The relationship between Board Independence and Accounting Conservatism and the effect of the Financial Crisis

Faculty of Economics & Business MSc Accountancy & Control 2013-2014 Master Thesis The relationship between Board Independence and Accounting Conservatism and the effect of the Financial Crisis Final version Floor Brouwers 5979560 Submission date: 18-06-2014 Supervisor: dr. G. Georgakopoulos Second reader: dr. S. W. Bissesur Master thesis Accountancy & Control, 2013-2014, 6314M0244Y

Abstract This thesis investigates the relationship between the independence of the board of directors and accounting conservatism and the moderating effect of the financial crisis. The effect of the financial crisis on the relationship was measured in three steps: (1) a change in board independence, (2) a change in accounting conservatism and (3) the impact of board independence on accounting conservatism. To measure accounting conservatism, the C-Score method of Khan & Watts (2009) was used. The sample used for the final regression comprised of 2.391 firm-year observations from S&P500 companies over the period 2002-2012. Results show that there is a significant positive increase in board independence, as expected in the first hypothesis. However, the change in accounting conservatism resulted in a significant negative decrease, contradicting the expectations from the second hypothesis. Therefore, this study concludes that in times of crisis companies want to restore investors confidence by aggressive accounting. Finally, for answering the question whether the change in accounting conservatism due to the financial crisis is associated with the change in board independence the results are not significant, due to a lack of evidence. 2

Table of Contents Abstract...2 1. Introduction...4 2. Literature Review and Hypotheses...6 2.1 Corporate Governance...6 2.1.1 The Agency Theory...7 2.1.2 The Board of Directors and Board Independence...8 2.2 Accounting Conservatism...9 2.2.1 Reasons for Conservatism... 10 2.3 The Interaction between the Board Independence and Accounting Conservatism... 11 2.4 The Financial Crisis... 13 2.5 Hypotheses Development... 13 3. Research Methodology... 15 3.1 Measures of Accounting Conservatism... 15 3.1.1 The Basu Model... 15 3.1.2 The Khan & Watts Model... 16 3.2 Measures of Board Independence and the Crisis... 17 3.3 Control Variables... 18 3.4 Empirical Model... 19 3.5 Sample Selection... 20 3.6 Descriptive Statistics... 22 4. Results... 24 4.1 Change in Board Independence... 24 4.2 Change in Accounting Conservatism... 27 4.3 The Impact of Board Independence on Conservatism... 29 5. Conclusion... 32 References... 33 Appendix A: Definition of Regression Variables... 37 Appendix B: Results Regression C-Score... 38 3

1. Introduction One of the main internal corporate governance tools within a company is the board of directors (Hermalin & Weisbach, 1988). The most important activities of the board are monitoring as well as giving advice to management of the company and protecting shareholder interests. Advising management includes consulting on strategic and operational decision making in the best interest of the firm. Monitoring contains keeping track of management with regard to activities itself, as well as management acting with care to the interests of the shareholders (Hermalin & Weisbach, 1988). Moreover, the board oversees, too, legal and regulatory compliance. A very important aspect is the separation and distinction of responsibilities between the board and management. Jensen & Meckling (1976) argue that conflicts of interests can arise between managers and other parties, as managers control the firm but are not company stakeholders, resulting in managers acting in their own interest instead of in the interest of the shareholders. To be effective in their role, members on the board must be characterized by independence as more independent boards ascribe higher quality reporting and lower earnings management (Ahmed & Duellman, 2007). Much research has been done between corporate governance and the relation with accounting quality. The main area of focus within this field of research has primarily been on earnings management. Klein (2002) found a negative relation between board independence and abnormal accruals. Moreover, Xie et al. (2003) argued that the composition of an audit committee within the board is related to the likelihood that a firm will engage in earnings management. The extent of earnings management represents one possible element of accounting quality whereas another aspect of quality is the topic of earnings conservatism and timeliness. Timeliness refers to the length of time taken to reflect information in earnings (Basu, 1997). Conservatism is accountants tendency to require a higher degree of verification for recognizing good news than bad news in financial statements (Basu, 1997). Accounting conservatism is a fundamental characteristic of financial reporting and is considered to be the most influential principle of valuation in accounting (Watts, 2003). In the past, auditors often ignored accounting conservatism as they argued that it did not represent reliable numbers (Givoly & Hayn, 2002). Nevertheless, accounting conservatism also has benefits for the users of financial information because it enhances efficient contracting, tax optimization and the reduction of litigation risk (Watts, 2003). Other literature has investigated the link between board structure and timeliness of earnings. Ahmed & Duellman (2007) and Beekes et al. (2004) reported that the number of independent, non-executive, board members and the 4

number of financial experts are positively related to accounting conservatism. However, there is no explanation in the existing literature to provide an explanation on the influence of the financial crisis on the relationship between independence of the board of directors and accounting conservatism. The current financial crisis is seen as the crisis with the most impact since the Great Depression (Vyas, 2011). The crisis originated in the financial sector and affected economies all over the world (Brunnermeier, 2008). This thesis researches the effect of this important event on board independence and accounting conservatism, adding a new feature to the incomplete literature. Therefore, the following research question will be tested: What is the effect of the financial crisis on the relationship between board independence and accounting conservatism This study contributes to the existing literature in different ways. Research has been done on the relationship between board independence and accounting conservatism, however, in relation to previous studies this research did not only use a data sample from before the financial crisis, but also a combination of the years prior and during the crisis. Therefore, this study distinguishes by differentiating between the pre-crisis and during crisis periods. By answering the research question, a contribution will also be made to corporate governance literature, as board of director is an important tool of corporate governance. Thus, this study provides evidence regarding the effect of board independence on conservatism. From a societal point of view, the study will contribute in a way that firms can anticipate to the financial crisis by adapting board independence and accounting in a conservative manner. In order to answer the research question, the research is divided in three parts. First board independence will be examined by measuring independence in the pre-crisis period (2002-2007) and the within-crisis period (2008-2012). Subsequently, the C-Score method by Khan & Watts (2009) will measure accounting conservatism. This method requires a regression analysis in order to calculate conservatism. Conservatism too, will be researched in the two different crisis periods. Finally, this study will examine whether the change in board independence has impacted accounting conservatism. 5

The remaining structure of this paper consist of a literature review of the key literature in the area of corporate governance, the agency theory, the board of directors, accounting conservatism and the financial crisis in chapter 2. These areas are the core of the development of the hypotheses. Subsequently, the research method will be described in chapter 3, followed by the results in chapter 4. In chapter 5 a conclusion will be provided and limitations are discussed. 2. Literature Review and Hypotheses 2.1 Corporate Governance Corporate governance has gained a lot of interest in the beginning of this decade due to the high amount of corporate collapses and financial scandals that have taken place in big organizations such as Enron, Arthur Andersen, WorldCom, and Parmalat (Cohen et al., 2010). It called for more transparency and accountability to help restore investor confidence in the stock market and to protect these private and institutional investors. As a result, the United States presented a new law called the Sarbanes-Oxley act of 2002. The Sarbanes-Oxley act is a law that set standards for U.S. public company boards, management and public accounting firms, and is an example of an external corporate governance mechanism (Cohen et al., 2010). Denis & McConnell (2003) argue that corporate governance instruments can be divided into two categories, being internal and external corporate governance mechanism. The legal system, the takeover market and market competition can be described as mechanism of external corporate governance. Whereas internal corporate governance mechanisms are instruments that companies can deploy to create strong corporate governance, examples are the board of directors, committees and ownership structure. Corporate Governance can be interpreted in many ways and several economists have been given several definitions over the time. These definitions range from purely economic definitions to more global, all-encompassing definitions. For example, Shleifer & Vishny (1997) argue that corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. Another definition for corporate governance is: Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of 6

rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance (OECD, 2004, p. 11). Finally, Merchant & Van Der Stede (2007) define corporate governance as the set of mechanism and processes that help ensure that companies are directed and managed to create value for their owners while concurrently fulfilling responsibilities to other stakeholders. These different definitions and interpretations can lead to a general view that outlines that corporate governance describes relationships between managers, the board, shareholders and other stakeholders. This ensures an adequate systems of controls, encourages transparency and accountability and aims to manage the company in the best interests of shareholders and stakeholders. 2.1.1 The Agency Theory Corporate governance is a mechanism used to control the agency problem, and therefore the agency problem is one of the most important theories explaining corporate governance. The agency theory describes the problem that can occur in the principal-agent relationship between the company s management and its shareholders (Jensen & Meckling, 1976). In most large public companies there is usually a separation between ownership and control. Within these companies the ownership is divided between different shareholders, who all have a say in the company. This theory defines shareholders as the principle. The actual control of the company is in the hand of the management, who are in charge of the day-to-day business decisions. The company s management is called the agent. The agency theory defines the relationship between the principle and the agent and describes how to resolve conflicts between those parties (Jensen & Meckling, 1976). There are two main assumptions within the theory. The first one argues a conflict of interest between the principle and the agent. This is caused by the fact that managers and shareholders have different interests and different goals, and that the agent is risk-averse. These are reasons that the agent makes decisions based on self-interest, and those decisions are not the same as the principle would make, based on the goals and interests of the shareholder. This is due to the theory that every party will act in their own self-interest first (Jensen & Meckling, 1976). The second assumption within the agency theory is that the principle is not capable to control the actions 7

of the agent and monitoring the actions of the agent is hard and costly. This leads to information asymmetry because the principle does not have enough information, as he does not know the goals of the agent (Jensen & Meckling, 1976). To conclude, corporate governance is an instrument to mitigate the conflicting interests in the relationship between the principal and the agent and to monitor the actions of the agent, thereby reducing agency problems. Moreover, Eisenhardt (1989) acknowledges this fact and argues that accounting standards and good corporate governance mechanisms are instruments to moderate agency problems. 2.1.2 The Board of Directors and Board Independence Shareholders of companies do not have the knowledge and the time needed to control, monitor and guide the actions of the management, the company has a mechanism to perform these tasks, hence is done by the board of directors. As mentioned before, the board of directors in an internal corporate governance instrument to solve problematic issues between management and stakeholders (Fama & Jensen, 1983; Baysinger & Butler, 1985). The board of directors has the power to determine the structure of the management team as well was their remuneration. The board of directors has two main roles, the first role is monitoring and advise the management and the second is to protect the interest of the shareholders (Hermalin & Weisbach, 1988). Furthermore, the board supervises legal matters and regulatory compliance. There are a lot of characteristics that can be allocated to a board of directors. In order to be effective in their tasks, members of the board must have financial knowledge, do not have extensive board tenure, have an independent CEO and board size must not be too big (Carcello et al., 2011; Dechow et al., 1996; Bowen et al., 2008; DeFond et al., 2005). Another very important characteristic of the board is to be independent (Klein, 2002), an independent board is characterized by more outside, non-executive, directors on the board compared to inside, executive, directors. Jensen & Meckling (1976) describe that boards with a high rate of outside directors help reduce agency problems due to the control of outside directors on opportunistic behavior of managers. Additional research done on an independent board of directors shows that more independent boards attribute to lower earnings management and higher quality of information (Klein, 2002; Xie et al., 2003). Furthermore, the association between board independence and 8

fraudulent reporting has been researched by Dechow et al. (1996) who have investigated board independence and analysts rating of financial statements quality. An independent board with a high number of outside directors decreases the possibility of financial fraud, as Beasly (1996) found a negative relation between independent board member and financial fraud. Finally, Ahmed & Duellman (2007) found a positive relation outside directors and accounting conservatism, suggesting that a more independent board will use more conservatism compared to a board that has more inside board members. 2.2 Accounting Conservatism Accounting conservatism is a phenomenon, which was firstly described by Basu (1997). In his paper, Basu (1997) researched return data from firms in the period 1963-1990 by using a reverse regression method and found negative returns had a much higher impact on earnings than positive returns. From these results, Basu (1997) concluded that conservatism exists. Basu (1997) defines conservatism as accountants tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses (p. 7). This implies a systematic difference in timeliness of earning in a way that earnings are more timely and sensitive in reflecting bad news than good news. Givoly & Hayn (2000) also acknowledges conservatism within firms in the USA in the period 1950-1998, using several methods. Similarly to the study of Basu (1997), they found evidence of conservatism, and this conservatism increased over the researched years. Studies have shown a number of ways in which conservatism can be useful. Conservatism is found to improve debt efficiency, leads to better managerial decisions on investments, and reduces conflicts between agents and principles as described in the agency theory (Watts, 2003; Ball & Shivakumar, 2005; Ahmed & Duellman, 2007). Also, Watts (2003) and Basu (1997) state that when earnings reflect bad news more quickly than good news, more useful information is generated leading to an increase in decision usefulness of financial reporting. For a long time auditors did not do anything with conservatism because they believed that it did not represented reliable financial statements (Givoly & Hayn, 2000). However, research showed that conservatism did increase over the years (Watts, 2003). Givoly & Hayn (2000) also recognized that companies were engaging in conservative reporting and found an increase of conservatism. Also, Ball & Shivakumar (2005) acknowledged the increasing importance of conservatism by showing a growth in conservatism in 2002, after the accounting scandals and corporate collapses of Enron, Arthur Anderson etc.. 9

2.2.1 Reasons for Conservatism The article of Watts (2003) explains the increase in use and the importance of conservatism, as found by several researchers (Lobo & Zhou, 2006; LaFond & Watts, 2008; Givoly & Hayn, 2000).This paper is the main research in the area of conservatism that explains the reasons for firms to report conservative. Those explanations are: contracting, litigation, taxation and accounting regulation (Watts, 2003). The contracting explanation by Watts (2003) can be divided into compensation contracts and debt covenants. In general, contracting describes that managers have incentives to influence results in a positive way, but conservatism limits this because gains needs a higher degree of verification. This is positive for shareholders, because conservatism decreases their risks and this goes together with managers receiving less bonus rewards. This is called compensation contracts (Watts, 2003). Debt contracting is described by Watts (2003) as reducing risks for debt holders, because debt providers want to reduces the threats that come with lending money to companies. Litigation is an explanation for conservatism as understated asset and earnings are much less subjected to litigation as the overstatement of assets and earnings (Watts, 2003). When a company does overstate its assets, the market will drop for the company when the overstatement is found out. This drop results in losses for shareholders of the company, whom are harmed financially and can sue the company. This litigation threat is an incentive for auditors and managers to report conservatively, because otherwise they face high litigation costs (Watts, 2003). The reason that regulations are related to conservatism is because when firms overstate their assets due to rules this could lead to losses for shareholders. Those shareholders can hold standard setters responsible which could result into political consequences for the regulators (Watts, 2003). This leads to regulators creating conservative rules, to protect themselves and protect shareholders for losses due to overstatements. With regard to taxation, conservatism companies recognize all their costs made in the current fiscal year, but only recognize a part of the gains. This reduces their profits and reported income and leads to a lower tax payable in the current year (Watts, 2003). 10

2.3 The Interaction between the Board Independence and Accounting Conservatism Accounting conservatism and corporate governance, specifically the board of directors are connected to each other in several ways. Watts (2003) describes that conservatism helps to solve a bias that is created by information asymmetry. The information generated through accounting systems is used by directors on the board to monitor and advise managers. Managers also have information for the board of directors, however they can hold back important information, or information for the board can be biased in favor of the managers (Ahmed & Duellman, 2007). Since conservatism needs a higher degree of verification for good news, gains for example, the chance of managers overstating earnings decreases (Basu, 1997). So, accounting conservatism is a tool that averts managers from producing biased information, which leads to bonuses and overcompensation (Ahmed & Duellman, 2007; Watts, 2003). Ball (2001) states that conservatism, with timely recognition of losses can help the board to recognize negative net present value (NPV) investments. Managers could try to postpone or even elude reporting losses negative NPV projects because this could cause negative performance evaluation for the managers, timely recognition could help to prevent this (Ahmed & Duellman, 2007). So accounting conservatism can serve as a mechanism for directors on the board to identify negative NPV projects, and thus helping to identify and investigate bad investments by top management. The probability of corporate collapses can be reduced through accounting conservatism, and shareholders could boost this accounting mechanism by communicating with the board of directors and their connection with top management (Lim, 2011). Reporting conservatively leads to a more timely disclosure of losses compared to gains. This way financial issues will surface in early stages (Garcia Lara, 2009). So through conservatism, the directors on the board notice losses and can intervene to prevent the company from collapsing (Lim, 2011). Fama & Jensen (1983) describe that agency problems cannot be solved only through a good board of directors, nor only with accounting conservatism. However, the connection between these instruments does lead to a reduction in agency problems and also to a fair representation of accounting information by managers. As previously described, this connection between accounting conservatism and the board of directors can lead to better monitoring of management, a decrease in biased information, the investigation of managers poor investment decisions by the board, and it reduces the probability of corporate collapses (Lim, 11

2011). Garcia Lara (2009) also states that an effective board leads to more transparency, a decrease in earnings management and more independence between top managers in the company and directors on the board. An effective board can be defined as an independent board, which is a board with a high percentage of outside directors on the board. Conservatism turns out to be a very suitable mechanism for the board to monitoring, managing and advising management. Therefore, it can be assumed that boards that comprise of a high number outside directors would want more accounting conservatism. On the other hand, a board that has a high number of inside directors probably would want less accounting conservatism. To conclude, an independent board of directors will be positively related to accounting conservatism. Beekes et al (2004) researches the connection between earnings timeliness and conservatism, and the composition of the board of directors. They argue whether different characteristics of the board lead to changes in conservatism and timeliness of earnings. The sample they use for their study consists of non-financial companies from the United Kingdom from the years 1993 to 1995. Beekes et al. (2009) used the Basu (1997) model for the reverse regression to measure the timeliness of the timeliness of earnings for both good and bad news. The authors predict that firms with a high proportion of outside board members are timelier in the recognition of bad news and less timely in the recognition of good news scenarios. The predictions are validated by their findings, which point out that firms with boards dominated with outside directors have increased earnings timeliness when it comes to bad news (Beekes et al., 2004). They conclude their research by stating that the composition of the board of directors is an important factor with respect to the timeliness of bad news in earnings and conservatism. Ahmed & Duellman (2007) extended on the study by Beekes et al (2004). They also researched the connection between conservative accounting and independence of the board, which are proxied by board of director characteristics. The sample they use consist of firms from the United States from the years 1999 to 2001. The research of Ahmed & Duellman (2007) differs in three ways of the research by Beekes et al. (2004). Firstly, as described, Ahmed & Duellman (2007) use a sample with firms from the US, they state that the results found by Beekes et al. (2004) might not hold in the US due to differences in legislation between the UK and US GAAP. Second, Beekes et al. (2004) use only one measure for accounting conservatism whereas Ahmed & Duellman (2007), besides from the Basu (1997) model, add two additional measures, being a market-value proxy and an approach by 12

Roychowdhury & Watts (2007) using backward-cumulation. Lastly, instead of only researching board independence, Ahmed & Duellman (2007) use a broader set board characteristics. Therefore, compared to Beekes et al. (2004), Ahmed & Duellman (2007) preform a more extensive research on a different sample. The findings by Ahmed & Duellman (2007) are the same as the findings from Beekes et al. (2004), which prove that the percentage of outside members on the board is positively related to conservatism. Also they find that the percentage of inside members on the board negatively related is to conservatism. Their results hold after controlling for variables like industry, firm size, leverage etc. Ahmed & Duellman (2007) conclude by stating that for the reduction of agency costs in the firm, accounting conservatism supports the board of directors. Overall, taking the findings of Beekes et al. (2004) and Ahmed & Duellman (2007) into account, it can be argued that firms that comprise of a strong governance system, as an independent board of directors, are more likely to use conservative accounting. 2.4 The Financial Crisis The collapse of the housing market in the United States in the end of 2006 was an important aspect in the start of a huge recession within the financial systems (Vyas, 2011). Brunnermeier (2009) states that the stock market in the US lost around eight trillion dollar of its value between 2007 and 2008. Also, the recession led to a series of bankruptcies in financial institutions like Lehman Brothers and Bear Stearns. The downfall of the US markets led to financial decline and affected markets worldwide due to economic globalization. Banks all over the world had to write down bad loans for hundreds of billions of dollars. The crisis not only affected banks and financial institutions, but it also led to declines in customer wealth, and downturns in economic activities. All these aspects let to the consideration that this 2007 financial crisis is the most severe financial crisis since the Great Depression of 1930 (Vyas, 2011; Brunnermeier, 2009). Governments, academics and other people are currently trying to figure out all the factors that triggered this financial crisis, and how can it be prevented in the future. 2.5 Hypotheses Development This thesis researches whether the latest financial crisis had an effect on the relationship between the independence of the board of directors and accounting conservatism. To research this, three hypotheses were developed. Starting with the effect of the crisis on the variables 13

board independence and accounting conservatism. The relation between these two together with the moderating effect of the crisis will tested through hypothesis 3. Weak corporate governance has been cited as one of the causes of the East Asian financial crisis (Mitton, 2002). Corporate governance could have made countries more vulnerable to a financial crisis. Today research again questions corporate governance, as the Organization of Economic Cooperation and Development (OECD) blames weak corporate governance as one of the main causes of the current financial crisis (Kirkpatrick, 2009). As described by Jensen & Meckling (1976) (see paragraph 2.1) a good corporate governance system and boards with a high rate of non-executive directors help reduce agency problems due to the control of outside directors on opportunistic behavior of managers. Knowing this regulators want to improve corporate governance standards and companies will try take better care of stakeholders and investors. Corporate governance in the form of an independent board of directors is a mechanism to protect these stakeholders and investors, for their protection board independence should increase during the crisis. This leads to the following hypothesis: H1: Relative to the pre-crisis period, board independence has increased during the financial crisis. Research has been conducted on the effects of crises on conservative accounting, as this is not the first crisis companies had to withstand. Vichitsarawong et al. (2010) examined whether the Asian Crisis impacted accounting conservatism. Their results showed that during the crisis firms used less conservatism. A possible explanation for the decrease of accounting conservatism is, to reduce the negative impact on firms, the need of these firms to release good news to rebuild investors confidence (Vichitsarawong et al., 2010). Gul et al. (2002) investigated the same crisis as Vichitsarawong et al. (2010) and measured the effects on conservatism focusing on Hong Kong. They acknowledge the fact that during the crisis period, firms were less conservative. Gul et al. (2002) give the explanation that companies operating in a financial crisis can lead to more aggressive accounting by managers compared to a period of prosperity. Contrary to research that shows a drop in accounting conservatism, there are studies that show an increase in conservative reporting. Walsh et al. (1991) describe that in times of crisis companies can engage in big bath accounting. The crisis is a period were companies can make a clean sheet, as the stock market is already very low and reporting all losses does not affect 14

the stocks more. So, in periods of crisis there is an increasing level of conservatism (Walsh et al., 1991). Research done by Vyas (2011) on the 2007 financial crisis showed an increase in the number of lawsuits during this crisis and a wave of shareholder class action litigation. Conservative accounting is an instrument to reduce litigation risk (Watts, 2003). Not only the number of lawsuits increased during the financial crisis, Vyas (2011) found that contracting conflicts, and therefore contracting costs increased during the financial crisis. Both litigation and contracting are described by Watts (2003) as the most important reasons for conservative accounting. Accounting conservatism is a useful tool to reduce these litigations costs and contracting conflicts. Francis et al. (2013) describes that use of more conservative accounting is a way to control for agency costs. Based on prior studies of accounting conservatism in crisis periods, it could be argued that conservatism decreases, and on the other hand, there is research suggesting an increase in conservative reporting. The research on the increase of conservatism outweighs the findings on a decrease. This leads to the following hypothesis: H2: Relative to the pre-crisis period, accounting conservatism has increased during the financial crisis. Conservatism is an important mechanism for accounting, and it also has positive effects on corporate governance. As described in paragraph 2.3 there is a relation between board of directors independence and accounting conservatism. In this thesis, the objective is to examine the impact of the change in independence of the board of directors on accounting conservatism, moderated by the financial crisis. This analysis leads to the third hypothesis: H3: The change in accounting conservatism due to the financial crisis is associated with the change in board independence. 3. Research Methodology 3.1 Measures of Accounting Conservatism 3.1.1 The Basu Model Basu (1997) describes accounting conservatism as the tendency to require a higher degree of verification to recognize good news as a gain than to recognize bad news as a loss. He created a regression model of asymmetric timeliness based on the differential reaction of good and 15

bad news in earnings. To measure conservatism, Basu (1997) uses stock prices as a proxy for good and bad news. These stock prices can be positive and negative, where negative stock returns indicate conservatism because losses are recognized earlier than profits. The model of Basu is specified as: X i = β 1 + β 2 D i + β 3 R i + β 4 D i R i + ε i (1) Where i indicates the company, X is earnings, R is returns and D is a dummy variable that is used to show the effects for negative returns with 1 if return (R) is negative, and 0 otherwise and ε is the residual error. Basu s (1997) expectation is that earnings are more sensitive for bad news than for good news. β 4 coefficient shows whether a company is conservative, β 4 is higher when a company is more conservative. This shows that earnings are more sensitive for bad news than for good news. β 3 coefficient measures the sensitivity of good news, which is positive returns on earnings, because when annual returns are positive the dummy variable is 0. The Basu model has certain limitations, of which one is by Givoly et al. (2007). They found that the level of conservatism is influenced by other factors like time periods, countries and reporting regimes, which are generally related to conservatism and therefore influencing the measurement method of Basu. Ball & Shivakumar (2005) state that the model of Basu (1997) does not make a distinction between profit or loss components into earnings that arise as a result of earnings management and random errors. Therefore, the model only identifies the existence of gains and losses, not the timeliness. Furthermore, Givoly & Hayn (2000) describe a limitation of the method of Basu, being that the method depends on the stock price movements for bad news and good news. This leads to the fact that bad news is only reflected by negative stock returns, therefore assuming that every negative stock return is bad news and therefore a signal for conservatism. Due to these limitations, and the fact that the Basu (1997) model does not take into account firms-specific measures, the C-Score method designed by Khan & Watts (2009) is used, as this method incorporates these measures for accounting conservatism. 3.1.2 The Khan & Watts Model The model by Khan & Watts (2009) is based on the model by Basu (1997) and is designed to calculate the level of conservatism with the use of firm-year measurements. Khan & Watts 16

(2009) believe that firms within an industry react in a different way to conservatism and that these reactions are influenced by firm-specific characteristics. This differs from the Basu (1997) model of asymmetric timeliness, which measures conservatism in an industry. These firm-specific characteristics added by Kahn & Watts (2009) are market-to-book ratio, size and leverage. To estimate timeliness reflecting both good news and bad news, Khan & Watts (2009) created the G-Score for the timeliness of good news, and the C-Score for the timeliness of bad news. These scores are created as a linear function of the added firm-specific characteristics, resulting in the following equations: G-Score = β 3 = μ 1 + μ 2 Size i + μ 3 M/B i + μ 4 Lev i (2) C-Score = β 4 = λ 1 + λ 2 Size i + λ 3 M/B i + λ 4 Lev i (3) Where Size is the natural log of market value of equity, M/B is the market-to-book ratio, and Lev stands for leverage which is the debt-to-equity ratio. As previously stated, the above equations are linear functions, by substituting β 3 (G-Score) and β 4 (C-Score) by respectively equations (2) and (3) in equation (1) and implementing additional terms to control for the firm-specific characteristics separately, Khan & Watts (2009) created the following empirical regression model: X i = β 1 + β 2 D i + R i (μ 1 + μ 2 Size i + μ 3 M/B i + μ 4 Lev i ) + D i R i (λ 1 + λ 2 Size i + λ 3 M/B i + λ 4 Lev i ) +( 1 Size i + 2 M/B i + 3 Leverage i + 4 D i Size i + 5 D i M/B i + 6 D i Leverage i ) + ε i (4) Being only interested in the timeliness of bad news, the C-Score, the G-Score will not be determined. To estimate the C-Score for each firm-year and thus get to the measure of conservatism of Khan & Watts (2009), a few steps have to be followed. Firstly, it is necessary to run the cross-section regression as stated as equation (4), where coefficients λ 1 to λ 4 are to be found. These coefficients helps calculating the C-Score as stated as equation (3). The higher the C-Score is, the greater the degree of conservatism. 3.2 Measures of Board Independence and the Crisis This study researches the relationship between board of directors independence and conservatism while taking the financial crisis as a moderating variable into account. As 17

previously stated, conservatism is measured by the C-Score and calculated using the Khan & Watts (2009) method. Conservatism is the dependent variable in the second regression. The used independent variables are described with the following proxies: Percentage of Non-Executive Board Members (%NEBM) is the proportion non-executive members of the board of directors. Non-executive board members are seen as independent board members. Fama & Jensen (1983) describe a positive relationship between independent members on a board and accounting conservatism. Crisis is a dummy variable, which takes the value of 0 when firm-year observations are in the pre-crisis period (2002-2007), and 1 when the firm-year observations are in the within-crisis period (2008-2012). Percentage of Non-Executive Board Members * Crisis (%NEBM*Crisis) is an interaction variable showing the proportion of non-executive members on the board divided in the precrisis period and within-crisis period. 3.3 Control Variables In this study eight control variables are used to control for conservatism, because this is the dependent variable: Size is a control variable for conservatism because larger firms have higher political costs related to smaller firms. Higher political costs lead to more accounting conservatism as described by Watts (2003). Furthermore Ahmed & Duellman (2007) argue that large companies have more symmetric information and are timelier in disclosing information compared to smaller firms. Market-to-book ratio complies as a control variable, as Khan & Watts (2009) describe that accounting conservatism requires a higher degree of verification for losses compared to gains. This indicates a cumulative understatement of the book value of assets compared to the market value. Leverage is a suitable control variable, as Watts (2003) describe that firms with a lot of leverage are more likely to account in a conservative manner due to higher shareholder and debt-holder conflicts. 18

Volatility is used as a control variable because companies who have significant growth options relative to assets, have more volatile stock returns, which is used as a proxy for firmspecific uncertainty (Khan & Watts, 2009). Volatility is likely to be higher in times of bad news compared to times of good news, so conservatism is expected to be positively related to volatility. Cycle is short for investment cycle and is used as a control variable. Based on Khan & Watts (2009) there is an expectation that the investment cycle is positively associated with conservatism due to the increase of agency costs in this variable. This suggests the longer the investment cycle and the greater the firm-specific uncertainty, the more conservative the firm s accounting. Big 4 is used to control for companies that might act more or less conservative when having an auditor from a Big 4 audit firm. The Big 4 auditors are Ernst & Young, Deloitte PriceWaterhouseCoopers, and KPMG. Herrmann et al (2008) researched this connection and argue that companies engaged in more conservative accounting when audited by a Big 4 auditor. This acknowledges the research by Michas (2011), who found earnings reported in a more conservative manner by companies with a Big 4 auditor. Big 4 is a dummy variable which takes the value of 0 when a company is audited by a non-big 4 auditor, and 1 when a company is audited by a Big 4 auditor. Growth is the percentage of annual sales growth. Roychowdhury & Watts (2007) describe that firms with high growth rates use less conservative accounting. Therefore, evidently growth and accounting conservatism are negatively related. Profitability is another variable stated by Yunos et al. (2010) to be a common control for conservatism. Yunos et al. (2010) argue there is a positive relationship between profitability and conservatism whereas companies with higher profitability apply more conservatism in accounting. 3.4 Empirical Model With the independent, dependent and control variables the following empirical model is estimated: Con = α 0 + α 1 %NEBM + α 2 Crisis + α 3 %NEBM*Crisis + α 4 Size + α 5 M/B + α 6 Lev + α 7 Vol + α 8 Cycle + α 9 Big4 + α 10 Growth + α 11 Prof + ε (5) 19

Where: Con %NEBM Crisis %NEBM*Crisis Size M/B Lev Vol Cycle Big4 Growth Prof Conservatism measured by the C-Score and calculated by the method of Khan & Watts (2009). The proportion of non-executive board members as described by the company. Dummy variable; 0 for firm-year observations is the pre-crisis period (2002-2007) and 1 for firm-year observations in the within-crisis period (2008-2012). The proportion of non-executive members on the board divided in the precrisis period and within-crisis period. Size of the company. Market-to-book ratio, market value of equity divided by book value of equity. Leverage, debt divided by equity. Volatility, the price movement of the company stock. Investment cycle of the company. Dummy variable for Big4 auditor; 0 for companies audited by a non-big4 auditor and 1 for companies audited by a Big4 auditor. Growth in annual sales of the company. Profitability of the company. 3.5 Sample Selection An important factor of this research is the financial crisis, therefore, companies from the United States are used as it is suggested that the crisis started in this country and that their stock markets were directly influenced and impacted early (Erkens et al., 2012). The sample consists of the firms that are included in the S&P 500 index. The sample comprises of the all the companies from the index excluding the financial and assurance firms as these companies are eliminated due to the fact that this sector had an important impact on the start of the crisis (Erkens et al., 2012). Moreover, also due to their circumstances of the companies in this period and because these companies accounting characteristics differ from other companies, making it hard to compare. 20

The data collected consists of firms between the years 2002 and 2012. This sample can be divided into two periods. Firstly the pre-crisis period, which is from 2002 to 2007. Secondly, the period is the within-crisis period, which is from 2008 to 2012. The data is extracted from the Datastream database. Table 1 shows how the sample for the final regression is obtained. The total sample consists of firm-year observation from the companies in the S&P 500 for 11 book years. Financial and assurance firms, with SIC codes of 6000 to 6999, are excluded. Subsequently, firm-year observations with missing data are deleted from the sample. Lastly, the top and bottom 1% of the data of the variables used is trimmed using STATA. This is done in two steps, first the top and bottom 1% from the variables needed for the C-Score calculation are excluded, next the same is done for the second regression. This is to for control outliers, as described by Khan & Watts (2009). Therefore, the final sample is 2.391 firm-year observations. Table 1 Sample Number of Sampling procedure observations Total sample 2002-2012 5513 After excluding financial institutions, real estate and assurance (SIC 6000-6999) 4391 After excluding firms with missing data for variables required for regression 3119 After excluding firms with data in top and bottom 1% of variables required for regression C-Score 2690 After excluding firms with data in top and bottom 1% of variables required for regression 2391 Table 2 shows the firm-year observations divided in different industries, the classification of the firm-year observations by industry was made based on the SIC codes of the different companies. Manufacturing represents the largest part of the sample with 41,57%. 21

Table 2 Observations per industry Number of observations Percentage of sample Industry SIC code Agricultural, Production-Livestock and Animal Specialties 1000-1999 182 7,61 Manufacturing 2000-3999 994 41,57 Transportation, Communication, Electric, Gas and Sanitary 4000-4999 384 16,06 Wholesale and Retail Estate 5000-5999 305 12,76 Services 7000-8999 387 16,19 Not Available NA 139 5,81 Total 2391 100 3.6 Descriptive Statistics Table 3 defines the descriptive statistics of the independent variable, the dependent variables and the control variables. This table includes the observation, the mean, standard deviation and the minimum and maximum per variable. Table 3 Descriptive statistics Variable Observations Mean Std. Dev. Min Max C-Score 1 2391-0,061 0,778-5,860 5,834 NEBM 2391 68,711 10,505 27,190 80,150 Crisis 2 2391 0,588 0,492 0,000 1,000 NEBMCrisis 3 2391 41,247 35,310 0,000 80,150 Size 2391 16,355 1,024 14,147 19,226 M/B 2391 3,363 2,558-10,392 19,227 Lev 2391 0,314 0,341 0,000 2,176 Big4 2391 0,998 0,041 0,000 1,000 Growth 2391 9,110 15,382-35,330 79,150 Prof 2391 0,122 0,056 0,004 0,296 Cycle 2391 0,036 0,022 0,001 0,131 Vol 2391 26,020 7,882 12,740 52,260 Note: see Appendix 1 for variable definitions 1 Independent variable 2 Moderating variable 3 Interaction variable 22

Tabel 4 Correlation matrix C-Score NEBM Crisis NEBMCrisis Size M/B Lev Big 4 Growth Prof Cycle Vol C-Score 1,0000 NEBM -0,0267 1,0000 0,1918 Crisis -0,2092 0,1629 1,0000 0,0000 * 0,0000 * NEBMCrisis -0,2033 0,3060 0,9779 1,0000 0,0000 * 0,0000 * 0,0000 * Size -0,1360 0,0501-0,0048 0,0030 1,0000 0,0000 * 0,0143 ** 0,8148 0,8851 M/B -0,1365-0,0661-0,0928-0,1024 0,1642 1,0000 0,0000 * 0,0012 * 0,0000 * 0,0000 * 0,0000 * Lev 0,1085 0,0719 0,0988 0,1082-0,2618-0,3058 1,0000 0,0000 * 0,0004 * 0,0000 * 0,0000 * 0,0000 * 0,0000 * Big4 0,0035 0,0026 0,0073 0,0036 0,0391 0,0088 0,0214 1,0000 0,8643 0,9006 0,7204 0,8585 0,0562 *** 0,6654 0,2947 Growth 0,0756-0,0573-0,1690-0,1678 0,0404 0,0573-0,0950 0,0057 1,0000 0,0002 * 0,0051 * 0,0000 * 0,0000 * 0,0482 ** 0,0051 * 0,0000 * 0,7812 Prof -0,0430-0,0934 0,0003-0,0215 0,0887 0,2664-0,2867 0,0050 0,1702 1,0000 0,0353 ** 0,0000 * 0,9879 0,2943 0,0000 * 0,0000 * 0,0000 * 0,8058 0,0000 * Cycle 0,0202-0,0552-0,0933-0,0935-0,0415-0,0083 0,0360-0,0259 0,1367 0,3635 1,0000 0,3228 0,0069 * 0,0000 * 0,0000 * 0,0426 ** 0,6861 0,0783 *** 0,2058 0,0000 * 0,0000 * Vol -0,0148-0,1090 0,0699 0,0497-0,1488 0,0459-0,0364-0,0014 0,1516 0,0660 0,1149 1,0000 0,4708 0,0000 * 0,0006 * 0,0152 ** 0,0000 * 0,0249 ** 0,0751 0,9468 0,0000 * 0,0012 * 0,0000 * Note: see Appendix A for variable definitions * significant at 0,01 level ** significant at 0,05 level *** significant at 0,10 level 23

Table 4 shows the correlation matrix for the variables used in the regression. From the matrix there can be concluded that NEBM (board independence) is a significant positive correlated with the financial crisis, 0,1629, which is described in the first hypothesis. The second hypothesis describes the connection between the crisis and the C-Score (accounting conservatism). From the correlation matrix can be concluded that this is a significant negative correlation. However, hypothesis 2 expects a positive relationship between the crisis and the C-Score. Another relation worth taking a look at is the of the board independence and accounting conservatism, the correlation matrix shows a value of -0,0267, there is a negative correlation between these two variables which means that when board independence increases, conservatism decreases, which is opposite to the expectations. 4. Results This chapter will answer the hypothesis using tests and regressions conducted. First, the change in board independence due to the financial crisis is tested. Second, the change in accounting conservatism due to the financial crisis is tested. Lastly, a regression analysis will show whether the change in accounting conservatism due to the financial crisis is associated with the change in board independence. 4.1 Change in Board Independence H1: Relative to the pre-crisis period, board independence has increased during the financial crisis. Figure 1 illustrates the change in board independence, with board independence measured by non-executive members on the board of directors from 2002 to 2012. Note, that in this paper the assumptions is made that the crisis started in 2008, as it emerged in the end of 2007. 24