit committee member can be qualified as a financial expert. Consequently, the required financial knowledge at audit committees has been researched and measured in different ways. I will use the definition of a financial expert that is given by the Security and exchange commission (SEC). We proposed to define the term "financial expert" to mean a person who has, through education and experience as a public accountant, auditor, principal financial officer, controller or principal accounting officer, of a company that, at the time the person held such position, was required to file reports pursuant to Section 13(a) or 15(d) of the Exchange Act, or experience in one or more positions that involve the performance of similar functions (or that results, in the judgment of the company's board of directors, in the person's having similar expertise and experience), the following attributes: (1) An understanding of generally accepted accounting principles and financial statements; (2) Experience applying such generally accepted accounting principles in connection with the accounting for estimates, accruals, and reserves that are generally comparable to the estimates, accruals and reserves, if any, used in the registrant's financial statements; (3) Experience preparing or auditing financial statements that present accounting issues that are generally comparable to those raised by the registrant's financial statements; (4) Experience with internal controls and procedures for financial reporting; and (5) An understanding of audit committee functions. 12

13 Krishnan and Visvanathan (2008) state that accounting financial expertise is significant positively correlated with conservatism. The results of Beasley et al. (2004) show that the SOX requirement (presence of at least one member with financial expertise) lowers the probability of aggressive earnings management. This suggest that the more expertise members of an audit committee have, the more it is effective in limiting earnings management and thus better audit quality. Abbott et al. (2001) find the same results with a different measure for audit quality (the occurrence of restatements). Dhaliwal et al. (2010) show that the most positive impact on accrual quality will be achieved when firms have a combination of experts of accounting and finance-literate in the audit committee. So they do not only suggest that a financial expert has a positive influence on audit quality, but also gives recommendations what financial knowledge the most effect has on the functioning of an audit committee. These findings are all in line with the requirements of SOX. Gosh et al (2010) examined what the impact of financial expertise is on absolute discretionary accruals for the post-sox period. They find no evidence that could suggest that the presence of a financial expert in the audit committee is associated with earnings management. Although there is not much evidence that does not support the SOX requirement, there is no complete consensus about the impact of the financial expert on the audit committee. To sum up, SOX requires that an audit committee must include a financial expert. Most research in this area suggests that financial knowledge in the audit committee improves corporate governance (Defond & Francis, 2005). Improved corporate governance assumes that the financial reporting quality is high and as a consequence the level of earnings management is low and it is more likely that an auditor will issue a going-concern report. This leads to the following hypotheses. H2a: Financial expertise in an audit committee is negatively associated with earnings management. H2b: Financial expertise in an audit committee is positively associated with the likelihood that an auditor will issue a going-concern report Audit committee size Size is an audit committee characteristic that is not addressed in SOX (2002). The Blue Ribbon Committee (BRC, 1999) recommends that an audit committee must have at least 3 13

14 members (and a maximum of six). The minimum of 3 members is according the BRC (1999) necessary because then the audit committee can provide appropriate monitoring. These members have the necessary skills and knowledge and different views to fulfill the oversight role. The decision to appoint more members is based on the trade-off between the benefits of an additional member and the cost of the negative effects larger groups can have. Negative effects could be poorer communication and more slowly decision making. The objective is to have a audit committee not so large as to become unwieldy, but large enough to ensure effective monitoring (Bédard et al., 2004). There has been done far less research in this area. Anderson et al. (2004) conclude that larger audit committees are associated with improved audit quality. Gosh et al. (2010) show a strong association between audit committee size and absolute discretionary accruals. On the other hand, Bédard et al. (2004) are unsuccessful in finding that audit committee size reduces earnings management. Overall, the (few) research that has been done goes in the direction of a larger audit committee. A larger audit committee is assumed to be more effective. Therefore, I would suppose that the size of an audit committee is positively related with audit quality. When the financial reporting quality is high the level of earnings management will be low and the likelihood that an auditor will issue a going-concern report is higher. These statements lead to the following hypotheses: H3a: Audit committee size is negatively associated with earnings management. H3b: Audit committee size is positively associated with the likelihood that an auditor will issue a going-concern report Audit committee activity The final characteristic of an audit committee is also not mentioned in SOX (2002). But like the size, the BRC (1999) also gives their recommendations about how active an audit committee must be. They suggest that audit committees should have a meeting at least four times per year. This recommends the BRC because otherwise the audit committee is not capable of fulfilling its duties. The audit committee should interact and deliberate frequently to improve the monitoring process. Prior research shows that an active audit committee is associated with a lower incidence of fraud (Abbott et al., 2004) and earnings restatements are less likely to occur (McMullen and Raghunandan, 1996). These conclusions can be seen as a result of proactive 14

15 or reactive audit committee behavior. When an audit committee behaves proactive, then they would like to prevent low audit quality by increasing their number of meetings per year. In such a way they demand higher financial reporting quality from the auditor and management (Ghosh et al., 2010). This suggests a negative relation between the frequency of audit committee meetings and the level of earnings management. And a positive relation between a more active audit committee and the likelihood that the auditor will issue a going-concern report. According to Jensen (1993) audit committees often increase the frequency of meetings in the presence of problems. So Vafeas (1999) argues that the frequency of meetings is not a proactive measure but a reactive measure. The frequency of meetings serves as a reactive measure to an escalating problem at hand. This suggests a positive relationship between the number of audit committee meetings and earnings management (Ghosh et al., 2010). And a negative relation between a more active audit committee and the likelihood that the auditor will issue a going-concern report. To sum up, the BRC (1999) suggests that audit committees should have a meeting at least four times per year. Otherwise they are not capable of fulfilling their duties. They should interact and deliberate frequently to improve the monitoring process. Prior research shows that an active audit committee is associated with a lower incidence of fraud (Abbott et al., 2004) and earnings restatements are less likely to occur (McMullen and Raghunandan, 1996). So this suggests that more frequent meetings are associated with better governed firms (Defond & Francis, 2005). But this does not suggest that there is always a negative relation between the number of meetings of an audit committee and earnings management and the likelihood that the auditor will issue a going-concern report. According to Jensen (1993), audit committees increase their number of meetings when they recognize problems at an organization. So then you would expect the relations the other way around. To solve this problem, there will be conducted an additional test. This additional test will examine whether the negative or positive outcome (of the regression) of the audit committee activity is indeed a result of proactive or reactive behavior. After the additional test there will be clearance about the direction of the relationship between frequency of meeting of an audit committee and the level of earnings management and the likelihood that the auditor will issue a going-concern report. For now, there is only a suggestion that more active audit committees will lead to higher financial reporting quality. The following hypotheses are showing that relation: H4a: More active audit committees are associated with earnings management. H4b: More active audit committees are associated with the likelihood that an auditor will issue a going-concern report. 15

16 3. Research design 3.1 Research method To answer my research question I will test the 8 hypotheses. To examine if there is a relationship between audit committee characteristics and audit quality I will use regression analysis. The measure for audit quality will be the level of earnings management and the likelihood that the auditor will issue a going-concern report. The relation between the audit committee characteristics and the level of earnings management will be explored with a framework based on Jamil and Nelson (2011), Gosh et al (2010) and Bédard et al. (2004). Dechow et al. (1995) developed a model for detecting earnings management. This model is a modified version of the model of Jones (1991) and demonstrates the most power in detecting earnings management. Thus, I will measure audit quality in this framework by the level of earnings management with the model from Dechow et al. (1995). The association between the likelihood that the auditor will issue a going-concern report and the audit committee characteristics are explored by a framework based on Carcello and Neal (2010). The additional test for audit committee activity is also based on the research of Gosh et al. (2010). This test will be examining the relation between discretionary accruals and the likelihood of receiving a going-concern opinion and the number of audit committee meetings. If it is a reactive measure then I would expect that audit committee activity increases in face of financial reporting concerns. In other words, this suggests a positive relation between the variables. And if there is a negative relation, audit committees are taking a proactive stance and meeting more frequently to limit earnings management (Gosh et al., 2010). 3.2 Estimating discretionary accruals The first measure for audit quality is the level of earnings management. To obtain this information I will have to estimate discretionary accruals. As mentioned before, the modified Jones Model will be used. Dechow et al. (1995) have concluded that this model has the most power to detect earnings management. They have modified the original version of the Jones Model because the original version assumes that discretion is not exercised over revenue in the estimation and event period. The modification is designed to eliminate the conjectured 16

17 tendency of the Jones Model to measure discretionary accruals with error when discretion is exercised over revenues (Dechow et al., 1995, pp. 199). Therefore the only adjustment in the modified version is that the change in revenues is adjusted for the change in receivables in the event period. The modified Jones model assumes unlike the original version that all changes in sales on credit in the event period are a result of earnings management. This is based on the interpretation that it is more easier to manage earnings by using discretion over the recognition of revenue on credit sales than by using discretion over the recognition of revenue on cash sales. Thus by estimating the level of earnings management with the modified Jones model, the level is no longer biased towards zero when the earnings are managed mostly through the management of revenues (Dechow et al., 1995, pp. 199). Modified Jones Model: TA t = a 1 (1/A t-1 ) + a 2 ( REV t REC t ) + a 3 (PPE t ) + ʋ t (1) Dependent variable Operational measure TA t Total accruals scaled by lagged total assets A t-1 Total assets at t-1 REV t Revenues in year t less revenues in year t-1 (scaled by total assets at t-1) REC t Net receivables in year t less net receivables in year t-1 (scaled by total assets at t-1) PPE t Gross property plant and equipment in year t (scaled by total assets at t-1) α 1, α 2, α 3 Firm-specific parameters (denote the OLS estimates of α 1,α 2 and α 3 ) Total accruals consist of two parts, nondiscretionary accruals and discretionary accruals. After estimating total accruals and the nondiscretionary accruals I will calculate the number of discretionary accruals for every firm. I will use this value for the first regression model. This model could be biased without using the absolute value of discretionary accruals. The level of earnings management could be biased towards zero because this way of estimation assumes that the lower (more negative) the value of discretionary accruals the better it is. This is based on the reasoning that conservatism is good although it is achieved through earnings management. Therefore a negative value of discretionary accruals does not mean that there is none or less earnings management, but the management just has exercised its discretion to manage the earnings under the true value (conservatism). To overcome this possible biased outcome the regression model which investigates the relation between audit committee characteristics and earnings management will be run also with the absolute value of discretionary accruals as measure for earnings management. 17

18 3.3 Regression Models 1.The association between earnings management and the audit committee characteristics are explored by the following framework: Earnings management = β 0 +β 1 ACind + β 2 ACfinexp + β 3 ACsize + (2) β 4 ACmeet + β 5 SIZE + β 6 LEV + β 7 ROA + β 8 GROWTH + β 9 LOSS + β 10 BIG4 + ε Dependent variable Earnings management Independent variables ACind ACfinexp ACsize ACmeet Control variables SIZE LEV ROA GROWTH LOSS BIG4 Operational measure Discretionary accruals (DACC) =Total accruals non discretionary accruals Absolute value of discretionary accruals (ABS-DACC) Operational measure Proportion audit committee members who are not affiliated with management Proportion audit committee members are qualified as a financial expert according the definition from SEC Number of audit committee members Number of meetings per year Operational measure Firm size in natural log Ratio: Total liabilities/ total assets Ratio: Net income/ total assets Ratio: Total assets (t)- Total assets (t-1)/ Total assets (t-1) Dummy variable: 1= loss, 0= profit Dummy variable: 1= firm is audited by one of the four biggest accountancy firms (PWC, Ernst&Young, KPMG or Deloitte), 0= firm is not audited by the big4 2. The association between the likelihood that the auditor will issue a going-concern report and the audit committee characteristics are explored by the following framework: GC-opinion = β 0 + β 1 ACind + β 2 ACfinexp + β 3 ACsize + β 4 ACmeet + (3) β 5 Default + β 6 PriorOPN + β 7 SIZE + β 8 ZFC + β 9 LOSS + β 10 BIG4 + ε 18

19 Dependent variable Operational measure GC-opinion Dummy variable: 1 = going-concern report, 0 = unmodified report Control variables Operational measure Default 1 = debt default (credit rating is D), 0 = other PriorOPN 1 = prior year going-concern report, 0 = unmodified report ZFC Zmijewski s financial condition score (ZFC), higher ZFC score indicate greater financial distress *The remaining variables are already defined in the previous section. 3. The additional test to explore if the audit committee activity is a result of reactive or proactive behavior: AC-activity = β 0 + β 1 Earnings Management + β 2 GC-opinion + β 3 SIZE (4) + β 4 LEV + β 5 ROA + β 6 GROWTH + β 7 LOSS + β 8 BIG4 + ε Dependent variable Operational measure AC-activity Number of meetings per year * The remaining variables are already defined in the previous section. 3.4 Control variables In all the three regression models the control variable size is included. In relation to earnings management it can be argued that large firms are more likely to explore the possibilities of legal creative accounting to reduce political costs (Warfield et al., 1995). Therefore I would expect a positive relation between firm size and the level of earnings management. The relation between the likelihood of receiving a going-concern opinion and firm size is assumed to be negative. Carcello et al. (1995) argue that large firms are less likely to fail in comparison with smaller firms. So in the first place they have less chance that an auditor needs to issue a going-concern opinion. Secondly, an auditor may hesitate to issue a goingconcern opinion to a larger company because he is afraid to lose the high fees that large clients generate (Mckeown et al., 1991). Further, I would expect a positive relation between audit committee activity and firm size. A control mechanism like an audit committee is not costless. Small companies may have difficulties to maintain a more active audit committee. Large firms can benefit from economies of scale which result in monitoring benefits. These benefits increase with firm size (Menon and Williams, 1994). 19

20 Firms with a high proportion of leverage have incentives to manage earnings (Defond and Jiambalvo, 1994). For example if a company has to meet the conditions of debt covenants it could be tempting for managers to exercise their discretion to manage earnings. Therefore I would expect a positive relation between the level of earnings management and leverage. The agency theory supposes that problems that arise from conflicting incentives of managers and debt holders can be reduced by increased monitoring (Jensen and Meckling, 1976) With this reasoning in mind, Menon and Williams (1994) argue that firms with high leverage should be more likely to maintain an active audit committee. Consequently, I suppose that the relation between audit committee activity and leverage will be positive. To control for potential changes in firm performance, return on assets (ROA) is included as control variable. It could be that an increase in earnings quality is associated with a change in the performance of a company (Baxter and Cotter, 2009). So I would expect a negative relation between earnings management and ROA. Also the relation between audit committee activity and ROA will probably be negative. When the ratio of return of assets is high, the performance of a company is good and there is less reason for the audit committee to meet more often. Growing companies have according to DeFond and Subramanyam (1998) litigation based reasons for making less aggressive accounting choices. Therefore I assume that the relation between earnings management and the level of growth is negative. Further, I would expect that the relation between audit committee activity and growth is positive, because a growing firm goes hand in hand with uncertainties. These uncertainties could be an incentive for the audit committee to meet more often. Loss is included as control variable, because firms which are in financial distress have higher incentives to exercise their discretion to manage the earnings (DeFond and Subramanyam, 1998). Also high financial distressed firms are more likely to receive a goingconcern opinion and audit committees should be more active in face of the problems. So I would expect a positive relation between earnings management and firms which reported a loss, a positive relation between the likelihood that the auditor will issuance a going-concern report and loss, and lastly, a positive relation between audit committee activity and loss. When a firm is in default it is more likely that the auditor will issue a going-concern report (Chen and Church, 1992). If a company does not receive a going-concern opinion when it is in default, the chance is high that the auditor would be blamed. Therefore it is likely that the auditor tries to prevent such a situation. The cost of failing to issue a going-concern report when a company is in default is particularly high (Carcello and Neal, 2000). Thus, I 20

21 assume that the relation between the likelihood of receiving an going-concern opinion and debt default will be positive. If a company received a going-concern opinion the prior year, the chance is high that it will receive also a going-concern opinion the following year. Nogler (1995) argued that before auditors will issue a clean opinion after a going-concern report, the firms must have demonstrated significant financial improvements. This leads to the assumption that the relation between the likelihood that the auditor will issue a going-concern report and the prior year opinion will be positive. Zmijweski s financial condition (ZFC) score measures the level of financial distress. The formula is as follows: *X *X *X3 X1 = Net Income/Total assets X2 = Total Debt/Total assets X3 = Current Assets/Current Liabilities The higher the ZFC score, the higher the level of financial distress. The more financial distress a firm is facing, the higher the chance of receiving a going-concern opinion (Carcello et al., 1995). Therefore I would expect a positive relation between the likelihood of receiving a going-concern opinion and the ZFC score. The last control variable that will be used is a dummy variable for Big4 accountancy firms. Large auditors are more successful in detecting (aggressive) earnings management (Becker et al., 1998). Thus I assume that the relation between earnings management and Big4 will be negative. The relation between the likelihood that the auditor will issue a goingconcern report and Big4 should be positive. Overall the audit quality of Big4 accountancy firms is higher than non-big4 (DeAngelo, 1981). One of the reasons for that is that the importance of one client relatively to total clients of a Big4 is small. They do not consider (or less than small accountancy firms) the fees that they could lose when they need to issue a going-concern report. Further I would expect a negative relation between audit committee meetings and Big4, because Big4 accountancy firms are likely to deliver high audit quality. 3.5 Sample and data collection The sample consists of US listed companies, because the rules of SOX about audit committees holds only in the US. The data will be gathered from COMPUSTAT, Risk Metrics and Audit Analytics database for the year I have chosen for this year because it had to be in the post-sox years. Moreover, I would like to use the most recent data that are available in the different databases. The data for 2012 are not all available yet, so that is why 21

22 I will investigate the data for The time period of my investigation is only one year. The reason for this relatively small period is that the data about the frequency of meetings are not available in the different databases. Therefore these data need to be hand-collected from the proxy statements of the firms. I will need two samples to run the three different regression models. The regression model that explores the relation between (absolute) discretionary accruals and audit committee characteristics and the additional regression model which investigates if there is a (positive or negative) relation between the number of audit committee meetings and (absolute) discretionary accruals and the likelihood of receiving a going-concern opinion will use the same sample. The regression model which explores the relation between the likelihood of receiving a going-concern opinion and the different audit committee characteristics cannot use the same sample. This last model includes only firms with the highest Zmijewski s (1984) financial condition score, so the firms with the highest financial distress. The reason for this precondition is that firms who suffer financial distress are more likely to receive a going-concern opinion. From the two different datasets we get after merging and dropping missing data, I will subtract all the financial companies and utilities (6000 SIC codes). Finally, the dataset for regression model one and three has been sorted on size and the other dataset has been sorted on the ZFC score. This last step is taken because I need the 200 largest firms and the 200 firms with the highest ZFC score. 200 observations have been chosen because that is large enough for a reliable sample and just doable to collect by hand in a small period of time. Table 1 presents the details of the two samples selection procedure. Table 1 Sample selection procedure Sample 1: Is used for the investigation of the relation between earnings management and audit committee characteristics and for the additional test to explore if audit committee activity the result is of proactive or reactive behaviour. Initial sample size (after merging the data of different databases) Less financial companies and utilities (6000 SIC codes) 1473 firms 311 firms 1162 firms 202 largest firms (based on firm size = total assets in natural log) 202 firms Missing data on audit committee meetings 2 firms Sample for hypotheses H1a, H2a, H3a and H4a and additional test (regression model 1 + 3) 200 firms 22

23 Sample 2: Financial distressed firms Is used for the investigation of the relation between the likelihood of receiving a going-concern report and audit committee characteristics. Initial sample size (after merging the data of different databases) Less financial companies and utilities (6000 SIC codes) 818 firms 27 firms 791 firms 209 firms with highest ZFC score 209 firms Missing data on audit committee meetings 9 firms Sample for hypotheses H1b, H2b, H3b and H4b (regression model 2) 200 firms 23