Outside Directors, Board Effectiveness, and Abnormal Accruals

WP 99/006

Posted: 14 Jun 1999

See all articles by Ken V. Peasnell

Ken V. Peasnell

Lancaster University - Department of Accounting and Finance

Peter F. Pope

Bocconi University; London School of Economics and Political Science

Steven Young

Lancaster University - Department of Accounting and Finance

Date Written: February 1999

Abstract

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

JEL Classification: M41, M43, G32, G34

Suggested Citation

Peasnell, Kenneth V. and Pope, Peter F. and Young, Steven, Outside Directors, Board Effectiveness, and Abnormal Accruals (February 1999). WP 99/006, Available at SSRN: https://ssrn.com/abstract=163992

Kenneth V. Peasnell (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+44 1524 593631 (Phone)
+44 1524 847321 (Fax)

Peter F. Pope

Bocconi University ( email )

Dept of Accounting
Milan, 20136
Italy

London School of Economics and Political Science ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Steven Young

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
+441 5245-94242 (Phone)
+441 5248-47321 (Fax)

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