Does Increased Board Independence Reduce Earnings Management? Evidence from Recent Regulatory Reforms

Xia Chen

Singapore Management University

Qiang Cheng

Singapore Management University

Xin Wang

University of Hong Kong – School of Business

Review of Accounting Studies, Forthcoming

October 2014

Abstract:

In this paper, we examine whether recent regulatory reforms requiring majority board independence are effective in reducing the extent of earnings management. Firms that did not have a majority of independent directors prior to the reforms (referred to as non-compliance firms) are required to increase their board independence. We find that, while non-compliance firms on average do not experience a significant decrease in earnings management after the reforms compared to other firms, non-compliance firms with low information acquisition cost experience a significant reduction in earnings management. The results are similar when we examine audit committee independence and when we use alternative proxies for information acquisition cost and earnings management. These findings indicate that independent directors’ monitoring is more effective in a richer information environment.

Does Increased Board Independence Reduce Earnings Management? – Introduction

In response to the widespread corporate and accounting scandals in the late 1990s and early 2000s, in 2002, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) proposed new corporate governance rules for the listed firms, which were approved by the Securities and Exchange Commission (SEC) in 2003. These rules required the listed firms to have a majority of independent directors on their boards. One of the primary objectives of this reform is to enhance the monitoring by the board, particularly the monitoring of the financial reporting process. Duchin et al. (2010) examine the impact of this board structure reform on firm performance and valuation. They find that after the reform, firms with an increase in board independence experience an improvement in firm performance if the information acquisition cost for independent directors is low. However, ex ante, it is unclear how the increased board independence as a result of this reform will affect earnings management and whether earnings management is a channel through which this reform influences firm performance, given the mixed evidence on the association of board structure and earnings management in the literature.

In this paper, we directly test whether an increase in board independence in response to this reform is associated with a decrease in earnings management. Moreover, in light of the potential ineffectiveness of outside directors’ monitoring due to the lack of information (e.g., Jensen 1993; Adam and Ferreira 2007; Duchin et al. 2010), we investigate whether the impact of the increase in board independence on earnings management varies with the cost of information acquisition. If independent directors’ monitoring is more effective when the cost of information acquisition is low, we expect to find a stronger association between the increase in board independence and the reduction in earnings management for firms with lower information acquisition cost than for those with higher information acquisition cost. Our tests thus (1) provide evidence on the effectiveness of the board structure reform in reducing the extent of earnings management and (2) complement Duchin et al. (2010) by shedding light on one of the channels through which increases in board independence can enhance firm value.

Our sample includes 1,587 firms with board data from BoardEx for the period 2000-2005. We split the sample into two groups. The first group, 55 percent of the sample, satisfied the regulatory requirement before the reform and is referred to as compliance firms; the second group, 45 percent of the sample, is referred to as non-compliance firms. To comply with the regulatory requirements, non-compliance firms have to increase board independence. Exploiting this exogenous change in board independence for non-compliance firms, we adopt a differencein-differences research design. Specifically, we use an indicator for non-compliance firms as the instrument for the ex-post increase in board independence and use compliance firms to control for the time-trend of earnings management during our sample period (e.g., Cohen et al. 2008). In the main tests, we examine whether there is a significant reduction in earnings management from the pre- to post-regulation period for non-compliance firms relative to compliance firms and whether the reduction is greater for non-compliance firms with lower information acquisition cost. As an alternative research design, we use the non-compliance indicator to predict the change in board independence and base our tests on the predicted change in board independence; we obtain similar results.

Board Independence Earnings Management

See full PDF here.