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SUMMARY: This study investigates whether the expertise, independence, and activities of a firm's audit committee have an effect on the quality of its publicly released financial information. In particular, we examine the relationship between audit committee characteristics and the extent of corporate earnings management as measured by the level of income-increasing and income-decreasing abnormal accruals. Using two groups of U.S. firms, one with relatively high and one with relatively low levels of abnormal accruals in the year 1996, we find a significant association between earnings management and audit committee governance practices.
We find that aggressive earnings management is negatively associated with the financial and governance expertise of audit committee members, with indicators of independence, and with the presence of a clear mandate defining the responsibilities of the committee. The association is similar for both income-increasing and income-decreasing earnings management, suggesting that audit committee members are concerned with both types of earnings management and do not exhibit an asymmetric loss function similar to that of auditors.
Keywords: audit committee; financial expertise; earnings management; abnormal accruals.
Data Availability: The data used is from public sources identified in the manuscript.
INTRODUCTION
Concerns about earnings management (e.g., Levitt 1998) and recent high-profile accounting scandals have led most of the investing community to call for more effective audit committees as a mean to improve the quality of financial statements (e.g., Blue Ribbon Committee [BRC] 1999; securities and Exchange Commission [SEC] 2000). In response to these calls, regulators have adopted regulations on the functioning of audit committees in a number of areas including the expertise of their members, their independence, and their activities. The latest example of such regulation in the U.S., the Sarbanes-Oxley Act of 2002 (hereafter SOX), requires that at least one audit committee member have financial expertise, that all the members be independent from the firm's management, and that the committee oversee the accounting and financial reporting processes as well as the audit of the financial statements.
While prior research on actual fraudulent financial reporting deficiencies provides evidence that is generally consistent with the assertion that some of the practices recommended or required by regulators are associated with lower likelihood of fraud (Beasley 1996; Abbott et al. 2004), there are questions as to whether they also reduce...