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And approved by
r. ElizabethttSordon
r. Samir El-Gazzar
Dr. Yangru Wu
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UMI
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This study examines the effectiveness of different monitoring devices derived from
some corporate governance factors, institutional ownership, and the quality of the audit
process with their relation to earnings management behavior. Assuming that earnings
management is an opportunistic behavior by managers that is not in the shareholders interest
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in the long run, the study expects that those corporate governance variables that improve the
alignment of interests between managers and shareholders will be related to lower levels of
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with their relation to earnings management behavior, and expects that the magnitude of
earnings management will decrease with the level of institutional ownership in the firm and
the quality of the audit process.
Using a sample of manufacturing companies during the years 1999 and 2000, the
study applies different models suggested in the accounting literature to isolate discretionary
accruals. The results support the expectations regarding the effect of the independent
directors on the board, independence of the audit committee, institutional ownership, and the
effect of the audit quality. The results are, however, inconsistent with the expectations that
earnings management will increase with the CEO tenure and board size. The results show
that the magnitude of discretionary accruals is negatively related to both of the CEO tenure
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and board size. The results also dont show any systematic relation between earnings
management and the CEO duality. Tests of some interactions between the corporate
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governance variables indicate that the independence of the audit committee may be a
function of the board size. The negative relation between earnings management and audit
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committee independence variable was significant only for big board observations (board size
above the median). However, these interaction tests show no signs of interaction between the
CEO duality and both of the CEO tenure or the board independence. The observed negative
relation between earnings management and both of CEO tenure and board independence
variables holds for both the CEO duality and non-duality observations. Interaction tests also
indicate that the monitoring function of independent directors on the board is more effective
when board independence is combined with higher institutional ownership, better audit
quality, and bigger board size. Additional tests also examined the industry effect and the
effect of loss avoidance incentive. The results of these tests show that the different
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monitoring devices examined in the study are less effective in the situations when managing
earnings upward can reverse negative earnings to be slightly above zero. Tests on different
industry segments show that the effect of these monitoring devices is generally similar in
different industries.
This study contributes to the earnings management literature by examining different
models suggested in the literature for isolating discretionary accruals including those models
that control for the previous performance such as the portfolio adjusted models. The study
also contributes to the current debate about the effectiveness of different corporate
governance structures by examining new corporate governance factors with their relation to
earnings management, both in individual basis and the possible interaction between them. In
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management.
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addition, the study tests the effect of institutional ownership variable on earnings
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ACKNOWLEDGEMENTS
To my big family, the Egyptian people, who paid for my scholarship using hard money
they need
And
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Table of Contents
I. Introduction and Focus of the Study................................................................................-1 A. Introduction............................................................................................................... -1B. Focus of the Study..................................................................................................... -8C. Major findings of the study...................................................................................... -17II. Background.....................................................................................................................-21A. Earnings Management Incentives and Techniques.................................................. -211. Earnings Management Incentives........................................................................ -21-
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1. The Corporate Governance as a Monitoring Device............................................ -292. The Institutional Ownership as a Monitoring Device.......................................... -36-
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3. The Audit Quality as a Monitoring Device.......................................................... -39III. Prior Research................................................................................................................ -42A. Prior Research on Corporate Governance Factors................................................... -42B. Prior Research on the Effect of Institutional Ownership......................................... -51C. Prior Research on the Effect of Audit Quality......................................................... -56IV. Research Hypotheses and Methodology........................................................................ -58A. Research Hypotheses.............................................................................................. -581. Independent Directors on the Board.................................................................... -582. Audit Committee Independence........................................................................... -593. Independent Directors Ownership...................................................................... -604. The CEO Tenure.................................................................................................. -615. The CEO-chairman Duality................................................................................. -616. The Board Size..................................................................................................... -627. The Institutional Ownership................................................................................. -648. The Audit Quality................................................................................................. -65vi
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B. Research Design....................................................................................................... -661. Measurement of Earnings Management............................................................... -662. Univariate Analysis.............................................................................................. -733. Multivariate Analysis........................................................................................... -744. Other Control Variables....................................................................................... -79C. Sample Selection......................................................................................................-81V. Empirical Results........................................................................................................... -83A. Descriptive Statistics..........................................................................................-83B. Univariate Analysis............................................................................................-84C. Multivariate Regression..................................................................................... -86-
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References............................................................................................................................ -97TABLES
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Table 1. Sample Selection.................................................................................................. -107Table 2. Descriptive Statistics............................................................................................ -108Table 3. Correlation Coefficients....................................................................................... -110-
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Table 4. Independent Samples T-test. All Explanatory Variables..................................... -111Table 5. Multivariate Regression Analysis........................................................................ -113Table 6. Multivariate Regression Analysis with Interaction Terms...................................-114Table 7. Independent Samples T-test. Combination of Variables......................................-115Table 8. T-test Results for Differences in Means of the IND Variable..............................-116Table 9. Interaction Regression Analysis...........................................................................-116TablelO. Independent Samples T-test. Industry Groups.....................................................-117Tablel 1. Multivariate Regression Analysis-Industry Groups............................................ -118Tablel2. Loss Avoidance Test............................................................................................-119VITA...................................................................................................................................-120-
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the informativeness of accounting earnings over the past several decades as measured by the
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Since earnings management behavior may affect the quality of reported earnings and
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its usefulness for investment decisions, it may weaken the investors confidence in the
financial reporting process. This behavior also may lead to misallocation of economic
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resources into less efficient investments. Because this behavior may have a significant effect
on the quality of information provided to investors, the SEC and other federal agencies are
concerned about earnings management (Healy & Wahlen, 1999) especially after the collapse
of big companies, partially because of different accounting malfeasances. Because of this
accounting misconduct, it appears to many market participants that different monitoring
mechanisms that are supposed to protect the investors interests have failed to prevent or
detect earnings management and warn investors about accounting manipulations.
The collapse of some companies as a result of accounting manipulation by mangers
has raised serious questions about the effectiveness of the monitoring devices to protect
investors interests and control managerial opportunistic behavior. These monitoring devices
include different corporate governance factors such as independent directors on corporate
boards, independence of the audit committee, and other factors that may affect the share of
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power inside the board and, therefore, the quality of corporate governance structure and its
effectiveness to protect shareholders interest in the long run. Such corporate governance
factors include the CEO-chairman duality, the CEO tenure, and the board size.
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institutional ownership in the company is also perceived to be another monitoring device that
may help to align the interests of both managers and shareholders and is expected to reduce
any potential opportunistic behavior by managers, in addition to the independent audit
process conducted by outsider auditors.
Recently, federal regulatory agencies have expressed increasing concerns about the
quality of corporate governance in the U.S corporations, and issued new regulations to
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improve governance and the independence of both the board of directors and the external
auditor. For example, the Sarbanes-Oxley Act issued on July 2002 has addressed a wide
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range of corporate accountability issues. Among the key provisions of the legislation are:
- Create a Public Company Accounting Oversight Board to establish auditing standards and
regulate accountants who audit public companies;
- Prohibit auditors from providing non-audit services to audit clients, except with oversight
board pre-approval;
- Require CEOs and CFOs to certify their companies annual and quarterly financial
reports, subject to civil and criminal penalties;
- Require public companies to have an audit committee composed entirely of independent
directors;
- Prohibit issuers from extending new personal loans to directors and executive officers.
The SEC has also reacted to these regulations and expressed concern about the
independence of the board and audit committee members. On its release No. 33-8220 issued
on April 9, 2003, the SEC required issuing companies to have independent audit committees
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composed of members who are not affiliated person(s) of the issuer or any subsidiary of the
issuer apart from his or her capacity as a member of the board and any board committee".
The release also required companies to disclose additional information about the audit
committee members on the annual report in addition to the proxy statements. In addition, the
commission required issuing companies (see Release No. 33-8177 issued on January 23,
2003) to disclose whether they have at least one "audit committee financial expert" serving
on its audit committee, and if so, the name of the expert and whether the expert is
independent of management. A company that does not have an audit committee financial
expert must disclose this fact and explain why it has no such expert.
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and the audit committee in particular. Major stock exchanges modified their listing
requirements to mandate listed companies to have audit committees composed of directors
with no relationship to the company that may interfere with the exercise of their
independence. The general theme behind these regulations is that independent audit
committees will better serve as a monitoring mechanism of the financial reporting process.
For example, on November 2003, the New York Stock Exchange issued its new corporate
governance rules for the listed companies (Section 303A of the NYSEs listed company
manual). Among the major requirements of these rules are:
- Listed companies must have a majority of independent directors on their boards. For
purposes of these new rules, the Exchange also tightened the definition of independent
director,
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ownership, and audit process as external monitoring devices on different finance, investment,
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and accounting decision-making situations. These situations include merger and acquisition
decisions, adoption of some acquisition defense techniques, filing for bankruptcy, R&D
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investments, and accounting fraud, among others. The corporate governance factors
examined in previous research include independent directors on boards, CEO tenure, CEOchairman duality (i.e., CEO also holds the board chairman position), stock ownership of
independent directors on the board, in addition to the board size. However, the results of
these studies on the efficiency of different monitoring devices are mixed. For example, some
studies found that higher percentage of independent directors on the board is related to lower
probability of bankruptcy (Daily & Dalton, 1994a), higher returns to target company
shareholders during the takeover period (Cotter et al, 1997), adoption of takeover defense
techniques that benefit the target companys shareholders (Brickley et al 1994, Mallette &
Fowler 1992, Cochran et al 1985, and Singh & Harianto 1989 among other papers), better
financial performance of the company (Baysinger & Butler 1985), and lower probability of
fraud in the financial statements (Beasley, 1996). These results indicate that the percentage of
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independent directors on the board represents an efficient monitoring device that aligns the
interests of managers and shareholders. However, other studies found no evidence that
independent directors on the board are related to better performance (e.g., Bhagat & Black
1999; and Agrawal & Knoeber 1996) and that the companies with higher percentage of
independent directors have lower R & D expenditures (Hill & Snell, 1988), which may be
inconsistent with the assumed guardian role of independent directors. Prior research also
suggests that CEOs who hold the board chairman position have above-the-average power and
can dominate the board decisions and mitigate any monitoring role by independent directors.
However, the results of studies that addressed the effect of CEO-chairman duality are mixed.
For example, Daily & Dalton (1994b) and Elloumi & Gueyie (2001) found that firms in
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which the CEO serves as board chairman are more financially distressed and are more likely
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to go bankrupt. Daily (1995), however, found no evidence that the leadership style is related
to the reorganization success of distressed firms. Research that examined other corporate
governance factors reported that large boards are generally less efficient than small boards
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(Patton & Baker, 1987) and that the stock ownership of independent directors encourages
them to exercise their monitoring role effectively and align the interests of managers and
owners (Hambrick, 2001).
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Baysinger et al. (1991) find that institutional ownership is positively related to R&D
expenditures. However, Graves (1988) reports a negative relation between R&D spending
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of contracts that specify the roles of various stakeholders (i.e, managers, owners, creditors)
and define their rights, obligations, and payoffs under various conditions. The interests of
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potential conflict of interests may still occur as some participants try to achieve their personal
goals. Within such framework that separates ownership from control, the operations of the
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firm are conducted and controlled by its managers without major stock ownership positions.
In theory, managers are agents of the owners, but in practice managers may control the firm
for their own interests. This conflict of interests was described in the agency problem
developed by Jensen and Meckling (1976) who argued that when managers own less than
total common stock of the firm, they will be more likely to engage in activities that maximize
their personal wealth even by reducing the value attributed to owners.
The agency model proposes a number of corporate governance mechanisms that are
designed to reduce agency costs associated with the separation of ownership and control.
Their purpose is to align shareholders and managers interests. In general, governance
mechanisms can be classified into two broad categories, internal and external. Internal
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mechanisms include board structure variables such as the independent directors on the board
and its committees, board size, and CEO-chairman duality. Internal mechanisms also include
debt financing, managerial and directors shareholdings, and their compensation plans. In
addition to the concentrated shareholdings by financial institutions or by blockholders and
the external audit process, a key external mechanism is the market for corporate control. The
probability of replacement following acquisition provides a direct incentive for top
management to perform in the best interest of shareholders and maximize the firms value in
the long run*. The most common monitoring mechanisms discussed in literature can be
summarized as follows:
1. Composition of the hoard: it is widely believed that outside directors play a larger role in
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monitoring management than inside directors. Fama (1980), for instance, argues that the
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inclusion of outside directors as professional referees enhances the viability of the board
in achieving its control function. This also lowers the probability of top management
colluding with other board members against the shareholders interests. Outside directors
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are usually respected leaders from the business and academic communities and have
incentives to develop and protect their reputation as experts in decision control. On the
other hand, it is argued that the monitoring role of independent directors will be less
effective when those directors are overcommitted in terms of the number of directorships
they hold in different companies because directors who hold too many directorships may
not have enough time for close monitoring attention for management (Lipton & Lorsch,
1992). However, Li & Ang (2000) reported evidence that the mere number of outside
directorships doesnt affect the directors performance in monitoring management
* For more discussion about different monitoring mechanisms, see Agrawal & Knoeber (1996), John & Senbet
(1998).
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especially in situations that require this directors expertise. The effectiveness of the
boards monitoring function is also affected by its size. While the boards capacity for
monitoring increases as more directors are added, the benefit of a larger board size may
be outweighed by the incremental cost of poorer communication and decision-making
process usually associated with larger groups. Therefore, limiting the board size may
improve its efficiency. In addition, the effectiveness of the board may be affected not
only by its composition (i.e., proportion of outside directors) and size but also by its
internal administrative structure and composition of its committees. For example, the
audit committee provides an oversight responsibility for the firms financial reporting
process on behalf of the board of directors and, therefore, the independence of that
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committee will improve the quality of the financial reporting process and the reliability of
the financial information provided to shareholders. Other administrative structure
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variables that may affect the effectiveness of the board include some leadership
characteristics such as the CEO tenure and the CEO-chairman duality (the two positions
are held by the same person) versus the CEO-chairman non-duality. For example, Jensen
(1993) argues that when the board chairman is also holding the CEO position, it is much
more difficult for the board to perform its critical function effectively and, therefore, it is
important to separate the CEO and chairman positions for the board to be effective. The
long CEO tenure may also reflect either an above-the-average power for that CEO, or a
relatively less sever agency problems (Hermalin & Weisback, 1991). In both cases, the
CEO tenure may affect the effectiveness of the monitoring function entitled to the board
of directors.
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2. The M&A marketfor control: The threat of being a target in a takeover transaction is an
external monitoring mechanism for managements behavior. Because the incumbent top
managers of the target company usually lose their jobs after the acquisition (especially in
the hostile takeover), they will have more incentives to work for the best interest of their
shareholders to avoid any hostile takeover in a proxy contest. For example, Kennedy &
Limmack (1996) found a significant increase in the rate of target company CEO turnover
following the takeover, and that the target companys share price had a pre-bid poor
performance especially for those target companies from which the CEO was
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increased debt reduces free cash flow and, therefore, limits managerial discretion (Jensen,
1986b). Rather than spending excess funds on projects that have negative net present
values, debt requires managers to use these funds to serve the companys debt. Although
the increased leverage may have its own costs (directly in the form of debt service costs,
and indirectly in the form of increasing probability of bankruptcy), the threat caused by
failure to make debt service payments serves as an effective monitoring mechanism that
makes the firm more efficient. Such monitoring function of debt is more important for
firms that generate large cash flows but have less growth opportunities. Investment
bankers and analysts may also play an important role in this monitoring function of debt
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financing. As firms go regularly to financial markets to obtain debt, these markets will
have opportunity to evaluate the firm, its management, and its proposed projects. The
monitoring role of the debt financing may also be exercised through the debt covenants
usually attached to debt contracts.
4. Large investors and institutional ownership: When the control rights (such as votes) are
concentrated in the hands of small number of investors, it will be much easier for them to
take actions and monitor the managerial behavior than when control rights are split
among many investors. That concentration of ownership can take several forms including
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monitoring management rather than acting traditionally as a free rider. Those large
investors also have enough voting control to put pressure on the management in some
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cases, or even to remove the management through a proxy fight or a takeover. Because a
significant part of the wealth of large investors is in stake in the firm, they have
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increasing benefits from conducting monitoring activities to ensure that managers do not
engage in non-value maximizing behavior. Because of the economics of scale of
collecting and analyzing information about the firm, these potential benefits to large
investors are more likely to exceed the costs of these activities. Therefore, it is expected
that large external shareholdings will undertake a more active interest in important
corporate issues and play a vigilant role in monitoring the managers behavior.
5. The external audit process: The audit process conducted by external auditor is obviously
another external monitoring mechanism on managers behavior. The main objective of
the audit process is to add reasonable assurance that the financial reporting process is
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consistent with enacted professional standards, and that the financial information
provided are free from significant misstatements. As argued by Wallace (1980), the
external audit process adds value to the financial information conveyed through financial
statements and enhances the reliability of that information. The monitoring mechanism
exercised through the external audit process is expected to be more efficient with the
increase in the quality of audit services provided by external auditor. DeAngelo (1981)
argued that the quality of external audit process will improve when the auditor is
substantially independent. Big auditing firms have more clients and their revenues dont
essentially depend on any specific one or a small group of these clients. These big
auditing firms are also more exposed to litigation risk if any third party incurs a loss as a
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result of the auditors failure to meet their professional responsibilities and conduct the
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due process to detect and present any significant misstatements in financial statements.
Therefore, DeAngelo (1981) argued that big auditing firms will be more effective in
exercising their monitoring function and will provide a higher quality audit.
6. Executive and directors compensation: Executive and directors compensation plans have
also been proposed to achieve alignment of interests. The conflict of interests between
owners and managers would be substantially reduced if executive and directors
compensation plans more tightly related pay to performance. To achieve that alignment
of interests, firms use a variety of cash-based bonus plans and stock-based plans such as
stock options or restricted stocks. The underlying performance measures used in these
compensation plans can be based on some accounting measures or stock market-based
performance measures. For example, Rappaport (1986) observed that early executive
compensation performance plans were market based. However, during the 1970s,
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performance measures for granting options shifted from marked-based to accountingbased measures. In recent years, performance has moved again to market-based
measures. The directors compensation is a relatively recent phenomenon and it goes
hand in hand with the increased directors responsibility. In the past, directors did little
monitoring and received nominal fees for their services. However, board members today
take a greater monitoring role by overseeing the appointment and assessment of officers,
helping implement strategy, representing shareholders, and assuring that the company
fulfills its public responsibilities. Some companies pay part or all of the directors annual
compensation in stock and stock options or finance their directors retirement with
stocks. If compensation is a significant motivating factor for directors, their stock
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ownership will align their interests more closely with those of shareholders. Therefore,
some studies found that directors of top-performing companies hold more stock than do
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their counterparts at poor performers, suggesting a positive link between director stock
ownership and company performance.
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In this study, I focus only on the following monitoring mechanisms and examine their
relation to the earnings management behavior as measured by discretionary accruals:
1. Corporate governance factors: I focus only on some board composition factors that are
commonly suggested in prior finance, organization management, and accounting
literature to affect the effectiveness of the monitoring function entitled to the board. The
board composition factors tested in this study include independent directors on the board,
audit committee composition, stock ownership of independent directors, the CEO tenure,
the CEO-chairman duality, and the board size. Prior studies in finance, management, and
accounting literature show that board of directors is more efficient in conducting its
monitoring role if the board includes a higher percentage of independent directors, the
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the CEO doesnt hold the chairman position, and the CEO is less tenure. These studies
also show that small boards are usually more efficient than large boards. Therefore, this
study expects that the earnings management as measured by discretionary accruals will
be negatively related to the percentage of independent directors on the board, their
ownership of the companys stock, and the independence of the audit committee. The
discretionary accruals are also expected to be positively related to the CEO-chairman
duality, CEO tenure, and board size.
2. Institutional ownership in the firm: The study expects that financial institutions
ownership in the firm will provide an additional monitoring mechanism that may reduce
the earnings management behavior. Therefore, discretionary accruals are expected to be
negatively related to the institutional ownership in the firm.
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3. Quality of the external audit Prior auditing research has suggested that big auditing
firms are more independent. Because big auditing firms have deeper pockets and more
exposed to litigation risk, they are expected to provide a higher-quality audit process.
Therefore, these firms will be more likely to detect and prevent earnings management
behavior. This study uses the auditor size as a proxy for the audit quality and expects that
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discretionary accruals will be lower when the company is audited by a big-auditing firm.
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